Ignorant options
The Stock Exchange website states: “Options are financial instruments whose value is not autonomous but derives from the price of an underlying asset of various kinds (real, as in the case of raw materials such as wheat, gold, oil, etc., or financial, as in the case of shares, bonds, exchange rates, indices, etc.). The term “derivative” indicates this dependence. We can therefore define options as financial contracts that give the purchaser the right, but not the obligation, against payment of a price (premium), to exercise or not the right to buy (Call) or sell (Put) a given quantity of a given financial asset, called the underlying, on or before a given expiry date and at a given strike price.”
Options have many advantages, including having significant leverage over the risk capital invested (making them very speculative) and allowing the investor to implement various investment and hedging strategies. 
There are, however, important disadvantages. The first is the often exorbitant cost, both in terms of trading commissions and the illiquidity of some instruments that lead to significant gaps between bid and ask. The second is the time component which greatly reduces the probability of realizing a capital gain.
The market often offers the possibility of investing in call options without incurring high costs or having time limits. These opportunities are given by stocks that have very high leverage and where the equity component has gone almost to zero. At one time these cases were relegated to companies close to bankruptcy but today there are several cases where we have quality companies whose equity component in EV tends to zero. Although these stocks should still be considered significantly riskier than the average listed company (the risk varies greatly depending on the case) and weighted accordingly, we believe that this group of companies often has extremely attractive risk/return profiles (high risk but even higher return potential) and offers an attractive alternative to a simple speculative call option.
Below we give just a few examples of these ignorant options, of which there are in fact many on the market.
Telecom Italia. Even after KKR’s bid and the attention it has attracted, the stock has a capitalisation of around €8.5 billion and net debt of €27 billion. This gives an enterprise value of €35.5bn, with equity accounting for only 24% of that. The company is now trading at 5.6x EBITDA (only 2.6x, however, excluding Brazil, Inwit, Fibercop, Noovle and tax losses). A rerating of just 20% of this multiple, from 5.6x EBITDA to 6.7x EBITDA, would double equity. If there were no rerating, but the company maintained an FCF yield of around 15% (telephone rates are already very low today, so it is likely to succeed), in just over 6 years the company would replace 8.5 billion of debt with equity, leading the stock to double again. On the downside, given the political and strategic implications of a company owning the fixed-line network of a major country, we believe the possibility of the stock going bankrupt or being subject to super-dilutive capital increases is very limited (but not zero). In the latter case, if the investor has been careful not to expose himself too much, he will be able to take part in it, avoiding dilution and finding himself with a less upside but more solid stock. As you can see, the risk-benefit profile looks interesting. Exposure to the savings share, which pays 7% (if the company is profitable) is probably the best choice.
Japanese regional banks. All banks are options as we wilfully learned during the great financial crisis of 2008. Today most banks (excluding those in the US) trade below tangible equity despite the fact that the business is much less risky and the capital is much stronger. Some fifteen years of forced expiation by the regulator, we believe, is enough and the sector is ready to return to “normal” valuations. No business survives if it does not earn its cost of capital and banks are gradually getting there, even in a difficult economic environment with zero interest rates. We therefore believe that inevitably this sector will return to trading above tangible equity. For many institutions this means doubling. The downside is certainly related to loan losses which, given the leverage of the business, could theoretically lead to the destruction of all capital. However, as mentioned, today’s banks are much more diversified and solid and this hypothesis, although not to be excluded, seems remote. So the risk/benefit profile of the sector is very interesting. There are also niches that deserve special mention and certainly stand out as attractive options. We are referring here to Japanese regional banks, companies that on average are not covered by analysts and trade at between 0.1x and 0.25x tangible equity despite being profitable, having solid capital and paying dividends. In addition, the sector is subject to a flurry of consolidation. We engage with this sector on a daily basis to drive improvements in ESG factors with excellent results and we believe this will attract the interest of other investors. We see a particularly attractive option opportunity here.
Veon. Another phone caller. No wonder. If banks have been in purgatory for 15 years, telephone companies have been for more than 20 years. In the already devastated industry, Veon is to the other telephone companies what poor Anna Karenina is to the high school girls in the film ‘Apple Time’. Although legally Dutch, the company has a 50% exposure to the Russian market, an economy that as we know, is going through a difficult phase for political reasons. It is also exposed to Ukraine (no comment…) and Kazhakistan (no comment…). It is also exposed to other Central Asian economies that are not doing well, such as Pakistan, Turkmenistan and Uzbekistan. Finally, it is exposed to Bangladesh, the only area that is not currently causing concern. In the past, to underline how unfortunate the company is, it was exposed to the terrible Italian market (through Wind) and other geopolitically unstable countries such as Algeria and Egypt. At one time this exposure was viewed with great interest, given the strategic importance of the sector and the demographics in these areas. After 10 years of emerging currency devaluation, geopolitical and economic issues, investor interest in the emerging and frontier region has plummeted. Veon is well managed and represents an important asset in the areas in which it operates and therefore benefits from some attention from governments. The company is also well diversified, which protects it from nasty surprises. However, its 50% exposure to the Russian market represents a substantial risk. The company is worth around $2.5bn on the stock exchange and has net debt of around $8.2bn. So the enterprise value is $10.7 billion and the equity represents 23%, similar to the value we have on Telecom Italia. Yet, here the debt is only 2.5X the EBITDA vs 4X for Telecom Italia. This offsets the higher cost of its debt. The company has EBITDA of $3.7 billion, trades at 2.9x EV/EBITDA and pays a dividend of over 12%. A rerating of EV to 5x EBITDA would cause equity to quadruple (5×3.7=18.5 18.5-8.2=10.3 10.3/2.5=4.1x). Again, the ignorant option looks interesting.
Carpe malum
The apple is an exceptional fruit. It is rich in mineral salts and vitamins of the B group; therefore, it is good for the intestinal mucous membranes and the mouth, prevents the impoverishment of nails and hair, fights tiredness and lack of appetite. In addition, its citric and malic acids contribute to the wellbeing of the person, particularly the digestive system, because they facilitate digestion and maintain acidity. Finally, it is easy to grow, tasty, cheap and, above all, keeps for a very long time at the right temperature. Its namesake in consumer electronics also proves to be quite long-lived and absolutely beneficial. In fact, its exceptional upward trend has turned $1,000 invested 20 years ago into $1.5m. 
The results released on Thursday are very good. What do they tell us? They tell us that thanks to gorilla shoulders and a good organisation, logistical problems have not affected Apple and the company has benefited from this by gaining market share. They tell us that all it takes is a modest increase in market share and a reduction in investments to make Free Cash Flow explode. This is in absolute terms. In relative terms, even optimistically annualising a bombshell quarter, we “only” arrive at a decent FCF of 5%. We are then told that 33% of active mobile phones are now Apple (1.8 billion). Considering that there are about 800 million active users in Western countries and almost half of them have iPhones, it turns out that of the 4.5 billion active users in emerging countries, over a quarter are Apple. This is an incredible achievement given the cost of its devices. It is the result of an exceptional brand that makes it capable of forcing the personal budgets of many individuals just to own it. Clearly it can hardly grow from here in terms of penetration. However, if these 1.8 billion active users manage to make them spend more on services the leverage is there, but at 25x profits (only a small discount compared to 20x ebitda as it has no fixed assets to depreciate) this leverage seems already priced in.
The company would like to turn 1.8 billion iPhone users into service consumers. In fact, only half of all iPhones in use are paying subscribers to one or more of Apple’s services. Now let’s dream and put ourselves in the shoes of the stock buyer who wants an upside. Let’s look at the opportunities. Let’s assume that all active Apple phones become paying subscribers (compared to, as we said, a scant half today). Let’s further assume that the current average amount paid by subscribers doubles. This means that each Apple phone owner will pay about $200 per year for Apple services, compared to the $100 paid on average by half of Apple phone owners today. A lot considering most of its active phones are in Emerging Countries. We can say the blue sky scenario. It would be another 150 bln USD per year of top line which at 60% operating margin would be 90 bln USD which taxed would come to about 72 bln USD of higher net profit, so a total profit of 170 bln USD. This would bring the P/E down from 25x to 16x, not a particularly low multiple for a very optimistic assumption… In fact, thinking that growth like the one just assumed in services will be realised is difficult, with the regulator pushing to limit the fees it charges on third-party apps purchased. Assuming even greater growth than the assumption just made implies a certain amount of fantasy.
To see an upside in the stock today, you have to not only discount strong growth in iPhone-related services, but also discount strong growth in new areas where the company can leverage the Apple brand. This makes sense, but so far Apple have not been able to innovate their phones, let alone imagine something new! Cook is not Jobs. He is an administrative man with great political skills, a formidable manager without much imagination. Let us remember that he is the one who in 2017 did not even grant a meeting to Elon Musk who wanted to sell him Tesla at 5% of what it is now worth…
On the negative side, Apple’s risk is represented (as is often the case) by the very factor that gave it the opportunity to become and remain hegemonic in its segment: lack of competition. We wonder if the release of the new Google Pixel 6 phone does not represent the awakening of a giant (Alphabet) that seemed to have made a non-competition agreement with Apple. This new phone takes advantage of a great brand, is technically equal to or better than the iPhone and costs less. Introduced in November, it was very popular, but there were not enough units due to a chip shortage. As chance would have it, it comes out when the agreement between Alphabet and Apple allowing Google to be the search engine for Safari (for a payment of USD 15 billion per year) seems to be on the verge of collapse for antitrust reasons. Another powerful giant with an appealing brand, Sony, seems to have chosen to not really compete with Apple to sell them millions of sensors (e.g. the IPhone 13 has three Sony sensors). The Xperia PRO-I, the Xperia 1-III and the Xperia 5-III are great phones. They are just priced at unreasonable levels and no advertising is done. But the more Apple’s cash-flow grows, the more potential competitors might want a piece of the pie and not just settle for the crumbs. We find companies like Sony and Alphabet much more attractive in terms of growth potential (eating market share from Apple could be very profitable…), lower risk (both are much more diversified than Apple) and valuations (they trade at 8x and 15x EV/EBITDA respectively versus Apple’s 20x). To think of LVMH launching a phone at the top end is less than unthinkable, as are many others. Let us remember that making a mobile phone today is much less complicated than in the past. As Apple teaches us, it is no longer necessary to manufacture directly or invent something new.
As with value, 80% of the effort is in finding the positive inflection point, i.e. when the stock turns up, starting a positive trend, so with growth, 80% of the effort is in finding the negative inflection point, i.e. when the stock turns down, starting a negative trend. Apple seems close to this inflection point and in any case the risk/reward profile is not attractive in our view. As mentioned above, the potential upside does not seem comparable to the downside. However, the last part of a trend is always the most violent and irrational. It’s the part that breaks the legs and makes those who are resisting the trend throw in the towel, and it’s the part that brings in (or takes out) the last big wave of investors. Let’s remember that Apple has surprised the market to the upside for two decades now. It represents the forbidden fruit for those who short stocks. Anyone who has dared to touch Apple and gone short has felt the fires of hell. Including us who, although we do not go short, have stayed away from investing our clients’ savings here.
Just as all it takes for apples to lose their freshness is to raise their storage temperature a little, Apple would only need to lose a little market share to see its valuation painfully downgraded. For now, however, market share continues to rise and, as the great Horace teaches us, it is only fair that shareholders enjoy the forbidden fruit today.
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