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Options Straddle/Strangle Trade for Ahttp://caps.fool.com/Blogs/AddNewPost.aspxpollo (APOL)

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November 08, 2009 – Comments (0) | RELATED TICKERS: APOL

I am thinking about doing a straddle or strangle trade for Apollo Group (APOL), the largest for-profit education company and the owner of the University of Pheonix.

Background: Two weeks ago, APOL stock plummeted almost 20% in one day when it was announced that the SEC was investigating them for some of their revenue recognition practices. The end result could be either the SEC finds nothing, which will likely cause the stock to return to pre-investigation levels, or the SEC does find something, which could result in serious damage to the company. I believe this is a case of a "binary outcome" - the stock is either going up or down a lot. If this is true, the probability of the outcomes is not in a standard distribution (bell curve), which is how the options are priced, so there may be some opportunity for profit.

The bull case: Just looking at the numbers in the financial statements, Apollo is very undervalued. It has grown revenues at 23% on average over the past 10 years (26.5% in 2009), is very profitable with a 60% ROE and 26% operating margin, and has a strong balance sheet with more cash than debt. Apollo has a very scalable business model - each course that is developed can be reused by any number of students, so that each additional student results in very high incremental profits, especially if they take their online courses. It is also the leader in for-profit education, which in a fairly stable industry that is probably not going away any time soon. The industry is even somewhat counter-cyclical since many unemployed people go back to school.

Most other companies with these kinds of stats would command very high valuations, but APOL is trading at 14.6 P/E and 10.4 P/FCF. A conservative DCF analysis gives me a fair value of about double times their current price. I found it interesting how low the CAPS score was (2 stars) for a seemingly high-quality company with an attractive valuation. If their business continues to succeed, this stock would undoubtedly be a huge winner. At these prices, it seems there is a lot of downside already priced in.

The bear case: On the other hand, Apollo has a history of unscrupulous behavior. It has already been investigated by the SEC in the past. From a comment in CAPS by FunesDMemorious, I found an article by Citron Research revealing some shady practices in their business that would be very troubling to me if I were a shareholder. In the worst case scenario, they could be found guilty of deceiving the Department of Education, resulting in their loans from the government being revoked, which currently makes up over 80% of their revenue. This would most likely destroy Apollo's business. I am not sure if the current SEC investigation has to do with these practices (not much detail has been released about it), but I could see them being interrelated somehow, in which case one investigation might lead to another. Also interesting is the huge amount of insider selling in the past year.

Conclusion: I don't feel like I know enough about the situation to take a side. But I do believe that the stock will move sharply. Right now, the stock price is trying to reflect APOL's fair value, which is the average of two extremes. Once the situation plays out, the stock should gravitate toward one of these extremes. It seems to me that a straddle or strangle option trade is the best way to profit in this case.

Let me know what you think. One question I do have is, how long do these investigations take (minimum/maximum time)?

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