Nike Reports Second Quarter Results; Shares Split

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Late last week, athletic footwear and apparel heavyweight Nike (NYSE: NKE) reported strong second-quarter results. Revenue of $6 billion was 7% higher than a year ago, and it was also slightly better than consensus expectations. Earnings were also better than expected, growing 11% year-over-year to $1.14 per share, aided immensely by a large share buyback. We plan to adjust our report and fair value estimate on Nike to account for the stock split soon.

We like to focus on Nike’s gross margins, which were down 30 basis points year-over-year to 42.5%. Though we are pleased to see gross margin declines moderate, we are a bit worried that gross margins are going to be permanently lower than the high 40’s range we saw near the end of the previous decade. A combination of higher input costs and lower average selling prices across different geographies could lead to a lower gross margin threshold.

However, this is only acceptable if it drives stronger overall sales and income, in our view. Total SG&A increased just 6% on an absolute basis, while falling 40 basis points as a percentage of sales. Marketing spending remained flat, as the company was able to leverage increased direct-to-consumer spending into stronger sales.

On a geographic basis, Nike’s performance was relatively scattered. North America continued to be strong, with footwear revenues surging 13% year-over-year to $1.5 billion. Often thought to be Nike’s most mature product category in its most mature market, footwear has continued to benefit from higher average selling prices, great relationships with retail partners, and resurgence in the basketball market. The Jordan XI retro that was released the Friday before Christmas may be the best single day release the company has ever had (the original shoe came out over 15 years ago). Apparel also performed well, with sales up 19% compared to a year ago. However, the segment benefited significantly from the NFL license, which wasn’t included in the comparable period of fiscal year 2012. Overall, sales in North America jumped 17% to $2.4 billion.

The most obvious winners from the strong performance are Finish Line (NASDAQ: FINL) and Footlocker (NYSE: FL), which combined account for a large portion of Nike’s North American business, particularly in footwear. We expect Finish Line to benefit slightly more than Footlocker since the company has just recently gained access to more premium products (which could allow it to close its performance gap relative to its large peer). Dick’s Sporting Goods (NYSE: DKS) is a firm we’d normally see benefitting from Nike’s strong results, but we’re worried that a relatively warm start to the winter may have pressured sales going into the holiday. The company was highly promotional with after-Christmas sales, suggesting that the holiday may not have gone as well as planned.

Western and Central Europe were a bit weaker for Nike, growing 4% and 7%, respectively, on a constant-currencies basis. Without question, broader economic pressures are negatively impacting the European consumer, but we also think Nike faces stronger competition from the region’s native leader, Adidas. Though popular classic styles continue to sell well, the more fashion-centric European consumer has not been as quick to adopt the higher-priced performance items (think LeBron, Kobe, and Jordan) as casual styles. Nevertheless, strong order trends—up 11% excluding currency fluctuations in Central/Eastern Europe—suggest the second half of Nike’s fiscal year may be stronger.

Emerging markets and Japan were both strong, with sales growing 18% and 13%, respectively (excluding currency). The emerging markets business tallied over $1 billion in sales during the quarter, and the momentum in markets such as Brazil remains incredibly strong. With the 2014 FIFA World Cup and 2016 Olympics taking place in the rapidly-growing nation, we see fantastic long-term catalysts to propel brand momentum in South America during the next five years. On the other hand, Japan is nowhere near as robust. Yet, a focus on products and easy comparisons has allowed Nike to return to growth in the country. Order trends in both markets look strong, though we remain much more optimistic about emerging markets.

In a stark departure from the rest of the company, China was a complete disaster, in our view. Sales of footwear dipped 9% compared to the prior year, apparel sales fell 17%, and total sales fell 12%. Broader economic headwinds remain prevalent, but management took responsibility for the drop in sales. CEO Mark Parker mentioned a change in fit geared toward the Chinese consumer has started to hit the market. Management also indicated that the company will focus on clearing inventory and maintaining brand positioning, which resulted in a Futures decline of 7% (excluding currency) during the period. Though basketball continues to perform well, the consumer doesn’t have the developed-world appetite for running that has helped propel growth in the US. We also believe it’s important to remember that Nike shoes are a luxury in China, so a more cautious consumer can impact sales immensely. Though Nike may face headwinds in China in the near term, we continue to like the firm’s long-term brand positioning.

Overall, we thought results were fairly strong, though China was not good at all. We’re happy to see the company sell off both Cole Haan and Umbro, as Cole Haan never really made much sense and Nike Soccer overtook Umbro, making the brand fairly irrelevant after the parent harvested crucial sponsorships. Management reiterated its guidance for high-single to low-double digits revenue growth for fiscal year 2013, with stronger gross margins and higher SG&A spending. Earnings per share should be higher thanks to the company’s large share repurchase program.

Still, we think shares of the athletic giant are fairly valued following its split. Although shares trade at a price-to-earnings discount to peers Under Armour and lululemon, we do not find its valuation particularly attractive. We continue to like Finish Line as a possible derivative idea, as it trades at a discount to its peer and our fair value estimate. However, neither firm makes the cut for addition to the flagship portfolio of our Best Ideas Newsletter.

Valuentum has no positions in the stocks mentioned above. The Motley Fool owns shares of Dick's Sporting Goods and Nike. Motley Fool newsletter services recommend Nike. 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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