Why Investors Shouldn't Get Used to Nike's High Earnings Growth

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Nike (NYSE:NKE) is seeing its digital business boom during the pandemic, but overall, the business is still in recovery mode, with revenue growing by just 3% in the fiscal third quarter. Adjusting for currency, revenue actually fell by 1% year over year.

However, the untold story for Nike has been stellar performance on the bottom line. In the last quarter, a higher gross margin and lower operating expenses contributed to growth in earnings per share of 70% over the year-ago quarter. 

If Nike could sustain that level of profit growth, the stock would look like a steal even at its high forward price-to-earnings ratio of 42. But as the economy reopens, management is planning to ramp spending back up to drive long-term growth. Here’s what that could mean for Nike in the near term.

Image source: Nike.

Unsustainably low expense levels

One reason for the tremendous boost in earnings growth last quarter was a relatively easy year-over-year comparison to the year-ago quarter, when Nike reported a drop in earnings per share of 22%. But a reduction in marketing expense, or what management calls demand creation expense, also played a key factor. 

The lack of live sports during the pandemic disrupted Nike’s ability to market its brand, which caused management to reduce spending on demand creation as a percentage of revenue. “Prior to COVID we were at something like 9% or 10% of revenue and it fell to about 7% in the first half,” CFO Matthew Friend explained during the fiscal third-quarter earnings call. 

Demand creation expense dropped by 18% in the most recent quarter and 24% for the nine-month ending period. That amounted to $652 million less spent for demand creation over the last three quarters, which contributed to a boost in net income. 

Historically, Friend explained, Nike has managed its total operating expense at 33% of revenue, but over the last year that fell to 29%. But with so much opportunity for growth, particularly in women’s apparel, international, and e-commerce, management feels that these levels are not sustainable: 

“We’re going to be accelerating investment in Q4 against our biggest growth opportunities, women’s. We’re going to continue to be investing internationally […] We’re going to be investing behind Jordan. And we are going to continue to invest against digital.”

— CFO Matthew Friend during the fiscal third quarter 2021 conference call 

Near-term expectations

Nike will face an easy year-over-year comparison in the fiscal fourth quarter, given the year-ago collapse in revenue and profits at the start of the pandemic. Management expects revenue to be up 75% year over year. Analysts expect Nike to report earnings per share of $0.51, as compared to a loss of the same amount in fiscal Q4 2020. 

But as Nike regains the pace of spending on demand creation and other expenses, earnings growth comparisons over last year may get more difficult. Analysts’ estimates currently forecast Nike to report $1.13 in earnings per share for the August-ending fiscal first quarter, compared to $0.95 in the year-ago quarter. That’s a year-over-year improvement of 19%.

Investors should put this in context with management’s long-term outlook, which calls for a mid-teens annualized increase in earnings per share. This forecast stems from the anticipated benefits of management’s Consumer Direct Acceleration strategy. This involves continued investment in creating a seamless shopping experience between physical stores and digital, and better realigning product creation to meet the specific needs between men’s, women’s, and kids. 

Nike also expects to see an improving gross margin, as digital sales continue to grow as a percentage of total revenue, and as the company begins to use data analytics to inform new product design and manage the supply chain. 

Expect a possible short-term hit

Nike is a growth company, but investors need to be careful about extrapolating recent earnings performance out too far. Management’s long-term outlook for earnings growth hasn’t changed, yet the stock’s price-to-sales ratio has increased from around 3.6 in 2019 to 5.5 at the current quote. Unless management raises its long-term forecast for earnings growth, that large increase in the valuation doesn’t seem warranted.

If an increase in operating expenses causes earnings growth to decelerate back toward Nike’s long-term target, that could pressure the stock price at these lofty valuation levels.

 

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.