Palo Alto Networks Looks Too Cheap Due to Its Strong FCF - Short Put Plays are Attractive

Palo Alto Networks (PANW) stock looks way too cheap here. This is based on its strong free cash flow (FCF) and FCF margins. Its adj. FCF was up 7.5% YoY and FCF margins are high at 38.8%. This makes short-put plays attractive here both as an income play and a way to buy in cheaply.

As of morning trading on Monday, April 15, PANW is at $275.05, down 26% from its recent peak of $371.97 on Feb. 12. The stock is now near its lows after the Feb. 20 release of its fiscal Q2 earnings for the quarter ending Jan. 31.

But that report, although disappointing to investors showed to investors that the cyber security software company's free cash flow (FCF) was still strong. Based on my analysis the stock could be worth over $360 per share, as much as $368 per share in the next year. That is over 33% higher than today. 

FCF and FCF Margins Strong

The company reported that its Jan 31 quarter revenue was up 19% YoY and its FCF for the quarter was $654.8 million. Moreover, on a trailing 12-month (TTM) basis, the company made 7.5% more adj. FCF (i.e., $2.922 billion, vs $2.718 billion a year earlier).

This was highlighted in a recent GuruFocus article I wrote on March 6, “Why is Palo Alto Networks So Cheap?” In that article, I show that the company's FCF margins, on a TTM basis, were high at 38.8% (i.e., $2.92b adj FCF on $7.53b in TTM revenue). Therefore, assuming the company can keep generating this high level of FCF margins, its FCF should continue to move higher. For example, analysts now project revenue will rise to $8.0 billion this year ending July 31, and up to $9.16 billion by the next FY ending July 2025.

As a result, if its FCF margins average 39% by the end of next FY, FCF could reach $3.57 billion (i.e., 0.39 x $9.16b). That means its valuation could rise significantly from here.

Target Price for PANW Stock

If the company were to pay out 100% of its FCF as a dividend next year, PANW stock would likely end up with at least a 3.0% dividend yield. That means that if we divide $3.57 billion by 3.0%, its market cap valuation would be $119 billion. 

That implies its market cap today of $89.3 billion would rise by over one-third to $119 billion. In other words, PANW stock is worth at least 1.338 more than its price today of $275.05, or 368.34 per share.

This is higher than other analysts' recent price targets, but not by much. For example, Refinitiv's survey (seen in Yahoo! Finance's summary page) of 41 analysts shows that their average price target is $336.63, or 21.8% higher. Moreover, AnaChart, a new sell-side analyst tracking service that tracks how well analysts perform, shows the average of 40 analysts is $305.19, or 13% higher.

The bottom line is that PANW stock looks way too cheap here and there is a good consensus among analysts, as well as from evidence of its high FCF margins.

One way to play this is to short out-of-the-money (OTM) put options, both as an income play and to also set a disciplined buy-in target price.

Shorting OTM Puts as an Income Play and Buy-In Price

Since the put options for PANW stock are now high it makes sense to take advantage of this by shorting them. That way you can earn extra income if you are already a shareholder in PANW stock, and also set a buy-in price if you want to hold off until the stock falls. 

For example, look at the May 3 expiration period, 18 days from now. Barchart's option chain shows that the $270 strike price, which is 2.76% below today's price, trades for $5.00 per put option contract on the bid side. 

That means that a short-seller of these puts can make an immediate 2.02% put yield (i.e., $5.45 / $270.00). Here is how that works out.

PANW puts expiring May 3 - Barchart - As of April 15, 2024

If the investor secures $27,000 with their brokerage firm, they can then enter an order to “Sell to Open” 1 put contract at $270.00. The secured $27,000 allows the account to buy 100 shares should PANW stock fall to $270.00 and the put option holder exercises his option on or before May 3.

But the investor gets to keep $545 (i.e., 100 x $5.00) immediately, no matter what happens. That means that his breakeven price is $270-$5.45, or $264.55 per share. This is a good buy-in entry price and 3.8% below today's price.

You can also see that more conservative investors can sell short the $260 strike price and receive $255 after securing $26,000 with their brokerage firm. That is a lower yield of almost 1.0% (i.e., $2.55/$260 = 0.98%). But at least there is now over a 7% lower breakeven level for the short seller.

If PANW stock stays flat the investor can repeat this trade. Over a quarter, it's possible that the expected return (ER) can be over $2,180 at the $270 strike price, an ER of 8.07% (i.e., $2,180/$27,000) if the same level of put yield can be achieved. Even with the lower $260 strike price, the investor can make close to 4% in 90 days.

The bottom line is that this is a good way to buy into this cheap stock and also gain extra 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.