What's Nike Inc.'s Secret Sauce?

By Markets Fool.com

There's no argument that Nike is the king of sportswear and foot apparel. Even though the company's been around for more than 50 years, it's showing no signs of slowing down. In fact, its investor-relations Web page repeatedly defines Nike as a "growth company."

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In its June 25 earnings report, the company announced another record quarter and stellar results for fiscal 2015. Some highlights:

  • Overall company revenue increased 10% year over year to $30.6 billion. The Nike brand continues to be king within the company's portfolio of products, bringing in $28.7 billion, or about 93% of total revenue.
  • Net income came in at $3.3 billion, a notable 22% year-over-year increase. This performance was a result of strong revenue growth, gross margin expansion, and a lower tax rate of 22.2% for the year -- as opposed to 24% during fiscal 2014.
  • Diluted EPS increased 25% to $3.70, a reflection of the growth in net income and revenue.
  • Worldwide future orders for June to November total $13.5 billion, a 2% year-over-year increase -- or 13% excluding foreign exchange headwinds.

That's just a quick snapshot. Focusing on one single quarter or fiscal year isn't enough to illustrate the ongoing potential a company can unlock for shareholders for years to come. As I looked at whether Nike can keep the momentum going, I discovered some notable factors and strategic developments for ongoing growth.

Management
One of the factors I most admire about Nike (and one that I think is important to examine for any prospective investment) is its management. Phil Knight, one of the founders, remains at the helm as chairman of the board. He's been a director since 1968, four years after the company was founded. Despite various top-level changes over the years, Knight has remained a leading executive at the forefront of core decisions.

Current CEO Mark Parker will replace Knight as chairman next year, and Parker has been around for a long time, too. He joined Nike in 1979 as a footwear designer and has been at the forefront of the company's development and innovation efforts for more than 30 years. His roles have included vice president of consumer products and marketing, VP of global footwear, and co-president of the Nike brand. He's also responsible for strategic acquisitions such as Converse and Hurley International. Under Parker's leadership, Nike's sales have doubled, bringing the market value of the Nike brand to well over $90 billion and counting.

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Parker was recently offered a stock award worth $30 million, contingent on his remaining at the helm for the next five years, and 60% of the stock award will be tied to revenue and earnings-per-share growth from fiscal year 2016 through fiscal 2020. He'll earn the remainder of the offering if he remains at the company through June 20, 2020. Well-known tech executive Tim Cook, who's part of Nike's compensation board, contributed to the decision to make the offer to Parker.

Although Knight is stepping down as chairman, he says he intends "to continue to work with Nike" and looks forward "to contributing to its future well after my chairmanship ends."

Strategies for continued growth
What makes Nike a growth company, and can it keep the momentum going? Here are a couple of notable factors.

First is Nike's aggressive focus on its direct-to-consumer strategy, or DTC. Selling to consumers through Nike stores and on its website cuts out the middleman and boosts margins.

In fiscal 2015, DTC revenue grew 29% year over year to $6.6 billion, excluding foreign exchange implications, with the opening of new stores and a robust e-commerce business contributing to results. As of May 31, there were 832 DTC Nike Store locations, compared with 768 a year ago. The company noted 16% growth in comparable-store sales, as well as a 59% growth in online sales. For the fourth quarter of 2015, gross margin expanded 60 basis points to 46.2% -- the notable boost coming from a combination of higher prices and continued growth in higher margins resulting from the DTC business.

The DTC strategy is fairly new, and the results the company has been seeing are just the beginning of the potential this shift can -- and probably will -- have in expanding gross margin and increasing revenue and profit for years to come.

The second factor in Nike's growth is its strategic and ongoing investments in R&D, technology, and demand creation. Nike's management seems to have mastered the art of making strategic investments that not only continue delivering strong returns but also keep strengthening and growing the brand. Nike's expenses in putting the brand at the forefront of every important sporting event, or in signing top athletes as ambassadors, may seem excessive, but the strategy has worked. A solid, notable, and consistent average ROIC of more than 20% over the past 10 years is just one metric that bears it out.

Valuation
This stock is expensive, currently trading at its 52- week high of about $113 per share. The current P/E is 32, well above its five-year average of 23. The forward P/E currently stands at almost 25 times earnings. Taking it one step further, the PEG ratio -- price/earnings to growth -- is 1.6, an indication that, at current prices, investors may be paying up for future earnings growth. (A PEG of less than 1 is ideal, as it implies paying less for future growth.)

But if Nike is a "growth" company, it should make sense that we're paying a premium for what's to come. Investors need to ask whether the growth prospects make sense and whether the company has as much to give as it's leading us to believe. I would say it does, but investors will have to research and draw their own conclusions.

Final thoughts
With highly acclaimed names under its umbrella, contracts with top stars in all major sports, the Jordan brand, and a universally recognized corporate identity, Nike isn't likely to disappear in the decades to come. Sure, there's competition from other names in the athletic space, but no company operating in Nike's industry has been able to keep up with its growth pace and popularity.

Nike looks like a winner for years to come, even with some inevitable stumbles along the way. Yes, the valuation is steep. But are you willing to pay a premium for what's likely to come, or will you choose to stand on the sidelines? The choice is yours.

The article What's Nike Inc.'s Secret Sauce? originally appeared on Fool.com.

Mabel Nunez owns shares of Apple and Nike. The Motley Fool recommends Apple, Nike, and Under Armour. The Motley Fool owns shares of Apple and Under Armour. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.