Is Nike Ready to Sprint or Stumble?

Leo is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Nike (NYSE: NKE), the largest sportswear retailer in the world, rallied sharply after announcing its second quarter earnings on December 20. During its second quarter, the Beaverton, Oregon-based company posted adjusted earnings of $1.14 per share, or $384 million, on revenue of $5.96 billion. Analysts on average had expected Nike to earn $1 per share on revenue of $6.01 billion.

Nike’s adjusted earnings of $1.14 per share excluded $137 million in losses incurred by its non-performing Umbro and Cole Haan brands. Earlier this year, Umbro, its soccer unit, was sold to Iconix Brand Group (NASDAQ: ICON) for $225 million. Cole Haan, its brand of higher-end footwear, is in the process of being sold to Apax Partners for $570 million.

This was an 18% decline in EPS on a 7.4% decline in revenue from the same quarter last year. Although Nike beat on earnings per share while missing on revenue, shares rallied nearly 8% during the following week.

Was this sudden bullish sentiment justified despite seemingly mixed earnings? Although Nike has grown its top line for four quarters in row, its net income has declined for three consecutive quarters due to shrinking margins. Before investors invest in Nike, there are some key factors to consider.

North American Sales Surge

Nike’s strongest region during the second quarter was North America, which posted 17% sales growth. Advance orders for December 2012 to April 2013 rose by 14%, which bodes well for the current quarter. Apparel sales, carried by an increased demand for its NFL sportswear, surged 19%.

Chinese Sales Slump

Nike’s triumphs in North America were offset by a decline in China, which posted an 11% sales decrease to $577 million. Advance orders also dropped by 7%. Demand for Nike’s flagship footwear remained strong, although demand for sports apparel waned considerably. Sterne Agee analyst Sam Poser called Nike’s situation in China “a tale of two companies,” stating, “Footwear is extremely strong, and apparel needs a lot of work.”

Nike president Charles Denson stated that the company was revamping its apparel line for its Chinese customers, offering “tighter fitting” apparel that would be more in line with current fashion trends in the mainland. Nike is also converting its Converse brand from a licensed brand to a wholesale one in China, and using steep discounts to clear out older inventory.

This shift from a higher-margin business model to a lower-margin one dependent on heavier sales volume has raised red flags with some investors. In addition, Denson’s plans of offering more appealing apparel are unproven and speculative, and are simply a reiteration of his comments during Nike’s first quarter earnings call in September. Cannacord Genuity analysts forecast Nike’s downturn in China to continue for the next two quarters.

The Rest of the World Gains

Western Europe reported a 2% decline in sales, but Japan, Central Europe and the Emerging Markets posted strong gains that offset the decline. Total global orders for Nike’s products rose 7%, excluding foreign exchange impacts, coming in slightly lower than the consensus estimate of 7.1%.

CFO Don Blair forecasts that sales for the third quarter will rise by a “low double-digit” percentage, topping analysts’ estimates of 4.7% growth to $6.12 billion. Currency impact is expected to reduce global sales growth by one percentage point.

Margins Continue to Contract

Nike’s gross margin contracted for the eighth consecutive quarter, as costs of raw material and labor rose throughout Asia. These problems were exacerbated by a negative currency impact and a transition to lower margin products. The company’s gross margin slid 30 basis points to 42.5%. Nike management believes that the margin contraction would reverse by the end of the fiscal year, at the same time as its reversal in China.

Is Nike Fundamentally Cheap?

Let’s take a look at how Nike measures up to other publicly traded rivals in both the footwear and apparel industries. Adidas is closest to Nike in terms of its reputation and business model, while comparatively younger brands Under Armour (NYSE: UA) and Lululemon (NASDAQ: LULU) have demonstrated remarkable success in producing strong revenue growth by expanding out of niche markets.

<table> <tbody> <tr> <td> <p><strong>Company</strong></p> <p><span><span><span>(12/25/2012)</span></span></span></p> </td> <td> <p><strong>Trailing P/E</strong></p> </td> <td> <p><strong>Forward P/E</strong></p> </td> <td> <p><strong>5-year PEG</strong></p> </td> <td> <p><strong>12-month Performance</strong></p> </td> <td> <p><strong>Market Cap</strong></p> </td> </tr> <tr> <td> <p><strong>Nike (NKE)</strong></p> </td> <td> <p><span><span><span>22.1</span></span></span></p> </td> <td> <p><span><span><span>17.5</span></span></span></p> </td> <td> <p><span><span><span>2.5</span></span></span></p> </td> <td> <p><span><span><span>9%</span></span></span></p> </td> <td> <p>47.6 billion</p> </td> </tr> <tr> <td> <p><strong>Adidas </strong></p> </td> <td> <p>17.6</p> </td> <td> <p>14.6</p> </td> <td> <p><span><span><span>3.1</span></span></span></p> </td> <td> <p>36.2%</p> </td> <td> <p><span><span><span>18.6 billion</span></span></span></p> </td> </tr> <tr> <td> <p><strong>Under Armour (UA)</strong></p> </td> <td> <p><span><span><span>46.7</span></span></span></p> </td> <td> <p><span><span><span>32.9</span></span></span></p> </td> <td> <p><span><span><span>1.9</span></span></span></p> </td> <td> <p><span><span><span>34.6%</span></span></span></p> </td> <td> <p><span><span><span>5.15 billion</span></span></span></p> </td> </tr> <tr> <td> <p><strong>Lululemon (LULU)</strong></p> </td> <td> <p><span><span><span>47.2</span></span></span></p> </td> <td> <p><span><span><span>33.4</span></span></span></p> </td> <td> <p>1.4</p> </td> <td> <p><span><span><span>58%</span></span></span></p> </td> <td> <p><span><span><span>10.9 billion</span></span></span></p> </td> </tr> </tbody> </table>

Adidas, which trades in the OTC markets as an ADR, is clearly the cheapest from a fundamental standpoint, and has comfortably outperformed most of its industry peers over the past twelve months. Adidas is also less than half the size of Nike, which means it could also have more room to grow.

Meanwhile, growth and momentum investors favor Lululemon and Under Armour, which have both demonstrated strong year over year earnings and revenue growth. During its third quarter, Under Armour posted 25% earnings growth on a 24% gain in revenue. Earlier in December, Lululemon posted third quarter earnings that rose 44.4% from the prior year quarter on a 37% surge in revenue. Both Lululemon and Under Armour have lower 5-year PEG ratios than Nike or Adidas, signifying stronger and faster growth expectations down the road.

That leaves Nike stuck in the middle, with less growth potential than its momentum peers, but trading at a higher multiple than its more mature competitors. Nike pays a quarterly dividend of $0.42 per share, a 1.6% yield at current prices, but the yield is too paltry to attract serious dividend investors.

Lacing Up for the Sprint Ahead

Looking forward, Nike expects its Flyknit running shoes, Nike+ FuelBand movement-tracking wristbands, and NFL apparel to generate strong revenue growth for the remainder of the fiscal year. CEO Mark Parker is especially optimistic regarding the growth potential of Flyknit, which features a knitted, rather than sewn, upper (the part of the shoe that cover the toes and the top of the foot). Flyknit shoes are also more lightweight due to the use of less materials. Parker told analysts that he believes that Flyknit would soon join the ranks of Nike’s Lunar and Free brands, which now generate $2 billion and $1 billion in annual sales, respectively.

Although a new successful product line would strongly boost Nike’s top line, investors should watch for a reversal of the company’s fortunes in China and its gross margin contraction before committing to the stock. Despite Nike's relative strength in recent trading, there are quite a few fundamental hurdles that the company still has to clear before it can become a solid investment.

leokornsun has no positions in the stocks mentioned above. The Motley Fool owns shares of Nike and Under Armour. Motley Fool newsletter services recommend Lululemon Athletica, Nike, and Under Armour. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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