Nike: Good Long Term Potential But Lacks Near Term Visibility

By Ashish Sharma - July 24, 2012 | Tickers: CROX, DECK, NKE | 0 Comments

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Last month, Nike (NYSE: NKE) reported poor results for the fourth quarter ending 31^st May. Earnings per share of $1.17 in 4Q12 represented a $0.06 drop from 4Q11 and were $0.20 below consensus estimates of $1.37. While revenue growth was largely in line, gross margin pressures (down by 153 bps versus 100 bps guidance) caused by higher product costs, investments in digital R&D, and unexpected customs assessments continued to limit EPS growth. A Western Europe restructuring charge, higher than expected tax, negative FX, and share count also contributed to the EPS downfall by $0.04, $0.03, $0.02 and $0.01 respectively. Stock prices have adjusted accordingly, and investors are now wondering if this offers a buying opportunity or if prices can sink further. Let’s have a look at the future risks as well as the positives going forward.

Positives going forward

Nike has a huge global growth opportunity long term. The athletic footwear/apparel market is expanding swiftly. The Nike brand is just as popular among serious athletes, who participate in competitive sports, as among general athletic footwear/apparel buyers. The company should benefit from  increasing consumer spending on athletic apparel and footwear, especially in developing countries.

Apart from China and FX, demand remains solid, and with easing input costs, there is an opportunity to bring back the 280bps of gross margin gap from the peak attained in FY10.

Also, except China, where future orders have been poor (2% growth), there are solid future order trends (in constant currency) in the other markets. Japanese and Western European markets have improved significantly with 1% (versus -6% in 4Q11) future orders growth in Japan and 8% (versus a mere 1% in 4Q11) future orders growth in Western Europe.

Future Risks

China is the third biggest contributor in the EPS after emerging markets and North America. Thus, as a high margin (~36%) business, slower growth in China (~20% of the profits) significantly impacts the overall EPS growth profile. Moreover, a repositioning of the brand could put operating margins at risk. There is a chance that China could be a drag on earnings for several years.

SG&A as a percentage of sales of 30.7% in 4Q12 was worse than the consensus estimate of 30.5%, mainly because of sales leverage. Analysts are bullish on the growth in 1Q13 in preparation for major sporting events. I, however, remain skeptical and believe the company can miss EPS expectations, with a correction in store if sales are not as robust as expected.

Inventory growth with respect to sales growth presents another concern. Inventory growth of 23.4% exceeded sales growth of 12.2%, with the majority of the inventory growth in North America and emerging markets (sportswear inventory levels in China and Western Europe also elevated). Inventory growth is expected to exceed sales growth through the first half of fiscal 2013 as well.

Nike remains very sensitive to currency fluctuations. Given Nike’s global revenue base (~60% of Nike’s sales are outside the United States) and international production units (98% of Nike’s footwear production and most of Nike’s apparel production is manufactured outside the United States), any adverse currency fluctuations can affect operating results and negatively impact Nike’s bottom line.

Nike is also under significant threat from competition. The active wear market is getting crowded with Nike, Adidas, Reebok, and Puma all trying to expand their reach from the primary athletic wear consumer to an active wear or lifestyle consumer, creating an intense competitive environment. Adidas’ acquisition of Reebok further strengthens competition.

Recommendation

Nike is trading at a forward PE of 15.83x, which is at a huge premium (81%-84%) to its domestic competitors - Crocs Inc (NASDAQ: CROX) and Deckers Outdoor Corp (NASDAQ: DECK) - in spite of the fact that, as per consensus estimates, Nike’s expected EPS growth is just 13.7% as compared to 18.9% for Crocs and 20.44% for Deckers. Crocs and Deckers also have no long-term debt on their balance sheet. In addition, analysts expect Crocs to see significant growth in EPS in the next several years.

While some investors may want to step in on recent weakness, we still believe it is too early. Nike could continue to drift lower as investors struggle with China’s impact on Nike’s longer-term earnings growth profile. We remain optimistic about NKE’s long-term growth potential and market position, but we are waiting for improved visibility to margin stabilization and earnings growth acceleration before recommending the shares. Our recommendation is to avoid Nike for the time being.

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