Bullish on Apple

Nov.19.10 | About: Apple Inc. (AAPL)

Apple Inc. (NASDAQ:AAPL) is hardly a well kept secret – it is one of the most widely followed and admired companies in the world. And for good reason. Consumers can’t get enough of Apple’s products and revenues and profits maintain breakneck growth year after year. But for some reason, Apple’s stock market value reflects a company whose growth will hit a wall in the next couple of years. It may come as a surprise to some, but Apple’s earnings have risen even faster than its stock price. For a nice graphical presentation, see this article.

Is the growth story over?

Here is how the valuation looks at the moment: Apple has $51 billion in cash and marketable securities, which comes to around $55 per share. Subtracting that from the share price ($308.43 at the time of writing) leaves us with roughly $253 per share. Apple had earnings of $15.15 per share in the last twelve months, giving us an ex. Cash P/E ratio of 16.7. That would be considered normal for a company with decent, but unremarkable, growth potential. Potential explanations for this valuation are concerns about Steve Jobs’ health as well as increasing competition against the iPhone coming from Android and elsewhere. I consider the concerns valid, but they must be weighed against the upside potential Apple still has.

First, an overview of Apple’s performance in the last ten years (click charts to enlarge):

In the words of Morningstar’s Apple analyst: “… Apple has weathered the current economic downturn relatively well …”, an amusingly understated interpretation of the company’s performance in the last few years.

Whereas some see the reliance on the US consumer as a negative for Apple, a look at Apple’s revenue composition and breakdown of growth would lead me to a different conclusion: there is still tremendous opportunity in foreign markets. As the table shows, growth in America, while still rapid, is tame in comparison to the explosive growth elsewhere. Apple is ramping up its store openings in China in anticipation of further growth there.

Here is a breakdown of revenue. The iPhone is the big seller, but Macs keep gaining market share. With each successful product launch, the allure of using Apple’s operating system increases.

My Apple options strategy

There is nothing wrong with simply buying Apple shares – clearly I expect the shares to appreciate in coming years. I am using a different approach, however. As I think there is limited risk to the downside and significant upside potential (but probably nothing like what we’ve seen in the last 10 years), I am willing to use options to gain some leverage. My approach is a so-called diagonal call, in essence a covered call writing strategy, where instead of owning the shares, I own long-term call options. I am long the January 2012, 320 strike option and short the Jan 2011, 340 strike. At current prices you could expect to pay around $43 per share for the long-term option and to receive $4.3 per share for selling the shorter-term option at 340.

On dips I’m planning to either sell out of the money puts (if options premiums are high) or buy calls expiring in 2013 (if premiums are low). In addition to increased leverage, this strategy allows for more flexibility than simply buying and holding and if well executed can generate significant income. The key is not to get too greedy by selling calls at strikes too close to the share price. If you share my bullish opinion on the shares, you will want to be sure to gain handsomely on strong upwards moves.

Disclosure: Author is long AAPL.