Why we invested

The cannabis theme first caught our attention in December, when a United Nations (UN) commission voted to remove cannabis from Schedule IV of the 1961 Single Convention on Narcotic Drugs. The decision removed it from being in the company of more dangerous and addictive substances like heroin and cocaine. Many investors around the world looked at this move and saw it as a major step to normalising the substance. Immediately after this announcement, prices of cannabis-related stocks began to climb. 

While the change had no immediate material effect on the space, it was seen as a symbolic victory and a sign to nations that it was acceptable to reconsider punitive criminalision policies. Days later, the US House of Representatives passed the Marijuana Opportunity Reinvestment and Expungement Act (MORE) which decriminalised cannabis on a federal level. 

In January 2021, some states in America began renewed efforts to legalise cannabis locally. Lawmakers in New Mexico, New York, and Connecticut all made overtures to either medicinal or recreational legalisation. A strong first day of legal sales in Illinois also spurred the belief the industry was profitable. 

In February, a group of German researchers published a study demonstrating the benefits of medicinal cannabis on patients with Parkinson's disease. 

By this time, the continued stream of positive news flow had reached equity markets - from the start of November to the 10th February, AdvisorShares Pure Cannabis ETF had appreciated approximately 183%. 

We began to initiate investments in the theme during the month of December and continued to build positions in companies such as Creso Pharma (ASX:CPH), ECS Botanics Holdings (ASX:ECS) and Elixinol Wellness (ASX:EXL) throughout January.

Towards the end of January, it became clear Joe Biden would enter the White House with a Democratic House and Senate. In theory, this would make it easier to pass legislative priorities which strengthened thematic tailwinds and confirmed our view that immanent short-term volatility would present opportunities.

Why we exited

We have since exited our investments in the cannabis theme for multiple reasons. 

After significant runs into March, we saw most businesses in the sector become over valued without any real shift in company fundamentals. We also saw a slowing of progress from a governmental and legislation perspective. When it became apparent further legal developments in the industry would be delayed by Congress, prices began to return to more normalized levels, though still inflated. 

In February, companies issued their half-yearly reports and financial statements. The general market reaction was negative, as business fundamentals could not justify current trading levels across the board.

As companies within the sector saw their share price continue to decline in late February and early March, it became apparent the theme required further developments to be in play once again. We subsequently exited our investments.

What we want to see next

To begin reaccumulating investments in the cannabis sector, we would like to see several developments. 

The most important is legalisation, not just in the United States but around the world where there are significant markets for medicinal and recreational cannabis. 

In the United States, legalisation of cannabis would break the regulatory shackles that has been holding the industry back. It would open access to funding from federally registered banks and allow companies who sell cannabis to trade on national stock exchanges (thereby providing easier access to capital). 

Further developments in the medicinal space would also be beneficial for the theme. If positive research continues to be published around the globe, we expect to see renewed investor interest. 

Mergers or acquisitions in the sector would also be positive - this would allow larger companies to gain access to better distribution channels and expand market access. Ultimately the objective is to improve business profits and margins, which will make the companies more attractive investments.

Laureola Australian Feeder Fund

Approximately nine months ago, we provided a review of our investment case for Nike in 'A Marathon, Not A Sprint'. With the benefit of time, vaccines, additional data points illuminating how consumer behaviour has shifted as a result of the pandemic, and further clarity on Nike's operational performance, it is a good time to take stock and revisit the business again.

The slide below is taken from our investor update presented in October 2020, and summarizes the key points underpinning our initial investment thesis for Nike back in August of 2019.

Source: AIM

While the narrative around Nike for much of the last 18 months has been 'work-from-and-stay-at-home-winner', our view was always that this misses a much more pertinent fact: that the company is undergoing a structural change in its business model that would mean its margin profile would materially increase over the next three to five years. From our October 2020 note:

Prior to our initial investment, we estimated that the sale of a Nike product through its direct-to-consumer (DTC) channel is substantially more profitable than through the traditional wholesale channel. Management have subsequently confirmed this, stating that the sale of an incremental unit through its owned digital channels generate roughly twice the revenue (due to Nike not having to provide a wholesale discount). In the [September 2020] result, management further quantified the margin impact of digital sales: roughly 10% higher gross margins, translating to roughly twice the operating profit of products sold through the wholesale channel.

Sales through Nike's digital channels accounted for ~30% of all revenues in the most recent quarter [ended August 2020]. With management indicating they expect this to increase to between 40% and 50% (and possibly higher) over time, it implies that Nike's historical gross margin profile (in the low-to-mid 40% range) will likely move closer to 50% over the medium term. Nike also plans to modestly expand its own physical retail channel by investing in smaller stores that effectively operate as an extension of the digital channel, allowing for customers to order online and pickup in-store, order in-store for home delivery, or simply function as a small-footprint showroom for consumers wanting to try before they buy.

Combined with increased insight derived from 'owning' the consumer relationship through its own stores and digital channels, we also think there are efficiencies to be gained in general operating and (in particular) marketing expenses over time. All told, we believe it is not inconceivable for Nike to expand operating margins somewhere between 4% to 6% over the next several years due to a combination of mix shift towards DTC channels and revenue growth.

The valuation impact of this margin uplift is material. In theory, by simply shifting the destination where consumers choose to purchase goods from Nike, the business could end up selling the same number of products at the same retail price but end up dramatically increasing profits. By vertically integrating its distribution to be more in-house, Nike is effectively reclaiming margin back from the wholesale channel.

Pulling Ahead of the Pack

Last week, Nike reported quarterly results for the period ended 31 May 2021, where management discussed many of the key drivers of performance for the businesses over the next several years. We were happy to hear that an increased focus on Women's shoes and apparel is bearing fruit, as this was a market Nike has historically underserved. (Turns out there's money to be made in specifically catering to the needs of ~50% of the population!) As this trend matures, we expect it to drive faster organic revenue growth for several years, underpinning market share gains.

Of further interest was the fact that Nike sees the changing positive attitude towards healthier lifestyles coming out of the pandemic as an opportunity to grow the overall market by promoting sports participation, particularly among younger consumers. The combination of greater insight into consumer preferences is driving not only more targeted product development, but also more targeted (and effective) marketing spend.

The interaction of these factors (a structural shift towards healthier lifestyles, expanding into underserved market segments, the shift towards a DTC-business model, and other efficiency gains from investing in technology over the past several years) lead to management issuing the following medium-term (2025) guidance:

• Revenue growth ranging between high-single-digit to low-double-digit, driven by the material opportunities in Women's, apparel, the Jordan brand, digital channels, and international markets. This is several percentage points higher than the average mid-single-digit revenue growth rate of the past few years.
• NIKE DTC will represent approximately 60% of total revenues by FY2025 (from ~40% currently), led by the growth in digital channels.
• NIKE-owned digital will represent approximately 40% of the business by FY2025. Partnered digital channels (large wholesale partners such as Footlocker, JD Sports, etc.) will make up a further 10% of revenues, for an overall digital channel mix of 50%.
• Driven by the mix shift towards Nike's DTC sales channels, gross margins will reach a 'high-40%' number by FY2025 (from a low-to-mid 40% range historically).
• Greater efficiency on operating costs will see the operating margin reach a high-teens percentage by FY2025 (from a 12% to 13% range over the last decade).
• The combination of all the above should lead to earnings per share growth of mid- to high teens out to FY2025.
• Importantly for us, capital expenditures are not guided to materially increase to fund these initiatives, meaning the free cash flow conversion of the above accounting earnings growth should be strong.
• Lastly, this means that returns on invested capital will end up being higher than the previously guided 'low-30%' range, meaning that Nike will continue to create enormous value for its owners.

Of late, the market has been focused on short-term issues, such as port disruptions in the US (meaning inventory was not able to be timeously distributed to consumers for a period), or a consumer boycott of Nike product in China (which seems to be dissipating already). Historically, such short-term 'glitches' are when long-term investors have the opportunity to purchase great businesses with a margin of safety. (Our initial investment in August 2019 was made at the height of the US/China trade war rhetoric; buying a US brand with a meaningful percentage of sales into China was not exactly the flavour of the month.)

By focusing on the longer-term developments that were not yet obvious in the reported numbers - specifically, the change in profitability enabled by the channel mix shift - and understanding the benefits of Nike's 'portfolio' approach to its business (across regions, categories, brands, and sporting codes), the long-term investor would have found much to like. As the margin uplift driven by the DTC shift is now better understood by the market at large, the market valuation has begun to reflect this; in fact, it rallied by nearly 15% on the day following its most recent result as the market capitalised the long-term margin structure into the valuation today. To us, Nike is a case in point where short-term market volatility can benefit the patient investor in buying a quality business at a margin of safety.

While we are sure there are still many unforeseen and unexpected challenges Nike will have to navigate out to 2025, the combination of its strong competitive advantages in brand (and, we believe, in execution), strong cash generation, a conservative balance sheet and a high-quality management team steering the ship gives us comfort that the business is a high-quality compounder, and will be for many years to come.