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Palo Alto Networks (PANW) stock is down 27% today to $268.23 down from $366.09 yesterday, after releasing its fiscal Q2 earnings for the quarter ending January 31. This downdraft has led to unusual options activity, mostly in near-term expiry put options. As a result, it is a good opportunity for short sellers of out-of-the-money puts as an income play.
This action in PANW stock options can be seen in today's Barchart Unusual Stock Options Activity Report. The report shows that there are three tranches of options with large unusual activity.
For example, the $260 strike price puts that expire on Friday, Feb. 23 have shown 1,639 contracts traded. That is over 11 times the prior outstanding number (i.e., OI or outstanding interest) of contracts. This can be seen in the column Vol/OI in the table below.
The same can be seen for the $250 strike price put option that expires on Feb. 23. The Vol/OI metric is over 8x for this put option.
Huge Opportunity for Short Sellers
These out-of-the-money (OTM) put premiums are very high. For example, the $260 strike price put option expiring Feb. 23 is trading for $4.60 on the bid side and the strike price is 3.06% below today's price. This means that the short seller of these puts, with just 2 days until expiration, can make an immediate yield of 1.77% (i.e., $4.60/$260).
Moreover this high premium provides good downside protection. For example, the breakeven price is $255.40 (i.e., $260-$4.60) and PANW stock would have to fall another 4.78% before the short seller would begin to have an unrealized capital loss.
This opportunity is even better with the $250 strike price put. The premium is $1.95 for a strike price that is 6.8% out-of-the-money (OTM) (i.e., $250/$26823-1). That means that the short seller can make an immediate yield of 0.78% (i.e., $1.95/$250).
The bottom line is that these are two easy ways for existing shareholders in PANW stock to make money. Alternatively, a short seller could sell the $260 strike price put and buy the $250 put as downside protection, as a hedge if the stock keeps falling.
But that does not seem likely. Let's look at what happened with the company's earnings.
Violent Reaction to Earnings Forecast
Most of the downdraft in PANW stock seems to be an overreaction. Investors were disappointed in the company's future guidance, according to a report by CNBC.
Moreover, Palo Alto Networks actually produced really good results. The cybersecurity company's revenue was up 19% YoY in the quarter and its operating margin rose 580 basis points to 28.6%, up from 22.8% a year earlier. That can be seen on page 30 of its slide presentation.
In addition, its adjusted free cash flow (FCF) came in strong at $654.8 million, which represented 27.9% of its $2,347.2 million in quarterly revenue. For the trailing 12 months (TTM) the company generated almost $3 billion in adj. FCF ($2,932.7 million) on $7,527.4 million in sales, or a margin of 39%.
FCF Forecasts and Price Target
In fact, Palo Alto Networks said it expects to continue to make between 38% and 39% in adj. FCF margins for the full year ending July 31, 2024. That implies that it could achieve over $3 billion in adj. FCF, based on analysts' estimates of $8 billion in sales this fiscal year (i.e., 0.39 x $8.0 billion = $3.12 billion).
Moreover, next year analysts are forecasting $9.4 billion in revenue. So using a 39% margin implies that adj. FCF could rise to $3.666 billion. In other words, FCF could push the stock substantially higher from here.
How high? If we apply a 3.3% FCF yield metric (the same as multiplying FCF by 30.3x), as I did in my last article, the market cap could rise to over $111 billion (i.e., 30.3 x $3.666b). That is 31.2% over today's market value of $84.65 billion.
In other words, PANW stock could be worth 31% more sometime in the next 12 months, or over $351 per share. This makes today's violent reaction to the company's forecasts seem overdone.
As a result, it might make sense for adventurous investors to short these OTM puts, given their high yields.
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.
