Last week shares of Nike (NYSE:NKE) fell 6% after the company reported lower than expected revenues and issued tame guidance. Sales increased 5.9%, missing by $40 million, as weakness in North America, the company's largest segment, offset strong performance internationally. Nevertheless, analysts remain bullish on the outlook, and the majority of the sell-side research houses reiterated their buy/overweight ratings for NKE. Evercore analyst Omar Saad says the pullback presented "one of the best entry points for the stock in 20 years". Shares have rebounded during the past week, but with a consensus price target of $66.22, NKE may still seem like a compelling buy for many investors. While we do like the long-term outlook, we urge caution.
Nike is up against some major challenges in its North America segment, which accounts for almost half of NKE's total revenues. The most obvious is increased competition from Under Amour (NYSE:UA) and Adidas AG, who have taken a slice out of NKE's dominant share of the basketball shoe market. But in our view, the bigger problem is fundamental economic weakness in the US, an issue that few analysts are talking about. Apparel is a cyclical industry, and economic conditions have deteriorated in recent months. NKE, with its ability to innovate and produce technologically superior products that create their own demand, is better insulated than most apparel companies to these headwinds. However the company is not immune. The combination of flat income growth and increased competition will make it more difficult for NKE to raise prices.
This means the company will depend more on volumes for growth. In the latest quarter, sales in North America were flat, despite price increases, which implies that volumes declined. Management blames the weak reading on a difficult comp from the prior year when West Coast port strikes caused orders to shift into the comparable period. NKE claims that its futures order book reflects healthy demand, and points to a 6% uptick in orders scheduled for delivery in the US for the next six months. But this number is considerably lower than the 9% increase analyst were expecting, and pales in comparison to last year's 13% forecast. If the weak performance in the latest quarter were the result of port strikes rather than weak demand, order growth would not be less than half of what it was last year. Labor strikes to not stop people from ordering goods, they just increase the time it takes for customers to get what they ordered.
Weak demand and increased competition caused inventories to pileup in the latest quarter. Inventories as of May 31 2016 increased 12% over the prior period. NKE had to resort to promotions and discounts to liquidate its excess inventory, which contributed to the 30 basis point decline in gross margin. Given the impact of last year's port strikes, the inventory reading is especially poor. As the Wall Street Journal explains, "inventories swelled in the second quarter [last year] as West Coast ports cleared backlogs of imports that had piled up during a labor dispute". In the same period last year, NKE's ending inventory increased 10% y/y. Talk about a difficult comp. Management expects inventory to remain an issue going into the next quarter, and interpret the declining turnover as a sign of weaker demand.
Nike might be a great pick for long-term investors: the company has meaningful competitive advantages, a history of strong growth, and trades at a forward P/E of 20.6, compared to a 10-year average of 26.2. But NKE's latest results confirm that it is up against some real challenges in its largest market that will not subside soon. Nike's strategic shift away from wholesale to direct-to-consumer channels leaves the company more exposed to an economic downturn. As Morningstar explains, "retail channels require greater investment and higher overhead; profits also tend to be more cyclical with the economy. In the latest quarter, SG&A grew faster than revenues as the company invested heavily in DTC platforms. Higher operating leverage will be a problem if NKE can't grow volumes in the US. In summary, Nike is a solid choice for long-term investors, but investors should be wary of ongoing weakness in the US, which could weigh on the stock in the short-term.
Disclosure: I/we 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.