Nike’s Q2 Excels, But Warns of Cost Pressures

Excluding the impact of currency fluctuations, sales increased 11%, driven by strength in running and basketball footwear as well as growing momentum in apparel. Total Nike Brand orders for delivery through April 2010 were up 11% to $7.7 billion and also ahead 11% in constant currencies.

 

NKE shares, nonetheless, were off slightly after the report, reflecting some profit-taking after hitting $92.30 last week, the highest price since its initial public offering in 1980. Some analysts had hoped for even gaudier futures., but a bigger worry was rising input costs that Nike said will cause its fiscal 2011 gross margins to dip at least 50 basis points below 2010. NKE expects the margin “headwinds” to ease over the next 12 to 18 months.

“As supply and demand find a new normal in the recovering economy, our industry is going to experience margin pressure due to rising input costs,” CEO Mark Parker warned on a conference call with analysts. “While the impact of these cost pressures has been delayed for us, these factors have not diminished. We expect to see these external forces play out for the remainder of the fiscal year.”

But the margin pressure warning was the rare negative note delivered on the call. In the quarter, total worldwide Nike brand sales gained 9.5% to $4.22 billion and would have been up 10% at constant exchange rates. The gains were driven by growth in all seven Nike brand key categories except sportswear, which was down slightly compared to the prior year. The brand grew in every geography except Japan. Nike's direct-to-consumer businesses grew double-digits and online saw its 15th consecutive quarter of double-digit sales growth.      

 

North America Poised for More Gains on Record Backlog…

By category, Nike Brand footwear sales increased 11.1% to $2.58 billion. Apparel climbed 8.4% to $1.38 billion. Equipment sales slid 3.3% to $234 million. In constant exchange rates, sales grew 12% in footwear, 9% in apparel while sliding 5% in equipment. Earnings before interest and taxes (EBIT) for Nike Brand was up 6.0% to $721 million.

On the call, Nike brand President Charlie Denson said Nike's apparel business is being particularly driven by strong demand for the Nike Pro base layer collection and he sees “a direct connection between on-field performance and consumer preferences off the field.”

He also said the running category overall is benefitting from efforts began just over two years ago to refocus on innovation that has resulted in successful launches with the Luna, Nike Free and Flywire platforms. The category's success also reflects Nike's increasing “emphasis on young runners and the new running boom that we are fueling around the world” In Q2, Nike executed 105 events in 28 countries with over 850,000 runners, an all-time record for the company.

Denson highlighted the opening of two Nike running-only destinations in Stanford, CA and Covent Garden in London and noted that over 400 running retail partner destinations have been transformed year-to-date to a new running layout. Said Denson, “It's a global strategy that we will continue to execute with our direct-to-consumer business, our brand retail partners and especially with the core specialty running shops that serve the serious runner.”

Regarding basketball, Denson said the category “continues to actually gain momentum,” helped by the launch of the new Kobe Bryant shoe as well as strength with LeBron and Jordan models. He also cited “the emerging talent of Kevin Durant, who is actually becoming a bigger and more effective, I guess, driver of the basketball business.” The apparel piece of basketball is likewise “very strong,” driven by Nike Pro in North America as well as overseas growth due to basketball becoming “more and more of a global sport.”

Denson also cited the “tremendous potential” he sees in women's training given the renewed interest women have in core fitness. The Nike Free campaign will be a major effort this spring, he added.

Finally, Denson highlighted Nike's new partnership with the NFL, which includes on-field uniforms and begins in 2012. He described it as “one of the biggest and most meaningful sports marketing investments in our history, and I'm confident we'll bring the most innovative performance product to the game at the highest level.”
In the North America region, Nike brand sales advanced 13.6% to $1.7 billion, reflecting double-digit growth in wholesale equivalent revenues. All categories except sportswear grew versus the prior year, led by double-digit growth in running, basketball and men's and women's training. Currency-neutral futures increased 16%, the highest growth in over 10 years, driven by double-digit increases in all categories. North America direct-to-consumer sales increased 17% for the quarter as comps in Nike-owned stores increased 13% and online sales increased 26%, both driven by higher traffic and average transaction.

 

By category, apparel revenues in North America jumped 22.0% to $538 million. Part of the growth was attributed to the development of new category concepts with retailers such as Foot Locker, The Finish Line and Dick's Sporting Goods, which have increased apparel space and consumer demand. Futures for apparel increased 24% with double-digit growth in almost every category. Footwear sales in the quarter grew 10.4% to $1.08 million, driven by accelerated demand for Lunar and Nike Free running products and new basketball products. Footwear futures grew 15% with balanced growth across every category. Equipment revenues added 6.7% to $80 million.
EBIT in North America grew 23.8% to $359 million, driven by revenue growth and SG&A leverage.

In Western Europe, sales were down 6.5% to $843 million but grew 2% currency-neutral with most territories seeing higher revenue for the quarter. Football and running were the key category growth drivers. On a currency-neutral basis, footwear grew 6% and apparel was flat. Currency-neutral futures were up 3% at quarter-end as Nike anniversaries strong prior-year orders for the World Cup.

EBIT in Western Europe declined 19.4% to $141 million, primarily due to currency headwinds. SG&A also rose as investments were made in its direct-to-consumer business and it anniversaried low levels of spending in Q2 last year.

In Emerging Markets, Nike Brand revenues climbed 24.4% to $755 million, reflecting 19% growth on a currency-neutral basis. Every category and every territory, except Australia and New Zealand, posted higher revenues with Brazil, Argentina, Mexico and Korea driving the largest share of the growth. Futures grew 15% as all categories grew except football, reflecting comparisons to the World Cup.

Fiscal Q2 EBIT for the emerging markets increased 13% to $194 million as the top-line growth was partially offset by higher SG&A and lower gross margins.

“Markets like Brazil, Mexico and Korea are playing a bigger role in the Nike growth story,” said Denson. “We have strong teams on the ground, and they're connecting with consumers, who have a huge appetite for sport and sport lifestyle.”

In Greater China, Nike brand sales grew 19.6% to $482 million, including a two point currency benefit. Growth was fueled by expanding points of distribution and strong performance and running, basketball and men's training, which all increased more than 20%. Currency-neutral futures grew 14% with double-digit growth across most key categories. Fiscal Q2 EBIT for greater China jumped 39.2% to $174 million, driven by revenue growth, higher gross margins and SG&A leverage.

In Central and Eastern Europe, Nike Brand sales grew 7.2% to $223 million and 12% on a currency-neutral basis – continuing recent positive momentum. Revenues in Russia increased 40% and both Turkey and Central Europe grew in double-digits. All categories reported higher revenues with football (soccer) and running the key drivers. Currency-neutral futures rose 11% even with tough comparisons to the World Cup.

 

Fiscal Q2 EBIT for Central and Eastern Europe declined 10.2% to $44 million, due largely to the negative impact of currency on gross margin and profit translation. Futures were up 11% excluding currency changes.

In Japan, Nike brand sales were down 14.0% to $192 million and were down 21% on a currency-neutral basis. EBIT fell 20.0% to $36 million. Japan's futures were down 5% in constant currencies. Nike, Inc. CFO Don Blair said that although gross margins improved and inventories were lower, “we believe it will take time before we see a significant improvement in growth and profitability” in the region.

Sales in its Other Business segment – Cole Haan, Converse, Hurley, Nike Golf and Umbro – grew 13.5% to $631 million and were up 13% in constant exchange rates. The gains reflected double-digit growth at Cole Haan, Converse, Hurley and Umbro. Converse exceeded $1 billion in reported revenue for the past 12 months, and also opened its first two free-standing stores in New York City and Boston. Nike Golf grew at a single-digit pace.
Fiscal Q2 EBIT for Other Businesses soared 68.6% to $59 million, driven by revenue growth, higher gross margins and SG&A leverage. 

Overall NKE gross margins overall improved 80 basis points to 45.3% due to a higher mix of full-price sales and fewer and more profitable close-out sales resulting from strong demand for products and cleaner inventory positions, as well as improved profitability from direct-to-consumer operations. These factors more than outweighed higher costs for air and ocean freight.
Selling and administrative expenses were up 9% to $1.6 billion mainly due to operating overhead, which increased 14% to $1.0 billion.

 

This increase was a result of additional investments made in both its wholesale and direct-to-consumer businesses, higher performance based compensation expense and meeting and travel expense increases given comparisons to reduced levels last year. Demand Creation spending was inline with the same period last year at $574 million.

Looking ahead, Nike said it hasn't changed its goals for the year. On a currency-neutral basis, revenues for Q3 are expected to grow at the top end of the high-single-digit range with reported revenue growth slightly lower due to weaker foreign currencies. Gross margins for the second half of the fiscal year are expected to be below record levels seen in the second half of Fiscal 2010 due to downward pressure from input costs.

“As we purchase product for calendar 2011, we are seeing the effects of higher input costs, such as cotton and labor,” said Blair. “Given the scope and complexity of our product lines and supplier base, changes to input costs do not flow directly and immediately into our product costs, making it difficult for us to call the peak. And while we are working hard with our suppliers to increase capacity, we also expect higher-than-normal levels of air freight, at least through the first half of FY 2012, to meet strong demand.”

To offset these cost pressures, Blair said Nike will continue to work with suppliers to increase capacity and reduced product costs; and will also tightly manage inventories to maximize margins and minimize closeouts, including its own stores. Blair also said Nike will be continuing to work across their footwear and apparel product lines to identify opportunities for “surgical price increases on a market-by-market basis.”

The expected gross margin decline of at least 50 basis-points this fiscal year through May 2011 will reflect negative margins in the second half that will offset positive margins so far. The fiscal fourth quarter is expected to be “more significantly affected” than Q3 as cost pressures intensify and comparisons to the prior year become more challenging.

 

Demand creation is expected to grow at a mid-single-digit rate for the year with Q3 growth in the high-single-digits and Q4 spending below the prior year as its anniversaries heavy investments in the World Cup. Nike also expects operating overhead to grow at a mid-single-digit rate for the year, reflecting increased investment in its direct-to-consumer businesses balanced by increased efficiency in its core operating functions.