Name That Trade – NKE Edition: At The Money IV in Oct Looks Cheap Given Potential Volatility Surrounding FQ1 Report

by Dan September 14, 2012 12:11 pm • Commentary

Back in mid June when NKE was above $100 I bought a July Put Spread heading into their fiscal Q4 earnings as the company very aptly fit into my theme of shorting U.S. multi-nationals with large revenue exposure to Western Europe and Asia.  When the company reported in late June, the stock got drilled on weakness in both regions and I really thought this theme would continue to play out for the balance of the year for high-end consumer discretionary names which rely on Europe and Emerging Markets for a big chunk of future growth.

Since the earnings gap, the stock has filled in the entire move, which is essentially what has happened with some of NKE’s higher end peers like TIF and COH which also suffered summer swoons.    The analysts community remains very mixed on the stock though with 10 Buys and 13 Holds, and a downgrade coming just yesterday from Citi Analyst Kate McShane.  She took the rating down from Buy to Neutral but actually raised estimates and takes price target from $98 to $101,  here are some excerpts from her note to clients:  

Downgrading on Limited Stock Upside; Top Line Likely to Slow Further – For the last several qtrs, Nike’s P/E multiple expansion has been driven by double-digit top line growth rates due to strong innovation, global secular growth and higher prices. While we expect futures to still be healthy, futures could start to decelerate to below ~10% over the next 12 mos as the company laps several growth drivers.

Nike’s Valuation Is Correlated to Rev Growth; Putting More Onus on Margins – We measure a 0.61 correlation between NKE’s forward P/E and revenue growth. Revenues will likely start to decelerate further from current levels as we anniversary price increases of 5-7% and the lack of one-time sporting events, and continue to experience challenging environments in China and Europe.

Gross Margins Should Improve Throughout the Year; But Not Enough to Drive Valuation – We see easing GM comparisons on lapping of higher costs, air freight & work-through of inventory taking hold in 2H when top line growth starts to lap more difficult compares. Further, Yue Yuen, one of Nike’s main factory partners reported better GM on better efficiencies and lower costs from a shifting of facilities, which should help Nike GM as well. We now estimate Nike’s GM’s could be up 35bps (up from 14bps originally).

Raising Estimates and Target Price; But Not Enough to Drive Valuation — We are raising ests today to highlight improving GM’s and a still robust top line. However, even with these higher ests (and a best case scenario for GMs which we highlight above), we cannot obtain a valuation to justify a Buy. Our FY13 EPS goes to $5.24 from $5.05 on slightly better gross margin assumptions and our FY14 EPS stays the same. Our target price goes to $101, up from $98.


MY VIEW: It would be a total “Monkey” trade to just look at your screens, which has been a sea of green for over a week and just buy the stocks that are red, with the hope that rising tides will lift all boats. Whats interesting about NKE’s relative weakness (NKE down ~2% on the week vs the SPX up ~2%) is that none of what the ECB or the Fed has done will help NKE sell their Lebron X sneaker at it’s whopping $270 price tag in China.

The company will report Q1 earnings on Sept 27th, after the close, and the results could be setting the stock up for somewhat of a binary event. If the company misses and guides lower for the second consecutive qtr, the stock would likely re-test the July lows below $90, but if the company is likely to show better than expected results on the heels of the Olympics and actually guide better than expected, the stock, which has been a laggard (basically unchanged on the year), could see a move back above its 200 day moving avg of about 102 and even take a shot at previous support of $105.

At the money implied vol of about 25 in Oct (which captures earnings) puts options prices at a fairly cheap level relative to the 60 and 9o day realized vol of about 29 and 28 respectively.  That said, it is fairly obvious that vol is melting in about every asset class, and the implieds are very rich to the 30 day realized vol of about 17.5.


Bulls: If you believe that the market rally will continue to broaden out, and NKE’s Q4 results were a one quarter blip, the OCT 100 calls offered at 1.75 (stock ref $96.75) look fairly reasonable on both a premium and vol basis.   These calls could also serve as a very practical stock replacement strategy for current longs looking to define their risk into a potentially volatile event.

Bears: If you want to press the short here and think that the potential second consecutive miss causes a re-test of the July lows, the Oct 92.50/87.50 Put Spread at 1.00 (stock ref $96.75) seems like a reasonable risk reward for convicted bears in the name.