Nike Executives Discuss Their Shrinking Gross Margins (NKE)

| About: Nike Inc. (NKE)

On Nike's Fiscal 4Q conference call, executives discuss goals to raise Nike's shrinking gross margins:

Don Blair, CFO

Consolidated gross margins declined 50 basis points for the year due largely to lower footwear margins. As we’ve seen throughout the year, the key drivers of lower footwear margins were higher input costs, such as oil, price value investments in Europe and Japan, and mixed shifts to products in regions with lower margins, partially offset by upsides of about a 100 basis points from favorable foreign exchange rate hedges.

The decline in fiscal 2006 gross margin, however, was more than offset by tight expense management, as we delivered 80 basis points of SG&A leverage for the year, due entirely to slowing growth of operating overhead....

Jeff Edelman - UBS

... you’ve mentioned a number of times in calls adding additional value in certain markets. Are we seeing a change in the business model, where you’ve got to redesign and operate with a lower gross margin to hit a certain price point? Or am I missing something here?

Charlie Denson. President of the Nike Brand

No, actually, Jeff, it’s just the reverse. What we have done traditionally is taking targeted sections of the product line and design to gross margin expectations, as opposed to taking current models down. I think that’s one of the things that we’ve been pretty good at over the last couple of years, where we have addressed specific weaknesses, either in our product line or at price points within the marketplace; approaching it more on a design to a price versus pricing a design

Mark Parker, CEO

One point we have also talked about a little bit is that when we launch new products, sometimes we may launch a little bit aggressively from a value standpoint and then move the margins over time. So that is one thing that we do fairly regularly...

Bobby Ohmes - Banc of America Securities

If I may, let me ask it this way: it looks like your revenues and your futures orders are tracking for you to hit the top line, long-term aspect of that goal that you put forth. What is different about fiscal ‘07 ex-options that would prevent you from getting there, if you made the top line part of that long-term goal?

Don Blair

Well, when we talk about our long-term model, there is movement in various and sundry pieces, but one of the things we believe we can do over time is grow our gross margins. That may or may not be something that you will see in a shorter-term period. That is something that, as Charlie spoke to, we manage our financial model pulling all the levers. What we have at the moment is a somewhat more difficult gross margin environment, and that’s why we have been pretty aggressive in managing our cost structure and leveraging our overhead.

So it is really a combination of factors, but when the model is operating as it was two or three years ago, we were seeing some fairly significant expansion in gross margin. So it’s a different model for every year that we play it. What we have to do is pull all the levers to make sure we deliver for the shareholders...

Margaret Mager - Goldman Sachs

First of all ... could you connect your outlook for the first quarter gross margin to be down and the full year gross margin to be flat? I take it you are thinking somewhere along the way it is going to be up. Can you just outline what you see changing that will help lift the gross margin as you go through the fiscal year?....

Mark Parker

Well, let me quickly hit gross margin. You’re asking a good question, Margaret. If you look at this year’s performance — fiscal ’06’s performance or the past year’s performance — we actually saw an erosion of gross margin over the course of the year as oil prices started to flow into our product costs and as we also started to see some increases in labor.

As we’ve talked about before, we lock our prices in some time in advance because we also are setting our wholesale prices. As a result, when you have a price increase for oil, as an example, or labor, it tends to move into our cost structure over a period of time.

Our expectation is that we are going to start to anniversary some of those higher costs in the second half of the year and that some of our other initiatives are going to start to flow through.

We also believe that with the growth of some of our fairly profitable businesses that haven’t been affected as much by those factors, we are going to see some shift in mix.

So those are some of the key elements here, basically because if you look at ‘06, we’re going to start to anniversary some of those lower numbers and we will perform a little better in the back half.

Don Blair

Your question on return on invested capital, let me start there. I think as you know, there’s really two major drivers of ROIC, operating margins and then operating assets turns. We think we have great opportunity to improve on both.

On the margin side, we will continue to drive the top line and manage the middle of the P&L in order to deliver on our long-term earnings targets, so that is important. Then as it relates to the asset turns, we have we think significant opportunity to reduce our invested capital base...

Virginia Genereux - Merrill Lynch

Coming into this quarter on the gross margins, you said they might be down around 100 bips, which is rare detail for you, sir. They came in a little lower than that. I’m just wondering, what happened intra-quarter? I know, a lot of things, but was it clearing some of this inventory in Europe and Japan? What are the vagaries that might have impacted gross margins for May, total company?

Don Blair

Virginia, there is a tremendous number of moving parts. As you know, we are in many, many currencies. We’ve got lots of different mixes and customer bases and different discount structures and so on. The year-over-year impact on the fourth quarter was input costs, as we have discussed. We talked about improving value in Europe and Japan, and that comes in the form of discounts, in some cases; more often in terms of product investment.

We have also seen a change in the mix of products, both in terms of individual styles, as well as shifting growth to the U.S. and the Americas, which have slightly lower gross margin percentages.

So it’s a lot of moving parts. I said it was my expectation that we would be over 100 points down in the first quarter. The precision level on this line item in the P&L, it is pretty tough to get that close. That’s why we try to manage the P&L holistically and not just one line item.

Virginia Genereux - Merrill Lynch

Understood. On Margaret’s question, if you are down 100 and change in August, to get to flat for the year, you’ve got to have a couple of quarters that are up 50 to 100. I just want to be clear on —

Don Blair

It is not quite at that level. But the math, as Margaret said, is that we are going to have to have an offset to that. Yes, we will have to be up in some quarters, and our expectation at this stage is that we can see some margin growth for some of the quarters in the back half of the year. Obviously, that is something that we will continue to monitor, and if there is a significant change in that, we would obviously be talking to you about it.

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