Nike: Dump On The Rally (NYSE:NKE)

The market often falls in love with stocks and Nike (NYSE:NKE) is one of the prime examples in the current market. Despite the weak apparel retail market and the fact the footwear giant was one of the worst offenders with over ordering, the stock is one of the priciest in the market. My investment thesis remains ultra Bearish on the rally back to $130.

Selling More For Less

Nike has focused the last 2 years on selling a lot more product, but the company hasn’t focused much on improving profits. The recent FQ2’23 results were a prime example where revenues were up a whopping 17% over last year and some 29% over the pre-covid levels of $10.3 billion in the November 2019 quarter.

The problem is that Nike has only generated a small boost in EPS during this period. For the last quarter, the adjusted EPS was just $0.85 while the athletic apparel giant earned $0.83 last year and $0.78 back in FQ2’21.

The company faces this scenario due to entering the 2022 holidays with extreme inventory levels. The company saw inventories double to nearly $10 billion causing gross margins to plunge.

The big issue showed up in the gross margins where the FQ2’23 margin plunged 300 basis point to only 42.9%. The athletic footwear giant had regularly pushed the gross margin 46.5% in the last couple of years.

Nike had to spend the holiday season liquidating excess inventory making one question whether sales would actually end up in the year ahead without the lower pricing. The company still has an inventory balance of $9.3 billion, up 43% from the prior year period.

Worth noting is that Nike has seen sales surge without a huge boost in operating expenses. Demand creation expenses were only up fractionally from the prior year to $1.1 billion. Total SG&A expenses were just 31.0% of revenues and the footwear giant is probably going to need to spend more to continue to capture the market in the future. Without constrained SG&A spending, EPS would’ve fallen dramatically with the lower gross margins.

The biggest risk to the sector is that Nike ends up giving up sales like every other sector that saw solid growth during the wild covid years of the last couple of years. Most consumers were pushed into more outdoors and athletic pursuits in the last couple of years with the ability to work from home, but the return to the office might force more spending on work clothes over workout or casual outfits.

Oddly, Asset Panda detailed past inventory issues listing Nike with a pattern for running into inventory issues. The blog post didn’t even discuss the current problem questioning the premium valuation assigned to the business.

Worse Case

The biggest problem facing shareholders is that Nike has already generated massive growth since the start of covid, yet the earnings targets aren’t very high in relation to the stock price. While analysts are forecasting a huge rebound to earnings, the stock already trades at 27x FY25 EPS targets of $4.74.

The athletic footwear company will need a whole lot to go right over the next few years to continue growing revenues at a nearly 8% clip annually. On top of this, the company has to turn in massive EPS growth once the inventory issue is resolved by the May quarter as forecast by consensus estimates.

A company with ~8% revenue growth targets in FY24 and FY25 after coming out of a period where sales were possibly elevated by the push towards outdoor athletic entertainment and work from home isn’t appealing trading at a lofty valuation. The best outcome is that Nike continues to report solid revenue growth leading the industry higher while margins return to prior levels allowing the company to hit aggressive EPS growth.

The worse outcome is a scenario where Nike faces consumers having closets full of athletic apparel and footwear leading to a growth slowdown. In this scenario, the stock has substantial downside with EPS targets falling from current levels.

Under the best outcome scenario, the stock shouldn’t have much upside, but Nike might rally back to yearly highs of $150. Under the worse outcome, the stock could fall some 50% with the best possible price of $80 with Nike trading at 20x the $4 EPS estimates for FY24 and a possible scenario where EPS cuts lead to an even lower price for the athletic apparel company. Nike might only generate a $3 EPS stream similar to back in the 4 quarters prior to covid. A simple 20x multiple of those earnings leaves a stock in the $60s, or over 50% below the current price.

Takeaway

The key investor takeaway is that investors shouldn’t chase the recent rally in Nike. The stock could rally back to the 52-week highs of $150, but Nike is already priced for perfection here. The biggest risk to investors is that some scenario along with the worst case outcome unfolds leading to a much lower stock price. While this isn’t the base case, investors need to fully understand the upside potential is low while the downside risk remains a very plausible outcome.