Nike Q2: It Depends On How Much Patience You Have

Summary:

• Nike’s Q2 performance missed revenue estimates, and management lowered the company’s revenue outlook for Q3 and Q4.
• Innovation has been paying off for Nike, but it may not be enough to overcome short-term challenges in a promotional environment.
• Nike’s cost-saving program should boost margins and benefit shareholders, but uncertainties remain in the Chinese market.

Investment Thesis

Last time I talked about Nike Inc (NYSE:NKE) back in October 2023, I talked about the company’s first quarter performance and how the company has found its mojo in China. I also highlighted how the Women’s Soccer World Cup helped the company regain its footing in the EMEA region.

Since the article was published, NKE has been up 7.6%. Although the stock has underperformed the S&P 500, which has been up 11.7% during the same period, this is mainly due to the 16% drop seen in the stock post its Q2 results.

In this article, I dissect Nike’s second quarter performance and argue how when it comes to this sneaker giant, long term investors’ patience is going to be tested like never before.

A Snapshot of Nike’s Second Quarter

Nike’s Q2 EPS of $1.03 beat analyst estimates by $0.18, while revenues of $13.39 billion missed analyst estimates by $40 million. Gross margins came in at an impressive 44.6%, expanding by 170 bps, and inventories were down 14% Y/Y.

Management, however, shocked investors by suggesting that the environment is likely to remain promotional during the second half of the year. As such, they lowered the company’s revenue outlook, with Q3 revenues now expected to be slightly negative and Q4 revenues to be up by low single digits, both coming in below street expectations. Furthermore, during the earnings call, management also announced a cost-saving program designed to cut costs by $2 billion over the next 3 years.

Nike’s Bet on Innovation Doesn’t Solve Short-Term Challenges

Majority of the management’s commentary during the earnings call focused on innovation. Even while announcing the cost-cutting program, CFO Matthew Friend mentioned that a majority of the $2 billion in cost savings “will be invested to fuel future growth, accelerate innovation at speed and scale, and drive greater long-term profitability.”

With inventory levels improving, Nike can afford to focus on innovation, unlike a couple of years ago, when management continued to focus on bringing out new products even as existing inventory was at an uncomfortably high level. Some of the company’s latest products did do well in the second quarter. For instance, the company’s latest trail show Ultrafly saw strong growth, in line with the increased popularity of trail running. Furthermore, innovation in the Women’s category, which led to the creation of statement leggings such as Zenvy, Go, and Universa, have also been increasingly popular among women. So, Nike’s ability to innovate has certainly been paying off for the company.

The issue I have is that while innovation will help the company to keep growing in the long-term, it cannot help the company overcome the promotional nature of the environment in the short-term. Indeed, despite introducing innovative products, the company saw Q2 revenues in the footwear and apparel categories decline 5% and 1% y/y, respectively, in one of its biggest markets, North America.

And if one takes a broader picture, it would suggest that Nike management has much to worry about in the third and fourth quarters. For instance, U.S. retail sales during the holiday period, rose 3.1%, according to Mastercard, significantly below estimates of 3.7% and well below last year’s figure of 7.6%. Consumers continued to hunt for “big deals”, as they remained price conscious.

Therefore, while Nike’s ability to innovate makes it a safe bet for the long-term, the innovation is unlikely to mask the company’s short-term challenges given how price conscious the consumer has become. As things stand, in my opinion, it is extremely difficult to predict how long it will take for the company’s innovation to fully play out.

Nike’s Cost Savings Plan Should Further Boost Already Impressive Margins

One of the positives from Nike’s second quarter was that despite a challenging macroenvironment, the company was still able to boost its gross margins. Q2 gross margins came in at 44.6%, y/y boost of 170 bps.

The cost-saving program, whereby the company is expected to cut up to $2 billion over the next three years, would, in my opinion, either keep the margins at healthy levels or boost them even higher. The program therefore, is a blessing for the company, since it should keep its bottom line at healthy levels.

The company will of course channel some of the savings to fuel innovation, but it is unlikely that the amount re-invested would be very high, especially given the macroenvironment that the management is predicting for the second half, and given that the innovation pipeline is already healthy.

Therefore, the real winners of the cost-saving program are likely to be Nike shareholders since this program puts the company at a good position to maintain its generous dividends and buybacks.

Nike’s China Story Continues to Remain Riddled with Uncertainties

Nike’s performance in China continues to remain unconvincing. In Q2, while Apparel and equipment performed strongly, revenues from the footwear segment were down 1% y/y. Having said that, the company saw plenty of positives in the region during the quarter gone by, with brick-and-mortar sales growing double digits during the country’s National Day holiday and the company outperforming the industry during the Double Eleven holiday.

If one takes a more holistic viewpoint with respect to Nike in China, then the picture remains a bit unclear. Nike has certainly made a spectacular comeback in recent months in the region. However, when one combines the macro volatility in the region with how the Chinese economy has fared in recent times, it would still take a few more quarters for things to pan out for the company in the region.

There is a lot to be positive about Nike’s performance in the region, but to what extent the company can sustain the performance remains to be seen.

Valuation

Item	FY24 Projections	Rationale
Sales	$51.7 billion	Company estimates along with author’s projections
Gross Margins	44.9%	Company Estimates
Total Gross Profit for FY23	$23.21 billion	= 44.9% of $54 billion
SG&A Expenses	$17.2 billion	Company estimates along with author’s projections
Other Expenses	$300 million	Mid-point of Company’s Estimates
Tax Rate	18.2%	Company estimates
Total Net Income	$4.7 billion	= (1-0.182) x ($24.25 billion – $17.4 billion – $0.250 billion)
Number of Shares Outstanding	1.20 billion	Source: Refinitiv
Projected FY24 EPS	$3.92
Projected Forward P/E	28.5x	Source: Refinitiv
Forward PEG ratio	1.8	Source: Refinitiv
Projected FY25 EPS	$4.54
Target Price	$130.00	= 28.5 x $4.54

Click to enlarge

Source: Refinitiv, Author’s Calculations & NKE Q2FY24 Earnings Call

NKE now sees FY24 revenues growing at 1%, which would translate to $51.7 billion. The company continues to expect gross margins to expand by 140 to 160 bps. Given the cost-saving program planned by the company, I have assumed gross margins to expand by 160 bps, which translates to 44.9%.

The company’s SG&A expenses, including a one time restructuring charge of $400 to $450 million, is expected to grow mid-single digits. I have therefore assumed SG&A expenses to grow 5%, which puts FY24 SG&A expenses at $17.2 billion.

Other expenses are expected to be between $275 and $325 million, so I have assumed the midpoint figure, which is $300 million. The tax rate is expected to be in the high-teens range, so I have assumed the same tax rate as FY23, which stands at 18.2%.

Combining all these figures results in a net income of $4.7 billion. According to Refinitiv, the company has 1.20 billion shares outstanding, in terms of free float. This results in an FY24 EPS of $3.92.

The company’s historical forward P/E multiple, according to Refinitiv, is at 28.5x, which is the multiple I have assumed for my computations. The company trades at a forward PEG ratio of 1.80, which would result in an earnings growth rate of 16%. This translates to FY25 EPS of $4.54.

At a forward P/E of 28.5x and FY25 EPS of $4.54, the price target of the stock becomes $130, which represents an upside of approximately 27% from current levels.

My valuation on NKE has changed since my last article ($130 vs $121) for three reasons. First, I have based my valuation on FY25 EPS (compared to FY24 EPS last time). Second, I have assumed stronger gross margin expansion for the company during this period (160 bps Y/Y vs 150 bps). Finally, I have assumed a higher forward P/E multiple this time (28.5x vs 27x) because I am of the opinion that the company’s ability to innovate and its cost-saving program should be a strong catalyst for its bottom line.

Risk Factors

In the short-term, there are numerous risk factors to consider. Anytime a company’s management cuts its sales outlook, it implies that the short-term path remains murky. And for Nike, the story is no different. The company has already warned that the environment is likely to remain promotional for the foreseeable future, which suggests that the company’s stock would be volatile at least over the next few months.

Moreover, while the company is focused on innovation, there is always a significant possibility that some of the innovation attempts could fail, which would cause further shocks to the company’s top line.

Finally, the company’s footwear segment continues to underperform across its major regions, especially North America and China. The promotional environment is likely to continue to put pressure on the footwear segment. The extent to which Nike’s innovation can offset this downward trend is extremely unclear.

Concluding Thoughts

At least Nike management was honest when it comes to the company’s near-term future. Management has cut the sales guidance and has adopted a cost saving program to try and offset the macroeconomic headwinds that are likely to persist for the foreseeable future. From a long-term perspective, however, the company continues to remain the best-in-class. Focusing on innovation continues to remain the right move given how this strategy has paid off not just in the quarter gone by but also in the past.

However, from investors’ perspective, there is a tremendous amount of patience that would be needed. The outlook looks murky for the foreseeable future. However, the long-term trends continue to look promising thanks to both the company’s latest tactical move and its track record on innovation.

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Analyst’s Disclosure: I/we have a beneficial long position in the shares of NKE either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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