Hewlett-Packard's (HPQ) stock price has fallen off a cliff over the past year, currently trading at just half of the market price one year ago and almost a third of its 5-year high from 2010. The stock currently trades at $18.87 per share.
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HPQ data by YCharts
After a slew of large acquisitions over the last decade, which failed to be worth their cost, HP hired Meg Whitman, former CEO of Ebay (EBAY), to lead the company in its transition to an (IBM)-like business model. As we'll see, the pessimism surrounding HP has made the stock an incredible value. The downside to this pessimism is that the stock could still drop considerably from the current price.
Quick Valuation
I will use a discounted cash flow analysis to estimate the fair value of HP. I use a discount rate of 15%. I will use owner earnings instead of free cash flow in my analysis, which is shown below.
| (In Million $) | 2011 |
|---|---|
| Net income | $7,074 |
| Depreciation & amortization | $4,984 |
| Investment/asset impairment charges | $885 |
| Stock based compensation | $685 |
| Other non-cash items | $734 |
| Interest Payments | $695 |
| 3-year Avg Capital Expenditure | $-4,122 |
| Owner Earnings | $10,787 |
Owner earnings for 2011 came in at $10.8 billion. The most recent balance sheet puts HP's net debt at $11.43 per share with a float of 2.03 billion shares. Assuming zero future growth HP is worth $24 per share, which shows just how absurd HP's current market price is. Assuming just 3% growth HP is worth $34 per share. Currently HP trades at a huge discount to both of these values, but in order to protect against further price drops one option is to sell cash-covered puts with an $18 strike price and attempt to buy HP at an even lower price than it's trading at today.
Selling Puts
An option has three components: A strike price, a premium, and an expiration date. By selling a put option, you are giving the buyer of that option the right to sell you the underlying stock at the strike price on or before the expiration date. The buyer pays you the premium in exchange for this right. You keep this premium no matter what happens, but are required to buy the stock if the option is exercised.
Selling a cash-covered put option can end in one of two ways. If the stock never dips below $18 per share before the expiration date the option will expire worthless, you will not be required to buy any shares, and you're free to write another put. If, however, the stock does go below $18 per share and the option is exercised, you are required to buy the stock at $18 per share, which will be higher than the current market value.
Let's take a look at the different put options available to sell with a $18 strike price:
| Expiration Date (Days until expiration) | Strike Price | Premium (Last Trade) | Annualized Return |
| Aug 2012 (31) | $18 | $0.37 | 24.2% |
| Nov 2012 (122) | $18 | $1.14 | 18.9% |
| Jan 2013 (185) | $18 | $1.56 | 17.1% |
| Feb 2013 (213) | $18 | $1.78 | 16.9% |
| Jan 2014 (549) | $18 | $3.45 | 12.7% |
The August 2012 expiration date provides the largest annualized return, receiving a $0.37 premium on a $18 investment, resulting in an annualized return of 24.2% (2.06% in 31 days). So if you sell an August 2012 $18 put option you immediately receive a premium of $37 (all options are in blocks of 100 shares) and you have $1,800 tied up for 31 days. If the option expires worthless you can then write another put and collect another premium. If the option is exercised, you will buy 100 shares of HP for $18 per share, a price which you have already determined is a comfortable entry point.
The downside to this strategy is that if HP tanks, say to $16 per share, you are forced to pay $18 per share and suffer an immediate "on paper" loss. Of course, had you simply bought shares at the current price or even waited for the price to reach $18 and then bought shares, you would have suffered the same fate. But by selling puts you are able to offset this "on paper" loss with premiums.
Conclusion
By selling HP puts you are able to generate a 24.2% annualized return on investment as you wait for the stock price to drop to $18 per share. HP is already grossly undervalued, but this strategy allows you to possibly pick up shares at an even further reduced price while making a solid return on your investment in the meantime. You should only sell puts on stocks that you would like to own and at strike prices that you are comfortable paying. The worst thing that can happen with this strategy is that you end up with shares of a company that you want to buy at a price that you are willing to pay. Otherwise, you collect a premium and can repeat the process again. It's a win-win for a long-term investor.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I may open a long position in HPQ within the next three months.
