/Palo%20Alto%20Networks%20Inc%20HQ%20sign-by%20Sundry%20Photography%20via%20Shutterstock.jpg)
On Nov. 20 Palo Alto Networks (PANW) announced a 2-for-1 stock split with an ex-date of Dec. 12, along with stellar earnings and free cash flow (FCF) results for its fiscal Q1 (ending Oct. 31). As a result, value investors are taking note, given that the company guided for very strong FCF margins for this fiscal year ending July 31, 2025.
PANW is trading at $386.77 in morning trading on Friday, Nov. 29. Based on analysts' revenue projections, PANW stock has an underlying value of at least 18% higher or $456 per share. This article will delve into that valuation.
I discussed the company's valuation in an Oct. 29 Barchart article, “Palo Alto Networks, a Free Cash Flow Gusher, Attracts Value Buyers.” My target price was $426.36 then, and now I have raised it based on the company's strong FCF margins.
(Note: investors can buy PANW shares before the ex-date to benefit from the upcoming stock split. That way they are guaranteed to receive 2 shares of PANW for every one they own.)
Strong FCF Results
Palo Alto Networks, which provides cybersecurity solutions to companies worldwide, grew its revenue by 14% in the quarter. However, more importantly, its free cash flow (FCF) was $1.4655 billion, representing a whopping 68.5% of revenue.
Palo Alto Networks books most of its annual FCF during this fiscal Q1 as its subscription revenue renews annually. As a result, it's important to look back over the past year to measure results.
For example, in the last 12 months (LTM) the company generated $3.257 billion in FCF, according to Seeking Alpha's data. That represented 39.3% of its LTM revenue of $8.288 billion in revenue. This was on par with the 40.6% FCF margin it made in last year's Q1 period over the prior 12 months.
Moreover, management indicated in its guidance that it expects to make between 37% and 38% FCF margins for this fiscal year ending July 31, 2025. As a result, we can use this to set a reliable price target.
Target Price for PANW Stock
Analysts are projecting that FY 2025 revenue will reach $9.15 billion and rise over 15.6% to $10.58 billion the following year. That implies its run rate over the next 12 months (NTM) is almost $10 billion ($9.865 billion on average).
Therefore, if we assume that the company can deliver at least a 38% FCF margin as it says it will do (even though it generated a higher 39.3% FCF margin in the last 12 months), its NTM FCF will be $3.75 billion:
$9.865 b x 0.38 = $3.7487 billion
That is 15% higher than the $3.257 billion in FCF it generated in the last 12 months. This implies that PANW stock could be worth much more.
For example, using a 2.50% FCF yield metric (i.e., its historical average and equivalent to a 40x multiple) the stock could be worth $150 billion:
$3.75b / 0.025 = $150 billion
That is 18% higher than its present market cap:
$150b projected mkt cap / $127 billion mkt cap today = 1.181 = +18% upside
Therefore, PANW stock could be worth up over $456 per share:
$386.77 price today x 1.18 = $456.39
Analysts Agree PANW Looks Cheap
For example, Barchart's analyst survey shows a mean price target of $415.68, and Yahoo! Finance has an average price target of $409.89 per share from a survey of 53 analysts.
Moreover, AnaChart.com, a new site that tracks analysts' price targets and their performance records, shows that 35 analysts who've recently written on PANW have an average $412.52 price target.
Note that these price targets are over $400 per share, (or $200 after the upcoming stock split).
Therefore it makes sense for value investors who own the stock or are considering buying it to also short out-of-the-money (OTM) put options. That way they can gain income while waiting for PANW to fall to a lower strike price.
Shorting OTM Puts
I discussed this play in my prior article where I discussed shorting $335 strike price puts for a $8.10 premium, i.e., a 2.42% short-put yield. That put expired worthless, so the investor made a good yield. However, if they also owned the stock the investor gained the upside from PANW's rise.
Similarly, it makes to not only own PANW today but also short out-of-the-money puts at the $375.00 strike price put option for the Dec. 27 expiry period. These puts are trading for $5.30 on the bid side.
Therefore, the investor can make an immediate yield of 1.413% (i.e., $5.30/$375.00), for a strike price that is about 3.00% below today's price.
This means that if PANW falls to $375.00 the investor who has to secure $37,500 in cash with their brokerage firm will have to buy 100 shares with that cash. However, given the income already received, the breakeven price for the investor's buy-in is actually $369.70 (i.e., $375-$5.30), or 4.48% below today's price.
So, this play allows the investor to lower their buy-in cost and gain income while waiting for the stock to fall. Note that the delta ratio, which measures how far the put price will move per dollar move in the underlying stock, is low at just -0.303. That roughly implies a low 30% probability that the stock will fall to this strike price.
The bottom line is that PANW stock looks very cheap here to value investors. One way to play this over the next month is to short OTM puts at lower strike prices.
