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Palo Alto Networks (PANW), the cybersecurity solutions company, reported impressive fiscal Q4 earnings on Friday, Aug. 18. Its huge free cash flow (FCF) and high FCF margins immediately wowed markets. PANW stock is soaring as a result, up almost 15% in early trading on Monday, Aug. 21 to $241.00.
However, the stock could rise much further. This is based not only on the 38% growth in its fiscal Q4 (ending July 31) of its high adjusted FCF but also the high FCF margins (i.e., FCF/revenue) it is generating.
FCF Growth and Margins Soar
For example, in the year ending July, FCF margins soared to 39% on revenue of $6.89 billion, up 25.2% YoY.
This FCF margin was significantly higher than the 33% adj. FCF margin it made last year. This can be seen on page 18 of its fiscal 2023 slide presentation.
Moreover, the company guided analysts to expect at least 37% to 38% margins in the coming year. Combined with higher revenue forecasts from analysts, that means that FCF will likely keep growing
For example, analysts are forecasting revenue of $8.18 billion for the year ending July 31, 2024, according to Seeking Alpha's survey of 28 analysts. That is 18.7% higher than the $6.89 billion in revenue it produced for fiscal 2023.
That implies that at a 38% FCF margin, adj. free cash flow next year could hit $3.1 billion. That is significantly higher, i.e., 16.4% higher, over the $2.67 billion in adj. FCF it made during fiscal 2023.
We can use that to set a price target for PANW stock, even over its runup today. Here's how.
PANW Stock Price Target
For example, using a 3% FCF yield metric, we can see that Palo Alto Networks could have a market capitalization north of $100 billion. By dividing our estimate of $3.1 billion in adj. FCF by 3.0%, we get a target market cap of $103.3 billion.
This is the same as multiplying the adj. FCF by 33x (i.e., the inverse of 3% is 33x, since 1/.03=33.3). So, 33.3x $3.1 billion equals $103.3 billion.
That $103.3 billion market cap target is 27.8% higher than its market cap today of $80.8 billion, based on 335 million shares outstanding. In other words, PANW stock could potentially rise to $308 per share (i.e., 27.8% higher than today's price of $241.00).
One easy way to play this on a conservative basis is to short out-of-the-money (OTM) put options. This allows the investor to gain extra income and also potentially lower their buy-in cost.
Shorting OTM Puts in PANW Stock
For example, for the period expiring Sept. 8, PANW puts at the $240 strike price, which is 5% below today's price, trade for $2.82 per put contract. That shows that the put option premiums are elevated and worth shorting.
For example, this short-sale trade provides an immediate yield of 1.23% to short sellers of PANW puts at that strike price.
Here is what that means. An investor who secures $23,000 with their brokerage firm can then enter an order to “Sell to Open” 1 put contract at the $230 strike price for the Sept. 8 expiration date.
The account will then immediately receive $280. That is why the yield is 1.23% since $280 is 1.23% based on the investment of $23,000.
Now the short-put trader waits to see if PANW stock will stay above $230.00 per share until Sept. 8, 18 days from now. Moreover, even if the stock falls, the short put investor has a breakeven price of $227.20 ($230 strike price - $2.80 premium received).
That means their breakeven is 5.72% below the price today. This is because even if the stock falls to $230.00 the investor gets to keep the $2.80 already received.
Even if falls to $230.00 the exercise of the puts allows the investor to own 100 shares of PANW stock at a lower price than today. The investor can then sell OTM calls with these shares, a trade known as a covered call sale.
This shows that investors can expect to see PANW stock move significantly higher. One way to conservatively play this is to sell short OTM puts.
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.
