Listen Up by DED

So, you listen to me and you listen well. Are you behind, on your credit card bills? Good. Pick up the phone and buy LEAPS. Is your landlord ready to evict you? Good. Pick up the phone and buy LEAPS. Does your girlfriend think you’re a fucking loser? Good. Pick up the phone and buy LEAPS! 

I want you to deal with your problems, by buying LEAPS!

Apple 10-Year Thesis by DED

Summary

Apple has disclosed the approach it will take to cash management in light of the new flexibility in the US tax code. The company has full access to its $285 billion today. Grasping the size and extent of Apple's cash stockpile and its ability to generate additional cash is awe-inspiring and not well-understood. By 2026, a share price of $500 and $11.50+ annual dividend per share is not really a stretch.

A Tale Of Two Reactions

In the after-hours session on Thursday, Feb. 1, 2018, following Apple's Q1 FY18 earnings release, shares initially dipped 2-3%. However, as investors digested the information and CEO Tim Cook and CFO Luca Maestri went through the conference call, shares recovered, ending the evening session up about 4%, around $174. The next day in normal trading, amidst the backdrop of a large general market decline, Apple stock was slammed as the shares fell to $160.5. At the time, that was the lowest closing price for the year.

I believe Thursday's after-hours traders grasped the profound news from the conference call in a way that traders the next day did not. Some of the analysts that follow the stock touched on the paradigm shift in Apple's use of cash, but few have had the chance to update their financial models and grasp all of its implications. This article will explain what the traders in the later hours of the extended session on Feb. 1 appeared to intuitively have understood.

No More "Foreign" Cash And Apple's Plans

Due to the Tax Cuts and Jobs Act (TCJA), Apple now has access to all of what used to be its foreign cash. The company has stated that it will pay $38 Billion in repatriation fees in accordance with the law. Many analysts and investors are still thinking under the old paradigm that Apple can only access the cash on which the repatriation tax has been paid. That is not how the new law works. It is a "deemed repatriation" with the 15.5% tax on past foreign earnings due according to a specified schedule over the next eight years. Apple has full access to all $269 Billion of its "foreign" cash today.

Maestri and Cook provided a conceptual framework for how the company is viewing its capital return program and cash management in light of the new law and the company's full access to its cash pile. Maestri stated, "We are targeting to become approximately net cash neutral over time."

Later in the call, he expounded, "And so we are now in a position where we have $285 billion of cash, we've got $122 billion of debt for a net cash of $163 billion. We have now the flexibility to deploy this capital. We will do that over time, because the amount is very large. As I said earlier, we will be discussing capital allocation plans when we review our March quarter results. And when you look at our track record of what we've done over the last several years, you've seen that effectively we were returning to our investors essentially about 100% of our free cash flow. And so that is the approach that we're going to be taking."

Summing up the discussion at the end of the earnings call, Cook stated, "What Luca is saying is not cash equals zero. He's saying there's an equal amount cash and debt, and that they balance to zero. Just for clarity."

Simple assessments may look at the $163 Billion in net cash and attempt to project an impact to the capital return program and future business decisions based on that sum alone. But that is only part of the equation, and actually, the minority part. Apple has a business model that generated $47.7 Billion in Free Cash Flow (FCF) in FY17 and is on track to generate $54 Billion+ in FY18. A long-term analysis of how Apple gets to a cash neutral position as Cook/Maestri indicated over time must also consider all of that FCF.

Capital Return Forecast/Proposal

This article outlines a conservative plan for the capital return consistent with Apple's stated objectives. It then provides a comprehensive financial impact assessment that helps reveal the profound impact that the company's pursuit of its stated goals for cash management will have for shareholders. It represents one long-term shareholder's thoughtful recommendation for the board and executives, covering an 8.75-year period through the end of Fiscal 2026.

Here are the major assumptions and tenets of the program:

  • Apple executes the Cook/Maestri plan with the now repatriated funds over the next eight years, decreasing the $163 Billion in net cash to approximately $0. For simplicity, it assumes a debt balance close to current levels at the end of the time period.
  • Net income, following the initial lift from lower taxes in 2018, grows at a rate of 6.9% annually through 2026, consistent with the growth since introduction of the iPhone 5 and Apple's expansion in China.
  • Free cash flow follows net income growing 6.9% annually 2018-2026.
  • The modified FCF in the model builds in the continued acquisition of new small businesses at the current rate + 6.9% additional per annum.
  • Apple pays its $38 Billion repatriation tax per the statutory schedule.
  • Apple front-loads the share repurchases. 18th (taking advantage of lower per share prices). It spends $84 Billion for repurchases in FY18 and an amount that declines by 10% annually in each of the ensuing eight years, leading to $36 Billion in buybacks for FY26.
  • Apple increases its quarterly dividend by 50% for 2018 and 15% for every year thereafter, maintaining a yield in the 2.0-2.3% range.
  • Purchases of stock for Net Share Settlement total $2.1 Billion in 2018 and increase 6.9% per annum through 2026. This results in no impact on share count for the stock-based compensation.
  • Apple's trailing Price/Earnings (PE) multiple hovers around 15.6. While this seems significantly under-priced relative to the market and its technology mega-cap peers, it is what investors seem to be willing to pay for AAPL, so I won't argue that one here.

Capital Return Program's Impact

  • Share count drops from 5.18 Billion at the end of FY17 to 3.21 Billion at the end of FY26, a 37.8% decrease in shares outstanding.
  • Quarterly dividend reaches $2.89/share, $11.56 annually. The payout ratio by 2026 would amount to about 38% of modified FCF.
  • Apple's market capitalization would surpass $1 Trillion by the end of 2019 and reach $1.6 Trillion by the end of 2024, a 7.5% Compound Annual Growth Rate (CAGR) from current levels ($160.5/share), in line with likely broad market returns.
  • With the constantly declining shares outstanding, Apple's share price would reach $492 per share by the end of FY26, a CAGR of about 13.8% from the end of FY17, well ahead of likely market returns.
  • Earnings per share in 2026 would total $31.6 with the reduced share count.

Conclusion

Most long-term Apple shareholders would be quite happy with a $500 share price and an almost $12 annual dividend rate by 2026. This proposal is a forecast that follows the outlines of the cash use philosophy CEO Tim Cook and CFO Luca Maestri discussed in the Feb. 1, 2018, conference call.

When the market closes on Monday, Feb. 5th, the quarterly blackout period for Apple's share buybacks will end. It will be prime time for Apple's cash machine to get back to work and take advantage of the misplaced reaction to the company's Q1 FY18 results. The company has $44 Billion in buyback authorization remaining until April's capital return update, and it should buy as much as possible in the range of $155/share. Investors might consider whether they should too.

Primary Principles Of The Program

  1. Front Load. It is very beneficial for Apple to front-load the buyback program. This maximizes the impact for long-term shareholders. My proposal is for a minimum of $84 Billion in share repurchases in FY18. This takes advantage of the low share prices of today for a greater reduction in the number of shares over the eight-year window. Others may recommend a larger repurchase in 2018, but I believe $84 Billion is in the sweet spot. Apple can realistically execute it within the guidelines of statutory and SEC limitations. It is also not so large as to raise the ire of political backlash against the whole program.
  2. More Dividends. Apple should get its dividend up to par with other large-cap companies. Since the financial crisis, S&P 500 yield has hovered between 1.8% and 2.2%. The long-term average is 4.36%. Implementing the 50% increase this year and 15% over the time horizon keeps Apple in line with the post financial crisis S&P average and maintains flexibility to increase the dividend should rates or inflation move significantly higher.
  3. Reasonable (Conservative) Growth Expectations. 6.9% annual growth in net income following the large tax reform stimulated bump in 2018 reflects the level of net income growth Apple delivered since the iPhone 5 launch. Moreover, the future for Apple looks very bright. 6.9% income growth may be too low, given the strong growth in high margin service revenue, the resurrection of iPad unit growth, continued increases in global iPhone demand, expected growth of the middle class in emerging markets, especially China and India, transition to 5G over the nine-year time horizon, likely introduction of one or two additional new product categories, and continued solid management of spending and expenses. Keeping the analysis conservative, however, it seems like a very reasonable number

LEAPS Masterclass: Options Scenario #1 - The Basics by DED

Option Scenario #1 - The Basics

A call is merely the right—but not the obligation—to buy a stock at a specified price for a limited period of time. So a June call to buy APPLE at $140 per share gives the owner of the call the right to buy APPLE at a price of $140 per share gives the owner of the call the right to buy APPLE at a price of $140 per share until the call expires in June (the third Friday of each month is considered the expiration date for listed options). If at the expiration date APPLE stock is trading at $148, the call would be worth $8. This is because the right to buy stock at $140, when the stock can be immediately resold for $148, is worth $8. If, on the other hand, APPLE stock is trading at only $135 on “the call’s expiration date, then the call expires worthless. This is because the right to buy stock at $140 (usually referred to as the strike or exercise price) isn’t worth anything if everyone can just go out into the marketplace and purchase the same stock for $135. Well, that just about covers the basics—except there’s one more step.  

Pretty much whenever the stock market is open, the options market is also open. There aren’t listed options available for every stock that trades, but options do trade on thousands of the largest companies. Therefore, if a stock has listed calls, you can usually buy and sell them during market hours up until their respective expiration date. In our example, the June $140 calls to buy APPLE stock were trading for months prior to their June expiration. We’ve already discussed what the call would be worth on its expiration date. The question is: What is the fair value of the call before the expiration date? To be more specific, how much should you pay for the calls if you buy them in April, approximately two months before they expire?

Let’s assume that APPLE is trading at $148 in April, two months prior to June expiration. We already know that, if it were the third Friday in June, these APPLE calls would be worth $8. In April, however, these calls are worth more than $8. They’re more likely to be trading closer to $11.375. Why? There are really two reasons. First, the owner of the calls doesn’t have to lay out $140 for another two months, yet he is entitled to all of the stock’s appreciation until June. Think about it. If APPLE stock were to gain another $10 per share by June expiration, then APPLE would be trading at $158. The owner of stock (since April) would have a gain of $10 on his $148 investment. On the other hand, if the APPLE June $140 calls could be purchased for only $8 in April, then the owner of an $8 call option would also make $10 in the same two-month period. (That’s because, on the expiration date, the owner of the call could purchase stock at $140 and sell it for $158; after subtracting the $8 initial cost, the profit would be $10.) This result wouldn’t be fair.

After all, the owner of the stock laid out an additional $ 140 for the same amount of profit. The owner of the call received the upside in APPLE’s stock without having to invest an additional $140. To compensate for this, the amount of interest that could have been earned on the $140 for the two months until expiration should be reflected in the price of the call. It is. Assuming a 6-percent interest rate, the interest earned on $140 would be approximately $1.40 per share. So, in addition to what’s known as the intrinsic value of the call—the amount by which the call is already in the money (in our example, the difference between the market price for APPLE of $148 and the exercise price of the call of $140, or $8)—an imputed interest rate for the amount of money the call buyer didn’t have to lay out for the two months is also included in the call price. That’s how we move from a call price of $8—the intrinsic value of the call—to approximately $9.40—the value of the call including the interest on the $140 the buyer of the call didn’t have to lay out.

But I said the call should trade at approximately $11.375. What accounts for the nearly $2 difference between the $9.40 we already figured and the actual price of $11.375? Clearly, there has to be another benefit to owning calls—and there is. The buyer of the call can only lose the amount of money invested in the call. While this doesn’t sound all that great, when you compare it to owning the common stock of APPLE, it is. This is because, at the June expiration date, if APPLE stock falls to $140 per share, the owner of the call loses his original investment of $11.375. If APPLE stock falls to $130 per share, the owner of the call loses the same $11.375—at $120 per share, or even $80 per share, the call owner only loses $11.375. Sounding better yet?”

It’s pretty obvious what happens to the poor owner of APPLE stock in this scenario. At a price of $140 at the June expiration date, the APPLE holder is down $8 from his April purchase price of $148. At a price of $130 in June, he’s out $18; if APPLE’s at $120 he’s out $28; and at a price of $80—the loss gets really ugly—he’s out $68 per share. See, there is an added benefit to owning the calls—it’s the benefit of not losing any more money after the stock falls below the strike (or exercise) price of $140 per share. What’s that worth? Well, in this case, it’s probably worth about $2. So, if you pay the $2 in “protection money” as part of the purchase price of the calls, then your cost of $9.40 moves closer to the $11.375 price we talked about before. The $2 cost for assuming the risk below $140 is actually the same as the cost of the put option.

The bottom line is that buying calls is like borrowing money to buy stock, but with protection. The price of the call includes your borrowing costs and and the cost of your “protection”—so you’re not getting anything for free, but you are leveraging your bet on the future performance of a particular stock. You are also limiting the amount you can lose on the bet to the price of the call.

That’s why buying LEAPS, which are merely long-term options, can be an attractive way to trade your investment ideas.

While LEAPS don’t have an unlimited life, they can usually be purchased up to two and a half years before they expire. This often gives ample opportunity for the stock market to recognize the results from an extraordinary corporate change (like a spinoff or restructuring) or a turnaround in fundamentals (like an earnings gain or the resolution of an isolated or one-time problem). Additionally, two and a half years is often enough time for many just plain cheap stocks either to be discovered or to regain popularity. Since current tax law favors holding investments for more than one year, buying LEAPS is also a way to receive long-term capital gains treatment while receiving the leverage benefits of an option investment.

In most cases, your decision to invest in LEAPS will simply be a by-product of your ongoing research efforts. Before you even begin thinking about LEAPS, a special situation or an undervalued stock will catch your attention as an attractive investment in its own right. Only after an investment passes this first hurdle will you bother to check whether a chosen investment situation has LEAPS available for trading. At the very least, being able to compare the risk/reward of a stock with the opportunities available through an investment in the related LEAPS will provide you with another good investment choice.

Thanks,
Matt


This is for education purposes only, past performance is never indicative of future results, this is not advice, nor am I or OP responsible for anything you do in your own account so don’t be dumb because it’s on you.  This is a social network for traders not Goldman Sachs.

Excerpt from the New York Times Bestseller, The Big Short by DED

These are the sections of the book which first gave me the idea to apply LEAPS to Apple.  Which is what eventually led me to Steve.


As he scrambled to find office space, buy furniture, and open a brokerage account, Mike Burry received a pair of surprising phone calls. The first came from a big investment fund in New York City, Gotham Capital. Gotham was founded by a value investment guru named Joel Greenblatt. Burry had read Greenblatt’s book You Can Be a Stock Market Genius. (“I hated the title but liked the book.”) Greenblatt’s people told him that they had been making money off his ideas for some time and wanted to continue to do so—might Mike Burry consider allowing Gotham to invest in his fund? “Joel Greenblatt himself called and said, ‘I’ve been waiting for you to leave medicine.’” Gotham flew Burry and his wife to New York—and it was the first time Michael Burry had flown to New York or flown first-class—and put him up in a suite at the Intercontinental Hotel…

…what happened next led Jamie & Charlie, almost by accident, to the unusual approach to financial markets that would soon make them rich. In the six months following the news of its troubles with the Federal Reserve and the Office of Thrift Supervision, Capital One’s stock traded in a narrow band around $30 a share. That stability obviously masked a deep uncertainty. Thirty dollars a share was clearly not the “right” price for Capital One. The company was either a fraud, in which case the stock was probably worth zero, or the company was as honest as it appeared to Charlie and Jamie, in which case the stock was worth around $60 a share. Jamie Mai had just read You Can Be a Stock Market Genius, the book by Joel Greenblatt, the same fellow who had staked Mike Burry to his hedge fund. Toward the end of his book Greenblatt described how he’d made a lot of money using a derivative security, called a LEAP (for Long-term Equity AnticiPation Security), which conveyed to its buyer the right to buy a stock at a fixed price for a certain amount of time. 

There were times, Greenblatt explained, when it made more sense to buy options on a stock than the stock itself. This, in Greenblatt’s world of value investors, counted as heresy. Old-fashioned value investors shunned options because options presumed an ability to time price movements in undervalued stocks. Greenblatt’s simple point: When the value of a stock so obviously turned on some upcoming event whose date was known (a merger date, for instance, or a court date), the value investor could in good conscience employ options to express his views. It gave Jamie an idea: Buy a long-term option to buy the stock of Capital One. “It was kind of like, Wow, we have a view: This common stock looks interesting. But, Holy shit, look at the prices of these options!

 The right to buy Capital One’s shares for $40 at any time in the next two and a half years cost a bit more than $3. That made no sense. Capital One’s problems with regulators would be resolved, or not, in the next few months. When they were, the stock would either collapse to zero or jump to $60. Looking into it a bit, Jamie found that the model used by Wall Street to price LEAPs, the Black-Scholes option pricing model, made some strange assumptions. 

For instance, it assumed a normal, bell-shaped distribution for future stock prices. If Capital One was trading at $30 a share, the model assumed that, over the next two years, the stock was more likely to get to $35 a share than to $40, and more likely to get to $40 a share than to $45, and so on. This assumption made sense only to those who knew nothing about the company. In this case the model was totally missing the point: When Capital One “stock moved, as it surely would, it was more likely to move by a lot than by a little.

Cornwall Capital Management quickly bought 8,000 LEAPs. Their potential losses were limited to the $26,000 they paid for their option to buy the stock. Their potential gains were theoretically unlimited. Soon after Cornwall Capital laid their chips on the table, Capital One was vindicated by its regulators, its stock price shot up, and Cornwall Capital’s $26,000 option position was worth $526,000. “We were pretty fired up,” says Charlie.

“We couldn’t believe people would sell us these long-term options so cheaply,” said Jamie. “We went looking for more long-dated options.”

It instantly became a fantastically profitable strategy: Start with what appeared to be a cheap option to buy or sell some Korean stock, or pork belly, or third-world currency—really anything with a price that seemed poised for some dramatic change—and then work backward to the thing the option allowed you to buy or sell. The options suited the two men’s personalities: They never had to be sure of anything. Both were predisposed to feel that people, and by extension markets, were too certain about inherently uncertain things. Both sensed that people, and by extension markets, had difficulty attaching the appropriate probabilities to highly improbable events. Both had trouble generating conviction of their own but no trouble at all reacting to what they viewed as the false conviction of others. Each time they came upon a tantalizing long shot, one of them set to work on making the case for it, in an elaborate presentation, complete with PowerPoint slides.


This is for education purposes only, past performance is never indicative of future results, this is not advice, nor am I or OP responsible for anything you do in your own account so don’t be dumb because it’s on you.  This is a social network for traders not Goldman Sachs.

LEAPS Masterclass: Day 1 Summary by DED

The term LEAPS is nothing more than an acronym for a long-term option contract (Long-term Equity Anticipation Security). 

The bottom line is that buying calls is like borrowing money to buy stock, but with protection. The price of the call includes your borrowing costs and and the cost of your “protection”—so you’re not getting anything for free, but you are leveraging your bet on the future performance of a particular stock. You are also limiting the amount you can lose on the bet to the price of the call.

While LEAPS don’t have an unlimited life, they can usually be purchased up to two and a half years before they expire. This often gives ample opportunity for the stock market to recognize the results from an extraordinary corporate change (like a spinoff or restructuring) or a turnaround in fundamentals (like an earnings gain or the resolution of an isolated or one-time problem). Additionally, two and a half years is often enough time for many just plain cheap stocks either to be discovered or to regain popularity. Since current tax law favors holding investments for more than one year, buying LEAPS is also a way to receive long-term capital gains treatment while receiving the leverage benefits of an option investment.

In most cases, your decision to invest in LEAPS will simply be a by-product of your ongoing research efforts. Before you even begin thinking about LEAPS, a special situation or an undervalued stock will catch your attention as an attractive investment in its own right. Only after an investment passes this first hurdle will you bother to check whether a chosen investment situation has LEAPS available for trading. At the very least, being able to compare the risk/reward of a stock with the opportunities available through an investment in the related LEAPS will provide you with another good investment choice.

Reading Material:

You Can Be A Stock Market Genius - Joel Greenblat

Understanding LEAPS - Allaire

What is included in this course:

1.  6 weeks, 3 days a week (Tue, Wed, Thurs), 2-hour sessions @8pm EST.

2.  24/7 access to me via phone or email regarding leaps.

3.  When the six weeks is over, I will be your leap buddy and see u through until u are comfortable on your own.  You are not trading in a box - I will be there until u succeed.

Please email me (matt@optionsplayers.com) with any questions or concerns.  

Thanks,

Matt


This is for education purposes only, past performance is never indicative of future results, this is not advice, nor am I or OP responsible for anything you do in your own account so don’t be dumb because it’s on you.  This is a social network for traders not Goldman Sachs.