Hold Nike Until Its China Problems Are Resolved

Jul.23.13 | About: Nike Inc. (NKE)

Nike Inc. (NYSE:NKE) has an ambitious global growth plan and is presently in the third year of a five year plan to increase sales by 40% to a total of $27 billion. It is also aiming to grow profit by 15% annually up to the year 2015. This means that it will have to expand dramatically outside the U.S. market into high margin countries like China and Brazil. It is already the frontrunner in the sportswear market in China with a 12% market share but faces tough competition in Adidas AG (OTCQX:ADDYY) at 11.2% as well as domestic Chinese rivals such as Li Ning. China is already its second largest market after the United States and the company expects other developing markets such as Brazil, India, and Central and Eastern Europe to realize double-digit increases in sales adding $3 billion to $3.5 billion in revenue. It is also expanding its own retail operations in order to achieve better operating margins and get quicker feedback from the market on new products.

Problems in China

At one time, it seemed as if all Nike had to do was to open new stores and wait for new entrants from the middle class to come shopping. Unhappily for the company, this is no longer true and it has been losing ground to Adidas AG for fashionable street clothing and to Hennes & Mauritz AB (OTCPK:HNNMY) for affordable but fashionable clothing. A little more than one year ago, it was so optimistic about China that it predicted that sales would double in four years to $4 billion. Now it is faced with the reality of falling sales over the next two quarters which would mean declining sales over five consecutive quarters. So far, the lackluster performance in China has been offset by an 18% sales growth in the United States and the stock continues to perform well gaining by more than 20% this year compared to 18% for the S&P 500. The company blames the problems on sluggish GDP growth and shifting consumer preferences but believes that its strategy is still the best for the market. Moreover, rival Adidas was quicker at discounted prices in order to get rid of unsold inventory accumulation. The company has also realized that it cannot rely on the power of its brand and needs to provide customers with better fitting clothing.

The latest financials

The company reported satisfactory results for the fourth quarter of fiscal 2013 with a 7% growth in sales to $6.7 billion and a 1.1% increase in operating margins to just under 44%. Profit rose by 22% to $668 million translating into an EPS of $0.76 per share, $0.02 ahead of analysts' estimates and up 27% year-over-year. Dividend payout has been raised again and the dividend yield stands at about 1.3%.

The importance of the Converse brand

Converse is now a billion dollar product for which Nike paid a mere $305 million in 2003 and now looks like a winning investment because it is producing annual revenues of four times the purchase price. Total revenues in 2012 were $1.3 billion. Nike does not often acquire other brands to supplement its own Swoosh brands and has, in fact, sold Umbro and Cole Haan to concentrate on just four brands Nike, Jordan, Converse and Hurley. It has also sensibly decided to let Converse operate independently and cater to its own strong fan following without attempting to impose the Swoosh on its product lines. Converse is now growing at a compounded annual growth rate of almost 13% compared to 5.3% for its parent. Apart from providing brand diversification, Converse also caters to people looking for inexpensive sneakers and is one of the budget options that are well manufactured with attractive looks. In fact, I would bet that many customers do not even know that the brand is owned by Nike. The fact that Nike has left Converse alone is proof that it realizes the strategic importance of the brand to its overall portfolio.

The bottom line

The company has performed consistently beating the analysts' consensus estimates by almost 10% for four successive quarters. However, at this point in time till new investors in the company should keep NKE on their watch list until we have seen how the China problems are handled and how discretionary spending in the developing countries is going to stand up. Meanwhile, if you are already a shareholder, you should hold any existing position in the stock.

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.