Spotify Technology (SPOT) stock is rising ahead of expected earnings for Q3. Last quarter Spotify produced strong free cash flow (FCF)and analysts expect this to continue. This is also raising SPOT stock's put option premiums. That makes them worth shorting now for income and to set a lower buy-in price.

SPOT is at $386.08 in midday trading on Tuesday, Oct. 22. That is up significantly from its recent low of $322.77 on Sept. 6. However, it could still be worth a good deal more based on its strong free cash flow margins and analysts' higher revenue forecasts.

Higher Price Targets

For example, 37 analysts surveyed by Yahoo! Finance have an average price target of $397.59. Moreover, Barchart's survey has a mean price target of $396.21 from analysts.

Moreover, AnaChart, a site that tracks analysts' price targets to see how well analysts have performed, has a significantly higher price target. It reports that the average of 30 analysts who've recently published on SPOT stock have an average of $431.52 per share. That represents an 11.7% upside in the stock.

It's easy to see why this could be the case. For example, last quarter (Q2) Spotify generated €490 million in FCF on €3.807 billion in revenue. That represents a 12.87% FCF margin. 

This is even higher than the FCF margin it produced in the last 12 months (LTM. Seeking Alpha reports that Spotify generated $1.395 billion in FCF on $15.5 billion in LTM sales. That represents a lower 9.0% FCF margin. In other words, the company is squeezing out more cash from its operations. 

In the last six months, as the table above shows, its FCF margin was 9.4%. As noted earlier, in Q2 it was much higher at 12.87%. But let's use that to forecast its ongoing FCF. For example, analysts now project sales next year will rise to $19.65 billion, up over 15% from $17.07 billion.

So, if we apply a 9.0% FCF margin, we can expect Spotify could generate $1.7685 billion next year. Using a 2.0% FCF yield metric that implies its market cap could rise to $88.425 billion (i.e., $1.7685b/0.02). This is 14.4% over its $77.28 billion market cap today.

In other words, SPOT stock could be worth 14.4% more than $386, or $441 per share. That is close to the $431 price target average reported by AnaChart.

One way to play this is to sell short out-of-the-money (OTM) put options in nearby expiry periods. The reason is the put option premiums are very high.

Shorting OTM Puts

For example, the Nov. 15 expiration period, a little over three weeks away, shows that the $370 put option strike price has a bid side premium of $13.65 per contract. That strike price is over 4% below today's trading price (i.e., is out-of-the-money). This means that SPOT would have to fall by over $16.00 before these puts have any intrinsic value - and it has to happen in 24 days.

Therefore, the short seller of these puts can make an immediate 3.689% yield (i.e., $13.65/$370.00). That is a very high yield for such a short period.

Here is how that works. The investor secures $37,000 in cash or buying power with their brokerage firm. That way there is collateral to potentially buy 100 shares at $370.00, in case SPOT stock falls to $370 on or before Nov. 15.

But the account will immediately receive $1,365 after entering an order to “Sell to Open” 1 put contract at this strike price. That $1,365 in income (which can't be taken away) represents almost 3.7% of the $37K invested for the next three weeks.

This also provides good downside protection to the investor. For example, even if SPOT falls to $370, the investor's breakeven price is $370-$13.65, or $356.35. That is 7.5% below today's price.

The bottom line is that Spotify could have some good upside from here. But even if it stays flat or falls slightly in the next 3 weeks, one good way to play this is to short out-of-the-money put options.

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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.