Nike’s Annual Report and Some Suggested Reading

Two days ago, Nike filed its 10K annual report with the SEC and I’ve been through it. I’m not going to spend a bunch of time doing a detailed analysis of their already reported results if only because there wouldn’t be a lot of insight to be gained. But there were a few comments in the fine print of the report and in the conference call that I thought were relevant to thinking about the business environment.

As part of that process, I want to point you to a book called The New Rules of Retail, by Robin Lewis and Michael Dart that Roy Turner at Surf Expo turned me on to. It’s also available for Kindle. Let me make the connection between the book and Nike by starting with a quote from Nike Brand President Charlie Denson talking about how the Nike brand achieved a 21% increase in revenues during the year.

“We did it on the strength of our product innovation, the power of the brand, and the differentiation we create through distribution,” he said. Nike Inc. President and CEO Mike Parker notes, “There’s a strong appetite for authentic brands and genuine innovation. Digital technology is just beginning to show what’s possible in products, services and at retail. And new partnerships continue to advance how products are manufactured and distributed.”
 
You might be tempted to say, “Well, no kidding” but having just finished the book, I heard more in that statement than I otherwise might have.
 
The New Rules of Retail (published in 2010) makes a number of predictions we can already see coming true. It says that just to be in the game, you have to do all the operational stuff well. Not just well- really well. And you have to keep improving. That’s no longer a strategic advantage, but the price of entry. I’ve been saying that for a few years, though not with such strategic eloquence, so you can begin to see why I like this book. Like all of us, I’m partial to people who confirm what I think.
 
They also say that “The ultimate collapse of the traditional retail/wholesale business model is now clearly visible.” I’ve said retailers are becoming brands and brands are becoming retailers.  I’m liking the book more and more.
 
They think that as much as 80% to 90% of traditional department store revenues will be generated by their own or exclusive brands. They suggest that retail stores “…will become hybrid enclosed ‘mini-malls’ for increased traffic and higher productivity.” They think Amazon will open stores. They expect preemptive strategies like pop-up stores to “…become proactive strategies as opposed to marketing opportunities.” They expect big retailers “…will accelerate the roll out of their smaller free-standing ‘localized’ neighborhood stores.”
 
They say some other intriguing (or maybe scary?) things too, but I’ll let you read them for yourself and look at the examples they provide.
Why is this happening? Because the consumer has near perfect information and an almost endless number of choices. What to do?
 
The authors suggest that successful companies will do three things. First, and as a condition for accomplishing the other two, they will control their value chain; especially at points of contact with the consumer. This does not mean owning your whole value chain.
 
Second, with consumers expecting more and better all the time and to get things the way they want them, companies have to far exceed the consumers’ expectation. They will accomplish this by creating a “neurological connectivity” with their customers. I know that sounds a bit like voodoo, but the book explains it very well. Think Starbucks or Trader Joes. Or Vans, though that’s my point of view.
 
Third, they will have “…to gain access to consumers ahead of the multiplicity of equally compelling products or services, and precisely where, when and how the consumer wants it.” They call this preemptive distribution.
 
Now, with those three actions in mind, go back and read the quotes from the Nike conference call I started with. The book’s authors note that in all the companies they interviewed, none used their exact words, but the successful ones were doing what they suggested. By the way, they spend quite a bit of time talking about VF and how it’s following their prescription. That’s an interesting read.
 
My immediate reaction on finishing the book was that doing what they say is required was damned expensive and required a strong balance sheet; especially in a lousy economy. Though they don’t address the financial cost of their strategy, I suspect they would agree as they believe “50 percent of retailers and brands will disappear.”
 
They don’t talk about a time frame, so it’s hard to know what to think about that prediction. And they don’t say anything about new brands being created. If their prediction is over three years, it’s pretty harsh. If it’s over 40, it’s probably a low estimate given normal brand cycles.
 
So probably you’re not as big as Nike and might not have their balance sheet. The message isn’t, “If you’re not big you’re doomed.” The message is, first, business was way more fun and easier in the 90s and I really miss that. Second, rapid disruptive change is never something any of us really like, but it’s full of opportunities for the people it doesn’t paralyze.   Some of that opportunity comes from the fact that your competitors may be paralyzed.
 
Third, Lewis and Dart wouldn’t disagree that you still need to know your customers and give them what they want. It’s harder than it used to be, but you also have some technology tools you didn’t have before. In that sense at least, nothing has changed.
Okay, wasn’t this supposed to be about Nike or something?
 
Nike’s revenues for the year were up for almost all categories and brands to $24.1 billion (including Cole Haan and Umbro which they are selling). Sales at Hurley fell from $252 million to $248 million. Nike reports total action sports sales at $499 million, up from $470 million the previous year. That’s 2.1% of Nike’s total sales for the year. I guess “action sports sales” means Hurley plus Nike Skate. Maybe it includes some Converse sales.
 
We know that Hurley lost money, though they don’t say how much. Lower gross margins as well as higher selling and administrative expenses as a percentage of sales contributed to Hurley’s loss. But they are still confident in Hurley’s future. Mike Parker noted in the conference call, “…we’re confident our NIKE, Converse, Jordan and Hurley brands have virtually unlimited growth potential.”
 
Nike’s gross profit margin fell from 45.6% in 2011 to 43.4% in the year ended May 31, 2012. The decline was “…primarily driven by higher product input costs, including materials and labor, across most businesses. Also contributing to the decrease in gross margin were higher customs duty charges, discounts on close-out sales and an increase in investments in our digital business and infrastructure.”
 
I found the mention of higher customs duties interesting. They note in the 10K, “The global economic recession resulted in a significant slow-down in international trade and a sharp rise in protectionist actions around the world. These trends are affecting many global manufacturing and service sectors, and the footwear and apparel industries, as a whole, are not immune. Companies in our industry are facing trade protectionist challenges in many different regions…”
 
On pages four and five, they talk about issues with importing into the European Union, Brazil, Argentina and Turkey and about trade relations with China. Among the reasons the Great Depression lasted so long was the imposition of various “beggar thy neighbor” trade policies (including the Smoot-Hawley tariff act in this country) that reduced worldwide economic activity.
 
Looks like all the world’s helpful and friendly politicians are at it again. You know, I knew they would, but I really hoped they wouldn’t. I better move on. Oh- 58% of Nike’s revenues are from outside the U.S.
 
Well, this is interesting. I’m looking at an income statement with no restructuring charges, goodwill impairment, or intangible and other asset impairment. There’s no “adjusted earnings” offered as an explanation for something or other. No EBITDA reconciliation to GAP. No discontinued operations (There will be next quarter because of the plan to sell Cole Haan and Umbro). There’s hardly any interest or “other” expense. Just net income that rose for the year from $2.13 to $2.22 billion, or by 4.2%. That decline in gross margin really hit them hard.
 
Okay, I’m worried. If too many companies start just reporting what they earned without resorting to various explanations, reconciliations, and obfuscations, who’s going to need me to figure it all out? Where will I be if we have straight forward, easy to read financial statements? I sure hope this isn’t a trend.
 
Revenue in North America rose from $7.58 to $8.84 billion, or by 16.6%. Earnings before interest and taxes were $2.01 billion, up from $1.74 billion the previous year. Revenue from Western Europe was up 7.1% to $4.14 billion, but earnings fell 18.2% from $730 million to $597 million. China sales rose from $2.01 billion to $2.54 billion and earnings rose 17.3% to $911 million.
 
Nike ended the year with 384 retail stores in the U.S., but 109 of those are Cole Haan which will go away when they sell the brand. Hurley had 29 stores. Non-U.S. retail stores totaled 442 including 69 Cole Haan. Direct to consumer revenues totaled 17% of total Nike brand revenue (not Nike, Inc.) And comparable store sales grew 13%.
 
If Nike starts renting space in a Macy’s and stocks and manages the inventory itself, will they call that a “store?” For all I know, they are already doing that. The distinction between brand and retailer just keeps blurring.
  
Nike’s balance sheet is more than solid, with $3.7 billion in cash, a current ratio of 3.0, almost no long term debt and $10.4 billion in equity against $5.1 billion in total liabilities.
 
Nike’s doing well given economic conditions not even they can shrug off. Most importantly, I think they have a clear vision of where brands and retail are going.

 

 

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