Today, heavy, unusual trading volume in long-dated Paramount Class B (PARA) call options highlights investors' bullish views on PARA stock. Investors are anticipating the merger with Skydance will close on or before Oct. 4, which should boost its FCF growth.

PARA is at $12.00 in midday trading on Wednesday, May 21. The stock is well off its lows in April and starting to approach its 6-month highs, as can be seen in the Barchart chart below.

The heavy volume in the PARA call options can be seen in today's Barchart Unusual Stock Options Activity Report. As seen below,  a large investor or set of investors traded the $13.00 call options expiring on August 15, which is 86 days until expiration.

That is higher than the present price, so it is an “out-of-the-money” (OTM) trade. The key point is that over 6,000 contracts traded at that 8.7% higher OTM price. That is over 42 times the prior number of outstanding call option contracts at the $13.00 strike price for expiry on Aug. 15.

Note that the midpoint premium is 27 cents, so a buyer of these call options is betting that PARA stock will rise over $13.27 on or before Aug. 15. That is over 10.5% higher than today's price.

So, why are investors so bullish on PARA stock?

Why Investors Love PARA Stock

For one, the company is solidly profitable, especially from a free cash flow (FCF) standpoint. It also pays a good dividend, and PARA stock has a 1.68% dividend yield. Very few other entertainment stocks can make these claims.

In Q1, Paramount Global, the owner of CBS Television network and streaming channels such as Paramount+ with Showtime, MTV, Nickelodeon, etc., had 6% lower revenue than last year. But after excluding the one-time Super Bowl revenues from last year, its sales were up by +2%.

Paramount Global also generated $123 million in free cash flow (FCF). Although this was lower than the $209 million in FCF last year, that increase was mostly due to the prior Super Bowl.

Moreover, the company's adj. OIBDA (operating income before depreciation and amortization), a cash flow measure before working capital and capex spending, was $688 million. Although lower than last year, it still represents almost 10% of the company's quarterly revenue (i.e., 9.6% of $7.19 billion in Q1 sales).

We can use that to put a simple valuation on PARA stock. 

For example, based on analysts' revenue estimates of $28.42 billion this year, Paramount could potentially produce $2.84 billion in OIBDA this year. 

After deducting $228 million in projected capex spending, and $600 million in working capital outflows, its FCF could be $2 billion.

Therefore, using a 5x multiple PARA stock could be worth $10 billion (i.e., $2b x 5x). That is still 17.6% higher than its market cap today of $8.5 billion. In other words, PARA could be worth over $14 per share (i.e., 1.17 x $12 = $14.04).

Merger Arbitrage

But that assumes the planned merger with Skydance doesn't go through. Right now, Class B (PARA) shareholders are set to receive cash equal to $15.00 per share, according to CNBC, if the deal goes through. (PARA shareholders can also elect to receive new Class B shares, according to the WSJ, but it is unclear when or if they will be immediately listed after the deal closes, or remain private. For purposes of this merger arb calculation, we use the cash alternative).

In effect, then these call options buyers are hoping the deal goes through and their investment for $13.27 (at the midpoint) upon exercise of the call options in August, will make a return of about 13%:

  $15 / $13.27 -1 = 0.1303 = +13%

In effect, this is a merger arbitrage investment, with the call options buyers hoping to make an annualized return of about 26% (i.e., assuming the merger closes in 6 months - i.e., mid-October).

But even if it doesn't close, the investors have a potentially good long-term return if the stock is worth at least $14 per share without the Skydance merger.

The bottom line is that investors in these call options have a potentially good investment.

However, investors should be careful. If the merger does not go through, PARA stock could at least temporarily tank. The downside risks could be high. Merger arbitrage does not come without significant risks, and investors should be careful to copy this unusual call option activity.