Even though Nike (NYSE:NKE) beat estimates on the top and bottom line in FQ1, the stock traded roughly 4% lower after earnings. The numbers look strong on the surface, but when you dig a little deeper a few issues emerge.
NKE grew revenues 7.7% (10% on a currency-neutral basis), which beat expectations. Sales increased 6% in North America and were up double digits in all international markets. DTC increased 22%. Growth has never been much of a problem for NKE but it seems like Nike now has to do more to generate growth. SG&A expense grew 12% (much faster than revenues) due to a 25% increase in marketing, even though NKE shifted some of its operating expense overhead into COGS in the latest quarter.
Despite higher average selling prices, gross margin declined 200 basis points in the quarter. Granted, much of the decline was due to temporary or discrete items such as FX, a higher mix of off-price goods and costs associated from exiting the golf business, and you should see some improvement in the back half of the year. Nevertheless, we do think the higher mix of off-price goods reflects weakness in the retail apparel sector, and this could create some pressure on margins going forward. For the full year, management expects gross margin to contract 125 bps.
Lower gross margin and a higher SG&A rate more than offset the benefits of positive operating leverage, and operating margin declined more than 300 bps y/y from 16.9% to 13.5% (Nike's five-year median operating margin). Investors should pay less attention to the 9% EPS growth and record 30.1% return on invested capital and recognize that it was largely the result of a one-time benefit related to the resolution of a foreign tax credit that pushed the effective tax rate down to 2.5% (compared to 18.4%) last year. Holding tax rates constant, net profit margin would have been 11.5% instead of 13.7% (last year's net margin was 14%). An 11.5% margin is much more in line with NKE's historical levels of profitability over the last five years, and net margin will contract from FQ1 levels through the rest of the year.
There are a few other areas of concern. Worldwide futures orders came in weaker than expected at 5% growth (7% constant currency) while investors were expecting 8%. The soft reading reflects increased competition from Under Armour (NYSE:UA) and Adidas (OTCQX:ADDYY) as well as a shift from performance products toward lifestyle fashion brands such as Lululemon (NASDAQ:LULU). Overall consumer spending is slowing and competition in the apparel space continues to heat up, and these factors are weighing on inventory turnover. Ending inventories increased 11% in the quarter, outpacing revenue growth yet again, and this has become a bit of a trend with NKE. Inventory turnover has steadily declined over the past five years from 4.77 in 2011 to 3.79 TTM. Part of the increase is due to a growing portion of DTC sales (which requires more inventory to be on hand). But we think NKE could do a better job managing its working capital. Inventory is a major use (rather than source) of cash, and the main reason why NKE's OCF often falls below NI. For a company with high returns on capital, NKE's cash flow yield is surprisingly low (3.2%).
I'm not trying to scare investors away from NKE, and we think the stock can be a great long-term investment at the right price. NKE's latest quarter was only strong on the surface. FQ1 was full of signs suggesting that the retail environment is getting more competitive, and the selloff was justified.
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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.