NKE – The Math Nobody Is Doing

Takeaway: NKE’s superior relative guide is driven by one major factor – e-commerce. $1bn+ at 70% GM = over half of incremental GP and 6% EPS growth.

Nike’s EPS beat as well as its initial below-consensus guidance for FY16 were not a surprise.  What is a surprise is the composition of the earnings algorithm – and that's the part of the discussion that will be missing this morning. So here’s our two cents. Consider the following…Nike, Ralph Lauren, and VF Corp all guided to about a 500bp hit to top line growth over the next year due to FX. But that contributes to down double digit EPS at RL and +4% EPS at VFC, but double digit growth in earnings at Nike. Despite the biggest FX hit Nike has felt in over five years, the company basically plans to leverage its top line growth rate into earnings by a factor of 2 (+msd sales into +dd eps). And let’s not forget that this is Nike we’re talking about -- it rarely gives initial guidance that it does not ultimately beat (usually by a wide margin). We’re definitely not averse to owning Nike as it sits on our Long Bench, but we’re concerned about valuation and such little room for error at the precise time the most important person in the company is retiring.

 

NKE – The Math Nobody Is Doing - NKE fx guidance 3

 

We chalk it up to two factors… a) the impact of e-commerce on the model, and b) how well this company (notably Don Blair) manages the financial model.

 

A)     Consider e-commerce for a minute.

  1. E-commerce was up 42% in the quarter, which is a sequential slowdown from 2Q’s 66%. But looked at on a 2-year run rate, underlying growth remains at peak levels. We think that Nike has plans to set new peak levels in FY16. How we’re doing the math, e-commerce represents about 6% of Nike’s sales. That’s about $1.8bn today. We think the company will add between $1bn-$1.2bn in FY16, or 55%-65% growth. Nike will probably tell you that we’re too aggressive. But let’s put the accountability pants on. In Oct 2013, the company said that e-comm would go from $540mm in 2013 to $2bn in FY17. It appears to be hitting that goal 1-2 years ahead of plan. It didn’t purposely sandbag, but rather it’s such a dynamic growth opportunity with more and more growth opportunity by the day.
  2. The margin on those sales is a big consideration. How we do the math, e-commerce sales are about 20points margin accretive. That’s outlined in the following table. But more important than the actual gross margin rate is the magnified amount of gross margin dollars as Nike captures a full retail price instead of one with a 50% wholesale discount. A 20%+ margin on a 2x price = nearly 4x the gross margin dollars.
    NKE – The Math Nobody Is Doing - NKE margin math
  3. Yes there are increased working capital requirements, which Nike will have to manage. There will be a learning curve there. But outright capital spending and incremental SG&A investment on e-commerce is shrinking – for now at least – given what Nike has been investing (much of it quietly) over the past three years.
  4. We could actually make the argument that 100% of the e-commerce spend will be incremental – as in, not take away from its wholesale business (FL, FINL, HIBB). Not over the long term, but temporarily. The point is that Nike is going to manage its wholesale model with kid gloves. It will say and do all the right things, as will its partners. But make no mistake, it will aggressively push the envelope with its e-comm model along the way. It will only know it pushed too far when some serious channel stuffing is apparent in the wholesale channel (ie. higher inventories, lower comps at FL, or maybe even 24% growth in a sub-par outlet like KSS in the last qtr).  And at that point, the right decision will likely be to still grow e-comm aggressively.
  5. In the end, we think that e-commerce growth will account for $750mm-$900mm in incremental gross profit – or about 60% of gross profit growth.  That also translates to 5-7% in EPS growth. Back to the comparison to other companies above, we think this largely explains away why Nike is growing earnings 2x the rate of sales while other non-durables brands are flat to down.  

 

B)      The financial model, and the Don Blair factor, are far simpler. The cross currents impacting Nike’s financials are nothing short of fierce. But the consolidated numbers always manage to balance out and produce consistent results. This is all Blair. We’re not saying that he micromanages daily regional P&Ls, but rather, he has a process for managing the financials such that when one region or business line is challenged, another will always pick up the slack. He built a finance organization from the ground up, and to his credit, has set in motion a process that is bigger than any one individual. That said, things will change when he leaves – perhaps not in the finance organization at all, but in other parts of the company where people ‘behaved’ in a shareholder-friendly way simply knowing that Blair is there.  See our write up on that below. 

 

 

Previous Note on CFO Retirement from 2/12/15

 

02/12/15 05:39 PM EST

NKE - CFO Retirement = Negative Development

 

Takeaway: This is a bad event. The business is absolutely fine – no issues there. But Blair is as good as they come. Stay away for now.

 

There’s no sugar-coating this announcement from Nike that CFO Don Blair is retiring. We’ve always said that there’s only one person we’d be worried about leaving Nike, and that is Don.  The reason is that aside from having tremendous credibility with the investment community, Don has served as a critical bridge for Mark Parker (CEO) into the world of cost management, capital deployment, and ROIC – which is key for a CEO who is otherwise (brilliantly) focused on brand, design, and the consumer.  

 

To be clear, we’re pretty certain that this is not a sign of an impending blow up. Business at Nike is fine, and he is leaving while he’s on top. In fact, to his credit, Don would absolutely not leave if the company was trending in the wrong direction – and he’ll be there until October 31 of this year. Anyone looking for a blowup during that time period will be disappointed.

 

Andy Campion is perfectly appropriate as a CFO for Nike, Inc. – but as much as people will argue that serving as CFO of the Nike Brand prepared him for this job, we’d say that there is a massive difference between being the CFO of a subsidiary (albeit a huge one) and being the outward-facing CFO of a company that's in the top 10% of the S&P 500. Even Don Blair had an extremely painful initial 2-3 years while he navigated through the confusing internal forecasting process inside Nike. The fact is that Don is one of the best CFOs that I (McGough) have known in 22 years.

 

The learning curve for his successor will be steep. And keep in mind that Don fought hard (and won) serious clout for the Finance organization in a company that is traditionally Brand and Marketing-driven. With Don no longer as the anchor, we think we’re likely to see more political tussles internally – potentially for a few years – while the new regime is established.

 

We’re taking Nike from our Long list to our ‘Bench’ until we get more comfort in organizational structure. If we were looking at an 18 multiple, we’d hang in there. But at 23x, we’d rather wait. 

 


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