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NKE: No More Hall Pass

Big questions go far beyond a lousy print. Though we call financial controls into question, we think the global growth story here is very much intact. Nike just put up an uncharacteristically weak, unusual and inconsistent year.  The Board knows this. It won’t happen again.



These results deviated from our expectations more than any other Nike quarter in over a decade. The print was simply bad... No ifs, ands or buts about it. Yes, there were one-off factors that contributed to about 75% of the $0.20 miss from the consensus, but there are much bigger questions to be asked and answered.


Here’s what bugs us…

  1. This is the third quarter in a row where Gross Margins came in off of management’s’ guidance. After adjusting for a shift in R&D and a negative customs ruling for 4-years of imports, NKE came in right in line with (Nike’s loosely defined) guidance. But two quarters in a row of missed expectations on GM was suspect for this company to start with. Now they miss it again on a reported basis. The market will no longer extend a free pass on this one.
  2. Gross Margins are sitting at the lowest point since 2004, and that’s the case while inventory growth is improving on the margin, and Nike is sitting on a very healthy order book in aggregate. We should absolutely, positively be seeing margins go the other way.
  3. Is it me, or was the company’s tone on that conference call way too laid back? This was a gnarly, hairy quarter, and the after-hours reaction was the most negative Nike has seen in over a decade.  Hubris has not been Nike’s friend in the past 20-years, as it’s one of the only things that has routinely gotten Nike in trouble. Fortunately, it’s our sense that many of the factors that have caused this have been systematically weeded (or breeded) out in recent years. In addition, we’d note that when the company sticks to its plan and ignores the near-term whim of the Street, it has almost always proves to be a value-creating strategy. But all-in we’d rather have seen less of a gap between current operational activity and Nike’s portrayal of that that picture.
  4. Futures growth in China of 2% on a constant $ basis (5% R$). This is so bad. We all knew that there was trouble brewing in China. We saw it in Nike’s inventories last quarter and then with competitors like Li Ning which blew up 2 weeks ago due to inventory issues. But 2% order growth is far too Japan-esque. In fact even Japan grew at a greater rate. On the plus side, revenue and EBIT were both up 21% in China, and inventories did not get worse on the margin. But we’d rather have seen an inventory cleansing process lead to a pick-up in orders. Remember that this is a 38% margin business. We could care less if they give up a few margin points to keep the growth growing. That didn’t happen. Does this mean that China won’t be a $4bn business in 3 years? Not at all. But it cannot continue to push product into the market without negative implications. What it goes to show is that Nike China is human. Macro matters.
  5. One thing we never thought we’d ever ask ourselves with Nike is the efficacy of its financial controls. No one who understands the innards of this company would argue with the statement that it is arguably in the top 1% of public companies as it relates to financial integrity. But facts are facts, and missing Gross Margins three times in a row in a business model that Nike built around being able to control such a big part of this (futures allow the company to lock in costs, reverse engineer product inputs, and manage FX) simply smells uncharacteristically ‘un-Nike’. One needs to wonder if the financial controls are lacking. We think that nothing has deteriorated from a control perspective. But perhaps with the business being more global, more consumer direct (i.e. with Nike having to eat higher costs as opposed to passing to retailers), and being broken out in so many dimensions – region, product, consumer – that the business is outgrowing systems that are in place for managing a traditional wholesale model with a high degree of forecast accuracy. This thought process is over-simplified, of course. But it would be intellectually dishonest to not ask it.


Now…the good news.

  • We’re likely coming in ahead of consensus at $5.75, $6.75, and $8.00 for May13, 14 and 15, respectively. That’s 20% CAGR, and more than 2x implied guidance for the upcoming year. Call us a glutton for punishment after everything noted above, but consider the following…
  • We think that the company’s revenue and SG&A guidance is light for the upcoming year. Consider that Nike is just coming off a very big investment cycle. Capex is leveling off, and the SG&A spent over the past two years on R&D for products such as FlyKnit, Fuel+ and NFL are FY2013 revenue events – not 2012. So those that are concerned about the product cycle rolling over will be sorely mistaken. We think that NFL alone will grow into a $500mm business in 2-years, and Fly/Fuel will accelerate throughout FY13 with minimal cannibalization.
  • Add a sale of Cole Haan and Umbro (for which Nike gave excellent disclosure) and we’re likely looking at around another $800mm-$1bn by year end in cash to play with. The point here is that Nike is entering into a cash flow harvesting cycle.
  • Mid-high single digit top line growth (guidance) would suggest 2H that would need to come in low-single digit (1Q is tracking to come in North of 10%, we think). That’s simply too hard to model.   
  • In addition, what FX impact is bad for Sales/Gross Margin is good for SG&A.  We think that the company downplayed this.
  • Nike is making a call now that gross margins will be ‘up slightly’ for the year. The only way management would make this statement is if plan is much higher. Our rather strong sense is that Nike knows that its credibility is on the line, and cannot handle another disappointment. This would capsize much of the goodwill Nike has fought so hard (and subsequently won) from the investment community over the past decade. We’re not banking on anything above guidance, bc the reality is that we revoked Nike’s hall pass as being one of the very few that we’ll give the benefit of the doubt for GM expansion. But in adding back ‘1-offs’, the hit to raw materials, and giving Nike better pricing, we think it nets out to GM improvement better than 50bps.


There will, no doubt, be a host of analysts dueling Friday morning with downgrades vs. falling on swords defending the name. We definitely were looking for a better number in the quarter – there’s no masking that. But our rather strong sense is that the global growth story here is very much intact. Nike just put up an uncharacteristically weak, unusual and inconsistent year.  The Board knows this. It won’t happen again.


For those of you who have had this name in a pile on your desk, do yourself a favor over the holiday week and move this file to the top of the heap. Tomorrow might not be the time to buy it – or next week or next month. But we don’t think that the time to step in will be as far out as next quarter. 


Please contact us for our updated models.


-          LUV fleet has aged, but less quickly than the fleets of legacy carriers.  The gap has widened.

-          Airlines are aging their operating assets unsustainably, so current free cash flow is not sustainable.

-          This should eventually be good news for aircraft OEMs with respect to US demand.





Expert Call/Sector Event:  We are hosting an expert call on Industrial sector antitrust policy, with a focus Airline industry consolidation.  We will focus specifically on US Airways bid for AMR, as well as changes in antitrust policy with respect to the Industrials sector.  Our expert will be Lisa Harig, a Partner at McBreen & Kopko and head of the firm’s Washington D.C. office.  She is a former in-house counsel for Trans World Airlines, Inc. and BearingPoint, Inc.  Ms. Harig represents domestic and international clients, including airlines, manufacturers and individual aircraft owners.  Her practice focuses on a wide range of corporate, transactional, compliance and regulatory matters, including representation before the U.S. Department of Transportation and Federal Aviation Administration.  Please contact us or your Hedgeye Sales representative to participate.  The call is scheduled for July 10th at 11AM. 


Sector Comment:  Chinese heavy equipment sales continue to deteriorate – falling 20% to 30% year over year across the board.  This is not a vote of confidence for future construction activity.  This might impact commodity prices, but it also is a negative for competitors like CAT and Komatsu with exposure to the market.  Weak demand at home may eventually force SANY and Zoomlion further into developed markets.  Our macro team has done excellent work on growth in China.






CONCLUSION: Despite what appears to be a buying opportunity in Korean equities ahead of what is likely to be a positive inflection in the country’s domestic fundamental story, it is our view that the prudent thing for investors to do at the current juncture is wait – specifically for quantitative confirmation and increased clarity from Chinese policymakers on how they plan to address their latest bout of economic deterioration in the immediate term (if at all).


Overnight, the South Korean Finance Ministry lowered its official 2012 growth estimate by -40bps to +3.3%; additionally, it reduced its 2012 inflation estimate to +2.8% from +3.2%. While we don’t assign much weight to the economic projections of governments or their affiliated institutions in our research process (look no further than the CBO or the Fed to see just how painfully wrong such forecasts can be), we are keen to note that revisions such as these are typically leading-to-concurrent indicators of policy shifts. On that front, the South Korean Finance Ministry also introduced a KRW8.5 trillion ($7.4B or 0.7% of GDP) stimulus package designed to assist small businesses and low-income earners.


As an aside, we continue to find favorable countries who’ve protected the USD-based returns of international investors by supporting strength (relative or absolute) in their currencies. South Korea has been one of Asia’s shining stars in this regard over the past month, outperforming other Asian currencies vs. the USD by +190bps (on a regional median basis) as the table below highlights.




On the fiscal policy front, South Korea can surely afford to loosen its purse strings a bit; it’s central government budget surplus is just shy of +2% of GDP (officially at +1.8% in 2011). Their fiscal prudence has also contributed quite nicely to their strong current account position of +2.7% of GDP (2011) – giving South Korea dual surpluses where they are most supportive (in the currency market). Additionally supportive is South Korea’s relatively pristine sovereign debt/GDP ratio of 33.2% – particularly in the current Global Macro environment where consensus is literally being forced to [finally] comprehend the statistical relationship between excessive sovereign debt (beyond the Rubicon of 90%) and economic performance.




On the monetary policy front, both 1YR OIS and NDF markets continue to take the Bank of Korea’s cues of stability quite literally (they’ve been on hold for just over 1YR now), which ultimately translates into relative hawkishness in an environment where most other emerging and developed market central banks have a clear easing bias.




Furthermore, a real benchmark policy interest rate of 0.75% is supportive of cross-border capital flows into the South Korean economy – as is the government’s recent decision to exempt foreign investors from paying taxes on their foreign currency deposits as well as lowering tax rates for domestic banks that attract incremental foreign currency deposits.




As always, capital chases yield. As such, we are fundamentally inclined to [virtually] invest our “capital” in the South Korean economy at the current juncture – particularly given the country’s favorable TREND-duration GROWTH/INFLATION/POLICY outlook. On this score, Philippines and Thailand are the only other countries in Asia that currently qualify as TREND-duration fundamental long ideas based on this proprietary screening process.




As you likely focused on in the prior sentence, we can’t stress enough how important it is to our research process to have unique processes by which we derive our fundamental and risk management conclusions. In South Korea’s case, the country’s benchmark KOSPI equity index is in a Bearish Formation, which means it is quantitatively broken across all three of our risk management durations (TRADE, TREND and TAIL). We are smart enough to know that we are not smarter than Mr. Market; as such we are keen to interpret the latest economic trends out of South Korea with a grain of salt, rather than through the purview of rose colored glasses in anticipation of a positive inflection.










As we look for explanations as to why South Korean equities remain broken, the intellectually lazy answer would be to point a [fat] finger at the European sovereign debt and banking crisis. For a more quantified explanation, we instead point to recently souring trends in the global information technology sector (23.7% of the KOSPI index) and in the Chinese economy (far and away South Korea’s largest export market at 24.4% of total shipments).


As we’ve pointed out in our recent research, growth expectations for each have come down in recent weeks, with the Technology Select Sector SPDR Fund or “XLK” (bearish TRADE and TREND) underperforming the S&P 500 by -134bps since the start of MAY and the Shanghai Composite Index (also bearish TRADE and TREND) underperforming the S&P 500 by -344bps over that same duration. In the interest of keeping this analysis tight, we won’t belabor this point further; for more details, refer to the following notes/conclusions: 

  • WHAT’S ASIA SIGNALING ABOUT TRENDS IN THE TECH SECTOR? (APR 30): The relevant growth data emanating from Asia suggests the tech sector is at risk of deteriorating operating metrics over the intermediate term.
  • CHINA’S INCREMENTAL GROWTH SLOWDOWN CONFIRMED (MAY 29): While Deflating the Inflation remains a bullish catalyst for the Chinese economy, the lag between this event and the turn in both the reported growth data and growth expectations may have just increased. As such, we are of the view that waiting and watching for clarity is the best strategy in the immediate term for China.
  • CHINA’S RATE CUT IS LIKELY A BAD SIGN OF WHAT LIES AHEAD (JUN 7): We don’t see the early innings of this Chinese rate cut cycle as a signal to get bullish on China’s economy or equity market at the current juncture. Moreover, we do not find it prudent for investors to increase their asset allocation exposure to commodities here. 

All told, despite what appears to be a buying opportunity in Korean equities ahead of what is likely to be a positive inflection in the country’s domestic fundamental story, it is our view that the prudent thing for investors to do at the current juncture is wait – specifically for quantitative confirmation and increased clarity from Chinese policymakers on how they plan to address their latest bout of economic deterioration in the immediate term (if at all).


Darius Dale

Senior Analyst

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HedgeyeRetail Visual: NKE Futures vs. Margins. Tough to be Bearish

When Nike's futures are up, inventories are trending down AND it's coming off the worst Gross Margin hit in 10-years, it's tough to build a bearish margin story over the next year.  


HedgeyeRetail Visual: NKE Futures vs. Margins. Tough to be Bearish - 6 28 2012 2 36 23 PM

FL: Going The Distance

SECTOR: Hedgeye Retail (@HedgeyeRetail)




Foot Locker has had its share of near-term problems as it struggled with sales and its European business. We’ve been bullish on the long-term TAIL duration of this stock as the company works its way around the European business climate and focuses on growth. We got bullish on the company before it reported Q1 earnings based on strength in domestic trends and came in above our consensus estimate.


With Q2, we expect the company to put aside any issues that have been plaguing it for some time, paving the way for a better second half of 2012. With domestic trends coming in well above expectations, we think that FL has the gusto to beat Q2 earnings estimates. Also, coming out of Q2, FL’s sales/inventory spread improved on the margin which is a positive for gross margins. Coupled with the top-line coming in ahead of expectations should result in materially higher EPS numbers this year and next. Basically, the best is yet to come for FL. Have patience with this one.



FL: Going The Distance  - FL growthchart

SBUX: The $100 Million Question

HEDGEYE ANALYST: Howard Penney, Managing Director of Restaurants (@HedgeyeHWP)




The recent acquisition of La Boulange Bakery by Starbucks (SBUX) raises some questions. First and foremost is the price of $100 million for a bakery chain that CEO Howard Schultz justifies through a growth strategy. The goal is to expand the La Boulange footprint by distributing its goods throughout Starbucks stores and making it a nationally known name. Bringing French baked goods to the masses is a strategy that has a high likelihood of working out, similar to how Americans have embraced Italian espresso.


SBUX: The $100 Million Question - SBUX bread



But the concern we have at the moment is distribution. In a note written by Maury Rubin’s City Bakery Daily, he outlines the issues related to the logistics of shipping and distributing freshly baked goods:


Many years ago, when Starbucks first moved into New York City, they asked if City Bakery would consider being a supplier of baked goods. I was completely interested, until I learned the required delivery schedule: orders needed to ship to a central location by 6pm to be sold the next day. In our bakery, then as now, we bake every thirty minutes all morning long. The goal is to have pastry on our counter that was in the oven within the hour when bought. For Starbucks, we would need to have baked 15-18 hours before the fact.”


Howard Schultz believes that the way La Boulange handles its logistics justifies the $100 million price tag. In reality, it will probably require further capital expenditures to keep the quality associated with La Boulange products after they are shipped since it is highly unlikely existing Starbucks stores will be retrofitted with the ability to produce baked goods.


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