On Friday’s Options Action on CNBC, my co-panelist, Carter Braxton Worth of Cornerstone Macro Research discussed the technical set up in Apple (AAPL) after last week’s sharp post earnings drop, while Dan and I discussed the fundamentals. I detailed an options trade idea targeting a retest of AAPL’s long term uptrend, essentially a move back to the mid $80s, that could be purchased for a small premium outlay, with the worst case scenario the trade losing below $80.20 on June expiration, or down almost 15% from current levels, watch here:
I wanted to take the opportunity to add a few more points at how I arrived at my near term thesis for AAPL and how I chose the trade structure and strikes of the options trade:
If you’re not familiar with Apple Inc. and their products, most likely you’re reading this by accident. Otherwise chances are good that you’ve purchased an Apple product, service or shares in the company either directly or via an investment fund or ETP. Although they don’t mention it in the description, Apple is the most profitable company in the world…by a lot. Looking at the past 12 month earnings Apple has earned 50.678 billion USD, more than the next two most profitable companies, Berkshire Hathaway and JP Morgan combined. Another superlative? Apple is one of the least expensive companies in terms of valuation. As measured by Price/Earnings ranks cheaper than 92% of the companies in the Russell 1000 Index, this with an impressive track record of revenue growth every single year from FY2001 to FY2015.
It’s not all good news for shareholders though, AAPL shares are down almost 11% year to date. It’s performance is worse than 84% of the Russell 1k and in the same ballpark as names that have been hard hit by bad news such as Chipotle Mexican Grill which is reeling after a food poisoning scare dropped same-store-sales by 30%, or biotechs such as Celgene and Gilead which have been beaten up with many others in the sector as the business model of biotech and pharmaceutical companies come under public scrutiny and ire. Apple by contrast is widely admired, their products well-liked, with enviable brand loyalty. Add an astonishing 40% gross margin and the weakness of their share price may be difficult to understand.
This week was a tough one. Carl Icahn, the largest individual investor, announced that he had sold his entire stake in AAPL. The company’s earnings, stellar by almost any company’s measure, disappointed investors, coming in ~ 5% lower than many on the street had expected. Their outlook also disappointed the street, and a plan to reduce channel inventories implied that iPhone 6s and 6s Plus were lower than the company expected. In fact iPhone unit sales declined for the first time ever year over year. Ultimately this gets to the heart of the issue. Apple is a hardware company. 87% of their revenues comes from the sale of hardware, and the largest piece of that business is iPhones. The company has largely avoided falling prey to investor concern about their dependence on fickle consumers’ demand for their single most important product because time and again their results spoke for them. Although no single product appears poised to take the place of the iPhone, the way the iPhone itself took the place of the Blackberry, but market saturation might be enough to cause investors to pause.
Value trap is a term applied to stocks that look very cheap in terms of the valuation multiple, only to become cheaper and cheaper as investors recognize their business is on the wane. Is Apple becoming a value trap? That may be a bit premature. This was a concern a several years ago when in terms of multiples AAPL valuations were even lower than they are today. On April 19th, 2013 the company was valued at 222 billion USD, excluding cash, which works out to ~5.6x the 39.672 billion in net income the company had earned in the 12 month period ending March 30th, 2013. Presently the enterprise value of Apple is ~360.4b, which is ~ 7.14x the 50.456 billion the company earned in the 12 months ending March 26th of this year. There a couple ways to look at this. One way is to say that investors are not as concerned about the company’s over-dependence on the iPhone now as they were three years ago today. Another way to look at it, perhaps somewhat more pessimistically, is that investors are returning to that point of view, which in turn implies there could be additional weakness. The 2013 multiple would imply an $80 stock price!
One should remember too though that the substantial cash balance the company holds, can and will be used in part to fund substantial stock buy backs. Buy backs have the net effect of creating support as the share price falls. Buy backs would not have been in effect this week while the company was reporting earnings, but could begin again in short order, and one would expect them to. While I believe it’s possible that AAPL could fall further, I certainly wouldn’t short the stock here, or buy puts outright because both the relative cheapness of the shares and the enormous buy back will create support. Given $80 would represent the dead low in terms of valuation versus current earnings, I think it would be reasonable to get long the stock at a small premium to that level.
With that in mind, if one is inclined to make a bearish bet, without any risk to the upside if AAPL should bounce here, consider the June 90/85 1×2 put spread. On Friday when I did the trade one could put it one for ~ 20 cent debit. This is the most one risks if AAPL shares should bounce here. Maximum profitability is achieved if AAPL finishes at $85 on June expiration. If it falls further than that one faces the risk of being “put the stock” (getting long) at the lower strike of the spread, or $85, however net of profits on the move from 90 to 85, the effective purchase price would be ~$80. I’m comfortable buying it at ~$80 as that represents ~5.6x trailing 12 month earnings (ex-cash). Again that represents the trough low in terms of valuation.