After we’ve finished picking on Tesla Inc. (TSLA) – twice actually, over the past week alone – it’s time for us to move to the next flower from which we might be able to drink some bearish/defensive nectar, as we are adding some hedges to our portfolio against a market potential reversal in the coming months.

Sure thing, when you’re a bee flying from one flower to another, looking for yummy nectar, things don’t always end up the way you would like them to.

(Source: Bee Movie)

Similarly, investors who are around long enough know that sometimes things don’t work out just as you planned, and instead of drinking delicious nectar, you end up drinking the Kool-Aid.

Nonetheless, we believe that in this case, where we’re picking on Apple (AAPL), we’re more likely to have an happy end, just as is the case with the “Bee Movie”.

Here’s how and why.

The Trade

Just like The Decision by Lebron James, we are going to make this very special (though without ESPN getting involved this time round) and, without further ado, make the special announcement regarding The Trade:

(Source: Wheel of Fortune, Trading alert, January 7th 2020)

Yes! We do call a top on Apple; well, sort of…

Before we move to the arguments supporting this trade, here’s how this trade looks like, using a screenshot from Charles Schwab (SCHW):

And here’s the P&L diagram, again using a screenshot from Schwab:

Until 4/17/2020

The truth is, the above chart is good only for illustrative purposes, so here are the exact relevant levels (until 4/17/2020):

AAPL Price AAPL 04/17/2020 360.00 C AAPL 01/15/2021 300.00 C Total P&L*
<=$300 Expire worthless Expire worthless $3,055
$330.55 Expire worthless ($3,055) Break-Even
$360 Expire worthless ($6,000) ($2,945)
>$360 (Price-360)*100 GAIN (Price-300)*100 LOSS ($2,945)

*Including all premium received/paid; Based on one contact sold on each side of the trade.

As you can see, we are having about 10% cushion until this trade breaks even (at $330.55). Our maximum gain is limited to $3055, but the maximum loss is also capped at $2945 (per the above screenshots).

However, another important aspect is the different dates we’re using here.

Volatility, for itself, isn’t too high (to say the least) from a historical perspective. (As an option seller, you wish the implied volatility to be as high as possible to maximize your premium.)

ChartData by YCharts

However, when we combine the share price with volatility – there hasn’t been a better time, post the subprime crisis era, to sell options on Apple as it’s now. Below you can see the ratio of AAPL share price to its 30-day rolling volatility.

Data by YCharts

As such, we’re happy to be sellers of options right now.

However, while we sell a long-dated (1/15/2021), lower-strike ($300) CALL, we are buying (as a protection) a short-dated (4/17/2020), higher-strike ($360) CALL. That way, we pay a relatively small amount on hedging the risk, capping our loss (only till 4/17/2020, and subject to certain assumptions) to less than 10% (see more details below).

Post 4/17/2020

What will happen after 4/17/2020? There are two main options (pun intended) we may choose from:

  • Close the long-dated CALL at or before 4/17/2020 so that we remain with no (naked) exposure. This would be relevant if AAPL drops by a lot till then, and we can cash out by taking much/most of the profit (over only 1/4 of the time to expiry)
  • Buy another protective CALL at the then-prevailing prices and roll this trade, hedged the same way (more or less), for another period. We may choose a different strike (than $360) and/or a different tenor (than 101 days), but the concept remains the same.

The point to keep in mind is: We wish to pay as little as possible (for the protection) and be in place to cash out, if and when we wish to, with maximum flexibility on how we decide to play this going forward.

This is the reason why this Call Spread is called Diagonal: Not only are the strikes different (Vertical), but the expiry dates different too (Diagonal).

Risk Aspects

Of course, if we reach 4/17/2020 and we decide to buy another protective CALL, it would cost us something – an amount that we can’t determine right now. This, by itself, will reduce the maximum gain that this trade might potentially fetch, and it may even become so pricey (to buy another CALL) that if we choose to do so, the entire potential gain will be lost.

For example: If AAPL trades at $359 on 4/17/2020, the $300 CALL (that we just sold) will be trading well above $60 and the $360 CALL (that we just bought) will expire worthless. At that point, we might need to either buy back (to close) the $300 CALL at a price that might be as high as $90 or buy a new protective call (with a $360 or higher strike) that may cost up to $30.

The point is, while the loss until 4/17/2020 is allegedly capped at 10%, it’s only so under the assumption that AAPL will keep trading at no more than $300/share (perhaps slightly higher). In such case, the maximum loss is indeed ~10%. However, if the stock keeps rising, it’s possible that the loss will get bigger and we assume that it might reach about 20% under the (extreme) scenario that we’ve drawn above (i.e., AAPL trading at $359/share on 4/17/2020).

Nevertheless, since up to 20% is a normal downside potential for almost any trade that one might execute, we assign a risk rating of 3 for this trade, as we don’t see it being more risky than any other trade with an average market risk.

The Ten Commandments / Arguments (against Apple)

Why do we expect AAPL to stall very soon, and why are we quite comfortable to call a top in here? For various reasons: ten arguments, to be more precise, and here is the full list:

1. Apple is no Bitcoin

This is already an absurd valuation, based on what we wrote last week:

Last but not least: Bitcoin (BTC-USD)! Hmmm, sorry, my bad! Not Bitcoin, but Apple.

Why the confusion, you ask? Because it seems that AAPL is trading in a similar pattern and volatility to the ones we used to see out of the cryptocurrency.

Why so? Because if that wasn’t the case, it wouldn’t be perfectly fine for a company named after a fruit to add $100 billion to its market cap every month, on average, over the last couple of months.

Don’t believe me? Here’s how Apple’s market cap has grown over the years.

Only $86 billion is missing for AAPL to reach the $1.4 trillion market cap mark. Can the company break its own record, which has been set only a week ago (on the last trading day of 2019), and reach this milestone in less than 25 days?

ChartData by YCharts

In this “anything-can-happen” type of market, we can’t rule that out. For that to happen, AAPL needs to trade at about $320/share. Less than 6.5% away, i.e., within a hair/day to two.

2. Unprecedented insanity

It’s Tim Cook’s Apple, not Elon Musk’s Tesla, we’re talking about. Trading at no less than $300/share… with over a 100% price (not total) return over the past year (+/-)!

That, folks, is insane!

Data by YCharts

I mean, how many times have you see a company worth over $1 trillion moving from trading 40% below its highs, making a new record high, over a period of only twelve months!? Let me give you a hint: There’s only such case in the history of Wall Street.

ChartData by YCharts

3. Growth is already slowing and is expected to slow further down the road.

Apple revenue for the twelve months ending September 30, 2019 was $260.174 billion, a 2.04% decline Y/Y.

To put that into perspective:

  • Apple’s FY 2018 revenue was $265.595 billion, a 15.86% increase from 2017.
  • Apple FY 2017 revenue was $229.234 billion, a 6.3% increase from 2016.

Using analysts’ revenue estimates for the coming years, the growth rate is expected to be about 5.5% (per annum), well below the company’s historical average.

Data by YCharts

4. Declining profitability is not supporting the rising valuation

EPS is in the exact same position as revenue, even after estimates for upcoming years have been lifted recently (following the last quarter’s earnings) by a wide margin.

Next fiscal year might show an improvement of $1.86, but the following year will only see a $1.14 rise.

Data by YCharts

It’s important to note that even these improvements are not due to Apple’s operational results, but entirely attributed to the company’s repurchase program (We will touch upon this hereinafter, in details).

After all, over the past twelve months, ending on 9/30/2019, Apple’s operating and net income have fallen by 10% and 7% (!), respectively.

ChartData by YCharts

How come such operational results support such a jump in the stock price!?

5. P/E ratio at post-subprime crisis high

Never before (Take 1) has Apple traded at such a hefty multiple. This is the highest current and forward P/E since Lehman Brothers collapsed!

Data by YCharts

6. EV/EBITDA at post-subprime crisis high

Never before (Take II) has the EV/EBITDA ratio, current and forward alike, been as high as it is now.

ChartData by YCharts

7. Technically speaking, AAPL is overvalued

The stock is trading at least 20% above its long-term rising channel (and likely fair value – see next point).

Data by YCharts

8. Fair value is well below the current market price

About a year ago (1/3/2019 to be precise), AAPL lost almost 10% in a single trading day and suffered a 39% drawdown, after issuing its first profit warning in 16 years. The stock has rallied 114% since then and now has a market cap of over $1.3 trillion.

Here’s the full chart of the unreal performance over the past 54 weeks, starting with a 39% decline, which was then followed by a 114% gain.

Yeah, that’s perfectly normal. Just another day in the office…

Furthermore, AAPL is up about 74,000% since its IPO in 1980, translating into an annualized return of ~18.4%.

Add to that a new all-time high today, of course… and it’s more like an 18.5% CAGR right now…

Apple Returns since its IPO on 12/12/1980. AAPL is up about 74,000% since its IPO in 1980, translating into an annualized return of ~18.4%.

But what is the fair value for AAPL now, based on everything we now know? Bullish, if you ask both the authors that write on this platform…

(Source: Seeking Alpha, Author Ratings)

… as well as those who write outside of this platform:

(Source: Seeking Alpha, Sell Side Ratings)

From a trading perspective, we can live happily ever after with the average price target of $273.60 and even with the median price target of $282.50.

What we find a bit funny is to see Needham, for example, downgrading Apple from Strong Buy to “just” a Buy, yet raising the price target from $280 to $350, a new Street high.

Over the past year, you can see that more and more analysts have moved from the sidelines (Neutral rating) and taken a stand. Interestingly though, both the bulls (greenish bars) and the bears (reddish bars) have received more votes, at the expense of the yellow bar.

Over the past 13 years, the highest P/E multiple of AAPL was 25.26x, the lowest was 9.32x, and the median was 15.39x.

Combining this data with the projected EPS for the coming years, of $13.09, $14.86, and $16.00, we get the following scenarios:

(Source: Author calculations)

Being reasonable, and looking to keep everybody happy, we believe that the base-case scenario is the one that brings AAPL back to its historical multiple of around 15x.

As such, we assign a fair value of between $201.46 and $246.24 to the stock, with $228.54 being the official target, for the record. That implies a downside potential of about 24% compared to the current price of the stock at about $300/share.

Nonetheless, we can’t rule out that the market would take the stock down only to the $246.24 area, which only implies an 18% downside potential.

As we wrote in the article on Tesla:

We don’t suggest anyone to short the stock. First of all, we believe that in order to short a stock, one needs to have a 20% downside potential at the very minimum. Secondly, a stock that’s benefiting from such a hype should be left alone, at least until the current, short-term enthusiasm fades away. Thirdly, when one is shorting a stock, it’s much more prudent to do that against a long position which is similar in nature. At this point in time, we don’t feel that such a counterpart candidate exists

So, we’re not shorting the stock straight, however we do lean towards the bearish side, and we’re looking to benefit out of a potential decline.

9. Apple is likely to become less aggressive with its buybacks

Many are asking how can it be that the price of a mega-cap stock like AAPL doubles in a matter of a year, especially when neither its financial results (during that year) nor market expectations (going forward) suggest that this is even remotely justified!?

ChartData by YCharts

The answer is quite simple and it’s a combination of few aspects, which are related to one another, in Apple’s playbook:

  • Huge pile of cash, a result of both profitability and growing debt
  • Ability to borrow at ridiculous rates, thanks to the Fed’s policy
  • An aggressive repurchase program that has enabled the company to reduce the number of outstanding shares substantially.

As a result, over the past seven years, Apple put about 1/3rd of its outstanding shares to sleep, using buybacks that have grown from literally nothing to circa $70 billion for the twelve months ending on 9/30/2019.

By the way, Apple is the ultimate queen mother of buybacks, no matter what time frame you look at: Q3 2019, TTM, or past 5 years.

Apple’s $247.8 billion worth of buybacks over the last 5 years is more than tripling or quadrupling (!) the amounts spent on buybacks over the same period by the five companies that are ranked 2-6 among the top 20 list:

  • Microsoft (MSFT): $74.5 billion
  • Oracle (ORCL): $74.5 billion
  • Wells Fargo (WFC): $69.0 billion
  • JPMorgan Chase (JPM): $68.9 billion
  • Bank of America (BAC): $60.8 billion

(Source: Goldman Sachs)

Thing is, in spite of the Apple’s ability to borrow at near-zero cost, thanks to the Fed’s monetary policy (see here, here, and here), when you use so much money to buy back your own stock, it might run out if the pace and magnitude are so extreme.

Over the past decade, as a direct result of its aggressive buybacks, fueled by profits but also by debt, the company has seen its net cash position (gross cash minus debt) shrinking.

At the end of Q3 2019, this net cash position stood at “only” $95 billion (all relative, yeah? It’s still Apple we’re talking about) – the lowest level since 2011!

ChartData by YCharts

The company still has $79 billion of potential buybacks under its current authorized repurchase program, but according to Barron’s, this huge (buybacks) party might become a smaller party soon enough.

Its shares now yield 1%. Apple could take a more-balanced approach and double its dividend while cutting back the annual buyback program by $15 billion to around $52 billion. That would result in a 2% dividend yield, in line with that of the S&P 500 index (SPY).

ChartData by YCharts

If, and when, Apple indeed reduces the amount it’s allocating to buybacks, that’s a major event, possibly a game-changer. True, even $52 billion is a huge amount that most companies don’t even dare dreaming their market-caps reaching to, but it’s still a 25% cut that would certainly take some steam off.

10. There’s no such thing as a bad time/day to start playing some good defense

We don’t mind start adding some hedges when the market is quite stretched and certainly not cheap as a whole.

It’s not only the longest bull market in history without a 20% drawdown (on a closing basis)…

… but it’s also a market that:

  • Trades near its all-time high; and

  • Has many investors that won’t like to wait and see their 11 years of phenomenal gains start shrinking, if and when.

ChartData by YCharts

Bottom Line

There’s no real need to have an official, separate “bottom line” for this piece, as we have already given it to you in full:

  • Apple trading at $300 is pure insanity.
  • Operational results don’t support this valuation, no matter how you look at stock – past, present, or future.
  • The only reason this is happening is massive buybacks that are likely to get cut soon.
  • Fair value is below $300, according to most analysts, and surely according to our calculations.
  • Nonetheless, the downside potential isn’t big enough to warrant a straight short-selling of the stock.
  • Therefore, opening a Diagonal Call Spread seems both timely and prudent.

Nevertheless, you just received one… and with that, our job explaining this trade has come to an end.

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

Additional disclosure: Short AAPL 01/15/2021 300.00 CALL
Long AAPL 04/17/2020 360.00 CALL

TipRanks: Sell AAPL.

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