Better authors than I have tackled the question of what Apple (NASDAQ:AAPL) as a company is worth and whether it is a good investment so this article will have a smaller scope. It will look specifically at the (strongly) rumored Apple iWatch and what effects it could have on Apple.
Is there an iWatch?
There has been no official announcement from Apple that they are working on an iWatch, but there have been a number of promising clues.
Various senior Apple figures have made dropped what can be seen as hints to the development of the iWatch (at least when taken in context with the other clues). When discussing the future of consumer technology, Bill Campbell (an Apple board member) said "When you start to think about glasses or watches, they become as intimate as the cell phone was".
Apple has trademarked the iWatch name in a number of countries and hold patents for a flexible wrist mounted display (for those of you who remember the 90s - think a high-tech slap band). On their own, these are proof of little more than Apple's ability to innovate and prepare for the future, but they add to the other clues. The patents also provide a tantalizing hint that the iWatch might not follow the traditional gadget on a wrist strap pattern that watches have followed since they stopped living in pockets but that the wrist strap would be the gadget. If true, this would give the iWatch a lower profile and larger usable surface area which would increase the user appeal. The patents and manufacturing head start could provide an excellent moat against competitors moving into the wristband segment.
Recent hiring and acquisition by Apple also supports the thesis they are working on an iWatch. Paul Deneve (former CEO of Yves St. Laurent) is leading "special projects". It is possible that he was merely hired for his luxury branding expertise (as Apple faces similar problems to YSL in needing to convince consumers they are worth the premium price) but as an iWatch would be the most permanently visible Apple product (believe it or not, even the most addicted iPhone user keeps it in their pocket more than their hand) someone who understands fashion would be an asset to the project. Another key hire with related experience is Jay Blahnik. The fitness guru was heavy involved in the Nike (NYSE:NKE) Fuel Band, which suggests Apple is looking to use the iWatch to increase their presence in the rapidly growing smart fitness market. Apple has also been hiring fingerprint authentication experts and former employees of medical sensor companies.
Overall it looks highly likely that Apple is at least attempting to develop some sort of wearable technology which seems likely to be a watch - at least in the sense that it will be worn on people's wrists.
What will the iWatch do?
Speculating about what the iWatch will do is fun, but probably meaningless. I will admit to spending far longer than I should have dreaming up things I would want a smartwatch to do. However, I came to the conclusion that the exact features do not matter. There are two reasons for this. Firstly, different users have different killer apps. I am excited by the prospect of various health and fitness applications as the current iteration of self-measurement/analysis tools are all somewhat lacking or rely too much on manual input. For my friend, the ability to get unmissable notifications of phone calls/emails and check texts without taking his phone out of his pocket prompted him to get a Pebble. He wishes it could do more though, and an iWatch almost certainly will. Secondly, Apple is smart enough and good enough at design that whatever the iWatch does it will either be better than what is already out there or will do a much wider variety of things, or very possibly both. You can find more than enough informed (and uninformed) speculation on the Internet anyway so there is no need for me to add to it.
Market potential of the iWatch
This section will focus on the direct potential of an iWatch to add new revenue to Apple's bottom line. To estimate this, we need to produce two numbers - how many people will buy an iWatch and how much profit Apple will make on each unit.
We shall start with the sales. This is an important number in its own right as even if Apple merely breaks even on the first year of iWatch sales (which is unlikely given their past successes) they are building smartwatch market share for the future and wrapping the users up tighter into the Apple "universe"(discussed further in the intangible benefits section).
One way of estimating the market size for an iWatch is to assume that it will only be of interest to existing Apple phone customers. Assuming this will also help prevent rampant optimism in making our volume estimates. Deciding how many customers Apple has is actually harder than it sounds. There are 250 million iCloud accounts so this will be a useful first estimate (and a sanity check on other estimates). There are an estimated one billion smartphone users in the world. Approximately 29% of these smartphones are estimated to use iOS. This suggests there are roughly 290m Apple phones in use. So this gives us a potential market of 250m to 290m.
Predicting the uptake rate for the iWatch is difficult. Watch wearing has declined in recent years (due in no small part to the rise of the smartphone). However, stories about the death of the watch are massively exaggerated - 86% of people surveyed owned a watch and 72% of people under 30. Obviously owning a watch is not the same as wearing one, but it at least expresses a willingness to wear a watch - if it provides benefits. The problem with dumb watches (and why I rarely wear one) is that they only provide one and a half benefits - telling the time and looking pretty - both of which can be achieved through other methods. The iWatch on the other hand is likely to offer a variety of attractive new features.
The worst case scenario is that the iWatch is as successful as the Pebble (150k units sold so far). This seems highly unlikely because Apple is a much stronger brand than Pebble and will have a much more significant advertising budget. I believe the Pebble represents the first (or possibly the zeroth) generation of smartwatches and that we will see exponential growth in demand over the next few years. In other words, the smartwatch market will follow the pattern we saw with mp3 players, smartphones, and tablets. Apple was somewhat late to the party in all of these categories but entered with a superior product when demand was exploding and created a dominant position.
The average smartphone is replaced every three years. This suggests absolute best case sales of 33% of iPhone users on the assumption that one third of potential users purchase a new technology. This is clearly far too optimistic but would give us sales of 82m to 96m. If we reduce that by 75% (to reflect the rate of watch ownership in young people) we are still left with 61m to 72m. We will examine this case as it is informative even though unrealistic.
To estimate Apple's profit per unit, we need to guess how much an iWatch will sell for and what proportion of that would be profit.
Pebble smartwatches cost $150. The Nike+ Sportwatch costs $150 or $170. The iPod Nano costs $140. It is almost certain that the iWatch will cost more than these devices as it is likely to combine the features of all three. A 32GB iPod touch costs $300. It seems unlikely the iWatch will cost more than what is effectively a mini-tablet. We are left with an approximate price range of $200 to $250 for the iWatch.
The simplest estimate of Apple's profit margin on an iWatch is that it will be about 25% as this is the company-wide net profit margin. The profit margin is dependent on the costs of production and final sales price so is difficult to calculate accurately as these do not exist yet. So, even though it is rather simple, taking that 25% estimate ensures we are not going to be wildly wrong and hopefully any mistakes are erring on the side of caution. This suggests Apple are likely to make about $50 to $60 per iWatch.
The absolute best case sales scenario of 72m units a year at $60 a unit produces profits of $4.3 billion. While this is a huge amount of money, it is only just over 10% of Apple's earnings last year. Now, a 10% increase in earnings is definitely nothing to be sneezed at, especially in one of the world's biggest companies, but it is not game changing. The fact is that Apple is just simply too big for any new product to significantly alter its fundamentals.
One of the benefits of a successful iWatch would be to rekindle Apple's reputation as an innovative company. Many commentators will tell you that this is good because it will revive Wall Street's "faith" in Apple and the share price will go up. That is entirely possible, but also mostly irrelevant to my purposes as a long-term investor. The short-term opinion of the market is mostly noise. The real benefit is in improving Apple's reputation with consumers. Consumers want innovation and exciting new products and features even if they never use them. If a company is capable of top end performance it enhances their reputation (just look at how much money and effort tire companies put into supporting motor-racing). The smartwatch market is still very immature and Apple has an opportunity (as they did with the iPhone, iPad, and iPod) to create a category defining product. If they achieve this it will not only benefit sales of the iWatch but it will also improve Apple's reputation so when a consumer is comparing phones a part of their mind will be saying "Apple phones must be good because they made the iWatch - what has Samsung (OTC:SSNLF) done?".
Another difficult to measure benefit of the iWatch is that it serves to further lock customers in to the Apple "universe" - and once a user is in they tend to stay in. We can see this in statistics such as the fact that only one third of the people who own an Apple product and that fewer iPhone users defect (replace their iPhone with a different device) than any other operating system (let alone Android manufacturer). Estimates on defections vary (from 78% to 93%) but the surveys consistently show Apple as having the highest loyalty.
The Apple universe effect both grows and protects Apple's market share. It helps grow market share because once people have acquired one Apple product the synergies (real or imagined) between that product and other Apple products encourage further purchases. Once someone is accustomed to the iTunes-phone-tablet-laptop-(watch) system it is difficult to break free by buying non-Apple products - and every Apple product purchased (even including apps) makes it less likely the user will defect. It is unlikely that iWatch will be another gateway to the Apple universe since it will almost certainly rely on a nearby Bluetooth device for its best features but as it is likely to be the device users interact with most frequently, it could be a very strong contributor to keeping users in the universe.
A possible risk of the iWatch is that it would cannibalize the sales of the iPod Nano. However, I actually view potential Nano customers buying iWatches as a positive event for Apple. The iWatch will cost more which means more profit. It will more tightly integrate the user into the Apple universe thanks to watch-phone synergies that do not exist with the Nano. The iPod Nano also has fewer differentiating features from competitor products than the iWatch so is less likely to generate brand loyalty.
As I said in the introduction, I will not be attempting to argue whether Apple is a good buy or not at current prices. I am long Apple, and the iWatch is part of my reasoning for that - I think the market may not be factoring in all the intangibles. The rest of the reasoning for my position is the work of other authors which I will not attempt to duplicate or take credit for.
Any Apple iWatch will have an evolutionary effect on Apple's performance rather than a revolutionary one. Even immediate and ridiculous success would on its own only produce a pretty good year. The benefits of the iWatch are more about strengthening Apple's long term position through a tighter universe and more innovative brand than they are about incredible sales numbers.
Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.