On Thursday after the market closed, the world’s largest sports apparel company—Nike (NYSE:NKE)—reported its fourth quarter earnings results. The market was pleased with the results as shares traded up over 3 percent in the after-hours market, and they nearly reached their all-time high of $80.26/share.
This investor enthusiasm was largely a result of the company’s strong sales figures. The company reported revenues of $7.4 billion, which beat analyst expectations by $60 million. This figure is 10.4 percent higher than the company’s sales a year ago.
However, earnings were a different matter. Earnings came in at $698 million vs. $690 million in the fourth quarter of last year. This 1 percent increase in earnings growth pales in comparison to the company’s revenue growth rate, which indicates that the company is having problems maintaining its margins. Investors should keep in mind that the comparison isn’t quite this bad on a constant currency basis: The strong dollar over the past year makes the company’s foreign sales look weaker, and profits would have been $30 million higher otherwise, or $728 million, which is nearly 6 percent higher than the fourth quarter last year. But investors also need to keep in mind that last year Nike paid a slightly lower tax rate—22.9 percent vs. 23.5 percent–and so the comparison is actually slightly worse than this.
While these results are generally positive aside from the margin compression, one has to wonder whether Nike shares are worth the premium valuation that the market is giving it of 26 times earnings. Considering the company’s strong brand value, its international growth potential, and its history of strong management, one can certainly argue that the stock is worth more than a similar company that lacks these qualities. Furthermore, if one assumes that the company’s sales growth rate can trickle down to the bottom line in the future then 26-times earnings doesn’t seem so expensive, especially in a low interest rate environment.
But this last statement is filled with ‘if’s that I don’t think are worth betting on in this market environment. Regarding the company’s margins, Nike isn’t the only company facing margin compression as labor costs rise in developing countries and as commodity prices appear to be heading higher. These trends could continue to put pressure on Nike’s margins, and this would mean that the company’s sales growth might not convert into earnings growth. In this scenario earnings growth would be minimal, and on a price to earnings basis the shares would have to decline in value.
Price to earnings multiple compression is also a possibility in a rising interest rate environment. If interest rates rise, then investors will be less willing to pay these nose-bleed valuations for quality “bond-like” stocks, as they will be able to get this yield elsewhere in the bond market. Thus those companies that trade with premium price to earnings multiples because they have been consistent cash-flow generators over the long term are vulnerable to the downside, and Nike is on this list.
Given these points, there is little doubt that Nike is a quality company that is outperforming in a weak environment. But at the same time it faces the same problems that other companies face, and its shares are vulnerable to the downside given its premium valuation. Thus, despite the market reaction, I would avoid Nike shares for the time being, and if I were long I would use the positive momentum to take profits.
Disclosure: Ben Kramer-Miller hase no position in Nike.