McDonald's Corp. (MCD) reported 1.5% lower global comp sales on Oct. 29, and its recent E. coli outbreak pushed MCD stock down. These could be temporary issues. The good news is that it hiked the dividend by 6%, and MCD now looks attractive historically.
MCD closed at $295.21 on Friday, down over 6.7% from its recent peak of $316.56 on Oct. 18. The company and the CDC reported an outbreak on Oct. 22 of E. coli from McDonald's Quarter Pounders which has now affected 90 people in 13 states. The outbreak seems to have been contained and the risk is now low.
This has hurt the company's reputation. That could have ongoing effects on McDonald's brand. Nevertheless, it seems to be a temporary issue.
This provides an opportunity for value buyers in the stock.
Recent Earnings and Dividend Increase
McDonald's reported a 3% YoY revenue gain but comp sales were down 1.5% globally in the third quarter, despite an increase of 0.3% in the U.S.
In addition, its operating income and diluted earnings per share were both down 1.0% YoY. However, it reported that after one-time charges the latter was actually up 1.0%.
However, the good news is that the company felt strongly enough about its outlook and cash flow to raise the dividend by 6% to $1.77 quarterly. (Note: McDonald's still has not yet released its cash flow statement or its quarterly 10-Q, so we don't know its free cash flow (FCF) performance for the quarter).
That works out to an annual $7.08 dividend per share (DPS). This gives investors in MCD stock a dividend yield at today's price of $295.21 of 2.40%.
This is significant since this is a higher yield than the stock has had over the past 4 and 5 years. That implies there is an opportunity for value investors.
Price Targets
For example, over the past 4 years, according to Seeking Alpha, MCD stock has had an average yield of 1.89%. That implies that if the stock returns to its average, it would be worth $374.60 per share (i.e., $7.08 DPS/0.0189 = $374.60).
In other words, MCD could be worth $79.39 more, or +26.9% more (i.e., $374.60/295.21-1). But, let's not get too excited yet.
For one, Morningstar reports that the average 5-year yield has been 2.23%. That implies a much lower price target of $317.49, although this is still 7.5% higher than today's price (i.e., $317.49/$295.21-1).
In addition, analysts' price targets are higher than today's price, but not as high as $374.60. For example, Yahoo! Finance's survey of 33 analysts shows an average of $323.13, and Barchart's mean is $323.55. But these prices are still 9.5% higher than today's price.
Moreover, AnaChart, a new site that tracks analysts' price targets and their performance, shows that 29 analysts who've recently written on MCD have an average price of $331.32. That is over 12.2% over Friday's closing price.
In other words, based on its historical dividend yield and analysts' price targets, MCD stock looks cheap here. But what if MCD stock keeps falling?
One way to play this is to sell short out-of-the-money put options. That way the investor can set a lower buy-in price target in nearby expiry periods and get paid while waiting to see if this occurs.
Shorting OTM Puts
For example, look at the Nov. 29 options expiration period, 27 days from now. That is a little less than four weeks and a little more than 3 weeks away. This is the period where options premiums tend to decrease the fastest - which is good for short sellers of put options.
The $280 put option strike price is attractive since it is over 5% lower than the Friday trading price (Nov. 1) and yet still has a premium of $1.42 per put contract. That represents an immediate yield of 50 basis points to the cash-secured short-put investor (i.e., $1.42/$280.00 = 0.507%).
This means that an investor who secures $28,000 in cash or buying power with their brokerage firm can enter a trading order to “Sell to Open” 1 contract at $280.00. The account will then immediately receive $142.00 as a credit. That is why the investment has a 0.507% yield.
As long as MCD stays over $280 on or before Nov. 29, the account will not have the cash assigned to buy 100 shares at $280. But even if that happens, the investor gets a lower buy-in price. Moreover, their breakeven is lower since the income has already been received. That works out to $280-$1.42, or $278.58, or 5.63% below the Nov. 1 closing price.
Moreover, investors willing to take on more assignment risk can short the $285.00 strike price and receive $2.11 in premium. That is 3.46% below the Nov. 1 price, but it yields 0.74% to the investor shorting this put option.
Keep in mind that the dividend yield for these investors, if their strike price buy-in prices are assigned, are much higher. For example, at $280, the $7.08 DPS provides an annual yield of 2.53%. That is a 5.42% higher dividend yield than investors in the stock at today's price.
The bottom line is that MCD looks cheap here and one way to play this is to short OTM puts in nearby expiry periods to achieve a lower buy-in price and higher yield.
On the date of publication, Mark R. Hake, CFA did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
