Yesterday, the Fed made a monster announcement. It is willing to take interest rate hikes off the table this year in an effort to remain “flexible” as the economy’s prospects continue to be uncertain. That made investors quite happy, at least for a time.
Shares across the board rose on the announcement with the Dow posting a 435-point day. This is certainly good news to most companies, small and large. Higher interest rates make borrowing and financing new products, equipment, offices and stores more expensive. So, a halt in new hikes is definitely well received on Wall Street.
But there are certain companies that are even more impacted by interest rates. And one that just got a huge gift.
When you think about McDonald’s, you likely think about golden arches, cheap burgers and drive thru. But McDonald’s Corporation (MCD) is a different entity altogether.
You see, the Corporation isn’t about flipping burgers or selling French fries. It is in the real estate business. More than 92% of all McDonald’s stores are franchise owned. Meaning each restaurant is independent from McDonald’s Corporation.
Instead of running all of those stores, it owns the properties and buildings. It leases them to the franchisees.
Sure, it does own a little less than 8% of the restaurants themselves. And it does help out with equipment purchases. It also sets the menus, handles most of the marketing and tells franchisees how to run their businesses. But its main revenue source is the rents it charges to those small business owners.
While interest rates certainly affect those franchisees, when they want to upgrade their stores and hire more workers, rates really affect McDonald’s Corporation’s business.
You see, real estate is obviously directly impacted by changing interest rates. When rates are high, property buyers are less likely to buy. That means companies like McDonald’s aren’t able to expand as fast as they’d like.
So, with rates halted where they are, McDonald’s won’t face higher mortgage rates. Now, a lot of that is passed on to franchisees already. But by not needing to pass on those rates, those businesses are able to grow and continue paying their rents. This move, or lack of a move, by the Fed is good for everyone in this specific company.
This also comes at a crucial time for McDonald’s.
Timing Is Everything
The company has a two-pronged operating plan right now.
First, it is actively trying to move the few remaining Corporation-owned stores over to franchise-owned. With lower overhead on property prices, mortgage rates and rents, that makes it easier for the company to do so.
Second, it is revamping its U.S. businesses. It is helping out thousands of its franchisees to modernize their businesses: new touch screen kiosks, adding delivery services and updating the look inside and outside each store. The Fed potentially capping rates, at least for a time, allows these renovations to go forward much cheaper. The less money going to banks for interest payments means more money for these important improvements.
Of course, all of this comes at a strange time for McDonald’s investors. The very day the Fed made this decision, the company itself released its 2018 financial results.
For the fourth quarter, the company produced higher-than-expected earnings and in-line-with-expected revenue. Ordinarily, this would be great and send shares up. But it also announced slower-than-anticipated growth.
Now, that growth and its 2019 projected growth rates are based on the pre-Fed announcement. It was just about three hours after McDonald’s announced its finances that the Fed announced it was going to be more “flexible” this year and might not raise rates at all.
For a company that relies so much on real estate and interest rates, that’s a big change in just three hours. Fortunately, investors haven’t quite picked up on it yet.
Shares are down about $3.50 each since the Fed made its move yesterday. In reality, they should be up by at least that amount. That gives us a great trading opportunity.
A Trade For Short Term Bulls
If a trader is looking to profit off a misalignment in a stock’s share price, he could simply buy those shares and wait for the market to right itself. But that takes a lot of capital and can take a long time.
Another, much more lucrative and short-term play would be to enter a bull call spread trade. This is where the trader buys a call option on the stock he thinks will rise. Then, he sells a second call option with a higher strike price. This reduces the amount of money he has at risk (by lowering the amount to enter the trade) in exchange for a capped profit potential.
Source: The Options Industry Council
Unless that trader believes that a stock is going to skyrocket, this is the smart move. McDonald’s, as nice as this opportunity is, is not likely to double overnight. It should rise in light of all of this new information. But it is a bit past the point of “skyrocketing” any time soon.
Let’s look at a specific bull call spread trade on McDonald’s to see exactly how much a trader could make with this scenario…
A Specific Trade on MCD
If a trader wanted to enter a bull call spread on MCD, he could buy March 15 $180 calls for $3.15 per share and sell March 15 $185 calls for $1.31 per share for an entry price of $1.84. Since each call contract represents 100 shares, that’s a net debit to the trader’s account of $184.
That’s his total risk. This trade cannot lose more than the $184 (plus commissions) it takes to open it. To find the total profit, we need to do a tiny bit of math.
The difference in strike prices represent the total amount of money that would be left in the account at the end of the trading period if shares go up. After you subtract the entry cost to get into it in the first place, you find the total maximum profit. That works out to $3.16 per share or $316 total ($185 – $180 = $5; $5 – $1.84 = $3.16; $3.16 x 100 shares = $316).
So, this trade comes with a total risk of $184. It comes with a maximum profit of $316. That’s a 172% return on the amount at risk. You can’t beat those returns if shares do rise.
For this potential to become realized, shares of MCD would have to rise above $185 by March 15. That’s six weeks for this stock to go up by just $6 per share… or 3.4%. That’s definitely achievable if investors realize how great the Fed’s news is for the real estate giant.
— The Option Specialist