The quarter was nearly spot on with what we were looking for...big EPS beat based on a margin inflection, particularly on the Gross Margin line. The consensus was expecting (based on guidance) -2% EPS growth, and we were at +16%. The company delivered 21%. But the company was definitely a downer on the forward outlook as it relates to a step-up on the promotional environment, and its willingness to sacrifice top line in F3Q as opposed to giving up its gross margin and race competing brands to the bottom of the profitability spectrum. That's what we want to see from Nike right now, given that our bullish view is predicated on a multi-year margin turnaround. To that end, the company also announced a $2bn cost savings plan over 3-years that will cost $450mm in severance costs in 3Q. We knew about the layoffs, as did the Street, as it leaked out several weeks ago. The most disappointing number in the quarter to us was the digital growth of only 1%. If I was locked in a dark room and could only have one number about a company's quarter, it would be the digital traffic trend -- and it was abysmal for Nike this quarter. That should turn meaningfully in the coming quarters. Guidance for 3Q revenue was uninspiring, coming in 'down slightly'. To be 100% clear, we don't believe that, nor do we believe most of what Nike management says, as the company has among the worst forecast accuracy in the business. That comes from how people are compensated inside the company -- to beat targets set with the C-Suite, which is why it perennially beats and lowers. But the fact is that we're likely in the middle of a recession right now, so the anemic top line growth rate -- especially when comping against $3bn of apparel inventory clearance next year -- is borderline believable. What is 'in the bag' is the gross margin inflection, which is coming from better price integrity, in part due to exclusive product stratification across its wholesale and DTC network (it's the only brand that does not compete with it's retail customers and cause discounting), better wholesale margins, the shift to DTC (which should be a multi-year tailwind), freight recapture, and China margins rebounding. Add on top of that the $2bn in cost saves on the SG&A line, and we underwrite a return to an 18% EBIT margin by year 3 of our model from 13% today -- on a meaningful top line acceleration starting around the Olympics in 2H24 -- if not sooner based on market share recapture in the running category, which spells problems for DECK/HOKA and ONON -- both Best Idea Shorts. That gets us to North of $7ps in earnings power (vs $3.23 last year), or a stock near $180 -- a far cry from the ~$110 its trading down to after hours. Importantly, we think that the 'innovation is dead' narrative, which is the widely held view on the Street, will be proved 100% wrong in calendar '24. The company has yet to let the cat out of the bag regarding what it is launching next year -- and we think it will be astoundingly destructive to the competitive landscape. It's tough not to own Nike when revenue is accelerating, gross margins are on an upswing, inventories are firmly under control (down 14% this quarter), and to boot it's benefitting on the SG&A line from cost cuts. If I've ever seen a recipe for Nike to smoke numbers in the upcoming year, this is it.
We can't NOT comment on Foot Locker here, as Nike called out a few wholesale partners like Dick's and JD Sports in its commentary but left out FL. We went long FL at $16.50 (stock now at $30) based on what's largely a 1-factor model -- that sentiment had become way too negative just ahead of a time that Nike will go back to FL in size at some point in 2024. The pushback we get on this view is HUGE. Why? Because it contradicts what both FL and NKE management teams are saying. To be clear, I (McGough) don't give a crap about what the management teams are saying. They're lying. They're having discussions today about re-forging their partnership, and taking the 'Nike ratio' inside FL from about 50% today to what I think will be back to 70% over a 2-year period. There's a cat and mouse game going on here and they're posturing one story to the Street and another internally. For students of history, we saw this same story play out about 22 years ago when the two fell out of bed, and they were both faced with a revenue problem at the same time -- the same problem that exists today. Nike wants a capital commitment out of FL that it will elevate the brand -- which it will almost certainly get -- and the path of least resistance to the mutual revenue problem will be fixed. Do we like FL now as much as we did at $16.50? No. But we still think there's $7-$8 in EPS power at FL given the torque it has in its margin level -- and even with a junky sub 10x multiple we get to about 75% upside. FL remains a Best Idea long. This narrative between the two parties will change...and then we'll see the Street upgrading FL on it.
