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Takeaway: What happens when you hold a balloon under water for a decade? Watch Nike/Foot Locker and find out.

Conclusion: We spent the better part of last week with investors in London. We went in armed with one of those 100-page slide decks outlining all our ideas. But it took only a few hours for us to realize that the part of our presentation that would get the most traction by a long shot, was the 30-pages we allocated to Nike, Foot Locker and the other Athletic names. While this is a very datapoint-driven space, we’d argue that the biggest disruptive forces in the industry today were started in motion nearly a decade ago when Nike decided to shift incremental capital to build a DTC platform, and fund that with excess growth in the wholesale channel in the US. Now the building part is largely done, and the wholesale channel is very full of Swooshes. People have to get a handle on the economic freight train that’s about to tear through these brick & mortar stores. Without respecting history and decisions made behind the scenes – which might be different from posturing on conference calls – we think that bulls might have just enough research/confidence to sell (NKE) too early, and bears (on FL) might cover a multi-year short way too soon.

DETAILS

We think that bulls on Foot Locker are missing a huge negative fundamental turning point, and bears are bearish for the wrong reasons. It will get far worse than anyone thinks.  This is not the typical ‘internet is taking over, so short the legacy retailers’ call. There’s a lot more to this, and it has been in the works for the better part of a decade. We’re simply just starting to see the result now, which is likely to accelerate every year throughout this as well as the subsequent economic cycle.

Paradigm is Breaking Down. To start, let’s just remember that manufacturing and distribution in the Footwear space has remained largely unchanged for the better part of 40 years since Phil Knight built it. We’ve got the same consolidated factory base in Asia (while there are about 20,000 factories for apparel, there are only 30 factory groups for sneaks), the same consolidated group of Brands (half dozen), and a largely fragmented group of retailers on a global scale.  As such, consumer behavior related to buying shoes has largely not changed, either. While other industries have evolved, this one has not. It’s been very anti-Darwin.

But this paradigm is finally breaking, and we don’t think that people appreciate 1) what has happened, or 2) that the changes started behind the scenes a decade ago, and 3) that the manifestation of said changes is starting to rear its head today – quite purposely at the end of this economic cycle.

This change is great if you own content that consumers want — like Nike, UnderArmour and Adidas. But if you’re stuck between the all mighty Consumer and those Jordan 23s, Nike FlyKnit AirMax 180s, Yeezys or Curry 1s, then you (i.e. FL, FINL, HIBB and most other brick&mortar distributors) are in very deep trouble. Case in point, take a look at Sports Authority, which is headed for Ch11 once again.

This Change Starts with Nike, which leads not only with consumers, but also with innovation, suppliers, distribution, and just about every other area.  Consider this. Nike generates about a 51% Gross Margin when it sells a $100 pair of shoes to Foot Locker. But it garners about a 68% margin when it sells on nike.com. That’s nice, but it’s not what we care about. We care about the Gross Margin dollars – not the rate. On that very pair of sneakers, Nike gets about $23 in Gross Profit from that ‘wholesale’ sale to Foot Locker. But it gets about $85 (by our math) when it sells direct. In other words, there is a magnifier effect, and the dot.com margin dollars go up by a factor of 3-4x.

NKE/FL  |  Critical Context on NikeLocker - 1 25 2016 FL chart1

Anyone wonder why Nike has had such strong Gross Margins over the past year when almost every other global ‘consumer non-durable’ company had its margins kicked in the teeth? Nothing has changed with Nike’s FX exposure – it’s still there. It’s simply been offset by the significant impact of a 68% gross margin e-commerce business growing at 50%. In fact, take a look at the chart below, which shows that in the latest quarter for Nike the wholesale business accounted for only 42% of incremental growth – the first time ever that Nike’s own DTC business carried more than 50% of growth (EVER is a long time).

NKE/FL  |  Critical Context on NikeLocker - 1 25 2016 FL chart2

Furthermore, Foot Locker has always been the most important single entity on Nike’s P&L, but this year FL and Nike retail will be around the same size. Starting in FY17, Nike will be its own biggest customer – and that spread will only accelerate.

NKE/FL  |  Critical Context on NikeLocker - 1 25 2016 FL chart3

                                                                                                                                       

It’s no secret that Nike announced last year that it would grow e-commerce to $7bn by 2020, which is a huge jump from its current $1.4bn (only 4% of sales). We think Nike is sandbagging, by the way, and that it will build its e-comm operation to about $11bn – adding $10bn in e-comm sales in the next 4-years. Let’s say 60% of that is in North America…we’re talking $6bn in incremental revenue to Nike. To put this into context, the entire Athletic Footwear industry is likely to add about $6bn in retail over that time period alone.

Why Now? But nobody is asking WHY Nike is building its e-commerce presence now. We think that could be answered by the chart below that looks at two of its retailers – Foot Locker and Finish Line. It shows the percent of sales that came from Nike over time. This is only through 2014, but by the time 2015 is reported we think they’ll be closer to 80%. We’d argue that both companies are two of Nike’s best off-balance-sheet assets. But mathematically, they really can’t get much better.

NKE/FL  |  Critical Context on NikeLocker - 1 25 2016 FL chart4

Both companies show a material pick up in Nike penetration starting in 2008. For the record, that’s when Nike started materially shifting incremental manufacturing dollars from ‘Lean Manufacturing’ to building an e-commerce platform that was consistent with its Brand name. While percentages may vary among competitors, the slope of the line remains the same. You could look at Dick’s, Sports Authority, Hibbett, Academy, and even Kohl’s, Macy’s and Nordstrom. You’ll see the same trend all around.

The critical point is that Nike accelerated penetration in its wholesale accounts over the past eight years while it built up its distribution network, on-premise manufacturing capability (i.e. you go to a Nike store, build a shoe and it is made before your eyes), and ability to ship single pairs efficiently to consumers rather than a containerload of 5,000 units to wholesalers. We’d argue that Nike funded growth in the DTC platform by way of outsized (and unsustainable) growth at its wholesalers.

Higher ASPs? Not for B&M. So let’s fast-forward… we’d argue that Nike is largely penetrated in virtually all its wholesale doors in the US. We’re seeing higher price points, which is great. But most of those higher-priced shoes are available only at nike.com or Nike’s ‘snkrs’ app. With those two taken in context, is it any surprise that Nike finally said in public that it will massively accelerate its e-commerce? Not at all.

Watch What They Do, Not What They Say. And yes, Nike says good things about Foot Locker on its investor calls. But seriously, what else do you expect? “We’re going to do our best to decimate the equity value of all the hard-working Foot Locker employees!”?  Not a chance. In public, Nike plays very nice in the sandbox, but don’t think for a minute that it won’t do whatever is in its power to drive its own shareholder value. Over half of employees at Nike are paid in stock. They care.  Nike does not have a mandate to gain share at Foot Locker or any of these retailers. It’s perfectly fine staying at 80%, or even drifting lower if need be to fuel its more-profitable e-comm biz.

Retailers Need Nike Allocations, Like a Fish Needs Water. THAT’s one of the keys to FL. While NKE share went from 50% to 80%, productivity went from $380 to $575, and margins went from 3% to 12.5%. FL was closing stores at this time, so it’s tough to say how much was Nike vs then-CEO Hicks being smart. But one thing is clear above all…when Nike as a percent of a retailer goes up, it’s good for traffic, good for ASP, great for margins, and usually a big positive for the stock.

Rate of Change is Critical! Also…and this is important given the pushback we get on this, all we need to see is for Nike’s ascent inside a footwear retailer to stop, and it’s a negative event. So we’re not arguing that Nike is going to hang FL out to dry. But by simply maintaining its presence, or keeping a 70-80% ratio, it is a negative rate of change for FL. What if it goes to 60%? It’s been there before, and there’s no reason why it can’t go there again – not to mention that 60% share in a specific account is nothing short of massive in any industry.


And no, it does not suffice if UnderArmour or Adidas (with Yeezy) picks up the slack on Foot Locker’s shelves. They don’t drive traffic (at least YET in the case of UA).

We think that the biggest financial tie-in for Foot Locker is with its SG&A. Why does this matter? Because the company is sitting on a 19% SG&A ratio, which is the lowest we’ve ever seen for any mall-based retailer. That’s how the company can comp 5%, and leverage that into a 30%+ EPS growth rate. We’ve seen that upside time and time again as FL rose from the ashes since the last recession. But unfortunately, leverage works both ways.

Our estimates for FL three years out are 30% below the street, as we think it’s at peak earnings today.  Importantly, this is not the kind of story that will play out with a simple press release. This is a 40-year paradigm that is unwinding over a 5-year period. We think that three out of four earnings announcements will be negative – over and over again – at least based on current expectations. Along the way, we should see significant multiple compression, and margin erosion that will cut cash flow and torpedo that argument that we hear over and over about ‘FL throwing off so much cash”. It does until it doesn’t.

NKE/FL  |  Critical Context on NikeLocker - 1 25 2016 FL chart5

We think that there are also key changes with the manufacturing process, lead times, transit times, and changes that Nike might make to its Futures Program. All of these are key offensive weapons that the company has been investing in for the past decade. We’ll be back with a separate note on this, and which dominos fall in which order.