Nike, Inc. Q3 Earnings Hurt by Rising Input Costs

 

“In the past, we've taken a fairly surgical approach to pricing,” said Don Blair, Nike Inc.'s VP and CFO, on a conference call with analysts. “Beginning in spring 2012, we'll take more significant price increases across a broader range of styles. As always, we'll carefully consider each pricing action to maintain a competitive consumer value proposition.”

 

Net income in the quarter reached $523 million, or $1.08 a share, compared with $497 million, or $1.01 cents, in the year-earlier quarter. That was below analysts' average expectation of $1.12 per share. The miss sent NKE shares down 13.7% last week to close at $77.38 on Friday, but the broader implication of Nike’s input costs concerns was felt across the market. The weekly footwear index tracked by Sports Executive Weekly (see below) fell 10.3% for the week versus a 1.9% dip for the S&P.

 

Revenue in the fiscal quarter ended Feb. 28 climbed 7.0% to $5.1 billion and were up 8% excluding currency changes. Nike Brand futures orders were up 11% and increased 9% currency-neutral. Management noted that the strong gains came despite challenging comparisons to last year's World Cup-fueled results, particularly in the Emerging Markets and both European regions.

 

Nike Brand revenues grew 9% on a constant-currency basis, somewhat lower than the futures growth reported last quarter, due primarily to lower off-price sales and modestly higher cancellation rates versus an unusually low rate last year. Revenues for Other Businesses grew 1% currency-neutral as double digit growth at Converse and Cole Haan was largely offset by lower revenues at Umbro and Nike Golf, which both faced difficult prior-year comparisons. “I feel good about our Q3 results and I know we have the potential to do even better,” said Mark Parker, Nike, Inc. president and CEO, on the conference call. “Specifically, consumer demand for our products and brands is extraordinary.” He noted that many economies are seeing “a vigorous return to growth,” specifically China, Brazil and other developing countries, while countries like Japan, Spain, Italy, and Greece are taking longer to regain momentum. “Our largest market, the U.S., is somewhere in between.

 

And while the relationship between economic growth and consumer confidence isn't entirely predictable, it's clear that consumers remain under pressure from high unemployment and emerging inflation.” But Parker believes Nike's scale, operational capabilities, and pricing power will at least help the company mitigate rising input costs better than many others. “Over the longer-term, I expect cost factors will continue to ebb and flow, albeit at different speeds,” said Parker. “Consumer-driven companies with strong brands and compelling products will be in the best position to maintain their margins.”

 

Nike Brand revenues were up 8.0% in the quarter to $4.41 billion. Nike Brand footwear grew 7.6% to $2.86 billion. Nike apparel grew 11.6% to $1.29 billion. Equipment was down 4.9% to $232 million. On a currency-neutral basis, revenues rose 8% in footwear and jumped 13% in apparel but slid 3% in equipment.

 

Charlie Denson, Nike Brand president, reported that the brand grew in every one of its categories, with five of those categories growing at double-digit rates. Nike’s direct-to-consumer business delivered strong comp store growth in both factory and inline stores, and another quarter of double-digit growth online. Regarding the price hikes, he said Nike has already been increasing price, albeit strategically, on Fall/Holiday product but the next step will feature “more of a across-the-board increase to make sure we maintain price value relationship across the entire product line as we move into 2012.” He stated, “Over the coming seasons, we'll approach these pricing actions on a style-by-style, market-by-market basis. And we'll do what's right for both our near-term financial health as well as our long-term growth and competitiveness.”

 

In North America, Nike Brand revenues advanced 9.3% to $1.84 billion as all categories except sportswear grew versus the prior year, led by double-digit growth in running, men's and women's training, and football (soccer). Footwear sales climbed 7.3% to $1.27 billion, driven by strong demand for Lunar and Nike Free running products as well as men's training models. Apparel sales surged 17.9% to $481 million, driven by new category presentations at Nike-owned retail stores and at retailers such as Foot Locker, Finish Line and Dick's Sporting Goods. Equipment sales declined 4.7% to $81 million. “Our new Nike Brand and category stores are performing above early expectations,” said Denson. “Our executions with Dick's, Footlocker and Finish Line, are helping Nike and our partners deliver great and strong results. And there are more on the way.” Direct-to-consumer sales in the North America region increased 20% for the quarter, as comp sales in Nike-owned stores increased 13% and online sales jumped 28% for the quarter. Operating earnings in North America gained 5.0% to $423 million as revenue growth and operating expense leverage were partially offset by lower gross margins and higher demand creation. North America futures were ahead 11% at quarter-end. Denson said he still feels Nike is gaining share in North America overall against competitors. “I think it's category-by-category,” he said. “I think we still feel very good about our running business. We still feel very, very good about our basketball business. Men's and women's training is coming online and action sports is still doing very well. So, overall, I think you have to break it down category-by-category, but on an overall basis, I still feel confident that we have the ability to gain share.”

 

In Western Europe, Nike Brand sales grew 6% on a currency-neutral basis, reflecting broad-based growth across nearly every territory, category, and product. Currency-neutral footwear sales grew 6%, apparel increased 7%, and equipment advanced 4%. Due to unfavorable exchange rates, reported revenues slumped 2.4% to $907 million.

 

Operating earnings in Western Europe declined 19.1% to $161 million. Futures were up 4% on a reported basis and were flat currency-neutral. In Central and Eastern Europe, Nike Brand sales grew 11% currency-neutral, fueled by double-digit growth in Russia, Turkey and Poland. From a category perspective, running and football (soccer) powered the growth. Currency-neutral sales increased 9% in footwear, 13% in apparel, and 18% in equipment. On a reported basis, total sales improved 5.0% to $251 million.

 

Operating earnings advanced 23.9% to $57 million as higher revenues and SG&A leverage more than offset lower gross margins and unfavorable foreign exchange. Futures were up 9% on both a reported and currency-neutral basis.

 

In Greater China, revenues increased 18% on a currency-neutral basis, driven by expanding points of distribution and double-digit growth in sportswear, running, men's training and action sports. On a currency-neutral basis, footwear grew 16% and apparel jumped 28% while equipment was down 23%. On a reported basis, Nike Brand revenues grew 21% to $554 million.

 

China's operating earnings increased 23.9% to $57 million, driven by higher revenues and gross margins. Greater China's futures were up 19% on a reported basis and 13% on a currency-neutral basis, including double-digit growth across most key categories. Denson said Nike remains on track to double its China business by FY 2015.

 

In Japan, Nike Brand currency-neutral revenues were down 16%, with footwear off 12%, apparel sliding 16%, and equipment tumbling 38%. Japan's operating earnings fell 22.5% to $31 million. Japan's' futures were up 4% on a reported basis and 2% currency-neutral. Blair noted that Nike's organization and assets in Japan have not been significantly affected by the earthquake and tsunami that has wrecked havoc in the country. “It's too early to fully assess the financial impact of these ongoing events on our business — and we have not done so in our guidance — but we do anticipate there will be a negative impact on our revenues and profits for this geography.”

 

In Emerging Markets, Nike Brand revenues increased 15% on a currency-neutral basis. Footwear grew 15%, apparel gained 13%, and equipment increased 15%. Every category and every territory, except South Africa, posted higher revenues, with Mexico, Argentina and Korea driving the largest share of the growth.

 

On a recorded basis, revenues grew 18.6% to $643 million. Emerging markets' operating earnings climbed 36.2% to $173 million, driven by strong revenue and margin growth, as well as SG&A leverage and favorable foreign exchange. Futures were running up 21% on a reported basis and 18% on a currency-neutral basis. Futures grew in all categories except Football, reflecting difficult comparisons to the World Cup.

 

Other Businesses segment revenues increased 1.2% to $663 million and were up 1% on a currency-neutral basis for the quarter. Double-digit growth at Cole Haan and Converse offset sales declines at Nike Golf, due to shifts in the timing of product launches, and Umbro, which faced comparisons to strong World Cup sales last year.

 

Operating earnings were down 19.0% to $85 million as lower operating margins reflected unfavorable product mix and SG&A deleverage. Overall Nike, Inc. gross margin declined 110 basis points to 45.8% of sales mainly as a result of higher product costs, elevated freight costs, including additional airfreight incurred to meet strong demand for Nike Brand products, and a smaller proportion of license revenue due in part to the conversion of Converse’s U.K. business to direct distribution. Airfreight accounted for 50 basis points of the decline.

 

Marketing expenses rose 3.0% to $578 million due to marketing support for key product initiatives and investments in retail product presentation for wholesale accounts. Inventories were up 18% at the quarter's end, driven by higher demand, growth in replenishment programs for high-turnover styles, and pre-builds to maximize the productivity of factory capacity. The increase also reflects extremely low levels last year when inventories were down 13% at the end of the 2010 fiscal third quarter. Inventory growth was said to be driven by in-line product while close-outs are actually a smaller percentage of total inventory than last year.

 

Blair said inventory levels are expected to grow faster than revenue for the first half of fiscal 2012, but inventory and revenue growth are expected to come back into line as new factory capacity “comes on stream.” Cash and short-term investments at period-end were $4.5 billion, 11% higher than quarter-end last year. Regarding cost inflation, Blair noted that the company continues “to experience higher than normal levels of air freight to meet tremendous consumer demand for products” and expects these headwinds will continue through most of fiscal 2012. Besides raising prices to offset inflation pressures, Nike is leveraging its supply chains, managing inventories carefully, and working with suppliers to increase capacity and reduce cost.

 

“While inventory for Q3 grew significantly to support strong demand, we continue to experience capacity shortages for some technical products,” added Blair. “However, as a result of the work we've done to consolidate our supplier base, our factory partners have the financial and operational ability to build capacity and reduce product costs. To address the current shortages, our suppliers have added new footwear and apparel production lines over the last nine months, and have committed to significant additional capacity expansion through the next fiscal year.” For the current fourth quarter, Nike expects reported revenue to grow at a high-single-digit rate as Nike Brand futures growth is partially offset by lower at-once and off-price sales. Gross margin is expected to be at least 300 basis points below last year's record 47.4% of sales due to increasing pressure from input costs.

 

For the full year fiscal 2011, NKE continues to expect gross margin will be at least 50 basis points below the prior year. Marketing expenses for fiscal Q4 are expected to decline at a mid- to high-single-digit rate due to the absence of World Cup spending. Fourth quarter operating overhead should grow at a low-single-digit rate, reflecting ongoing investment in its direct-to-consumer business.

 

Looking to fiscal 2012, Nike expects full-year revenue growth at or slightly above its high-single-digit target range, as strong consumer demand continues and higher prices provide a lift in the back half of the year. However, downward pressure on gross margin – due to higher input and air freight costs, as well as foreign exchange headwinds – is expected to more than offset continued SG&A leverage, will continue to drive gross margins lower on a year-over-year basis.