The last time that Nike Inc. (NKE, Financial) reported earnings results, the stock plummeted 13% in a single trading session. Despite weakness in the company’s report, I wrote that I still believed the stock was being underestimated by the market.
Fast forward to a few days ago and Nike’s stock surged more than 12% as the company reported better than expected results for its latest quarter. Following this price movement, Nike is now trading above its long-term valuation multiples, but I think the stock is still trading at a discount; here's why.
Quarterly highlights
Nike reported earnings results for the secon -quarter of its fiscal year 2023 on Dec. 20. Revenue grew 17.3% to $13.3 billion, topping expectations by $740 million. Earnings per share of 85 cents was slightly higher than the 83 cents the company had in the prior year and 21 cents above estimates. Net income of $1.3 billion was essentially unchanged from the prior year.
Revenue for Nike Direct grew 16% on a reported basis (25% on a currency neutral basis) to $5.4 billion, driven by a 25% increase (34% on a currency neutral basis) for Nike Brand Digital. As we can see, currency exchange was a huge headwind.
Wholesale revenues were up 19% (30% on a currency neutral basis). Converse, a much smaller portion of the business, grew 5% (12% on a currency neutral basis) to $586 million due to strength in North America.
By region, North America grew 30% in constant currency, Europe/Middle East and Africa was up 33%, and Asia Pacific and Latin America was higher by 8% and Greater China fell 3% on a reported basis but improved 6% on a currency neutral basis.
There are some negatives found within the report. The first is the decline in gross margin, which fell 300 basis points to 42.9%. Still, this was better than expected. Markdown of products occurred mostly in North America due to excess inventory. Inventories were once again high, up 43% to $9.3 billion.
According to Morningstar (MORN, Financial) analysts, Nike is expected to report earnings per share of $3.42 in full fiscal year 2023.
Takeaways
Top-line growth was the best that Nike has seen in the trailing 12 months. Revenue results for the past three quarters were up 3.6%, down 0.9% and up 5%, respectively. The earnings per share beat was the widest by far in the most recent quarter.
Nike’s long-term success is driven by the strength of its brand and the close attention it gives to customer preferences and engagement. This includes going straight to the customer instead of focusing on agreements with retailers. The strength in Nike Direct and e-commerce shows that consumers are responding to the company’s investment in this area. The company has leveraged the 160 million active members in its loyalty program to boost results in these channels. This is a massive customer base, one which few, if any, competitors can match.
Moving to gross margin, Nike’s products are, like most manufactured items, becoming more expensive to make due to higher inflation costs. While some costs can be passed on to customers, not all of these expenses can be. Thus, Nike has seen a decline in gross margin, as wages are not keeping up with inflation, thus reducing consumers' purchasing power. When coupled with markdowns to clear inventory, the margin picture becomes worse. The good news is that the negative impact on gross margin wasn’t as bad as expected.
Inventories still remain high, which will mean that discounting on products will most likely continue to be an issue. The good news here is that inventories did fall $336 million on a sequential basis. There is still inventory to be cleared, but this could mean that Nike has now seen peak discounting. If so, then margin pressure could begin to abate.
The strict policies regarding Covid-19 in China had kept a lid on growth in the region for Nike, but that seems to be changing. The impact is already being felt by the company. Revenue for the region fell 19% on a reported basis and 20% in constant currency in the first quarter of the fiscal year. As many of these restrictions have now been lifted or modified, Nike saw a drastic improvement in business in China. As Nike’s most important growth region, this will be a significant tailwind to the business if further growth returns following the easing of restrictions in the region.
Nike’s capital returns to shareholders are very high. The company repurchased 16.5 million shares at an average price of $97 during the last quarter, which is good value considering Wednesday’s closing price. In June, Nike authorized an $18 billion share repurchase program to be conducted over a four-year span. The company has $16 billion, or 8.8% of the current market capitalization, remaining on its authorization as of the end of the second quarter.
The company also raised its dividend 11.5% for the Dec. 28 payment date, extending Nike’s dividend growth streak to 21 years, though the forward dividend yield is still tiny at 1.16%.
Valuation analysis and return potential
Using Morningstar analysts' estimates for the fiscal year, Nike is now trading at 33.8 times earnings estimates. This is considerably higher than the forward price-earnings ratio of 27.8 that shares were trading with the last time I looked at the name.
The average price-earnings ratio for the last decade is just under 30 when you remove the artificially high multiple due to Covid-19 in 2020. Nike is now trading a premium to its long-term average valuation.
The GF Value chart is much more appealing.
Nike is trading just below $116. With a GF Value of $144.61, the stock has a price-to-GF-Value ratio of 0.80. The stock could gain 24.8% if it were to reach its GF Value. The forward dividend yield added in could bring the total return potential in the mid-20% range.
The stock isn’t cheap in a historical basis, but Nike has a very high GF Score of 94 out of 100, suggesting the potential for high outperformance based on historical studies conducted by GuruFocus. The GF Score results from top scores for growth, value and profitability, a solid score for financial strength and a middling score for momentum.
Final thoughts
Nike’s second-quarter results had multiple positives, including a return to high levels of revenue growth. Net income was flat and earnings per share was up slightly, but this was a reversal from the declines seen in the first-quarter of the fiscal year.
Nike’s direct-to-consumer business continues to deliver and e-commerce investments have paid off. Growth was evident in most regions, with China showing a very strong sequential improvement. Inventories remain high, which will pressure gross margin as the company works to clear product.
Following the surge in share price, Nike is trading above its historical average levels. This might give value investors pause, but still, I believe the stock is undervalued based on the GF Value chart and growth prospects. However, I would still prefer to wait for a pullback in the share price in order to secure more of a margin of safety.
