NKE: Solid Q. But Trajectory Will Change

I expected a good quarter from Nike, and with a 12% move in the stock in the back half of last week (up to $66.66) I think the market did too. While the actual results did not surprise me, the upbeat tone of the conference call definitely did. I outlined the case last week why the stock should not have traded up in advance of this quarter, as the meaningful headwinds the company will face this year will materially alter the quality of earnings as FY09 progresses – which I suspected would begin to be apparent on this call. Now the question is whether I take the tone of the call at face value, admit that there’s not the downside in the stock I initially suspected, and simply cut bait? Or do I use the insight gained from the call, stick to my analytical guns, and stand firm that there are issues that the industry and the company will be talking about in 3-6 months that it is not talking about today. I’m going with the latter.

I’m taking my estimate for the year down by a nickel to $4.09, and while not expensive at $62, I absolutely cannot argue one iota of multiple expansion given the headwinds Nike faces. Performance from this point forward needs to come from pure earnings juice. Again…tough to bank on. Here’s a few things to chew on…
  • 1) A few big positives… a) On the plus side, how can anyone not be impressed with Nike’s order book? The 2-year run rate across all regions is virtually unchanged from 3 months ago – about 10% in aggregate in constant dollars. B) Gross margins +233bps were solid. Ahead of my number (though they gave it back in SG&A). The incremental call out seems to be ‘lower than expected cost increases out of Asia.’ This is one of the factors that I think will change meaningfully over the course of the year.
  • 2) Nike is a ‘Beater.’ Nike beating each quarter is written in the cosmos. It has missed only 1 quarter in 6 years. And that was by a penny. In looking at history, we see that Nike needs a beat of at least +4% for the stock to not go down on the event. It takes a beat of 12% or better to get a post-quarter rally. This time we got +11%. Definitely a net positive, but within historical guidelines.
  • 3) Let’s look at what drove the beat. One region that smoked my expectations was Europe. 20% revenue growth on trailing 6 month futures of 6% is monstrous. It came in double my model. But tough to ignore that 15 points of this growth was due to FX. Also tough to look through the fact that the Euro is at 1.467, and just a few short weeks from having 0% yy change. Check out the chart below showing EPS surprise history vs. FX change. Not good.
  • 4) Nike needs the Dollar’s slide over the past few days to continue. Management noted that its’ model assumes no change in FX. With the greatest global geopolitical/macroeconomic cross currents we’ve arguably seen since the great depression, I cannot imagine FX stays still. Maybe it goes for them, maybe against them – but I’m inclined to think we see increased volatility here. In fact, this is the first quarter in almost 3 years where reported futures were not greater than constant dollar futures in Europe.
  • 5) Not a coincidence that EPS growth is so closely tied to changes in FX (see Exhibit below). Bulls might say that EMEA margins were down 54bps – so how can that mean that FX helped? The answer there is that Demand Creation spend (Olympics and football) was disproportionately high this quarter, as it more than offset the improved gross margin in EMEA. Total margins in EMEA were 24.9% this quarter. Down slightly vs. last year, but let’s not forget that they were in the high teens/20% range before FX ran up.
  • 6) I really really really don’t like the trajectory of the P&L.
    a. Revenue growth just hit 17%. 7 points of which was FX, and another 2-3 was Umbro.
    b. Nike is expecting full year revs in high single digit, in line with LT plan. If we assume that it is not sandbagging, a 9% annual rate, and its guidance for 2Q (where it has solid visibility) then simple math backs us into a 4Q top line that is flat with the prior year at best.
    c. Gross margin improvement just peaked – as it relates to incremental FX-related growth, product cost, and yy compares against pricing and supply chain initiatives put in place last year.
    d. 97% of the industry’s footwear is made in China (bad). Nike is less exposed at about a third, but it also is far overexposed to Vietnam (also a third of its footwear production). Three weeks ago, Hanoi announced 28% inflation – its highest rate in 16 years. In Vietnam and Thailand we’ve seen factory workers strike because mid-teens wage increases are not enough to keep pace with inflation. Ultimate, this has to impact Nike. They’re big and smart enough to pass it through to the rest of the global supply chain, but that process is lumpy.
    e. SG&A is clearly the buffer for the remainder of the year. +29% this quarter, and slowing to a negative number by 4%.
    f. ‘Other Expenses’ turn into other ‘income’ as FX hedges are market to market at more favorable rates.
  • So the bottom line is that we’ve got a global growth story that is facing a slowing global growth environment, increasing risk of global stagflation, and has a P&L trajectory where sales and gross margins are decelerating, but are likely to be made up by SG&A, ‘other’ income, and lower tax rate. That shows the power of how Nike manages its financial model. But I simply do not understand why putting capital to work here at $60 makes sense. I like it closer to a 5-handle.