Don't Tell The iWatch What It Can't Do

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 |  About: Apple Inc. (AAPL)
by: Cary Hammer

Summary

The iWatch will not be a watch. It will be a unique indispensable item you never knew you needed.

It will create a new market category and set a new bar for the tech industry.

Considering the wristwatch market when speculating about the success of the iWatch is like considering tapioca pudding when trying to predict the weather.

You think Apple is making money now? Just wait.

Paulo Santos recently posted an article titled An iWatch Cannot Move The Needle Much, making the case that the introduction of the iWatch will not make a substantial difference to Apple's (NASDAQ:AAPL) fortunes. While Santos' argument is cogent and well-stated, I believe he takes entirely the wrong perspective in viewing both the iWatch product and the potential market for it.

Just Another Watch?

Santos' thesis assumes the viewpoint that with the offering of the iWatch, Apple will be entering the wristwatch market and thereby competing with the likes of market leader Swatch. The article posits the question "If Apple was able to dislodge the Swatch Group at the top of the watchmaking heap, what would the impact be on Apple's P&L?", assuming that the most optimistic projection of iWatch sales would be for Apple to match Swatch's annual revenues.

This seems an inappropriate benchmark to use, as the iWatch will not by any means be just a watch. It will assumedly have so many more functions -- phone communications, health monitoring, maps and GPS directions, texting, voice-requested information, perhaps music and video and games and who knows what else -- that timekeeping will be seen as a minor feature, as it is on the iPhone. The only similarity this product will have to a wristwatch is that they both reside on your wrist. Judging the market for the iWatch by comparing it to watches is like predicting sales of Google Glass by looking at the market for eyeglasses.

Yes, consumers that purchase an iWatch will not additionally buy a regular watch, but this is for Swatch to worry about. Apple doesn't need to lie awake thinking that people won't buy an iWatch because they already have a watch. Did people not buy an iPad because one of the many things it lets you do is read eBooks, and they already have books?

A New Market

Another flaw, I think, in Santos' analysis is in equating Apple to the top individual company selling watches (Swatch) and assuming that Apple can't do better than their piece of the market. There are currently over 200 watch manufacturers dividing up the worldwide revenue pie. Estimating iWatch revenues by comparing to the sales of one of the 200 companies (albeit the most successful one) makes for, I believe, a fallacious analysis, given that the iWatch will, at least initially, have no direct competitors. It will have, so to speak, 100% of the iWatch market.

Incidental Revenue

I think the most important factor in what the iWatch will mean for Apple is something there seems to be little or no mention of in the financial press. Apple's biggest struggle right now is how to distinguish its flagship product, the vaunted iPhone, once the epitome of a breakthrough product, against increasingly indistinguishable competition. The iWatch is going to be the key to that challenge.

Once rumored to be a standalone product, it now seems likely that the iWatch will be an add-on to the iPhone. I would be greatly surprised if this weren't true; this makes perfect sense from a practical standpoint. Rather than having to build telephone capability and internet connectivity and GPS into the iWatch itself, greatly increasing its cost as well as its size, these functions will be channeled through the iPhone, which already provides them.

But crucially, this means that you can't use the iWatch without an iPhone. This will give iPhone a huge marketing advantage, pushing a lot of phone customers that are on the iPhone/Android fence firmly over to the iPhone side. Even for those customers that don't want to spring for the iWatch at the time they purchase their phone, I expect many will not want to lock themselves later out of the iWatch option by going with Android.

This could mean a huge increase in market share for the iPhone. When taking into account the higher price of the iPhone compared to the expected price point of the iWatch ($149-$299, another indication that this can't be a standalone product), as well as increased iTunes sales, the revenues generated for Apple from this iPhone sales bump could even be comparable to the amount directly garnered by iWatch sales. This is a key factor to take into account when prognosticating how much the iWatch will move the needle for Apple.

The Numbers

So where is the needle going? Well, let's assume that Apple itself is in the best position to guess how well the iWatch will do, and start with the unit sales that Apple seems to be expecting. Based on its orders from suppliers, it seems like Apple is planning on moving 3-5 million of its new game changer per month. Let's take the middle and go with 48 million/year.

The expectation for price is $149-$299 per unit, but the low end of this seems unlikely to me for a device this sophisticated, so let's skew the average a little and go with $250.

48M x $250 = $12 billion revenue.

This should pay for some really nice foosball tables in the new Apple headquarters. But we're not done yet. What about that iPhone sales bump we're looking for? Now, it gets difficult to prognosticate with any accuracy, but let's give it a shot anyway.

The expectation for 2015 smartphone sales overall is 1.4 billion. Of those planning to purchase a smartphone, about 31% are undecided as to iPhone vs. Android. That's 434 million people, more than the population of the U.S. plus the number of Hershey bars that, lined up end to end, would circle the earth at the equator (though to avoid excess melting, I would suggest doing it somewhere else). I would think it reasonable to guess that somewhere between 5% and 25% of these consumers will be swayed over to iPhone by desire for compatibility with the iWatch (remember, we're including those who don't elect to purchase the iWatch at the same time as the iPhone). That's 21.7 million to 108.5 million additional iPhones sold. Apple brings in $549-$849 for each iPhone sold, so let's say $699.

Bottom estimate:

21.7M x $699 = $15.2 billion

Top estimate:

108.5M x $699 = $75.5 billion

Now it looks like Apple can afford coasters for the foosball tables so they don't get water rings. But let's throw in another factor. Assumedly, you'll need iOS 8 on your iPhone to use the iWatch (iOS 8 has the Health app), and iOS 8 only works on the iPhone 4s or later. So what about folks that decide to upgrade their older phone to be able to use the iWatch? The proportion of iPhones out there that are version 4 or older is about 27%. There are currently 500 million iPhones worldwide, so that gives us 135 million older ones.

Since consumers that still have an iPhone 4 presumably don't tend to be the got-to-have-the-latest-thing-right-now type, let's figure just 5% to 10% of them trade in their clunker so they can use an iWatch. So:

5% to 10% of 135 million = 6.75 million to 13.5 million more iPhones sold

(6.75M to 13.5M) x $699 = $4.7 billion

Lastly, we factor in iTunes revenue resulting from these additional iPhones. The average iTunes user spends $40/year. By the numbers above, the iWatch brings Apple:

Bottom estimate:

21.7 million + 6.75 million = 28.45 million new iTunes customers

28.45M x $40 = $1.1 billion iTunes revenue

Top estimate:

108.5 million + 13.5 million = 122 million new iTunes customers

122M x $40 = $4.9 billion iTunes revenue

The Grand Total

Putting this all together, we get:

Bottom estimate:

$12B + $15.2B + $1.1B = $28.3 billion revenue directly and indirectly from iWatch

or getting greedy and going with the top estimate:

$12B + $75.5B + $4.7B = $92.2 billion revenue

That much capital deserves capital letters: $92.2 BILLION.

Comparing this to Apple's current annual revenue of $176.04B, we see an increase in revenue of a very healthy 16.1% to 52.4%.

Looks like the needle is moving.

Conclusion

The iWatch is not just a new kind of wristwatch, or a new iPhone peripheral. It's the final fulfillment of the promise made to us so long ago by Chester Gould's Dick Tracy comic strip of the "two-way wrist radio", and it will also strap many other useful and entertaining capabilities to your wrist for the ultimate in convenient everything. It will streamline your life and welcome you to the future.

But not if you have an Android phone.

Disclosure: The author is long AAPL. 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.