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Oracle Corp (ORCL) reported strong results yesterday for its fiscal Q3 ending February. Its free cash flow (FCF) was up 68% on a trailing 12-month basis. As a result, ORCL stock is spiking today, up over 12% to $128 per share. However, based on its strong FCF the stock could still be as much as 26% undervalued.
The company reported that its cloud-based revenue was up 25% and total revenue was up 7% on a YoY basis. Moreover, the company signed several large contracts which more or less guarantees that revenue will continue to stay strong.
In addition, its free cash flow was up 68% to 12.258 billion on a trailing 12-month (TTM) basis. That also represented a gain of over 21% from the prior TTM FCF of $10.1 billion. This can be seen in the table below from page 7 of its earnings release.
More importantly, the company's TTM FCF represents over 23.3% of its TTM revenue of $52.5 billion, based on data from Seeking Alpha. That is useful since it will allow us to forecast the company's FCF going forward.
Free Cash Flow and Target Price
For example, analysts covering ORCL stock now forecast that revenue for the year ending May 2024 will be $53.25 billion. And for the following year, they project $58 billion in revenue.
As a result, if Oracle keeps generating a 23% FCF margin, its next fiscal year FCF could rise to $13.34 billion (i.e., $58 billion x 0.23).
This is important since the stock market valuation can be projected using this figure. For example, using a 3% FCF yield metric we can estimate its market cap will rise to $444.7 billion (i.e., $13.34/0.03). That is over 26% higher than its market cap today of $351.9 billion.
This is based on an assumption that if the company were to pay out 100% of its FCF as a dividend, the stock would end up with at least a 3.0% dividend. Today, its dividend yield is much lower at 1.40% (i.e., $1.60 in dividends per share / $128.00).
So, there is plenty of room for the stock to move higher. For example, if the market eventually gave the company a 2.0% FCF yield valuation, its market cap would be $667 billion. That is about 90% higher than today's stock price.
The net result is that ORCL stock is worth at least 26% more at $161.28 per share. One way for existing shareholders to play this is to sell short out-of-the-money (OTM) put options as an income play.
Shorting OTM Puts for Income
For example, the $124 strike price put option in the March 28 expiration period trades for $1.32 per contract. That period is a little over 2 weeks away and the strike price is over 3% below today's price. That means there is at least that much downside protection.
For the short seller of these puts, they can generate an immediate yield of 1.06% (i.e., $1.32/$124.00). Here is how that works out. An investor who secures $12,400 in cash and/or margin with their brokerage firm can apply to sell these puts. Once approved they enter an order to “Sell to Open” 1 put contract at the $124 strike price for the March 28 expiry period.
The account will then immediately receive $132 (i.e., 100 x $1.32 on the bid side). That represents 1.06% of the $12,400 invested.
Downside Risk
So, as long as the stock stays above $124 for the next 2 weeks the investor will not have any obligation to buy 100 shares of ORCL stock at $124, using the $12,400 already secured. But, even if this happens, the investor still keeps the $132 already received.
Therefore the breakeven point is $124-$1.32, or $122.68. That is 4.6% below today's spot price of ORCL stock. Even if the investor is assigned to buying the shares, and if there is an unrealized capital loss, they know they bought in at a good price. The target price over the next year is $161.28, or 30% more than the $124 strike price.
The investor can then also sell out-of-the-money (OTM) covered calls to gain extra income. That could help improve any unrealized capital loss position in ORCL stock.
The bottom line is that Oracle looks cheap here and investors can play this by shorting OTM puts.
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.
