Apple’s New Launches Look Good, But Don’t Expect Large Upside From The Watch Yet

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On Tuesday, Apple (NASDAQ:AAPL) announced a pair of large-screen iPhones, a new mobile payment service and a wearable device – dubbed the Apple Watch – which is the company’s first new product category since the launch of the iPad. Anticipation of the new product launches was largely responsible for driving up Apple’s stock price by over 20% this year and by the looks of the it company met expectations, with the stock remaining largely flat at the end of Tuesday’s trading. While the iPhone update is an incremental, although meaningful, upgrade to a mature product,  it should give shipments a boost since it fills a void in Apple’s phone lineup and marks the company’s entry into the fast growing large-screen mobile phone market. While the mobile payment and watch bets look impressive, displaying Apple’s typical attention to detail and ease of use, they are in effect an upsell to the company’s existing users and will have to compete in markets in which few companies have found success in the past. Below is an overview of the company’s new products and how they are likely to impact its performance going forward.

Trefis has a $97 price estimate for Apple, which is about in line with the current market price. We will be updating our model to account for the recent product introductions.

See our complete analysis for Apple here

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Shipments and ASPs Could Rise As iPhone Enters Phablet Territory

Apple finally launched two large-screen versions of its iPhone – the iPhone 6 and iPhone 6 Plus, which will sport screen sizes of 4.7 inches and 5.5 inches, respectively. The devices will come with a refreshed design, faster A8 processors, improved cameras and near field communications (NFC) connectivity. Large screen sizes have been a key driver of smartphone sales of late, as users increasingly choose to consume media and use their phones for more productivity-focused applications. The lack of a large screen device is likely to have been a liability for Apple in the past, as many high-end customers have been flocking to premium large-screen Android phones from vendors such as Samsung (PINK:SSNLF) who have made large screens the centerpiece of their smartphone strategies. However, with the launch, Apple will effectively fill up the void in its smartphone lineup. Accordingly, we believe that the company could see a stronger upgrade cycle given the possibility of pent-up demand from consumers who were holding off from buying new phones in anticipation of larger iPhones. Moreover the phablet market (typically phones with screen sizes of 5.5 inches and above) is expected to be the fastest-growing segment of the smartphone market, with IDC forecasting phablet shipments to grow at a CAGR of around 60% between 2014 and 2018. In comparison, sales of regular smartphones are expected to grow at an annual rate of around 5.5% in the same period. [1]

With the two new handsets, we believe that the iPhone product line could also see higher average selling prices. Apple will maintain its usual $649 (off-contract) price point for the iPhone 6 with 16 gigabytes (GB) of storage capacity, while pricing the iPhone 6 Plus at $749 onwards. While Apple has typically launched iPhones in 16 GB, 32 GB and 64 GB capacities, charging a $100 premium and $200 premium for the higher storage models, the company is offering its new flagships in 16 GB, 64 GB and 128 GB models, eliminating the 32 GB model. This should have a positive effect on the company’s average selling prices, since we believe that many customers would likely pay the $100 premium for the 64 GB model. This could have a beneficial impact on gross margins as well, since we estimate the incremental cost of a 64 GB model over a 16GB model to be less than $30. While the large screen sizes and new design could translate to slightly higher manufacturing costs compared to previous flagship iPhones, we believe that any impact of this should be offset by the higher ASPs.

Apple Pay Could Aid Margins, But Increasing Merchant Participation Will Be Key

Apple also entered the mobile payments fray with its Apple Pay offering, which allows customers to make payments at both brick-and-mortar as well as online stores. The service will use NFC technology and will be compatible with the company latest iPhones and the Apple Watch. While there have been several efforts targeted at the mobile payment space – which is expected to touch $100 billion in the United States over the next 5 years, according to Forrester Research – most ventures have failed to gain significant traction. However, we believe that Apple has a good shot at success for multiple reasons. Firstly, the company has been able to form key alliances that are required for payments systems. Apple Pay will work with leading retailers including Macy’s, McDonald’s and Whole Foods in addition to other merchant locations across the United States that have contactless payments enabled. ((Apple Announces Apple Pay, Apple, September 2014)) Apple has also partnered with the big three payment networks (American Express, MasterCard  and Visa) as well as some of the country’s most popular banks, which together account for 83% of transaction volume. Secondly, Apple’s tightly integrated model of controlling both the hardware and software of the phone, as well as some dedicated hardware such as Secure Element (a chip that stores encrypted payments information) and Touch ID authentication, should help to ease security concerns and make consumers more comfortable with mobile payments. Thirdly, unlike previous efforts in the mobile payment space which were confined to particular handset models and cellular networks, [2] Apple Pay will be carrier-agnostic, and will use the company’s latest flagship phones which are likely to see a strong installed base going forward. This could eventually encourage more vendors to upgrade to NFC systems and support the company’s service.

According to the Wall Street Journal,  the card-issuing banks have agreed to pay a per-transaction fee to Apple for payments made though Apple Pay. Banks typically collect fees from merchants for each credit card transaction that they process. [3] Overall, we believe that the Apple pay service could have a reasonably positive impact on the company’s profitability, given the potentially high-margin nature of transaction fees. However, scaling up the merchant base is likely to be a key near-term issue. While the company claims that it has lined up 220,000 merchants that will accept Apple Pay, this number represents less than 2.5% of all merchants who accept credit cards in the United States. [4]

Apple Watch Looks Impressive, But Don’t Expect A Very Meaningful Value Upside

Apple entered the wearable technology space with its first smart watch, dubbed the Apple Watch. While the device will fundamentally provide a gateway to an iPhone – allowing users to receive notifications, send messages, access maps and use Siri, Apple’s digital assistant –  it will also offer health and fitness features and the ability to run its own apps. The watch will have a starting price of $349 and will hit stores in early 2015. The watch will be offered in three styles and two different sizes and will be compatible with various iPhone models beginning from the iPhone 5. While the Apple Watch is certainly impressive, the wearable technology market remains in its infancy, and smart watches have yet to sell in large numbers. Global shipments of smart watches and activity trackers stood at around 2.9 million units as of Q1 2014, according to ABI Research. [5] In comparison, about 300 million smartphones were shipped globally during the same period. Several companies including Samsung have been participating in the smart watch space, but none of the products have been big critical or commercial successes, plagued primarily by poor user interfaces, weak battery life and lack of meaningful use cases. While Apple’s device addresses some of the design and interface issues of previous smart watches and adds a solid set of fitness features, we believe that its battery life and the perceived incremental utility that it offers beyond a smartphone will determine its uptake in the market.

Either way, we don’t expect the Apple Watch to add very significantly to Apple’s near-term sales or current valuation, given the company’s large size. For instance, we have modeled Apple’s CY 2015 iPhone sales at around 190 million units. Assuming that one out of five iPhone buyers purchases the watch, it would translate to sales of about 38 million units for the year. Assuming sales of the base version of the watch, priced at $349, this would translate to additional revenues of about $13.3 billion. This barely moves the needle in terms of Apple’s top line, considering that we are projecting CY 2015 revenues of around $187 billion. While estimates of the watch’s bill of materials and manufacturing costs are not available yet, we think it is safe to assume that its gross margins should at least line up with Apple’s average given the company’s scale and efficient supply chain. Although volumes could grow further as prices decline and use cases become clear, we think it’s unlikely that the watch category will be as big as the iPhone or iPad divisions in the near term.

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Notes:
  1. A Future Fueled by Phablets – Worldwide Phablet Shipments to Surpass Portable PCs in 2014 and Tablets by 2015, According to IDC, IDC, September 2014 []
  2. Apple’s Push Into Mobile Payments, New York Times, September 2014 []
  3. Can Apple Solve Riddle of Mobile Payments With Apple Pay Service?, WSJ, September 2014 []
  4. Apple Pay Is Here — and There’s Just One Big Problem, Time, September 2014 []
  5. Apple Boss Makes His Boldest Bet Yet, WSJ, September 2014 []