Palo Alto Networks (NASDAQ:PANW) recently reported impressive free cash flow margins in Q2, with expectations of continued success in Q3. Trading at $242.72 as of September 1st, PANW’s stock is viewed as a compelling value proposition, potentially undervalued by 27%, with a fair value estimated at $336.41 per share. As a result, short sellers of PANW put options are finding profitable opportunities.

These short sellers are capitalizing on the sale of out-of-the-money (OTM) puts with near-term expiration dates, allowing them to earn additional income while awaiting PANW’s stock price to appreciate.

We discussed this strategy in our August 21st Barchart article titled “Palo Alto Networks Impresses the Market With Huge FCF Growth and Margins.” Following the release, the stock saw a 15% increase, reaching over $241.00 per share, and has remained relatively stable since, making it an attractive candidate for selling short OTM puts.

Before delving into this strategy, let’s examine Palo Alto Network’s current undervaluation.

Robust Free Cash Flow

On August 18th, the cybersecurity software company reported a 26% increase in fiscal Q4 revenue, reaching over $2 billion, and a full-year sales growth of 25.3%, totaling $6.893 billion. Furthermore, their adjusted free cash flow (FCF) surged to $2.67 billion, a remarkable 45.9% increase compared to the previous year’s $1.83 billion.

Of paramount importance is the adjusted FCF margin, which stands at an impressive 38.7%. This figure, calculated by dividing $2.67 billion in adjusted FCF by $6.893 billion in sales, reflects a substantial improvement over the 33% adjusted FCF margin from the previous year.

This high FCF margin provides Palo Alto Networks with significant opportunities, such as reducing convertible debt and initiating stock buybacks. The company also indicated its intent to maintain strong adjusted FCF margins in the range of 37% to 38%, which is often surpassed in practice.

Price Targets

In a previous article, we illustrated that PANW stock is potentially valued well above $300 per share based on its FCF margins and expected sales growth. Using a FY 2024 sales forecast of $8.18 billion, analysts predict adjusted FCF could reach $3.1 billion, yielding a potential market cap of over $100 billion based on a 3% FCF yield.

This contrasts with the current market cap of $74.3 billion, suggesting a potential 38.6% increase in stock value. Under this analysis, PANW stock could be worth $336.41 per share.

Notably, other analysts have set even higher price targets. For instance, Yahoo! Finance reports an average target price of $273.60 per share, indicating a 12.7% upside from the current price.

Generating Income by Shorting OTM Puts

As PANW stock does not offer dividends, some investors seek additional income while waiting for the stock to reach its target price. One relatively straightforward and risk-mitigated approach is to short out-of-the-money (OTM) put options, as we discussed in our previous article.

For instance, we previously recommended shorting the September 8th expiration puts with a $130 strike price. At that time, on August 21st, these puts were trading at $2.82 per put, providing an immediate yield of 1.23%. Today, these puts have declined to just 24 cents.

This decline in put option premiums is favorable for short sellers. It may be prudent to roll over these options by “Buy to Close” and then “Sell to Open” new expiration put strike price trades.

For example, for the period ending September 29th, approximately 3 weeks from now, $130 strike price puts are trading at $2.30 per put option. With a strike price over 5.3% below the current stock price, this trade offers a 1.0% yield. An investor securing $23,000 in cash and/or margin with their brokerage can “Sell to Open” 1 put contract at the $230 strike price for the September 29th expiration, immediately receiving $230.00, equivalent to a 12% annualized return.

Furthermore, even if the stock price rises, the investor retains the income generated, making this a sound strategy for income generation alongside long-term shareholding.

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