This quarter definitely has the bears quaking in their boots. Unfortunately I’m one of them. Solid quarter – penny beat after the $0.03 tax benefit – but the top line number was all that matters – and with 13% growth (8% constant currency), and with 3% growth in North America, it’s all that the bulls need to see. Quite frankly, it’s been years since I heard Nike management more bullish on a call. The top line numbers support it, though I also think it HAS TO send an extremely positive message to the ‘rank and file’ to stem the internal toxicity flowing through the org chart in Beaverton. But that bullishness is all that matters today. If the company’s bullishness wasn’t diametrically opposed to the direction of the consumer in nearly every region of the world and the dysfunction in the organization today, I might consider covering here.
Here's Why I’m Still Short it.
- The artful element here is that the company stealthily took down the full year EPS by 5% suggesting only 5% EPS growth for the year – which is pathetic for a company of this caliber. It also hockey-sticked it – implying down earnings in the first half, and an acceleration in sales and margins in 2H. The guide down was part of my short call in that we’d see a 1Q guide down on top of a good 4Q print, and then setting up Nike to miss the hockey stick for the first time in 5 years.
- With the US business growing in the low single digits – something it’ll be hard pressed to accelerate over the course of this year – it’s relying on global growth to drive this operating model. That’s the problem. If you listened to our Macro Team’s 3Q themes today, you’ll see that we’re basically ‘short the globe’. Very bearish on Europe, Emerging markets, and even looking for more moderate growth out of China.
- On top of that, Nike should feel the effect of the employee churn in another two quarters. Nearly every person I speak with on the buy side dismisses this, but it’s a real risk. We’ve seen press releases that 11 people have been fired – which is huge. But what’s huger are the other 50 people that my sources say have been let go at levels just below the threshold needed for a press release. Nine out of 10 of these have been on the brand/product/marketing side. That’s a difficult hurdle to overcome.
- Aside from slowing growth, if there’s one thing that gives me pause it’s the flow through rate. The company grew its top line by 13%, gross profit by 15%, and yet EBIT only grew by 4%. I get the World Cup spending, but one thing that was abundantly clear is how NKE is upping the ante on spending in its direct to consumer business. This is permanent. It’s not one of those short term ‘ah, let’s give em a pass on weak flow through bc of a one time investment’ thing. SG&A leverage is simply not in the cards here. This is a multi-year spending initiative. It’s 100% worth it to facilitate the burst in growth we should see meaningfully impact results in another 2-3 years. But its here and here to stay. This needs to be a top line and margin story. The biggest bull case re financial setup into 1Q is that Nike reverted to Quad 4 in our SIGMA framework – the best inventory position we’ve seen in 20 quarters. That mitigates 1Q margin risk.
- Speaking of digital, this was – by a country mile – the most bearish Foot Locker read I’ve ever heard from a Nike call since 2002-2003. I didn’t even count the number of times management talked about digital and DTC. It was a lot. I think it mentioned wholesale once in a positive manor. DTC accounts for 29% of revenue today, and the digital component grew at 41% this quarter. When you do the math, there was a 170bp positive impact to sales simply by the gross up of bringing sales in house. That also suggests that its US wholesale business was down. I’m short FL, and very comfortably so.
- Today Nike is trading at the highest relative multiple in history. For real… Historically trades at about a 25% premium to the S&P if we go back 10 years. On more ‘temporarily depressed’ earnings in recent years it’s tested a 50% premium. But today we’re looking at 100%. I repeat – 100%. Never been higher. Ever. If Nike can buck the global growth slowdown in 2H AND cruise right through the employee angst/transition without missing a step, then it deserves every last bit of its 32x multiple. But I’m taking the under on that one.
When we issued our Black Book on going Short Nike after capturing the long term move to the upside, I said at $75 that this is ‘dead money at best’. Needless to say that after-hours trading is telling me that I’m flat out wrong in that regard by $4 at a minimum. But let’s reverse engineer the earnings we need to see on what is a realistically sustainable multiple for Nike. I hate to pick one out of the air – but it’s one of the greatest brands in the world, a great steward of capital, and a (volatile) long term EPS grower of 12-14% with a killer balance sheet. What’s that worth? Let’s give it a 50% premium to the market. We’re looking at about a 25x multiple. That gets us to $3.15 in EPS this year to justify the current price. I’m at $2.53. Shorts will capitulate on this print, but not me. The leaps of faith you need to make in order for this to be a $85-$90 stock are so far beyond my comfort level.
Is Inventory Understated?
The inventory position looked great relative to sales growth. However, we think Nike’s internal Fx practices may be causing inventory to appear lower than reality.
As part of Nike’s centrally managed Fx program, standard foreign currency rates are assigned twice per year to each geographic operating segment. These rates are set 9 and 12 months in advance based on average market spot rates.
Inventories for cost of sales for geographic operating segments reflect the use of these standard rates to record non-functional currency product purchases in the entity’s functional currency. Differences between assigned standard foreign currency rates and actual market rates are included in Corporate.
A market outlook for a weaker dollar in the past relative to quarter end would be deflationary for reported inventory levels just as a strengthening dollar will be inflationary for future inventory levels.
This would be a good IR follow up question.
