Will The iPhone Mini Save Apple?

| About: Apple Inc. (AAPL)

Apple (AAPL) has fallen nine percent in the past month and investors are scratching their heads. Apple started 2012 with a strong run but has been grounded since hitting $705 in September. Optimism surrounding the company has vanished and the media is now extremely critical of Apple. Now more than ever it is important to monitor developments for Apple and its competitors. Below I will layout the reason why I continue to recommend Apple and, as a supplement, present complementary option strategies. For details on my methodology please consult the first article in the series as well as my Instablog.

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(Source: Yahoo! Finance)

Apple was finally starting to gain traction with David Einhorn's lawsuit and the rumored iWatch but the stock dropped three percent last week after briefly touching $480. As I have been reiterating since Apple's Q1 report, I believe Apple will remain stagnant for much of 2013 and investors should not anticipate a huge "pop" in the near term. Investors need to reset their expectations and be content with modest outperformance, if any. For this reason, selling out-of-the-money covered calls is a great approach as your probability of missing significant appreciation is minimized. As a general rule, if you already long Apple, I would consider selling a covered call if the stock appreciated by at least three percent the previous week. This would rule out selling covered calls for most investors unless Apple bounces on Tuesday.

Early in 2013, I presented three catalysts that Apple will need to move materially higher:

  • Apple increases its share repurchase plan significantly
  • Apple increases its dividend payment significantly
  • Apple announces a breakthrough new product

The third possibility may be coming closer to a reality. Apple was awarded a patent for an all-plastic unibody (think original MacBook style) iPhone sans home button or front camera. Despite the very boring patent design, a lower cost iPhone should get all Apple shareholders excited. This "iPhone Mini" is not exactly a breakthrough new product, but it fills a market need and there is a demand for a less expensive iPhone in the rest of the world. The budget iPhone Mini has been such a hot topic for so long that I could see investors and analysts latching on to this patent as proof that Apple is working on a low-cost iPhone for well over a year. If the patent was applied for in early 2012, logic dictates that Apple was working on designs for years before that - yes even during the Steve Jobs era. Even if this is not the final iPhone Mini, this is proof that Apple is at least exploring creating an iPhone for more budget conscious users.

The real question about the iPhone Mini will be about margins. To answer this, we need to take a detailed look at all of Apple's related products. One of the reasons why Apple's stock has been pressured recently relates to declining margins. In Q1 2013 overall gross margins were 38.6%. iPhone margins can run as high as 58% depending on the model while iPad Mini margins are much lower around 35%. I believe that Apple would target a $200 total price to consumers unlocked (or free with carrier subsidy) and margins around 40% to at least prevent overall margin erosion.

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I utilized publicly available third party reports as well as Apple's reported financial information to arrive at estimated margins and ASPs for Apple main products. As you can see, the $200 price point is a logical extension and would fill a gap. The next task was to estimate the iPhone Mini's margins, which was quite challenging. I relied upon iSupply teardowns for the iPhone 5/4S as well as the iPhone 3GS. The iPhone Mini would have many components similar to the iPhone 3GS but the iPhone 5 reveals areas where Apple has been able reengineer the design to reduce costs. Large areas of potential cost savings are the display, mechanical/build, and camera. Based upon my admittedly crude calculations, I believe that Apple could bring a basic iPhone Mini to market with a $199 base starting selling price. The phone would be different enough from the current iPhone line that cannibalization risks would be minimal

I would like to note that Apple is granted a huge number of patents every year (1,136 in 2012) and most are likely for defensive purposes. There is no guarantee that the iPhone Mini will ever be released, but I am sure Apple is well aware of the tremendous global opportunity. Before I close, I would like to address those who will point to the comments of Apple executives that are opposed to releasing a low-end iPhone. SVP Phil Schiller stated, "despite the popularity of cheap smartphones, this will never be the future of Apple's products." CEO Tim Cook did his best job to avoid the question on the recent earnings call (below) but left the impression that Apple is not focusing on a lower-end iPhone. I believe the issue is how the question is worded. Apple will never release a "cheap" product but will sell products at low price points. The iPod Shuffle is available for under $50 and is built very well: it is not a cheap product. If Apple feels that it can make a quality iPhone for $100, I believe that they will. Apple has historically been nimble and adaptive to changing trends so I expect we will see an iPhone Mini in the next two years. Even if the launch is far off, it is never too early to see positive leakage into the stock price with this type of product. Stay tuned.

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(Source: Seeking Alpha Q1 2013 Transcript)

Below I present three possible scenarios and the potential returns for the Apple options:

  • Apple Down 5%
  • Apple Unchanged
  • Apple Closing at 50 Day Simple Moving Average (SMA)

These scenarios are forecasts and there is no guarantee that they will come to fruition. For more information on the fundamentals of covered calls, consult Investopedia. I utilize conservative covered calls to simultaneously generate income and reduce your effective cost basis.

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Additionally, if you would like even more information, I have prepared a sensitivity analysis for absolute return and percent returns, respectively. After studying the information above, these two charts make it easy to pick a strike price based on where you believe Apple will close at the end of the week. Estimate where you believe Apple will close and select the strike price with the highest return.

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With this information, executing a buy-write on AAPL February 22 $460s is the preferred risk-return strategy as an opening Apple transaction. The option has a potential return of $5.59 (time value) and should provide coverage against a slight drop. This is a short trading week so option values are suppressed. This strategy is excellent for long-term Apple investors who want to generate income while still staying long the stock. An alternative approach is to sell out-of-the-money $455 puts and collect the premium without having to purchase the stock outright. The $455s are currently trading around $3.50 and appear to offer the best risk-reward profile for the week. Note that if the stock declines to the strike price, you are obligated to buy the stock (or closeout the position). You should always consider the risks (particularly with naked calls or puts) raised in this article in light of your personal circumstances (including financial and taxation issues) in consultation with your professional financial adviser.

Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Please refer to profile page for disclaimers.

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