The post-Steve Jobs era got off to a rocky start last week, as judged by the stock market. After showing resilience all year in the face of economic uncertainty, AAPL sold off against a backdrop of broader market gains as investors were disappointed with earnings that fell short of Wall Street whisper numbers.
I've written about Apple in the past -- with an astounding run rate of roughly ~$30B annual free cash flow, shares trading at $392 appear cheap. Analysts may obsess over the recent earnings report, but the key question regarding Apple is quite simple: Has it peaked? With its visionary leader now gone, is this as good as it will get for Apple? Sure, the company will milk successive versions of its iPhone and iPad lines for a time, but eventually those products will reach saturation point, if competition doesn't pressure margins first. Without Steve Jobs at the helm, will Tim Cook, Jonathan Ive and the rest of the crew be able to dream up the next insanely great Apple product?
Sadly, Apple's own history suggests odds are not likely. During Jobs' first absence from the company, then-CEO John Sculley admits Apple managed to generate heady profits by milking the Macintosh product line, ironically the same product which led to Jobs' ouster. Initially a market failure, a few modifications led to strong sales of the revolutionary computer. In an interview, Sculley attributes Apple's (brief) post-Jobs success to the co-founder he ousted from the company:
My decision was first to fix the company, but I didn’t know how to fix companies and to get it back to be successful again. All the stuff we did then were all his ideas. I understood his methodology. We never changed it. So we didn’t license the products. We focused on industrial design. We actually built up our own in-house design organization, which they have to this day. We developed the PowerBook… We developed QuickTime. All these things were built around Steve’s philosophy… It was all about sales and marketing and the evolution of the products. All the design ideas were clearly Steve’s. The one who should really be given credit for all that stuff while I was there is really Steve.
Of course, the circumstances are clearly different now from Jobs' first departure from the company -- it would be safe to assume that current management will strive to maintain the culture that Jobs instilled. And while the next big thing may be in question, Apple will make billions selling iPhones and iPad for a few years at least. Some analysts are even speculating buybacks and/or dividends may be on the horizon. So while Apple's long-term outlook may be hazy, the near-term looks bright and perhaps there may be some money to be made by investors.
Assuming Apple shares are worth $500, how should investors play it?
The easiest thing to do would be to buy AAPL shares outright. If we set a sell point at $500, buying in at roughly $400 leads to an expected gain of 25%. Viewed another way, we would be risking $400 to gain $100 per share. The true risk is probably not $400, since that would require AAPL to go to zero, but let us suppose it to be the 52-week low of roughly $300, so going long AAPL risks $100 to gain $100. Buying Apple shares outright may not risk $400, but it exposes and ties up capital for a decent 25% gain. Investors can do better by looking into options.
A simple strategy to go long Apple is buying long-dated AAPL calls which are deep-in-the-money, which means options where the current share price exceeds the strike price by a large amount. Investors will pay a premium above AAPL's current trading price in return for nearly identical upside exposure as the common stock, but for only half the cash outlay. In options lingo, we need to find options with high delta.
Let's see how it works using the January 2013 AAPL $200 call option, last traded at $199.41. We get a per-share price of $399.41 by adding the $200 strike price to the cost of the option. Because AAPL closed at $392.87, we are paying a $6.54 premium per share ($399.41 per-share option price less $392.87 actual share price) to open this position.
On the flip side, we only have to spend $199.41 per share to go long AAPL. These calls have a delta of 0.995, which means for every $1 gain in AAPL translates to $0.995 gain for these calls, basically a 1-to-1 correspondence. This gives us leverage to Apple's share price. If AAPL hits our assumed value of $500, we gain $100, but we only spent $199.41 per share via the call options, so our return is over 50% vs. the 25% gain by going long the common stock. The cost of this leverage is the $6.54 premium paid.
Theoretically, there are risks to this approach, but other than the option premium and perhaps an extra commission, they are virtually identical to the risks of going long AAPL common stock. Normally, option positions risk running out of time before the expected share price moves are realized but deep-in-the-money calls negate this risk -- if January 2013 rolls around and Apple shares are still around $400, investors can simply exercise the call option and own the shares outright by paying the $200 strike. Investors will have to sell the calls if they wish not to be assigned the shares. On the other hand, if shares dropped precipitously below $200, the options investor loses the entire $199.41 paid for the contract, but the investor who bought AAPL shares also loses roughly the same amount (less the call premium) via the share price, so there is little risk in substituting a deep-in-the-money call for common stock.
In one important way, deep-in-the-money calls are less risky than buying AAPL outright -- total possible loss of the call option trade is the price of the option which is $199.41 (if shares drop below the $200 strike by January 2013) while total possible loss of AAPL common stock is $392.87 (if shares go to zero). It is highly unlikely AAPL shares will see $200, much less zero, anytime soon, but the risk exists. Also, if Apple declares a dividend, the option investor will miss out on the cash payment but presumably, the market would greet such news warmly and price it into the shares and call options.
While I am not convinced Apple can maintain and build upon Steve Jobs' legacy, conservative investors who are convinced AAPL is worth $500 per share would do well to consider going long via this simple call option strategy. As an alternative to buying shares outright, long-dated deep-in-the-money call options offer the same long exposure but with more leverage at the cost of minimal added risk.