Name That Trade – $MCD: A Ketchup Trade?

by Dan October 20, 2015 2:19 pm • Commentary

Event(s): At 8am eastern, Thursday, Oct 22nd McDonald’s (MCD) will report their Q3 results. Later that morning, at 11 am, they will host their annual analyst meeting.  The options market is implying about a 2.8% move between now and Friday’s close.  With the stock trading at $104, the Oct 23rd weekly 104 straddle (the call premium + the put premium) is offered at $2.90, less than 3% of the stock price, if you bought that you would need a move above $106.90, or below $101.10 to make money.  The average one day earnings move over the last 4 qtrs has been less than 2%, while the 10 year average has been about 1.7%.

Fundamental Changes Afoot: The analyst meeting is of specific importance as the company has no shortage of activist investors who have taken stakes in the stock in 2015. And that’s come at a time when sentiment towards the product and same store sales have not been worse in years. Also, fast food competition is off the charts. And not just in burgers. The company has been forced to broaden its appeal. Activists may push for more re-franchising of company owned stores, opening the door for the potential for the company to spin-out their real estate holdings in the form of a real estate investment trust (reit).  All of this with the backdrop of a new CEO who took over in March!

Price Action / Techncials: Obviously the stock has been newsy of late, and investors appear to be positively pre-disposed as it is less than 1% from its all time highs made last week, up 11% on the year.

After spending the better part of the last 5 years consolidating between the low $90s and $103, the stock just recently broke out to a new all time highs:

MCD 5 year chart from Bloomberg
MCD 5 year chart from Bloomberg

The stock is on the verge of a a massive long term break-out if the company can clearly demonstrate a plan to return to high single digit earnings growth and reinvigorate sales growth:

MCD 10 yr chart from Bloomberg
MCD 10 yr chart from Bloomberg

One big reason for a potential breakout would be a catch-up trade, as MCD is up only 130% from its 2009 financial crisis lows, while the S&P 500 is up 205%.

Valuation:  MCD trades 22x 2015 earnings that are expected to decline this year for the second consecutive year, which places the stock well above a market multiple and its current year P/E at a 10 year high:

from Bloomberg
from Bloomberg

MCD is in the midst of a $20 billion capital return plan announced last year, with the goal of completion by the end of next year. The dividend yields a healthy 3.25%

Our Take:  The company appears to be on the wrong side of global taste buds and health trends.  They are taking some steps to rectify this, but with 82% of their stores run by franchisees, this may be easier said than done as there have already been some fairly vocal complaints about the breakfast mandate (here).

The combination of poor customer sentiment, capital return, the stock’s relative under-performance to peers and the broad market, new management’s focus on transformation and the fact that activists appear ready to pounce, make the stock a good long candidate on pullbacks to the mid $90s. In the very near term though, the stock price may reflect some of these high expectations and if there is no specific decisions on reit structure on Thursday, investors may look to take profits.

Potential Catch Up Trade: We don’t see a huge reason to get in front of this week’s events, and would love a long entry below $100 near the 200 day moving average around $97.  One trade we might consider (stock reference $104) on a move lower would be selling the March 90 Put at 1.50 and buying the March 110 call for 2.20, with a net debit for the bullish risk reversal of 70 cents.  On March expiration you would be put the stock at $90 (really $90.70 as you have to add the premium paid for the trade), down about 13%, but have upside above $110.70 (the long call strike plus the premium paid).   This trade structure offers closer to the money participation on the long side, with the worst case scenario being put the stock at recent technical support. (note if we got a move lower we would adjust strikes lower).