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NKE: A Lot To Chew On

Initially, this onion smells punk. But when you peel back a layer or two, you see that growth is coming from the right places, and the US is inflecting. Oh, and by the way, guidance is ridiculous.



About 16 hours ago, I was sitting in our conference room in New Haven telling Keith and the rest of our investment team that I’m well ahead of the consensus for Nike. Given that there’s enough levers here such that Nike can print almost anything it really wants, I said that the one number I would be genuinely disappointed to see is a single-digit revenue growth rate. I was at 11.4% vs. the Street at 8.9%. We saw 7.7% -- not good.


Yeah, futures looked good, both in absolute terms and the trajectory. Also, inventories were down 13% on top of 8% revenue and 7% futures growth (+10% futures in constant $). The balance sheet was like an impenetrable wall of iron.

Some people might like the penny beat. But let's face it... Nike ALWAYS beats and guidance was cloudy at best. I’m staying true to my earlier comment/concern on revenue. The good news is that many parts of guidance make absolutely no sense to this (self-proclaimed) rational thinker. Also, when diving into the top line, I’m seeing the composition look better than it might indicate at first blush.


Here are some key puts and takes (in no particular order)…

1)      On revenue growth: There are actually encouraging signs from key parts of the business.

  1. US: North America revenue operating margins and futures all accelerated. In fact, when we look at the math behind the 8% futures growth number, we know that apparel (25%) of total was up mid-teens, which suggests that footwear is up around 6%. Either Nike’s share gain in the US is accelerating materially, or the market (in product other than toning!) is beginning to accelerate. We’ll take either.
  2. The biggest disaster of the quarter was Western Europe. 2% revenue growth, and a 17% decline in EBIT. Perhaps I’m being harsh given that constant dollar futures accelerated from 0% to 7% to 11% over the past 3 quarters. But they gave it all back in FX (from 12% to 11% to -2%). Maybe the metaphor of Western Europe failing to show up at the World Cup is still fresh in my mind and I’m clouding the two. But with EBIT margins down in the qtr by 470bp, you can’t blame me.
  3. Central and Eastern Europe: Here’s some irony for you…but the same countries whose teams are surprising on the upside at the Cup are also doing the same on Nike’s P&L and order book. A coincidence with close to zero investment significance, I know. But humor me...
  4. China is crushing it. Teens revenue growth, with margins up 266bps ON TOP OF 923bps improvement last year. As we’ve noted, China is approaching a $2bn revenue organization for Nike. With a 15-20% growth rate, and less than 30% of its $10bn in COGS sourced in China, we’re approaching a point where a floating Yuan is a wash for Nike – which gives it a competitive leg up.
  5. Japan: The Japanese economy has done a whole lot of nothing for what -- 20 years? Nike’s business is doing much of the same. Seriously, I’m beginning to wonder why they even do business there.
  6. Emerging Markets: 46% EBIT growth and 30% futures??? They’re crushing it here.

The bottom line is that we’re seeing solid growth in the most important regions – such as China, Emerging Markets, Central/Eastern Europe, as well as an inflection point in the US. Results are being dinged by Western Europe and Japan. The former is particularly important, as we can’t flat out ignore it. But the US is 1.7x the size of Western Europe. If the US turn continues, which we think it will, then it could offset much of a Western Europe decline.


2)      Gross margin guidance. I was pretty surprised to hear the company note that full year gross margins should be off by 100bp this year. Actually, my surprise very quickly turned to doubt. Much of the rationale was chalked to FX. But let’s face two facts…

  1. As much as the $/Euro has been all over the map in recent weeks, the weighted average impact across all of Nike’s trade partners is quite benign over the next 4-quarters using prevailing FX rates. Check out the chart below. Prior quarters of major (-100bp+) GM erosion was the result of a -5%-7% FX hit. We’re not anywhere in that ballpark today.
  2. Another point is that the facts show that the company’s least reliable guidance metric has been gross margins – by a long shot. Check out the accountability grid below. It shows what they said vs. what they did. Not exactly predictable. Our strong view is that conservatism won over this time around due to global risk factors, and the fact that they’re just heading into their 1Q11 and want a hurdle that they can clear with their eyes closed.

NKE: A Lot To Chew On - nkefc


NIKE: YouTubing Gross Margin Guidance 

NKE: A Lot To Chew On - Nike Gross Margin Guidance Table


3)      Acquisitions. For the first time ever, I am baking acquisitions into my Nike model – which normally goes against what I stand for. But there are four reasons why…

  1. NKE’s cash and short term investments are topping $5bn, or $10.50ps.
  2. We continue to see decoupling between ROIC and ROE, and both management and the Board knows it, and does not like it.
  3. Bernanke pandered yet again yesterday – in effect keeping the return on Nike’s hard-earned cash close to zero. While I don’t think they’ll relax standards, even an ROIC dilutive acquisition would be better than 0%.
  4. The acquisition strategy will be focused on buying licenses of brands it already owns and controls – as hinted at the analyst meeting.  Converse outside of US/Canada is the best candidate. I’m assuming $500mm in acquisition capital spend by end of calendar year with a 10% yield. Then I’m assuming assuming $1.5 in repo and 25% growth rate in dividend.


4)      Non-op income: Here’s another change to the model. With lower revenue and gross profit from FX (even though I am haircutting vs. the co’s guidance) we need to take up non-operating income due to higher marked-to-market on FX hedges.


NKE: A Lot To Chew On - FX and Non Operating Income


5)     Check this out... There has been only one quarter in the history of Nike where the cash cycle (Days Recievable + Days Inventory less Days Payable) has been less than 90 days. This quarter it came in below 75. No joke...


When all is said and done, I’m at $4.55 for this year, and $5.45 for next. That’s a dime below my estimate heading into the quarter. Though I suspect that by the time the Street is finished hitting plug-n-play on their models, I’ll end up 10-15% ahead. 


As noted earlier today, one of my main concerns is any sort of ownership rotation this name goes through as there is a transfer of earnings from the gross profit line, to SG&A leverage and non-operating income as it relates to how the company manages risk in its business to keep plowing forward.


Yes, I’m disappointed by the revenue. The Street’s numbers will be all over the place based on the guidance. But quite frankly, I don’t know which one of those two I trust less. But there’s much to the components of the quarter that give me the confidence that Nike is executing on the core plan I think is necessary to create value for shareholders.


NKE: A Lot To Chew On - NKE SIGMA


MGM Macau is likely to see continued improvement under Grant Bowie but net IPO proceeds to MGM are still unlikely to reach the suggested $500m.





While MGM Macau is unlikely to ever produce the type of numbers we see at WYNN, we do believe that they can continue to fix the sins of the past and materially improve results at the property.  So what went wrong?


When MGM entered Macau, there was no shortage of hubris.  They embraced the build it and they will come approach.  With MGM’s gaming expertise and brand name, and Pansy’s knowledge of the market, it was a slam dunk, right?  Well, Pansy is not a casino operator and has no experience as a property manager, and MGM did not have a track record of operating successfully outside the US.  MGM brand recognition was indeed high, in the mid 90% range.  Unfortunately, it was the movie studio that was well recognized.  Not many people in Asia knew MGM as a great casino brand.  Oops.


Here are/were some of the problems:

  • Bad layout that appealed to a US player but not an Asian player
    • Fixed
  • No marketing or sales function at the property
    • Now they have a marketing team in place
  • Surrounded by construction
    • Ceased, now that Encore and One Central are open
  • Confusing logo
    • Recently rebranded to MGM Macau instead of MGM GRAND MACAU
  • Had no business plan and strategy
    • We’ll see whether improved performance is a result of market strength and/or Grant Bowie’s strategy
  • Too many FTE’s
    • Cut 1,000 FTE’s from August 2009-March 2010
  • Too much bureaucracy with the 50/50 structure
    • Still an issue
    • Investors will penalize the IPO multiple
  • Too conservative with whom they dealt and lent money
    • Becoming more aggressive in the way they manage their business but only extend credit to players with assets outside of China
    • Increasingly extending credit to junkets

There is no question MGM is benefiting from the incredible strength of the market.  Unfortunately, market share continues to languish after a push forward late last year.  However, margins are expanding and the increasing use of junket and direct play credit should boost share going forward. 




MGM Macau generated only $150 million in EBITDA in 2009.  However, with Grant Bowie’s changes and the strength of the market, we are projecting $240 million for 2010 and $279 million for 2011.  We think it is fair to base the IPO valuation on a range of $250-300 million.  Based on that level of EBITDA, we calculate the net cash proceeds to MGM of only $178-380 million after factoring in expected joint venture debt and the repayment of MGM’s intercompany receivable (~$100MM), which will get repaid before divvying up the IPO proceeds.   We assume 20-30% of joint venture is sold through the IPO. 




Some may argue for a higher multiple range but we think investors will severely punish the IPO valuation for the joint venture structure and a lack of control.  The valuation may be enhanced somewhat by a credible and well-articulated Cotai strategy but investors are unlikely to ascribe significant value to that part of the story given the huge amount of Cotai supply coming online and MGM’s dismal development track record. 


Based on our research and analysis we believe it is unlikely MGM generates the $500 million in net cash proceeds it is expecting.

Austerity's Rift: Europe vs USA

Position: Short France (EWQ)


Heading into the G20 this weekend there’s a noticeable rift between Europe and the USA vis-à-vis the issuance of austerity measures to address government budget deficits: many European countries are wearing the proverbial “accountability pants” to address fiscal imbalances while the Obama administration has yet to critically address the government’s excess spending and future obligations. Maybe that’s why Peter Orszag (Obama’s budget director) is leaving.


Yesterday, in an emergency budget speech, UK Chancellor of the Exchequer George Osborne outlined initial go-forward spending cuts and tax-generating measures (in a formula of roughly 80/20) to shave down the country’s budget deficit. Here are the main tenants of the budget:

  • 25% cut in the budgets of government departments starting April 2011 through 2015 (a spending review is expected for released in October)
  • Tax on banks with liabilities greater than £20 Billion (the tax is expected to generate approx. £2 Billion annually)
  • Increase to the Value Added Tax (VAT) from 17.5% to 20% starting January 2011
  • Increase in capital gains tax for higher tax bracket earners, to 28%. No change (18%) for low to middle income earner
  • A 2 year wage freeze for all but the lowest paid among Britain’s 6 million public servants and a 3 year freeze on benefits paid to parents for rearing children
  • Cuts to the housing benefit and disability allowance
  • Decrease in corporate taxes, staggered over 4 years from 28% to 24%

In his speech Osborne stressed that he is “not going to hide the hard choices from the British people”. Obviously managing growth while cutting spending will be a great challenge for the newly elected Cameron government. UK growth is currently estimated by the Treasury for +1.2% this year and +2.3% next year. Interestingly, the emphasis to lower corporate taxes is in direct response to the government’s fear that an unfavorable tax environment would drive corporations out of the UK.  


Noteworthy, following the budget announcement, Germany and France expressed their support for a bank tax. While we don’t expect any concrete policy to come from the G20 this weekend in Toronto, we do expect the talks to surround the UK’s fiscal tightening and the growing rift between Europe’s “action” and Washington’s “inaction” in shoring up budget imbalances. 


As Keith has affectionately stated: a country can kick the can of debt down the road for only so long.  Maybe America will take a hint from the Europeans.


Matthew Hedrick

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FOMC Update: Professional Politics

Sadly, in what is becoming a proactively predictable statement of conflicted US Federal Reserve monetary policy, Ben Bernanke opted to pander to the easy money policy that has amplified both the volatility of markets and the cyclicality of price inflation/deflation since he took his lead from Alan Greenspan.


Our advice this morning was to respect the cost of capital. Promising a risk free rate of return of ZERO percent to both domestic and foreign investors will not inspire investment. We live in an interconnected world where capital seeks yield. Ask the Brazilians and Chinese what they think about that…


Whatever you do, don’t ask Ben Bernanke and his troubadour of the willfully blind at the Federal Reserve for an economic forecast. If he didn’t see economic growth and inflation in the last 12 months he’s definitely not going to see it now. Like a broken clock, he’ll eventually get it right – the double dip we are forecasting for both the US economy and US housing will be here come Q4. By then, Bernanke will be formally cutting his economic forecasts.


As a reminder, Bernanke’s forecasts on US economic growth are about as far out in the stratosphere of nod as we have seen in some time. That said, given his outlook, he should have the Fed Funds Rate at least 100 basis points higher than where it stands today (he is looking for upwards of 4% GDP growth in the US in 2011). So it’s time he either raises rates in line with his forecast or just takes a chainsaw to his forecasts.


Wait – he can’t cut his forecasts because lowering the GDP estimate will make the US deficit/GDP calculation look worse than Greece’s come 2011. Better hope for another “great depression” that “no one could see coming”, then cut forecasts after the fact I guess…


In today’s statement he went as far as to say that the “labor market is improving gradually.” I couldn’t make that up if I tried. If he’s forecasting these kind of economic growth numbers, I guess he needs to provide a narrative to support the forecasts – this is called confirmation bias (bad).


Looking at the latest monthly US unemployment report and round of May housing numbers, Mr. Macro Market has already provided the only economic forecast that should matter to Americans. As any good risk manager who has managed real capital in his or her life would say, it’s on the tape.


Maybe he’s not serious about forecasting. Maybe he just is who he is – a good natured academic trying his best to be a professional politician.



FOMC Update: Professional Politics - 1

NKE: Thoughts Ahead of the Print

Look for a big beat and a shift in EBIT guidance to be sales+GM to sales+SG&A leverage. It's important to understand the underlying rationale as to why. If people don't get it and the stock trades down, then opportunity knocks for those not involved.



A few considerations heading into Nike this evening.


First off, I’m at $1.17 vs. the Street at $1.05.


2) The big beat should be on revenue. I’ve got ‘em growing 11.4% -- vs. the Street at 8.9%.


3) They might choose to spend some of the upside on the SG&A line, but I’m inclined to think that they show more than one might think. Keep in mind 2 things…

   a) This is their 4Q, and they don’t have as much leeway to push/pull rev and costs between quarters.

   b) The prior year, Nike laid off 7% of its workforce. Morale was awful. The people that made the cut are pumped to be part of the starting lineup. Above all incentives, people at this company are paid based on hitting pre-tax income targets. They NEED to get paid this year.


4) Even though trendline futures should accelerate 300-500bps, Don Blair is likely to be cautious with guidance – like he is every quarter without fail.  My sense is that the company will stand by its ‘high single digit revenue growth and mid-teens EPS growth’ model for the year, though the constituents may change. Why?

   a) The co will have to acknowledge that 1H revenue will be strong – as futures will dictate so. But it will not give any color on 2H.

   b) In that regard, as NKE anniversaries FX benefit on GM and World Cup spend on SG&A, the margin equation will likely shift from being a GM story in 1H to being an SG&A leverage story in 2H.

   c) Tack on the perceived uncertainty about the Yuan (even though Nike’s revenue organization is nearly as big as its sourcing organization in China – ie a Yuan revalue is a near wash), and I don’t think that this guidance will make people step on the accelerator to buy the stock due to a potential ownership rotation – even with a big print.


If the multiple compresses despite better earnings, this is a great shot for those who thought they missed this name on the first ride up.

Softlines Production in China: A Deeper Look

Here's a look at share trends over time for producers of US apparel and Footwear. Don't get caught in the web of extrapolated changes in the Yuan across Softlines retail.


Without a doubt, the question I’ve been peppered with the most this week has been what the dispersion is of apparel and footwear production by country – especially China. Not a surprise given the revaluation of the Yuan.


Here’s some eye candy showing the obvious…that about 36% of apparel that we wear is made in China, but closer to 76% of footwear.  Facts are facts, but I think that these numbers can be misleading. First off, why did China’s apparel share triple over 8 years? Partially bc an archaic quota system was removed that opened up apparel trade between the US and non-WTO countries. But also because the currency arb allowed it to occur. If a strengthening Yuan makes production cost-prohibitive, then several things will happen – 1) China will likely lower its VAT tax to offer some form of relief to exporters, and 2) other Asian and Latin American countries are likely to gain share vis/vis undercutting China on price.


This is not to say that there will not be transitional pains…but simply that we cannot look at Macro changes like this in a vacuum.


Softlines Production in China: A Deeper Look - Apparel Import Table


Softlines Production in China: A Deeper Look - Footwear Imports

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