Nike: Gearing Up For The Olympics Through Innovation

Summary:

• Nike’s third quarter performance exceeded expectations, with higher revenues and EPS despite headwinds from restructuring charges and demand creation expenses.
• The company’s pivot to innovation is still in early stages, with some positive signs of consumer acceptance but no significant impact on overall fortunes yet.
• The upcoming Paris Summer Olympics could provide a catalyst for Nike’s latest innovations and offer evidence of the success of its innovation strategy.

Investment Thesis

Last time I talked about Nike, Inc. (NYSE:NKE), I talked about the company’s second quarter performance and how the company’s pivot to innovation is likely to test the patience of investors.

In this article, I analyse the company’s third quarter performance and offer an update on how the company’s innovation is progressing, and argue how the Paris Summer Olympics should be a positive catalyst for the company’s latest innovation.

Third Quarter Highlights

Nike had a better-than-expected third quarter. Revenues came in at $12.43 billion and while they were only marginally higher y/y, they beat analyst estimates by $136.5 million. Non-GAAP EPS came in at $0.98, beating analyst estimates by $0.22. Gross margins continued to remain impressive, expanding by 150 bps (1.5%) to 44.8%, despite taking a hit of 50 bps (0.5%) due to restructuring charges. The company continued to spend on demand creation, as evidenced by a 10% y/y increase in demand creation expenses, which subsequently caused SG&A expenses to increase 7% y/y.

Going forward, the company, however, sees headwinds arising from a combination of higher markdowns, franchise lifecycle management and worsening foreign exchange. As such, the company now expects gross margins expanding by 120 bps. SG&A expenses, however, although expected to grow low single digits, are expected to come in better than the management’s prior guidance.

The company, as a result of franchise lifecycle management and the subdued macro outlook, sees revenues in the first half of FY25 to be down low single digits. However, overall, FY25 revenues and earnings are expected to grow y/y.

Nike’s Innovation Strategy: It’s Still Early Days

Last time I wrote about NKE, I mentioned how Nike’s pivot to focus on accelerating innovation cannot offset the tough macro conditions in the short term. This continues to be the case, even after the third quarter.

However, some signs show that consumers are warming up to the company’s new designs. For instance, during the Q3 earnings call, management disclosed that the company’s new models entered its top 20 growing footwear franchises during the third quarter. Innovation in basketball footwear, through Ja, Sabrina, and Kobe, helped the company generate double digits in the third quarter in the basketball segment. Finally, the company’s launch of Alphafly 3 helped generate growth in the running segment.

Despite these positives, there is still no sign of a tangible shift in the company’s fortunes. Innovation continues to be a long-term bet and at this point, the company is focused more on generating demand, as evidenced by the $1 billion in demand creation expenses, and on undertaking structural changes in anticipation of the innovation paying off in the long term. For instance, the company continues to ramp up investments in design, product creation, and merchandising. The company has already pulled back existing models such as the Air Force 1 and reduced the supply of Pegasus as it becomes set to launch the new Pegasus 41.

As mentioned earlier, the franchise lifecycle management is expected to weigh on gross margins, and as acknowledged by the management, is also expected to create short-term headwinds in Nike Digital. And the ramped-up innovations have only translated into a 4% y/y growth in North America and a 3% y/y growth in the Greater China footwear segment. EMEA saw a decline of 3% y/y in the footwear segment.

Paris Summer Olympics Should Offer Much Needed Catalyst for Nike

There is a potentially strong catalyst for NKE, arriving in the summer, in the form of the 2024 Paris Olympics. Earlier this week, the company launched Olympic kits for the teams the company sponsors, which include US athletes across all sports, the athletics teams of Canada, China, Kenya, Germany, and Uganda, the basketball teams of China, France, Japan, and Spain, and even the breakdancing team of Korea.

The Paris Olympics should act as a catalyst for revenue growth for the likes of Alphafly 3. Furthermore, the company also launched new products on the Air Platform, for athletes in track & field, football, and basketball, ahead of the Olympics, which should also boost revenues. Finally, in the build-up to the Olympics, the company is also set to launch Maxfly2 and Victory 2 in May, the Pegasus 41 in June, and the G.T. Hustle and the Air Zoom Mercurial in July.

The Olympics could not have come at a better time for the company, especially since, as I mentioned in the previous section, the company is betting on its “multiyear innovation cycle,” amidst a challenging macro environment. To what extent the company can translate the Olympics fever into tangible sales would provide investors with sufficient evidence of whether the company’s pivot to innovation is working.

Nike’s China Story Shows Promise

The last time I wrote about Nike, I thought that Nike’s China story “remains unconvincing.” The third quarter, however, was more promising, as all three segments (Footwear, Apparel, and Equipment) showed positive growth in the regions, albeit in single digits. NKE’s Apparel segment, in particular, continues to be impressive, generating 11% y/y to date.

And while Digital continues to underperform, this is not surprising, given that Chinese consumers are shifting their preferences from online shopping to shopping in physical stores. Furthermore, although NKE’s DTC strategy in China continues to underperform, its wholesale segment is offsetting this. In the third quarter, the wholesale segment grew 12% y/y, more than making up for the 1% decline seen in Nike Direct. NKE’s Jordan brand grew double-digits in the third quarter, and with the company launching the region’s first Jordan World of Flight in Beijing last month, I would expect the segment to continue to demonstrate strong growth in the coming quarters.

Valuation

Item	FY24 Projections	Rationale
Sales	$51.7 billion	Company estimates along with author’s projections
Gross Margins	44.5%	Company Estimates
Total Gross Profit for FY23	$23 billion	= 44.5% of $51.7 billion
SG&A Expenses	$16.71 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	$4.9 billion	= ($23 billion – $16.71 billion – $0.3 billion) x (1-0.182)
Number of Shares Outstanding	1.19 billion	Source: Refinitiv
Projected FY24 EPS	$4.12 billion
Projected Forward P/E	27.5x	Source: Refinitiv
Forward PEG ratio	2.06	Source: Refinitiv
Projected FY25 EPS	$4.67
Target Price	$128.00	= 27.5 x $4.67

Click to enlarge

Source: LSEG Workspace (formerly Refinitiv), Author’s Calculations, Seeking Alpha & NKE Q3FY24 Earnings Call

NKE management continues to see FY24 revenues growing at 1%, which would translate to $51.7 billion. However, as mentioned earlier, gross margins, as a result of higher markdowns, franchise lifecycle management, and worsening foreign exchange, are now expected to expand approximately by 120 bps, which translates to 44.5% (vs my previous estimate of 44.9% due to the assumption of gross margins expanding by 160 bps).

The company’s SG&A expenses are now expected to grow by low single digits, a definite improvement from the prior guidance that assumed a growth by mid-single digits. I have, therefore, assumed an SG&A growth rate of 2% and this is mainly due to restructuring charges. According to management guidance, SG&A would have been flat if restructuring charges were excluded, so a 2% growth is a reasonable estimate in my opinion. This translates to FY24 SG&A expenses of $16.71 billion.

There are no changes to my assumptions on other expenses and the tax rate. So for my calculations, other expenses are assumed to be $300 million and the effective tax rate is assumed to be 18.2%. Combining all these figures results in a net income of $4.9 billion. According to LSEG Workspace (formerly Refinitiv), the company has 1.19 billion shares outstanding, in terms of free float. This results in an FY24 EPS of $4.12.

The company, according to LSEG Workspace (formerly Refinitiv) currently trades at a forward P/E of 23.5x, significantly lower than its 2-year historical median multiple of 27.5x and its 5-year historical median multiple of 30.5x. From a long-term perspective, I am optimistic that the company’s innovation will pay off. However, given the challenging macro environment NKE currently faces, I have assumed the forward P/E of 27.5x for my calculations as opposed to 30.5x.

The company, according to Seeking Alpha, currently trades at a forward PEG ratio of 2.06, which would translate to earnings growth of 13.3%, which is in line with its long-term average EPS growth, according to LSEG Workspace (formerly Refinitiv). Furthermore, the FY25 EPS growth rate is half the EPS growth rate expected for FY24, which is realistic in my opinion given the challenging macro environment. At this growth rate, FY25 EPS is expected to be $4.67.

At a forward P/E of 27.5x and FY25 EPS of $4.67, the price target of the stock becomes $128, which represents an upside of approximately 39% from current levels.

I have reduced my price target marginally (the previous target was $130) for two main reasons. I have assumed a lower forward P/E multiple compared to last time (27.5x vs 28.5x). And the FY25 earnings growth has also been reduced.

The significant upside in NKE’s stock should not come as a surprise. The stock is already down a little over 8% in the last month, which includes a 7% decline post the earnings release. Having said that, investor sentiment on the stock is extremely negative, as evidenced by the D+ grade on Seeking Alpha’s Momentum Grade. As a result, I would expect the stock to continue to face headwinds in the near term. My valuation is based on a long-term perspective.

Risk Factors

My risk factors for the company have not changed since my last article on the company. The short-term path for the company remains murky. Macroeconomic conditions across all its key markets continue to be challenging, which could weigh on sales in the short term.

Then, there is the risk that the company’s innovation does not translate to the success anticipated by both investors and management alike, which could cause further shocks to the company’s top line.

Finally, while the company’s footwear segment has demonstrated some form of growth in North America and China, the increase in demand creation expenses suggests that the promotional environment is pressuring these segments. Innovation is not going to bail the company out in the short term, in my opinion.

Concluding Thoughts

Nike continues to go through challenging times. The company’s pivot to innovation is showing some results, but not enough for investors to cheer. The increase in demand creation expenses, which have affected gross margins, suggests that translating innovation to sales has been a challenge. However, the Paris Summer Olympics should offer some welcome relief for the company and would be the first major test that would examine whether the company can translate innovation into tangible sales.

From a long-term perspective, however, the innovation should pay off, as the company gives its existing products a complete refresh. And the fact that consumers are warming up to the new products, especially in China, is promising for the long term.

From a valuation perspective, the recent beatdown in the stock offers an incredible opportunity for investors to accumulate. Having said that, this stock would demand a tremendous amount of patience, as the company navigates through treacherous waters. As such, in my opinion, NKE is not for the faint-hearted.

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Analyst’s Disclosure: I/we have a beneficial long position in the shares of NKE, LULU 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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