Costco Wholesale (COST) reported 7.1% higher comp sales on Dec. 12 for its fiscal Q1 ending November and strong free cash flow margins, pushing COST stock's value higher. One way to play this is to sell short OTM puts for a lower buy-in.
Today, COST was up over $1,000 per share to over $1,005.54 in midday trading. This is up 15% in the last month and a half from its recent low of $874.18 on Oct. 31.
However, the stock may have further to go. I discussed this in my Sept. 17 article, “Costco Wholesale's Strong Free Cash Flow Could Push COST Stock 20% Higher.”
I argued that based on Costco's FCF margins it was worth $1,057 per share. Now, based on its recent Q1 FCF margins, the value of COST stock is even higher. This article will show why.
Strong Revenue and FCF Growth
For the quarter ending Nov. 24, Costco said comp sales were 7.1% higher over last year and net sales were up 7.5%. More importantly, the company generated almost $2.0 billion in free cash flow (FCF) from $62.15 billion in sales.
That means that its FCF margin hit a recent high of 3.2%. Last year its FCF margin was 2.6%, as I reported in my last article. Moreover, its Q1 FCF margin last year, after deducting a one-time $2 billion working capital inflow, was just 2.79%, compared to 3.2% this quarter.
That implies that if this continues over the next year, its FCF could rise significantly over the $6.63 billion it produced last fiscal year ending Aug. 31.
Forecasting FCF and a Price Target
For example, analysts estimate sales over the next 12 months (NTM) will average $282.2 billion. So, assuming Costco generates at least 2.80% FCF margins, its FCF could hit $7.9 billion, up 19% over last fiscal year's $6.63 billion.
That implies that the value of COST stock could be much higher. For example, using a 1.50% FCF yield metric the value of COST stock could be 18% higher than today. Here's how.
First, let's calculate the future market cap of Costco stock. This assumes that 100% of its FCF is paid out to shareholders. The dividend yield would be 1.50%.
$7.9 billion NTM FCF / 0.015 = $526.7 billion NTM mkt cap
$526.7 b / $447.5 billion mkt cap today -1 = 1.177 -1 = +17.7% higher market cap
Since COST stock is at $1007 today, this implies its value over the NTM period could rise 17.7% to $1,185 per share.
Analysts Agree
Analysts have raised their price targets in the last 2 months since my last article. AnaChart.com reports that the average of 30 analysts is $1,044.91, up from $940.03 in my last Barchart article on Sept. 17.
Moreover, some of the best analysts, who have good track records according to AnaChart, have raised their price targets since the earnings release.
For example, look at the table below. It shows that three of the highest-rated analysts have upped their prices.
The “Price Targets Met Ratio” column shows that the analysts circled above have met their price target over 90% of the time. That means they have good track records, which is why AnaChart's tracking of these analysts matters so much. That means their price target increases have a good deal of credibility.
The bottom line is that based on its FCF and analysts' targets, the value of COST stock is higher, even after the recent runup in COST stock.
One way to play this, in case the stock temporarily drops, is to set a lower buy-in price target, and get paid while waiting. That is what happens when you sell short out-of-the-money (OTM) put options in near-term expiry periods.
Shorting OTM Puts
For example, look at the Jan. 10, 2025, option expiration period. It shows that the $980 strike price, 2.5% below today's price, has a price of $8.85 on the bid-side.
That provides a short seller an immediate yield of almost 1.0% (i.e., $8.85/$980 = 0.90%).
Moreover, the delta ratio is low at -0.283, implying less than a 30% chance that the stock will fall to this level in the next 25 days (a little over 3 weeks from now).
This means that any investor who secures $98,000 in cash or buying power with their brokerage firm can then enter a trade to “Sell to Open” 1 put contract at this strike price for Jan. 10 expiry.
The account will then immediately receive $885.00. That works out to 0.90% of the $98K invested.
Moreover, more enterprising and less risk-averse investors can short the $990 strike price and secure $99,000 with the brokerage firm, or $1,000 more at risk. In return, they can receive $1,210 in income, for a short-put yield of 1.22% over the next three weeks.
The bottom line is that this is one way to set a buy-in target price below $1,000 and get paid while waiting. In fact, the breakeven price will be lower.
For example, the $980 short-put investor will still have a profit as long as COST stock stays over $971.15 per share ($980-$8.85), or 3.6% lower than today's price.
Long-term investors in COST stock can make extra income doing this play. If the stock falls to this strike price, their secured cash will be assigned to buy 100 shares per put contract shorted. Either way, it looks like this is a good way to play COST stock, given its higher underlying value.
