After Samsung Electronics’ (PINK:SSNLF) Galaxy Gear launch earlier this week, investors will be closely following Apple’s (NASDAQ:AAPL) Sept. 10 media event for its potential entry into new product categories. While a cheaper iPhone is expected, Samsung’s smartwatch launch makes it likely that Apple will have a similar announcement to make either this year or the next. Such a move will not only help Apple expand its mobile hardware ecosystem but also mitigate the impact of a high-end smartphone market nearing saturation. To be sure, we expect the smartphone market to expand at a faster rate than the overall mobile phone market as smartphones cannibalize feature phone sales. However, most of that growth is going to come from the low-end in the emerging markets where profit margins are low and being rapidly eaten into by rising competition.
Offering an attractive smart accessory like a smartwatch will boost the iPhone’s appeal as well as 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 due to its larger base of high-end smartphone users. (see Limited Upside To Samsung From The Smartwatch Experiment) Our $600 price estimate for Apple is about 20% ahead of the current market price.
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$9 billion market opportunity
The reason why smartwatches sound attractive for a company like Apple is because of the potential to have high margins similar to smartphones. The global watch industry is expected to generate around $60 billion in revenues this year with gross margins as high as 50-60%, as evidenced by Movado and Fossil’s recent financial statements. While Movado’s gross margins last quarter was at around 54%, Fossil’s was a little higher at 57%. The reason we have chosen these companies is because they 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, 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 a little higher.
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 hence may not appeal to a broad segment of users. It may therefore make sense to look at Apple’s own iPhone sales or subscriber base to gauge the market opportunity. We estimate that Apple will have sales of about 150 million iPhones this year with an average selling price of around $600. If about 20% of these buyers choose to purchase the iWatch as well, Apple could sell as many as 30 million smartwatches annually. At $299 apiece, which is what Samsung has priced its smartwatch at, the iWatch could net Apple $9 billion in additional revenues in its debut year.
Considering that Apple’s user base is more on the higher end, the iWatch could find a good number of takers. Going forward, if Apple is able to lure 30% of its high-end customers into purchasing its smartwatch, there could be an upside of about $7 billion to our long-term EBITDA forecast. For our EBITDA estimates, we assume the iWatch’s margins declining from around 55% initially to 45% by 2020. This translates into a value addition of about $60 billion, or $60 per share (10% of our current price estimate).
It may seem like a big value to be captured in absolute terms. But our estimate of iWatch sales of 30 million units gradually increasing to over 75 million by the end of our forecast period (30% of 250 million long-term iPhone sales) is actually pretty conservative considering that there are close to 600 million active iTunes accounts currently. Also, the launch of the cheaper iPhone could open up the emerging markets to the iPhone potential, the halo effect of which which could boil over to the iWatch as well. Admittedly, however, not many buyers in emerging markets would splurge on expensive accessories, limiting the iWatch potential there. Our conservative 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 temper their demand.