January 31, 2015
How to Book a 24% Annual Return
on a 7-Cent Move in McDonald's
By Joseph Hogue
Above all the earnings and geopolitical news last week, the big headline was a turnover in the executive suite of the Golden Arches.
Under the oversight of Don Thompson, the $90 billion fast-food behemoth posted declining sales. And the stock price languished in 2014 as the S&P 500 posted a double-digit gain for the year.
After nearly two and a half years at the top, investors blamed Thompson for a string of poor menu rollouts and almost five consecutive quarters of lower U.S. same-store sales. McDonald's (NYSE: MCD) reported a 21% drop in global profits when it announced fourth-quarter earnings earlier this month, sending shares 1.5% lower on the day.
Investor disappointment was short-lived though, and MCD jumped more than 5% when the company announced that Chief Brand Officer Steve Easterbrook would take over as CEO in March.
But can the 47-year-old Brit remake the American fast-food icon?
Competition has been tough in the space for years, and sales were already in decline when Thompson took over in July 2012. Easterbrook had been successful on several fronts at McDonalds UK, but it may prove more difficult to turn a global ship.
But for investors looking to hedge their risk and book double-digit returns, he may not have to.
Can This Iconic Brand Return to Glory?
McDonald's UK saw its market share decline to 12% in 2006, according to Euromonitor data, on weakness in the brand and competition. Easterbrook came in to lead the division that year and immediately went to work on the brand. This included launching a website to answer consumer questions and petitioning to change the dictionary definition of "McJob" from a dead-end job.
Under Easterbrook, Euromonitor reports UK market share increased every year since 2006, reaching 15.7% in 2013, while global market share declined 0.4%.
Easterbrook left the company in 2011, but returned in 2013 as McDonald's chief brand officer. He brought on former Yahoo (NASDAQ: YHOO) and Amazon.com (NASDAQ: AMZN) executives to spearhead a digital campaign and helped launch Apple Pay.
Despite its competitive struggles, McDonald's still commands an industry-leading operating margin. Its median operating margin of 31.2% is roughly double Chipotle Mexican Grill's (NYSE: CMG) 15.7% and Yum Brands' (NYSE: YUM) 14.7%.
For investors, McDonald's is a cash machine, returning an average of $5.3 billion annually through dividends and stock repurchases over the past five years. The company said it plans to return $18 billion to $20 billion in cash to investors between 2014 and 2016.
Beyond the company's strong profitability and cash return, the investors regularly call for McDonald's to unlock some of the value trapped in its massive real estate holdings. At the end of 2013, the company owned 45% of the land and 70% of the buildings in its network.
That amounted to nearly $34.4 billion in real estate holdings, or about 38% of the company's market capitalization. A sale of real estate assets into a real estate investment trust (REIT) could mean a huge cash return to investors and a more tax-efficient business model.
Turnaround or No, Profit With This Trade
Shares trade for 18.3 times trailing earnings, near their five-year average P/E of 17.4 and well below the industry average of 24.3 times earnings.
While we will have to wait and see if the new CEO can turn the company's fortune, strong value and an iconic brand should mean limited downside risk. Over the near term, investors are likely to give Easterbrook and the shares the benefit of the doubt, at least until his first full quarter is reported in July.
The strong value proposition and limited downside makes MCD a perfect candidate for a put selling strategy.
Now, I know some of you may stop reading right here, thinking options are too risky. But when used properly, put selling is a conservative, high-income strategy.
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If you're not familiar with this strategy, by selling a put option on MCD, we are agreeing to buy 100 shares per contract at the option's strike price if shares are below that price when the option expires. For accepting the obligation, we are paid a premium, which lowers our cost basis. If shares are above the strike price at expiration, that premium is ours to keep free and clear.
With MCD trading for $92.44 at the time of this writing, we can sell the MCD Mar 92.50 Puts for a limit price of $2.75 a share ($275 per contract).
If MCD does not close above the $92.50 strike price, which is just above the current price, at expiration on March 20, we will be assigned shares. Since we received $2.75 in options premium, our actual cost is $89.75 per share, a 3% discount to the current price.
We want to make sure we have enough money in our account to cover the potential purchase. This means setting aside $8,975 for every put contract we sell, plus the $275 we collected from selling the puts.
If MCD rises just $0.07 between now and March 20, and closes above $92.50 on expiration, we keep the premium for a gain of 3.1% in just 47 days. If we were able to make a similar trade every 47 days, we would generate a 24% annual rate of return.
Given Easterbrook's prior successes, I would be inclined to give the new CEO the benefit of the doubt as to whether he can turn around slumping sales. And the company's strong value proposition and real estate holdings limit the downside risk. A put selling strategy offers the opportunity to make income now on a stock I wouldn't mind holding on to.
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