Carnival Corp Stock Is Too Cheap - Short Out-of-the-Money Puts and Calls for Income

Carnival Corp (CCL) stock remains deeply undervalued after its recent quarterly strong free cash flow and FCF margins. One way to play this for existing investors is to short OTM puts and calls as an income play.

CCL stock is at $17.33 in morning trading on Tuesday, July 30. This is down 9.6% from a recent high of $19.18 on July 16. That drop is much less than many tech stocks.

Nevertheless, CCL stock looks very cheap here. I discussed this in the June 25 Barchart article, “Carnival Corp Stock Be Worth Over Double Its Present Price More Based on Its Huge FCF.”

Projected Free Cash Flow

I showed how CCL stock could be worth at least $43.42 per share, or over twice its present price. This was based on its strong free cash flow, representing the fact that tourists are now flocking to cruises.

Management also indicated that the company expects to see “substantial free cash flow.” I think there is also even the possibility of the company returning to paying a dividend at the end of the year.

This is based on its high FCF margins. For example, in the most recent quarter ending May 31, the company generated $1.3 billion in adjusted FCF. That represents 22.5% of the $5.781 billion in sales for the quarter.

Moreover, analysts now project that sales this year ending Nov. 2024 will hit $24.83 billion, and next year it will rise to $26.01 billion. That represents an average run rate of $25.42 billion in sales over the next 12 months (NTM).

Therefore, applying a 22.5% FCF margin to this NTM sales estimate leads to a projected $5.72 billion in NTM adj. FCF (i.e., $25.42b x 0.225 = $5.72b). That is a significant result and a major turnaround for the company. That means it could easily afford to pay a dividend as I explained in my prior article.

Price Target Based on FCF Yield

Moreover, even using a very conservative 10% FCF yield metric implies that Carnival Corp's market cap could rise to $57.2 billion (i.e., $5.72b/0.10 = $57.20 billion. 

That is 252% higher than its present $22.67 billion market cap. In other words, CCL stock could be worth 2.52x its present price of $17.33, or $43.67 per share.

What if the company were to return to paying a dividend? That provides another way to value CCL stock. 

Price Target Based on Dividend Yield

In 2020 it stopped paying a quarterly 50 cents dividend, or $2.00 annually. If the company were to return to paying this it would cost just $2.53 billion, as there are 1.2678 billion shares outstanding.

In other words, the projected $5.72 billion in adj. FCF covers this $2.53 billion dividend cost by more than 2.2x. The market would likely give the stock at least a 5% dividend yield as a result.

So, dividing $2.00 in dividends per share by 0.05 results in a price target of $40 per share (i.e., $2.00/0.05 = $40.00). That is still 2.3x today's price. In other words, CCL stock remains deeply undervalued here.

Keep in mind that if the company were to return to paying a dividend, it would become a huge catalyst for the stock rising to this price target. In fact, even with just a $1.40 annual dividend (i.e., 35 cents per quarter) and applying a 5% yield, the minimum price target is $28.00 per share (i.e., $1.40/0.05 = $28.00).

Analysts' Targets

Analysts agree that CCL stock looks cheap here. For example, Yahoo! Finance reports that the average price target of 18 analysts is $21.88 per share, or +26% higher than today's price.

Moreover, Barchart's survey shows a mean price target of $22.50 per share. AnaChart, a new sell-side analyst tracking service shows that the average of 18 analysts' recommendations is $22.84 per share.

The bottom line is that from every standpoint, including free cash flow, FCF margins, FCF yield, dividend yield, and analysts' price targets, CCL stock looks cheap here.

One way to play this, especially for existing shareholders, is to short out-of-the-money (OTM) puts and calls in nearby expiry periods.

Shorting OTM Puts and Calls

Look at the August 23 expiration period, 24 days from now. It shows that the OTM strike price put options have high premiums. For example, the $16.50 put option strike price has a 37 cents premium on the bid side.

That means that the short seller of these puts can make an immediate yield of 2.24% (i.e., $0.37/$16.50) over the next 24 days. Moreover, if the investor already owns the stock they can get any upside in CCL if it were to rise to the price targets mentioned above. 

In the meantime, the $16.50 strike price provides good downside protection as it is 4.8% below today's price.

CCL puts expiring Aug 23 - Barchart - As of July 30

Moreover, covered call yields are attractive as well. For example, the $19.00 call strike price has a 22-cent bid side premium. That represents an immediate yield of 1.27% (i.e., $0.22/$17.25). Moreover, it allows the stock to appreciate almost 10% before any obligation to sell shares at that price would be triggered.

The bottom line is that shorting OTM puts and calls here is a way for existing investors to make extra income while they wait for CCL stock to rise to its true value.

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.