After outperforming the S&P 500 for most of the last decade, Nike (NKE 0.45%) stock has underperformed over the last three years. The company posted strong revenue growth last year, but it has struggled with too much inventory, relying on discounting to move merchandise.
Investors have been mostly concerned about the company's falling profit margins, as well as the weakness in China, which was a key growth driver of its business before the pandemic.
The stock has rebounded from its 2022 lows but is still 37% off the all-time high reached in 2021. With China reporting robust growth in the last quarter as its economy recovers from COVID-related disruptions, on top of better inventory controls, is it safe to buy Nike stock now?
What is going right for Nike
Total Nike brand revenue, of which two-thirds is driven by footwear, was up 16% on a currency-neutral basis in fiscal 2023 (ended May 31). While footwear revenue growth decelerated to a year-over-year increase of 10% in the fiscal fourth quarter, the company is moving in the right direction.
The full-year growth in Nike brand footwear looks very strong considering the weakness across the retail industry from rising inflation and its impact on consumer spending. Shoppers certainly are making room in their budget for Nike sneakers, which says a lot about the company's brand power.
As CEO John Donahoe stated on the earnings call, "Where other brands strive to grow their slices of the pie, we're able to grow the pie itself." Nike generated $35 billion in sales of footwear last year, including sales of Converse. You can make the argument that Nike is athletic the footwear industry.
Nike delivered this growth while holding inventories flat versus the prior-year quarter, which is a reversal from the excess inventory levels a year ago. While net income was still down 28% year over year last quarter, tighter inventories that better match demand should begin to drive better product margins and a return to earnings growth.
What will get the stock moving higher
The reason why Nike stock didn't move higher following the latest earnings report is that management's outlook on operating expenses still leaves open the possibility that earnings growth could be weak for the foreseeable future.
It's good to see Nike projecting more favorable transportation costs and full-price sell-through of merchandise, all healthy signs for margin performance. But management still expects selling, general, and administrative expenses, including marketing spend, to rise slightly faster than revenue this year as it invests to drive demand ahead of key sporting events.
Nonetheless, analysts expect Nike to report earnings growth of 20% in fiscal 2024 as improving product margin could offset the increase in operating expenses. After seeing gross profit margin fall to 43.6%, Nike expects to turn that around in the current fiscal year.
Relative to its top footwear competitor Adidas, Nike is looking very strong. Adidas reported flat revenue growth last quarter with revenue in China down 9% as it struggles with the sales void of Yeezy footwear, which it discontinued last year.
Nike reported a strong sales increase of 16% on a currency-neutral basis in its Greater China segment. A continued recovery there is a promising sign for the company.
Don't expect big returns
The downside to buying Nike stock is the company's size. As a global brand with $51 billion in annual revenue, Nike is vulnerable to softness in the global economy. Europe is still weak as soft demand kept the company's growth limited to a single-digit increase in this market. Apparel sales were even weaker on its home turf, down 2% in North America during the quarter.
But an improving global economy over the next few years could be a big positive catalyst. Analysts expect Nike to grow earnings by about 14% annually over the next five years, which makes the stock's forward price-to-earnings ratio of 29 look fairly valued. The company's investments in expanding its digital business and improving inventory levels in the near term could lead to better margins and bottom-line growth. Nike's long-term earnings growth estimate was in the mid-teens before the pandemic.
At these valuation levels, investors shouldn't expect big gains. There might be other apparel companies that can outperform Nike over the next decade, but if you like its dominant position and are looking for an opportunity to buy shares, it could still outperform the broad market. That said, I would keep the position small as part of a diversified portfolio.
