Nike Battles Upstart Under Armour, High Expenses

NEW YORK (TheStreet) -- Nike (NKE), the world's leading manufacturer of athletic footwear, apparel and equipment, delivered good quarterly results with strong direct-to-consumer sales growth. In the meantime, its rival Under Armour (UA) has also impressed investors with a blowout performance. And in the coming quarter, Nike will likely continue posting strong numbers for direct-to-consumer sales.

Is Nike a slam dunk, then?

Maybe not.

Investors should remain cautious, as Nike is still struggling to rein in its expenses. Moreover, the business's performance in China and other emerging markets is far from satisfactory. The company has not reported any growth in combined revenues from these two regions in the first six months of the current fiscal year.

Nike's shares have risen by nearly 10% in the last six months, to $72.67. Its price-to-earnings ratio is 24.8, making Nike considerably cheaper than Under Armour by that metric.

Growing the Top and Bottom Line

In its recent quarterly results, Nike posted an 8% year-over-year increase in revenues to $6.43 billion, which was slightly below market expectations of $6.44 billion. The company's net income rose by a massive 40% from last year to $537 million, or 59 cents per share, just above market expectations of 58 cents per share.

However, this enormous increase in profits was largely due to the $137 million in losses related to discontinued operations that were included in the prior year's results. Considering just the income from continuing operations, Nike's profits are up a modest 3%.

The business benefited from an increase in sales of higher-margin products, as Nike's gross margin increased by 140 basis points to 43.9%. The firm's margins also improved due to lower input costs and 20% growth in comparable-store sales in direct-to-consumer stores.

Moreover, Nike's total global future orders are up 12%, which shows a bright outlook. Orders were up 8% in the previous quarter and 6% a year ago. The business's future orders indicate expected growth in sales of athletic footwear and apparel between December 2013 and April 2014.

Meanwhile, Under Armour came forward with even better results, with double digit top and bottom-line growth. Unlike Nike, the business's revenues and profits surged by 35% and 28%, respectively, from last year. Under Armour's 36% growth of direct-to-consumer sales also easily surpassed Nike's. Like Nike, Under Armour also benefited from a favorable sales mix, which is why the business's gross margins expanded by 100 basis points to 51.3%.

While Under Armour's results were clearly better than Nike's, both companies have posted strong direct-to-consumer sales numbers and are more optimistic about the future, which is evident in Under Amour's guidance and Nike's future orders.

In the coming quarter, I think Nike will likely post double-digit growth in direct-to-consumer sales. The company has other problems, though.

Rising Sales and Administrative Costs

On the flip side, Nike's selling and administrative expenses are now taking up a greater portion of the company's sales. Over the last year, the business's sales and general expenses have increased by 13.7%. These expenses now represent 32.5% of the company's revenues, as opposed to 30.8% in the same quarter last year and 29.5% in the previous quarter.

Despite having a favorable sales mix, the company's earnings growth has lagged behind its revenue growth. Nike could only manage a 3% increase in profit from an 8% increase in revenue.

Developed vs. Developing World

Nike has been able to grow its top and bottom line, albeit at a modest pace, with improving future orders. However, a deeper look inside its operations reveals that nearly all of this growth can be attributed to its performance in North America and Europe. Most notably, as compared to last year, in Western Europe Nike's revenues and earnings before interest and taxes jumped by 18% and 12% respectively. This was due to Nike's much-talked-about "strategic reset" applied in early 2012.

Nike is clearly making inroads in this market, which is the home ground of Adidas (ADDYY). Nike has been increasing its market share in the region at the expense of Adidas. Moreover, Nike has also reported a 26% increase in future orders from Western Europe, which means that the business will likely continue to deliver solid performance in the coming quarter.

But Nike has struggled with growth in emerging markets, China and Japan. In emerging markets, Nike's quarterly revenues dropped by 4% from last year, as the business reported declining sales of footwear, apparel and equipment. Earnings in emerging markets also dropped by 18%.

In Japan, Nike's sales fell 13% due in part to a weak yen, but earnings grew by 4%.

In China, Nike's growth has lagged considerably behind all other regions. In the first six months of the current fiscal year, on a constant currency basis, Nike has reported just a 1% increase in sales in China, with zero growth in the footwear segment, the primary revenue driver. During this period, Nike has reported $3.1 billion in total revenues from China and emerging markets taken together, which shows zero growth from the $3.1 billion revenues it reported in the same period last year. Meanwhile, in the corresponding period, Nike has witnessed a 6% year-over-year drop in total earnings from China and emerging markets.

In other words, without any top line growth and a shrinking bottom line, Nike has made little inroads in the developing world.

Nike, however, is still optimistic about its future in China. The business attributed its success in North America to its strategic reset, which it later applied to Western Europe. It is now planning to do the same in China.

Nonetheless, the company's future in China remains uncertain. It faces tough competition from other international players, as well as powerful local brands such as the Hong Kong-listed Li Ning (LNNGY), which is virtually unknown in North America but is a household name in China.

At the time of publication, the author held no positions in any of the stocks mentioned.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

Sarfaraz A. Khan is a capital market analyst and finance writer. Khan earned an MBA from the University of Aberdeen, located in the heart of the UK's oil and gas industry. Not surprisingly, his specialty lies in energy stocks. He also covers consumer goods, services sector, technology stocks, emerging markets and ETFs. His work appears on Seeking Alpha, Motley Fool and TheStreet.

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