Nike (NKE -1.19%) shares sold off after its latest earnings report as supply chain issues weighed on third-quarter results.

Revenue in the quarter rose just 3% to $10.4 billion, missing estimates at $11.02 billion, and declined in all of its operating regions except for China, where sales spiked as it lapped the impact of the COVID-19 pandemic in the December to February period.

Nike cited "supply chain challenges, including global container shortages, and U.S. port congestion," for the decline in North America, while mandated store closures cooled off performance in the EMEA (Europe, Middle East, and Africa) region. 

However, looking beyond the top-line results, there were some bright spots in the quarter. In spite of weak sales growth, earnings per share jumped 70% to $0.90 as the company slashed marketing expenses, in part because of COVID-19, and showed off strong growth in gross margin, a key metric that shows how much revenue Nike keeps after accounting for direct costs like manufacturing and running its stores.

What was most impressive was that gross margin rose 130 basis points to 45.6%, its best mark since 2016. Let's take a closer look at why that's so important.

Five style of Nike Zoom sneakers.

Image source: Nike.

The Nike Direct strategy is working

Nike's strategy over the last four years has been characterized by the Consumer Direct Offense, which promised to double speed, innovation, and direct connections with consumers to move closer to the customer.

During that time, Nike has made significant progress on its Direct business, which includes digital channels like Nike.com and the SNKRS and Nike apps, as well as the company's own stores. The company has also prioritized wholesale relationships with retailers like Nordstrom and Foot Locker willing to elevate the Nike experience inside their stores and downplayed relationships with those who won't. It stopped selling on Amazon, for example. 

The 45.6% gross margin, its best since before it launched the Consumer Direct Offense, is a clear sign that the strategy is paying off. Management credited a favorable Nike Digital mix and said that Nike Direct gross margins contributed to the gross margin expansion. CFO Matthew Friend said on the earnings call that the gains were "being fueled by a higher mix of digital which carries a higher gross margin rate, as well as optimization of new pricing capabilities using advanced analytics in North America."

Friend also said, "We now expect gross margin to expand up to 75 basis points versus the prior year, reflecting the continued shifts we've seen to our more profitable NIKE Direct business," showing the expansion should continue

Nike's Direct business is emerging as not only a key source of competitive advantage but also its biggest driver of profit growth. Digital sales have grown by more than 70% in the year, and its digital business, including partners, now makes up more than 35% of its total business. Over the coming years, the company expects the digital share of the business to reach 50%. Nike Direct sales were up by 16% in the third quarter, though the company didn't disclose the overall share of Direct revenue. 

A bright future

Building up its own direct-to-consumer business should deliver steady gains in gross margin as eliminating retail partners allows Nike to charge more for its products, leading to higher margins, and have greater control over their distribution. Unlike its wholesale business, digital sales are scalable, as once the company has infrastructure like its apps in place, incremental sales will increase margins. And the company is set to deliver an increase in gross margin this year even as it's had to adjust its business in a number of ways to manage the COVID-19 pandemic. Even as most of the apparel industry has struggled during the crisis, Nike has delivered solid profit growth over the last year. 

Keep an eye on gross margin over the coming quarters as it should move higher. That's the key to increasing profitability for the sportswear leader.