When Nike (NKE 0.52%) reported its fiscal 2023 first-quarter financials on Sept. 29, the results looked solid at first glance. The business generated revenue of $12.7 billion and earnings per share of $0.93 in the quarter ended ended Aug. 31, both exceeding Wall Street analyst estimates. However, the stock tanked by double-digit percentages immediately following the announcement.
Investors need to pay attention to a huge issue that this top apparel company is currently facing, which revealed itself in the latest financial update.
That's a lot of shoes
While Nike's sales increased 3.6% year over year -- quite a strong showing given that revenue grew 15.6% in the prior-year quarter -- what spooked investors in the earnings announcement was the fact that inventories shot up 44%. And this balance, now at $9.7 billion, sent the stock sharply lower.
Throughout the worst of the coronavirus pandemic, companies struggled to acquire enough merchandise due to strained supply chains across the global economy, leading these businesses to order as much inventory as they could. But now, with the bottlenecks easing and the situation normalizing somewhat, inventories are rising more than expected.
In Nike's case, the company decided to place its holiday orders ahead of time, a move that backfired. Delayed deliveries of prior orders exacerbated the problem. Inventory levels in North America, Nike's biggest market, which accounted for 43% of revenue in Q1 2023, skyrocketed a whopping 65% year over year.
Proper inventory management is critical for a company such as Nike. It's a balancing act. If there's not enough merchandise on hand, it could lead to lost sales and customers flocking to competing brands. On the other hand, too much product ties up cash that could be utilized for other corporate initiatives, like marketing expenditures, investing in research and development, or returning capital back to shareholders in the form of dividends or stock buybacks.
And then there's the challenge of trying to get rid of all the excess sneakers and clothing, forcing the company to resort to costly promotions and discounts that can impact profitability and hurt the brand's image.
While Nike's gross margin will certainly be negatively impacted in the current quarter, the leadership team believes that the inventory problems plaguing the business were at their worst during the most recent quarter and that they will start to ease going forward. That's clearly a positive sign for Nike shareholders.
"We expect that total inventory in North America peaked in Q1, and we anticipate seeing sequential improvement over the year as we rebalance supply and continue serving strong consumer demand," said CFO Matt Friend on the recent earnings call.
Take a long-term approach
This inventory headwind will work itself out in due time. To give Nike credit, it has been an extremely difficult operating environment over the past couple of years for every business, but especially for companies that sell physical goods. And Nike hasn't been spared from this challenge.
Historically the company's fastest-growing region, Greater China has been facing pandemic-related lockdowns that have seriously hurt the financials. In the latest quarter, this market saw sales decline 16% year over year, whereas every other region posted gains. This situation contrasts with the state of affairs in the U.S., where restrictions eased a while ago and consumer demand remains strong despite high inflation.
If you zoom out, however, you'll see a business that is still at the top of the list when it comes to brand recognition -- not just in the apparel industry, but in general. And this sustained consumer relevance is powerful because it increases the chances that the company will be able to weather any near-term headwinds.
Investors who can look past the current inventory problem -- and who believe in the long-term prospects of Nike -- can buy shares today at a steep discount of 50% off their all-time high. That seems like a pretty smart decision.