Shares of Apple (AAPL) are down 17.8% after a disappointing launch of its new iPad mini and recent management changes. While the company has always supplied analysts with a buffet of reasons to be either positive or negative on the shares, bears seem to be in control lately. With longer-term revenue in tact, investors willing to use options may be able to get this tech titan at a record discount.
Bears in control
In a rare miss, the company reported earnings of $8.67 per share in the fourth quarter, below the $8.75 per share expected by analysts. Revenue also missed with $35.02 billion against a consensus of $37.18 billion for the quarter.
Paul Kedrosky of Bloomberg called the iPad mini an imitative product, a break from the company's first-mover advantage in the past. Kedrosky also talked about a hole in the company's product releases going into next year since most of the existing products have recently come out with updates.
The fact that sales of the Kindle Fire by Amazon (AMZN) surged to the highest since its launch after the announcement for the iPad mini is telling. While Apple products will continue to perform well and demand a price premium, the new iPad was not impressive enough to overcome its high price point. It is understandable that Apple would want to protect its 37.4% EBITDA margin, but it risks customer attrition to other companies.
While management has downplayed recent changes to key executive leadership, the company does seem to be trying to address missteps like the failure in its new Maps app.
As an interesting mental exercise, look at Apple as a percentage of world GDP under different growth scenarios. The company grew its market capitalization at a compound annual rate of 35% in the 15 years to 2012. At a current market cap of $557 billion, the company represents about 0.8% of the $70 trillion world economy. If the company continues to grow at this rate, and assuming 4.5% annual growth in global GDP, Apple will represent a fifth (22.2%) of the world economy by 2025. It's the iWorld!
I think even the most bullish iFan would agree that this is not realistic.
Bulls wait to fight another day
Despite the miss on earnings and recent product missteps, the company is still one-of-a-kind in its brand leadership and innovation.
The company grew net earnings by 23% over the same period last year on a 58% increase in iPhone sales. While sales of iPads were weak at only 14 million, much of this was due to customers holding out for the upcoming iPad mini release. Management projected earnings of $11.75 per share for the current quarter on revenue of $52 billion, also below expectations but representing a 12.3% gain in sales over the comparable quarter last year.
The iPad still dominates the tablet market with an estimated 68% of total sales and should be able to hold up even in the face of increased competition. Market dominance in a product line that is growing by upwards of 67% in unit sales per year supports strong revenue estimates for the near future. While it is a smaller portion of total revenue, the iPod controls more than 65% of the market for personal media players and provides the company with significant amounts of cash.
The company controls 69% of the tablet market and 10.4% of smartphones in China and is planning to open between 30-35 new stores in fiscal 2013. The company's aggressive positioning in emerging markets should help it drive sales even if revenues come under pressure in the United States and Europe.
Valuing a company that continues to surprise
While trying to put an exact target on the shares over the next year may be little more than guesswork, I think you can build a range around conservative estimates for earnings growth and price multiples.
The company has grown net income by an annualized 64% over the last five years on annualized revenue growth of 45% over the period. This year's earnings increased by 61% on revenue that was 45% higher than last.
Analysts are expecting an average increase of just 16.7% in earnings per share next year on an increase of 15% in revenue. Given the company's history, I think this is overly conservative. Even the harsh retail environment of 2008 saw earnings growth of 38% over the prior year. Still, I want to build a range around conservative estimates so we will be using growth between 20% and 40% in our scenarios.
Our price multiple assumptions are a little more realistic than those used for earnings growth. The shares have averaged 18.7 times trailing earnings over the last two years with a decade low of 11.9 times in January of this year. In fact, at the current multiple of 13.06 times, the shares have only been cheaper 2.2% of the time over the last two years.
The matrix below shows possible one-year price targets around estimates for earnings growth and the price-earnings multiple.
While the most conservative estimate is 8% below the current share price, all other scenarios point to strong share appreciation in the next year.
Using options strategies for an historic discount
I am a long-term investor but often use options as a way to build a position at a discount to current prices or to lower my risk within the position. The three strategies below vary in terms of risk and return with the covered call being an insurance strategy, the bull spread being a speculative bet and the put-write falling between the two. I prefer long-dated options like the January 2014 LEAPs used in the examples below.
For the strategies below, I assumed a target price of $684.48 which is the average of the 20% EPS growth with a 15 times multiple and the 30% EPS growth with a 10 times multiple shown above. Investors may want to increase or decrease their target price and the options strike prices according to their own risk tolerance.
Covered Calls involve selling call options against a long position in the shares. The investor collects a premium for selling the right to another investor to buy the shares away at a certain price. Selling calls with a $685 strike price lowers an investor's cost to $534 per share, just above the worst-case scenario above. If the stock is above our target in one year, the investor sells the shares to the call buyer and realizes a 28% return.
Bull spreads involve buying a call while selling another call at a higher strike price. If the shares trade between the two strike prices at expiration, the investor keeps the premium on the sold calls and buys at the lower strike. If the shares trade above both strike prices, the investor takes no position and makes the difference between the two prices. There is the risk that the shares trade below both strike prices, in which case the investor loses the entire investment. Buying January 2014 calls with a strike of $350 against calls with a strike of $685 means an investment of $189.98 per share and a cost basis of $539.98 if a position is eventually taken. The investor realizes a gain of 76% if Apple closes above our target of $685 in January 2014.
Cash-secured put writing involves selling put options against a stock. The investor promises to buy the shares if the price falls below the strike price at expiration. If the shares end above the strike price, the investor keeps the premium paid and no position is taken. Most brokers will allow investors to sell the options without enough cash to buy the shares if the option is exercised but I like to keep enough cash on hand to cover the position and lower risk. Selling the January 2014 put options with a strike of $685 means the investor collects $158.38 per share now and lowers the potential cost of a purchase to $526.62 per share. If the shares close above our target on expiration, the investor realizes a return of 30%. As an added bonus, the investor earns interest on the cash held in the brokerage account until the options close out as well.
Using options for an historic discount
Investors should understand the risks and underlying assumptions before opening options strategies. Even the most risk-averse investor should be able to use options as a rational part of their portfolio. Each one of the scenarios above lowers the cost basis on shares of Apple to below $540, more than 6% off of the current price and well below 10 times expected earnings of around $58.7 per share next year. This price multiple is a significant discount below the 11.9 price-earnings low set in January and a good opportunity to build a position.