Apple Is Tier 1

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"And, by the way, the bulk of the billions in Berkshire Hathaway has come from the better businesses. ... And most of the other people who've made a lot of money have done so in high-quality businesses."
-- Charlie Munger

At Tier 1 Investments, I seek out and invest in elite businesses. These include companies with the most valuable brands, best management, superior products and services, and strongest competitive advantages. I call these businesses Tier 1 enterprises, and no company fits that description better than Apple (NAS: AAPL) .

The world's most valuable brand
Renowned finance professor and valuation expert Aswath Damodaran has said that the value of a brand is directly correlated with a company's pricing power. All you have to do is compare the price of a Mac versus a PC with similar capabilities, and you can see clearly Apple's ability to charge a premium for its products. But Apple's brand also supplies the company with other advantages. The first is an informational advantage; consumers know that if they see an Apple logo on a product, it's going to be high-quality, stylish, and on the cutting edge of technology. Another advantage is the psychological concept of social proof. The more popular Apple becomes, the more people want to own its products and become part of the in-crowd. Fool co-founder David Gardner wrote in Rule Breakers, Rule Makers that "it's often the power of the brand that can create and sustain [a company's] success." I believe that's true, and the power of Apple's brand is undeniable.

Superior products and services
Apple's products consistently rank at the top of the list in terms of capabilities and customer satisfaction. The numbers bear this out. iPad sales surged 166% in the fourth quarter, and Mac sales rose 26% as Apple continues to gain share in the personal computer market. Most impressive of all is that Apple just recently reported that it sold 4 million iPhones in just three days.

Apple's products are not just great on a standalone basis; they operate in an ecosystem where owning one product makes owning other Apple products more valuable to the user. And the new iCloud service is a game-changer. It allows users to store their documents, music, and photos in the cloud and access their content on all of their Apple devices. This will increase the stickiness of Apple's already sticky products. Once people buy an Apple product, they'll be even more likely to remain an Apple customer.

A deep and wide moat
Apple has numerous competitive advantages. Perhaps its most glaring is its fortress-like balance sheet. Apple has more than $80 billion in cash and no debt. Even more impressive is Apple's cash-generation ability; the juggernaut earned more than $30 billion in free cash flow in the past year. Apple has been using its cash to purchase patents and advanced technologies such as its acquisition of speech-recognition company Siri, whose software is now an impressive new feature on the iPhone 4S. Apple's massive size also gives it scale advantages over its competitors, as well as purchasing power over suppliers. But I believe Apple's greatest competitive advantage is its culture of innovation. Good enough is not good enough at Apple. The company is constantly moving forward. It disrupts and even creates entirely new industries and has shown the uncommon willingness to cannibalize its own products with newer, even better products.

Even now, strong management
Steve Jobs was a visionary leader, and he rightly deserves all the praise that has been bestowed upon him after his death. Many people fear that Apple's incredible performance was directly tied to Jobs' ability as a master CEO. But I believe part of his brilliance is in instilling his beliefs and ideology in his people and the organization as a whole. New CEO Tim Cook was Jobs' hand-picked replacement and was Jobs' right-hand man for years. Cook joined Apple in 1998 and served as chief operating officer from October 2005 until being promoted to CEO. Cook is known as a supply-chain genius -- a skill-set that is becoming increasingly important as Apple's global operations continue to expand. Although Jobs was a once-in-a-lifetime CEO, I think Apple is in good hands with Cook leading the charge.

Risks and why I'd sell
I will not understate the importance of Steve Jobs to Apple. His resignation as CEO was jarring even though it was somewhat expected. Cook is an operational wizard and is well versed in Apple's culture. He served under Jobs for 14 years and ran the company's day-to-day operations during Jobs' medical leaves of absence three times since 2004. But the question remains: Can he drive innovation at Apple the way Jobs did? Can anyone? The answer may be no. But at the current stock price, I don't think the market is expecting much in the way of innovation.

So if Cook and Apple's deep bench of talented executives can keep delivering incremental improvements to Apple's existing products, shareholders should be well rewarded over the next few years. If Cook can drive innovation in a way that's anything close to what Jobs has done, than Apple shareholders will be very happy.

Apple also faces some external threats. Several formidable competitors are gunning for the company's market share in multiple businesses. Google's (NAS: GOOG) Android is the market leader in smartphone operating systems, and Amazon.com (NAS: AMZN) just recently entered the tablet market. And of course, Microsoft's (NAS: MSFT) Windows is always a threat. These are top-tier companies and not to be taken lightly. I've accounted for these threats (and others) in my valuation. But if these rivals do more harm to Apple's business than I anticipate, I'll recommend selling Apple.

Valuation
Many look at Apple's $400 stock price and nearly $370 billion market cap and wonder how much bigger the company can get. But the more important question is what's driving Apple's growth now -- and what will drive it in the future. I see big things ahead for Apple's products, its international sales, and its role in business. Once you look at these catalysts, you see that Apple is worth much more than what we're paying for it today.

Valuation is an inexact science, especially for a dynamic growth company like Apple. But I ran Apple through an intensive valuation process, looking at factors like sales growth rates for the iPhone, iPad, Mac, iPod, and iTunes, as well as the impact that competition from Google, Amazon, and Microsoft could have on average selling prices. Using what I believe are conservative estimates, I arrived at a valuation of about $500 per share. But keep in mind that my valuation doesn't account for much innovation. So Apple could potentially be worth a lot more if the company can create a blockbuster new product such as an actual Apple TV, which could boost Apple's revenue and earnings by billions of dollars.

The Foolish bottom line
Apple is one of the best companies in the world, and the recent pullback in the share price makes the stock even more of a bargain. That's exactly the type of opportunity I look for at Tier 1 Investments, and so I will be buying shares, making it the first holding in my Rising Stars portfolio.

Next steps:

  • If you'd like to follow along with Tier 1 Investments as I build out the rest of my portfolio, keep checking back in with my Rising Stars page, which is updated with all of my buy recommendations.
  • Keep track of Apple's share price and breaking news by adding Apple to My Watchlist.

At the time this article was published Joe Tenebruso is short put options on Apple. The Motley Fool owns shares of Microsoft, Apple, and Google. Motley Fool newsletter serviceshave recommended buying shares of Microsoft, Apple, Amazon.com, and Google, as well as creating bull call spread positions in Microsoft and Apple. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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