Two Surprising Ways In Which Nike Is Growing Its Business

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We recently revised our price estimate for sports giant Nike (NYSE:NKE) from $68 to $85 following an extremely strong quarter, which saw the company boost its revenue by 15% and reverse a trend of declining gross margins,  to post a 120 basis point increase, on the back of a sales mix richer in high-margin products and a higher contribution from the direct to consumer business.  The reasons behind Nike’s growth are the same ones responsible for its growth in the past — namely high revenue growth through innovation in product types across all sports categories and all geographies, and a high market share in the premium footwear segment. [1] However, the company is also unlocking value in a few unusual ways.  Below, we take a look at a couple of those factors.

We have an $85 price estimate for Nike’s stock, implying a discount of  about 12%  to the current market price.

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Direct-To-Consumer Channel Performing Well

In the second quarter of fiscal year 2015, Nike’s Direct To Consumer (DTC) revenue increased 30% driven by strong comparable store growth and the strong increase in online sales. The DTC channel is a higher margin segment as Nike does not have to share any of its revenues with middle men. Delving further into Nike’s DTC business, we find that the e-commerce business delivered another strong quarter with 66% revenue growth. Moreover, at just over 20% of Nike’s DTC revenues today, the e-commerce business clearly has opportunity to grow. The company expanded nike.com’s footprint in the quarter, launching sites in Japan, the world’s third largest e-commerce market, and Brazil, thereby further extending its commercial reach for consumers in this key growth market. The advantages of the e-commerce channel are such that it allows Nike to reach customers even in areas where it has no brick-and-mortar store presence. As the emerging markets grow and the demand for sports apparel, sports footwear, and sports equipment grows with it, it is essential that Nike is well positioned to be able to meet this demand. Further expanding its distribution channels to support the e-commerce business is extremely important for Nike. [2]

One region in particular where Nike’s DTC business is coming in handy for the company is China. Given that China is one of the largest markets for athletic footwear and apparel in the world, the geography provides a significant growth opportunity for Nike. We have already written about the problems Nike faces in establishing a strong foothold in this market. (See: Nike’s China Problem) Previously beset by the accumulation of unsold inventory and an  indifferent response to new product launches, Nike decided to reset its strategy for China in fiscal 2014. In 2014, Nike tested new merchandising concepts in China, which drove comparable store sales for the quarter up 22%. [3] The sports retailer also changed the assortment of inventory it sells to wholesale partners in China, undertook the re-profiling of multiple stores in the region, and reduced the levels of inventory considerably. Moreover, Nike has positioned itself as a relatively premium brand in China compared to its brand positioning in Europe and North America.

Despite all these factors, Nike’s growth in sales to wholesale customers in China was considerably outpaced by the company’s direct to consumer business in the country. While sales to wholesale customers in China increased by only 13%, sales made directly to consumers jumped by a whopping 50%. Over the first half of fiscal 2015, sales made to wholesale customers in China have increased by 12%, while sales made directly to the consumer have grown by a massive 49%. [4] As a result, for the first half of fiscal 2015, the direct to consumer business makes up for just over 20% of Nike’s business in China. For the second quarter, it made up   over 25% of the company’s China business. [4]  If Nike’s DTC segment can repeat its second quarter performance in China, the company will realize a considerable boost to its margins from the regional business.

NIKE Exploits A Loophole

Most of the sneakers sold in the U.S. are made outside the country, usually in places where cheap labor is easily available. However, the cheap labor costs are usually offset by the fact that shoe companies have to pay a 37.5% tariff on sneaker imports. Nike, however, seems to have found a way around this problem for its Converse brand. How has Nike done this? By proving that Converse shoes are actually slippers. Nike did this by creating a process for the manufacture of Converses that makes its shoes slippers in the eyes of the law. Under U.S. law, sneakers are defined as footwear having a rubber sole, while slippers are defined as footwear with a fuzzy sole. Converses are manufactured in such a way that they have a rubber sole covered by a fuzzy layer which quickly wears off when the sneakers are actually worn. [5]  As a result, the company has been able to keep the average unit price of its Converse shoes down to $55 since slippers are only subject to an import tariff of 3%. The move seems to have worked since Converse revenue has grown at an average of 12% for the last two years, outpacing the company wide growth rate by around 3.5%.

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Notes:
  1. Sneakernomics: The Sneaker Business Is A Premium Business, Forbes, April 2014 []
  2. NIKE CEO Focuses on Q2 FY15 Results, Seeking Alpha, December 2014 []
  3. NIKE’s CEO discusses F4Q2014 Results, Seeking Alpha, June 2014 []
  4. Nike 10-Q, SEC [] []
  5. This Is Why Your Converse Sneakers Have Felt on the Bottom, Smithsonian Magazine, September 2013 []