In a report entitled, “Is the Finish Line a step too far?,” Morgan Stanley initiated coverage of JD Sports Fashion Plc with an “Underweight” rating largely due to concerns over its recent mega-acquisition of The Finish Line. Part of that concern is that the merger comes as Nike and Adidas are rapidly expanding their direct-to-consumer (DTC) channels.

“Having been to the US recently to meet with management, we are cautious about JD Sports’ largest acquisition to date of Finish Line,” wrote Amy Curry, the lead analyst on Morgan Stanley’s U.K. team in a note. “We are unconvinced by its strategy to inject apparel into these footwear stores.”

Internal analysis by Morgan Stanley rating the quality of malls across the U.S. also “suggests that Finish Line locations are lower quality than first meets the eye.”

Finally, Morgan Stanley is concerned about JD Sports’ reliance on Nike and Adidas as they are growing DTC sales. Including Finish Line, Morgan Stanley estimates that 50 percent of JD Sports’ sales are Nike products and 20 percent are from Adidas. Curry noted that Morgan Stanley’s U.S. team believes Nike could deliberately reduce its wholesale revenues in North America by 2 to 3 percent per year over the next four years.

Wrote Curry, “We believe leading brands will increasingly keep their most exclusive, premium product for their own channels and that the winning third-party distributors will be those selling mid- to low-tier product (Amazon, Dick’s Sporting Goods, Sports Direct).”

On the positive side, Morgan Stanley noted that JD Sports has a proven track record of expanding through acquisition after having made over 40 across a range of sportswear retailers, outdoor retailers and brands since 2002. In the past five years, sales have expanded at a 20 percent CAGR, driven mainly by acquisitions. JD’s share price has also taken off, vaulting eightfold over the same five-year period and in August surpassed the market cap of Marks & Spencer for the first time.

Curry also wrote that while Finish Line had been struggling for a few years, JD’s management has identified a number of opportunities to improve the businesses’ performance.

These include JD’s expectations that it will be able to improve Finish Line’s gross margin by 300 to 400 basis points by reducing markdowns. JD, according to the note, believes Finish Line has been “buying too broadly, leaving it with too much stock of lower-performing product and too little ‘hot’ stock.”

JD also plans to convert five Finish Line stores to the JD flagship banner by the end of 2018. If successful, about 40 will be converted in 2019. Morgan Stanley pointed out that in Europe, JD banners for JD Sport are much profitable and productive than non-JD banners.

JD also believes Finish Line will be able to benefit from increasing “sales densities,” or adding more product to Finish Line doors, by sourcing better product and adding more apparel.

Other ways JD is looking to shore up the acquired Finish Line operation is the already-announced plan to close a double-digit number of loss-making Macy’s in-store shops, continuing to evaluate other closings, and reducing overhead, particularly at headquarters.

But after having visited Finish Line’s headquarters in Indianapolis, the analyst still cited five key concerns:

  • Past U.K. expansion challenges in the U.S.: Tesco, Primark and Next are a few U.K. companies that have failed or are struggling in their attempts to enter U.S. retailing. Several acquisitions – including Ratners of Kay Jewelers, M&S of Brooks Brothers and Kings Supermarkets, and Sainsbury of Shaws Supermarkets – also haven’t panned out. Wrote Curry, “Although there are clearly risks when it comes to relying on historical precedents, we think potential JD investors would be unwise to ignore the fact that UK retailers have a very poor record when it comes to ‘cracking’ the US market.”
  • Apparel expansion risks: Apparel accounts for just 6 percent of Finish Line sales compared to around half of sales in the U.K. JD banner and the part of the turnaround plan envisions significantly expanding the higher-margin apparel category at Finish Line. But Curry wrote that U.S. consumers do not generally purchase sports apparel in a sneaker store as also evident from Foot Locker’s struggles to increase its penetration of apparel. As shown by Morgan Stanley data, U.S. consumers prefer to buy athletic apparel from department stores or brands’ own stores. Expanding activewear has also been a focus for department stores such as Kohl’s and the analyst implied JD may be underestimating the competitive landscape for athletic apparel in the U.S. Curry did note that JD indicated that a number of urban chains, citing Jimmy Jazz and DTLR, have found success selling apparel alongside footwear.
  • JD retrofit risks: Morgan Stanley said the JD brand is “almost unknown” in the U.S. and while JD has had success converting banners to the JD format in Europe, acceptance may prove more difficult in the crowded U.S. market. The report noted that the U.S. has almost five times more square footage per capita than the U.K., and 12 times that of Germany. Curry wrote, “In such a large and over-served retail market, we think it will be difficult for the company to raise brand awareness.”
  • Weak real estate: An analysis in September 2017 by Morgan Stanley’s U.S. Retail and REITs team showed that about a third of Finish Line’s mall locations are in “Grim Outlook” and “At Risk” malls. Morgan Stanley believes “stand alone Finish Line stores and Macy’s concessions seem to be at similar risk.”
  • Management focus: JD Sports has sent a small team to the U.S. (fewer than 10 so far, they estimate) and may need to send significantly more. Curry wrote, “We think that, to bring the JD culture to Finish Line, the business will need considerable management resources from the UK. The risk of doing that, however, is a reduced level of management focus on its core operations.”

At the same time, Morgan Stanley noted that Nike and Adidas are both looking to grow their  DTC businesses. DTC already represents 30 percent of Nike’s business. Morgan Stanley estimates that Adidas will expand e-commerce from 7 percent penetration in 2017 to 14 percent in 2020. Consumers are also increasingly preferring to shop for athletic footwear and apparel through brands’ own channels, according to Morgan Stanley’s internal surveys.

Curry wrote that although the DTC expansion by brands is an issue as the whole for JD Sports, Finish Line faces higher risks because the chain is particularly dependent on Nike product and Finish Line is a less important distribution channel for Nike product in North America than JD is in Europe. Nike also appears to have “more wholesale ‘clean-up’ to do” in the U.S. than other countries, Morgan Stanley believes.

Morgan Stanley initiated coverage on JD Sports with an “Underweight” rating and a 355 pence price target. Shares of JD closed Friday at 432.10 pence.

In Morgan Stanley’s “bull case,” JD will be able to turn around the Finish Line business and follow up with more accretive acquisitions. If JD is able to maintain 7 percent comp gains and roll out the productive JD format across 500 Finish Line stores, Morgan Stanley said the stock’s upside could be as much as 700 pence.

Curry wrote, “The Finish Line acquisition alone is nearly as large as the other 40 acquisitions JD has undertaken over the past 20 years. If the acquisition proves successful, it could transform JD’s earnings.”

Image courtesy Finish Line