Nike (NKE) Gets Dragged Down by Higher Expenses and Lower Margins

Nike reported its first quarter earnings last week, which topped analyst estimates on both the top and bottom lines, but investors were not impressed, due to a disappointing year over year profit decline. For the quarter ending on August 31, Nike posted a profit of $1.23 per share, or $567 million, on revenue of $6.7 billion. This was a 9.6% decrease in earnings and a 9.7% gain in revenue. Analysts had expected Nike to earn $1.12 per share on revenue of $6.4 billion. Although Nike handily topped estimates, analysts expressed concerns regarding its weakening gross margin, increased expenses, higher tax rate and negative currency impact. Increased competition in domestic and international markets in an increasingly fragmented athletic footwear market was also cited as a cause for concern.
CEO Mark Parker was upbeat regarding Nike’s third quarter results. “We had a strong first quarter and a great start to the fiscal year. Nike delivered an amazing array of innovation across some of the biggest moments in sport.” Regarding Nike’s long-term future, Parker remarked, “We’ll continue to make strategic investments across our portfolio of businesses to capture our full potential over the long term and drive shareholder value.”

Nike’s gross margin slid from 44.3% to 43.5%, marking the seventh consecutive quarter that margins have declined. Higher material and labor costs, exacerbated by a strong U.S. dollar over the past year, were the primary culprits. Overhead costs also soared 18%, due to higher marketing costs, especially during the London Olympic Games and the European Football Championships. Nike also shifted towards lower margin businesses, and transformed its Chinese market for Converse into a direct distribution one. Both strategies cut into its gross margin. Expenses also increased due to increased investments in its wholesale segment and higher costs for opening new stores. Futures orders increased by 6%, or 8% excluding currency impacts, to $8.6 billion.

Nike is intending to sell its underperforming Cole Haan and Umbro subsidiaries during the next year. Excluding Cole Haan and Umbro’s results, earnings actually came in 4 cents higher, at $1.27 per share. During the quarter, revenue from Cole Haan and Umbro grew by 6%. Meanwhile, revenue from Nike’s core brands surged 16%, while its other brands climbed 9%. The company posted growth across all global segments except for Japan.

During the third quarter, Nike repurchased 8.2 million shares, worth $779 million, as part of its 4-year, $5 billion repurchase program initiated in September 2008. Under the program, $4.9 billion of the shares have been purchased. Nuke also recently initiated a new, 4-year, $8 billion share repurchase program. Nike finished the quarter with $3.3 billion in cash and cash equivalents, down $433 million from the prior year quarter. A higher effective tax rate of 27.5% across the company, up from 24.3% a year earlier, also weighed on the bottom line. Shares of Nike trade at 16 time forward earnings with a 5-year PEG ratio of 2.3, meaning that although the stock is fundamentally cheap, it is unlikely to double any time soon. The stock has traded in a wide 52-week range between $81.01 and $114.81, and pays a quarterly dividend of 36 cents per share – a 1.5% yield at current prices.

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