Retail sector facing ‘full-on inventory crisis,’ analyst says

Cowen Managing Director John Kernan joins Yahoo Finance Live to discuss Nike earnings and stock performance, the inventory crisis throughout the retail sector, consumer spending, supply chain woes, and the outlook for Nike.

Video Transcript

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BRIAN SOZZI: Yep, we're still watching shares of Nike today after reporting first quarter earnings that beat expectations, but took a hit from high inventory and continued a continued slowdown in China sales. The athletic apparel maker saw inventory inflate 65% year over year in North America and net income fall by 22%. Cowen managing director John Kernan joins us now. John, good to see you here this morning. So what's your first trade on the stock?

JOHN KERNAN: Yeah, look, the stock's down 12%, and that's about how much we are taking down our EPS estimates for both this year and next. We're in an inventory crisis in the entire sector in North America in particular. Nike told us that last night. When you look at the balance sheets of all the companies in the sector right now, and you look at the amount of units and the dollar amount of inventory on the balance sheet, you're in a full-on inventory crisis as we go into the holiday.

BRAD SMITH: What does it tell you about the in-transit inventory particularly? And we were talking about this sort of earlier. The in-transit inventory grew approximately 85%, according to Nike. How does that start to get worked through? How does the logistical element of this inventory start to get rectified?

JOHN KERNAN: Yeah, in-transit inventories are elevated all over the sector. It's a function of a supply chain that has been disrupted. All of these companies have chased low cost sourcing in far East Asia, and they've chased volume there. To an extent when there's macro pressure, the supply chain backs up. The ports back up. And everybody's inventory builds.

We need a totally different planning-- buying, planning, and allocation model in this sector going forward. The working capital disruption that this sector has faced needs evolution. We cannot go through-- investors do not want to see volatility in free cash flow and working capital like this.

BRIAN SOZZI: Well, John, as they say, you know what tends to often roll downhill. So who is going to be impacted by this inventory crisis you're seeing at Nike? Is it a Foot Locker? Is it a Dick's Sporting Goods? Is it a finish line? Is it a Macy's? Because there are finish line shops inside Macy's. What does it look like?

JOHN KERNAN: Sure, Nike called out some of their wholesale partners last night in a positive manner. Dick's Sporting Goods was one of those. So is JD Sports. They did not mention Foot Locker, but Nike has upped their partnerships within-- membership platforms with some of their key wholesale partners. We think Dick's Sporting Goods is actually poised to have a very strong third quarter. I think they're in a position to actually raise guidance despite some of their vendors being way over inventory.

When you look at some of the competitors in the space, that they're going to start reporting earnings in late October or early November, we certainly think you'll see guidance reductions at Under Armour, Adidas, Puma, Skechers, Haines Brand, and others. There's just too much inventory. Demand is slowing, particularly in the e-commerce sector, where companies have been overearning since COVID. And it's a tough situation. Expectations, from an earnings standpoint, have not bottomed in this sector.

BRAD SMITH: OK, and so what does that-- because you were mentioning your updates on the earnings front and what your expectations are now. Given the inventory backup and the issues that we've laid out and that Nike themselves have disclosed and perhaps what we're expecting from some other brands to have to continue to navigate through as well, the material impact to the actual revenue forecasts that companies are putting out now, if you're looking at inventory that was supposed to be meant for back to school season now making it into the holiday season, and now holiday season inventory making it into the early moments of 2023.

JOHN KERNAN: Yeah, the only light at the end of the tunnel here is that we do think this quarter, this calendar third quarter for everyone, will represent peak inventory growth. And that as you promote through the holidays, you get into spring, summer of next year, which seems like a long way off at this point. You actually could be in a good inventory position as we get into the fall of next year.

But you need time to cycle through this inventory. The industry is going to have to be promotional. I think maybe by spring, summer next year as we start to get earnings from some of these companies, you start to see inventory balances declining year over year. That would be a great thing to see, but I think we're at least six months away from that.

BRIAN SOZZI: John, why-- and I'm not calling you out here. I'm just curious. Why are you sticking with an outperform in the price target you have?

JOHN KERNAN: Yeah, look, with Nike, their long-term targets of a high teens operating margin, if they can get there-- and certainly, it's going to take longer than we initially anticipated. This is a company with over $7 in earnings per share potential. It's trading very cheap on that long-term potential, but there's a lot of disruption in the market now.

There's so many moving macro pieces between FX, geopolitics, consumer demand, inventory levels. We've never seen an environment like this. Nike will scale and will win over the long-term if they push towards that high teens operating margin. There's tremendous earnings power potential in the business. It's just going to take probably a year or two longer than we initially anticipated.

BRAD SMITH: In this environment for the consumer, even as Nike was talking about the loyal member foundation, should we expect more or less from that loyal member foundation in times of any kind of spending pullback at the household level?

JOHN KERNAN: Nike is very sophisticated and understanding their customer acquisition cost, their customer lifetime value, probably more so than any company in this sector. But look, when your inventory levels are this high, particularly in apparel, it's very degrading to gross margin. They took their gross margin guidance down meaningfully.

Nike is doing things digitally at scale that other companies in this sector are not capable of doing. A lot of that comes down to their membership and the very high customer lifetime value they have with some of their consumers. So Nike will scale digitally more than any company in this sector over the next five years. I think that'll flow through to the bottom line, that high teens operating margin. They will get there at some point. It's just probably [AUDIO OUT] time.

BRAD SMITH: Yeah, well, to your point, the digital business has nearly tripled to exceed $10 billion in revenue over the past three years. So we'll continue to watch that very closely. It's about 24% of total Nike brand revenue in fiscal 2022. Cowen managing director John Kernan. John, appreciate the time and the breakdown.

JOHN KERNAN: Thank you.