Name That Trade – $AAPL: iWatching Apple

by Dan September 3, 2014 1:40 pm • Commentary

Apple’s success in the smartphone and tablet market is undeniable.  Whether they created the categories is debatable, but they certainly refined the offerings and brought an elegant, easy-to-use solution to the masses. Since the 2007 introduction of the iPhone and the 2010 introduction of the iPad, Apple has seen its Mac market share rise significantly from below 5% globally a decade ago to just about 10% in the quarter just ended, demonstrating the massive halo effect of their products.

But longer term questions emerged in recent years. Has this ecosystem gotten stale as the company has not introduced a new product since the iPad in 2010? Have competitors like Samsung whittled away at Apple’s design strength to make the hardware virtually indistinguishable?   Has Apple forsaken the mid to lower end of the increasingly mobile world in emerging markets?  Is Apple too dependent on mobile devices, a segment that is certain to be commoditized in the coming quarters/years where competitors will be forced to compete on price, thus putting a dent into Apple’s industry leading margins?  Will Chinese look a likes hurt high growth expectations for mobile devices in a region that is imperative to future growth?

These questions will be answered in the next year or so. But one thing is certain, a new product hit to replace declining market share in iPads and high end smartphone saturation is a must.  The promise of Apple dominating the living room has been all but a dream up until now as AppleTv remained a “hobby” for the company.  And despite the iTunes/App Store moving up to a double digit revenue contributor, the company will need to get some serious leverage out of a new Beats music offering, as well as a suite of essential services possibly attached to wearables and payments to really move the needle, per MacRumors.com:

revprod

What is clear is that Tim Cook has been successful at carrying on Steve Job’s famed “reality distortion field”, despite no shortage of miscues and missed opportunities that most investors have swept under the rug in the past few years.

It is important to remember that almost every iPhone since the intro in 2007 has had some sort of minor issue from battery, antenna, screen strength, size, Siri to Apple Maps. And there are a few more. For a company that has launched only one smartphone a year (except last), the Apple PR machine has for the most part avoided widespread customer discontent, with Tim Cook as recently as WWDC in June highlighting iOS7’s 97% satisfaction rate vs. what he claims are levels equaling half of that for some Android versions:

satis

The main point here, is that just as the company is guaranteed to launch new phones, there are no guarantees that the phones won’t have issues in addition to what is likely to be limited supplies at the onset.

As for iPad, the product was one of, if not the fastest growing product lines on a unit basis the company ever launched. But soon after AAPL saw lower cost Asian competitors make a serious dent in initial market share, with Apple’s being cut in half in the last 2 years, per Business Insider:

ipadms

chart courtesy of Statista

The iPad while initially billed as “magical and revolutionary” by Steve Jobs in 2010, has lost its pixie dust. Despite being a great product that fits seamlessly in their ecosystem, it remains to me a massively “discretionary” device, that Apple consumers will likely have to make a hard decision on when faced with the purchase decision of a rumored $400 iWatch.  Which brings me to another important point, iPod empowered the use of iTunes, then when iPhone came out it all bit killed the iPod.  Apple is about to introduce a 5.5 inch “phablet” iPhone that will be dangerously close in size to the iPad mini at 7 inches, and likely cannibalize sales there.

So you get the point, they must make new hot product category!

As we head into next week’s Apple media event, which many believe will be the launch of two new iPhone’s, an iWatch, and integrated payments services, it is important to note that all of these new “potential” products pose a risk to AAPL’s stock.  Why? Because the release dates are far from certain. Initial rumors suggest that the new 4.7 inch iPhone will be ready for sale Sept 19th, but given some manufacturing snafus, and component shortages, the 5.5 inch phablet version may not be ready until October or November.  The iWatch, if it even happens, may not be until the new year, while the payments system is also a 2015 thing.

So the question is what is IN the stock at current levels?  Prior to today’s 3.25% decline (was 4.5% at the lows earlier) in Apple, I would have said a whole of lot is IN the stock.  Despite the company’s fairly huge commitment to buying back shares (bought back more than $50 billion in shares since Sept 2012) and paying more than $20 billion in dividends, the stock still trades on the prospects of new product cycles.  Since Tim Cook took the helm as CEO in late 2011, I think it is a universal belief to say that almost every product introduction has been evolutionary, not revolutionary, as consumers and investors had become accustomed to under Steve Jobs.

So when you ask yourself as an investor who has witnessed the almost 50% rally from the January lows, to yesterday’s all time highs, do new products like wearables or services offer upside from a sentiment standpoint?  Or is the potential for a near-term pullback greater due to staggered launches or products that might not have passed Steve Job’s ready for the masses test.  I would say from all time highs, the latter has higher odds.

As for today’s price action, it is downright strange for the largest market cap company in the world to lose more than $20 billion in value in a matter of hours on no news.  I would hardly say that Samsung’s launch event of new smartphones in New York this morning, or a potential downgrade, should have served as such catalysts. But let’s be honest, Apple is a fairly crowded trade and the epitome of a safety trade as bulls point to cheap valuation, massive commitment to cash return, fortress balance sheet, activist investors on their heels, and arguably the most sought after product portfolio in all of technology. And obviously expectations are high:

“Later this year, we’ve got the best product pipeline that I’ve seen in my 25 years at Apple” – Eddy Cue

In a post last month (MorningWord 8/20/14: $AAPL No-Brainer No More) when Apple was around $100, I concluded, as the title suggested:

the stock faces the same headwinds that it did back in September 2012. Despite (or at least accounting for) the enthusiasm for fabulous new products, both then and now.  Can Apple again be a double digit eps grower again?  No doubt. All they have to do is continue to listen to Mr. Icahn and lever up and buy back stock with the $130 billion in net cash on their balance sheet.  The stock is amazingly cheap when you ex-out that cash, as it was back in September 2012.

Trust me, I am not calling a top on Apple.  If the company does live up to their increasing unit expectations for iPhone 6, if they re-invent digital music with Beats, if they introduce a suite of services including payments, if they figure out how to grow iPad units in the enterprise, if they finally deliver on more than a hobby in the living room/connected home, if they dominate wearables and create a new category and continue to make inroads into China, then yes, Apple will be the first Trillion dollar market cap company.

But recent history tells us that having multiple consumer hits at the same time will be a tall task.  The likelihood of the stock rising 30- 50% from here, without a meaningful pullback or a long basing period, is not great.

The options market also sees a lot riding on the Sept 9th event. Implied volatility is ramping up into the launch event as if it’s an earnings release:

AAPL 1yr chart of 30 day at the money implied vol from Bloomberg
AAPL 1yr chart of 30 day at the money implied vol from Bloomberg

The Sept12th weekly 100 straddle (stock about $100) is currently suggesting a $5.50 move for the event (in either direction), but given today’s move on very little news that is starting to seem cheap.

So thinking about today’s price action as we head into next week’s media event, expectations clearly got a bit high. And not just with  investors. The blogosphere has reached a fever pitch. As has the financial media. All fueled by Apple management’s recent comments.  My Fast Money friend Karen Finerman, who is long Apple stock, stated on the show last night that she had sold calls against her long stock position in an effort to take in a little yield, but also to potentially create a small cushion to her long as she also feels the hype is getting a bit much.  If implied vol continues to ramp into the event as we expect, overwriting, or possibly collars (selling call and using the proceeds to buy puts) could make a ton of sense for those who fear that today’s price action (down 3.5%) is a precursor to a potential “sell the news” reaction.

This post was not meant to hate on Apple. I’m a huge fan of the company, I have more than 15 of their devices in my home, and they have become essential to my family’s digital needs, for entertainment, school and work, and I am not likely to replace any of them anytime soon. But the stock is another story given the current set up in my view.  The point of the post was realistically state some of the risks to the story heading into a potentially volatile event.  In my mind the potential for a flop in the wearable space in their initial foray, and Cook’s first real product with his stamp on it could be a fairly apparent realization that the innovation gap that Apple enjoyed over most competitors has narrowed for good.

I have no position in the stock or options on the stock, but the set up for this trader is leading me to a short volatility strategy on the eve of the event. Stay tuned.