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Summary

  • Rumored iWatch is likely coming.
  • Will it fulfill a real need?
  • How many will sell?
  • What will it add to the bottom line?

The beauty of Apple (NASDAQ:AAPL), from an investor's point of view, is that they have, over the last fourteen years created new gadgets that have each become almost a necessity in our lives.

For over a year now we have been hearing rumors of a forthcoming iWatch. We hear rumors of sapphire displays, curved displays, biometrics, health sensors and more. While evidence mounts for some of these rumors, we are all unsure as to what it will bring, if it comes at all.

For the investor, however, the main question is different. So, when this astounding new product comes out, what can we expect for revenue growth? For margins? What can we expect for the bottom line?

It is, of course, impossible to answer that. However, I will try to pass on some thoughts I have been having on the topic on some boundaries for expectations here. But first I must digress just a bit to build a background for my case.

Needs

In 2001, they released the iPod. Digital music players had been out for several years, but Steve Jobs and his team wove their magic to solve the three problems that were holding them back: speed, capacity, and most of all, usability.

With the built in hard drive - before Gigabyte memory was available - it solved the capacity problem. The surprising use of Firewire communications made data transfer run at acceptable speeds. Finally, the revolutionary scroll wheel interface that allowed you to very easily navigate a menu system with clear fonts, solved the usability problems [original iPod press release]. As history has shown, it was a great success.

This was the modern version of Sony's (NYSE:SNE) CD Walkman (originally the Discman), released in 1984 that had been so popular, but now the player was so much smaller and could hold 1000 songs or more.

The fact is, people love music and want it with them all the time. So while we think that the iPod created a new need, it really served a pent up need that already existed. Thus, they became ubiquitous, and began to lead the slow march that returned Apple to favor in the public eye.

Similarly, the iPhone created a new brand new category of cellphone. All previously existing "smartphones" were re-categorized as feature phones in comparison to the new, fully functional computer-in-your-pocket smartphone. Once again, Apple did this by a combination of pushing technology to its current limits, and designing a revolutionary, easy to use interface. Apple discerned a pent up need (easier to use phone interface), and translated this into a new product category.

iWatch - needed?

My point here is that, in both cases, Apple solved existing problems for real needs/desires in order to create the new product. The question then is, will an iWatch do the same?

The answer is yes and no.

In today's society, most people feel they "need" a cellphone. A smartphone is highly desirable or a real need depending on one's use. For the road warrior, or anyone out in the field for their job, it is pretty much a necessity. For others it serves their lifestyle, but not a necessity.

So the iWatch may find a similar usage case. For those who use their phones constantly, the ability to quick check calls and messages without pulling out the actual iPhone may be a real advantage. Of course, if there are health sensors built in, then the athletes or those with related health concerns will definitely benefit.

For most people, however, I think the iWatch will be a gadget whose added value is mostly a novelty. Of course some may want it as such, but for the average person, it will never be that desired.

Let's look at some numbers.

Watch sales data

According to the Federation of the Swiss Watch Industry (FH), approximately 1.2 billion watches were produced last year, with China accounting for just over half of these and Hong Kong over half the remaining. The chart gives sales and average export prices.

(click to enlarge)

An interesting point on the sales is shown in the chart below. While the overwhelming number of even the Swiss watches sold were at an under 200 CHF price point, the majority of revenues came from the highest price category with only 1.6 million sales. In fact, all over 200 CHF sales accounted for less than 10 million units world wide, or less than 1% of sales. (1 CHF = $0.90 USD.)

(click to enlarge)

Apple is likely to price the iWatch in the $249 - $299 range, where it will make equivalent gross margins to the iPhone. So can we infer anything about possible market for the new product.

It is extremely difficult to do so, because in a sense, the iWatch is not really a watch - it is so much more. The customer base is not really that of the traditional watch, although they obviously overlap.

In a Forbes article, the Trefis Team suggests that the iWatch could add $50 billion to Apple's value. The problem with their analysis is that they try to correlate with the existing watch market, particularly the high end. But this is totally irrelevant. When someone buys a high end watch, they are buying not just a timepiece, but a piece of jewelry. They want to show off their wealth with a more or less exclusive item. The iWatch will most likely be very attractive, but it will not be exclusive, selling millions per year, and it will not be a piece of jewelry.

Trefis also models that Apple will eventually sell the new devices to 25% of iPhone customers. To me this appears exorbitantly high.

Realistic expectations

Digital Trends reports that last year 2 million smart watches were sold. Samsung (OTC:SSNLF) makes the Galaxy Gear watch, which runs Google's (NASDAQ:GOOG) Android operating system. They reported that they had shipped 800,000 in its first two months, although recently the price has been dropped to $100, showing poor demand.

It is reasonable to make a few assumptions here:

  1. As a new product category, it will grow - most likely quickly.
  2. If Apple introduces an iWatch it will probably lead the pack.
  3. Since an iWatch most likely will not work with Android, sales will be incremental, adding to overall sales, not stealing from others.
  4. Almost 500 million iPhones have been sold since the original model. Subtract 100 million for older models, and another 100 million for broken or no longer in use units and we have a (very rough) number of 300 million iPhones eligible to pair with the iWatch.

If we ultimately address 25% of compatible iPhone users, then that would be 75 million units. Even over three years that would be 25 million a year or 12 times last year's total smartwatch sales.

If the Galaxy Gear (which got negative reviews) sold 400,000 per month, I think we can reasonably expect the iWatch to sell 2 - 4 times that, or 0.8 - 1.6 million per month.

Bottom line

At this rate we have sales of just 10 - 19 million per year. If ASP is $299 (and likely less) this gives a maximum revenue of $5.7 billion. Not very much of an increment for an annual revenue (TTM) of $174 billion. Even at 21% profit margin (source: Yahoo finance), this adds just $1.2 billion to the profit, or $1.33 cents per share annually.

So it seems that the new iWatch really has a short term potential of adding a mere 3% to Apple's revenues and profits. Not the huge surge that some investors are expecting.

Conclusion

A new iWatch may capture the imagination of people and perform much better than represented here, but this analysis shows that a realistic expectation is that it will only add about 3% to the financial picture.

It will likely add to overall value of Apple's line in many ways. Showing renewed innovation, it may attract new customers. However, in the end, even if it performs twice as well as described here, it will only bring a 6% increase in revenue/profits. Investors should adjust their expectations accordingly.

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.

Source: Apple iWatch: A Big Deal Or Not?