What Happened to Nike?

Deep Dive

Edited by Brian Birnbaum

Nike’s decline in large part stems from management compensation’s skew toward the short term from 2020-2024. This is an extremely valuable lesson for long term investors.

Nike’s future looks much brighter with the new CEO Elliot Hill.

On a first principles basis, Nike’s earning power has withered since 2020 because management incentives were skewed towards short term financial performance instead of long term value creation. While new and niche competitors like On, Lululemon, and others have emerged as symptoms, the etiology of Nike’s disease can be traced back to decreased investments in the core value driver of its business: creating additional brand power and consumer demand through inspiration and motivation.

In the graph below you can see how demand creation expenses as a % of revenue declined to the ~8% level during John Donahoe’s tenure as CEO (boxed in red)--considerably lower than pre-pandemic levels. I believe it’s the primary driver of Nike’s decline. While contemporaneous earnings calls included all the right buzzwords, such as culture and innovation, the graph below evidences that they were most focused on cutting costs and increasing profits in the short term.

Reading Donahoe’s remarks in the Q3 FY2020 earnings call reveals no particular reason for concern. He makes emphasis on the importance of Nike continuing to bring athlete-driven innovations to the market and inspire people. But his CFO at the time, Andy Campion, managed to summarize quite succinctly the pain that was to come for Nike shareholders. He essentially said that by leveraging digital tactics of various forms, Nike could save on demand creation expenses going forward:

There's quite a bit of flexibility in demand creation. And actually it ties back to your question about sport. As John mentioned in his remarks, we've done some really creative things from a digital connectivity perspective with huge impact.

So, quick, low-cost, extraordinary impact and we think within demand creation we can save quite a bit of our powder for the return to a sport that we see within fiscal year ‘21.

There was nothing wrong with Nike’s push to strengthen their digital footprint. It was the execution–or more specifically, the capital allocation. Once they figured out they could obtain a higher return on marketing dollars via digital, for the time being, they chose to decrease investments instead of increasing them. Per the management incentive structure (more on this soon), the digital lever goosed their own interests rather than those of the shareholders’.

The above remarks show that management wasn’t focused on Nike’s long term value. If they were, they would’ve continued investing in demand creation, leveraging the higher efficiency of their digital channel. Instead, they chose to lower demand creation expenses as a % of revenue, thus prioritizing short term financial profits with the ostensible intent to expend the excess returns when the world re-opened in 2021.

The graph above reveals a lack of follow-through. Demand creation expenses as a % of revenue remained flat as the world returned to normal. Management stated in the subsequent earnings calls that they had created a “new operating model,” with higher capital efficiency.

Their behavior is due in part to overfitting the “new normal” narrative. For some time the world thought that life was never going back to normal, which led even the most extraordinary managers to over invest in this direction. As I noted earlier, however, I believe management’s behavior during Donahoe’s tenure is best explained by the structure of their incentive package, whose influence was skewed toward short term profits.

Nike’s FY2020 annual report reveals that, in his first year, Donahoe’s short-term incentives were worth $9.5M, while his long term incentives were worth $9M. His short term incentives were based on specific EBIT targets. Digging into the “long term” incentives, $5.4M were stock options based on price targets vesting annually over a four-year period–not an overly long term incentive. In reality, only $3.6M of his total compensation was tied more purely to longer term performance.

Reading the Q2 FY2025 earnings call (Elliot Hill’s first ever as CEO), it seems Nike Digital evolved over Donahoe’s tenure into a competitor of wholesale partners. Indeed, it would follow that management also chose to pursue the higher margins and capital efficiency of the digital channel at the expense of alienating wholesale partners. Nike’s products being predominantly physical, this also seems like an instance of prioritizing short term financial performance.

CFO Matt Friend’s remarks during the Q2 FY2025 earnings call were highly insightful:

As Elliott said, NIKE Digital has become a platform where we have been capturing demand and competing with our wholesale partners rather than creating and growing demand for our brands. This is why we must elevate the consumer experience, grow organic traffic and drive full demand.

You can see how this contrasts with Donahoe’s remarks during the Q3 2023 earnings call:

And while Direct, led by Digital, remains strong and will continue to drive our growth, our wholesale channel continues to be an important part of our strategy as we access key consumer segments and achieve distribution scale across the marketplace.

And finally, the Q4 FY2024 earnings call was a tacit confession of Nike’s focus on short term profits. In reiterating that Nike had re-focused on sport, management was confessing that it was previously focused on something else - short term profits. During the call, management also wanted to give the impression that Nike had successfully reset the organization and culture.

Donahoe said the following in the call’s Q&A section:

And then, Aneesha, on your second question, the way you asked it, I want to just distinguish one thing. You mentioned organizational reset. That's behind us.

And as I mentioned earlier, we are now completely aligned across the organization around sport, field of play. And our teams are focused, they're excited, there's just a tremendous amount of hustle throughout the organization and you can feel it.

In my deep dive I found many instances of Nike management prioritizing short term profits over long term value creation. Perhaps the most subtle and disturbing one is when management decided to increase the share of “seasonless” products in Q3 FY2020, as a result of the expensive and slow shipping. Meaning that, in order to make up for the slow shipping, they wouldn’t bother with providing seasonal newness and insteads sell products that are fit for every season.

In that particular instance, they decided to sacrifice newness (a key driver of Nike’s value) in order to continue printing profits in the short term.

Whichever way you look at it, all of Nike’s problems during and immediately after Donahoe’s tenure are the result of management incentives being skewed to the short term. Ultimately, Nike’s products have now lost some relevance because of the relatively lower capital assigned to inspiring customers, in the pursuit of immediate financial performance.

Nike’s decline is a perfect example of Charlie Munger’s famous quote: “show me the incentives and I’ll show you the outcome.”

Over the past few years we have seen world-class companies engage in diametric opposition to Nikes, sacrificing short term profits to enhance long term value creation. Notable examples of this have been Meta, Amazon, and Netflix. At first the market punished them with 50%+ declines in their stock prices, but now they trade much higher, tracking their respective free cash flow per share. In all three cases management was willing to take short term pain to create long term value.

The incentive package of Nike’s new CEO, Elliot Hill, is considerably skewed to the long term. In the short term, he has a $1.5M salary with a target annual bonus of 200%. In the long term, he has a $15.5M annual target incentive award - although the breakdown of this long term incentives has not been made public yet. The contrast to Donahoe’s incentive package is palpable, nonetheless, with a much heavier weighting toward long term objectives.

In the Q2 FY2025 earnings you can already see how this incentive package redirects management priorities. Nike now has to liquidate much of the uncool and thus unsold inventory to return to a pull marketplace. Before Hill stepped up, the plan was to do it slowly over the coming few years. In the Q2 FY2025 call Hill announced that Nike is going to accelerate inventory liquidation, although it is expected to yield short term pain:

I recognize that some of these actions will have a negative impact on our near-term results. But we're taking a long-term view here.

We're making the decisions that are best for the health of our brand and business, decisions that will drive shareholder value.

CFO Matt Friend emphasized in his prepared remarks that inventory liquidation will accelerate going forward:

We took some steps this quarter and we plan to accelerate inventory actions in our second half to drive a return to a healthy marketplace.

In particular, we are moving aggressively to reduce aged inventory, adjust supply with demand on NIKE Digital and ensure we have marketplace capacity for our newest product assortments.

While I need more quarters to assess Hill’s leadership and thus the overall odds of Nike getting back on track, you can see how his philosophy is immediately aligned with shareholder interests. He is taking the short term pain from day zero, in order to create value over the long term. Additionally, although Nike’s earning power has declined, the brand still has tremendous power^. With the right investments, it can get back to being number one.

As you can see in the graph below, revenue (orange) and net income (blue) are still considerably higher than they were in 2019, before Donahoe stepped up. At a price to earnings ratio of just over 23, Nike stock is starting to look like an asymmetric pick.

While I continue to monitor Hill’s execution over the coming quarters, I am pleased to take away this tremendously valuable lesson: when the leader of the company in question is not a founder operator, analysing incentives is of vital importance. This kind of problem is less prevalent among the kind of companies that I like to own, since the majority are led by founder operators. But the lesson will be especially valuable as these companies mature and come to be led by non-founders.

Stay tuned for my Nike update next quarter and until next time!

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