Description

We believe Nike is a short because earnings and multiple are at risk because competition is getting stronger at a time when the category is shifting away from Nike’s core competency.  Bulls under estimate secular headwinds around pricing and marketing trends and are generally too optimistic on the post-Olympics trade.  We believe Nike’s top line and earnings power will decelerate to mid to high single digits, and that its multiple will compress to slightly above its historical average.  This appears to be an opportunity to short a halo stock that is just beginning to lose its brightness.  At the current level of $59, the upside/downside is favorable.  We arrive at a PT of $44 based on FY17 eps of $2.10 multiple by a 20x.  Our FY17 estimates are based on a top line decelerating to 8%, flat gross margins and increased market spend.  We also use a 22% tax rate.

Nike’s market share is at risk.

·         The Global Sportswear Market (apparel and footwear) grows mid-single digit.  Nike has growth at a 9% CAGR over the past 5 years.

·         We believe that Sportswear Market and Nike growth rates will ultimately converge towards normalized apparel industry growth rates of low-single digits.

·         We believe that there are many cycles within the athleisure secular trend.  (If you believe that athleisure is a fad, then we are in late innings).

·         Nike has 23.2% share of the global and footwear market and 25% in NA.  Within North America, Nike is fully distributed at 24,000 points of distribution (vs. Under Armour at 11,000).  There are no more doors for Nike to open.  Nike is ramping its ecommerce biz, but that is still less than 10% of sales and won’t drive incremental unit sales.  China is also a hope.

·         The Sportswear Market has become crowded with sophisticated, well financed and increasingly panicky players who are chasing athleisure growth.  The cost of retaining star athlete and athletic program sponsors are skyrocketing (see below) even as the market is shifting away from performance and towards fashion.  This is exacerbated by online celebrity endorsers (Kanye West, Rihanna, Drake and Kendrick Lamar, etc.) who have a combined Facebook and Instagram follower base larger than the base of Nike’s elite athletes.  Nike is indexed to performance, while Adidas is indexed to fashion.  As a result, Adidas group is significantly outperforming the market (+4% in Q2 YTD), which suggests its finally regaining market share from Nike (+1% in Q1 YTD) and other players in North America.  Adidas group North American footwear revenues are up 28% in Q2 YTD.

·         The traditional market for Nike is shrinking (i.e. the specialty sports channel is closing stores and the department store channel has gone ex-growth).  Retailers are no longer beholden to Nike, and are supporting other brands.  Recent results point to declining purchases of Nike product by Foot Locker and Dicks Sporting Goods.  FL plans to open a flagship store in NYC that is brand agnostic.  Considering Nike accounts for over 70% of FL sales, this is a big deal.

·         In order to drive unit growth, Nike is being forced to sacrifice price (see below).  This will ultimately hit gross margins.

Negative pricing trends and increasing marketing spend will pressure earnings growth.  We are seeing high single digit earnings growth vs. mid-teens by sell side.

·         Bulls point to double digit, compounding earnings growth.  The uber bull case is that operating margins can grow from mid-teens to high teens as their “Category Offense” gets traction internationally and as Nike builds out vertical manufacturing.  We don’t believe either of these will occur any time soon.

·         For 3Q FY16 (most recent quarter) pricing for footwear and apparel in North America turned NEGATIVE at -1% and -3%, respectively.   This is the first time in several years that pricing has been negative.  This is important because price/mix has been a significant driver to the top line.  We believe that the $130 price point for basketball shoes is the new battleground price.  As evidence of this, we have seen increased discounting of the $180-$250 sneakers as well as confirming comments from retailers.

·         As demonstrated in the table below, price (i.e. higher ASP) has been the most significant driver of gross margin improvement and this is now reversing.

Source: Company filings

·         Marketing spend will pressure margins.  It is clear that athletic brands cannot grow without athletes (or celebrities) wearing their product.  Just over the past year, endorsement contracts have become outrageous.  We believe that Nike, Adidas and especially Under Armour are chasing endorsements at the worst time in this trend.  Each brand is forced to bid up for assets in order to prevent competitors from acquiring them.  For contracts that were up for bid over the past year, here are a couple of examples:

o Basketball.  Nike signed Lebron James to a lifetime contract reportedly worth a $1b and Kevin Durant to $300m for 10 years.  Adidas signed Damian Lillard to $100m for 8 years and James Harden to $200m for 13 years.

o Soccer.  Nike appears to have won the Chelsea contract away from Adidas for more than £60m per year and is rumored to be negotiating a £78m per year deal with Barcelona Football Club. Adidas pays Manchester United £750m and Real Madrid £1b, each for 10 year deals.

o Under Armour needs to use equity to entice athletes’ interest.  They extended contracts to Steph Curry, Cam Newton and Jordon Spieth, each likely with significant equity stakes.  This is because Under Armour doesn’t generate enough cash to compete in absolute dollar amounts with Nike and Adidas.  And Under Armour is getting more aggressive in the English and German soccer leagues.  In the least, they are disrupting the bidding processes.  http://espn.go.com/nba/story/_/id/15047018/how-nike-lost-stephen-curry-armour

o College athletic departments are also chased after by the athletic brands.  http://campusinsiders.com/news/richest-apparel-contracts-college-sports-10-22-2015

o We view the race to sign athletic assets as analogous to what happened when television networks outbid one another for sports rights.  The industry decelerated and subscribers shifted their viewing preference leaving the networks, like ESPN, with bloated contracts.  Should the athleisure trends decelerate meaningfully, the athletic brands will also be left with bloated contracts.

Nike growth is over indexed to Brand Jordan, which is decelerating and has an uncertain trajectory.

·         Mgmt has disclosed that Brand Jordan accounts for approximately $2.5b of total.  Mgmt hopes to grow this to $4.5b or by FY20.  Growth is expected to come from category expansion (i.e. sell to women and kids) as well as endorsement of athletic assets (i.e. Univ of Michigan is said to be placing the Jumpman logo on their sports uniforms).

·         Brand Jordan only accounts for 8% of sales, but we estimate it accounted for 20% of total sales growth for FY15.

·         Our channel checks are now suggesting fatigue for Brand Jordan from key accounts.  Specifically, there are too many launches.  According to Solecollector.com, there were 118 SKU launches alone in April 2016, 16 of which were Brand Jordan (15% of industry launches, but only 2% of industry sales).

·         We believe that Brand Jordan will face the similar unit and price deceleration that has plagued Nike’s Signature basketball shoe footwear in FY16.

·         The chart below illustrates how important ASP is for Brand Jordan.  We believe that ASP’s are in decline as the market moves to the $130 price point.

Source: Sports Scan

Sell side sentiment is high, long onlies are getting nervous and Nike cannot fail at the Olympics.

·         Sell side sentiment his high:  28 Buys, 8 Holds and 0 Sells.

·         But, 70% of the top 20 holders have been net sellers of Nike stock.  Short interest is only 1%.  There has also been a renewed interest in Adidas given its margin growth potential and reemergence which is shifting capital out of Nike.

·         Summer Olympics may not be the bolus that is expected.

o Bulls point to historical trading patterns post Summer Olympics suggesting that product innovation drives demand after being introduced at the games.

o Over the past two Summer Olympics, Nike introduced highly innovative products.   In Beijing, Nike introduced the Hyperdunk basketball shoe and the Lunarlite sole.  In London, Nike introduced the Flyknit Volt shoe.  Both Games were critical and marketing boons for Nike and these products helped drive valuation higher.

o As such, it is imperative for Nike to introduce similarly innovative products in Rio for the bull case around the Games to play out.  Thus far, Nike has only introduced lace up shoes and newer versions of older models.  The tone (Zika, political) and scandals (doping by athletes) could prove to be a headwind not just for the Rio Olympics but also for Olympic Games, in general.  Recall how long it took for baseball to recovery from its doping scandal.

Valuation is high and the timing to short is good now.

·         Sales have missed the last two quarters.  The historical relationship between Futures Orders and Revenue is breaking down, and Nike is not immune to bloated inventory levels.  For now, bulls are trying to explain away why the Futures and Revenue relationship is broken.

·         Over the last 35 years, Nike’s average growth rate has been 16.5% annually, while the average 1 year forward P/E multiple has been 15x, and occurred during amazing times for Nike (Jordan, Tiger Woods, Bo Jackson, etc.).  These compares to a current revenue growth rate of 9-10% and a current multiple of 23x.

·         Further, the spread between the 1 yr. forward P/E of Nike vs. SPX is near all-time high.

Catalyst

Deceleration in footwear market and resurgance of Adidas, Under Armour and other athletic brands.