Nike has done extremely well over the past two years. The company has continued to post remarkable gains in its core North American business, while taking over from Adidas as the biggest retailer of sportswear in Europe, and reviving its business in China, the world’s fastest growing market. In 2014, Nike recorded its most profitable year ever in North America, with reported earnings before interest and taxes rising faster at 14%, than reported revenues at 10%. That momentum has continued into 2015 with North America revenue growing in the high teens in the first four months of the year, led by strong growth in basketball, sportswear, and men’s training, along with modest growth in the women’s training and young athletes businesses. 

The remarkable performance in this geography shows the strength of the Nike brand as it has managed to capture the growth in the market and take market share from an ever rising number of competitors at the same time. The company is a market leader in the basketball and running categories, and leverages the insight gained from those segments to capture the significant growth opportunities in areas like e-commerce, apparel, women’s, and young athletes businesses. Nike applies discrete strategies to individual segments, identifying the opportunities in each category, and applying different strategies to capitalize on these opportunities, instead of applying a one-size-fits-all strategy common to the sportswear market.

Impact of China on Nike’s Prospects

Nike faces two fundamental problems in China, both of which are cultural.

1) Nike is a running and basketball shoe company from the U.S.. Its expansion into Europe was based on the strategy of targeting key players for sponsorships and leveraging those sponsorships to forge relationships with large-scale commercially organized leagues like the Barclays Premier League in England, and La Liga in Spain. A similar strategy isn’t possible in China for two reasons: no opportunities similar in scale to those in Europe exist, and the more popular sports in China, i.e. football and baseball, have limited appeal in urban areas.

2) Nike’s training and running categories haven’t received much traction in China because health clubs are traditionally seen as activities for rich people in the region. On the other hand, a culture of biking to work exists in China, but people do so mostly in street clothes, instead of spandex. Nike’s branding is based on encouraging strong identification with iconic sports-stars it uses to endorse its products. In a culture where parents are excessively focused on academic achievement, such a strategy has limited appeal. 

However, the company’s performance in China exceeded our expectations in the previous three quarters. For example, in the previous quarter, China revenues grew by 17%. Given that China is one of the largest markets for athletic footwear and apparel in the world, the geography provides a significant growth opportunity for Nike. And Nike’s strong performance over the past three quarters has helped Nike achieve the leading position in both the athletic footwear and apparel markets.

Previously beset by the accumulation of unsold inventory and an indifferent response to new product launches, Nike decided to reset its strategy for China in fiscal 2014. The company believes that it has made good progress on that front and expects to achieve sustainable double-digit growth from the region soon. The sports retailer also changed the assortment of inventory it sells to wholesale partners in China, undertook the re-profiling of multiple stores in the region, and reduced the levels of inventory considerably. However, Nike has positioned itself as a relatively premium brand in China compared to its brand positioning in Europe and North America. As a result, its wholesale partners are seeing strong comparable store sales growth and the profitability of stores that were re-profiled is also increasing.

For the nine months ended February 28, 2015, close to 45% of Nike’s revenue came from North America operations. In comparison, revenue from China formed less than 10% of the company’s overall revenue. Given that the Chinese economy can be potentially as big as the U.S. economy, we believe that Nike has the potential of growing its revenue to similar levels as that in North America. If that happens, and assuming the company retains its operating margins, the company can unlock significantly greater amounts of value. Additional revenue of $1.6 billion each year, with a net margin of 10%, and free cash flow margin of 8.5%, will translate into an additional 16 cents in earnings per share each year, and $2 billion in free cash flow over the period. This is not significantly accretive to the bottom line and shows that the company must increase its net profit margin to capitalize on the growth in its China business going forward.