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NIKE: THE NEW CORPORATE CAPITALIST?

Very ugly trajectory of earnings quality – as we expected. But on the margin, my sense is that Nike will be the poster child for a Corporate Capitalist looking to get a return on its cash that the Fed is taking away. Game-changing cash deployment is on its way…

I find it both ironic and frustrating is that if there is one company where Research Edge should dominate, it is Nike. Keith and I have made our respective careers, in part, on this name – me on the fundamentals, and him on the stock. We nailed this one (sales eroding for a multitude of company-specific and Macro factors, GM% weakening, with SG&A and non-operating items saving the day) but were both a full quarter early. It took us handing over the reins to my lieutenant, Casey Flavin, to pinpoint the timing. His analysis that the weighted average FX delta would equate to a 700bp drag on the top line (12/17: Eye on Nike FX – Rate of Change is Massive) proved to be absolutely spot-on. Note that Nike’s reported futures were down 1% -- 7% below the 6% constant currency growth rate.

I’m not going to dig into every facet of what happened in the quarter. Read someone else’s note for a news report. The only things I was genuinely surprised to see were 1) that inventories outgrew sales for the first time in over 2 years, and 2) margins in the US were down 340bp to 16.7% -- the lowest 2Q margin rate in over 10 years. Yes, US futures growth of 6% maintained the 3-4% 2-year run rate we’re been seeing from Nike, but it’s costing them.

Here’s the key issue from here. One thing that has always bugged me about Nike is its sense of competitive complacency. Perhaps that’s a bad way to phrase it given that the competitive nature and spirit of this company is fierce. But in the past when the industry and its key players faced its ups and downs, Nike would only target key competitors when threatened. This time it’s different. Now that he’s been on the job for a few years, I think that Mark Parker (CEO) has found a groove that will play out in the form of meaningful strategic action in 2009. My key industry theme of next year is that the companies with the brand strength, liquidity, and raw determination to put the nail in the coffin for smaller competitors will come out the huge winners. Nike is playing right into that theme.

I’d note that in order to really take advantage, Nike will need to deploy the capital to do so. The company has already said that it is taking down SG&A spending meaningfully – so to some extent it has drawn a line in the sand there (I would not mind elevated spending levels to make it REALLY uncomfortable for its competitors – even if painful to margins near-term). The other option is for Nike to go out and deploy its $2bn in net cash. Think of it this way – with that capital, Nike can buy Timberland, Zappos, and Lululemon – and still have cash to spare. These are game changers.

You should expect to see Nike go in different directions in ’09 (i.e. outside the traditional ‘buy new brands’ strategy). They’ll buy infrastructure on the cheap that will augment existing brands and content. (Note: they are slowing store growth now. Why? Because Nike has not cracked the retail code. The time might be approaching to buy someone who has).

Capitalists that are not beholden to liquidity constraints will have a field day in this climate. With Fed-Funds targeted at ZERO in the US, the income on Nike’s cool $2bn is getting lower and lower. The financial model is anything but complacent at Nike. Combined with the ‘crush the competition’ theme should set up ’09 to be a breakout year.

If the company’s cautious tone last night takes numbers down enough to a point where I think they are ‘slam dunk-able’ – about $3.50 – then this stock is a gift in the low $40s. If it fails to sell off on this event, then that probably just as bullish a statement as any.


Brian McGough
President and Director of Research
Nike’s position on our SIGMA chart is not enviable. Inventories growing too quickly for the first time in a while. Margin trajectory has trended well over the past 2 quarters, but will reverse course in 2H. Cash deployment next year on a game-changing acquisition or two will make this unhealthy trajectory somewhat irrelevant.

A SINGAPORE PREVIEW?

The lesson on taxes never seems to be learned. Whether it is high corporate taxes in the US forcing business out of the country or migration away from high income tax states, taxes do matter. In this case, at least one Australian gaming operator will capitalize on the large gaming tax differential between Macau and Australia. Macau confiscates 39% of gaming revenue while Australia is somewhere in the low to mid 20s depending on the state. Our sources indicate that the operator has reached an agreement with a Macau junket operator to bring its customers over to Australia in exchange for a 1.6% VIP commission, substantially higher than the prevailing 1.3% rate in Macau. A 1.6% commission would be unprofitable in Macau.

This may be a preview for Macau when Singapore opens in 2010. Singapore will tax VIP table revenues at only a 5% rate and some junkets are already in negotiation with LVS and Genting to operate VIP rooms at those facilities.

Argghh!: Somali Pirates Spark International Community

It is nearly a month to the day that we first wrote about Somali pirates hijacking a Saudi oil ship in the Gulf of Aden.

On the day the pirates made their demands Keith wrote in The Early Look (11/18):
“This morning the Saudi market is down another -3.5% and the United Arab Emirates tape is getting tagged for another -5.1% loss. This isn’t new. This is called deleveraging. This is “The New Reality.”

Today it’s clear the international community is willing to get in the curve of “The New Reality”. The U.N. Security Council voted unanimously yesterday on the US-drafted resolution to authorize nations to “use all necessary measures that are appropriate in Somalia in pursuit of pirates, as long as they are approved by the country’s transitional federal government.” The resolution encourages states to deploy naval vessels and military aircraft to carry out the operations.

China has proactively stated that it may soon deploy warships to the Gulf of Aden and Somali coast to escort its ships and prevent the disruption of commerce along one of the world’s most active sea routes. This comes in response to today’s pirate attack off the coast of Somalia in which the crew of the China Communications Construction Co. was forced to fend of pirates for five hours until coalition helicopters chased them off.

In this year alone pirates have attacked some 120 ships in the region, seized 60 of them, and have collected more than $120 million in ransom. Currently 14 ships and 240 crew members are being held hostage by pirates. This is non-trivial to say the least.

US Secretary of State Condoleezza Rice, who pushed for the resolution’s passage and stressed the importance of intelligence sharing to coordinate naval and military operations in the region, is cognizant of the unraveling political and security situation in Somalia. This in an important point to note for the resolution expects states to first get approval by the country’s transitional federal government. This last point seems unlikely to hold up.

UN Secretary General Ban Ki-moon has warned that Somalia may descend into “chaos” by the end of the month when an Ethiopian occupation force leave the country. Rice proposed a UN peacekeeping mission to Somalia, which Ban quickly rejected it, citing his past unsuccessful attempts to mobilize a strong international force in the region and unsafe condition for peacekeepers. To place Somalia under a UN flag, Rice would need the support of the vast majority of the 192 UN members to fund the operations.

China is putting its foot down and we’re behind any nation that steps up to the pirates. A joint effort from the international community is need to suppress them. This will have to come in the form of joint international intervention and must be proactively constructed with respect to the unstable Somali state.

Matthew Hedrick
Analyst


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DRI – LET EM RIP

DRI is going to report FY 2Q09 EPS on Friday and we don’t think things are as bad as people think. See our DRI post titled “DRI - Estimates May Have Gone Down Too Much” from November 26.

I just want to reiterate what I think could come out of the EPS call:

(1) Street consensus EPS numbers are too low for the company….
(2) Same-store sales trends are better than consensus (part of the reason why EPS estimates are too low).
(3) The company will have positive commentary about the cost side of the equation, especially seafood, chicken and wheat costs.
(4) Industry same-store sales trends in November, while still bad, are less bad than October.
(5) FY 2Q08 was such a disaster

We know that there will likely never be another national Casual Dining chain that can compete against Red Lobster or the Olive Garden. What is that worth? I bet more than 9x EPS….

USD Weakness: Thank You Goldman Sachs!

The good word from the big bird on the Street today is that “Goldman is going out negative on the US Dollar”… whether that is coming from their prop desk or their sell side desk is of little concern to me. Soon, they will probably be one and the same.

Regardless of the source, our holiday greetings go out to the global titans of reactivity. We’ve been making the USD short call for the last three weeks (proactively preparing our clients for the FOMC meeting), and it’s nice to get the free advertising. As a reminder, we had our critical “Trend” line support for the USD break a few days ago (see chart).

The US$ is down -11% in less than a month. This isn’t the etf for Kazakhstan… or is it? This is the world’s “reserve” currency chart – “Heli-Ben” and Hank support the house of Goldman’s message today – they always have.

“Re-flation” of the SP500 continues… and no one believes in it yet.
KM

Why Are Stocks Ripping Again? VIX, VIX, VIX...

We signaled this level on the VIX to our Tier 1 Macro clients on this morning’s 830AM daily macro call. The bullish “Trend” line of support for the VIX ends at 50.52. Any close below that line is very bullish for the US stock market.

Volatility collapsing in the face of accelerating volume (Tuesday’s US volume was +34% higher than Monday’s) and expanding breadth is not only a recipe for a short squeeze, but a rally that bull riders cannot afford to miss.

“Trend” in our macro model is much more important than “Trade” – the intermediate term trumps the immediate term, because that’s where the real money flows are. If this “Trend” line of Volatility breaks, you can be certain that asset allocators are going to dog pile back into American equities. Don’t forget, there is ZERO incentive to be in cash when rates on cash savings are negative (on a real basis).

I just refreshed my model and I’m moving my immediate term resistance line for the SP500 to 926.
KM

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