Published by Bob Ciura on March 24th, 2017
Both Nike (NKE) and Under Armour (UA) have hit a rough patch lately. Each company saw its share price drop heavily after reporting quarterly earnings.
In both cases, the market was disappointed with their growth rates.
That said, while Nike’s growth struggles could be described as a minor bump in the road, Under Armour’s growth has hit a brick wall.
This has taken a toll on their share prices, particularly Under Armour’s. Nike and Under Armour shares have lost 12% and 58% of their value, respectively, in the past one year.
Clearly, Nike investors have endured a much milder decline. Further helping to soften the blow for Nike’s shareholders, is that the company at least pays a dividend.
And, it has grown that dividend for many years: Nike is a Dividend Achiever, a group of 271 stocks with 10+ years of consecutive dividend increases.
You can see the full Dividend Achievers List here.
It may be tempting to view Under Armour as a better bet moving forward, because of its massive share price decline.
This article will discuss three reasons why Nike’s out-performance over Under Armour is likely to continue.
Reason #1: Profitability
Nike is much more highly profitable than Under Armour, and has grown its earnings-per-share at a high rate for several years.
Source: 2016 Annual Report
By comparison, Under Armour’s earnings-per-share declined 15% in 2016, even though revenue growth exceeded 20%.
This is because its margins fell. Gross margin declined from 48.1% in 2015 to 46.5% last year.
The company has seen its earnings-per-share growth rate dramatically deteriorate since 2011.
The biggest contributor to Under Armour’s declining growth rate is its SG&A spending.
Under Armour’s gross margin is actually higher than Nike’s. Nike generated a 44.8% gross margin over the first nine months of its current fiscal year.
However, Nike’s profit margin is far superior.
Nike generated net income of $3.2 billion in the first nine months of fiscal 2017, on $25.67 billion of revenue.
This means Nike’s profit margin was 12.6% in that time, while Under Armour’s profit margin was 5.3% in 2016.
The biggest reason for the difference is because Under Armour spends heavily on SG&A expenses like marketing and advertising.
Under Armour’s SG&A expense rose 21% last year, and nearly exceeded the company’s revenue growth in 2016.
Under Armour also issued $1.33 billion of debt last year year, which caused interest expense to soar 81% in 2016.
Management focuses on the company’s 20%+ revenue growth rate each year, but profits are ultimately what generate shareholder value over time.
Reason #2: Brand Strength
A big reason why Nike is so much more profitable than Under Armour is its brand strength.
Nike is the 28th most valuable brand in the world, according to Brandirectory. Nike’s brand is worth approximately $31.7 billion, up 13% from the previous year.
And, Nike receives a ‘AAA+’ rating for brand strength.
Meanwhile, Under Armour clocks in all the way down at #275 on the list.
Nike’s superior brand gives the company a significant competitive advantage, mainly through pricing power.
For example, on Nike’s fourth-quarter conference call, management noted that it is seeing double-digit market share gains in the $100-$150 segment in basketball shoes.
Its top brand positioning allows it to dominate the premium end of the pricing spectrum, particularly in core product markets like shoes.
Pricing power provides Nike with excellent returns on capital each year.
Source: 2016 Annual Report
Nike’s ROIC expanded even further last quarter, to 33%.
The differences in their respective brand strength is also evident in each company’s retail footprint.
Nike is a major seller to Foot Locker (FL), which is one of the few retailers doing well in the current environment.
Foot Locker’s comparable-store sales, which measures sales at locations open at least one year, rose 5% in the fourth quarter.
On the other hand, Under Armour’s retail strategy has been to focus on discount retailers. The company recently launched in Kohl’s (KSS) and has an agreement in place to launch in DSW (DSW).
Focusing further down the pricing spectrum isn’t necessary a bad strategy. It can open up a whole new customer demographic for the company.
But, it puts even more pressure on margins. It could compromise Under Armour’s brand image, and it also exposes Under Armour to the retailers getting hit hardest right now.
For example, Under Armour was disproportionately impacted by the Sports Authority bankruptcy.
Reason #3: Dividends
Profitability and brand strength provide Nike with huge free cash flow, which in turn gives it the ability to pay dividends to shareholders.
In fiscal 2016, Nike generated $2 billion of free cash flow. It utilized $1 billion for dividend payments last year.
Nike currently pays an annualized dividend of $0.72 per share, which amounts to a 1.3% dividend yield.
Although its dividend yield falls below the S&P 500 Index average yield of 2%, Nike makes up for this with high rates of dividend growth.
Nike’s quarterly dividend has doubled in the past years, good for a 14% annual growth rate on average. Last year, Nike raised its dividend by 13%.
The company has increased its dividend for 15 years in a row.
With another 10 years of consecutive dividend growth, Nike will become a Dividend Aristocrat, a group of companies in the S&P 500 that have raised dividends for 25+ years.
There is a very good chance Nike will indeed become a Dividend Aristocrat in 10 years.
Revenue and earnings-per-share continue to grow at a high rate, particularly in the company’s women’s and emerging market businesses.
Plus, the company maintains a payout ratio of just 50%, in terms of free cash flow generated last year.
This leaves plenty of room for 10%+ annual dividend growth going forward.
As previously mentioned, Under Armour does not pay a dividend, because it can’t. The company had $305 million of operating cash flow in 2016, but spent $387 million on capital expenditures.
This means Under Armour generated negative free cash flow, of approximately $82 million.
It seems only a short time ago, that Under Armour was a beloved growth stock. Its share price raced higher, as investors became enamored with the company’s strong revenue growth rates.
As so often happens with growth stocks, investors were too willing to ignore the company’s spending problems.
The prevailing belief was, that the company would be able to leverage its growth to obtain scale, which in theory would result in high profit margins.
But that has not happened, and investors are beginning to second-guess the company’s growth strategies.
For dividend growth investors, the choice is clear: Nike is the better stock to buy in the apparel space.