Nike Shares Rally Hard As Long Promised Margin Expansion Materializes

Mar.26.13 | About: Nike Inc. (NKE)

Shares of Nike (NYSE:NKE) are rallying in a response to a strong set of results, released after the market close on Thursday. The global developer, marketer and seller of athletic footwear, sporting equipment, apparel and accessories reported strong third quarter results.

Third Quarter Results

Nike generated third quarter revenues of $6.19 billion, up 9% on the year before. In constant currencies, revenue growth would have come in another percent point higher. Revenues came in slightly short of consensus estimates of $6.23 billion, due to a disappointing performance in China.

Nike managed to benefit optimally from this positive sales leverage. Gross margins increased 30 basis points to 44.2% on the back of easing material costs. Selling, general & administrative costs fell 10 basis points to 30.1% as slow growth in marketing expenses was offset by increased investments in the direct-to-consumer business.

Overall, net income rose 16% to $662 million. Diluted earnings per share rose even quicker, increasing 20% to $0.73 per share as Nike repurchased roughly 2% of its shares outstanding over the past year. Earnings comfortably beat consensus estimates of $0.67 per share on improving margins and the re-instatement of the Research & Development tax credit.

During the quarter, Nike repurchased 4.9 million shares for $253 million as part of its new four year long $8 billion share repurchase program. At this rate, the company continues to retire approximately 2% of its shares outstanding per year.

CEO Mark Parker commented on the results, "Our team delivered strong results in Q3. We did it with a relentless flow of innovation into our key categories. Given the diversity of our portfolio, we're able to capture big opportunities that drive sustainable, profitable growth. At the same time we continue to invest in new ways to enhance athletic performance, build strong consumer communities, and improve how we design and manufacture our products. That's how we increase our potential and drive shareholder value."

Ending The Year On A Strong Note

For the final quarter of the fiscal year of 2013, Nike anticipates revenues to grow at mid-single digit rates, surpassing consensus estimates of 2%. Note that the comparables for the final quarter are very difficult given the Euro football championship and the Olympics, which both took place during last year's fourth quarter.

The company expects to increase gross margins by some 50 basis points for the period, as material costs continue to ease and pricing remains strong.

Nike already gave some insights for the fiscal year of 2014, in which Nike expects to report high single-digit, or low double-digit revenue growth accompanied by mid-teens growth rates in earnings. The company will provide a more detailed update for next year at the presentation of the fourth quarter results in June.

Valuation

Nike ended its third quarter of 2013 with $4.0 billion in cash, equivalents and short term investments. The company operates with approximately $300 million in short and long term debt, for a significant net cash position.

For the first nine months of its fiscal 2013, Nike generated revenues of $18.6 billion. The company net earned $1.82 billion, or $1.93 per share so far. The company is on track to generate full year revenues just north of $25.5 billion, on which the company could earn around $2.4-$2.5 billion.

Factoring in a 11% jump the market values Nike around $53 billion. This values operating assets at approximately $49 billion, or roughly 2.0 times annual revenues and roughly 20 times annual earnings.

Nike pays a quarterly dividend of $0.21 per share, after accounting for its two-for-one stock split, for an annual dividend yield of 1.4%.

Some Historical Perspective

Long term shareholders in Nike have seen extremely good returns. The company has shifted its strategic focus from producing and marketing "plain" shoes and apparel, towards the lucrative market of accessories and gadgets. Furthermore, Nike has signed many multi-million sponsor endorsement deals with leading athletes to further increase its global appeal.

Over the past decade, shareholders have seen returns of over 300%, as shares rose from $14 in 2003 towards $59 at the moment. These returns even exclude the dividends being paid by the company along the way.

Between its fiscal 2009 and 2013, Nike has grown its annual revenues by roughly a third from $19.2 billion in 2009, to an estimated $25.5 billion this year. The company has grown net income by approximately 60% over the same time period, from $1.5 billion towards $2.5 billion. Earnings per share grew even quicker as Nike repurchased almost 10% of its shares outstanding during the time period.

Investment Thesis

Shareholders and analysts are wildly enthusiastic about the latest quarterly report. The growth momentum continues while innovations and stronger market positions finally seem to result in structurally higher margins.

The company continues to see many bright spots. North American revenues grew an impressive 18% compared to the year before. Nike furthermore surprised the market by reporting 8% revenue growth in Europe despite the economic worries. The company notes that even Europeans tend to show an interest in basketball at the moment. The strong performance in Europe is even more impressive given that the company reported double-digit revenue declines in Spain, Portugal and Italy.

The higher margins are the result of new innovations which are well-received by customers. Products like The Lunar, The Flyknit and The Free are boosting margins across the board. These new innovations are being combined with digital technology to measure and analyze training performance, just like professional athletes do. These new technologies allow Nike to increase the aesthetics of its products as well as boost its appeal as a sustainable producer.

Disappointing remains the situation in China, were revenues fell 9%. The company is in process to clean up its inventory to return to a "normal" market.

In December of 2012, I analyzed Nike's prospects after the company published its second quarter results. Shares rose 5% in reaction its second quarter earnings to $104 per share, or $52 on an a split adjusted basis. Factoring in Friday's gains, shares have risen some 15% ever since, driven by the strong market sentiment and the support from Nike's massive $8 billion share repurchase program.

I did not find the valuation of shares that appealing at the time. The latest report finally seems to demonstrate the much anticipated margin improvement, but yet shares are not that cheap, valued around 20 times earnings. The company does have sufficient financial flexibility to boost payouts to shareholders by increasing its current dividend yield of 1.4%, or accelerate its share repurchase program. The shareholder friendly financial strategy and Nike's long term commitment to boost operating margins will continue to provide support for its shares.

For now I remain on the sidelines on valuation concerns.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.