Waiting for Nike's China Growth Story

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

The world’s leading sports goods company Nike (NYSE: NKE) recently released quarterly results that topped analysts’ estimates. But the company is now expecting a decline in China in the next two quarters, and it has lowered its annual revenue and income estimates. Nike’s strengths come from good revenue and income growth, reasonable fundamentals and a stock that has outperformed the S&P 500 this year. But its current results were a mixed bag as despite reporting several key improvements, it continues to face the old challenges as the much awaited Chinese turnaround still eludes its investors.

The company has now reduced its revenue guidance for the year ending in May from as much as a low-double-digit growth to a high-single-digit number. Similarly, earnings forecasts have now been reduced from mid-teens growth to low-double-digit percentage growth.

Quarterly performance

Overall, Nike reported a decent quarterly performance on the back of strong demand for running shoes and basketball gear in North America in general and in the U.S in particular. The company’s profit rose 22% to $668 million or $0.76 per share, which was $0.02 above analysts’ estimates compiled by Bloomberg. However, the future orders for Nike's brand, excluding foreign-currency effects, rose 8%, below market expectations of 8.8%.

Nike’s stock has risen by 25% this year, easily outperforming S&P 500 ETF (SPY), which is up 19% in the corresponding period, but trailing Deckers Outdoor (NASDAQ: DECK), which is up by an impressive 46.7% this year.

Turnaround stock?

Deckers Outdoor was one of the most heavily shorted stocks, but its short interest has now fallen dramatically to below 9 million by the end of June from 15 million in the beginning of the year. This is a clear indication that despite six consecutive quarters of disappointing guidance, short sellers believe that the company is on the right track.

The company relies on fall-winter sales of its UGG-boots to drive its top and bottom lines, therefore its second quarter is usually its most difficult period. The company itself is expecting a loss and no revenue growth for its Q2 results due in one week -- but I am looking forward to its winter-fall guidance. That outlook could indicate improvements in its earnings and net profit margin for the next two years (as shown on its website). Its balance sheet is also strong with $410 million of working capital. It currently has a low return on equity but this would also improve with growth in earnings. Therefore, Deckers Outdoor has a very positive outlook.

China

Nike’s performance in China, from where it gets 9.7% of its revenue, needs a lot more work as the company continues to struggle in the country on the back of a slowdown in the Chinese economy. Its Chinese sales, excluding the currency effects, have fallen by 1% for the three months ending May 31 from the corresponding period last year. The current decline would mark Nike’s third consecutive quarterly drop in China.

Nike recently performed an overhaul of the top management of its Chinese operations, and is now working on making its goods more attractive to the sophisticated Chinese consumers, which is a step in the right direction.

Although the current fall is disappointing, I believe that it is still too early to make a judgment on Nike’s Chinese operations. Its performance hasn’t been stellar, but it is certainly not a failure. Everyone knew that China would be a tough market to operate in and it is proving to be just that. Nike continues to offer its products at discounts in Greater China, while its future orders for June through November have improved from a -8% reported previously to 0%.

The markets have been waiting for a turnaround of Nike's Chinese operations (which was highlighted in Deutsche Bank’s recent ‘buy’ call), but so far this hasn’t happened. And I cannot find any indication of this happening anytime soon, although there are clear signs of improvements.

Industry peer

Nike’s peer Under Armour (NYSE: UA) also operates in China but has a much smaller presence there. However, some analysts (such as Canaccord’s Lyon) have pointed out that during the fall-2012 season, Under Armour proved to be far more efficient than its bigger rivals, such as Nike and Adidas. Moreover, unlike Nike, the company has been selling its shoes and apparel without any discounts thus earning higher margins.

I believe that Under Armour is an attractive long-term growth story in the making with an increasing foothold in the international markets. The company is expecting an significant increase in revenue from $2.2 billion in 2013 to $4 billion in 2016, while the contribution of international sales to the top line will double from 6% to 12% in the corresponding period.

Margin improvement: Big positive?

Nike has made improvements in its gross margin. The company has been under pressure from rising labor and material costs in China. Nike has responded by increasing costs and improving its supply chain. It also divested its brands Cole Haan and Umbro in 2012, which were dragging its results lower.

In the previous quarter, Nike improved its margins from 42.5% a year ago to 43.9%. This would be Nike’s second consecutive year-over-year improvement after reporting nine straight declines. However, I wouldn’t call it a big positive or a significant improvement since overall, its margins are still in the downward trajectory (shown in the picture below).

<img alt="" src="http://g.fool.com/editorial/images/58241/001_large.jpg" />

Conclusion

Although Nike remains solid on the revenue and earnings front while North America remains its strong point, it continues to face headwinds in China. Its current year-over-year improvement in margin is a step in the right direction but it is also a decline from the previous quarter. As indicated earlier, for Nike, things are slowly moving in the right direction in China but a turnaround is nowhere near, which is evident in the expected decline in Chinese sales.

Several analysts have recently given Nike a buy rating but I believe that in the current mixed-bag results, a tough business environment with intense competition and an expected slowdown in discretionary spending, it is better to remain neutral on Nike. 

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Sarfaraz Khan has no position in any stocks mentioned. The Motley Fool recommends Nike and Under Armour. The Motley Fool owns shares of 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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