Image Source: Raul Gonzalez
By Brian Nelson, CFA
In a rapidly declining market as we have been witnessing the past many months, it becomes a relative “game.” Taking on outsize risk to drive positive returns is a quick way to the poor house. There are too many things working against the market for it to pull sustainably higher before year’s end, and we think investors are better off playing defense than attacking the bear. Things are bad out there, and they are likely going to get worse, “Things Are Bad Out There.”
It is perfectly reasonable and understandable to have been bullish during the first half of this year, as we were, to at least give the market some breathing room. After all, the past three-year returns (2019-2021) for the S&P 500 have been fantastic. It would have been premature to have pulled the rug on the optimism without identifying established trends as the foundation for a change in opinion.
But let me tell you — a lot has changed in the past several weeks, and we emphasized as much in our early July video, “I Have Been Wrong About the Prospect of Near-Term Inflationary-Driven Earnings Tailwinds.” Here’s what we said on that day in early July:
Perhaps we were somewhat late to the view that pressure on S&P 500 earnings growth might very well materialize after evidence of Walmart’s (WMT) and Target’s (TGT) disappointing quarterly earnings and outlooks a number of weeks ago, but it wasn’t until the Nike (NKE) earnings report, released June 27, that all but sealed the deal, in our view, that the probability of a recession in the U.S. is increasing.
We went bearish on the markets in mid-August, “ALERT…,” explained how we were expecting a huge market flush from late August levels in this video here, and how we continue to execute upon the Valuentum strategy. In case you have missed some of our work the past few months, here is a brief note to get caught up, “Now Bearish, We’ve Been Here Every Step of the Way.” With the S&P 500 down more than 20% so far in 2022, the year has become a relative “game,” and we would not be surprised if 2023 is yet another difficult year for investors.
Nike’s Margin and Inventory Problems
Nike’s first-quarter fiscal 2023 results, released September 29, weren’t great. Though revenue edged up 10% on a currency-neutral basis, the company’s gross margin tumbled 220 basis points, leading to a 20% decline in earnings per share. Inventories at Nike also increased 44% compared to the same quarter last year.
We don’t think Nike’s margin and inventory situation bodes well for other sports/exercise-related, basketball/gym/tennis shoes and athletic/athleisure apparel names, including the likes of Peloton (PTON), Lululemon (LULU), Under Armour (UAA), Yeti (YETI), adidas AG (ADDYY), as well as retailers such as Dick’s Sporting Goods (DKS) and Foot Locker (FL), among others. In particular, here’s what Nike had to say about the pressure on margins:
Gross margin decreased 220 basis points to 44.3 percent, primarily driven by elevated freight and logistics costs, lower margins in our NIKE Direct business driven by higher markdowns, and unfavorable changes in net foreign currency exchange rates, including hedges, partially offset by strategic pricing actions. The overall decrease in margins was primarily driven by North America, which took measures to liquidate excess inventory through NIKE Direct markdowns and wholesale marketplace actions.
Nike is a bellwether for the health of the Chinese market, too. As we outlined in this video here, from our perspective, China’s outlook is bleak, due in part to worsening mortgage market conditions and geopolitical uncertainty stemming from its relations with the U.S., not only as it relates to China-listed ADRs such as Alibaba (BABA) and Baidu (BIDU), but also as it relates to Taiwan (EWT). Here’s what Nike’s CFO Matthew Friend had to say about operations in China on its conference call transcript:
Next, I’ll provide some color around our results in Greater China. In Q1, revenue declined 13% on a currency-neutral basis, and EBIT declined 23% on a reported basis. NIKE Direct declined 2% on a currency-neutral basis with a 5% decline in NIKE Digital. While COVID-related disruption had meaningful impact on store operations and retail traffic, business performance and inventory management are ahead of plan as we continue to proactively recalibrate supply and demand.
Concluding Thoughts
Nike’s share price has been roughly cut in half this year, and its fundamental backdrop speaks of a serious impending global recession, in our view. Weak revenue performance, lower gross margins, bloated inventory, and significant troubles in China suggest even tougher times are ahead. Nike is a not included in any of the simulated newsletter portfolios, and we’d be cautious on it as well as the broader retailing industry as the U.S. enters what could be a deep recession in 2023. Things are going to get worse before they get better.
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Brian Nelson owns shares in SPY, SCHG, QQQ, DIA, VOT, BITO, and IWM. Valuentum owns SPY, SCHG, QQQ, VOO, and DIA. Brian Nelson’s household owns shares in HON, DIS, HAS, NKE. Some of the other securities written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.
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