China Still A Pebble In Nike's Shoe

By Stephen D. Simpson, CFA | October 01, 2012 AAA

The investment community seems to have locked on to Nike's (NYSE:NKE) "China problem," and this quarter's results aren't going to help. The good news is that investors can still take advantage of this situation to build a position in a stock that very rarely ever gets down to a fair price, let alone cheap. The bad news, however, is that results could slow in the interim and Wall Street is very much a "what have you done for me lately?" sort of business.

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Fiscal First Quarter Good on Almost All Metrics
It's hard to find much fault with the reported results that Nike delivered for its fiscal first quarter. Revenue rose almost 10% as reported, or about 15% on a constant currency basis. North America led the way with 23% sales growth, while emerging markets grew a little bit above 8% (or roughly 22% in local currency). Revenue in China rose about 8% on strong footwear, but weaker apparel. All in all, the company-wide growth rates for footwear, apparel, and equipment were all broadly similar.

Not only did Nike outperform on the top line, but margins were stronger than analysts expected. Gross margin did deteriorate from last year, by about 80 basis points, but that was better than expected. Likewise, Nike saw adjusted operating income fall about 12%, even though the company spent less on SG&A than analysts anticipated.

The Future Continues to Look Cloudy
Analysts pay a great deal of attention to Nike's futures orders; there has never been perfect correlation between futures trends and eventual reported results, but they are generally directionally similar. To that end, reported futures rose about 8% in constant currency, with 6% volume growth. North American futures continue to grow nicely (up about 13%), but China futures were down 6%.

Looking at the recent results at companies like Adidas (OTC:ADDYY), Li Ning and Anta, it sounds like there is a lot of inventory destocking going on in China, with the domestic rivals (Li Ning, et al) seeing the worst of it. What's more, the bigger companies such as Nike and Adidas are using their superior scale to push hard on discounts to hold (or gain) share. So while this adjustment process is bad for orders and tough on margins, I don't think there's anything fundamentally wrong with Nike's China business - if anything, the company seems to be gaining at the expense of weaker domestic competitors.

SEE: Top 6 Factors That Drive Investment In China

Can Nike Do It All?
There's not much question that Nike rules the roost when it comes to performance footwear; Adidas, Skechers (NYSE:SKX) or Mizuno may get the occasional win, but Nike continues to win the war. I wonder, however, if the company can do the same in apparel - a market that is ultimately much larger than footwear. VF Corp's (NYSE:VFC) North Face, for instance, seems to do more than hold its own with Nike in various outdoor markets. On the indoor side, Nike has yet to really land a telling blow against Under Armour (NYSE:UA) or lululemon Athletica (Nasdaq:LULU). Nike can certainly afford to take the attitude of "if you can't beat them, buy them" to a point, but I do wonder if Nike still needs to make a stronger R&D commitment to its apparel lines.

The Bottom Line
I still think Nike is well-positioned for above-average global growth for many years to come, and I don't think there are serious threats to the company's market position or returns on capital. But that's not to say that the company doesn't have some ebb and flow to its results; with concerns about China weighing on sentiment today, investors may have a relatively rare opportunity to build positions at reasonable prices. I continue to believe that Nike can grow its free cash flow (FCF) at a rate in the high single digits through the next decade. Couple that with a good balance sheet and below-average risk, and this is a solid stock for patient value-oriented investors.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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