Quantitative Easing

Nike’s gross margin is a problem

Nike Inc. (NKE, Financial) announced quarterly results last week which were not well received by the market. Shares fell nearly 13% in the trading session following the release. In total, Nike is down more than 48% on the year.

Nike has some issues in its business, but the stock is trading well below its GF value. Let’s take a closer look at the company and its latest quarter to see why I think Nike offers good value for money at this price point.

Quarterly Highlights

Nike announced results for the first quarter of its fiscal year 2023 on Sept. 29. Revenue rose 3.6% to $12.7 billion, beating Wall Street analysts’ estimate of $404 million. Excluding the impact of exchange rates, Nike sales increased by 10%. Net income of $1.5 billion, or 93 cents per share, compared to $1.9 billion, or $1.16 per share, for the same period last year. Earnings per share were 10 cents better than expected.

Nike Direct sales increased 8% to $5.1 billion. This channel was up 14% on a currency neutral basis. Nike Brand Digital revenue increased 16% on a reported basis and 23% excluding currency.

By region, North America grew by 13%, Asia-Pacific and Latin America by 5% (+16% at constant exchange rates) and Europe, the Middle East and Africa 1% (+17% at constant exchange rates). Greater China fell 16%. The Converse brand was up 2%.

Merchandise markdowns and higher expenses for dread and logistics drove gross margin down 220 basis points to 44.3%. Inventory levels rose 44% to $9.7 billion.

Take away food

Several weeks ago, I thought the market offered a good entry point for Nike Inc. (NKE, Financial). This view was based on the company’s previous quarter, where merchandise levels were higher, but the company was not discounting products in order to move them as demand remained high. As a result, gross margin increased by 120 basis points over the past fiscal year. The last quarter showed some cracks in my previous thesis.

First, gross margin contracted much faster than in the prior quarter as the company began to cut revenue at a much higher rate to eliminate inventory that had accumulated. Much of the increase in inventory took place in North America, where supply chain constraints led Nike to increase off-season products.

Inventories remain high, however, even after discounting activity, meaning markdowns will likely continue in the current quarter. Gross margins will therefore be under pressure again.

Another headwind is Nike’s performance in Greater China, which has been a real source of strength for the company historically. Sales in the region fell at a double-digit rate, following a 19% decline in the fourth quarter and a 5% decline in the third quarter of fiscal 2022. The weakness in these quarters was largely attributed to Covid-19 restrictions, but these had mostly eased by the end of fiscal 2022. Clearly, Nike is struggling in its most important growth region beyond simple lockdowns .

The third element affecting Nike is the strengthening US dollar, which has climbed more than 16% since the start of the year. Much of this increase is due to the Federal Reserve’s aggressive quantitative easing and quantitative tightening policies. With further interest rate hikes likely in the near term, the dollar could rally further. More than 50% of Nike’s revenue comes from international markets, so the company is likely to face continued exchange rate pressure.

All is not lost, however. Management said on the conference call that the company saw double-digit sales growth in September as back-to-school buying was robust. Some of the supply chain disruptions have been smoothed out, so markdowns may not persist well beyond the next quarter or two. A strong dollar is hurting results, but the good news here is that demand remains very high in international markets outside of China, as currency-neutral sales were all in the mid-to-high double-digit range. And in China, the year-over-year sales decline has at least slowed quarter-over-quarter.

Evaluation

The decline in share price also brought the stock back to a more reasonable valuation. Shares of Nike closed at $84 each on Oct. 3. Analysts expect earnings per share of $3.02 for this fiscal year, implying a forward price-to-earnings ratio of 27.8. Stripping out the artificially high 2020 multiple due to Covid-19, the average price-to-earnings ratio is just under 30 since 2012, according to Value Line. Thus, the share is valued at a discount compared to its historical valuation.

The GF Value chart rates the stock as significantly undervalued. Nike is trading at a 70% discount to its GF value.

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Final Thoughts

Nike’s stock was punished after the release of its fiscal first quarter results, and perhaps it needed a correction. The company had to reduce its products in North America in order to start properly scaling its inventory levels. Nike also continues to struggle in its most important growth region, and the currency also remains a headwind.

On the positive side, Nike’s stock is now more reasonably priced on a historical basis, and the reduction to its GF value is even greater than it was last month. It may take several more quarters for the company to bring its inventory back to lower levels, but Nike remains one of the world’s best-known and most valuable brands. For investors looking at the long term, I think Nike could be a great value proposition.