Apple (AAPL) has fallen 27% in the past month and investors are scratching their heads. Apple started 2012 with significant appreciation but has been in a tailspin since hitting $705. Optimism surrounding the company has vanished and the media is now extremely critical of Apple. Now more than ever it is important to monitor developments for the company and its competitors. Below I will layout the reason why I continue to recommend Apple (after much internal debate) and, as a supplement, present complementary option approaches. I utilize conservative covered calls to simultaneously generate income and reduce your effective cost basis. For details on my methodology please consult the first article in the series as well as my Instablog.
(Source: Yahoo! Finance)
Apple reported record earnings on Wednesday and finished the week with one of its largest declines in market capitalization ever. Apple reported $54.5B in revenue on sales of iPhones (47.8M), iPads (22.9M), Macs (4.1M), and iPods (12.7M). I forecasted most of the revenue metrics quite well except for Mac sales which lagged due to greater than expected supply constraints. In fact I was nearly perfect on both iPhone unit sales and total iPhone revenue.
I am sure you have read numerous stories already on Apple's performance so I will not bore you with every detail of the quarter. Bill Maurer wrote a strong analysis of the quarter on Wednesday and I suggest you read it if you have not yet gone through the earnings announcement. I would like to stress that this quarter was one week shorter than in the previous year so Apple's comparable performance was better than it appeared. I am going to tackle the important question of what happens next? Apple now sits essentially at its 52-week low and all Apple investors want to know is, should I still own Apple?
I have been long Apple almost uninterrupted for years and believed that the stock was heading for $750. As you can see from the chart above, Apple was outperforming the S&P 500 by 40% in September and now is lagging by approximately 15%. At this point it is not just a case of Apple selling off after being overheated, there are fundamental concerns surrounding Apple's performance. Although I use Apple's products and I am a fan of the company, I force myself to be very critical of the company as an investment. I am a student of history and I know that no technology company can remain on top forever; however, I do not believe Apple's time to cede the crown has arrived yet.
Motorola and Research in Motion (RIMM) have had the "it" phones in the past and have both fallen into irrelevancy due to resistance to change. I do not see that issue at Apple. A perfect example is the iPad Mini: Steve Jobs famously said that the company would not make a smaller tablet but Apple reversed course when it realized that there was a demand for the product. I suspect that Apple will adapt in a similar fashion to meet the needs of budget conscious consumers and perhaps even those who prefer phones with larger screen sizes.
I suggest that you ignore all of the hyperbole calling Apple broken or uncool as they are overstating the troubles facing the company. Let's not forget that Apple just had $55B of revenue last quarter - I bet a lot of companies would like to be "broken" if they could generate that type of revenue. I would like to briefly compare Apple and Amazon (AMZN). Apple earns so much money that investors are worried that its growth has to slow. In contrast, Amazon continually flirts with break-even thus the future profit potentials are seemingly unlimited. This same contrast is readily apparent with Netflix (NFLX) which proudly stated in its fourth quarter report that it earned a profit in 2012. Apple currently trades at a P/E of 10 while Netflix has an extraordinary P/E of 585 and Amazon has an astronomical P/E of over 3,000. I know which company I want to invest in.
I believe that Apple will be range bound between $400 and $525 for the remainder of 2013 unless one of the positive catalysts below occurs:
- Apple increases its share repurchase plan significantly
- Apple increases its dividend payment significantly
- Apple announces a breakthrough new product
Apple announced the re-initiation of the dividend in 2012 and began repurchasing shares to offset dilution but I believe that the company can do far more. In the first quarter of 2013 Apple generated $23.4B of cash from operations and used $2.7B on various acquisitions, leaving $20.7B in cash available for common shareholders. Apple invested most of the excess in marketable securities and dedicated $4.4B to shareholders ($2.5B in dividends and $1.9B in repurchases). Returning $4.4B to shareholders is nothing to sneeze at but is a small fraction of what Apple is capable of doing. Apple is currently utilizing only 21% of its free cash on shareholder beneficial payments and could easily double its standard repurchase plan with no adverse consequences. Currently Apple has a $10B standard repurchase plan and a $2B accelerated repurchase plan. The dividend could be increased modestly as well although there are overseas tax consequences to consider. If the dividend was lifted modestly from $2.65 per quarter to $3.00 per quarter (13.2%), the dividend yield would be 2.7%. I prefer the share repurchase as it would send an immediate, strong signal to the market that management believes Apple is a good investment at this price and that it plans to enrich shareholders immediately.
The third possible catalyst involves possibly the elusive iTV, a dramatically redesigned iPhone/iPad, or a yet unannounced product line such as wearable computing. Remember that Apple is famous for creating products that consumers do not know that they want yet and they will need to pull another rabbit out of their hat to appease analysts' concerns. A simple "evolutionary" improvement of the iPad will not do the trick here as the media will be quick to ask whether Apple has done enough to stay ahead of competitors. This puts Apple investors in a very unenviable situation in which they will face difficult for most of the year.
If you are still long Apple I cannot recommend that you sell now after such a steep 12.5% weekly decline. Despite numerous analyst price cuts, most price targets are still above $575. Personally I am lowering my 2014 price target to $610. With Apple trading below $440, now would be an excellent opportunity to slowly initiate a position or add to a small position but if you are already Apple-heavy, I suggest you hold. Based upon the fact that I think Apple will stay in a modest trading range, now is where covered calls can improve your returns. If you regularly sell calls that are decently out-of-the-money, you can reduce your cost basis Apple with a low probability of missing out on an Apple "pop". The rest of 2013 will be a test for Apple shareholders but I suspect the stock will be trading closer to $500 as the year progresses but things will not be pretty. If you cannot handle a possible dip down to $400 or have trouble tolerating this much volatility, sell Apple now. If you believe that Apple has a strong brand and will continue to innovate, I suggest you stomach this recent decline and stay long.
Below I present three possible scenarios and the potential returns for the Apple options:
- Apple Down 5%
- Apple Unchanged
- Apple Closing at 50 Day Simple Moving Average (SMA)
These scenarios are forecasts and there is no guarantee that they will come to fruition. For more information on the fundamentals of covered calls, consult Investopedia.
Additionally, if you would like even more information, I have prepared a sensitivity analysis for absolute return and percent returns, respectively. After studying the information above, these two charts make it easy to pick a strike price based on where you believe Apple will close at the end of the week. Estimate where you believe Apple will close and select the strike price with the highest return.
With this information, executing a buy-write on AAPL February 1 $450s is the optimal risk-return strategy as an opening Apple transaction. The option has a potential return of $4.30 (time value) and should provide adequate coverage against a moderate drop. This strategy is excellent for long-term Apple investors who want to generate income while still staying long the stock. There is substantial risk that Apple could decline further this week so an alternative approach is to sell out-of-the-money $430 puts and collect the premium without having to purchase the stock outright. The $430s are currently trading around $3.79 and appear to offer the best risk-reward profile for the week. Note that if the stock declines to the strike price, you are obligated to buy the stock (or closeout the position). You should always consider the risks (particularly with naked calls or puts) raised in this article in light of your personal circumstances (including financial and taxation issues) in consultation with your professional financial adviser.
Please refer to profile page for disclaimers.