For its fiscal 2016 first quarter, Nike (NYSE:NKE) reported quarterly revenue up 5% year-over-year, but net income up a whopping 23%. For net income to grow so much faster than sales shows just how successful Nike has been in its push to improve profit margin, which now sits at 11.25% over the trailing 12 month period.
This impressively high profit margin is one of the best in the industry and well ahead of competitors such as Under Armour and Adidas. Here is how Nike has achieved such success and how margins may grow even higher still.
In its 2015 10-K, Nike says that gross margin has benefited from "Delivering innovative, premium products that command higher prices while maintaining a balanced price-to-value proposition for consumers." Nike has been steadily changing its sales mix toward higher priced products which has helped to increase sales revenue faster than sales volume. For example, in fiscal year 2015 Nike increased footwear unit sales 9% while growing revenue 13% (17% excluding foreign currency fluctuations), showing the effect of Nike's pricing power in footwear where a pair of Lebron basketball shoes can easily run over $200.
The company continues to reduce manufacturing costs as well. This is no longer just about managing labor costs as it was two decades ago, when reports of less-than-ethical Asian manufacturing processes surfaced in 1991. Instead, Nike now reduces costs through technology and infrastructure advancements, as well as innovations in product materials. Together this helps Nike boost efficiency and reduce costs.
A February 2014 report by Deutsche Bank noted Nike's transformation in manufacturing its "Flyknit" footwear, going from labor intensive methods to highly automated technology. The analysts said this change could allow Nike to reduce labor costs by 50% per unit and decrease material usage by 20% (not by any specified time, but clearly the company is moving fast on these developments). The company continues to experiment with new technologies like 3D printing that are likely to help margins continue to grow by further reducing both labor and waste.
Growing direct-to-consumer sales
Nike's direct-to-consumer business helps cut out the middleman that would normally pocket a percentage of sales. Through e-commerce, Nike can eliminate much of the fixed cost associated with physical stores while also increasing its ability to up-sell products. For instance, the company's NikeID service allows customers to create custom shoes with their own designs and colors, for a fee of course.
In fiscal year 2015, Nike's DTC sales (including e-commerce and Nike owned stores) grew 29% year-over-year, which Nike says attributed to a 40 basis point increase in gross margin. DTC now accounts for 23% of total revenue, up from 20% in 2014. It is likely to make up even more of the top line in the future as the company continues to invest in digital infrastructure and increase its number of owned stores.
Nike paid an incredibly low effective tax rate of less than 20% in the recent quarter, compared with the effective tax rate of 39% that Under Armour pays. How is this possible? One way is that Nike receives more of its sales overseas in lower-taxed countries. So even though the stronger dollar has hurt sales growth recently, the continued overseas expansion has helped Nike to send even more of its sales to its bottom line.
Can the impressive earnings growth continue?
The company forecasts reaching $50 billion in annual sales by 2020. At its current profit margin, that would mean net income of $5.63 billion, a 42% increase over fiscal year 2015. However, 2020 income could actually be even higher.
From the premium pricing to efficiency gains and cost management, Nike is likely to see its profit margin increase even further.
Bradley Seth McNew owns shares of Nike and Under Armour. The Motley Fool owns shares of and recommends Nike and Under Armour. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.