Seeking Alpha

The Numbers Guys'  Instablog

The Numbers Guys
Send Message
We are just a couple of accountants (a/k/a numbers guys) with a passion for sharing our views on stocks, financial news, business and real estate. Having the experience of being executive level officers for several public and private companies, we tend to analyze things in a different way than... More
My blog:
The Numbers Guys
View The Numbers Guys' Instablogs on:
  • Apple: A Bullish Prediction and 3 Option Plays Based on the Charts
    There are many articles and commentary written about the fundamentals of Apple (NASDAQ:AAPL) and their fantastic products.  There is no arguing these facts.  Apple's stock price has surpassed many expectations over the last two years. This article is not about Apple's profitability or its next product release.  I believe in the fundamentals of this company. It trades at a reasonable PE of 16 times trailing earnings, all of their PE multiples (trailing, forward, and forward PEG) are at or near their 5 year lows, it has one of the best margins in the industry, and is flush with cash.  The focus here is on the technical aspects of Apple's stock chart which appear to be flashing a buy signal.  While the fundamentals are what a value investor will focus on before making a decision to buy, a technician, or someone that trades based on the technical indicators of a stock chart, will wait for the appropriate signal to flash in front of them.  I like to consider both the technicals and fundamentals when putting on a trade (a so called tech-namentalist if you will) and when both align, it is go time!

    The Technical Thesis

    Based on Apple's daily chart pictured below, there appear to be several technical indicators signaling a bullish move is on the horizon.

    Apple daily chart showing possible reverse head and shoulders formation

    1. Fibonacci Retracement Levels - Fibonacci retracement is a technical indicator used to determine areas of support (when a stock price stops going lower) and resistance (when a stock price stops going higher).  The key retracement levels according to Fibonacci are at 38.2%, 50.0% and 61.8% of the stocks previous extreme point.  Using the mid-November low and early February high as our extreme points for determining the horizontal retracement levels, Apple's chart appears to have bounced off all three at one point or another in the last three months.  In mid-April, the 61.8% retracement line of $323 held as the last line of support on Apple's pullback from it's mid-February high of just under $365 (This is a bullish signal!).  It proceeded to follow through on big reversal over the next week on higher volume (This is another bullish signal!). After another small pullback in early May, Apple seems to have found support at the 50% retracement line of $331 making a higher low from the mid-April pullback (Yet another bullish signal!).
    2. Reverse Head and Shoulders Chart Pattern - This has nothing to do with the shampoo and everything to do with a flashing buy sign for a technical trader.  The head and shoulders chart pattern and it's sister reverse pattern represent one of the most reliable chart patterns to a technical trader.  The reverse head and shoulders pattern consists of three troughs, with the middle trough (the head) being lower than the two outside troughs (the shoulders).  A "neckline" is formed at the point where resistance is met on the pullback from each trough.  The chart below shows the reverse head and shoulders pattern highlighted (dashed lines and circles).  While the pattern is not truly complete until the neckline is broken after the last trough is formed, I am doing a bit of foreshadowing on where the stock is going.  It is quite possible that the pattern never finalizes, but given the Fibonacci retracement support and the additional technical indicators mentioned below, the odds seem to be in our favor.
    3. Technical Indicators Show Bullish Trends - A look at a few popular technical indicators, Moving Average Convergence-Divergence (MACD), Force Index (Force) and Money Flow Index (NASDAQ:MFI), we can see some bullish patterns forming.  Without getting into too much technical detail, the MACD and Force show a bullish divergence from the price trend of the stock and the MFI appears to be finding a base just above oversold territory.  These indicators help confirm the Fibonacci retracement and reverse head and shoulders pattern described above.
    Enough with the Technicals, What's the Trade?

    So how can we generate a triple digit return over the next three weeks even if Apple doesn't do exactly what the technicals are telling us?  Very simple, we look to put on a credit spread using options.  While there are many ways you could play Apple, I like to hedge myself and use as little capital as possible, especially when trading a stock over $300.  This is why I prefer putting on a bull put spread, whereby I sell one out of the money put and buy a further out of the money put and collect the premium. The preferred outcome is for both options to expire out of the money at expiration.

    Here are three trades based on Friday's closing prices and utilizing the June 18 expiration options. 

    #1 - The Aggressive Bull Put Spread

    While I call this "aggressive," it is still more conservative than buying the stock outright.  The worst case scenario is that if Apple drops below your short strike put at expiration, you own Apple stock at that short strike.  A bullish put spread can be opened by selling the June 18 $335 strike puts and buying the June 18 $330 strike puts for a net credit of $1.55.  With a total of $3.45 at risk, the possible return is 45% and a whopping 820% on an annualized basis.  The tradeoff is the small $3.96 or 1.2% cushion to break even from Friday's close of $337.41, but if you believe we have found support and the only way is up, this could be a very lucrative trade.

    Apple bull put spread - $335/$330 June 18 expiration

    #2 - The Middle of the Road Bull Put Spread

    This bull put spread sets the short strike just below the 50% Fibonacci retracement line of $331 which has acted as support for the right shoulder of the reverse head and shoulders pattern described above.  By selling the June 18 $330 strike put and buying the $325 strike put, you receive a net credit of $1.04.  With a total risk of $3.96, the return is 26% and 479% on an annualized basis.  The break even point of $328.96 is over $2 below the 50% Fibonacci support line and $8.45 or 2.5% below Friday's closing price.

    Apple $330/$325 June 18 bull put spread

    #3 - The Last Line of Support Bull Put Spread

    This bull put spread provides the most cushion, but still has a great return.  By selling the $320 strike June 18 put and buying the $315 strike put, we are setting the break even point at $319.58, just below the most recent April low of $320.16 which is the top of the head of the potential reverse head and shoulders pattern as discussed above.  This is also just below the third Fibonacci support line.  With a net credit of $.42 on an investment of $4.58, this generates a 9% return or 167% annualized.

    Apple $320/$315 bull put spread

    While there are many ways to play Apple to the long side, these bull put spreads give substantial return and a bit more margin of error if we are not entirely correct on Apple's next price movement.  This can also be viewed as a cheaper way to get into Apple stock, with the worst case scenario being Apple stock getting put to you at the short strike with your basis in the stock equal to the break even points.

    Disclosure: I am long AAPL.

    Additional disclosure: I am long AAPL via a short position in OTM puts.
    May 28 7:22 PM | Link | 2 Comments
  • Time for Another Homebuilder Consolidation? Don't Bet on It!
    Given the recent run up in homebuilder stocks over the last several weeks, I have begun to wonder why we have not seen more consolidation in the homebuilding industry since the Pulte-Centex merger that was announced almost a year ago. Besides the recent bevy of positive housing data this past month, most, if not all, of the large public builders have significantly increased their cash positions over the past year, extended maturities on their long term debt and have started to reload their land positions. One might think with stream of positive news, the inevitable appetite to grow big and the perceived economies of scale that the combination of another two housing giants would make logical sense. Well, not so fast! Stock prices have far exceeded current fundamentals of the business. If you look at the top publicly-traded homebuilders, they are all trading at a premium to book value. Beazer (NYSE:BZH) trades at 1.06, which is on the low end, and NVR (NYSE:NVR), trades at 2.4, which is on the high end. Further, when you reduce for any outstanding goodwill and arrive at a Price to Tangible Book Value, three builders are trading above 2.0. Those are NVR at 2.36, KB Home (NYSE:KBH) at 2.20 and Pulte (NYSE:PHM) at 2.17. The average for the group is 1.75. In looking back at the Pulte-Centex merger, Pulte (PHM) acquired Centex at a price to book of 1.4, based on the Centex book value at the time of the announcement.
    The impact of such a premium over book value in a merger may not be obvious. When a company is acquired, regardless of whether it is a cash transaction or a stock-for-stock transaction, the purchase price is allocated to the assets and liabilities based on fair value. This is purchase accounting. The days of using the pooling method are long gone. Therefore, the individual assets, such as the real estate inventory, would be marked-to-market, typically based on a discounted cash flow analysis. Generally, you don't see much adjustment to the remaining assets and liabilities. For example, cash, payables, and other similar types of assets and liabilities typically represent their fair value so they generally get recorded at the basis in the financial records of the acquired company. If the company has a significant number of leases, you may have to set up an asset or liability for any below or above market arrangements. However, this is generally not significant for a homebuilder. If there is any excess of the purchase price over this allocation, it is required to be recorded as an intangible asset, which includes goodwill. Generally, in the homebuilding industry, there aren't as many specifically identifiable intangible assets such as patents, trademarks, customer lists or intellectual property that you find in acquisitions in other industries. Therefore, the excess of purchase price over allocated fair value is generally recorded as goodwill. If a transaction were to occur at these current Price-Book levels, this premium, which is quite large, would have to be either used to mark up the real estate inventory or recognized as goodwill. From an investor’s perspective, you can accept a modest amount of this premium, or goodwill, if you can argue that you will realize cash flow improvements or provide you entrance into a market that otherwise would have cost you significant start up costs. Regardless, the proof of whether it makes sense or not will be determined if the cash flows will support this additional premium. In fact, companies are required to analyze goodwill annually to determine if it is impaired. This analysis is generally based on projected cash flows. 
    In looking at the details of the Pulte-Centex merger, Centex’s price to book value of 1.4, equated to approximately $350 million of premium which had to be allocated. This amount represented approximately 11% of Centex's real estate inventory at the time of the announcement. Pulte, instead of marking the Centex inventory up, by some portion of the premium, actually wrote the inventory down by in excess of $1 billion, or approximately 1/3, and instead recorded approximately $1.5 billion in goodwill on the transaction. This represented approximately 40% of Pulte's equity at the time of the transaction. This would indicate that Centex’s assets, despite being subject to impairment analysis, were not considered to be fair value. That is not a criticism of Centex. As we discuss later, it just dispels the belief that while companies have been taking impairment adjustments, their assets in total are not at fair value, just those that were impaired. Further, in the 4th quarter of 2009, less than five months after completing the transaction, Pulte wrote off $563 million of the goodwill or over 1/3 of the amount initially recognized. In other words, Pulte has determined that the premium paid over the book value was impaired in less than 6 months. It should be noted that this was at a time when homebuilders had already taken the majority of their impairments and the reduction in the carrying value of their real estate had begun to slow down. Pulte effectively overpaid by approximately $4.65 per share ($563 million divided by the Centex shares outstanding). When you reduce the price paid, by the per share write off of goodwill, the true fair value was .77X Centex’s book value, or almost half of what Pulte actually shelled out!
    Given the level of impairments the homebuilders have taken on inventory over the last three years and the fact impairments in the last quarter are almost nonexistent, one would assume that a builder’s assets should approximate fair value today. However, the amount of goodwill and the subsequent impairments taken by Pulte in their acquisition of Centex should be an eye opener that this is not reality. Yes, it is true that the accounting rules require these builders to record their land and inventory at the lower of cost or fair market value.  However, that is only true when the assets are impaired. If the accounting rules truly made companies mark their inventory to fair value, then how would it be possible that Pulte would end up writing down Centex’s inventory at the time of the acquisition, considering the $1+ billion of impairments Centex had previously recognized over the 3 years preceding the transaction? The answer is very simple. In accordance with the accounting rules, a homebuilder analyzes its real estate inventory based on cash flows it expects to generate from developing and building it out over time. If the UNDISCOUNTED cash flows exceed the carrying value of that asset, there is no impairment. In other words, if a homebuilder projects that it can generate one dollar of positive cash flow, excluding the assumption of any interest costs or return on equity, it does not record an impairment writedown. Even if it takes ten years to generate that positive cash flow, as long as a homebuilder can legitimately support their cash flow assumptions, no impairment will be recorded. Homebuilders are carrying assets that may be providing substandard returns, but if they are generating a positive cash flow, then they are not required to write down the assets. Is this really fair value? Not quite.
    So, how likely is it that we see another Pulte-Centex like combination given the run up in builder stock prices and the resulting unsupportable premiums over book value?  Unless you know a CEO that likes to overpay for land and repeat the sins of the recent housing debacle, don’t count on it anytime soon. 

    Disclosure: Short MTH
    Tags: PHM, NVR, KBH, BZH, DHI, HOV, CAA, LEN, MDC, MTH, RYL, TOL, Homebuilders
    May 03 11:00 PM | Link | 7 Comments
Full index of posts »
Latest Followers


  • Open Table up this morning. Option trade recommendation looks good.
    May 9, 2011
  • Shorting the builders on any spike up next week. MTH, TOL, LEN, HOV and others don't make sense at these levels.
    May 22, 2010
  • Was Friday's action a dead cat bounce or did we find a bottom? Market was very oversold across the board. My guess is the "cat bounced."
    May 22, 2010
More »

Latest Comments

Posts by Themes
Instablogs are Seeking Alpha's free blogging platform customized for finance, with instant set up and exposure to millions of readers interested in the financial markets. Publish your own instablog in minutes.