Shares of Nike (NKE) were hammered Friday, falling 9% after the company blamed increased costs for earnings that lagged expectations. Furthermore, the company said margins will continue to contract for the rest of the year, until across the board price increases take effect in 2012. Margins were negatively impacted by higher costs for cotton, labor, and air freight, all of which will continue to pressure margins in the near term. How will these cost pressures impact Nike going forward, and what will they mean for rival Under Armour (UA)?
For the third quarter, Nike reported net income increased 5% to $523 million, or $1.08 per share, missing Wall Street expectations by $.04. Revenue was $5.1 billion, up 7%, and same store sales at Nike stores were up 13%. Gross margins came in at 45.8%, down 110 basis points. Future orders, a telling sign of growth, increased 9% in constant currency, matching expectations. Aside from the gross margins, all those numbers are pretty strong. The gross margins are a big concern though, especially considering 
management expects them to fall another 300 basis points into year end. The brand continues to expand in China, with future orders increasing 13% excluding currency gains. Emerging Markets also saw strong futures orders, up 18%, thanks to strength in Brazil. However, the CEO did mention that the global economic recovery was uneven, and that the US is "somewhere in between" vigorous growth and trying to regain momentum. This is important, because the US accounted for 34% of Nike revenue in fiscal year 2010, by far its largest market. While Nike is quickly becoming more popular in places like Brazil and China, the US is still its largest market, and the cautious comments from the CEO about the US should be cause for concern.
Given Nike's stumble, what does this mean for its smaller rival, Under Armour? As I explained in a previous article, UA is a strong, quickly growing brand mostly focused in the US. It is expanding its Direct to Consumer sales, which is helping to drive margin expansion. The brand is still not even 1/10 the size of Nike, and has a lot of room to grow, both in the US and eventually internationally. The Nike quarterly report knocked 5.6% off UA shares on Friday, and for good reason. UA will be facing the same rising input, transportation, and labor costs Nike is, and has less leverage to deal with price increases because it is a smaller company. While Under Armour should continue to be able to grow its brand through new store openings and new marketing agreements, a hit to margins could punish shares drastically. Trading at around 47 time earnings, any dent in the UA growth story from margin compression will cause that multiple to come in, and these high growth, high P/E stocks tend to fall hard and fast . UA will be able to raise prices, as Nike is planning to, so this will help defend the margins over the longer term. However, since UA is much smaller and less globally diversified than Nike, any further slowdown in the US will be a very big problem for UA.
The drop on Friday caused NKE to break through its 50, 100, and 200 day moving averages on 7 times the average daily volume, blowing through possible support in the 200 day at $79. While I think Nike is a great brand with strong long term trends, now is probably not the time to buy shares. The company said margins will continue to deteriorate, so expect analyst downgrades to fuel some more selling pressure this week. Aside from margin pressures, the company is also being hurt by the tragedy in Japan, so the company's 4th quarter may also come up light. The move in Under Armour did less technical damage, and shares held support of the 50-day at $62.61. However, given the margin compression Nike expects to see over the year, I'd prefer to see UA's next quarterly report before jumping into the stock. The shares trade at an expensive P/E and have no dividend, meaning they can fall both further and faster than shares in NKE did. Costs spiked quickly for both companies, so expect both NKE and UA to need some time to pass these higher costs through to consumers. The long term growth potential in both brands is still impressive, however short term cost pressures stand to hurt both stocks.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
