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…
- 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.
- 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.
- 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.
- 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.
- 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.