Palo Alto Networks Stock Is a Major Bargain, Especially for Short Sellers of Its Puts

Palo Alto Networks (PANW) made huge free cash flow margins during Q2, a feat that is likely to repeat in Q3. PANW stock, at $242.72 on Sept. 1, is still a bargain worth at least 27% more at $336.41 per share. As a result, short sellers of its put options are having a field day.

They are able to sell out-of-the-money (OTM) puts on PANW stock in near-term expiration periods. That provides extra income as they wait for PANW stock to rise.

We discussed this situation in our Aug. 21 Barchart article, “Palo Alto Networks Impresses the Market With Huge FCF Growth and Margins.” The stock soared 15% to over $241.00 per share, and it has stayed fairly level since then. That makes it ideal for selling short OTM puts.

Before looking into this strategy, let's discuss Palo Alto Network's bargain valuation right now.

Massive Free Cash Flow

On Aug. 18, the cybersecurity software company reported that its fiscal Q4 revenue ending July 31 rose 26% to over $2 billion. For the full year, its sales were up 25.3% to $$6.893 billion.

Moreover, its adjusted free cash flow (FCF), which came in at $2.67 billion, soared by 45.9% over the $1.83 billion it made the prior year.

But even more important, the adj. FCF margin came in at 38.7%, which is extremely high. This can be seen by dividing the $2.67 billion in adj. FCF by sales of $6.893 billion. This was well over the 33% adj. FCF margins it made in the prior year.

That means that almost 39% of every sales dollar goes straight to the bank account, as all its cash expenses are covered. This includes its normal operating costs, as well as its capex spending, as well as working capital changes.

Moreover, that is a very high FCF margin and gives the company huge opportunities. For example, Palo Alto Networks spent most of this money paying down its convertible debt. So, going forward it can begin buying back stock.

On top of that, the company indicated that its ongoing adj. FCF margins are likely to stay high. The company said it expects its adj. FCF margins to stay in the range of 37% to 38%.

This is likely to be below what is actually achieved, as the company often outperforms, just as it did this year.

Price Targets

In my last article, I showed that PANW stock is likely to be worth well over $300 per share. This was based on its FCF margins and expected sales growth. 

For example, using a FY 2024 sales forecast of $8.18 billion, from surveys of 36 analysts by Seeking Alpha, adj. FCF could hit $3.1 billion. This is seen by multiplying $8.18 billion in sales by a 38% adj. FCF margin.

Next, by using a 3% FCF yield, we get a potential market cap north of $100 billion. This is the same as multiplying FCF by 33.3x (i.e., $3.1 x 33.3 = $103 billion. This is a typical multiple for a company with such high adj. FCF margins.

Compared to its $74.3 billion market cap today, that implies the stock could rise by 38.6%. In other words, using this method, PANW stock could be worth $336.41 per share (i.e., 1.386 x $242.72 = $336.41).

Moreover, other analysts also have significantly higher price targets. For example, Yahoo! Finance reports that the average target price of 40 analysts is $273.60 per share. That represents an upside of 12.7% from today's price.

Shorting OTM Puts for Income

PANW stock does not pay a dividend. Some shareholders may want to gain extra income while waiting for PANW stock to rise to its price target. 

One relatively easy and risk-averse way to make income while holding shares in PANW is to sell short out-of-the-money (OTM) put options. In our last article, we discussed this strategy.

For example, we recommended shorting the Sept. 8 expiration puts at the $130 strike price. At the time, on Aug. 21, those puts were trading at $2.82 per put. That provided an immediate yield of 1.23% (i.e. $2.82/$230). Today, those puts have fallen to just 24 cents.

This is exactly what the short seller wants to see. In fact, given that the put option premium has dropped by over 91%, one could argue that most of the income has been made in that put strike price and expiration period.

Therefore, it makes sense to roll this over and sell short another expiration period. That involves entering an order to “Buy to Close” those puts and then making another order to “Sell to Open” a new expiration put strike price trade.

For example, for the period ending Sept. 29, which is a little over 3 weeks from now, the $130 strike price puts trade for $2.30 per put option. This strike price is over 5.3% below today's price and the trade provides a good yield of 1.0% (i.e., $2.30/$230).

That means that an investor who secures $23,000 in cash and/or margin with their brokerage firm can then enter an order to “Sell to Open” 1 put contract at the $230 strike price for expiration on Sept. 29. As a result, the account will immediately receive $230.00, which is 1.0% of the $23,000 invested. On an annualized basis that works out to a 12% return.

Moreover, even if the stock price rises, the investor gets to keep the income generated. This shows that this is a good way to generate income from PANW stock, on top of holding the shares for the long term.

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.