Global athletic apparel giant Nike (NYSE:NKE) posted fairly mediocre first quarter 2017 results on Tuesday. Revenue was up 8% y/y on a reported basis (10% y/y fx neutral) to $9.1 billion, and earnings per share were up 9% y/y to $0.73, mostly due to a decline in the share count as well as a one-time income tax benefit. Both numbers were well above expectations, but by no means did Nike execute a clean earnings beat. Let's dig into the financial performance, current fashion dynamics, and what price level makes Nike a buy.
Nike's financial performance was mediocre driven by a temporary setback in the fashion world
In spite of the nice headline beats as noted earlier, Nike's Q1 was not clean at all. Gross margins declined 200 basis points y/y to 45.5%. This was a talking point during the quarter, and management explained that the issue was the function of SG&A costs to COGS, higher off-priced sales, and exiting the golf business. Operating overhead moving to COGS as the company works on manufacturing issues makes perfect sense, as does the exit from the golf business. These are short-term in nature and should abate.
The area of concern is the off-priced sales. Nike was very promotional throughout the quarter, particularly in its DTC business. In my view, this is the function of Adidas (OTCQX:ADDYY) stealing the fashion spotlight. Styles like the Stan Smith, Ultra Boost, and Gazelle are all experiencing robust demand. Nike will claim it's a company of sport and innovation, but at the end of the day, the majority of the sneaker business is driven by fashion. Nike has a catalogue of comparable sneakers, but it is fair to say that Nike's portfolio of shoes from the 1970's is not nearly as strong as Adidas' portfolio. Until fashion tides change, which will undoubtedly be temporary, Nike will have a hard time driving marginal volume growth. This phenomenon will be temporary, and if/when the 1980's fashion or 1990's fashion becomes en vogue, Nike will be well prepared to capitalize.
This was reflected in Nike's North American futures orders, which were up only 1% y/y. Nike will no longer report this metric, and I agree, it is relevant now that Nike has such a large DTC presence. However, I think the timing is telling. Nike's unit growth is going to be flattish. Revenue growth should remain strong, as Nike is able to capture greater raw dollars with its DTC business, though it remains to be seen if the EBIT margin profile of the wholesale business is comparable. I suspect it is somewhat worse at this time.
Operating expenses were up significantly in the first quarter, jumping 12% y/y to $2.9 billion driven by a 26% y/y surge in demand creation expense. A few moving parts here-endorsement dollars overall are up as Adidas and Under Armour (NYSE:UA) are fighting to win college schools and European football clubs. Additionally, Nike had elevated advertising spend during the quarter for the Olympics, which should set-up for easy comparable quarter in Q1 of 2018. Nike anticipates only high single digit SG&A growth for FY 2017, but I will remain skeptical until I see the results borne out in performance.
Underlying strength in Jordan and China continues to be a bright spot
Not everything was negative for Nike in Q1. Jordan Brand experienced "double digits" growth, and I still see strong potential in the brand to capitalize on some of its legacy cash cow products. The company called out the "Banned" Jordan 1, which I believe can be released every other year and safely contribute $40-50M in sales. Some products have likely tested the upper bounds of market pricing, but I suspect Nike will be more selective on the products with which it decides to test new prices.
China was another area of strength for Nike in Q1. Sales jumped 15% on a reported basis (21% fx neutral), and I think the brand has done a tremendous job of connecting with the Chinese consumer and marketing its athletes. The company has built some inventory ahead of singles day, but overall, I think Nike's messaging will continue to drive double-digit growth after the firm cleared the channel of older product.
What price should you pay for Nike shares?
The quarter was frankly slightly worse than I expected, but I have not made revisions to my model significantly enough to change my valuation range of $65-68 per share. I would love to purchase shares are $45 which is about 19x FY 2017 earnings. This is a discount to Nike's recent valuation range and provides investors with a fairly large margin of safety for a company of its size with solid growth and income prospects.
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