Nike Digs in a Firm Market Foothold

Despite turmoil in its executive suite, Nike is steps ahead of rival Adidas-Reebok.
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While former

Nike

(NKE) - Get Report

CEO William Perez flew one fateful day last November aboard the company's twin-jet Gulfstream V at an altitude of 20,000 feet, traders on the ground watched TV footage of the aircraft's malfunctioning landing gear and sold shares as the plane circled in the air for six hours.

Nike's stock dropped 1.4% before Perez eventually landed safely. The shares recovered the next day after Perez declared he was ready to fly again. But just two months later, Perez's employer made clear that his days of traveling on Nike's private jet had come to an end. This time, the stock has yet to stabilize.

The Beaverton, Ore., sneaker giant announced last week that Perez would be replaced after just one year on the job by Nike veteran Mark Parker. Nike's founder, Phil Knight, changed his mind about bringing in an outsider to succeed him, citing leadership differences.

Since then, Nike shares have dropped 3.6%, while German sportswear company

Adidas

officially completed its $3.8 billion acquisition of

Reebok

. Is Nike malfunctioning while a newly formed rival takes flight in the athletic footwear market?

"There's going to be a significant battle waged between Nike and the combined Adidas-Reebok company over retail shelf space in the U.S. market," says John Shanley, an analyst with Susquehanna Financial Group. "Investors are concerned about the threat posed to Nike, and last week's news about Perez has people wondering whether Nike has a succession plan in place to deal with the threat."

Shanley concedes that a larger No. 2 player in the sneaker market could hurt Nike's profit margins as both companies ramp up advertising and marketing efforts. He says, though, that the market is overreacting to Nike's challenges, making the stock cheap.

"This is really the first time there has been a significant No. 2 player up against Nike for a long time," he said. "Adidas is well-financed. It's the leader in the European soccer market and it recently took over the No. 1 in Japan -- the most significant Asian market for athletic footwear. But the U.S., where Nike is still a clear winner, represents over half the world's sneaker market."

Currently, Nike holds about 44% of the U.S. market share for athletic shoes. A combined Adidas-Reebok would have less than half that amount, with about 11% share going to Reebok and 10% going to Adidas. The market is largely saturated, growing in concert with GDP, but Nike has achieved growth by acquiring successful brands such as Converse and Cole Haan. Last year, it entered the low-priced sneaker business by introducing Starter-branded footwear into

Wal-Mart

(WMT) - Get Report

.

"Given that roughly half of the domestic footwear market is priced below $50 per pair, we believe Nike's foray into the mass channel provides significant growth opportunity without diluting the premium Nike brand," said Morningstar analyst Brady Lemos in a recent research report. "Nike intends to dominate the low-priced market like the premium market, and we wouldn't bet against them."

Meanwhile, Nike holds 37% of the world's market share, while Adidas-Reebok will carry a combined 30%. Moreover, Nike's international business now accounts for more than half of its total revenue, up from 44% in 2000. The diversification in its business alleviates the economic risks posed by globalization and a consumer spending slowdown in the U.S. The company is the market leader in China, an athletic shoe market that's expected to double in size every year until 2008, when it will host the Summer Olympic Games.

"Nike remains the strongest and most dominant player in the U.S. and global footwear business, and it's going through a cycle that is still looking pretty strong to me," says Zu Cowperthwaite, a retail analyst at Evergreen Investments. "Also, we see Nike taking share from Reebok and Adidas as they go through their merger process. The deal should create a window of opportunity for Nike."

Considering its strengths, Nike's valuation looks low, with its shares trading at $81, about 14 times earnings estimates through 2006. Lemos' discounted cash-flow analysis of the company puts its fair value at $88. Cowperthwaite's analysis puts its fair value at $95 to $100.

More than anything, Nike's current price probably reflects concern about its executive succession plan and Phil Knight's ability to hand over the reins in a way that will produce sustainable leadership. Shareholders were largely satisfied with Perez.

In December, Nike reported that its fiscal second-quarter profits grew by 15% from a year earlier, beating Wall Street's estimate by a wide margin. Those results continued a string of successful quarters during which Perez conducted exhaustive strategic reviews with the company's senior executives.

"One of my primary missions as CEO is to make sure this company has the right strategies in place to sustain long-term growth and ultimately double the size and value of our business," Perez said to analysts in December.

In the end, Knight differed with Perez on how to reach that goal.

"Succession at any company is challenging, and unfortunately the expectations that Bill and I and others had when he joined the company a year ago didn't play out as we had hoped," Knight said in a statement last week.

The ultimate question is whether Nike can break from Knight's control (he's 68) and continue to hold the magic that Knight started when he began selling sneakers out of the trunk of his car and later signed Michael Jordan to an advertising deal -- perhaps Nike's greatest coup.

With or without Knight, Nike's logo, the swoosh, and its motto, "Just do it," are two of the most recognizable brands in corporate marketing.

"This is a very brand-oriented industry, and Knight has built one of the greatest brands in the world," Shanley says. "Giving the reins over to Parker will probably ensure that the same culture that made Nike what it is will continue."

Parker joined Nike 27 years ago as a designer, and later became a co-president of the company. He's credited with helping bring sneaker technology like Nike Air to market; he also oversaw the development of Shox shoes as well as a midrange running line. Parker has never run one of Nike's divisions, but his longtime working relationship with Knight bodes well for his chances to fit the bill.

Cowperthwaite says the chief threat to Nike's valuation is rising oil and commodity prices.

"Raw material costs, labor costs and freight costs are all on the upswing now," she says. "These could crimp Nike's profit margins, but that's an industrywide problem that won't last forever."