NKE | When Futures Fails to Lead…

Answer me this (and I know how most people will, but hear me out)… Nike put up an absolutely killer growth algorithm – leveraging 5% sales growth to 24% EPS growth, it beat the quarter by the second-widest margin in a decade ($0.68 vs our $0.61 and Street’s $0.53), EPS growth is #accelerating – full stop TREND and TAIL, the company just sandbagged the upcoming quarter and set up a 10-15% earnings beat at a time when sales are stabilizing (#fact = I’ll get a dozen replies saying that’s wrong).

For any company on the planet (not really, but you get it) this would be ragingly bullish. But of course, the herd of Wooly Mammoths in the room is the fact that North America Futures decelerated from -4% to -9%. Newsflash: Nike is losing share in the US. The world has known this for 18 months. Over the weekend, I stated the following…

• From a TAIL perspective, I WANT to see futures eroding and revenue accelerating – that’s the only way people will more consistently track the real underlying trends as opposed to what a 40-year old metric tells them (only 55% of the US biz – used to be 98%).

I meant what I said and I said what I meant.

Check out this chart showing the increased vol (ie lessening importance) of futures vs revenue. I could make the ‘futures don’t matter’ argument all I want. I’d be intellectually dishonest if I did, bc futures definitely matter – but they matter half as much – literally HALF – as over the past two decades when it was all that drove EARNINGS. Unfortunately, if you map out revenue trends based on futures in North America, you’re gonna be right for a day on the stock, and then wrong meaningfully on the model – and then the stock.

All in, I took my numbers up after this print. Nike guided to about $0.49-$0.52 for 4Q. I’m at $0.57, and am comfortable there.  My point for a while has been that revenue is stabilizing – sooner than people think. Would I have liked to see an acceleration in the quarter? Yes. That would have been more consistent with my call on the event. But to be clear we did not see an erosion in growth. Also consider the new Air Max and Zoom X (in the VaporFly 4%) cushion platform initiatives (also 2 others, but are smaller). These things have multi-year tailwinds – and are leveraged across all performance (and even everyday) categories.

At the same time Nike just missed GM% for the fourth time in a row. In Hedgeye-speak, that’s bullish. We’re anniversarying the margin/inventory gaffes of last year. We still have issues in the US, but on the margin, they are easing. Now we see a massing 175bp 4Q(May) GM% guidedown. I’m at -120bp.

Nothing from this print changed my TAIL call, and I think TREND setup will lead to 10%, 5%, 13% and 25% upside in 4Q, May ’18, ’19, and ’20, respectively.

If I was ‘captain long only’, or a HF with the mandate to own a company that won’t bow to the puts and takes associated with a 40+year paradigm being uprooted, then I’d own the heck out of it. And I’m not just saying over a super-duper long term horizon. I’d own it today as a money maker over 1-3 quarters (well before the late Dec print). I think people will be looking at $3.10 in EPS power for ’18 Calendar, with growth accelerating and Gross Margins recovering meaningfully – on its way to 50% GM. If that’s worth today’s 22x p/e – it’d probably be higher barring a major correction in the market. That’s a $68-$70 stock in nine months if I’m right.

The TAIL call (2-3 years) is probably closer to 25x on $4.00 = $100. I hate to seemingly pick a multiple out of the air, but if my thesis is correct, then we’re looking at a 20% EPS CAGR on a high-quality company with one of the best brands in the world, a pristine balance sheet, and a track record that’s simply not touchable for most companies in consumer discretionary.

Here’s what keeps me awake on this one.

Perhaps the biggest ‘multiple-compressor risk’ for Nike… If I’m a PM who owns it large, the last thing I want to see is a high-quality multinational flush with cash that will get dinged by the translation benefit of a strengthening dollar, and yet FAILS to see growth accelerating in the core US market. In other words, it captures the dollar downside, but fails to capture any domestic upside – and is underweight US retailers as it relates to benefits from tax reform. Would we see down earnings in this scenario – NO, I don’t think/model that we would. But if the bull case goes to $3 per share, then there is absolutely no reason why we cannot see a 15x multiple on that bad boy. There’s your $45 stock. We’d need to see serious brand erosion from here for that to happen – which means that the increased capital spend around the brand needs to have a negative return – which is highly unlikely. But I gotta at least consider this.

Near-term, that’s a draconian $10 down, or a very plausible $14-16 upside – with a call option on a double. I like that in a space that’s otherwise not long-able.  

 

Now here are the points from the print that concern me…

1. E-comm. The biggest negative for me is a paltry 18% growth in e-comm. No explaination other than ‘promotional’ – but that should drive sales – just at lower margin. If I was with Mark Parker in an elevator and could ask only one question, it’d be about this.
2. Just ‘Bag’ Futures disclosure and be done with it. The company is ridiculous with its fitures disclosure. We all know this already, but they can release futures numbers a minute after the end of the conf call w no discussion on the call? Just stop disclosing them and put us out of our misery (seriously – the company has a free pass to do that TODAY).
3. Cagey on ’18 – bc it has a pass to be. When management says “we’re in the early stages of our May 18 planning process” I don’t know who they think they are fooling. The fiscal year begins in 10 weeks. If the company is REALLY in the early stages of planning the year (which it’s not) then we should all be very worried. Management sounded confident bc the company already knows its plan – and it’s a good one. (ie better than consensus).
4. Defensive language – that’s rare for this company. I call foul on the “we’re still the biggest and best brand in the US” bit from management. They NEVER say that. It’s an irrelevant comment as it relates to the stock price if your losing share. That’s like Villanova saying ‘we’re the best in the Big East’ and then being beat by Wisconsin.
5. NKE ≠ HBI. What’s this ‘Edit to Amplify’ thing? While it makes sense from a Management Consultant standpoint – ie 75% of SKUs account for 99% of revenue – the reality is that this is Nike. That ratio is not that bad. If we have to hinge this model, in part, on some tag line that sounds WAY too much like HanesBrands’ ‘Innovate to Elevate’ initiative, then it’s a thin call (which it’s not).

Oh yeah, and I definitely walked away much more bullish (less bearish) on FL. I booted it down to the Short Bench. Nike needs it more than it has in years as it relates to US distro – especially with Nike e-comm only +18%. FL should comp msd for the next few quarters. If it doesn’t – then there is a SEVERE problem with that model.

HERE’S OUR NIKE NOTE FROM THIS WEEKEND

TAIL: The call is big…and our numbers match.

• Reversing a stale 40-year paradigm with how product is designed, manufactured and distributed.
• This is FAR deeper than the simplistic ‘Nike doing more e-comm’ call. If it was that easy to do, it’d be there already.
• Nike is playing down this strategic shift, and the consensus believes ‘em.
• Those that do believe think Nike started this process 3-years ago. They’re wrong. Try 11. We’re in the 8^th inning of the investment. Now harvesting.
• The shift to a DTC model ‘gifts’ Nike 4-6 points in revenue growth (consolidate the full $180 p/pair price instead of $81 wholesale equivalent).
  • Adds $12bn in revenue by May’20.
  • Incremental margin goes from 12% to 27%.
  • EBIT margin tests 18% vs 14% today.
  • EPS CAGR accelerates from 10-12% to 20-22%.
  • EPS of $4.25-$4.50 in May’20 – 30% above the Street.
  •  The only real downside is the model becomes more capital intensive.
    • DSOs down as shift to direct model, but
    • Finished goods inventories likely up more – even though new technology gets Nike 50% closer to market.
    • Payables extend due to added leverage over supplier base (including new US manufacturing partners – FLEX, and the companies Nike is seeding to keep FLEX ‘honest’).
    • Capex likely to trend up materially – from 3% of sales (peak in industry) to 5%. Gotta build up scale and spend the coin to support a 50% gross margin.
  • I mind increased capital intensity, but keep the following in mind.
    • Due to higher operating margins, we still get RNOA going from 44% today to 50% by May20.
    • Nike is extremely underlevered. I never gave it credit for high returns on capital, bc it simply did not invest enough of it (ie rising ROIC and declining ROE).
    • We’re finally seeing Nike put more money to work. Say what you want about Nike being a big spender…the reality is that it has proven itself as an extremely responsible and effective steward of capital.

TREND – revenue should drive the ‘3-Quarters or Less’ duration.

• The biggest factor that matters as it relates to the next 2-3 quarters is the trajectory of top line growth.
• The consensus thinks that we won’t see double digit top line growth here for another 7 quarters. SEVEN. ‘innovation dead, adidas, Jordan on a decline…’
• I think we’ll see it within three quarters. Here’s why...
  • Does anyone REALLY think that heads did roll as soon as it lost incremental share nine months ago?
  • Nike can get product to market much faster than most people think. It has 45 years of product it can tap in order to get retro product to market. We saw it this part quarter with a LeBron retro – exclusive initially to FL. We also saw it with an Air180 Flyknit – that actually looked nothing like the (increasingly stale) FlyKnit as we know it.
  • That’s exactly why FL is still comping – bc Nike is pushing in more product sooner than it had otherwise planned.
  • I’ve got North America sales accelerating by 400bp this quarter – the Street has zero incremental growth.
  • Sorry to disappoint – but I’m not giving ‘my futures estimate’. The reality is that the company does not even know the number until a week before the print. There are more moving parts than anyone thinks -- it’s arguably easier to model Global GDP bottom-up.
    • What I will say, however, is that we started to see a bifurcation in Revs vs Futures two quarters ago. That will continue.
    • I’ll never say ‘futures don’t matter’. Bc they do – directionally. But the R-squared breaking down fast.
    • Could NA futures be down 4% again? Of course. Could be down 6%. BUT, can just as easily be +1. Find me anyone who’s modeling that.
    • From a TAIL perspective, I WANT to see futures eroding and revenue accelerating – that’s the only way people will more consistently track the real underlying trends as opposed to what a 30-year old metrics tells them (only 55% of the US biz – used to be 98%).
  • Ultimately, I’m at $0.61 for the quarter, up 12.3% vs last year. The consensus is looking for a 3% EPS decline to $0.53. Realistically, Nike will keep guidance unchanged for the rest of the year – giving bears ammo to say that ‘Nike beat and guided down’. I’m Ok with that. In 4Q I’ve got EPS growth accelerating to 17%.

TRADE

Yes, the stock is working for the year-to-date. But short interest is at an 8-year high, revenue should accelerate, and if I’m right on the headline beat then this stock could start with a $6 very quickly. If I’m wrong on the top-line, however, I’m going to end up being wrong on the TREND call as well as the TRADE. While I’ll be the first one to beat McGough up over that one – I can’t imagine anything will come from this event to de-rail the TAIL call – which is about as big as I could find...period.