Apple Inc. Remains Tier 1

Bears are drastically underestimating this tech titan's growth potential.

Mar 31, 2014 at 7:00PM

At Tier 1 Investments, a Motley Fool Real-Money Portfolio, 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. It's an investment philosophy that has handily out-performed the market, with Tier 1 earning a time-weighted return of 74.63% since inception on Sep. 1, 2011, compared to the S&P 500's 62.41% return during that time.

Back in October 2011, I chose Apple (NASDAQ:AAPL) to be Tier 1's first holding, and a month later I added to my position. At the time, I felt that no company fit the description of a Tier 1 enterprise better than Apple, as the company had the world's most valuable brand, products that consistently ranked at the top of the list in terms of capabilities and customer satisfaction, a fortress-like balance sheet, tremendous cash-generation ability, and a renowned culture of innovation. That all remains true today.

Yet shares are down more than 20% from their all-time highs as skeptics question whether the company can continue to innovate, especially after the loss of visionary leader Steve Jobs. Bears will argue that Apple's days of supercharged growth are long gone, and that with several of its key markets saturated and competition clawing at its margins, continued earnings growth will be a very challenging endeavor for the once mighty Apple. These bears will further say that without Steve Jobs at the helm, the days of Apple disrupting entire industries with game-changing new products are over, and, at best, all Apple fans can hope for is a monotony of "evolutionary" product iterations.

If Apple's stock was a high-flying market darling, I might be more concerned about the bear argument. But that is far from the case. At about $540 per share, Apple is trading at a less than 13 times analysts' earnings estimates for 2014 and less than 12 times consensus estimates for 2015. If we back out the $159 billion in cash and investments  on Apple's balance sheet, those P/E multiples shrink to 9 and 8, respectively. At current prices, it does not appear that we're paying for any new product upside. To the contrary, I believe Apple's earnings power from its existing product lineup is being overly discounted by the market. Apple's price-to-earnings ratio of 13 represents about a 30% discount to the P/E of the S&P 500. Said another way, the market is assigning Apple a P/E multiple less than the average S&P 500 company. But, with the No. 1 brand in the world (recently valued at $104.6 billion by brand identity firm Brand Finance), nearly $160 billion in cash on its fortress-like balance sheet, $45 billion in annual free cash flow, returns on equity of 29%, 28% operating margins, and 21% net margins – Apple is anything but average.

What Apple's discounted P/E tells me is just how concerned investors are about Apple's ability to grow revenue going forward. And in that fear lies our opportunity.

While bears continue to lament Apple's recent dormant stretch of new product launches, Apple appears set to unwrap several very interesting products and services. CEO Tim Cook has been hinting at "new products in new categories " in 2014. Well, we're about to enter the second quarter of 2014, and here are some potential game-changers we might be in store for in the months ahead:

iWatch and wearable products
While unlikely to drastically move the needle for Apple, Morgan Stanley estimates this as a $17.5-billion-a-year market . Recent reports suggest that Apple may be adding health monitoring technology to the device, which could boost its utility and lead to higher demand than many investors are currently expecting.

A new Apple TV
The long-rumored, almost mystical Apple TV appears to be getting closer. Will it be an actual TV made by Apple or a set-top box-like device? That remains to be seen. What we do know for sure is that Apple TV generated more than $1 billion in revenue during Apple's last fiscal year, turning what was once a "hobby" into a full-fledged (although small by Apple standards) business. With Apple recently offering a $25 iTunes card with the purchase of an Apple TV, it appears that the tech titan may be clearing out inventory ahead of what, at the very least, should be an upgraded version of the device. But with Apple bringing on Comcast cable veteran Lauren Provo, and, according to The Wall Street Journal, attempting to secure long-term deals to secure Internet infrastructure, the signs point to Apple unveiling something even grander in the months ahead.

A payments service may be the furthest away from being launched, but could also be the most important new service for Apple. Forrester Research predicts that Americans will spend $90 billion through their phones and tablets using these services in 2017. Taking significant share in a fast-growing market of that size could be a true needle-mover even for a behemoth like Apple. It won't be an easy fight, but as suggested by Business Insider, with 600 million Apple IDs on file, most of which are linked to a credit card; fingerprint sensor technology that could be used to authorize and secure payment information; and Apple's iBeacon, iCloud keychain, and Passbook applications that could all help to further facilitate mobile shopping, Apple could be a force to be reckoned with in the payments arena.

Add these potential new products and services to recently announced initiatives such as CarPlay, which further strengthens Apple's ecosystem, and you can begin to see that the future may be far brighter for Apple than the bears will have you believe.

Tier 1's strategy
I want to increase Tier 1's ability to profit alongside Apple, before the skeptics realize their mistake. To do so, I will be selling "mini" puts on Apple. With this option strategy, I will be paid a premium to enter a contract to buy 10 shares of Apple at a specified time and price. Specifically, I will be selling the Apple January 2015 $550 puts, currently trading at about $55 per share. If Apple is trading at or above $550 on the Jan. 17, 2015, expiration date, the puts will expire worthless. And the $550 I receive in premium ($55 per share times 10 shares) will amount to an approximately 10% gain on the $5,500 at risk ($550 per share times 10 shares).

If Apple is trading below $550, I will be obligated to purchase shares at an adjusted price of $495 ($550 strike price minus the $55 per share in premium), or about 8% lower than today's $540 price. I think it's also important to note that I would be buying Apple in January 2015, after the company will have had time to grow its earnings and cash flow. So, in effect, I would be buying shares of an outstanding business at an even better valuation than is possible by simply buying shares today. And, importantly, I'd be very happy to purchase Apple shares at that adjusted $495 price.

Finally, between the time I sell the puts and the expiration date, I will have the option of buying back my puts or rolling them to other strike prices and/or expiration dates. And so, with this put writing strategy, there will be many ways to earn a profit.

The Foolish bottom line 
Apple remains one the most dominant businesses in the world and I believe that the market is undervaluing its future growth potential. While its stock may not be the rocket ship it once was, I find its valuation to be very attractive and its downside quite limited. And so, at least 24 hours after this article is published -- standard operating procedure for The Motley Fool's Real-Money Stock Picks program that's designed to give Fools the opportunity to buy ahead of us should they so choose -- I will be writing Jan. 17, 2015, $550 puts on Apple in hopes of profiting from the continued success of this Tier 1 enterprise.

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Joe Tenebruso manages a Real-Money Portfolio for The Motley Fool and is an analyst on The Fool's Stock Advisor and Supernova premium service teams. You can connect with him on Twitter @Tier1Investor. Joe has no position in any stocks mentioned.

The Motley Fool recommends Apple. The Motley Fool owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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