With growth in Apple’s (NASDAQ:AAPL) iDevice sales slowing, the focus has shifted to new products that the company may be planning to launch this year. Last quarter, Apple saw its year-on-year iPhone sales growth slip to 7% from 30% in the prior year quarter, despite benefiting from a full quarter of availability in China and the addition of NTT Docomo as a new carrier partner in Japan. Apart from the high-end smartphone market becoming increasingly saturated, the fact that carriers in developed markets – such as Verizon and AT&T – are spending less on subsidies to boost their margins has also contributed to the slow iPhone growth in recent quarters. On the iPad front as well, the company is seeing sales stagnate as ASPs fall amid a growing sales mix of the lower-priced iPad mini. Apple’s iPad revenues last year were nearly flat as compared to the previous year. With both the iPhone and the iPad unlikely to drive sales growth significantly in the near term, investors are looking at new product categories that the company has said it will enter this year.
While the company hasn’t officially declared anything, there is wide speculation that Apple is working on a smartwatch accessory, dubbed the iWatch. Although these rumors have been around for some time now, Samsung’s launch of the Galaxy Gear smartwatch late last year has increased anticipation that Apple could launch a competing product this year. Such a move would not only help Apple expand its mobile hardware ecosystem but also mitigate the impact of a saturated high-end smartphone market. It would boost the iPhone’s appeal and help Apple defend its margins going forward. The watch industry, as a whole, supports gross margins in the 50-60% range, which is right in Apple’s comfort zone. In fact, assuming price parity with Samsung’s $299 Gear, we estimate that Apple has a bigger market opportunity to tap than rivals due to its larger base of high-end smartphone users (see Limited Upside To Samsung From The Smartwatch Experiment). Our $630 price estimate for Apple is about 20% ahead of the current market price.
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Smartwatches Right Up Apple’s Alley
The primary reason that smartwatches sound attractive for Apple is the potential for high margins similar to smartphones. The global watch industry is expected to have generated around $60 billion in revenues last year with gross margins as high as 50-60%, as evidenced by Movado and Fossil’s recent financial statements. While Movado’s gross margin in Q3 2013 was at around 53%, Fossil’s was a little higher at 57%. Both these companies have limited presence in the under-$75 mass-market category, which Apple is also not likely to target with its initial smartwatch launch.
If Apple manages to capture about 10% of the watch market – an ambitious target to be sure – it could amount to additional revenues of about $6 billion and gross profits of $3-$3.5 billion. From an operating perspective, EBITDA margins could range anywhere between 15-20%, again assuming operational parity with Movado and Fossil. Considering Apple’s greater supply chain advantage, it is possible that the iWatch margins turn out to be slightly higher. Our long-term estimates for Apple’s EBITDA margins are currently in the 24-25% range, so the iWatch business model would fit right in.
However, sizing Apple’s iWatch opportunity in terms of the current watch industry may not be completely accurate. Apple’s smartwatch is likely to be a companion accessory to be used in sync with the iPhone, and therefore may not appeal to a broad segment of users. It might lure non-iPhone users to potentially enter the iOS ecosystem down the road, but it makes more sense to look at Apple’s current iPhone sales or subscriber base to gauge the near-term market opportunity. Apple sold around 150 million iPhones last year, at an average selling price of around $600. This year, we expect the figure to grow by about 20 million as Apple benefits from the China Mobile deal and widens its carrier net to bolster its emerging market prospects. If about 15% of these buyers choose to purchase the iWatch, Apple could sell around 25-30 million smartwatches annually. At $299 apiece, the price at which Samsung has priced its smartwatch, the iWatch could net Apple $8-9 billion in additional revenues in its debut year.
We don’t believe that Apple would price a smartwatch significantly higher than $299 given that the cheapest iPad mini is available at the same price. If the iWatch is launched as a companion accessory to the iPhone, pricing it at more than half the latest iPhone’s price could prove too pricey for even the high-end Apple buyer.
Healthy $50 Billion Value-Add
Going forward, if Apple is able to persuade around 25% of its iPhone buyers to buy its smartwatch, there could be an upside of about $4-5 billion to our long-term EBITDA forecast. For our EBITDA estimates, we assume that iWatch’s gross margins would decline from around 55% initially to 45% by 2020 and that its ASP would drop by a CAGR of 5% over the same period, as Apple builds a portfolio of cheaper iWatches over time. This translates into a value addition of about $50 billion, or $50 per share (7.5% of our current price estimate).
While this would be a lot of value to be captured in absolute terms, an estimate of 30 million iWatch unit sales gradually increasing to over 60 million by the end of our forecast period (25% of 250 million long-term iPhone sales) is not as outlandish as it may sound, given that there are close to 600 million active iTunes accounts currently. Also, Apple is getting more aggressive in pursuing geography-specific opportunities with its recent decisions to re-introduce the iPhone 4 in India and China, and launch a cheaper iPhone 5C in certain European and Asian markets (see Apple Introduces Cheaper iPhone 5C Targeting LTE Growth In International Markets). This could open up emerging markets more to the iPhone, the halo effect of which which could boil over to the iWatch. Admittedly, however, fewer buyers in emerging markets would splurge on expensive accessories, limiting the iWatch potential there. Our estimates take into account the fact that iPhone sales are supported by high carrier subsidies in the developed markets. Smartwatches, on the other hand, are unlikely to be subsidized, which would hamper demand.