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Qualcomm Inc. (QCOM) reported good results on Jan. 31, including strong free cash flow (FCF) and FCF margins for its fiscal Q1 ended Dec. 31. As a result, QCOM stock could be up to 18% undervalued. Moreover, short-term income plays are attractive.
The wireless telecom technology company said its revenue rose 5% YoY to $9.9 billion and diluted earnings were up 24%. Moreover, its FCF came in strong at $2.735 billion (i.e., $2.95 billion in operating cash flow less $214 million in capex spend).
As a result, QCOM stock is up 14.8% from $148.51 to $170.47 as of morning trading on March 11. But it's possible QCOM stock could be considered undervalued here, based on the company's strong free cash flow.
FCF and FCF Margins
Qualcomm's FCF figure of $2.735 billion represented 27.5% of its $9.935 billion revenue for the quarter. This is also in line with the last 12 months (LTM) FCF margin which was 27.2% (i.e., $9.887 billion in LTM FCF divided by $36.282 billion in LTM revenue).
Therefore, we can use that stable FCF margin to estimate FCF going forward. For example, analysts surveyed by Seeking Alpha forecast $9.7 billion in revenue for the year ending Sept. 2024. And for the next year, they estimate $10.75 billion. So, the next 12 months (NTM) run rate sometime this year will be $10.3 billion in revenue.
Therefore, applying a 27.5% FCF margin results in an FCF forecast of $2.83 billion. Moreover, if the company's margins improve slightly due to operating leverage to 28%, its FCF could be $2.884 billion.
Target Price
We can use that to set a price target for QCOM stock. Here's how. Let's assume that the company pays out 100% of its FCF as a dividend. Presently the company pays out about 35.6% in dividends (i.e., $3.515 billion in LTM dividends / $9.887 billion in LTM FCF).
Today the dividend yield is 1.88% (i.e., $3.20 in dividends per share/$170.47 price today). Therefore, if the company were to pay out 100% of the FCF as a dividend, it's likely that the dividend yield could improve.
For example, using a 1.25% FCF yield, the stock's market cap would rise to $230.7 billion. This can be seen by dividing the NTM FCF estimate of $2.884 billion by 0.0125.
That represents a potential gain of 21% over its existing market cap of $190.27 billion. This implies that the target price for QCOM stock is $206.27 per share (i.e., 1.21 x $170.47).
One way existing shareholders can play this while they wait for the higher price target is to sell short out-of-the-money (OTM) put options as an income play.
Shorting OTM Puts in QCOM Stock
Qualcomm's put options have high premiums. That makes them worth shorting in out-of-the-money (OTM) strike prices in nearby expiry periods.
For example, look at the March 28 expiration period, which is less than three weeks away. It shows that the 4.64% OTM strike price of $162.50 trades for $1.88 on the bid side. That implies that the immediate yield for the short seller of these put options is 1.07% (i.e., $1.74/$162.50).
But, to be more conservative, let's do the $160.00 strike price, which has a $1.21 premium and is over 6% below today's price.
That implies that the short seller can still produce a high yield of 0.756% (i.e., $1.21/$160.00). Moreover, if this trade can be repeated for the same yield over the next 90 days, i.e., 4x, the expected return (ER) is over 3% (i.e., 0.00756 x 4 = 3.024%). That is over 60% more than the annual dividend yield of QCOM stock (i.e., 1.88%).
This shows that investors in QCOM stock might find it worthwhile to put in orders to “Sell to Open” in out-of-the-money put options. That way they can gain extra income while they wait for a higher price.
But even if that does not happen and the stock falls below $160, the assignment of this trade will cause the investor to buy more shares at $160 per share. That is not such a bad thing, since at that price the yield is 2.0% (i.e., $3.20 in DPS / $160 stock price).
Moreover, investors have a lower breakeven of $160-$1.21, or $158.79 (since the income received lowers the overall cost). That means that there is almost 7% downside protection (6.85%, as $158.79 is 6.85% below today's price of $170.47).
The bottom line is that investors in QCOM stock have reason to believe that the price target could be substantially higher. They can make extra income by shorting OTM put options in nearby expiry periods.
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.
