Domino's Pizza (DPZ) produced excellent profit and free cash flow (FCF) growth in Q2, although its U.S. same-store sales growth was flat. Nevertheless, if its FCF can sustain this growth rate, DPZ stock could move significantly higher. That would be ideal for options traders, including long-call option holders and out-of-the-money short-put traders.
On Monday, July 24, 2023, Domino's reported that global sales were up 5.8% YoY, although for its U.S. stores open during the past 12 months sales were up just 0.1%.
Free Cash Flow is What is Important
Initially DPZ stock was flat after the results, but it's now trading up 4.5% from Monday at $403.81 in early Friday, July 28 trading. This is because investors now realize what is important for investors - its free cash flow growth.
For example, Domino's generated $204.3 million in first free cash flow, up 69% from the first half of last year when it made just $120.75 million.
Moreover, in Q2 alone it generated $127.6 in operating cash flow, and after deducting $18.9 billion in capex spending, its FCF for the quarter was $108.7 million. This was 13.6% over the prior Q1 FCF of $95.7 million, and also up 99% from last year's Q2 FCF of $54.4 billion.
The point is that Domino's is now on a run-rate FCF growth rate of at least 54.4% (i.e., 13.6% QoQ FCF growth rate x 4). That has major implications for its present valuation.
FCF Growth Can Push DPZ Stock Higher
For example, using the $108.7 million Q2 FCF level (i.e., $434.8 million annually) and assuming it grows by 54.4% over the next year brings it up to $671 million. That means at today's market cap of $14.13 billion, Domino's is at just 21x FCF.
Another way to look at it is the reverse - DPZ stock has a 4.76% FCF yield (i.e., 1/21x). A more normal valuation for the stock would be 33x FCF or a 3.0% FCF yield. That implies that its market cap should be significantly higher.
For example, if we multiply our forecast of $671 million in FCF over the coming year by 33x, the market cap should be $22.1 billion. That implies DPZ stock could rise by 56.7% (i.e., $22.1 billion/$14.13 billion).
In other words, DPZ stock is potentially worth $632.77 per share (i.e., $408.31 x 1.544). This has major implications for options traders.
Buying Long-Term Calls and Shorting Near-Term OTM Puts
For example, with a view that DPZ stock will soar over the next year, traders could buy calls that are 3 or 4 months out with a higher strike price than normal. For example, the $480 strike price calls for Dec. 15 expiration trade for $5.85, and the $500 strike price calls are at just $3.60 per call contract.
That means that the trader has 140 days to see DPZ stock rise 19% to at least $485.85 for the $480 call buyer and 24% for the $500 strike price call buyer. But if they believe the stock will start to move towards the $632.77 price target by the end of the year, this strategy could produce huge profits.
Moreover, on a near-term basis, traders can also make money by shorting out-of-the-money (OTM) puts. For example, the Aug. 18 expiration option chain, which is 3 weeks away, shows that the $392.50 strike price, 3.0% below today's price, trades for $4.30 per put contract. That represents an immediate 1.1% yield
That means that the trader show enters an order to “Sell to Open” 1 put contract at $392.50 (after posting $39,250 in cash and/or margin with their brokerage firm), and can immediately make $430.00. This $430 represents 1.1% of the $39,250 invested in the strategy.
In fact, if it can be repeated every 3 weeks, or 17 times a year, the annualized return could be over 19.3% annually.
This shows that there are good ways to make money in DPZ stock, despite its recent rise, based on its powerful free cash flow growth.
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.
