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.
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.