Chasing Nike’s (NYSE: NKE) dominant position in the athletic footwear business has been a tiring exercise for competitors such as Under Armour (NYSE: UA), Adidas (OTC:ADDYY), and Skechers (NYSE: SKX) over the past couple of years. In 2016, however, chasing Nike stock has proven to be an even more frustrating experience for investors.

Nike shares — currently trading at around $52 — have fallen almost 16% year to date, trailing not only the 11% rise in the S&P 500 Index (SPX), but also the 15% rise in the Dow Jones Industrial Average (DJI). At this rate, Nike — one of only three Dow 30 stocks in negative territory for the year — is poised to end 2016 as the index’s worst performer. Meanwhile, the other two Dow stocks in negative territory — The Walt Disney Company (NYSE: DIS) and The Coca-Cola Company (NYSE: KO) — have respective declines of only 1.11% and 2.84%.

Nike’s Future Value Is Not Futures
Placing a bet here on Nike stock — despite the company’s brutal year-to-date performance — is still not an easy endeavor, especially for investors who are looking for value and not just a good name.
Even with Nike shares losing almost 20% in the past twelve months, the stock is priced at a forward P/E at 22, which is still about four points higher than the S&P 500 SPX index. Assuming the shares were price on par with the rest of the market, the stock would likely trade today at around $43, or about 15% below current levels.

#-ad_banner-#In other words, Nike’s best-of-breed status still commands a premium, even as the company’s futures orders (sales scheduled for delivery) takes greater focus. In the fiscal 2017 first quarter, management noted that it will omit futures discussions from press releases, saying that, going forward, it will discuss futures orders only in the quarterly conference calls. This is because Nike shares have traded broadly on the basis of its futures metric.

While the company’s futures aren’t always a perfect representation of what’s immediately coming for revenue, keeping a watchful eye on the metric provides a good sense of where the markets are heading. Worldwide futures orders up 5% year-over-year and 7% in constant currency in fiscal Q1, though management seemed concerned about the prospects for the next couple of quarters. The company is projected to earn $2.35 per share in fiscal 2017, which would mark a year-over-year earnings-per-share rise of 8.7%. That’s growth is decent, but not breathtaking. Consensus estimates have trickled lower to coincide not only with tempered futures order forecasts, but also gross margin pressure.

Can DTC Boost Gross Margins?
There’s also concern about the strength of Nike’s business in several important markets. Nike’s Gross margin declined 200 basis points to 45.5% in fiscal Q1, driven by a combination of factors, including a 6% rise in overhead expenses and a rise in cost of goods sold. What’s more, with inventory rising 11% year over year, the company has had to rely more on its off-price mix, meaning its high-end products were moved to discounted retailers, resulting in lower profits.

Does this signal a trend that Under Armour and Adidas are catching up to Nike, causing the rise in inventory, or is this a temporary hiccup? My bet is that it’s the latter. Although gross margins have declined, it’s also important to focus on the reason. The 6% increase in “expenses” can also be called an increase in “investments.” Because Nike wants to rely less on off-price retailers and even long-standing partners like Foot Locker (NYSE: FL), the company is spending to grow its Direct-to-Consumer (DTC) business.

To that end, the management has increased spending in ways to grow Nike’s digital capabilities in consumer-focused infrastructure. What does that mean? Nike wants to control the shopping experience, not rely on mistakes by brick-and-mortar partners — many of which are suffering from the dominance of Amazon.com (Nasdaq: AMZN). Nike plans for its DTC revenue to grow by almost 2.5 times in the next five years, rising from $6.6 billion in fiscal 2015 to $16 billion by fiscal 2020.

The company, which beat its own 2015 target of $5 billion in DTC revenue by more than $1.5 billion, can use the DTC business to push sales of premium products. And given that the DTC segment will give it more control over pricing, inventory, and merchandising decisions, Nike can also realize higher margin accretion too, helping it achieve its goal 30 to 50 basis-point margin expansion each year through fiscal 2020.

What Does This Mean For Nike Stock?
Nike’s DTC business and e-commerce initiatives bodes well for Nike shares, though admittedly, they’re not in the bargain bin. Still, with fiscal 2018 EPS estimates calling for $2.66 per share, or 13% EPS growth, Nike can still pay. This is assuming Nike futures orders remain steady at 5% to 7% growth for all of 2017. Nonetheless, with the forward P/E down some 25% from last year, this is as cheap as Nike is going to be for a while. My value model puts Nike shares at around $62 to $65 in the next 12 to 18 months, delivering 21% to 27% returns during that span.

Risks To Consider: Much of my optimism is based on the assumption that Nike’s DTC business can take up a bigger portion of overall revenue in the coming years. Likewise, as the company focuses less on futures orders and its impact on revenue, it doesn’t mean the market will follow suit.

Action To Take: Nike should be kept on the watch list of investors who are looking for a company that pays a decent dividend yield and is trading at a relatively below-market price.

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