Takeaway: Nike will be a huge stock…over a 3yr duration. All of that said, no killer story is linear We'll take the under on the headline.

Let's be clear about something...we think Nike will be a huge stock, but that's over a multi-year (3-Yr) duration as the company simply annihilates both its own guidance and consensensus expectations as it adds $10bn in DTC revenue, $10bn in wholesale sales, and on top of that, a whopping $12-$13bn in Gross profit.  Yes, do the math, that's an incremental gross margin of 62.5% -- something that this industry has not seen since Converse started selling Chuck Taylor's in the early 1920s. Check out our comments below where we articulate the reasons behind this change, and why this has been in the works for the better past of 12 years, but is finally manifesting now.

The NKE story has 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 $33bn 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 $2.00 and change it will earn this year.

All of that said, no killer story is linear... (unless it's one of those linear 'race to the bottom' stories). There are a few things we definitely think pose risk to the quarter, futures, and guidance.

1. FL – About a month ago, Foot Locker management was the most bearish it’s been on Nike in roughly 56 quarters…yes, that’s 14 years. At first it was the discussion about how Basketball was down mid-single digits in the quarter. And mind you, basketball is 40% of the revenue, and Nike has a 95%+ share of FL basketball. That’s about 38% of FL revenue base that was under pressure. But then we heard CEO Johnson talk of the ‘big turn’ at Adidas, and how he would like more product from both Adidas and Under Armour. Of course, some if this is directly tied to Nike’s decision to push its own DTC agenda, but anytime we hear talk of price resistance at the high end of the Nike price spectrum we listen.

 

2. Concessions to the Sporting Goods channel to stabilize DKS – The sporting goods channel is facing the liquidation of 20mm square feet of retail space between TSA and Sport Chalet in the coming months, that will put clear price and sales pressure on Nike’s key distribution partner Dick’s. Nike does not want the customer accounting for $1.4bn in retail sales under financial pressure. There’s no doubt that the vendors, especially Nike, Under Armour and Adidas, are helping Dick’s out. Ed Stack absolutely played this down when asked on the last conference call, but the vendors would throw a fit if Stack commented on this – especially in detail – so he just dodged it. Is Dick’s getting better product? Yes. You may have not seen it yet, but you will. Is Dick’s getting a better price on existing product? Probably not. But is likely to get better terms on it, which will help its cash conversion cycle. The fact that Brands are growing faster with their own Direct business is irrelevant. They need at least one strong National retailer in this space.  In the end, it’s a net gain for Dick’s and a net loss for the brands, including Nike.

 

3. Inventories getting better in US – Inventory clean-up is well past complete at NKE (see NA SIGMA chart below), which has been a drag on margins for the better of 6 months. The supply chain, looks relatively healthy, with the sales to inventory spread at DKS going from -6% to -1% sequentially in 1Q16 and FL posting a positive sales to inventory spread. The only laggard is, you guessed it, FINL which reported a 300bps deceleration in that metric at -7%. That bodes well for the margin equation in 4Q and FY17, which already has the tailwind from the higher margin DTC business growing ahead of wholesale distribution.

NKE | More Can Go Wrong Than Go Right - 6 28 2016 CHART1

4. Brexit – Just when it appeared that currency may inflect to a topline tailwind in 2016, the UK’s decision to leave the EU sent the Euro back down to the level seen 3 months prior, and the Pound to all-time lows relative to the dollar, down 15% yy. The UK and Ireland are Nike’s largest territory in Western Europe which grew 14% in 3Q16. The region in total accounted for ~20% of sales and 30% of EBIT in FY15. Growth is now at risk since it is likely that economic growth will deteriorate in the coming years as Brexit slows both immigration and foreign investment.  Even if growth for Nike continues, the FX impact could essentially mean no growth on a reported basis for the next 12 months. At the very least it’s a convenient excuse for management to talk down earnings expectations over the near term.

As it relates to futures, our sense is that an uptick will be viewed by most as Olympic-related, or unsustainable otherwise. If they're down, then the market machine will blame Price Resistance at the high end, UA and Curry, and most of all, the huge momentum we're seeing out of Adidas.  We'll take the under on the headline.