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With a couple of decades of experience as an option market maker and institutional floor broker on the trading floor, I have some opinions (not always right). I do have a decent grasp of options and market mechanics. I have lectured and consulted for exchanges, the SEC, universities, and private... More
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  • Apple's Identity Crisis! - Options Strategy 0 comments
    Mar 7, 2013 3:58 PM | about stocks: AAPL

    As I sit here pondering this article, my iPhone buzzes with a text message as I am about to type, at some point we have all interfaced with an Apple (NASDAQ:AAPL) product (computer, iPod, iPad, iPhone, iTunes, QuickTime, etc.) Apple has both a huge fan base and has dominated the market headlines for years. Chances are if you run into a casual investor, they will have traded Apple or at the very least have an opinion about the stock. I would bet that more people know the price of Apple stock than any other stock on the planet.

    However, Apple is facing an identity crisis. No, I am not talking about marketing, branding, or even their product line. I am talking about what kind of company is Apple, from the investor's point of view.

    Apple is still a strong company and worth considering into any portfolio, however HOW should we position ourselves? I think it really depends on your belief in Apple's future identity, as either a Growth or Commodity driven company.

    Growth or Commodity?

    In the simplest terms, companies (stocks), are divided into two categories, for this article I will use "Growth" and "Commodity" companies. Let's define what I mean before we venture any further.

    A "Growth" company is defined (for simple purposes of this article) as:

    1. Primary revenue growth is coming from new customers.
    2. Growth is determined by meeting demand into the new market.
    3. Product/Service market is still being defined.
    4. Top line revenue/growth is strongly in the double digits.
    5. Growing margins.
    6. The stock is usually highly volatile.
    7. Investors buy these companies because they expect the company to keep growing.
    8. They are considered more risky.

    A "Commodity" company is defined as:

    1. Primary revenue is coming from an existing customer base.
    2. Growth is determined by increasing/fighting for market share.
    3. Product/Service market is well defined.
    4. Top line revenue/growth is usually in the single digits and sometimes in the low to mid-teens.
    5. Thin margins.
    6. The stock is usually has low volatility.
    7. Investors buy these companies because they usually pay a dividend.
    8. They are considered more conservative.

    The stock behavior and expectations between a Growth and Commodity company is also distinctly different. We expect huge gains in a Growth stock, with earnings always beating, top line revenue and sales growth increasing in double digits, and when they don't beat our expectations they are usually sent into a volatile frenzy. The commodity companies on the other hand see growth in the single digits; they are less volatile, and usually dividend payers. These companies have usually become staples in the industry as they fight for market share amongst competitors. Margins are significantly thinner than their Growth brethren.

    Captain Cook.

    Apple is an amazing sorry, from Woz and Jobs in a garage building the first home computers (note: I had an Apple ][) to innovations that changed the way we listened to music and used a phone. Apple, unlike most companies, received a "second chance" to again become a "Growth" company, with the birth of the iPod, iPad, iPhone.

    Apple's growth story is really a series of strung together growth-cycles of completely new product lines that were defining new market share, reaching a plateau of penetration, then becoming commodities and fighting for the balance of market share. Then a new product would come out and start the cycle again. It was rinse and repeat and it was an amazing success that helped drive the stock price 100s of points higher.

    Apple in some ways defined a new type of company, one that was both a commodity type company with amazing revenue on existing product lines and it was also a growth company with new product lines. This amazing cycle of innovation was driven by what many consider the Thomas Edison of our time, Steve Jobs.

    Tim Cook can no longer be just a stand-in for Steve Jobs. The product lines have reached their maximum growth cycle and are beginning to see growth plateau and these lines are quickly becoming commodity lines. Competition is heating up with now Google's Android and Samsung dominating market share.

    While Tim Cook maybe a great CEO, does he also have the innovation and tenacity that Jobs had to take huge risk and define a new product and new market share to keep that cycle of growth alive? Many are not so sure. The rumor mill, which is usually buzzing in the technology world of the next new "i" thing is fairly quiet. There is the talk of an "iWatch" and "iTV", but one wonders not only if they are in the pipeline, but will they dominate and define a new market and can Cook be the CEO to lead that next growth cycle.

    I don't think we know that answer and we may not know for some time.

    It is this fundamental question and concern that has seen a wave of Apple investors (and believers) leave for green pastures.

    The reality is that Apple stock is down over 35% and that is simply driven by the laws of "Supply and Demand". There were just more sellers than buyers and many of these sellers are wondering if the heady growth days are gone and if Apple is now a commodity company like so many of their competitors?

    Possibly the biggest catalyst in this identity crisis for Apple has been David Einhorn's law suit. Whether we agree or disagree with Einhorn, he has definitely brought this identity crisis to the forefront and has put that question to Apple. Should they become a commodity focused company, working on improving their existing product lines and fighting for market share, and thus rewarding investors with dividends and/or stock buybacks, or even perhaps acquisitions to buy market share? Or is Apple just in a quiet period ready to launch the new "i" thing that will define a new market, new growth cycle, and back to the "Growth" days?

    I am fairly confident that if Steve Jobs was still the CEO, Einhorn would be less likely to go "toe-to-toe", for I can hear Job's response; "If you don't think I am a great CEO then sell your shares, but don't dictate to me how to run my company!"

    It is Captain Cook's time to shine. However, what many investors want to know how is this new captain going to steer the ship. Is Apple still a Growth company or is it now a Commodity company. That is something we will learn in time and I am not sure if even Tim Cook can answer that question today.

    Investors in a quandary!

    This Apple identity crisis leaves investors in a quandary and there is no right answer. There are many that believe that Apple's growth days are gone and have now become a commodity company and others that believe that growth is just around the corner, perhaps with the "iWatch".

    If you are still a believer in those heady growth days than Apple is amazing you will probably buy at this level. Even from a technical standpoint it looks like the 400-450 range could be a bottom and consolidation area. However, for a growth stock to take off it also needs to convince others as well. For growth stocks are driven higher far more by the faith in growth than the balance sheet. The earnings are just confirmation in that faith in future growth. All those recent sellers, which drove down the price, need to be convinced and come back again as buyers.

    On the other hand if you are one that believes that Apple is now a commodity driven company, you will be paying far more attention to market share, top line revenue growth, sales growth rate, and the bottom line. You may also be in the same camp as Einhorn and believe Apple must begin thinking in this new paradigm and that stock pile of capital should be used for a dividend, a share buyback, or perhaps an acquisition. The price of stock in relation to this view of Apple also needs to be defined. For if the heady faith growth believers don't come back, then where is the perceived fair price for Apple as a commodity company? That will also be determined by the float (in case of a share buyback) or yield if there is a dividend, or perhaps more revenue and growth in the case of an acquisition.

    Value, relative to stock price, is all perception based on expectation. At the end of the day all markets work because two people agree on price, they just do not agree on value. One believes it is a good buy at this price and the other believes it is a good sale.

    Strategy

    I am uncertain as to how Apple will emerge from this identity crisis. We could see the new "i" product rejuvenate Apple's growth story and the flood of Apple growth believers could come rushing back into the market pushing this stock back up. However, that is an unknown at this point and any belief in that is simply relying on faith and hope.

    If we look at the math, Apple's market share in both the tablet and smartphone space is under serious threat. They are losing market share to Google and Samsung. Additionally the margins are getting squeeze by price competition as well as inflation. Cook already announced a price cut, which will certainly impact margins.

    However one can still play Apple for the long-run, regardless of view. It is possible that both the "Growth" and "Commodity" view can participate. While it may not be a "Growth" company it may still be an excellent "Commodity" company.

    One way to play this is with a long-term yield covered call strategy, in some respects killing two birds with one stone.

    A simple formula to determine the long-term call strike to use is based on your expectations for either GROWTH or COMMODITY view.

    For GROWTH believers:

    Set a reasonable expectation of where you see Apple's growth over one year. This can be done via a price level expectation or percentage. This will determine which strike to sell.

    Example:

    You believe Apple will be at or above $525 in one year. Then you would sell 1 January 2013 525 call for each 100 shares of Apple stock you own. The current price is $13.50.

    This would provide the following:

    a. 3.2% static yield. (13.5 / 422)

    b. 3.2% down side buffer if the stock were to decline. Break-even = 408.50 (Stock Price 422 - Call Price 13.5)

    c. Target Return of 27.6% (3.2% from the call + 24.4% if the stock appreciated

    (click to enlarge)Apple Covered Call - Growth

    For COMMODITY believers:

    Set a reasonable yield you would like to receive. You could think of it like a dividend. If Apple was to pay a dividend, how much should it pay? What would YOU be willing to receive for purchasing the stock.

    Example:

    You would want 7% yield per year.

    7% of 422 = $29.50

    Find the January Call options that are trading at $29 - $30.

    In this case it is the 460 call.

    This would provide the following:

    a. 7% static yield. (29.5 / 422)

    b. 7% down side buffer if the stock were to decline. Break-even = 392.50 (Stock Price 422 - Call Price 29.5)

    c. Target Return of 16% (7% from the call + 9% if the stock appreciated to the short call strike of 460)

    (click to enlarge)Apple Covered Call - Dividend

    Profit & Loss graphs provided by Silexx www.silexx.com

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Themes: OPTIONS, covered call Stocks: AAPL
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