Nike: Can it rise like a phoenix?

The secret sauce – the 7 powers analysis

The 7 Powers framework is a good framework to evaluate the sustainable competitive advantages of a company, providing an understanding of the factors contributing to a company’s market dominance. The 7 Powers framework, developed by Hamilton Helmer, includes scale economies, network economies, counter-positioning, switching costs, branding, cornered resource, and process power. Here is a short but not complete analysis of Nike through this lens:

1. Scale economies - Nike’s massive scale allows it to benefit from economies of scale. With global manufacturing operations and large production volumes, Nike can negotiate better terms with suppliers and lower production costs. Nike’s extensive global distribution network enhances its ability to reach customers efficiently, reducing per-unit distribution costs.
   
   
2. Network economies - Nike’s ecosystem, including the Nike+ app and Nike Training Club, creates a community of users that enhances customer loyalty and engagement. High-profile endorsements from athletes and sports teams amplify Nike’s brand value, attracting more customers and reinforcing network effects.
   
   
3. Counter-positioning - Nike continuously innovates with products like Flyknit and React foam, differentiating itself from competitors who may not have the capability or willingness to invest heavily in R&D.
   
   
4. Switching costs - Nike’s strong brand loyalty and connection with customers create high switching costs. Consumers are often reluctant to switch to competitors due to the perceived lower value. Nike’s membership programs offer exclusive benefits and discounts, further increasing switching costs for customers.
   
   
5. Branding - Nike’s brand is one of the most recognized and valuable in the world. It symbolizes quality, innovation, and athletic excellence. Significant investment in marketing and advertising, including iconic campaigns like “Just Do It,” strengthens brand equity and consumer trust.
   
   
6. Cornered resource - Nike has long-term contracts with top athletes and sports teams, giving them access to high-profile endorsements that competitors cannot easily replicate. Nike holds numerous patents for its innovative products, providing a technological edge over competitors.
   
   
7. Process Power - Nike’s advanced supply chain management and logistics capabilities ensure efficient production and distribution. Continuous investment in R&D and a robust product development process allow Nike to consistently launch innovative products.

Quality characteristics: High ROIC, EBIT expansion potential, and untapped growth

Despite its recent troubles, Nike’s history says that the company is a high quality company that has grown its revenue by 7% annualised since 2009 and maintained its market leading position. Historically, Nike has been very well run in terms of stable operating margin and an interesting growth profile. But supply chain issues since 2018 and the pandemic has eroded its previous stability and the company has clearly missed strategic boats when it comes to women and high growth markets such as Latin America and Asia Pacific.

Nike’s EBIT margin ended at 12.3% in FY24 which is below its margin levels from FY10 to FY19. While currently a weakness it is also here the upside lies. If Nike can fix its supply chain and distribution then it can maybe push EBIT margin back to the 13.5-14% range and unlock significant shareholder value.

As readers of our previous notes on quality companies will know we believe return on invested capital (ROIC) is an important measure of quality. In its FY24, Nike delivered a ROIC of 24.5% which is very high and easily puts Nike in the top 20% of companies globally on delivering high returns on its capital. As the chart below shows, its weighted average cost of capital (WACC) is around 10%, so even with its recent setbacks, Nike is a high quality company that delivers shareholder value.

A good and simple yardstick for quality is outperformance relative to global equities. Nike delivered significant outperformance for decades and from mid-2014 to late 2021 the stock was a champion of the market. Since then the stock is down 54% and the stock has now underperformed global equities over the past 10 years. Nike shares are up 118% compared to 144% for the MSCI World over the same period. The share price performance shows why Nike has become an interesting investment case to consider for investors. If Nike can execute on improving its EBIT margin, fix its distribution channels, improve its brand, and regain relevance with women then Nike may return to a strong stock market performer again.

Key risks: New markets, new competitors, brand, and omnichannel

There are always many different risks to consider as an investor. In Nike’s case, we believe there are four key risks to consider.

1. New markets – Nike saw significant growth in Greater China from 2013 to 2021, but this growth adventure has come to an abrupt end and the risk is that the rising tensions between the US and China will continue to make it difficult for Nike to grow fast in China. Its Asia Pacific and Latin America segment has a smaller share of revenue compared to 2018 which is a warning signal given these markets so grow in relative share and not shrink.
   
   
2. New competition – Adidas’s success with its Samba models is creating competitive issues for Nike in the short-term and in China a competitor such as ANTA Sports is taking market share. The industry is generally very competitive and other key competitors are Under Armour and Puma. As we stated in the section about its business, Nike seems to have lost the women segment with Lululemon growing fast among women and has grown the business from $1.6bn in FY14to $9.8bn in the last 12 months.
   
   
3. Brand – Nike’s brand is one of its key competitive advantages and thus also the key risk for investors. Its decision to lean into political debates might have hurt its brand among some segments of the population and its clear lack of offerings to offset the threat from Adidas’ Samba shoes is painting a picture of a company that is losing it a bit on innovation.
   
   
4. Omnichannel – Nike’s push of its own direct online channel went too far according to the CEO. There are many reasons for why Nike got blinded but one of them was likely a too high weight on profitability over long-term customer experience, balance distribution and brand awareness. Nike is trying to correct its mistake but its soured relationships with retail partners may be a drag on growth in the medium term.

What defines a quality company?

Quality companies can be defined in many different ways just like value. MSCI, which is world’s largest equity index provider, has defined it using three fundamental variables return on equity, debt to equity, and earnings variability. This definition makes sense because it can be applied to all companies regardless of which sector they are part of. The definition puts emphasis on profitability relative to the deployed equity, leverage ratio (less debt leverage relative to equity is good), and finally the predictability of the business with less variance in earnings being a good thing. In our past equity research we have also found that the lower earnings variability a company has the higher its valuation becomes, so this is a quality marker.

In our equity research note Top quality companies and how to decode their traits we focused on return on invested capital (ROIC) relative to the cost of capital (WACC) as the key measure to identify quality. Next we explained, that around half of those companies with the highest ROIC see their ROIC falling from the top to outside the top over three years due to competition or changing technologies. This is the quality trap that investors need to avoid. It is about finding enduring quality. The “7 Powers” framework is a good approach to analyse whether a company has enduring characteristics or not. Finally, a company can have a stable spread in ROIC minus WACC with a ROIC not in the absolute top and still be a phenomenal stock for shareholders. All it requires is that the business can invest a lot into the business. Historically, Walmart was exactly such a case.

The interesting thing about researching quality companies is that you cannot put it all into a formula. You must apply discretionary thinking about the business, its products, the company’s strategy, the industry drivers, technologies strengthening or weakening the business, because in the end the big returns about changes in expectations for the company.

Previous analyses of quality companies

The list below highlights our previous analyses of quality companies.

• Hermès: The pinnacle of timeless luxury and craftsmanship (26 June 2024)
• Otis: A one-way lift? (19 June 2024)
• AstraZeneca: From patent cliff to oncology leader (29 may 2024)
• Nvidia: Can it fend off the barbarians at the gate? (22 May 2024)