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HP Inc. (HPQ), the hardware company (not HP Enterprises - HPE), reports its earnings today for the quarter ending Jan. 31. Its put options show unusual trading activity today. This could be a good trade for short sellers, given how cheap HPQ stock is now.
The stock is trading for a 3.82% dividend yield and 8.4x forward earnings. Moreover, the company has been consistently profitable, producing $3.1 billion in free cash flow (FCF) in its last fiscal year ending Nov 30, 2023.
Given that its market cap is just $28.65 billion, its FCF yield now is a whopping 10.82% (i.e., $3.1b/$28.65b). That implies that the stock is undervalued at$28.93 per share
So, the put options activity reported by Barchart today in its Unusual Stock Options Activity Report might be an opportunity for short sellers.
The report shows that 6,000 puts expiring in 51 days on April 19 have traded at 22 cents for the $25 strike price. That is 31x the prior number of put contracts outstanding. Some large investors are either expecting a terrible earnings report and/or they may be shorting these puts for income.
After all the 22 cents in premium represents a yield of 0.88% at the $25 strike price. This strike price is deep out-of-the-money (OTM) at 13.6% below today's price. This looks like a good short play for income, especially if the investors expect to see the stock price stay stable or rise.
Let's look at what HPQ might be worth.
FCF Returned to Shareholders
Much of the company's FCF has been paid back to shareholders. For example, in the 2023 fiscal year, it spent $100 million in share buybacks and $1.036 billion in dividends. That $1.136 billion represented about 36.6% of its FCF.
The remaining FCF was used mostly to pay down its debt ($1.7 billion in debt reduction). It still has $9.25 billion in long-term debt, so this heavy debt paydown is likely to continue. But at some point in the next several years the company's FCF could likely end up in larger share buybacks and dividends.
That means that the stock could be undervalued for long-term shareholders. Here's why.
If the stock's value ends up with a slight improvement in the FCF yield metric, HPQ could soar.
For example, let's assume its FCF continues to grow to say $3.41 billion this year (i.e., up 10%). As a result, the FCF yield might improve slightly to 10% from 10.82%. This is the same as increasing the FCF multiple from 9.24x (i.e., the inverse of its FCF yield:1/0.1082) to 10x (i.e. 1/0.10).
Target Price
This means its market cap could be worth $34.1 billion ($3.41b x 10). That is up 19% from its existing $28.65 billion market valuation.
In other words, HPQ stock could be worth $34.46 per share. This assumes its FCF comes in strong this quarter like it did last year.
As a result, it might be worth copying this short option play for long-term value investors in HPQ stock. For example, even if the stock fell to $25, the dividend yield would be high at over 4.4% (i.e., $1.1024 dividend per share / $25).
Moreover, the FCF yield at this price will be very high. For example, assuming it produces $3.4 billion in FCF and with a 13.6% lower market value at $24.7536 billion, the FCF yield would be 12.28%. That would not be sustainable in the long run as the stock would be too cheap and would likely rebound.
So, the downside risk for the short put seller is not that great - again, assuming its FCF stays strong. For example, the short put seller could turn around and sell out-of-the-money calls or just hold the stock at the exercise price.
The bottom line is that it looks like large investors are trying to take advantage of high put premiums by shorting them at today's unusual put volume and price.
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.
