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Investment Thesis
The macro-environment finally caught up with Nike, Inc. (NYSE:NKE) as inventory levels and logistics costs along with problems in China led to an unimpressive quarter. In this article, I argue why there are plenty of issues plaguing the company in the medium term and why, in my opinion, the company’s management has not learnt their lessons.
Even Nike Digital Can’t Save the Company in China
Performance in China continued to remain a drag as evidenced from the company’s Q1 performance with revenues down 15% YoY and 11% on a currency-neutral basis. Operating margins declined 23% on a reported basis. Even the star of the previous quarter, Nike Digital, could not save the company in the region as sales from that vertical were down 5%.
The company management continued to maintain that a turnaround is due soon. During the earnings call, they pointed to the 25% growth in demand from Gen Z members and to the newly launched, localized Nike App becoming the number one brand shopping app, as signs that business sentiment is improving in China. The numbers coming out from the region, however, suggest otherwise. The dip in the performance of NIKE Digital is further proof that things in China continue to look dire for Nike.
Nike’s Excess Inventory Levels: Is Management Making the Same Mistake Again?
One of the standout items from Nike’s Q1 numbers was the excess inventory levels, which together with increased logistics costs, were responsible for a 220-bps decline in gross margins, as the company was forced to implement higher markdowns, especially across North America. Overall inventory levels were up 44% to $9.7 billion, primarily centered around North America.
Management, during the earnings call, attributed the excess inventory to a combination of transit time volatility, the decision made by the company to buy inventory for future seasons earlier, and the comparable inventory levels staying low last year due to factory closures in Vietnam and Indonesia. They now expect Q2 gross margins to decline by approximately 350 to 400 bps as a result of their decision to aggressively discount out-of-season products and lower the inventory levels. NKE’s management, during the earnings call, also tried to reassure investors and analysts by mentioning that Q2 is expected to see the worst of this inventory reduction and that post-Q2, they expect these levels to normalize.
I see a lot of problems with the final part of the management’s argument, which is that inventory levels are expected to normalize post-Q2. Nike was already at risk of suffering from an obsolete inventory given that transit times were elevated, as highlighted by the management during the Q4FY22 earnings call. The risk became a reality in Q1, so the excess inventory levels, in a way, are unsurprising.
The risk that the company now faces, however, is one that is induced by the management’s actions. I think John Donahoe and Co., made a huge mistake by placing orders for future seasons now, because I don’t think they have fully appreciated the extent of the slowdown that’s about to hit the company’s major markets.
When asked directly, during the earnings call, whether the management’s Q2 guidance factored in any potential recession, CFO Matthew Friend argued that they did not, because they continued to see strong consumer demand. Furthermore, he also said how they have seen double-digit growth in retail sales in the EMEA region, which was incidentally, the company’s lone bright spot in Q1. While these data points are certainly positive, these are early days. With the Fed’s moves threatening a strong slowdown, which might even transpire into a recession; the United Kingdom, which in my opinion, is falling victim to political moves that make no sense; and the rest of Europe on the brink of an energy crisis as a consequence of its economic war against Russia, I don’t see how company executives can confidently say that Q2 would be the worst and the rest of the fiscal year will go smoothly?
Furthermore, the company continues to utilize its strong innovative pipeline and bring out new products, which are already attracting tremendous amount of demand. Once again, while this is great news for the company, the question then becomes how does NKE continue to sell its old inventory, which given the company’s product pipeline, appears to be obsolete already?
I am just not sure how the company is going to get out of this vicious cycle, which, in my opinion, is of the company’s own making.
Nike Digital Continues to Shine Albeit At A Significant Cost
The company is not without its positives. Nike’s direct-to-consumer segment, NIKE Direct continues to do well, primarily because of the continued outperformance of NIKE Digital, its digital vertical. However, even within these positives, there’s reason to worry. As the Digital vertical shines, behind the scenes, the company continues to invest more money into this vertical as it fine-tunes and perfects it across all the company’s major markets.
Operating overhead expenses were up 12% YoY in Q1, amounting to $3 billion, and investments in technology and NIKE Direct costs were the main reasons behind it, along with the usual culprit, wages. Therefore, while the digital arm of NKE does continue to grow in all the major markets with the exception of China, the growth does come at a significant cost to the company.
Valuation
|
Item |
FY23 Projections |
Rationale |
|
Sales |
$47 billion (1% growth YoY) |
Company estimates along with author’s projections |
|
Gross Margins |
43.5% (250 bps decline) |
Company Estimates |
|
Total Gross Profit for FY23 |
$20.45 billion |
43.5% of $47 billion |
|
SG&A Expenses |
$15.98 billion (8% growth YoY) |
In line with FY22 |
|
Tax Rate |
17% |
Company Estimates |
|
Total Net Income |
$3.71 billion |
($20.45 bn – $15.98 bn) x (1-0.17) |
|
Number of Shares Outstanding |
1.56 billion |
Source: Refinitiv |
|
Projected EPS |
$2.38 |
$3.71 bn/1.56 bn |
|
Historical Forward P/E |
29.4x |
Source: Refinitiv |
|
Target Price |
$70.00 |
$2.38 x 29.4 |
Source: Author’s projections and Company’s Q1 Press Release
Nike now expects reported revenue growth of low to mid-single digits now that management expects 800 bps of foreign exchange headwinds. Given the macro headwinds that are out there and given that I am not convinced with the company’s moves with respect to inventory, I assumed a 1% growth in revenue, which translates to $47 billion in FY23.
The company now expects gross margins to decline by 200 to 250 bps compared to FY22. I assumed a decline of 250 bps given all the issues plaguing the company, which translates to FY23 gross margins of 43.5%.
The company’s SG&A expenses are expected to increase by high-single digits, so I assumed that they would increase by 8%, in line with FY22 growth rate, which translates to FY23 SG&A expenses of $15.98 billion.
The tax rate is expected to be mid-to-high teens, so I assumed a tax rate of 17%. Combining all these assumptions, the FY23 net income for the company amounts to $3.71 billion. According to Refinitiv, the total number of shares outstanding amounts to 1.56 billion. This leads to an FY23 EPS of $2.38.
The company’s 5-year historical forward P/E multiple stands at 29.4x, which is roughly where it’s trading now (26.82x), so I assumed this multiple in estimating my target price.
Combining all of this, I arrive at a price target of $70 for the company, which suggests a further downside of nearly 20.5% from the closing price on Tuesday, October 11, 2022.
Upside Risks
There are factors that can act as growth catalysts for the company, which would adversely affect my bearish thesis. For starters, the Men’s Football World Cup, which starts next month in Qatar could generate substantial sales for the company, to an extent that it allows the company to reduce its inventory levels at a faster pace than what I have factored in.
Then there’s a small but significant probability that the global slowdown is not as severe as expected and a recession is avoided or is short-lived, which would support the management’s predictions that inventory levels would normalize post-Q2.
Finally, there’s the possibility that the company recovers in China at a faster rate than expected, which would be a substantial boost to the company’s fortunes, especially for the Digital vertical.
Concluding Thoughts
One could argue that Nike is a company that has all the ingredients to recapture its glory days. However, in the medium term, I don’t see many positives for the company. I firmly believe that the company’s management has mismanaged its inventory levels again as I don’t think they fully appreciate the extent of the slowdown that’s about to hit the company’s major markets. Moreover, the company would require more investments in NIKE digital if it’s to sustain its growth, which, while great for the long term, will most certainly be a medium-term headwind.
While the upcoming Football World Cup in Qatar and next year’s Women’s Football World Cup could provide some relief, given the scale of inventory management the company has on its hands and given the macro environment the company currently finds itself in, that relief is likely to be negligible.
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