Adobe Inc (ADBE) generated strong free cash flow (FCF) and FCF margins in its latest quarterly report. Even after Friday's huge runup, ADBE stock still has a 22% upside over the next year. Shorting OTM puts could be a good play here.
ADBE rose 14.5% to $525.31 on Friday, June 14, after the company released its fiscal Q2 earnings on June 13. However, ADBE stock could have at least a 22% upside over the next year to $640 per share.
Strong FCF and FCF Margins
This is based on its FCF margins which rose to over 35.7% during the quarter. The company generated almost $2 billion in operating cash flow ($1.94 billion), and after a small capex spend of $41 million, its FCF came in at $1.899 billion. That represents 35.77%, almost 36% of its $5.309 billion in sales during the quarter (sales rose 10% YoY).
Moreover, this represents a significant increase in its FCF margins over the last year. For example, based on Seeking Alpha data, Adobe generated $6.368 billion in trailing 12-month (TTM) FCF for the year ending May 31. That represented 31.1% of its TTM revenue of $20.429 billion.
Granted, last year's Q2 quarter had higher FCF margins at 41.9% (i.e., $2.018b FCF/$4.816 b in sales). However, its Q2 FCF margins rose 15% from the TTM figure of 31.1% to 35.7%. This augurs well for the company's valuation in the future.
For example, analysts now forecast that sales for the fiscal year ending Nov. 2025 will rise from $21.47 billion expected this year to $23.94 billion. Assuming FCF margins stay at 36% over the next year, FCF could increase to $8.6 billion (i.e., 0.36 x $23.94b). That represents a 34% gain over its $6.4 billion TTM FCF.
This implies there could be a significant upside in ADBE stock.
Target Price for ADBE Stock
For example, what if the company were to pay out a dividend (it does not do so now) using all of its FCF? The market would likely give the stock at least a 3% dividend yield, and possibly as much as a 2.5% yield.
Here is what that implies. If we divide the $8.6 billion in FCF by 3.0% we get a market cap estimate of $286.7 billion. That is 21.8% over its existing $235.34 billion market value, even after Friday's run-up.
Moreover, using a 2.5% FCF yield metric, ADBE could have a $344 billion market cap (i.e., $8.6b/0.025 = $344b). That is 46% higher.
But just to be conservative, using a 21.8% upside ADBE stock could be worth $640 per share.
Analysts Target Price Agree
Analysts tend to agree with me. For example, Yahoo! Finance has a survey of 32 analysts showing that their average price target is $610.68 per share. Barchart's survey says the average analyst price target is $613.27 per share, an upside of 16.7% from here, even after Friday's rise. AnaChart.com's survey shows a $587.16 price target.
In effect, almost all analysts see a higher price for ADBE stock over the next year. AnaChart, a new sell-side analyst tracking service shows that Michael Turrin, of Wells Fargo, has a $700 price target for the stock. He raised that from $690 two days ago. According to AnaChart, he has hit his price targets over two-thirds of the time.
In fact, as the table above shows, all the highest-rated analysts who have changed their recommendations recently have hit their price targets well over half the time. They project higher target prices for ADBE. That should tell you something about how cheap the stock is now.
One way to play this is to sell short out-of-the-money (OTM) put options. The reason is to both gain income (as there is no dividend) and also possibly buy in cheaper if the stock falls.
Shorting OTM Puts for Income
For example, look at the July 5 expiration date for put options in ADBE stock, which is three weeks from now. It shows that the $510 strike price, which is 2.91% below Friday's close, are trading at $5.40 on the bid side.
That represents an attractive 1.0% yield to the short seller of these puts (i.e., $5.40/$510.00).
Here is how that works. The investor must first secure $51,000 in cash or margin with their brokerage firm. Then they can enter an order to “Sell to Open” 1 put contract for expiration on July 5, three weeks from now at the $510 strike price.
The account will then immediately receive $540. That is why this is a 1.05% immediate yield opportunity (i.e., $540/$51,000 invested over that period). The investor expects that the put price will slowly deteriorate to zero if the stock does not fall to $510 on or before July 5. That way they keep the yield (no matter what) and have no obligation to buy 100 shares at $510 with the secured cash.
This works especially well for existing investors to gain extra income. But it also represents a way for non-shareholders to set a buy-in target price. At least then, even if their short puts are exercised, the investor has a breakeven price of $510-$5.40, or $504.60, which is 3.94% below Friday's close. That makes it a bargain purchase price.
Moreover, if the investor can repeat this play over the next quarter, the expected return (ER) is $2,160 on the same invested amount. That means the ER yield is 4.235% over the next quarter. That is a fantastic potential return, even if the stock price stays level here.
The bottom line is that ADBE stock looks very cheap here. One way to play this is to sell short OTM puts to 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.
