There is unusual options activity in Shopify Inc (SHOP) today. A large tranche of out-of-the-money put options were traded. Investors see SHOP as undervalued, especially given its growing free cash flow (FCF).
The stock is trading for $72.60 and a large tranche of over 8900 put options were traded at the $64.00 strike price for expiration on Feb. 2, 2024. That is significant both because the strike price is $8.60 below today's price (i.e., out-of-the-money) and because there are only 30 days until expiration.
This large trade was reported in Barchart's Unusual Stock Options Activity Report. It is also significant because it represents a huge positive bet on SHOP stock if the trade was initiated by a short-seller of those puts.
For example, a short seller would have had to secure $56.96 million with their brokerage firm to sell short these puts. But in return, since the strike price received was 56 cents on the bid side, the account received almost a half million dollars. That is seen by multiplying 8900 contracts by 100 and by 56 cents (i.e., $498.4K).
That works out to an immediate yield to the short seller of 0.875% for one month's yield-to-expiration. So, the annualized expected return (ER), if the trade can be repeated 12x, is 10.5% (i.e., 0.875% x 12). That could bring in $5.98 million to the short seller if repeated every month for a year.
They must have a bullish outlook on Shopify stock. Let's look at one reason why that might be the case.
Shopify's Free Cash Flow Could Rise
Last quarter Shopify generated $276 million in free cash flow (FCF) and a 16% FCF margin. This was the fourth quarter it has had positive FCF. I expect that the company could generate at least a 20% margin during 2024.
Given that analysts forecast $8.34 billion in revenue in 2024, that means with a 20% FCF margin, free cash flow could hit $1.668 billion. That could be 3x the FCF it generated in the last 12 months (LTM) - $548 million.
In other words, the stock could rise considerably based on higher FCF. But how much?
Price Target for SHOP Stock Based on FCF Yield
One way to judge this is to use a FCF yield metric. That means you divide the FCF by its market cap. For example, $548 million in LTM FCF divided by its market cap today of $93.5 billion gives us an FCF yield of 0.586%.
What this means is that the market believes that if the company were to pay out 100% of its FCF as dividends to shareholders the dividend yield would be 0.586%.
So, that implies that if we divide our projection of $1.668 billion in FCF for 2024 by 0.6% (rounded up), the market cap for Shopify should rise to $278 billion. That implies a potential upside of 200% in SHOP stock.
So, just to be conservative let's use a 1.0% FCF yield metric. So, by dividing our $1.668 billion FCF estimate by 1.0% we get a market cap target of $166.8 billion. That is 78.3% over today's market cap of $93.5 billion.
This works out to a price target of $129.46 per share (i.e., $72.61 x 1.783).
In other words, there is still a huge upside in SHOP stock, given its massive free cash flow and FCF margins. No wonder it makes sense to short OTM puts here, given that SHOP stock looks undervalued.
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.
