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Trade view / 06 March 2017 at 15:09 GMT

Will Adidas deliver on its momentum? - #SaxoStrats

Head of Equity Strategy / Saxo Bank
Denmark
Instrument: ADS:xetr
Price target: 150
Market price: 160.70
Background

If there's one thing you learn trading equities it's to not short a strong momentum stock. With shares in German sportswear and shoemaker Adidas up 67% over the past year, it seems that it would not be an ideal candidate for a short position. Even scarier, the search engine volume on Adidas also shows strong growth in searches for the word Adidas coinciding with the company's strong revenue growth. Adidas' brand has clearly been gaining market share recently and is also making inroads into US rival Nike's home territory in the US.

Trend in the word Adidas on Google search engine
Adidas search volume on Google search engine

Source: Google Trends 

Despite the positive trend, we are issuing a negative view on Adidas shares before the company's fourth-quarter earnings release on Wednesday at 0630 GMT. Analysts estimate on average that Q4 revenue grew 12.5% from last year, more than twice the growth rate expected for Nike. So why are we negative on the stock?

Compared with its peers, Adidas scores negatively on all other major equity factors, except momentum. The valuation is above average, and it even comes with lower quality (return on capital) than the industry. The shareholder yield is also lower and realised volatility is higher than the industry. The recent 12% run-up in the share price is also something that normally translates into strong mean reversion effects. With a 12-month forward P/E ratio at 32.6x, expectations are insanely high for a manufacturer of shoes and sport equipment. The execution risk for the new management is high.

Adidas equity factors
Source: Saxo Bank (Quantitative Strategies team) 

The key focus in the Q4 earnings report will be the growth outlook for the North American market, which has recently seen a strong turnaround for Adidas as the company has succeeded in building its brand. Operating margins still trail competitors, and that will also be in focus.

The average absolute price change over Adidas' latest earnings releases is 3.6%. So, with at-the-money put options trading at 1.7%, the market seems to be under-pricing any downside risk from Adidas not meeting expectations. ATM calls are currently around 25-30% more expensive than puts over the earnings release, despite twice the volume transacted in puts compared with calls.

Our price target for after the earnings release is €150, representing the recent equilibrium price before a sell-side firm raised the stock to "buy" on February 27. Our price target represents a 6.7% decline from current price, which is almost twice the historical move over Adidas' earnings releases.

Management and risk description

Given the strong price momentum and the fact that the company reports earnings on Wednesday, we want to protect our negative view from any price jumps. The most sensible choice to achieve that goal is to buy put options on Adidas shares. This strategy will lock in our maximum loss and protect our short position against Adidas exceeding expectations for the 2017 outlook.

Adidas (ADS) weekly share price
Adidas share price

















Source: Saxo Bank

Parameters

Entry: buy put options on Adidas shares at €2.75, with a strike at €160 and expiry on March 17. The premium translates into 1.7% of the underlying.

Stop: since we are long puts our maximum loss and essentially our stop is the €2.75 or 1.7% of the underlying. Remember that with a single put contract you are buying the right to sell 100 shares, so the maximum loss per contract is €275 before any commissions etc.

Target: €150 based on our bet that the stock price is discounting too high expectations that could be missed on Wednesday.

Time horizon: short term as the puts expire in 10 trading days.


— Edited by John Acher

Non-independent investment research disclaimer applies. Read more
A compiled overview of Trade Views provided on TradingFloor.com is found here

3y
Dimitrios Tamvakas Dimitrios Tamvakas
This comment has been redacted
3y
Peter Garnry Peter Garnry
Strong outlook with Adidas raising 2020 targets. Share price up 4% in pre-market. We will close our position within the first hour of trading recouping what's left of the option value.

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