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Broadcom Inc. (AVGO) reported on March 7 impressive free cash flow (FCF) and FCF margins for its fiscal Q1 ending Feb. 4. As a result, AVGO stock could be worth up to 18% more. Existing shareholders can gain extra income by shorting out-of-the-money (OTM) put options.
The semiconductor manufacturer's stock fell 7% on Friday, March 8 to $1,308.72 per share. It's off 7.9% from a peak of $1421.39 on March 4. But this may be a “sell on the news” reaction from traders. The underlying value of AVGO stock was improved by these results.
Free Cash Flow and Margins
Broadcom reported that its revenue for the quarter rose 34% YoY to $11.96 billion, which was higher than expected by over $240 million. More importantly, its free cash flow (FCF), was up by 19.3% from $3.933 billion last year to $4.693 billion during the quarter.
Moreover, this $4.69 billion in FCF represented over 39% of its $11.96 billion of revenue. That is a very high FCF margin, although it was lower than the 44% FCF margin a year earlier. In addition, the prior quarter's FCF was slightly higher at $4.72 billion with a 50.8% FCF margin.
So, this probably reflects why AGO stock is down after the news. So, despite the revenue surprise, and the very high FCF margin, the market wanted to see higher margins.
Nevertheless, the company produced a good outlook and guidance. I submit that, based on its guidance, as well as analysts' revenue forecasts, AVGO stock is still undervalued. Here's why.
Target Price for AVGO Stock
For example, Broadcom said in its earnings release that it expects to see revenue this fiscal year ending Oct. 2024 of approximately $50 billion. Moreover, analysts project sales will rise to $56.86 billion next fiscal year. So, that means sometime this year it will be on run rate revenue in the next 12 months (NTM) of about $53.5 billion.
On top of this, management said that adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) will be 60% of revenue. That puts its NTM run rate adj. EBITDA at $32.1 billion.
We can use that to project FCF. For example, last quarter its adj. EBITDA was $7.156 billion. So, this converted into $4.693 billion in FCF, a ratio of about 65.6%. That implies that the run rate FCF for the next 12 months (NTM) of $21 billion (i.e., 0.656 x $32.1 billion).
This means that the market will be anticipating a $21 billion in FCF with which it can pay out dividends. Last quarter the company's payout ratio for FCF into dividends was 52% (i.e., $2.435 billion in dividends paid out of $4.693 billion in FCF). So, using this ratio, means that we can expect $10.92 billion in dividends in the next 12 months.
Right now AVGO stock has a 1.60% dividend yield. So using this yield, and dividing $10.92 billion by 1.60%, we can project AVGO will have a market cap of $682.5 billion. That represents a potential gain in market cap of 12.5% over its existing $606.5 billion market cap.
In other words, AVGO stock could be worth 12.5% more at $1,472 per share.
Another simpler way to estimate the stock's value is this. Take its $53.5 billion in revenue for the next 12 months and assume that its FCF margin will average 45% over the period. That sets FCF at $24.1 billion. Using a 3.2% FCF yield (i.e., twice the 1.60% dividend yield) sets its projected market cap at $752 billion. That is over 24% higher than today.
So, on average between these two valuation methods, AVGO stock could be worth 18% more at $1,544 per share.
Shorting OTM Puts for Income
One way existing shareholders can play this as they wait for the stock to rise is to sell short out-of-the-money (OTM) put options for income. For example, the March 28 expiration period, three weeks out, shows that put premiums are very high.
The $1,270 strike price put option, 3% below today's price, has a bid side premium of $36.30 per contract. That represents a 2.85% income play in less than 3 weeks for the short seller.
The catch is that the investor has to secure $127,000 (i.e., $1,270 x 100) in cash and margin to gain an immediate income of $3600 (i.e., $36 x 100 share per put contract). Nevertheless, the investor has plenty of downside protection. For example, the stock would have to fall to $1,233.70 (i.e., $1,270 - $36.30), or 5.7% below today's price before there would be a capital loss, even with an assignment forcing the investor to buy shares at $1,270.
The bottom line is that AVGO stock looks very undervalued here. Shareholders can take advantage of high put option premiums by shorting them for income.
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.
