NKE | CHANGE

Takeaway: NKE might be the best long-term idea we can find, but there are some serious short-term factors that will cause big buying opportunities.

Conclusion: We think that Nike is perhaps the best idea in retail as EPS more than doubles to nearly $5/shr, which is huge for a large cap name that is already operating at peak margins. The company should add $10bn in revenue over 4-years from e-commerce alone, which should take gross margins at least 5-points higher, past the 50% mark (a level most never thought achievable). But this transformation will also make its Futures model obsolete, and we think it’s a matter of time before it’s no longer reported to the Street. That won’t happen today. But we’ll inch closer as each quarter passes and earnings surprises on the upside, while the order book goes the other way. That’s going to create some fantastic buying opportunities. Though the Olympics and slightly better FX should help order levels and the company’s outlook, we’d rather wait for a point where there is some critical misunderstanding of the company’s growth and financials to make a ‘step in and buy before the event’ call. That does not exist today.

 

DETAILS

We like a lot more about Nike than we don’t, and the story is arguably more investable than ever. This company and story have become extremely complex, but the basic building blocks of what we like can be placed in the following buckets

a) Investing at a greater rate than ever in its product engine resulting in an arsenal that even its strongest competitors can’t replicate

b) Changing up the manufacturing paradigm for the first time in 40 years (initially what most of us know as FlyKnit – but this will change soon), which not only creates margin and working capital opportunities, but also gets Nike even closer to market (i.e. it will get 2-3 months out in an industry that is locked into a 5-6 month order window).

c) Dropping its attitude of deference and respect for the traditional footwear retailing channel, and getting the right product into the hands of the right consumers regardless of the poor growth and real estate decisions made by Nike’s traditional wholesale channel over the past 20 years.

 

Put these together, and we think that you’re looking at an incremental $10bn in sales at a 70% gross margin (vs $31bn in sales at a 47% margin today). When all is said and done, we think that gets you to almost $5 in EPS in four years versus the $1.85 it earned last year. Yes, earnings should more than double in 4-years for a large cap name with stable growth, a bullet proof balance sheet ($3/sh in cash), 75%+ share in some of its core businesses, dominant positioning in a global duopoly, and a structural advantage that could potentially never be overcome (i.e. what Google has over Yahoo).  Does it make sense to us that Nike is trading at an all time high price and multiple? Of course it does. But that doesn’t mean it’s expensive – at least for someone that follows our train of thought.

 

Now, please allow me to talk out of the risk management side of my mouth. This name might look ridiculously expensive for a person with a very short (TRADE) duration, who is only looking in the rear-view. They’ll see peak margins, a peak 30x multiple, and a futures growth rate (THE key stock driver) that has been running at a double digit rate for the past 10 quarters with a risk to reversion to a longer-term mean of 7-9%. Tack on short interest that is running at just 1.1% of the float (basically nonexistent), and the simplest roll in futures could send this name tumbling.

 

Two considerations

  • The first is that the Olympics this summer will definitely boost Nike’s order book. Now…if the futures rate STILL rolls over despite the Olympics, then Houston has a problem. Unlikely. But a strong consideration.
  • Second is that if we’re right, which we obviously think we are, then we’re going to see more than half of growth come from DTC channels – as we saw last quarter when Nike proved to be its own biggest growth engine for the first time in history. But think about it…If we see a $50 wholesale order that used to show up on the order book (futures) all of a sudden turn into a $100 fully consolidated sale through Nike DTC (online, retail), then we’ll have sales, margins and earnings going higher, but futures going lower. This is critical, as when this trend hits critical mass, we’re likely to see Nike start to consistently beat earnings and cash flow, but miss on an increasingly arbitrary statistic known as Futures.

 

The question then is when will PWC recommend to Nike that they stop reporting futures altogether. We think that is a near mathematical certainty. But, will Nike do so during a quarter when they are crushing it on every metric – including futures? Or will it happen in response to an otherwise ugly futures number that is the result of the wholesalers (like FL) tapping out on their ability to order more product because that part of the business is in a decline?  Nike always talks about playing offense. Let’s see if they do it right this time. We’re not worried about a change happening with tonight’s print. But a change should definitely be in the works.

 

Until then, this is a name for long term investors to buy on red as futures numbers revert.