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What Does Supply Chain Disruption Mean For Consumer Discretionary Stocks?

Did you see Nike’s earnings report last Friday (September 24)? Despite the Dow Jones clawing back a big chunk of its losses after touching roughly 33600 points and the S&P’s dip towards 4300, Nike’s stock plummeted.

And it was for a straightforward reason. Supply chain disruptions.

Nike’s earnings report for its first quarter of fiscal 2022 drastically disappointed investors. The stock fell more than 6% on the day (Sept 24) following its earnings report.

Yet, Nike’s earnings dip was not a one-day thing. Since the start of August, when the stock touched a peak high of $174.09, it’s been in free-fall. Before the market opened on September 27, the stock was sitting at about $149.59. So while that’s not quite bear market territory just yet, a 14.07% dip in little more than a month and a half is not ideal.

This poses a critical question. Is this a buying opportunity?

Nike is a giant in its space. It is a sportswear juggernaut and is the world’s largest supplier and manufacturer of athletic shoes, apparel, and other sports equipment. It also owns several well-known brands such as Converse and Jordan.

Yet Nike’s footprint on the sportswear and sneaker industry is probably even more extensive than you realize. Sure there are other significant players, such as Adidas, Puma, and Under Armour. But, according to Forbes, Nike accounts for 42% of the entire sector’s market cap. Forbes further claims that the second, third, and fourth largest companies make up a combined 41% of the market.

So in a sense, catching Nike at this level could be mouth-watering. Judging by what it said in its earnings announcement, though, more pain could be approaching.

What Exactly Made Nike’s Earnings Report So Alarming?

Because of the size and scale of Nike’s footprint, its latest earnings report and the supply chain disruptions it discussed are alarming for the sportswear industry and the supply chain as a whole for all Consumer Discretionary companies.

In its first quarter that ended Aug. 31, Nike reported sales of $12.2 billion and earnings per share of $1.16. On the one hand, yes, it slightly beat Wall Street EPS estimates of $1.12. But this is a misleading figure. There was less inventory in the marketplace causing Nike to offer fewer discounts and lower prices. This naturally led to better-than-expected earnings per share.

The lack of inventory paints a gloomy picture, and it’s all because of supply chain headwinds.

What tells the real story of Nike’s earnings is how it grossly missed the consensus forecast of $12.46 billion in revenue.

Nike has massive production facilities in Vietnam and Indonesia. While the Indonesia facility has since reopened, the Vietnam facility remains closed. Thank COVID measures for that.

The effect on Nike’s inventory could be even worse than they’re letting on, too. According to BTIG Senior Analyst Camilo Lyon, “COVID-related shut downs mandated by the [Vietnam] government began two months ago, so effectively Nike’s production factories have two months worth of lost unit production.”

This is no short-term headwind. Beyond COVID shutdowns, there are also labor shortages at ports delaying turnaround times for ships carrying large quantities of merchandise. Nike noted that it takes twice as long to get inventory from its manufacturing facilities to North America as before the pandemic, for example.

Look at what’s occurring at the ports of Los Angeles and Long Beach as evidence. About one-third of all imports into the U.S. pass through these ports each year. On September 25, 2021, it was announced that a record 62 cargo ships were waiting to dock at the ports of Los Angeles and Long Beach. These ships are stuck floating off the coast amid a severe supply chain crunch.

According to the trade publication Supply Chain Dive, in 12 of the last 13 months, the Port of Long Beach alone has broken monthly records for how much cargo has passed through. Year-to-date in 2021, 32% more freight was processed this year than in all of 2020, too. Backups at the port have only grown as the peak fall shipping season arrived, yet cargo ships waiting for berths have been relatively common all year.

Beyond shipping issues, there’s a global truck driver shortage as well. ​​According to Bloomberg, ships are backing up at other ports nationwide and taking longer to move containers from ships to trains and trucks. The supply chain bottleneck is only compounding with a shortage of truck drivers to collect and drop off the 20- and 40-foot steel boxes.

Meanwhile, this all is occurring as costs to move inventory between Nike’s manufacturing facilities to wholesale partners and customers worldwide are increasing.

No wonder Nike’s management noted the supply chain headwinds would start to hurt gross profit margins in the next quarter and for the rest of the fiscal year. These adverse supply chain effects are not expected to go away anytime soon. So much so that Nike’s management expects them to persist for at least the rest of its fiscal 2022. They revised future financial projects accordingly, and it was not pleasant to read:

“We now expect fiscal 22 Revenue to grow mid-single digits versus the prior year, versus our prior guidance of low-double-digit growth, due solely to the supply chain impacts that I just described. Specifically, for Q2, we expect revenue growth to be flat to down low single digits versus the prior year, as factory closures have impacted production and delivery times for the holiday and spring seasons. Lost weeks of production combined with longer transit times will lead to inventory shortages in the marketplace for the next few quarters.”

What Could This Mean For Consumer Discretionary Stocks as a Whole?

Consumer Discretionary is a sector also known as Consumer Cyclical. It refers to any company dealing with goods and services considered non-essential by consumers but desirable if their available income is sufficient to purchase them.

The global supply chain is a mess right now, and Consumer Discretionary plays could be the most adversely affected. We are seeing problems that reflect a combination of growing cargo volumes, a labor shortage, and COVID-related safety measures slowing the handling of each ship.

Costco is another example of a company being greatly affected by the supply chain crunch and the trucker shortage. Retail giant Costco reported earnings the same day as Nike did, and investors liked what they said a lot more.

Supply Chain

Yet, while Costco is considered a Consumer Staples stock, rather than discretionary, they’re facing the same sort of challenges.

Costco is reinstating some purchase limits on toilet paper, cleaning supplies, bottled water, and other “key items” due to higher demand as well as shipping delays caused in part by a trucker shortage, according to CFO Richard Galanti.

“A year ago there was a shortage of merchandise,” Galanti said. “Now, [suppliers] have got plenty of merchandise but there’s two- or three-week delays on getting it delivered because there’s a limit on short-term changes to trucking and delivery needs of the suppliers, so it really is all over the board.”

The fact that a Consumer Staple stock is dealing with the same type of headwinds as a Consumer Discretionary stock makes the climate for discretionary or cyclical plays even more troublesome. That’s because Consumer Staples are considered non-cyclical, meaning that they are always in demand year-round, no matter how well the economy is doing.

Overall: Be Cautious and Weigh the Pros and Cons

The Consumer Discretionary sector could be the most impacted by the current supply chain constraints. According to GlobalX ETFs, the troubles with Consumer Discretionary plays are driven by two major supply chain pressures having a significant impact on a large portion of the sector.

  1. As the most labor-intensive sector, labor shortages and the potential for higher wages may have the most considerable impact on this sector. This has implications across the industry, from department stores and hospitality services all the way to e-commerce platforms.
  2. Typically, during an economic recession, consumers delay discretionary and durable purchases. As such, this is a sector that generally had a significant downward revision in demand expectations during the first half of 2020. This had implications across the Consumer Discretionary sector from home appliance manufacturers all the way to auto manufacturers.

We haven’t even mentioned rising inflationary levels and potential tax hikes as possible headwinds too. Without purchasing power, Consumer Discretionary companies cannot perform well.

Having said all that, there are still some favorable factors for Consumer Discretionary stocks. Based on the University of Michigan’s preliminary consumer sentiment inching up to 71 in September from 70.3 last month, we’ve seen a moderate improvement in consumer sentiment.

The latest retail sales data was also a pleasant surprise. Retail sales in August inched up 0.7%, crushing market expectations of a 0.8% decline. Online retail sales also rose 5.3% last month after dropping 4.6% in July, amidst an increase in clothing sales, building materials, and furniture.

According to Mastercard SpendingPulse, U.S. retail sales — excluding automotive and gas — for the “75 Days of Christmas” spanning from Oct 11 to Dec 24 are anticipated to increase 6.8% from the prior year.

Plus, the Fed’s keeping its monetary policy dovish for a bit longer.

So while you could potentially do better than the Consumer Discretionary sector right now thanks to labor and supply chain issues, there are still some things to like. Weigh your options, and think things through very cautiously.

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