Andrea Verdelli
Following a plunge of about 15% after its 1Q23 results and having been down more than 50% since the all time highs, I think that it is time to keep Nike (NYSE:NKE) on our investment watchlist for potential buying opportunities. There is no doubt that Nike is increasingly seeing a tougher operating environment and this article hopes to look into this and evaluate if this is a good time to be buying Nike stock.
Investment thesis
Nike is operating in a very difficult environment as supply chain challenges continue to persist, high logistics and freight costs continue and the uncertainty remains with China’s covid policy. However, with the recent elevated inventory situation in North America, Nike looks to be fighting many different battles in multiple regions like China and North America. While the 1Q23 results were actually rather solid, there are significant near-term uncertainties and challenges for Nike. As a result, I think that Nike’s shares are actually fairly valued at the moment, as I will elaborate below, and advise investors to wait for a better entry point when these uncertainties clear up or has been priced in.
1Q23 results were solid
While the share price movement post earnings would have implied otherwise, Nike actually reported beats to its revenues and earnings. Revenues for 1Q23 came in at $12,687 million, 3% higher than that of the market consensus of $12,278 million. In addition, earnings per share came in at $0.93, about 1% higher than the market consensus for 1Q23 of $0.92.
However, looking past the beats of the revenues and earnings per share for 1Q23, there were some pockets of weakness in the business. Gross margins for 1Q23 came in at 44.3%, lower than the market consensus of 45.3%. This was due to headwinds caused by higher freight and logistics costs, higher markdowns seen in North America, and lastly, unfavourable foreign exchange impacts.
China problems
In the quarter, Nike management reported that revenues declined by 13% year on year while EBIT fell by 23%. The decline of China sales to $1,656 million was actually slightly better than expected as there were serious concerns by the market when Nike was heading into the 1Q23 results that China sales could cause a miss as there were many challenges faced by the China business due to the lockdowns imposed in the country. As such, I think that while there were negative impacts to the business with regards to the disruptions to Nike China’s operations as well as offline traffic in its stores, the management of the business operations was rather satisfactory for the quarter. I think that what was done well is that management continues to be proactive in adjusting its supply to the changing demand situation and as such, this led to better management of inventories than expected.
In my view, this is a short-term pain for Nike as tough operating environment in China causes some challenges for the overall business. However, in the long-term Nike remains the top brand amongst Chinese consumers as the strength of the Nike brand is one of the best in China and difficult to replicate. Furthermore, we are seeing more anecdotes from management that product innovation continues to bring real advantages to the business as they see very strong demand for its newer performance products like the Alphafly Next% 2 and the Pegasus 39. In addition, it was encouraging to see that Nike was gaining interest from Gen Z consumers in China as their demand grew 25% year on year. Lastly, the inventory levels in the region actually decreased by 3% year on year, as management was able to successfully sell off more products than they had anticipated.
As a result, I think that things are improving for the China business as management continues to remain confident in being able to reduce its higher inventory levels by the end of the year, and the long-term prospects of Nike in the region looks to be improving. Therefore, I think that management has done well in China thus far in a very challenging environment for the business, proving to investors that they are able to execute well in these situations.
Moving forward, for the remainder of the calendar year, I think that Nike has to carry out a balancing act in order to continue to meet expectations in China. The country remains to be one of the few with strict zero covid policies that is directly impacting Nike’s China business. While uncertainties remain about whether the government may change its policies, I think that there are increasing uncertainties about the Chinese economy as the zero covid policies takes a toll on the economy. As a result, I think that management needs to take a cautious approach in China in the near-term to balance the risks of a slowing economy with worsening consumer sentiment and one that might open up and reduce covid related restrictions. All in all, I remain confident in Nike in China in the long-term, but still remain cautious on the business given the risks we see in the region today.
North America inventory problem
While North America sales increased by 13% year on year in the 1Q23 quarter, inventory increased by 65% year on year in the North America business, while in-transit inventory grew even faster at 85% year on year growth. This in-transit inventory now makes up almost two-thirds of total inventory in North America. Taking this as it is, the higher inventory levels are certainly a big cause for concern as there are worries of a global slowdown that affects retail businesses like Nike, and this is certainly not a position that investors will want Nike to be in heading into the second half of the calendar year.
Delving deeper into the inventory problem, it looks like Nike is experiencing more of a timing issue. The higher inventory position was a result of timing issues due to multiple factors. First, there was the lower base of 1Q22 as inventory levels were suppressed at lower levels due to factory closures in Southeast Asia as a result of covid related disruptions. Second, management said that the higher levels of inventory was also a result of the deliveries of the past 2 seasons products that came in later than expected. Third, there was also an early delivery of this year’s holiday products. Lastly, supply chain disruptions led to uncertain transit times, as the long transit times in 2H22 reduced significantly in 1Q23, which resulted in the pulling forward of holiday orders. Putting all these together, this resulted in higher levels of inventory in the 1Q23 quarter.
The next step is how long will this timing issue last and what happens as Nike aggressively reduces excess inventory. The latter is slightly more predictable as it is expected that as Nike tries to reduce excess inventory in North America, we will see pressures on gross margins for the region for the rest of the year. Importantly, management did guide that they expect that 10% of Nike’s North America inventory will be subject to markdowns to clear the excess inventory.
As such, there will be a negative impact on gross margins for Nike in the rest of FY2023 as the company looks to offload and sell off its excess inventory position and recalibrate its North America business.
I am of the view that while the timing issue will likely be more easily addressed by management as the supply chain situation stabilising, barring any new supply chain problems emerging, the main concern investors might have pertains to the higher levels of inventory that Nike currently holds. While demand may still appear resilient in 1Q23, for the remainder quarters of the year, we may see demand fall off as consumer sentiment turns negative. With higher levels of inventory and a need to compete in a more promotional environment, this implies that management is walking a fine line as it has a huge balancing act on its shoulders in the next few quarters as it demonstrates its execution capabilities.
Reduced guidance may not be enough
Guidance was adjusted based on the fact that Nike continues to expect strong consumer demand, while factoring in the supply chain situation. The guidance for FY2023 sales is now in the low to middle single digits growth, as the company incorporates a larger headwind from foreign exchange fluctuations of negative 800 basis points compared to the previous negative 400 basis points impact expected.
Gross margins were understandably reduced as a well, as management expected a drop in 200 to 250 basis points year on year for gross margins, compared to the initial expectations of about flat to negative 50 basis points for gross margins. This is a result of the increased pressure on gross margins due to aggressive selling in the North America market resulting in negative 150 basis points pressure to gross margins, while the higher freight and logistics costs continue to bring about negative 100 basis points impact to gross margins. Lastly, foreign exchange headwinds also will contribute to negative 70 basis point impact to gross margin for FY2023. There will be some offset to these negative impact to gross margins as management expects some positive impacts from improvements in SG&A expenses.
Valuation
While it can be argued that from a P/E multiple perspective, Nike is trading below its historical average P/E after the heavy selling post 1Q23 results, I think that the shares of Nike are fairly valued at this moment as management has not yet baked in any potential weakness from the consumer end into its FY2023 guidance. While the macroeconomic environment remains uncertain, there are many signs that the slowdown in the economy could be inevitable and as such, consumer demand for Nike’s products could deteriorate in the near-term. That said, I incorporate in my financial model and forecasts Nike’s industry leading position, strong brand name, and resilience supply chain and inventory management practices.
Based on my DCF model, I assume a terminal multiple of 15x year 5 EBITDA, and discount back by a discount rate of 9%, deriving a 1-year target price of $94, implying 8% upside from current levels. As a result, I think that Nike’s shares are indeed fairly valued at the moment and the risk reward perspective is fairly balanced.
Risks
Macroeconomic environment
This is the biggest risk to Nike at the moment as investors are not convinced that if the macroeconomic environment worsens, the elevated inventory position could bring elevated risks to the company and prove to escalate the impact of what was a mistiming issue with the supply chain.
China risks
As Nike’s growth story depends in part on China, with continued covid disruptions and supply chain challenges, it could bring additional problems to the management team in China as it navigates a rather difficult operating environment in the near-term. That said, if China does not slowdown as I expect, then there is a chance that China may provide some positive upside to the investment case for Nike.
Conclusion
I remain optimistic about Nike’s long-term prospects as it looks to remain a market leader in the industry given its continued strong brand equity and growth story in China. That said, I remain cautious on Nike in the near-term as there are many problems that Nike needs to face in the near-term and it is walking a very fine line as it looks to balance these challenging environments. In China, while things do not look as bad in the 1Q23 report, I think that uncertainties remain as China’s covid policies remain unclear while the Chinese economy looks to be weakening. In addition, Nike’s North America business faces its own elevated inventory problems caused by mistiming issues. As a result of this higher levels of inventory, management expects weakness in gross margins for the rest of FY2023. Furthermore, this higher inventory position results in elevated risks for Nike should consumer demand fall as the macroeconomic environment deteriorates. My 1-year target price of $94 implies that the stock is fairly valued at the present moment and I think that investors should remain cautious on Nike shares in the near-term.
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