Oracle Corp. (ORCL) produced higher revenue in Q2 but lower free cash flow and FCF margins. However, ORCL stock is now off its highs and could be undervalued here. Shorting out-of-the-money puts is one way to play it.

ORCL closed at $169.66 on Friday, Dec. 20, down 11.5% from its high of $191.69. However, ORCL could be worth 16% more at $197 per share. This is based on its strong free cash flow (FCF) and FCF margins over the last year. This article will show how that works out.

Free Cash Flow Results

Oracle, which provides database storage, cloud storage, and software services to large corporations, reported on Dec. 9 that it generated 9% higher revenue YoY for the quarter ended Nov. 30. Its operating income was up 10% YoY and net income rose 12%. Due to large share buybacks, its earnings per share rose 24% over the past year.

However, due to heavy capex spending its free cash flow (FCF) for the quarter was negative. The CEO said during the conference call that capex spending of $4 billion, after being deducted from the $1.4 billion in operating cash flow, produced a negative $2.7 billion in FCF for the quarter.

However, that's not how Oracle looks at its cash flow. It likes to look back over the trailing 4 quarters. This is likely because its cash flows are higher during the two quarters when its clients renew their annual SaaS (software as a service) and database service subscriptions.

That can be seen in the table below which Oracle provided in its press release.

It shows that despite the 19% growth YoY in operating cash flow, its free cash flow (i.e., after capex spending) was 6% lower.  Again, this is on a trailing 4 quarter “look-back” basis.

The good news is that despite having a negative FCF quarter, its trailing 4 quarters FCF was positive $9.542 billion. That works out to 17.4% of its trailing revenue of $54.933 billion over the last year.

The point is that despite heavy capex spending, the company is still able to generate positive FCF over a full year.

This is similar to what I expected in my Sept. 13 Barchart article, “Oracle Delivers Strong Results and Guidance - ORCL Stock Is Still Cheap.”

Projecting FCF and a Target Price

In other words, we can still expect at least a 17% to 18% FCF margin on future sales. For example, management projected in its conference call that it expects total revenue to grow 9% to 11% on a constant currency basis this fiscal year ending May 2025.

Analysts expect that sales for the year ending May 2026 will rise to $64.91 billion, up from $57.7 billion this FY ending May 2025. So, on average sales in the next 12 months (NTM) will average $61.3 billion.

That implies that FCF could rise to $11 billion in the NTM:

    0.18 x $61.3 billion = $11.03 billion

As a result, if we assume the market will give ORCL stock a 2.20% FCF yield, the market cap could rise to $551 billion:

    $11.03b / 0.022 = $551.7 billion market cap

This is 16% higher than today's existing market cap of $474.5 billion:

    $551.7b NTM market cap / $474.5b -1 = 1.163 -1 = +16.3%

That implies that ORCL stock could be worth 16.3% more, or $197 per share:

   $169.66 x 1.163 = $197.31 p/sh target price.

Analysts Agree ORCL Stock is Undervalued

For example, Yahoo! Finance shows on its Analysis tab that the average of 35 analysts' price targets is $196.55. That is higher than the $178.49 price target I discussed in my Oct. 11 Barchart article, “Shorting Oracle Puts Is a Good Play Here - ORCL is Still Cheap.”

Moreover, AnaChart.com, which tracks analysts' price target performance, shows that the average of 26 analysts is $181.91 per share.

The bottom line is that analysts seem to agree that at today's price, the stock looks undervalued.

One way to play this is to sell short out-of-the-money (OTM) put options. That way an investor can set a lower buy-in price target and get paid while waiting for this to happen.

Shorting OTM Puts

For example, look at the Jan. 17, 2025, expiration period, which is 17 days to expiry (DTE). It shows that the $160 strike price, which is 5.69% below the closing price on Friday, Dec. 20 (i.e., out-of-the-money), has a bid price of $1.28 per put contract.

That means a short-seller of these puts makes an immediate short-put yield of 0.80%, or almost 1% (i.e., $1.28/$160.00). That is over next four weeks.

Here is how that works. An investor first secures $16,000 in cash or buying power with their brokerage firm. That acts as collateral in case the stock falls to $160 on or before Jan. 17, 2025, and the account is assigned to buy 100 shares at $160 (i.e., 100 shares per put contract x $160 = $16,000).

The account will then immediately receive $128 (i.e. 100 shares per contract x $1.28). That is why the short-put yield is 0.80% (i.e., $128/$16,000).

Note that the breakeven is 6.45% lower than the trading price for this investor:

   $160.00 - $1.28 = $158.72

    $158.722 / $169.22 -1 = 0.93352 -1 = -0.06448 = -6.45% below the trading price.

That gives the investor good downside protection. For example, the income can help defray any potential unrealized losses if the account is assigned to buy 100 shares at $160.00

Moreover, the investor can repeat this play to generate extra income while waiting for ORCL stock to fall to this lower buy-in price.

Summary

The bottom line is that Oracle stock could be undervalued for several reasons:

• It is expected to generate positive free cash flow over the next 12 months.
• Assuming an 18% FCF margin, its FCF could hit $11 billion, up from $9.45 billion in the last 12 months.
• That could push its market cap and stock price 16% higher to 551.7 billion and $197 per share, assuming a 2.20% FCF yield valuation.
• Analysts see a good upside in ORCL stock, which has fallen from its highs, with price targets ranging from $182 to $196 per share.
• One way to play it is to short out-of-the-money (OTM) puts in nearby expiry periods. A one-month-out short-put play has a 0.80% yield opportunity.

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.