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NetApp (NTAP), the cloud services and software company, released on Feb. 29 excellent fiscal Q3 results for the quarter ending Jan. 31. Its free cash flow soared to $484 million and a 27.9% FCF margin. As a result, NTAP stock spiked over 17% from $89.12 per share to almost $105 today.
However, based on the company's ongoing FCF margin guidance, it's possible that the stock could still be undervalued. That gives us a stock price target of over $123 per share.
FCF Guidance
For example, in the 12 months (LTM), it generated $1.159 billion in free cash flow. That works out to 18.7% of the LTM revenue of $6.25 billion.
The chart below from NetApp shows that the FCF has been somewhat jagged, likely dependent on net changes in working capital. For example, its FCF results in the last quarter worked out to 27.9% of revenue. This was up from 20.9% in the prior year's quarter and just 6.2% in the prior quarter.
But now the company guides (on page 14 of its slide deck) that its Q4 FCF margin says that the full year ending April 30 will result in a 20.9% FCF margin. In other words, its LTM results will increase from 18.7% of revenue.
We can use this to forecast the company's next 12-month (NTM) FCF. For example, analysts now project that revenue for the year ending April 2025 will be $6.52 billion. So, if we apply a 21% FCF margin against this, free cash flow could rise to $1,369 billion.
Setting a Price Target
This is 18.1% higher than the LTM FCF of $1.159 billion as of Jan. 31. So, theoretically that implies that the stock could be worth 18% more.
But we can also use an FCF yield metric to more precisely value NTAP stock. For example, given its market cap today of $21.68 billion, its LTM of $1.159b in FCF means the market is valuing the stock with an FCF yield of 5.345% (i.e., $1.159b/$21.68b).
So, using our NTM forecast of $1.369 billion in FCF and dividing it by a 5.35% FCF yield implies a potential market cap of $25.59 billion. That is 18% higher than today's $21.68 billion market cap.
In other words, NTAP stock should be worth at least 18% higher sometime in the next 12 months. That puts it at a target price of $123 per share or higher.
This assumes that the company continues to have a 21% FCF margin and the market values it at the same FCF yield level. If the margins increase with higher-than-expected revenue (say $1.4 billion in FCF), the FCF yield metric could improve to 5.0%. That would push its market valuation to $28 billion (i.e., $1.4b/0.05). That is 29% higher than today.
So, you can see, that just a slight improvement in its FCF margins can help push the stock significantly higher.
Shorting OTM Puts for Income
One way existing shareholders can play this is to sell short out-of-the-money (OTM) put options in nearby expiry periods and then repeat it. For example, the March 22 expiration period shows that the $100 strike price puts, 18 days from now), trade for 40 cents on the bid side.
That implies that the short seller of these puts can make an immediate yield of 0.40% (i.e., $0.40/$100). If repeated every 3 weeks for a quarter, the investor stands to potentially make 1.2%, or 4.8% annually.
This is on top of the annual 1.90% dividend yield that the company provides existing shareholders. So theoretically, the investor with these short put plays can make an expected return (ER) of over 6.7% in income. This assumes that they can repeat this trade 17 times a year.
That may not be likely as the stock's volatility will wax and wane and that will raise or lower its implied expected returns (i.e., due to its implied volatility). Nevertheless, this shows that additional income is available for shareholders who want to continue holding the stock for the long term for its higher target 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.
