NKE – Needs More Cowbell

Takeaway: Some great aspects of this print. But we need higher EPS growth than 12% to justify multiple expansion. We can’t get there, yet.

Conclusion: We said earlier this week that we’re no more or less excited about owning Nike based on the 4Q print. That statement holds true after the company’s results. Yes, Nike beat by $0.03. That’s what great companies do – they consistently beat expectations. And there is no question in our mind that Nike is one of the greatest consumer companies in the world. That’s more clear today than ever before. But that doesn’t mean it has to be one of the greatest consumer stocks. While it beat the quarter, cash flow contracted and NKE grew EPS by only 3% on 11% revenue growth.  Not a great quality quarter. Furthermore, we’re likely to see sales decelerate sequentially throughout the upcoming fiscal year, with EPS growth being fueled largely by World Cup spending simply not recurring. That’s not terrible by any stretch. After all, Nike is still in a more envious financial and operational position than most consumer companies. But at a 23x p/e, this stock is probably not going to go up due to multiple expansion. It needs outsized earnings growth. We’re currently looking at 11-12% growth for each of the next two years. If our numbers are right, then we can’t make the bet that the stock heads higher by anything more than the rate of earnings growth. But if 20% earnings growth becomes a reality, then we could argue a 25x p/e on a $3.60 EPS number and then we flirt with a $90 stock price. We don’t have the conviction top make that call today. We’re not changing any of our operating estimates, and are actually taking EPS down by about a nickel per year due to a higher tax rate. Financials are in table below.

 

Here are a few puts and takes on the results, as we see them.

  1. Brand Heat: While futures decelerated by a point, they still remain at an extremely healthy level – 11% reported and 12% in constant currency. North America was the most impressive, reaccelerating from 9% to 11% (a 150bp improvement in the 2-year trend). That’s most significant because last quarter the US market finally showed signs of ‘rolling over’. Those signs reversed course.
  2. Killer GM%: Nike’s Gross Margins were up 169bps to 45.6%, its highest rate in 4-years. Better mix and better margin close-outs accounted for the bulk of the upside. Though higher prices and strong online sales helped as well.
  3. Digital: We need to weigh-in on the company’s comments that ‘Digital is its top priority’ and it is more excited about online than ever before (growing 40% for the year). The company won’t volunteer these stats, but dot.com accounted for just about 2% of Nike’s sales in 2013, or about 12% of its total direct-to-consumer business. The reality is that Nike has the lowest e-commerce ratio of almost any company in the business.  We understand that this in part due to the fact that it has such a strong wholesale model. But keep in mind that when the company talks about growth in its e-commerce business, it is coming off an extraordinarily low base. It added about $200mm this year, compared to Nike’s $2.48bn in revenue growth.
  4. ‘Emerging’ Markets: Futures for Emerging markets were up only 2% in reported dollars, and 9% in constant currency. Maybe we’re missing something, but shouldn’t ‘Emerging Markets’ be growing faster than the two most mature markets – USA +11%, and Western Europe +25% (and even Central Europe +10%)? NKE is anniversarying the supply chain problems it had in Mexico in 1H, so sales compares should be getting easier there. This is an area we’d definitely like to see stronger.
  5. Share Repo: Nike repo’d 12.3mm shares for $912mm, an average price of $74.14. To be clear, that is a colossal amount of stock for Nike to repo in a single quarter. Interesting to hear management talk about having more growth opportunities than ever, and yet Nike is opting to also invest so much in its own stock. We're not doubting the growth opportunities, but this makes us sit back and reconsider whether we’re too conservative with our earnings estimates (i.e. what do they know that I don’t?).
  6. China Margins: Nike’s investment in a China HQ in Shanghai is a decision we absolutely won’t question. The company needs a central presence in China, and the landscape has developed enough such that they know where to be (and not to be). But, the big thing to watch is margins, which were down 521bp this quarter in China to 30.6%. China margins were once the greatest in Nike’s portfolio by a country mile (surpassing 39% just two years ago). But now they’re gravitating down closer to the US at 27% and Emerging Markets at 25%. Again, still very respectable levels by any measure, but the downward movement is a key trend to model.
  7. ROE Caught Up To ROIC: This quarter, Nike’s TTM ROIC was 24.5%. By our math, that equals ROE. That’s so important for this company. Nike always had an enviable trajectory of ROIC, but the problem is that ROE could not keep up because of all the cash on its books. The fact that Nike stepped up its repo as much as it did really had a dramatic effect this fiscal year. Nike definitely deserves a golf clap for that one – and then some.
  8. Women's – Good, Not Outstanding: Nike is really proud of its women’s business. It should be. Sales to women were up 12% last year to $5bn. That’s the size of 3 Lululemons. But on the flip side, it’s 1/3 the size of Nike’s men’s business. Perhaps it’s tough to grow relative to something that in itself is moving so fast. But as big of a focus as this is for management, we’d have thunk that women’s would grow a bit more than 12% for the year (with women’s training growing 10% to $1.1bn).

 

NKE – Needs More Cowbell - nke1

 

 

HERE'S OUR PRE-Q NOTE FROM EARLIER IN THE WEEK

06/25/14

NKE – Consider the World Cup Biorhythm

Takeaway: 23x p/e is a tough risk/reward for a company that can barely grow EPS when the brand is hotter than ever.

 

We’re no more or less excited about owning Nike into the 4Q print to be reported after the close on Thursday. A few thoughts…

  1. Revenue Looks Good: We could see a slight beat on the top line. The company guided towards a high single digit rate. The brand still has solid momentum in the US and Western Europe. In ‘Nike Speak’ high-single digit sales guidance equals 11-12%. The Street is at 9.6%.
  2. Gross Margin Expectations Appropriately High: The Street is already looking for a 44.7% Gross Margin, which is 75bps ahead of last year and represents a meaningful sequential pick-up in the 2-year trend. We’re seeing a shift toward higher GM jurisdictions (which could also help tax rate), so this is a reasonable expectation. But we’d be surprised by much more – especially given that inventories ended the last quarter +15%.
  3. Need SG&A to Shine – and It Won’t: So with a likely slight sales beat, and in-line GM, that leaves it all up to SG&A to save the day.  The problem is that in all our years covering Nike, we have never seen the company spend money at the clip (even relative to size) that we’re seeing today. Nike is one of the best steward’s of capital in this industry, so it’s earned the benefit of the doubt as it relates to its capital allocation process which will ultimately result in increased cash flow at some point down the road. But with the company spending an estimated $100mm-$150mm on World Cup, we can’t exactly bank on this being the quarter for an SG&A beat. Let’s consider that number for a minute. This coming quarter, UnderArmour will spend about $55mm in marketing on EVERYTHING. Nike will spend 3x that on one sporting event.
  4. The World Cup Factor: A few people have told us “there’s no way Nike misses during World Cup”. That’s probably true. There’s no way it will allow itself to be in the financial press as disappointing while the biggest sporting match in the world is being played out . But mind you that Nike has not beaten by more than a penny in each of the past three World Cups.
  5. Nike’s biorhythm; The problem is that the Cup is always played in conjunction with Nike reporting its fourth fiscal quarter. Aside from Nike spending huge sums of capital on this event, you need to take into account Nike’s own internal financial biorhythm.  The same factors that lead to conservative goal setting between regional GMs and the C-Suite (and subsequent EPS smoking in quarters 1 through 3 also lead to muted upside in Q4). Why? If you are a business unit head at Nike, you have to fight for a given SG&A budget in a given year. If you don’t spend every last penny, then the chance of getting a similar (or larger) budget next year is slim to none. We’ve all heard the stories about what most people would consider excessive spending at Nike (i.e. hiring rock bands to play at happy hour for your department). Most of those stories are true, and almost all happen in the fourth quarter.  The point is, if there is a quarter where you’re looking for NKE to beat on the SG&A line, 4Q probably won’t be the one – especially one where World Cup is being played in the back yard of Nike’s highest-profile National Team – Brazil.
  6. Guidance Not Headed Higher: The company already issued preliminary guidance for the May ’15 year “at or above our high-single-digit target range.“  It won’t come out and take guidance higher when the year is only four weeks old. They won’t take guidance down, either. But there’s an 80% chance it sticks with its previous comment, 15% chance it backs away, and 5% it guides higher.  

 

We’re not averse to owning Nike for someone who has an extremely long duration. But there’s no way we can justify putting money to work here for a company that is barely growing earnings when the brand is hotter than ever.  With the stock at 23x next year’s earnings, we simply think that there’s much better risk/reward elsewhere.