In 2015 the Montaka research team identified the worldwide proliferation of “athleisure” as a powerful investment trend that we could capitalise on. As people continued to turn to activewear as their everyday fashion choice, sales of Nike merchandise would benefit and shareholders should be rewarded handsomely – or so the first-order thinking goes. At Montaka however, we were much more interested in Foot Locker, where the tailwinds were the same but the price tag was a whole lot cheaper.
Considered investors, trendy fashionistas
Vogue we are not. By 2015 the sight of sneakers with suits or yoga pants at the grocery store was not unusual. If anything it was becoming more and more common. Athleisure, the fashion of wearing exercise gear in general social settings or in place of traditional business dress, had taken hold around the world. According to Morgan Stanley, global sales of activewear in 2015 were 50% higher than they were in 2007, just prior to the Great Recession. Between 2010 and 2015 sales of activewear worldwide grew at an average annual rate of 6%. And this is just the beginning.
Combining comfort and value, it makes good sense that athleisure should replace many of the clothes in our wardrobes. Yet we discovered that activewear accounted for just one fifth of global apparel sales in 2015. With momentum and the strength of social acceptability behind it (perhaps thanks to the millennial cohort) we determined that the athleisure trend would be here to stay for an extended period. Reflecting this, Morgan Stanley projected global activewear sales to grow by 5% annually from 2015 to 2020.
Nike dominant but shareholders likely less well off
As the largest seller of athletic footwear and apparel in the world, Nike had been a key beneficiary of the global athleisure trend. In its fiscal year 2015 Nike generated $30.6 billion in sales, representing an average annual growth rate of 10% since 2010. In this five year period, which coincided precisely with the surge in athleisure, Nike’s sales growth had accelerated compared to the company’s long run average sales growth of 8% per annum achieved over the past 20 years. Nike also generated high and stable earnings margins of around 15% and strong pre-tax returns on capital nearing 30%. Brand Nike was clearly behind a very high quality business that was making the most of the bright prospects that athleisure was providing. These are two necessary, but not sufficient, conditions for a Montaka investment.
Valuation gave us reason to pause. A novel approach we take to valuation at Montaka involves reverse engineering the expectations built into the current share price. Toward the end of 2015 Nike’s shares were trading at around $63, and we asked ourselves “what do you need to believe?” for this price to be fair value. We assessed that Nike shares were pricing in 10% sales growth and gradually expanding profit margins over the next three decades. When compared with Nike’s historical growth rates and profitability, the forecast growth for the overall activewear market, and the ongoing brand and distribution requirements to continue to expand into China and beyond, we determined that these expectations were too high. Everything needed to go right to justify the current share price and there was no margin of safety should a less prosperous scenario unfold. Nike shares had been bid up on high expectations by investors who were content with first-order thinking and there was no bargain available for our clients. We passed. But all was not lost.
Foot Locker a second-order bargain
Foot Locker is a high quality retailer of athletic footwear and apparel that has built a scale advantage over peers with its 3,400-store network worldwide. Foot Locker generates over $7 billion in revenues annually. From 2010 to 2015 Foot Locker’s sales grew at an average annual rate of 8%, driven by mid single digit sales growth at the store level and an increasing base of stores. Both profit margins and pre-tax returns on capital nearly doubled over this period, to 13% and 50%, respectively. And as a key partner of Nike, Foot Locker was well positioned to continue performing strongly from 2015.
As we turned our attention to Foot Locker we discovered that almost three quarters of retailer’s merchandise was Nike branded product. This made complete sense. For anyone who has ever visited a Foot Locker store in the US or around the world (as the Montaka research team made a point of doing) it is immediately obvious that that Nike is overly represented on the shelves and in the windows. From this perspective Foot Locker can be considered a large-scale distributor or even a “master-franchiser” of Nike. We quickly determined that as Nike goes, so goes Foot Locker. The difference was that Foot Locker shares were not reflecting this opportunity.
When we reverse engineered the expectations built into Foot Locker’s share price, which was around $65 at the end of 2015, we were particularly pleased. Similar to Wall Street analyst forecasts, the revenue growth projections priced into the shares was in the order of low single digits. We believed this was far too conservative for a business that had been growing near double digits, with accelerating same-store sales growth, and long run industry tailwinds underlying. Moreover, Nike had guided growth in its wholesale channel (read: Foot Locker) to be 7% per annum for the next five years.
At the same time operating leverage inherent in the retailing business model meant that profitability and earnings expectations were also too conservative. We foresaw ongoing margin expansion compared to the flat margin profile built into the stock price and supported by sell-side bank analysts. This time we bought the stock.
A better outcome for clients
In 2016 the divergent performance in the stock prices of Nike and Foot Locker was stark. Foot Locker shares returned 9% in calendar year 16 compared to a decline of 19% in the price of Nike shares (both before dividends). Foot Locker also outperformed the global equites index (which has the benefit of dividend payments) which returned 8% in 2016. Yet Montaka clients achieved an even better outcome than this would suggest.
As the share price of Foot Locker fell in the middle of the year, we took the opportunity to increase our holding in the business. Although the share price had declined by 16% to the end of June, Foot Locker’s earnings were still growing and the value of the business remained in tact. This offered an opportunity to buy more stock at an even cheaper price. Then in the second half of 2016 Foot Locker’s share price took off, appreciating by 29% compared to an 8% decline in Nike’s share price and a modest 7% gain for global stocks (including dividends).
The experience of Foot Locker in 2016 demonstrates the importance of second order thinking and having a differentiated view to the market. Only then can investors buy stocks at bargain prices that will provide superior risk-adjusted returns.
Christopher Demasi is a Portfolio Manager with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.
