Apple LEAPS

I picked up some long-dated Apple options recently as a value play, seeing how it has fallen back to its 52-week lows. I think the outcome of this position will be binary. Either it makes a lot of money when it expires or fails terribly making me look like an idiot.  A portfolio manager once told me,  buying value for Tech just doesn't work. One doesn't have to look too hard see that. Just check out Blackberry (Research In Motion).

For those who are not familiar with LEAPS, here's the full name -> Long-Term Equity Anticipation Securities. Basically they are publicly traded option contracts with expiration dates that are longer than a year. Joel Greenblatt mentioned the use of LEAPs in his book (You can be a Stock Market Genius) to lever up positions cheaply. This being said, options are not for everyone and definitely should not be a significant portion of your portfolio. The only exception is when you are a derivative trader in a bank. Otherwise, LEAPS can be quite useful when the following criteria are met:

(i) You have a strong view on a stock which you believe will be realised in 1-2years.
(ii) The target company does not pay significant dividends.
(iii) You believe your downside risks are small compared to the upside.

The flaw is that, LEAPS are typically only available for the large cap US stocks and have fairly low liquidity. I would only be considering deep in-the-money options here. This limits your downside. In the event that the stock goes nowhere for a year or two, you still have the option of exercising the option.

Based on Optionsxpress, an Apple Jan 2015 option with strike 330 is trading at US$114.75. At the current Apple share price of US$424, This represents an option premium of about US$20.4. Taking out the dividend payout of US$2.65 per share every quarter, the actual option premium is only US$1.85 for 21 months. The carry cost of the option would be (2.65*4 + 1.85*(12/21)) = US$11.65/annum. This only amounts to 2.75% of the stock price. Not a bad deal for cheap leverage. At a target price of US$550 for Apple, I expect an upside potential of ~90% for this option, well in excess of my return requirement should things go well. But of course, things could go the other thing, with Apple falling to below US$400. In this case, my position could easily half. Options are a double edged sword. Nonetheless, I believe at these levels, the downside risk for Apple is fairly limited.

Investment Thesis

Income Statement (US$m)	2007	2008	2009	2010	2011	2012
Revenue	24,006	37,491	42,905	65,225	108,249	156,508
COGs	(15,852)	(24,294)	(25,683)	(39,541)	(64,431)	(87,846)
Gross profit	8,154	13,197	17,222	25,684	43,818	68,662
R&D	(782)	(1,109)	(1,333)	(1,782)	(2,429)	(3,381)
SGA	(2,963)	(3,761)	(4,149)	(5,517)	(7,599)	(10,040)
EBIT	4,409	8,327	11,740	18,385	33,790	55,241
Other income, gains and losses	599	620	326	155	415	522
Profit before Tax	5,008	8,947	12,066	18,540	34,205	55,763
Tax	(1,512)	(2,828)	(3,831)	(4,527)	(8,283)	(14,030)
Net Profit	3,496	6,119	8,235	14,013	25,922	41,733
CFO	5,470	9,596	10,159	18,595	37,529	50,856
Capex	(986)	(1,199)	(1,213)	(2,121)	(7,452)	(9,402)
FCF	4,484	8,397	8,946	16,474	30,077	41,454
No. of shares (diluted)	878	902	907	925	937	945
EPS	3.98	6.78	9.08	15.15	27.68	44.15
DPS	0.00	0.00	0.00	0.00	0.00	2.65
PE	106.68	62.66	46.81	28.05	15.36	9.63
Ex-Cash PE	106.68	62.66	42.68	24.40	12.21	6.75

First some quick numbers. I won't go on about how Apple has been a success. The point I want to make here is, take a look at free cashflow generation. After budgeting for Capex, Apple generates US$41bn of cash as of end FY2012. This is a money printing machine. Based on the most recent quarterly report, Apple has over US$130bn in cash on its balance sheet. This is about a third of its market cap. Ex-cash, Apple's trailing PE is a measly 6.75. Best of all, most analysts expect Apple's top and bottom line to continue growing, albeit at a slower rate. A value investor might say, what's there not to like? The problem is that this is Tech, and the Tech industry has a nasty habit of being unpredictable and changing too fast.

Harbor no illusions, Apple is indeed in a tight spot. The smart phone sector is becoming more competitive. Besides Samsung, who is gradually eating Apple's lunch, Chinese manufacturers Huawei and ZTE are entering the market with cheap and affordable models. Worse, smartphone designs are converging. Competitors have no qualms about copying the designs of the market leaders. Even in the tablet space, the other companies like Amazon and Samsung are catching up.

Nonetheless, I believe on a mid-term horizon, Apple has been oversold. Apple used to be the most popular stock among US hedge fund managers, and now that position has been overtaken by AIG. What was once the most favored momentum trade for hedge fund managers has now come to an end. Obviously, there were a lot of losses to be cut, and much selling to be made. Since the 52-week high in Sep 2012, the glamour and hype around the stock is gone. The momentum players would have largely exited leaving behind a more stable shareholder base. Unless the US market shows a significant correction, I do not think Apple will fall any further.

On a mid-term basis, there are a couple of good things going for the stock. Tim Cook, the current CEO, has initiated dividend payout and shown to be more shareholder friendly. Many analysts also believe dividend payout ratio will rise significantly from here. On the other hand, there has been an active push from David Einhorn, a prominent hedge fund manager, for Apple to return excess capital to shareholders. David is well known for been spotting financial frauds. In fact, he has been so successful that as a short seller that stocks get "Einhorned" when he talks publicly about them. I believe Apple will gradually pay out some portion of the cash from its balance over the next two years. That in itself will be a catalyst for share price appreciation.