NKE | Full Contact Chess

1. This print was not a surprise. We noted that more could go wrong than right with this release, and that’s exactly what we saw. Even though the earnings algorithm was very respectable, and far better than any direct or even fringe peers, the fact is that every metric that matters turned negative on the margin.
   1. Sales missed. Nike confirmed price pressure with basketball that retailers raised last month.
   2. Futures slowed sequentially, and missed expectations in every region.
   3. Gross Margins were uncharacteristically weak.
   4. Inventories were quite weak – eroding sequentially by 500bps relative to sales.
   5. SG&A remains elevated (Olympics).
   6. Guidance suggests an acceleration throughout the year – but isn’t that a stretch w/Brexit and 23% of Nike’s sales in Europe?
2. “So…Hedgeye Retail geniuses, how in the world can you be bullish on this stock.” From a TREND perspective, we’re not. But if there is one single factor that people will miss in the quarter, it’s that the near-term stress to the model – particularly given that it involves friction with Nike’s US wholesale accounts (FL, FINL, HIBB, etc…) a channel Nike has increasingly stuffed over the course of this economic cycle – will lead to draconian change to Nike’s business model.
3. Our TAIL call is that Nike will add $10bn in incremental DTC at a 20 point margin premium to what it has today. Let’s be real about this…making a transition like this – especially in the US – will not be without its stretch marks. Nike won’t do this – and by ‘this’ I mean taking FL, FINL down from 70% of its inventory purchases from Nike to something about 20 points lower – when its business is humming. It will do so when it has to start playing some defense, like it is today. We’ll see similar moves by Nike at most other retailers except Dick’s – which is the sole winner here aside from Nike.
4. The punchline on Nike is that going from $2.00 in EPS to near $5.00, which is what we think will happen as it consolidates and builds a massive DTC business, is not a linear move over four years. There’ll be quarters along the way where the profit and growth algo looks pitiful. But that’s how Nike rolls, and it’s worked like a charm so far. Keep in mind that its capital investment to build this new business (and other business it’s not even talking about yet) are largely complete. That means when it kicks in it will be lightning fast, and ROIC-accretive almost immediately.
5. The Stocks
   1. NKE: We’d watch Nike drift lower from TREND perspective as the tape gets muddied by channel shifts. For people looking beyond two quarters, we’d be buying on the weak days, because the TAIL call here is extraordinarily powerful.
   2. FL: We’re short it. There’s no way FL comes out of this smelling better than it does today. Sales should weaken, gross margins should decline (remember 20%+ Europe exposure), SG&A and capex will BOTH head higher at FL tries to build up a more successful e-comm business. Management is good at FL, and it will spend where it needs to – and after its Nike business went from 50% to 73% of revs over six years it really did not have to invest at all (hence unsustainably low SG&A). Now that changes.
   3. FINL: Ditto as what we said with FL – except the part about good management.
   4. HIBB: It’s probably too strong to say that this is ‘terminal’, but it’s close. Growing into more expensive and more competitive markets, no online presence, and maxed out with Nike – all while sporting the highest margins in the industry. We’re modeling that margins get cut in half. No joke. Short.
   5. DKS: The one winner as it takes advantage of a generational land-grab with three competitors going Ch11. In addition, Nike will look to DKS as its new poster child for the retailer getting the most incremental Nike product. DKS already set expectations low for this year. Downside is minimal, and upside is tangible. We like this one. 

Basketball Energy ‘Really High’, Sales Not So Much

There was a considerable amount of real estate allocated on the call (particularly Q&A) to basketball, so forgive us in advance for beating a dead horse. We heard a lot from Nike management about Lebron James the athlete, and his win for the hometown Cleveland Cavaliers, but little about the Lebron product. Same goes for KD. As Nike echoed FL commentary on the premium product price resistance by what it didn’t say. And some of what it did say clearly validated the problem if you read between the lines. For example, look no further than the comment about the KD9 which sold out in its first limited release. The only problem is that the shoe retails at a 17% price discount to the KD8 at $150…close to the Kyrie and Chef Curry kicks price point. Definitely not where wholesalers expect Nike to be.

When it all shakes out, Nike’s basketball business was up 11% for the year. Nike Brand basketball was actually down 1% for the year, while Brand Jordan meaningfully drove the category in aggregate. For some odd reason, Nike started to disclose basketball excluding the Jordan brand – though one would think that the company would try to mask weakness in Nike basketball by lumping both together. We’ll give ‘em a golf clap for that one for transparency.  Though the 11% combined number is good at face value, keep in mind that it had been growing 20%+. Yes, Nike has the full portfolio to offset some of decelerating basketball growth, but the gap in ASP between a basketball shoe and a casual running silhouette has to hurt a little. The brunt of that, we think trickles down to its retail partners.

What It Means For Foot Locker, and other wholesale partners…

From 2009 through the 1^st half of 2015, FL rode the Nike basketball wave as category growth went from LDD to high-teens, FL comps felt the lift from a recession hit (and pre-Hicks agenda) -6% to HSD. Now as the Basketball tailwind rolls off, and FL turns more bearish on NKE than it has been in 14 years, we saw comps decelerate at FL from 7.8% to 2.9% in 1Q16. With NKE readjusting the price/value equation as evidenced by the KD9, that ASP tailwind that FL has relied upon for so long goes away, but the mall traffic problem still persists. Yet, the street is assuming that FL can re-accelerate growth in the back half of FY16 as comp compares continue to remain elevated. With Nike’s, results today, especially in this category we give more credence to the negative 2QTD comp commentary by FL, and are more bearish on its ability to shift the tides through the balance of the quarter.

This Isn’t Good For Foot Locker (or others) Either

This is as glaring a statement as Nike has ever made to its traditional wholesale partners. Yea, it buttered up the likes of Dick’s Sporting Goods and Foot Locker with statements on the call, but those are just words. The numbers here speak for themselves…mainly the acceleration of DTC as a % of total Nike Brand growth from ~20% in 2012 to 70% in FY16. In YY growth rates that’s the difference between 15% wholesale growth in 2012 and 2.8% growth in 2016. That point was hammered home in the most recent quarter when DTC grew 20%, and wholesale was flat. Maybe, the TSA bankruptcy and other disruptions offer a 1-2% buffer to the wholesale number this quarter, but the trend is overwhelmingly anti-wholesale.

Yes, there is plenty of talk about the outsized growth from AdiBok and UA footwear – but to keep things in perspective, for every 1% share in Nike NA footwear the company pulls away from the wholesale channel, AdiBok and UA would need to grow their corresponding businesses at 6% and 14% respectively.

Gross Margin Masking the DTC Benefit

By our math, the gross benefit in the quarter from outsized DTC growth (+20.4% vs. wholesale flat) should have been in the range of 50bps. That assumes an e-comm GM of about 70% and store GM of 50%. Unfortunately NKE doesn’t operate in a bubble and the combination of Fx and inventory management issues tampered the benefit, and will continue to do so through the first half of 2017. We still think the opportunity exists for Nike to continue to blow through historical peaks on its way to a 52% gross margin. But, over the near term there will continue to be volatility as NKE continues to learn from its new distribution paradigm. Some of the forces are outside the company’s control (Fx), but the inventory bloat accentuated by a sales to inventory spread of -6% looks like some severe growing pains caused by owning more of the distribution.

Soft Guidance

Nike guided as softly as a lunarlon insole, taking down 1Q expectations up and down the P&L. Top-line growth estimates disappointed at mid-single digits vs. 9% expected, gross margin assumed down 100bps vs. 80bps of leverage expected, and SG&A up mid to high teens vs. expectations +14%. NA is the biggest contributor to the downward top-line growth revisions (some attributable to NA sporting goods bankruptcies), capped off by FX pressure and unforecastable European softness due to the announced Brexit. SG&A makes sense given the push with the Euro Cup and Brazil Olympics, but we’re more than a bit surprised by the soft gross margin guide as the DTC engine continues to crank.

Looking at the full year, guidance implies growth accelerates in the back half. Overall numbers are relatively in line with consensus expectations with revenue up high single digits, gross margin +30-50bps, and SG&A up high single digits, with gross margin being main divergence, a bit lighter than the expected +70bps. This would imply FY2017 earnings per share growth in the high single digit range, below the prior initial guidance of low teens growth given on the 3Q call when TSA issues were known.  We criticized UA for having to guide down on Sports Authority after reiterating 2016 on it weeks before, but perhaps Nike could have been more proactive when it became apparent its #4 wholesale partner was going away, who appears to have never been mentioned on a conference call.