Teva Pharmaceuticals (TEVA), the generic drug maker based in Israel, posted good Q1 results today with revenue beating analysts' forecasts. Despite earnings falling short of projections, Teva reaffirmed its forecast for significant free cash flow in 2024. 

As a result, TEVA stock is 13% higher to $15.81 per share in morning trading. That has also led to unusual call options activity today based on a Barchart report. 

Today's Barchart Unusual Stock Options Activity Report shows high volumes in two tranches of out-of-the-money (OTM) call options. These are both at the same $18.00 strike price, which is 13.85% higher than today's price. But they both have different expiration periods.

The first tranche expires in 135 days on Sept. 20 and had over 7600 call option contracts traded today. The second expires in 44 days on June 21 and there were almost 8,700 calls traded.

This implies that the long investors in these call options believe that TEVA stock is undervalued and could move substantially higher. That could be based on the substantial free cash flow (FCF) projections that the company has made. More on that below.

Long or Short the Calls

But first, look at the premiums that the call options traded. The Sept. 20 call options have a mid-price of just 60 cents. That works out to about 3.80% of today's price of $13.81. That could mean that the initiating investors in these calls were short sellers. That is because 3.80% is a pretty good yield.

On the other hand, it works out to less than 1% per month (i.e., about 0.84% per month, or just 10% on an annualized basis. That is not a very good expected return.

Moreover, the 12 premiums for the shorter expiration period calls have a similar yield of 0.87% over the 44 days, or 0.60% per month and 7.1% on an annualized basis. Again, these are not returns for short sellers of these calls.

Therefore, I suspect that many of the initiating investors in these calls were long buyers. They tend to have a good outlook on TEVA stock. Moreover, some of the short sellers could be existing investors in TEVA stock who are selling covered calls. They are happy to sell to $18.00 and are willing to accept the lower covered call yields. 

Either way, both of these kinds of investors tend to bullish on the stock. One reason this could be is the company's outlook as stated in today's report.

Free Cash Flow is Strong

Teva reported 5% higher revenue in local currency terms compared to last year. Moreover, the Q1 $3.8 billion revenue figure was slightly above the $3.74 billion analyst predictions, according to Seeking Alpha.  

In addition, Teva reported that it had a positive FCF of $32 million. This is expected to rise substantially this year due its recent FDA approvals of generic drugs similar to Humira and Stelara.

For example, management said it expects to see $1.7 to $2.0 billion in FCF in 2024. Based on analysts' forecasts of $15.86 billion in sales for 2024, that works out to a FCF margin of 11.7%. Moreover, by next year, analysts project $16.4 billion in sales.

Therefore, based on an 11.6% FCF margin, the company could be on a run rate of $1.9 billion in FCF by 2025. This implies that the stock could rise substantially.

TEVA Stock Looks Cheap Here

Right now TEVA stock is cheap at just a 5.9x forward multiple of analysts' earnings per share (EPS) projections of $2.36 in 2024 and $2.67 EPS in 2025.

Moreover, using a very conservative 8% FCF yield, Teva's market cap could rise to $23.75 billion. This is the same as multiplying the $1.9 billion FCF estimate shown above by 12.5x. This market cap is one-third higher than its existing market cap of $17.92 billion.

In other words, the stock could be worth over $21 per share (i.e., 1.33 x $15.81 = $21.02). 

Even at a 10x multiple of FCF, the market cap would be $19 billion, or 6% higher (i.e., $16.75 per share). The average of these two price targets is $18.875.

So no wonder investors are buying out-of-the-money (OTM) call options in TEVA stock at $18.00 strike prices. Based on its free cash flow projections it looks very cheap here.