Is Domino's Stock On The Verge Of Crashing?

| About: Domino's Pizza, (DPZ)
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Dan David of GeoInvesting says shares of Domino's could crash.

David, who's been short the stock since $135, warns about Domino's high debt and rising fuel, food, and labor costs (including minimum wage violations).

For Domino's longs who are still bullish but want to limit their risk in case David ends up being right, we present two ways to hedge.

Dan David's Short Case For Domino's

Twitter (NYSE:TWTR), whatever its faults as a company and a stock (currently trading near an all-time low), remains a useful source of information, if you follow the right accounts. One of the accounts I follow is George Moriarty's, VP of Content and Executive Editor at Seeking Alpha. In the tweet screen captured above, George shared a short case for Domino's (NYSE:DPZ) made by Dan David of GeoInvesting.

David, who's been short Domino's since it was at $135, argues that the company doesn't deserve the multiple it's been given:

We looked at Domino's as a high flyer, a hedge fund darling, and tried to decide what they're doing better than the competition. What we came away with is really, not much," said David. "Management positions themselves as a pseudo technology company, with its pizza tracker and ordering pizza's by emoji, but that doesn't make it a technology company. They don't deserve a technology multiple.

David raised the following warnings about the company:

  • Its $2.2 billion in debt is unsustainable without some kind of refinancing.
  • Large increases in the minimum wage will increase its costs, as will increases in oil, pork, and cheese prices (David noted pork and cheese prices are currently at 3-year lows).
  • David expects more costs for violating minimum wage rules (Domino's is currently being sued by the New York Attorney General for underpaying workers in 10 New York locations).

David wasn't overly bullish on any of Domino's quick service competitors, but said Papa John's (OTCPK:PAPA) had a better valuation and better prospects.

Why Consider Hedging Domino's

In the comments on my previous article about another analyst's crash warning for McDonald's (NYSE:MCD), there was some confusion about the point of hedging, so I'll try to be clearer here. If you own Domino's and agree with Dan David's short thesis on the stock, you should sell your shares, and maybe even consider going short.

On the other hand, if you are still bullish on Domino's, but want to limit your risk in the event you end up being wrong and Dan David ends up being right, then you should consider hedging. We'll look at two ways of doing so below. If you'd like a refresher on hedging terms first, please see the section titled "Refresher On Hedging Terms" in our recent article on hedging Disney (NYSE:DIS).

Hedging DPZ With Optimal Puts

We'll use Portfolio Armor's iOS app to find optimal puts and an optimal collar to hedge Domino's below, but you don't need the app for that. You can find optimal puts and collars yourself by using the process we outlined in this article if you're willing to work through the iterations.

Whether you run the calculations yourself using the process we outlined or use the app, another piece of information you'll need to supply (along with the number of shares you're looking to hedge) when scanning for optimal puts is your "threshold," which is the maximum decline you are willing to risk.

This will vary depending on your risk tolerance. For the purpose of the examples below, we've used a threshold of 20%. If you are more risk-averse, you could use a smaller threshold. And if you are less risk-averse, you could use a larger one. All else equal, though, the larger the threshold, the cheaper it will be to hedge.

Here are the optimal puts as of Thursday's close to hedge 200 shares of DPZ against a greater than 20% drop by mid-December.

As you can see at the bottom of the screen capture above, the cost of this protection was $740, or 3.01% of position value. A few points about this cost:

  1. To be conservative, the cost was based on the ask price of the puts. In practice, you can often buy puts for less (at some price between the bid and ask).
  2. The 20% threshold includes this cost, i.e., in the worst-case scenario, your DPZ position would be down 16.99%, not including the hedging cost.
  3. The threshold is based on the intrinsic value of the puts, so they may provide more protection than promised if the underlying security declines in the near term, when the puts may still have significant time value.

If you don't want to spend this much to hedge against a greater than 20% decline over the next several months, you can consider hedging with an optimal collar instead.

Hedging DPZ With An Optimal Collar

When searching for an optimal collar, you'll need another figure in addition to your threshold, your "cap," which refers to the maximum upside you are willing to limit yourself to if the underlying security appreciates significantly. A starting point for the cap is your estimate of how the security will perform over the time period of the hedge. You don't think the security is going to do better than that anyway, so you're willing to sell someone else the right to call it away if it does better than that.

We checked Portfolio Armor's website to get an estimate of DPZ's potential return over the next several months. Every trading day, the site runs two screens to avoid riskier investments on every hedgeable security in the U.S., and then ranks the ones that pass by their potential return over the next six months. The site calculated a potential return of 13% for Domino's on Thursday, so we used that as the cap.

This was the optimal collar, as of Thursday's close, to hedge 200 shares of DPZ against a >20% drop by mid-December, while not capping an investor's upside at less than 13% by then.

As you can see in the first part of the collar above, the cost of the put leg was $590, or 2.4% of position value. But as you can see in the second part of the collar below, the income generated from the call leg was the same: $590, or 2.4% of position value.

So the net cost of this collar was $0. A couple of notes about this hedge:

  • Similar to the situation with the optimal puts, to be conservative, the cost of the optimal collar was calculated using the ask price of the puts and the bid price of the calls. In practice, an investor can often buy puts for less and sell calls for more (again, at some price between the bid and the ask), so in reality, this collar would likely have had a negative cost.
  • As with the optimal puts above, this hedge may provide more protection than promised if the underlying security declines in the near future due to time value (for an example of this, see this recent article on hedging Apple (NASDAQ:AAPL)). However, if the underlying security spikes in the near future, time value can have the opposite effect, making it costly to exit the position early (for an example of this, see this article on hedging Facebook (NASDAQ:FB) - Facebook Rewards Cautious Investors Less).

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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