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Takeaway: Incremental Gross Profit dollars from e-comm are now bigger than wholesale. Nike is officially its own most important customer.
We find it amusing that in the entire 60 minutes of prepped remarks and Q&A, not once did Nike management comment (nor did anyone ask) about the most significant financial milestone we’ve seen out of Nike in the Mark Parker era. Specifically, this marked the first quarter in history where Nike DTC accounted for a greater percentage of growth than its wholesale business. Calculate it any way you want…the results are the same.
- E-commerce grew 50% in the quarter and accelerated on a 2yr basis by 200bps. It now stands at (just) 5.0% of sales, compared to 3.5% last year. Those might sound like small numbers, and they are. That’s why this trend has so much room to grow. Nike states a $7bn goal (e-commerce) by 2020. We think it will be closer to $11bn. That’s an incremental $10bn from the $1.2bn it registered last year. This is where the consensus will prove not bullish enough on Nike, and not bearish enough on its wholesalers (FL, et all…)
- As a percentage of growth, e-commerce accounted for 35% of the incremental dollars in the quarter and DTC (inclusive of Brick and Mortar and e-commerce) made up over $150 of the incremental $300mm in revenue in the quarter. This is the first time we’ve seen that from NKE, ever. And it won’t be the last. *calculation note: we assumed that DTC growth numbers were exposed to the same FX headwind as the 8% company average.
- More importantly, DTC accounted for 60% of the incremental gross profit dollars in the quarter based on our math.
This is the first time EVER that wholesale accounted for less than 50% of incremental profit. This means that Nike itself is now a more important profit driver than all of its traditional customers combined.
Ultimately, this is what should push Nike’s gross margins past 50% (from 46%), which is where $8-$9 in earnings power becomes part of the discussion. That’s what we think you need to believe to own this stock today.
The Quarter – Golf Clap. But 3Q Should Be Big
For your average company, this was a great quarter. For an industry-leader like Nike that trades at 27x earnings, it was average – at best. Yes, the futures numbers remain explosive (15% global growth, and 14% North America), and the growth in China is mind-numbing (China is 33% of EBIT, and is growing at 30%+). But keep in mind that the key profit driver – Nike DTC – is not included in the futures numbers. The company actually missed revenue (growing only 4%), despite having put up a healthy 9% futures growth number in 1Q. Gross Margins looked great, thanks to e-comm, but the company would have missed the Street’s EPS expectation by $0.02 if tax rate did not help EPS by $0.06ps. Inventories are still high, as Nike put up the worst sales/inventory spread in 14 quarters – that’s a long time (see SIGMA chart below). Call it West Coast port delay overhang, call it an expeditious move on NKE’s part to reinforce the pull model in the US, but the fact remains that NKE is sitting on bloated inventory levels in its core market for the first time in a decade, and that’s not a positive event for the rest of the athletic supply chain web. The way we see it, Nike was overly conservative in setting 3Q EPS expectations. Nike basically guided top flat EBIT in 3Q, or about $0.90 per share. We think it will do over a buck.
Here’s our comments leading into the Quarter.
NKE | Key Issues
Here’s a quick overview as to what we’re looking for from Nike tonight.
- A Big EPS Beat: We’re at $0.93 vs the Street at $0.86. This company has not missed a 2Q in well over 10 years. It’s not gonna start now.
- Futures. We all know that 9 out of 10 times, the consensus futures estimate is +1/-1 the prior quarter’s 2-year trend. But that only proves to be correct 4 times out of 10. So the question is…are we plus, or minus. Let’s keep in mind that this is an unaudited number that management does not even know until 1-2 weeks before the print. That said, we’re looking for 15% Global C$ growth in Futures, including 10% growth in North America. The latter would represent a 400bp sequential slowdown from 1Q results.
- Bifurcation in Futures and Results. One of the key factors behind our long term call on Nike (and our short on FL) is that Nike is likely to build its e-commerce business from $1.2bn last year to $11bn by 2020. That’s nearly 60% ABOVE the e-comm target Nike gave the Street at its analyst meeting earlier this year. This means two things…
- Futures: At some point, futures will become extremely less relevant, as futures only applies to Nike’s wholesale business. Naturally, we’ll likely hear the company talk about this when there is the inevitable downturn in futures.
- Gross Margins: Gross margins are likely headed well over 50% vs the 46% it reported last year, as e-commerce margins are about 20 points above wholesale.
- E-commerce: We need to see growth this quarter of at least 40%. We’re modeling 50%. It’s going up against a tough comp vs last year (65%), but lets face it…when we’re making a case that e-comm will grow from $1bn to $11bn, going up against a ‘tough comp’ is absolutely irrelevant. Every quarter should be a tough comp, otherwise we’re simply wrong in our thesis.
- US Commentary: Here are a few points that matter a lot, both for Nike and for retailers like FL, FINL, DKS, HIBB, etc..
- Saturation: If we were to ask only one question on the call (we generally don’t ask our questions publicly on conf calls) it would sound something like this, “Over the past six years, Nike has increased its penetration in key wholesale accounts from 40-50%, to 60-80%. At the same time it used the resulting cash flow to invest in the plant, people and systems needed to aggressively grow the leg of distribution – Nike DTC (e-comm) -- that will propel Nike from $30bn in sales to $50bn. With zero square footage growth opportunities for the traditional retailers in the US, and Nike incrementally taking higher ASP product for its proprietary distribution network, how can the traditional retailers actually grow? We understand the ‘innovation agenda’, and the ‘category offense’, but unless Nike convinces the consumer to break out of a 35-year paradigm of per capita purchasing patterns – it seems like we’re at a point where it’s all about price for the legacy retail models. No?”
- Basketball: Not hugely relevant to Nike, but relevant to retailers like FL where about 40% of sales are basketball. FL recently said bball sales slowed, despite a 4% increase in the number of Nike launches during its reporting period, and a 7.4% boost in average price point?
- Inventory Levels: US inventories were elevated at Nike last quarter, and the company noted that it should be cleaned up by the end of Q3 (Feb). We need to see meaningful progress towards this goal, or at least increased confidence that it is being fixed. Reminder, Nike’s confidence in clearing out inventory might be bullish for Nike, but not necessarily the wholesale channel.
On-site Manufacturing: Nike has kept this out of the forefront of the discussion for two years now. But it’s going to be a very relevant, very soon. Aside from driving the DTC model, it will gain even more leverage over retailers who will pay top dollar (in raw cash, working capital, or in margins) to have this technology in stores. We don’t think Nike will talk about this specifically, but we think it becomes a part of the discussion in the next calendar year.
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"We’re likely to see sub 2% growth in Q4 (ends in a few weeks and the #GrowthSlowing data in NOV/DEC has been obvious)," Hedgeye CEO Keith McCullough wrote in a note to subscribers today. "That means that the probability of a US recession by Q2 of 2016 continues to rise."
Make no mistake. Wall Street had a terrible 2015. This year's consensus playbook was an absolute mess.
A sampling of some recent headlines that caught our eye:
- "For Stock Forecasters, 2015 Was a Hard Year to Get Right" -Wall Street Journal.
- "Warren Buffett has a year to forget" - CNN Money
- "The Big Short Was Only One Reason 2015 Was The Year of the Bears" - Bloomberg.
To be sure, the laundry list of Wall Street misses would be quite the Mea culpa. (But don't expect them to fess up.)
Let's take a quick run through some of this year's scorecard:
- Year-end S&P targets have come up well short of consensus' 2208 figure.
- Energy and financial stocks — supposed "must own" sectors — got train wrecked and are down 26%.
- Stratospheric U.S. economic growth estimates of around 3%-plus have been consistently confounded by economic reality.
- Meanwhile, Wall Street completely missed commodity-price deflation, (which has also run contrary to the Fed's prediction that it would all be "transitory"). The CRB index of commodities is down more than 20% this year.
Hedgeye CEO Keith McCullough reviews the worst calls
For good measure, here's one last example of the old Wall Street swing-and-miss. Oil has tumbled another 42% year-to-date. And yet, most 2015 storytelling began with the idea that lower "prices at the pump" would be a shot in the arm for consumer spending. That didn't work out so well. Consumption is slowing. (See the slide below from our October Q3 Macro Themes presentation.)
The list of Wall Street dogs goes on and on. We digress...
Luckily (for Hedgeye subscribers who stuck with our process) we tip-toed away from the consensus' face-plant and nailed investable ideas around #Deflation, #LateCycle / #GrowthSlowing and #LowerForLonger (rates). These are just a few of our non-consensus calls that proved correct, but confounded Wall Street throughout the year.
To be sure, our 30-some-odd analysts are also having a great year.
- Hedgeye Energy analyst Kevin Kaiser nailed the precipitous fall from grace of Kinder Morgan (KMI) along with broader bearishness on MLP stocks,
- Internet & Media analyst Hesham Shaaban has been spot-on with calls on LinkedIn (LNKD) and Twitter (TWTR)
- Our Healthcare team, led by Tom Tobin with their #ACATaper theme, continues to bear out what they see as a "Perfect Storm Is Brewing in Healthcare."
These are just a few of the many highlights.
Another prescient warning came from Hedgeye Senior Macro analyst Darius Dale back in late July, right before the death knell drop in the S&P 500. The S&P 500 had just made fresh all-time highs and, as Dale wrote, we were seeing a breakdown in a number of key market signals.
That raised this simple question:
"... Sell everything? As predicted in our previous refresh, the recent bullish-to-bearish reversals in Emerging Market Equities, Foreign Exchange and Commodities were, in fact, a harbinger for similar breakdowns across the Domestic and International Equities asset classes. Our recent decision to add SPY to the short side of our thematic investment conclusions confirm how we are thinking about this risk in real time. At the bare minimum, it implies investors would do well to reduce their gross exposure and/or tighten up their net exposure to global asset markets."
It was another big call Wall Street missed. The S&P fell off a cliff, dropping 12% before it bottomed in late August.
Where do we go from here?
If you're sticking with the one Wall Street firm that nailed 2015, then watch next year. Our Macro team has been sounding the alarm on a coming recession that we think may take hold around the end of the first half of 2016. (Click here for our latest recap of the recessionary data stream.)
You'd think that after such a bad year, Wall Street would shape up and ratchet back their rosy forecasts.
Anything to justify buying stocks yet again...
Time will tell whether we're right about a coming U.S. recession. We're sure, however, that you won't hear anything nearly as bold out of Wall Street.
Takeaway: A negative factor cocktail made for a Perfect Storm in November Existing Home Sales. Importantly, December should see the weakness reverse.
Our Hedgeye Housing Compendium table (below) aspires to present the state of the housing market in a visually-friendly format that takes about 30 seconds to consume.
Today's Focus: November Existing Home Sales
We knew the risk was to the downside for Existing Sales in November (see: They Are Who We Thought They Were) as Purchase Application demand was relatively soft in October, the 1st TRID related impacts would be manifest and some modest downside still existed to full re-convergence with Pending Home Sales. In short, we knew it would be disappointing but the extent of TRID related delays and thus the magnitude of decline remained a wild-card.
With Existing Sales down -10.5% MoM and -3.8% YoY, the decline was, indeed, remarkable. It should also, however, be (to quote Team Janet) “transitory”.
Looking to next month, the negative trinity of factors highlighted above reverses as Purchase Applications saw a notable uptick in Nov/Dec, TRID related delays resolve and recoupling to PHS should all conspire to drive a reversal in this month’s reported weakness.
As Lawrence Yun, NAR chief economist, noted:
"As long as closing timeframes don't rise even further, it's likely more sales will register to this month's total, and November's large dip will be more of an outlier."
We infrequently side with stakeholders with an embedded panglossian bias but, in this instance, we’d agree with that expectation.
What has not been transitory is the tight inventory environment. Units of inventory declined for a 4th straight month, retreating -3.3% MoM and -1.9% YoY to 2.04MM Units (note – inventory is not seasonally adjusted so the YoY change is relevant, particularly around seasonal shifts in activity). On a months-supply basis, the noisy decline in sales more than offset the inventory retreat, driving months-supply +8.1% MoM to 5.14-months – marking the 39th consecutive month below the traditional balanced market level of 6-months. Ongoing supply tightness in the 90% of the market that is EHS remains supportive of stable-to-improving HPI trends in the nearer-term.
As always, we’re more interested in the Pending Home Sales data (Nov release = next Wednesday, 12/30) as a cleaner, more real-time read on the underlying trend in purchase demand in the existing market.
About Existing Home Sales:
The National Association of Realtors’ Existing Home Sales index measures the number of closed resales of homes, townhomes, condominiums, and co-ops. Existing home sales do not take into account the sale of newly constructed homes. Existing home sales account for 85-95% of all home sales (new home sales account for the remainder). Therefore, increases in existing home sales tend to signify increasing consumer confidence in the market. Additionally, Existing Home Sales is a lagging series, as it measures the closing of homes that were pending home sales between 1 and 2 months earlier.
The NAR’s Existing Home Sales index is published between the 20th and the 22nd of each month. The index covers data from the prior month.
Joshua Steiner, CFA
Christian B. Drake