Domino’s Pizza (NYSE:DPZ) has delivered an impressive profit and free cash flow (FCF) growth during Q2, even though its U.S. same-store sales remained flat. However, the sustained FCF growth rate presents a promising opportunity for DPZ stock to experience substantial gains. This development has captured the attention of options traders, particularly long-call option holders, and out-of-the-money short-put traders.
On July 24, 2023, Domino’s announced a 5.8% year-on-year increase in global sales, but U.S. stores open during the past 12 months only saw a 0.1% rise in sales.
The Significance of Free Cash Flow
After the results were disclosed, DPZ stock initially showed little movement, but it has since climbed 4.5% from Monday’s figures, reaching $403.81 in early trading on July 28. The reason behind this surge is that investors have come to realize the importance of the company’s free cash flow growth.
For instance, Domino’s generated $204.3 million in free cash flow during the first half of the year, representing a substantial 69% increase compared to the same period last year when it recorded just $120.75 million.
Moreover, in Q2 alone, the company generated $127.6 million in operating cash flow, and after deducting $18.9 billion in capital expenditures, its FCF for the quarter amounted to $108.7 million. This is a 13.6% increase over the previous quarter’s Free Cash Flow of $95.7 million and an impressive 99% surge compared to last year’s Q2 Free Cash Flow of $54.4 billion.
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), which has significant implications for its present valuation.
Potential Impact on DPZ Stock
With a focus on the $108.7 million Second Quarter Free Cash Flow level (approximately $434.8 million annually) and assuming a 54.4% growth over the next year, it could reach $671 million. Based on today’s market cap of $14.13 billion, Domino’s is valued at just 21x Free Cash Flow.
On the other hand, if DPZ stock were to be valued at a more typical 33x FCF or a 3.0% FCF yield, the market cap should be significantly higher. For example, projecting $671 million in FCF over the coming year at 33x would suggest a market cap of $22.1 billion, indicating that DPZ stock could rise by 56.7%.
In essence, DPZ stock could potentially be valued at $632.77 per share (i.e., $408.31 x 1.544), carrying significant implications for options traders.
Options Trading Strategies
For traders anticipating a soaring DPZ stock over the next year, an approach could involve purchasing calls with extended expiration dates and higher strike prices than usual. For instance, the $480 strike price calls for Dec. 15 expiration currently trade at $5.85, while the $500 strike price calls are priced at just $3.60 per contract.
By adopting this strategy, traders have 140 days to witness DPZ stock rise by 19% to at least $485.85 for the $480 call buyers and 24% for the $500 strike price call buyers. If they believe the stock will approach the $632.77 price target by year-end, this tactic could lead to substantial profits.
Furthermore, traders can also generate immediate gains by shorting out-of-the-money (OTM) puts in the near term. For instance, the Aug. 18 expiration option chain shows that the $392.50 strike price, 3.0% below the current price, trades for $4.30 per put contract, providing an immediate 1.1% yield.
By executing an order to “Sell to Open” 1 put contract at $392.50 (after depositing $39,250 in cash and/or margin with their brokerage firm), traders can immediately earn $430.00, equivalent to 1.1% of the invested amount. If this can be repeated every three weeks, or 17 times a year, the annualized return could exceed 19.3%.
In conclusion, Domino’s Pizza’s robust free cash flow growth presents lucrative opportunities for traders, despite its recent surge in stock value.
Featured Image: Unsplash
Author Faith Yakubu 
