Nike Case

NIKE, INC.: COST OF CAPITAL

On July 5, 2001, Kimi Ford, a portfolio manager at NorthPoint Group, a mutual-fund management firm, pored over analysts' write-ups of Nike, Inc., the athletic-shoe manufacturer. Nike's share price had declined significantly from the beginning of the year. Ford was considering buying some shares for the fund she managed, the NorthPoint Large-Cap Fund, which invested mostly in Fortune 500 companies, with an emphasis on value investing. Its top holdings included ExxonMobil, General Motors, McDonald's, 3M, and other large-cap, generally old-economy stocks. While the stock market had declined over the last 18 months, the NorthPoint Large-Cap Fund had performed extremely well. In 2000, the fund earned a return of

20.7%, even as the S&P 500 fell 10.1%. At the end of June 2001, the fund's year-to-date returns stood at 6.4% versus −7.3% for the S&P 500.

Only a week earlier, on June 28, 2001, Nike had held an analysts' meeting to disclose its fiscal-year 2001 results.1 The meeting, however, had another purpose: Nike management wanted to communicate a strategy for revitalizing the company. Since 1997, its revenues had plateaued at around $9 billion, while net income had fallen from almost $800 million to $580 million (see Exhibit 1). Nike's market share in U.S. athletic shoes had fallen from 48%, in 1997, to 42% in 2000.2 In addition, recent supply-chain issues and the adverse effect of a strong dollar had negatively affected revenue.

At the meeting, management revealed plans to address both top-line growth and operating performance. To boost revenue, the company would develop more athletic-shoe products in the midpriced segment3--a segment that Nike had overlooked in recent years. Nike also planned to push its apparel line, which, under the recent leadership of industry veteran Mindy Grossman,4 had performed extremely well. On the cost side, Nike would exert more effort

1 Nike's fiscal year ended in May.

2 Douglas Robson, "Just Do ... Something: Nike's Insularity and Foot-Dragging Have It Running in Place,"

BusinessWeek (2 July 2001).

3 Sneakers in this segment sold for $70-$90 a pair.

4 Mindy Grossman joined Nike in September 2000. She was the former president and chief executive of Jones

Apparel Group's Polo Jeans division.

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on expense control. Finally, company executives reiterated their long-term revenue-growth targets of 8% to 10% and earnings-growth targets of above 15%.

Analysts' reactions were mixed. Some thought the financial targets were too aggressive; others saw significant growth opportunities in apparel and in Nike's international businesses.

Kimi Ford read all the analysts' reports that she could find about the June 28 meeting, but the reports gave her no clear guidance: a Lehman Brothers report recommended a strong buy, while UBS Warburg and CSFB analysts expressed misgivings about the company and recommended a hold. Ford decided instead to develop her own discounted cash flow forecast to come to a clearer conclusion.

Her forecast showed that, at a discount rate of 12%, Nike was overvalued at its current share price of $42.09 (Exhibit 2). However, she had done a quick sensitivity analysis that revealed Nike was undervalued at discount rates below 11.17%. Because she was about to go into a meeting, she asked her new assistant, Joanna Cohen, to estimate Nike's cost of capital.

Cohen immediately gathered all the data she thought she might need (Exhibits 1 through

4) and began to work on her analysis. At the end of the day, Cohen submitted her cost-of-capital estimate and a memo (Exhibit 5) explaining her assumptions to Ford.

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Exhibit 1

NIKE, INC.: COST OF CAPITAL

Consolidated Income Statements

Year Ended May 31 1995 1996 1997 1998 1999 2000 2001

(in millions of dollars except per-share data)

Revenues 4,760.8 $6,470.6 $9,186.5 $9,553.1 $8,776.9 $8,995.1 $9,488.8

$Cost of goods sold 2,865.3 3,906.7 5,503.0 6,065.5 5,493.5 5,403.8 5,784.9

Gross profit 1,895.6 2,563.9 3,683.5 3,487.6 3,283.4 3,591.3 3,703.9

Selling and administrative 1,209.8 1,588.6 2,303.7 2,623.8 2,426.6 2,606.4 2,689.7

Operating income 685.8 975.3 1,379.8 863.8 856.8 984.9 1,014.2

Interest expense 24.2 39.5 52.3 60.0 44.1 45.0 58.7

Other expense, net 11.7 36.7 32.3 20.9 21.5 23.2 34.1

Restructuring charge, net - - - 129.9 45.1 (2.5) -

Income before income taxes 649.9 899.1 1,295.2 653.0 746.1 919.2 921.4

Income taxes 250.2 345.9 499.4 253.4 294.7 340.1 331.7

Net income 399.7 $553.2 $795.8 $399.6 $451.4 $579.1 $589.7

$Diluted earnings per common share 1.36 $1.88 $2.68 $1.35 $1.57 $2.07 $2.16

$Average shares outstanding (diluted) 294.0 293.6 297.0 296.0 287.5 279.8 273.3

Growth (%)

Revenue 35.9 42.0 4.0 (8.1) 2.5 5.5

Operating income 42.2 41.5 (37.4) (0.8) 15.0 3.0

Net income 38.4 43.9 (49.8) 13.0 28.3 1.8

Margins (%)

Gross margin 39.6 40.1 36.5 37.4 39.9 39.0

Operating margin 15.1 15.0 9.0 9.8 10.9 10.7

Net margin 8.5 8.7 4.2 5.1 6.4 6.2

Effective tax rate (%)* 38.5 38.6 38.8 39.5 37.0 36.0

*The U.S. statutory tax rate was 35%. The state tax varied yearly from 2.5% to 3.5%.