A Very Amazon-Like Quarter

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

With no disrespect to Amazon.com, this quarter by Nike (NYSE: NKE) was very Amazon-like. While the company's overall revenues increased 10%, their diluted earnings-per-share dropped 10%. In Amazon's situation, showing massive revenue growth and sacrificing earnings makes some sense, as a company tries to transform the way people buy their goods. However, for an established company like Nike, this type of business plan doesn't work at all, and investors should be seriously questioning management priorities. Nike is arguably the most well-known sportswear brand in the world and should be able to leverage this name recognition into better margins and higher profits. However, through apparently some short-term thinking, Nike did exactly the opposite.

Nike Shouldn't Be Copying Their Competition

When a large well-established company seems to suddenly sacrifice margins to create growth, you have to wonder about the potential for the stock going forward. Nike is both well-respected in the sportswear market and the stock market, but won't be for long if the company continues down this path. Competitors like Under Armour (NYSE: UA) and Lululemon (NASDAQ: LULU) are fighting each other and Nike for market share. While smaller companies sometimes have to sacrifice margins to get sales, a company like Nike shouldn't have to. One could argue that Nike is trying to copy its competition by pushing products at lower margins to create faster growth instead of better earnings.

How Do You Turn 15%+ Sales Growth Into Lower Earnings?

Sales at each of Nike's main divisions increased by at least 15% across the board. For the same company to report diluted EPS down 10% is not a good sign for long-term investors. The company said lower EPS was due to lower gross margin, higher SG&A, and a higher tax rate. I could easily accept a higher tax rate, as that means the company reported more taxable income versus last year. However, higher SG&A, and a lower gross margin, means the company marked down prices and spent money where it didn't necessarily have to. This combination drove sales growth at the expense of EPS. In fact, looking across the board at all of the company's geographic markets, there was only one situation where sales were flat. Every other region and category showed increased sales, and many were up by double digits. What is strange is that while the company's EPS is down, Nike is trying to return value to shareholders. Looking at the company's financials, you can see that Nike is buying back shares and growing their balance sheet.

3 Positives And 1 Negative In The Financial Statements

There were three very positive items from Nike's financials. First, the company repurchased almost $800 million worth of shares at an average price of $95. Second, previous share repurchases caused the company's overall share count to be reduced by about 2.6% versus last year. Last, Nike's cash and investments both increased better than 35% on the year over year basis. What didn't quite make sense was the company's inventory growth of 10%. Future orders are expected to increase between 6% and 8%. If the company sees single-digit future orders, then you would expect inventory growth in the single digits as well. In the apparel industry, inventory levels have been a challenge at their competition. Investors should keep a close eye on Nike's inventory line item going forward. With all this being said, the challenge for investors is knowing what to expect from Nike in the future. 

Valuation Should Be A Concern

The stock market certainly has an appreciation for Nike's business as the arguable leader in the field, and the stock is valued as such. Shares sell for over 18 times forward earnings estimates, but earnings growth is only expected to come in at 8%. Their competition with Under Armour has been fierce and should continue in the future. To be fair, Under Armour has two challenges that have not plagued Nike until recently. First, Under Armour has been growing quickly, but the valuation on their stock has grown even faster. Second, the company's operating margin has shown compression as they have invested in new market opportunities. Under Armour's most recent quarter shows an operating margin at just over 3%. By contrast, competitor Lululemon shows a more reasonable valuation relative to their growth rate. In Lululemon's most recent quarter, the company's operating margin was just shy of 25%. By comparison, Nike's operating margin stands at less than half of this at just over 12%. Given these factors, I firmly believe investors should consider Lululemon as their lead investment choice in the sportswear market.

Conclusion

On a relative basis, Lululemon's stock is much cheaper than either Nike or Under Armour. For instance, Lululemon's PEG ratio is about 1.5 based on earnings estimates. When you consider that Nike's PEG ratio sits at 2.29 and Under Armour's PEG is at 2, you can see that the market may be under-appreciating Lululemon's faster growth rate. In addition, Lululemon is keeping their priorities straight by maintaining their high margin and fast growing business. This is the opposite of what has been happening at Nike, as the company has decided that greater sales and lower profits is an okay result. For arguably the most dominant sportswear company, investors should be less than satisfied with these results.

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MHenage 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.If you have questions about this post or the Fool’s blog network, click here for information.

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