Apple's iWatch May Have A 37% Net Profit Margin

Jun.25.14 | About: Apple Inc. (AAPL)

Summary

The criticism towards Apple's new product category is unwarranted.

Apple should have no problem with clearing 50 million in iWatch inventory.

I estimate that the iWatch will have a 36.74% net profit margin, and $5.5 billion contribution to net income.

I think Paulo Santos makes an interesting argument, but I'm not one to easily agree with what other Apple (NASDAQ:AAPL) critics have to say about the company, and I would argue that the iWatch may materially impact Apple eventually.

Paulo Santos states in his article:

So the question here is, can an iWatch move the needle for Apple? My own answer, which I will explain in this article, is that it can't. At least not to a great extent if using rational but optimistic assumptions. At most, one would expect Apple's entry into the watch space to match the size of its present leader. And even that would require a change in the consumption patterns for watches, as watches are presently seen more as jewelry or fashion accessories than as useful gadgets. Indeed, if the rumor is right and Apple starts manufacturing 50 million units, it will most likely lead to a significant charge down the road.

Looking over his argument, he makes a peer comparison to a company that generates $9.86 billion in revenue, and that the watch form factor doesn't hold a lot of potential, because he doesn't believe consumers will see the appeal in owning another consumer electronic device. However, I take on a differing stance; I believe that Apple's own internally created financial model for first year shipments is beyond a doubt reasonable, especially if we were to adhere to Apple's historical success in new product categories.

Reuters reports:

One of the sources told Reuters on Thursday that Apple expects to ship 50 million units of the so-called iWatch within the first year of the product's release, although these types of initial estimates can be subject to change.

I agree with these estimates, because they're in-line with the estimates I had published a couple months ago. So if you had been paying close attention to Seeking Alpha, you wouldn't have missed my forecast on first-year smartwatch shipments, which I publish below.

Source: AlexLeAnders

I came up with my first-year forecast by creating a function that modeled the first-year shipments of Apple's new product categories (read my previous article for more details). My estimate for first year iWatch sales is 42.43 million, and if Apple is gearing up for 50 million in unit shipment volume, it's likely that Apple will sell the first 50 million devices it produces. However, if need be, Apple will adjust production as sales figures come in from retail channel partners.

Looking specifically at more qualitative factors, 20% of the teenage demographic within the United States is willing to purchase the first generation iWatch at a $350 price point. Therefore, I'm fairly certain with high conviction that both qualitatively and quantitatively, a 50 million shipment figure is attainable.

Basic watch specifications, quoted from SA news currents:

Reuters adds the device will likely have a 2.5" touch display - LG Display is said to be the exclusive supplier - to go with a pulse monitor (should work with iOS 8's Health app) and wireless charging support. The watch face will protrude slightly from the band, creating an arched shape.

It's likely that the watch internals will come with Apple's custom semiconductor solution, which will be optimized to work for the specific form factor. Furthermore, the iWatch is likely to integrate better with its own respective ecosystem of hardware, which gives it an edge when compared to Android Wear.

Every unique computing form factor has its unique advantages and disadvantages. For example, I don't expect consumers to watch video, or send text messages on the iWatch. However, I expect the iWatch to be great for receiving notifications assuming artificial intelligence were to improve significantly. I write about the potential of smart watches in more detail in a previous article.

I estimate that the iWatch can generate an incremental $5.5 billion in net profit for Apple in the coming fiscal year. Analysts' consensus earnings are based on Apple's recent trend in net income, and isn't inclusive of future product categories, which is why I include iWatch sales into forecasted consensus for fiscal year 2015. After doing a full break-down, I think Apple's iWatch will have a profit margin of 36.74%, this is after factoring in taxes, bill of materials, and operating expenses. Currently, Apple's consolidated net profit margin is 21.42%, therefore the contribution to profit is significantly higher than other product categories, making it a bigger contributor to bottom line performance than what investors, or other analysts are estimating.

Retail pricing is likely to be in the $300- $350 per unit range, and while reported figures vary widely, I doubt Apple will price its product at entry-level pricing. Also, Taiwan's Topology Institute estimates that bill of materials will be $77, which is where the cost of revenue figure comes from. I also estimate that operating expenses per unit is $53.43; this figure was arrived at by averaging the operating expenditure per unit sold by Apple in fiscal year 2013. Apple spends approximately $53.43 per iOS/iMac in R&D and SG&A expenses. It's likely that operating expenses are likely to be less than this, as there are cost synergies. Finally, I factor in 35% income tax; however Apple is known to take advantage of foreign tax shelters, so this is also another very conservative estimate on profitability.

Therefore, the iWatch will contribute heavily to net income, even if the impact isn't felt as much on the top-line. Investors should disregard the skepticism that other analysts have on the new product category.

Apple is a buy, and I reaffirm my $101.28 price target on Apple.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.