Western Digital (NASDAQ:WDC), the world's largest hard drive manufacturer, was recently downgraded by an analyst at Citi along with competitor Seagate Technologies (NASDAQ:STX). The main reason cited for this downgrade is the deterioration of the PC market. Of course, a drop in demand for PCs will have a negative effect on Western Digital's profits, but the stock is so undervalued that it doesn't really matter. And with earnings coming up, the put option premiums for Western Digital have become quite lucrative. This could allow you to pick up shares at a great price and get paid handsomely to do so.
Western Digital currently trades for $35.55. On the balance sheet the company has about $4 in excess cash per diluted share. The free cash flow for fiscal 2012, which ended in June, was $2,350 on revenue of $12,478. In March of 2012 Western Digital closed a deal to buy Hitachi, effectively making it the largest hard drive manufacturer in the world. Since this took place well into fiscal 2012 the full effect of the merger isn't represented in the fiscal 2012 results. But even using these figures, WD had a FCF/share of $9.59. This puts the effective P/FCF, after backing out cash, at about 3.3.
So even if profitability decreases due to lagging PC demand, the company is so undervalued that the stock would still be cheap. Even if free cash flow gets cut in half the P/FCF would still be just 6.6.
Selling Put Options
By selling put options you are selling someone the right, but not the obligation, to sell you 100 shares of the underlying stock at the strike price on or before the expiration date. For this right you receive a premium.
Let's take a look at some interesting put options which could be sold:
|Expiration Date||Strike Price||Premium||Annualized Return|
|Nov 2012 (29 days)||$31||$0.48||19.49%|
|Nov 2012 (29 days)||$33||$1.04||39.67%|
|Jan 2013 (92 days)||$31||$1.19||15.23%|
|Apr 2013 (183 days)||$31||$2.18||14.03%|
|Jan 2014 (456 days)||$30||$4.40||11.74%|
The November 2012 put offers a staggering 39.67% annualized return, but the strike price is only 7.17% below the current market price. If earnings come up short the stock could easily drop this much. The November $31 put offers an equally impressive 19.49% annualized return (1.55% over 29 days) with a strike price a full 12.8% below the current market price. This creates a larger buffer and partially protects you against a severe earnings miss.
If you sell the November 2012 $31 put options, there are two possible outcomes.
- The stock never falls below $31 per share and the option expires worthless. You are not required to buy any shares and are free to sell another put option.
- The stock falls below $31 per share and you are forced to buy 100 shares of Western Digital at a price lower than what the market price is at that time. Your effective purchase price will be $30.52 after factoring in the premium.
I think that sentiment regarding Western Digital is overly pessimistic and that the stock is severely undervalued. The November 2012 $31 put options offers a way to buy the stock at a low price and to receive a 19.49% annualized return for doing so.