Nike

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Executive Summary

Nike is the largest athletic shoe and apparel company in the world with a market share of nearly forty percent. The company incorporated in 168, and has been headed by Phillip Knight, a co-founder and CEO, since its inception. Nike owns and operates over 700 factories worldwide and its products are distributed in 140 different countries.

Through extensive research amongst the consultants here at Prime Seven, we feel that our calculations prove that Nike's current share price is overvalued. In addition to this, we have also found that Nike has faced a decline in growth in revenue and net income, a decline in market share, a series of questionable labor practices, and a slumping United States Economy. For these reasons, we feel that the NorthPoint should not invest in Nike for its Large-Cap Fund.

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Nike's Decline

Despite past years of great success, Nike has recently fallen into a slump. With the rise in competition from shoemaker Adidas and resurgence from Reebok, Nike's market share in the athletic shoe and apparel industry has dropped off dramatically in 000; down nearly ten percent. Nike also experienced an enormous drop in its revenue growth, which may signal to shareholders that it has already plateaued as a corporation. Nike peaked in 17 with a forty percent increase in revenue, but has only topped out at a five and a half percent increase ever since. The decline in revenue can directly be attributed to their decrease in net income, which has only grown at just below two percent for the first six months of 001.

On 0/6/001, after the close of the market, Nike issued a press release revising its third quarter and fiscal 000 earnings because of problems arising from the impact of implementing new demand and supply planning systems developed by i Technologies. Nike has been working on its i software implementation since June 000 as part of a $400 million IT overhaul designed to streamline communications with buyers and suppliers and lower operating costs. However, glitches with the i demand and supply planning module led Nike to overestimate demand for some shoes while underestimating demand for others.

The resulting inventory shortages will reduce Nikes fiscal third-quarter sales by as much as $100 million. Earnings estimates for the quarter have been cut to 4 to 8 cents per share from 50 to 55 cents. Analysts at Dain Rauscher Corp. lowered their estimate on Nikes 001 earnings to $.0 per share from $.5 per share following the February 001 disclosure of the software problem. Its 00 estimates were lowered to $.51 from $.70.

001 has also seen Nike's stock price plummet. As the company's earnings fall, so goes the stock price. As of July 1, Nike's share price has fallen twenty three percent since the beginning of the year. It is currently trading at $4.0 a share but has dropped as low as $5.50. When compared with the S&P 500 (down 10.7%) and the Dow Jones Industrial (down 4.7%) Nike is not coming close to beating or even matching the indices.

Ethical Considerations.

Since 15, Nike has faced heavy scrutiny from the public and the media for its work conditions of foreign laborers. Nike operates around 700 factories worldwide with the majority of its manufacturing taking place in third world or underdeveloped countries where the labor is extremely cheap by United States standards. Workers in these countries, which in some cases include children under the age of 14, work twelve to fifteen hours per day at very low wages. In Nike's Vietnam factories, laborers are only paid on average seventeen cents per hour and receive only one bathroom break per day. Phil Knight, CEO of Nike, withdrew a thirty million dollar pledge to the University of Oregon (his alma mater) in response to a protest by students against sweatshops and unfair labor practices.

Nike has also faced ethical problems with its shareholders. In March of 001, a class action suit was filed by Nike shareholders in response to Nike executives violating federal securities laws by reporting false and misleading financial statements for its third quarter. The false reports were directly tied to the supply chain problems Nike experienced with its faulty i software.

Current State of United States Economy

Another factor shareholders should consider a reason not to invest in Nike is the current state of the United States Economy. After the most virtuous period of investing in the history of the financial markets, the S&P, Dow Jones, and NASDAQ have all declined for the past three quarters. This is a definite sign of a decline in consumer spending and business investing, and may even indicate the beginning of a recession.

Nike's performance this year may also offset the portfolio of the NorthPoint Large Cap Fund. The mutual fund managers at NorthPoint only look to invest in large and established Fortune 500 companies for their large cap fund, in which Nike most certainly qualifies. However, other companies that NorthPoint has invested in for its fund which include ExxonMobil, General Motors, M, and McDonalds, have by far outperformed Nike in the financial markets in 001 and are keeping the fund afloat while the rest of the economy continues to slide.

Cost of Capital

When determining the true value of a stock, one of the most important figures we must analyze is the firm's weighted average cost of capital, or WACC. The WACC is important not only because it measures the component costs of debt and equity, but also because it is used as the discount rate in stock valuation. If the actual price of the stock is higher than the calculated price, then the stock is overvalued. If the stock price is lower, then the stock is undervalued. In theory, the calculated price and the actual market price should be equal. Otherwise, there is an imbalance in the market.

WACC is calculated as follows cost of debt, Kd, is calculated by dividing interest expense by the firm's average debt balance. In this case, the cost of debt is 4.%. Next, cost of equity, Ke, is calculated using the Capital Asset Pricing Model, or CAPM. This method is considered the superior method of calculating cost of equity by most textbooks, and 7% of the S&P 500 CFOs agree according to a 1 survey. After these two calculations are done, they are weighted according to their percentage of the total value of the firm. In Nike's case, equity is 7% of the total capital while debt is 7%. Finally, we simply plug these numbers into the WACC formula WACC = WdKd(1-T)WeKe. This calculation yields a WACC of 10.1%, which is essentially equal to the estimated cost of capital in Exhibit .

Exhibit is very important because it shows what Nike's stock price should be. Calculating the value of the shares has three main steps. First, all future free cash flows are calculated. Then, these cash flows are discounted using WACC as the discount rate. It is important to note that the WACC must be used as the discount rate. Otherwise this calculation will result in incorrect data. Finally, debt is subtracted from the total value of the firm, and the remainder is divided by the total number of shares. The resulting stock price is approximately $6.14. Now that we know what Nike's stock price should be, we compare it to the current price of $4.0 and discover that the stock is overvalued. This is an indication that the price is going to go down in the future, especially since the economy is showing signs of a decline and possible recession. Evidence of a decline is also demonstrated by Nike's deteriorating profitability ratios. Almost all of the ratios, shown in the attached PowerPoint slides, have declined since 17, providing further evidence that Nike is not a good investment at this time.

Conclusion

Given our extensive quantitative analysis, Nike's declining growth in both revenue and net income, the current downward trend of the economy, and the ethical scrutiny that the company is facing, we feel that it would not be wise for NorthPoint to invest in Nike. Despite Nike's reputation for success, competitors such as Adidas, Reebok, and New Balance are slowly chipping away at Nike's market share. Although Nike has historically had a high stock price, the problems they are facing such as their multi-million dollar restructuring and supply chain miscalculations has caused their stock price to decline. Also, according to our quantitative analysis, Nike's weighted average cost of capital indicates that the stock is overvalued and, with the declining economy, the share price will fall to its equilibrium price and possibly even lower.

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