Athletic apparel giant Nike (click ticker for report: NKE) reported better than expected first quarter results Thursday afternoon. Revenues surged 10% year-over-year to $6.7 billion (15% ex-currency), which was better than the consensus estimate. Earnings fell 10% year-over-year to $1.23 per share, which was still significantly higher than the consensus expectation of $1.11.
We thought the quarter was a mixed bag, with several extremes. Gross margins fell 80 basis points to 43.5%, though the margin declines have started to moderate (margins were up 70 basis points sequentially). Higher input costs have primarily weighed on profitability, but the company has been able to raise prices across all market segments within the US. Unfortunately for the firm, that ability doesn’t necessarily translate globally, particularly in Europe and China, where the economy remains sluggish. SG&A also increased 220 basis points as a percentage of revenue, to 32.2%, driven primarily by the firm’s heavy investment in marketing for the Olympics and its new NFL license. Though these expenses undoubtedly hurt profitability during the first quarter, we’re confident in Nike’s global branding strategy and that these investments will pay off nicely in the long run.
When we look at the geographic breakdown, the varying performance makes it seem like Nike is several different companies. In North America, footwear revenues grew 20% to $1.7 billion. The magnitude of this number is stunning—the most mature of all of Nike’s markets, North American footwear, is posting Apple-esque growth rates. Apparel grew 26%, and the total geography grew 23%. The segment’s operating profit (EBIT) grew 17%, to $630 million. The quarter benefited from a one-time gain of the NFL license, but we’re still encouraged by the strength of new products utilizing Flyknit technology and a strong winter release schedule in basketball footwear. The performance in North America underlies why we think Nike is among the best run companies in the world. We also gather from these results that Under Armour (click ticker for report: UA), which does the vast majority of its revenue in the US, will have a very strong quarter.
We also saw strong revenue growth in Central & Eastern Europe, which advanced 16% excluding currency (2% reported), and Emerging Markets, which surged 22% excluding currency (8% reported). Nike’s continued focus on product innovation and knowledge of these markets should continue to drive growth in both burgeoning regions in the years ahead. Further, Nike will benefit from a few other drivers: local competition in these markets is weak; the growing middle classes love sports as much as Americans do; and Nike is the premium athletic brand in the world. We think the firm is extremely well-positioned to continue to grab market share in both the Central & Eastern Europe and Emerging Markets regions.
On the other hand, we witnessed weaker-than-expected results in Western Europe and China. Western Europe revenue grew just 6% excluding currency (down 5% reported), mostly a result of strong footwear sales (up 10% ex-currency). There are several factors in play here, but most of the underperformance was driven by poor economic growth and tremendous uncertainty in the region. Additionally, competition in the apparel space from adidas is much stronger overseas than it is in North America—the European consumer is more fashion-oriented than the technical-oriented North American consumer, in our view. In North America, athletic apparel leaks into mainstream fashion, where Nike is strong, whereas adidas is more of a lifestyle brand. We think footwear will continue to sell well in the region, but the outlook for apparel isn’t very strong.
In China, revenue grew 7% ex-currency (8% reported) to $572 million. Though the pace of growth is respectable, Nike has been hyping China as the next North America for several years now, but it doesn’t appear macroeconomic growth is willing to cooperate in the near-term. We think it’s readily apparent that the pace of Chinese economic growth is slowing. Apparel was down 1% excluding currency, and management acknowledged that industry-wide inventories remain elevated. Futures orders, though not a tell-all metric for Nike, declined 6% during the quarter, and management didn’t sound too thrilled with its near-term prospects in the region. We think Yum Brands (click ticker for report: YUM) and other fashion retailers will face similar hiccups in the near-term.
Still, footwear revenue grew 12% ex-currency, and we think the nation’s growing love for basketball will provide a nice tailwind. We are slightly worried about Kobe Bryant, probably the most popular athlete of all-time in China, is nearing the end of his career, and LeBron James has yet to resonate as much with consumers. In our view, Derrick Rose is the most likely NBA player for Bryant to pass the popularity torch to. Rose endorses adidas products, and his popularity could help adidas gain critical market share with younger lifelong consumers. Luckily, Bryant may want to play for several more years, so Nike won’t have to face this challenge just yet.
Overall, we continue to like Nike’s business and its focus on bringing innovate products to market that consumers want. The firm announced an $8 billion buyback program last week, which would shrink the share count by 20% at its current valuation. Nike isn’t a company that needs to use its buyback program to balance option grants, so we think the move will be accretive to earnings (especially given the paltry yields earned from cash sitting on the balance sheet). However, we don’t think it is the best use of capital since shares are fairly valued at this time. We prefer if firms buy back stock when their shares are underpriced. Further, given Nike’s valuation, we’re not ready to add it to the portfolio of our Best Ideas Newsletter.