Shares of Apple (NASDAQ: AAPL) surged nearly 140% in less than two years to an all-time high above $134 in May. Since then, however, the world’s largest company by market capitalization has fallen into a bear market, dropping more than 20% from its peak as bulls and bears duel over a bottom.
This scenario is nothing new for long-time Apple investors, though, and this may be a great opportunity to buy shares at a discount.
I think Apple’s growing ecosystem, rock-bottom valuation and massive cash position provide three major incentives to own shares heading into 2016. Plus, with the strategy I have in mind, traders could book a 38% annualized return.
It’s Not a Product Cycle — It’s an Ecosystem
The bearishness around Apple stems in part from the fact that next year is expected to show the first annual sales decline for the iPhone and concerns over a lull in the product cycle.
But these fears may be overblown.
Apple is expected to unveil the iPhone 7 in 2016 following the launch of the iPhone 6C.
Upgrades to the Apple Watch and iPad Air are also expected in the first half of the year.
Meanwhile, it’s been more than two years since the Mac Pro was updated, and new code found in Apple’s OS X El Capitan suggests there may be a new workstation in 2016.
While demand for desktops has declined over the past few years, such a long period before a hardware upgrade could result in a huge number of orders.
Besides the potential for hardware upgrades to reinvigorate the product cycle, Apple is pushing hard on services and the enterprise side as well. The enterprise segment signed a partnership with IBM (NYSE: IBM) and booked year-over-year sales growth of 40% in the company’s most recent fiscal year, which ended in September. And sales for services like Apple Music, Apple Pay and the App Store grew 10% in fiscal 2015.
Apple also recently announced a partnership with China’s UnionPay, a state-controlled syndicate with a monopoly on all yuan payment cards issued in the country. The partnership will bring Apple Pay to China in 2016.
While growth of the payment service has been sluggish in the United States, the deal gives Apple access to UnionPay’s massive network of 260 million customers. Alipay, the leading third-party online payment service in China, which is run by Alibaba (NYSE: BABA), reports 300 million users — a sign that Apple may find a more willing market for mobile payments in China than it has so far in the United States.
One thing Apple has done marvelously over its history is draw people in with new products and services and convert them to loyal customers of existing products and services. Add it all up and even if iPhone sales are sluggish in 2016 earnings should continue to grow thanks to the company’s ever-expanding ecosystem.
Oversold Apple Looks Like a Bargain
After a 20% haircut, shares now trade for 11.5 times trailing earnings, which is just below its industry average of 11.6. However, on closer inspection, Apple may be trading at a much bigger discount.
While the company is classified as an electronics equipment retailer in the consumer goods sector, this doesn’t reflect Apple’s strength in software or media — sectors where investors are generally willing to pay more for earnings. Plus, shares are currently trading at a 25% discount to their five-year average P/E of 15.5.
Based on estimated fiscal 2016 earnings of $9.74 and the five-year average multiple, shares could be worth more than $150.
From when I sit, Apple is extremely attractive from a growth and value perspective, but that’s not all — it also is a cash-generating machine. Management has increased the dividend by an average of 11% a year since it was reinstated in 2012, yet they still have over $200 billion in cash on the balance sheet. Meanwhile, free cash flow is approaching $70 billion a year.
Apple has to figure out something to do with all that green, and a special dividend certainly isn’t out of the question. But rather than wait for management to pay up, I plan to create my own income stream.
Earn an Annualized 38% Return on Apple
By purchasing 100 shares of Apple and then immediately selling a call option on the position, we can generate a potential 38% annualized return.
With AAPL trading at $108.61 at the time of this writing, we can buy 100 shares and simultaneously sell one AAPL MAR 115 Call, which is trading around $2.52 ($252 per contract), for a net cost of $106.09 per share.
If AAPL closes above the $115 strike price at expiration on March 18, our shares will be sold for that price. In this case, we will make $6.39 in capital gains, plus the $2.52 we received for selling the calls and the February dividend payment of $0.52, for a total return of $9.43 per share. This represents a profit of 8.9% over our cost basis of $106.09. Since we’d earn that in 86 days, it works out to an annualized gain of 38%.
If AAPL closes below the $115 strike price, we keep the premium and the shares and can sell more calls to generate additional income.
The March expiration comes after the company’s first-quarter earnings release, expected in late January, so there is some room for headline events to move the stock price.
Earnings are expected to come in 6.2% higher year over year at $3.25 per share. Plus, we may get an update from management on the company’s products and plans for its mountain of cash — all of which should help spur a recovery in shares.
– Joseph Hogue
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Source: Profitable Trading