MCD: Hello McNasty

by Dan December 22, 2015 3:19 pm • Commentary

On Friday’s Option’s Action on CNBC, my co-panelist Carter Worth made a fairly compelling case why shares of McDonald’s (MCD), one of the best performing stocks in the Dow Jones Industrial Average in 2015 could re-trace a bit of the recent break-out, possibly filling in the October gap. Watch here:

My other co-panelist Mike Khouw detailed an options trade that would benefit at the very least from a consolidation in the stock below $120 or a move lower by Feb expiration.  Mike’s trade, with the stock around $116.50 (as of Friday’s close), was to sell the February 120/125 call spread (selling one 120 call and buying one 125 call) and collect about $1.50.  If the stock is below $120 then you make the $1.50 in premium, between $120 and $121.50 make up to $1.50 and if the stock is between $121.50 and $125 lose up to $3.50. with a max loss of $3.50 above $125.

This is an ok trade if you think MCD’s could run out of steam, that options prices are high and you are only mildly convicted as to the potential for a sharp decline in the stock. While the trade has a high probability of success, the profits are limited to about 1.3% of the underlying stock price with potential losses of about 3%.  Sound trade idea, just not my cup of tea.

I’ll remind readers that back on October 20th, prior to the stock’s breakout of its multi-year consolidation between $90 and $105 we detailed a bullish zero cost risk reversal in March expiration as a stock alternative for those inclined to play for a breakout (here). We got the breakout, and it is now our view, as it is Carter and Mike’s that the stock incorporates a lot of good news.

In 2015 the company got a new CEO, fought off activists, overhauled their menu and for now halted what seemed to be never-ending declines in same store sales (SSS).

Consensus estimates now see 10% earnings growth next year, within 20 cents of their peak earnings of $5.55 in 2013, despite a continuation of sales declines, down 4% in 2016, down 13.5% from their 2013 peak of $28.1 billion to $24.3 billion.

MCD’s 25% gain year to date, without higher earnings revisions has left the stock trading at a trailing P/E of about 24x and forward of about 22x.  These are at least 10 year highs, and on a trailing basis at levels not seen since the dotcom bubble.  I suspect 2016 estimates have more to drop, making the stock look that much more expensive.

In the near term, any unexpected same store sales weakness, or some sort of mis-execution could cause the stock re-test the gap level near $110 (red line below), with a gap fill likely much harder to come by unless there was some sort of Chipolte (CMG) situation.

The October breakout level ($105ish, green line) is likely an area where investors would back up the truck if the stock were to come back there for non-company specific reasons:

MCD 3yr chart from Bloomberg
MCD 3yr chart from Bloomberg

The next identifiable catalyst for MCD will be their Q4 results on January 25th prior to the open. The company no longer release monthly sss as they discontinued the practice at the depths of their declines last spring as management likely deemed it was just adding to the stock’s volatility.

Over the next two months I want to target a move back to the October gap level of $110 

*Trade: MCD ($117.75) Buy Feb 115 / 110 / 105  Put Butterfly for 60 cents

-Buy to open 1 Feb 115 put for 2.66

-Sell to open 2 Feb 110 puts at 1.42 each or 2.86 total

-Buy to open 1 Feb 105 put for .80

Break-even on Feb Expiration:

Profits: up to 4.40 between 114.40 and 110 with max gain of 4.40 at 110

Losses: up to .60 between 114.40 and 115 & between 105.60 and 105 with max loss of .650 or less than 1% of the stock price below 105 and above 115.

Rationale:  This trade has a lower probability of success than Mike’s short call spread, but if I get the direction and the timing right, then the technical set up that Carter laid out has the potential to yield a much higher profit potential. It’s all a matter of how convicted you are.  This trade kind of attempts to thread the needle, but I suspect on a sell off the stock finds decent support at $110, a reasonable target.  If the stock were to sell off 6.5% in two months back to technical support, I could make 6.5x the money I risked on the short trade, I like that risk/reward.  Yes this is out of the money and long premium, but one of the reasons we are using a put butterfly structure to help offset some near term decay over the holidays and into the new year.