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Netflix (NFLX) stock is well off its highs and is good value now. NFLX is trading for $374.31 in morning trading on Friday, Oct. 6, which is well below its Sept. 11 high of $445.36 and the year-to-date high of $477.59 on July 19.
However, given Netflix's huge free cash flow (FCF), investors expect good results for Q3, expected to come out on Oct. 18. As a result, this is good for income plays like selling short out-of-the-money (OTM) put and calls options in near-term expiration periods.
FCF Could Power Netflix Stock Higher
I discussed Netflix's huge FCF in my Sept. 15 Barchart article, “Netflix Stock is Well Off Its Highs - Ideal for Value Buyers and Short Put Traders.” For example, Netflix made over $3.46 billion in FCF in the first of 2023.
This was disclosed on the first page of the company's Q2 shareholder letter. It showed that it made $2.117 billion in Q1 and $1.339 billion in Q2.
Last year, in Q3 Netflix made just $472 million in FCF. So any Q3 number that is $1.0 billion or higher will show that the company is making significant progress with its new pricing plan.
It will also show how well it weathered the actors' and writers' strikes in Q3.
But even more importantly, analysts will be looking at the company's FCF margins. Last quarter it was over 21% for the first six months of the year.
Here is why that is important. It could propel the stock higher if the margin stays at this level or rises.
For example, analysts project Netflix's revenue next year will rise over 13% to $38.23 billion, according to Seeking Alpha's survey of 40 analysts. If we apply the 21% margin to this forecast, the expected FCF could hit $8.0 billion for the year.
As a result, using a 4.0% FCF yield, Netflix's market cap could rise to $200 billion. This is seen by dividing $8 billion by 4%. It's also the same as multiplying NFLX by 25x, since that is the inverse of 4% (i.e., 1/0.04=25x).
The point is that since Netflix's market cap today is just $166 billion, the stock could rise by over 20% (i.e., $200b/$166b-1 = 0.205). This implies that NFLX stock is worth over $451 per share (i.e., 1.205 x $374.31 = $451.31).
Shorting OTM NFLX Put and Calls Options for Income
Last month we discussed selling short the $380 strike price puts for expiration on Sept. 30. The stock closed at $377.60 on Sept. 30, so these expired in-the-money (ITM). However, the investor was able to collect $3.33, so their breakeven price was $376.67.
In other words, by selling these OTM puts the investor was able to collect income and still had a profit, even though the short was exercised and the investor now had to purchase the stock at $380.
One thing that the investor can now do is sell out-of-the-money (OTM) calls against these shares. For example, the Oct. 27 call options at the $405 strike price trade for $8.28 today.
That means the investor can make a 2.19% covered call yield with just 3 weeks to expiration. That is seen by dividing the $8.28 premium received by today's price of $377 per share. Moreover, that strike price is over 7.85% over today's price. That means that if the stock rises to that price and the investor has to sell his shares at $405, they keep the extra 7.85% realized gain. The total potential return is therefore 10% (i.e., 2.19% +7.85% = 9.95%).
In fact, the $400 calls trade for $9.70. This provides a 3-week 2.57% covered call yield, as well as a potential 6.52% realized gain or a potential 9.09% return.
Moreover, another way to play this, without having to sell any shares if called, is to sell OTM puts. For example, the Oct. 27 puts at the $350 strike price trade for $9.35 per put. This strike price is 6.79% below today's spot price, equivalent to the OTM widths of the calls above, but the premium is higher.
Moreover, the yield is significantly higher. Here is why. The investor only has to risk $350 per contract. So the yield is $9.35 divided by $350.00, for a total yield of 2.67%. Moreover, the investor has no obligation to have to sell any stock, even if the stock falls.
Here is what that means exactly. The covered investor has to buy the shares at today's price but their return is lower since their investment cost is higher. This is because the spot price of $377 requires an investor to spend $37,700 or 100 shares in order to sell 100 covered calls.
However, the short put investor only has to secure $35,000 in order to sell short 100 puts. Therefore, with a similar premium level, the actual return is higher for the put investor since their investment cost is lower.
The bottom line is that Netflix stock is likely to move higher and it makes sense to short either covered calls or cash-secured puts for the value investor.
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.
