Lack of China Growth Limits Nike’s Upside

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The world’s leading sportswear firm Nike (NYSE:NKE) broke above $50 per share, a significant resistance level, after announcing better than expected results coming from North America in their last earnings report, but the stock has had trouble besting longer-term resistance near $56-7 per share.   Nike’s future growth is not predicated on North American growth, a saturated market, but rather China and other major emerging markets and there the picture is more muddied.  In this article we’ll go over the earnings report and lay out a potential trade based on Nike’s current performance and price.

Overall, global future orders are due to rise 6% through April, out of which the North American and Western European future orders are up 14% and 10% respectively.

Quickly running down the financials for the quarter, revenues increased by 7% from the same quarter last year to $5.95 billion and net income from operations rose 9% to $521 million. Factoring in the $137 million loss from discontinued operations related to Umbro and Cole Haan, overall net income fell to $384 million which is 18% lower from 2011 but 14% better than analysts’ expectations.  Umbro is being sold to Iconix Brand (NASDAQ:ICON) for $225 million while Cole Haan is being sold to Apax Partners for $570 million.

Nike earns 60% of its revenues from Footwear and 33% from Apparel. Despite its higher ASPs and falling raw material costs, Nike’s gross margin dropped by 0.3 percentage points to 42.5% due to increasing labor costs and currency fluctuations.

However, its Chinese fears remain as they were before. While other multinational consumer brands such as Yum Brands (NYSE:YUM) and Apple (NASDAQ:APPL) have successfully made the switch to catering to Asian tastes, brands like Nokia (NYSE:NOK) and Nike, though in radically different markets, are still working out how to find their way in the radically changing markets while pinning their future growth on Chinese consumers.

Nike is having a tough time convincing the Chinese market to buy into the Nike lifestyle and its expense. Although future orders from emerging markets are up 7% in China they are down 6% (in constant currency terms, it’s a decline of 7%) while in Western Europe, they are flat. Nonetheless, the overall 6% increase in future orders has caused a bump in share prices, especially in a buoyant U.S. equity market and strong recent rallies by both the Hang Seng (+20.3% since 6/29) and Nikkei (+17.5% since 8/31) indices are implying higher consumer demand due to looser – or in the case of Japan very loose – monetary policy.

While Nike is going strong in North America, its biggest market, falling revenue levels in Western Europe and China are troubling. In Western Europe, its sales are down 2% to $897 million while in China the drop was 11% to $577 million. The company’s quarterly EBIT has risen in all regions – including Western Europe – but in China they dropped by 16% to $185 million, suggesting that China is one market where Nike has no pricing leverage.

Within China, the company is facing strong competition from local brands, all of whom sell their footwear and apparel at considerably lower prices. Amid the economic slowdown in the country, Chinese consumers are willing to substitute Nike’s premium products with its rivals. There are no indications of this problem going away anytime soon.  Apple is beginning to find the same problem with the iPhone 5 – rapidly shrinking market share, just 9.1% in smartphones, is testament to that.

Nike’s growth in North America is impressive but advances there as a mature market will be in cannibalizing market share rather than growing with a growing new consumer base. As such, it does not offer much long term growth potential compared to China or other emerging markets. Nike recognized this during the conference call saying that they are happy with the North American results but need China for the long term growth. To do this Nike will be focused on improving inventory levels, which has created problems in the past while also ramping up apparel lines more suited to the Chinese consumer’s tastes.

But the struggles of Nike, Apple and even McDonald’s (NYSE:MCD) this year highlight the growing independence of Chinese consumers from the West’s brands.  This may be in its infancy but it is a trend worth watching – growing Chinese nationalism for home-grown brands.  The story simply isn’t as simple as 1.2 billion Chinese are getting rich so will American Company X.  As the consumer in China is presented more cost/benefit options and the economy works through the lingering effects of its mercantilist trade policies of the past 10 years it will be harder for U.S. and European companies to trade on their brand equity.

In closing, for Nike, I see the positives coming out of the current earnings release as being in the emerging markets region.  Besides that, its business is only growing in North America.  At this point Nike is an interesting trade alongside general equities but to add it to my core portfolio at this point I would have to see far better numbers coming from China along with better inventory management.  Trading at a P/E of 23 in a low-growth market is too high a risk to take versus the 1.5% yield the stock is paying.  A weekly close above $53.20 greatly improves the probability of the trade going your way from a longer-term perspective.

Looking at the monthly chart of Nike here’s the breakdown of the trade using my trading method as outlined in my book The BIG Trade adapted here to selling puts.  I’m bullish as a trader since Nike opened above January’s closing price.  Nike closed last week at $54.95 over January’s high price.  The table below is built from Nike’s price action over the past 1.5 to 3 years.

Since Nike opened above the January closing price of $54.06 it was in a very bullish posture.  And therefore we could look at any small move higher as an indication of the stock wanting to attempt a move to the January high.  There was a 90% chance that if Nike moved just $0.10 above its opening price for the month it would break the January high, which it did.

Breaking through January’s high ($55.57) that creates an outside month in February, i.e. a month in which the price broke either the low or the high.  At which point the probability that Nike breaks both the previous month’s high and low – which is noted as the ‘Engulfing month %’ on the chart below — drops to just 19%.  Nike, on average, moves $2.30 above its monthly opening price and $2.26 from closing price to closing price per month (Avg. Monthly Range).  So, there is very little chance of the stock moving in February to the January low of $51.40

As a trader I’m a buyer of Nike, or in this case a seller of puts below $50 – April $50’s are selling for around $0.50 per share — now that there has been a weekly close above January’s high.  At that point I have a 19% chance this month of the trade going against me and dropping below the December low of $51.40.  Since we are approaching the end of February, Nike has carved out a short-term consolidation between $51.40 and $55.90.  A weekly close in March below $51.40 would be a signal to cover the put and a close above $55.90 would be a signal to add to your position, moving either up in price or out in time.

Big Trade Statistics

Jan. High $55.57
Feb. Open $54.46
Difference $1.12
Avg Monthly Range $2.26
Avg. Move Above Open $2.39
Inside Month % 19%
Engulfing Month % 19%

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