Danaher Corp (DHR), the biotech/life sciences products firm, has had unusual call options activity today. It highlights the value of shorting out-of-the-money (OTM) “covered calls” in DHR stock as an income play.
The large unusual call options activity can be seen in Barchart's Unusual Stock Options Activity Report today. It shows that over 3,300 call option contracts were traded in the Feb. 23, 2024 expiration option chain at the $260.00 strike price. This is almost 14% above today's stock price of $228.24.
In other words, a mixture of enthusiastic investors in these call options, trading at a premium of 80 cents in mid-price, and short sellers of these calls produced this large activity.
Note that there are only 44 days until expiration, so those traders who bought these calls must have a very ebullient outlook on DHR stock. They may be impressed with the large free cash flow (FCF) that the company generates. More on this below.
Covered Call Activity Likely
But it also seems highly likely that much of the initiating activity in these call options could have come from existing investors. They may be selling call options against their existing shares, i.e., “covered calls.”
As a result, the 75 cents received on the bid side works out to an immediate yield of 0.33% with just a month and a half to go until expiration. That works out to an annualized expected return (ER) of 2.64% if this trade can be repeated every 44 days for a year.
Given that the call options are 13.9% out-of-the-money, these covered call investors make extra income without worrying too much that their shares will be forced to be sold at $260.00. But even if that occurs, the investors make over 14% (i.e., including the premium received) in a capital gain.
That could account for why so many call options were traded at this strike price. The Barchart report shows that this was over 30 times the prior existing outstanding calls at $260.00.
Let's look at why these investors may like DHR stock.
Underlying Fundamentals Look Attractive at Danaher Corp
For Q3 2023 Danaher Corp reported that its revenue fell 10.5% year-over-year (YoY) and Non-GAAP core revenue decreased 11.5% YoY. However, the CEO said this was “ahead of expectations” as the company had completed the spin-off of its water treatment company, Veralto Corporation (VLTO). For example, after certain adjustments, its core sales were down just 3.0% for the quarter and up 1.5% YoY on a nine-month (YTD) basis.
However, for Q4 the company expects its revenue will be down “single-digits” YoY. It did not give any outlook for 2024. However, analysts and investors may be too confused about the decline in sales.
For example, adding both the 2023 and 2024 expected revenue from analysts surveyed by Seeking Alpha shows that the combined company revenue may have only been 8.7% lower without the spinoff.
In addition, Danaher is still producing positive free cash flow (FCF). For example, in Q3 the company generated $1.311 billion in FCF. Comparing this with its Q3 revenue of $6.873 billion, this means its FCF margin was 19% (i.e., $1.311b/$6.873b).
So, based on analysts' forecast of $24.14 billion for 2024, this implies FCF could reach almost $4.6 billion (i.e., 19% x $24.14b = $4.587b). We can use that to value DHR stock.
Valuing DHR Stock Using FCF Yield
For example, using a 2.5% FCF yield metric, which is equivalent to 40x FCF (i.e., the inverse of 2.5% is 40x), that implies its market cap could rise to $184 billion (i.e., 40x $4.6b). This is 8.2% higher than DHR stock's present market value of $170 billion.
In other words, DHR stock could still be worth 8.2% more or about $249 per share.
That could be one reason why covered call investors have no problem selling calls at $260 for an expiration period of just 44 days. They would be happy to achieve this higher price than what the stock is worth now.
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.
