Chapter 1, Problem 2LIC

Nike: Somewhere between a Swoosh and a Slam Dunk

Nike, Inc.’s principal business activity involves the design, development, and worldwide marketing of high-quality footwear, apparel, equipment, and accessory products for serious and recreational athletes. Almost 25,000 employees work for the firm as of 2009. Nike boasts the largest worldwide market share in the athletic footwear industry and a leading market share in sports and athletic apparel.

This case uses Nike’s financial statements and excerpts from its notes to review important concepts underlying the three principal financial statements (balance sheet, income statement, and statement of cash flows) and relations among them. The case also introduces tools for analyzing financial statements.

Industry Economics

Product Lines

Industry analysts debate whether the athletic footwear and apparel industry is a performancedriven industry or a fashion-driven industry. Proponents of the performance view point to Nike’s dominant market position, which results in part from continual innovation in product development. Proponents of the fashion view point to the difficulty of protecting technological improvements from competitor imitation, the large portion of total expenses comprising advertising, the role of sports and other personalities in promoting athletic shoes, and the fact that a high percentage of athletic footwear and apparel consumers use the products for casual wear rather than the intended athletic purposes (such as playing basketball or running).

Growth

There are only modest growth opportunities for footwear and apparel in the United States. Concern exists with respect to volume increases (how many pairs of athletic shoes will consumers tolerate in their closets) and price increases (will consumers continue to pay prices for innovative athletic footwear that is often twice as costly as other footwear).

Athletic footwear companies have diversified their revenue sources in two directions in recent years. One direction involves increased emphasis on international sales. With dress codes becoming more casual in Europe and East Asia and interest in American sports such as basketball becoming more widespread, industry analysts view international markets as the major growth markets during the next several years. Increased emphasis on soccer (European football) in the United States aids companies such as Adidas that have reputations for quality soccer footwear.

The second direction for diversification is sports and athletic apparel. The three leading athletic footwear companies capitalize on their brand name recognition and distribution channels to create a line of sportswear that coordinates with their footwear. Team uniforms and matching apparel for coaching staffs and fans have become a major growth avenue. For example, to complement Nike’s footwear sales, Nike acquired Umbro, a major brand-name line of jerseys, shorts, jackets, and other apparel in the soccer market.

Production

Essentially all athletic footwear and most apparel are produced in factories in Asia, primarily China (40%), Indonesia (31%), Vietnam, South Korea, Taiwan, and Thailand. The footwear companies do not own any of these manufacturing facilities. They typically hire manufacturing representatives to source and oversee the manufacturing process, helping to ensure quality control and serving as a link between the design and the manufacture of products. The manufacturing process is labor-intensive, with sewing machines used as the primary equipment. Footwear companies typically price their purchases from these factories in U.S. dollars.

Marketing

Athletic footwear and sportswear companies sell their products to consumers through various independent department, specialty, and discount stores. Their sales forces educate retailers on new product innovations, store display design, and similar activities. The market shares of Nike and the other major brand-name producers dominate retailers’ shelf space, and slower growth in sales makes it increasingly difficult for the remaining athletic footwear companies to gain market share. The slower growth also has led the major companies to increase significantly their advertising and payments for celebrity endorsements. Many footwear companies, including Nike, have opened their own retail stores, as well as factory outlet stores for discounted sales of excess inventory.

Athletic footwear and sportswear companies have typically used independent distributors to market their products in other countries. With increasing brand recognition and anticipated growth in international sales, these companies have recently acquired an increasing number of their distributors to capture more of the profits generated in other countries and maintain better control of international marketing.

Financing

Compared to other apparel firms, the athletic footwear firms generate higher profit margins and rates of return. These firms use cash flow generated from this superior profitability to finance needed working capital investments (receivables and inventories). Long-term debt tends to be relatively low, reflecting the absence of significant investments in manufacturing facilities.

Nike Strategy

Nike targets the serious athlete with performance-driven footwear and athletic wear, as well as the recreational athlete. The firm has steadily expanded the scope of its product portfolio from its primary products of high-quality athletic footwear for running, training, basketball, soccer, and casual wear to encompass related product lines such as sports apparel, bags, equipment, balls, eyewear, timepieces, and other athletic accessories. In addition, Nike has expanded its scope of sports, now offering products for swimming, baseball, cheerleading, football, golf, lacrosse, tennis, volleyball, skateboarding, and other leisure activities. In recent years, the firm has emphasized growth outside the United States. Nike also has grown by acquiring other apparel companies, including Cole Haan (dress and casual footwear), Converse (athletic and casual footwear and apparel), Hurley (apparel for action sports such as surfing, skateboarding, and snowboarding), and Umbro (footwear, apparel, and equipment for soccer). The firm sums up the company’s philosophy and driving force behind its success as follows:

Nike designs, develops, and markets high quality footwear, apparel, equipment and accessory products worldwide. We are the largest seller of athletic footwear and apparel in the world. Our strategy is to achieve long-term revenue growth by creating innovative, “must-have” products; building deep, personal consumer connections with our brands; and delivering compelling retail presentation and experiences.

To maintain its technological edge, Nike engages in extensive research at its research facilities in Beaverton, Oregon. It continually alters its product line to introduce new footwear, apparel, equipment, and evolutionary improvements in existing products.

Nike maintains a reputation for timely delivery of footwear products to its customers, primarily as a result of its “Futures” ordering program. Under this program, retailers book orders five to six months in advance. Nike guarantees delivery of the order within a set time period at the agreed price at the time of ordering. Approximately 89% of the U.S. footwear orders received by Nike during 2009 came through its Futures program. This program allows the company to improve production scheduling, thereby reducing inventory risk. However, the program locks in selling prices and increases Nike’s risk of increased raw materials and labor costs. Independent contractors manufacture virtually all of Nike’s products. Nike sources all of its footwear and approximately 95% of its apparel from other countries.

The following exhibits present information for Nike:

Exhibit 1.31: Consolidated balance sheets for 2007, 2008, and 2009

Exhibit 1.32: Consolidated income statements for 2007,2008, and 2009

Exhibit 1.33: Consolidated statements of cash flows 2007, 2008, and 2009

Exhibit 1.34: Excerpts from the notes to Nike’s financial statements

Exhibit 1.35: Common-size and percentage change income statements

Exhibit 1.36: Common-size and percentage change balance sheets

REQUIRED

Study the financial statements and notes for Nike and respond to the following questions.

Why does Nike subtract deferred income taxes from net income when calculating cash flow from operations for 2009?