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Broadcom Inc (AVGO), the semiconductor design company focused on artificial intelligence (AI) applications, could be significantly undervalued based on its strong free cash flow (FCF) and FCF margins. Over the next year, AVGO could be worth at least 21% more than its closing price of $1,325.41 on March 28, or $1,60.72 per share.
Moreover, existing shareholders can take advantage of this situation by holding AVGO long-term and shorting out-of-the-money (OTM) put options in nearby expiry periods. That way they can gain extra income to enhance the stock's low 1.58% dividend yield.
I discussed this analysis in a recent Barchart article on March 10, “Broadcom Generates Impressive Free Cash Flow Margins, Implying AVGO Stock Could Be Worth 18% More.” At the time, AVGO stock was trading at $1,308.72, just after Broadcom released its fiscal Q1 earnings on March 7. I recommended shorting the $1,270 strike price put options expiring on March 28.
Since the put expired worthless, the short-put investors who followed this recommendation collected and kept the $36.30 in premium income for an immediate yield of 2.85% for an investment of just three weeks. That means it now makes sense to roll this trade over and do it again.
But first, let's review why AVGO stock could be worth over 21% more from here. After all, this benefits existing shareholders who both hold the shares and also short OTM puts for extra income.
Broadcom's Strong Free Cash Flow and FCF Margins
Last quarter Broadcom's revenue grew 34% YoY to $11.96 billion and its free cash flow (FCF) rose 19.2% to $4.693 billion. That means that its FCF margin was very high at 39.2% ($4.693b/$11.96b). That FCF margin was down a bit from the 44.1% FCF margin it made in last year's fiscal Q1, but it is still very strong.
The company revenues and strong FCF are being driven by the massive growth in demand for AI-related servers and AI application-specific integrated circuits (ASICs). This is also typical of other semiconductor design companies like Nvidia (NVDA).
Moreover, management had a strong outlook indicating that this year they expect to see revenue rising 39.5% from the $35.8 billion it made last fiscal year ending Oct. 2023. In addition, analysts now project that next fiscal year's revenue could rise to $57.08 billion.
Therefore, applying a 39.2% FCF margin to this estimate (i.e., the last quarterly FCF margin), free cash flow could rise to $22.375 billion. We can use that to estimate the value of Broadcom's stock.
Price Target for AVGO Stock
For example, if we assume that Broadcom were to pay out 100% of that FCF in dividends (right now it just pays out 52%, as I pointed out in my last article), the stock might end up with a 3.0% dividend yield. That is almost twice its existing 1.57% dividend yield.
Here is what that implies. For the stock to have a 3.0% dividend yield, its market cap would have to be $745 billion. This is seen by dividing the forecast $22.375 billion in FCF next year by 3.0% (i.e., $22.375b/0.03 = $745b). (This is because we assume theoretically that the company could pay out 100% of its FCF as a dividend). This is what is known as an FCF yield metric.
As a result, since Broadcom's existing market cap is $614.2 billion, the projected $745 billion market cap estimate is 21.3% higher. This implies that AVGO stock could be worth 1,607.72 per share.
This is close to a $1,650 price target from Susquehanna analyst Christopher Roland, according to CNBC. According to AnaChart, a new sell-side analyst tracking service, the average price target for buy-side analysts is $1,447.25 per share, 9.75% higher.
In fact, AnaChart shows that Mr. Roland has had a very good track record predicting Broadcom's stock price, with a performance score of 5.67, one of the highest in the analyst group that covers AVGO stock. In other words, his price target is likely to be hit.
One way existing shareholders can play this is to hold the stock and then sell short out-of-the-money (OTM) put options for extra income. Here is how that would work.
Shorting OTM Puts for Income
For example, look at the April 19 expiration period for the AVGO put option chain, three weeks away. It shows that three tranches have high levels of outstanding contracts: $1,280, $1,290, and $1300. These are 3.43%, 2.67%, and 1.92% below the closing price on March 28, so they are close out-of-the-money (OTM) strike levels.
However, the premium levels provide very good income opportunities. That can be seen in the table below.
It shows that the $1,300 strike price put options closed at $26.00 on the bid side, providing a short seller with a 2.0% immediate yield opportunity over 3 weeks (i.e., $26/$1,300). For those more risk-averse the $1,290 strike price provides a 1.71% yield (i.e., $22.10/$1,290), and the $1,290 strike price puts have a yield of 1.469% (i.e., $18.80/$1,280).
The bottom line is that these strike prices provide good income plays, especially if AVGO stock keeps rising as our price target implies. However, on the downside, the $1,280 strike price put play provides the most protection. This is because the breakeven price level is $1,280-$18.80, or $1,261.20, which is 4.844% below the existing price on March 28 of $1,325.41.
Moreover, this 3-week 1.469% yield is almost as high as the annual 1.58% dividend yield for existing shareholders. Rolling this trade over with the same yield every 3 weeks for a quarter provides an expected return (ER) of 5.876% (i.e., 1.469% x 4). In other words, it makes sense to be risk-averse here, as the ER is still very high.
All in all, this shows that existing investors can gain extra income by shorting OTM puts in AVGO puts that expire in nearby expiration periods.
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.
