Apple: Who Might Subsidize The iWatch?

Aug.26.14 | About: Apple Inc. (AAPL)

Summary

Apple's iWatch could create great value for several players in the healthcare space.

Apple may be able to monetize this value by convincing one or more of these players to subsidize the iWatch.

I consider three potential sources for iWatch subsidies and their limitations.

Investors should keep a close eye on iWatch subsidization, which could potentially facilitate its mass adoption.

Anticipation over the expected release of Apple Inc.'s (NASDAQ:AAPL) so-called "iWatch" currently has Apple investors quite excited. However, little is known about the potential market for wearable technology from Apple, resulting in a great deal of uncertainty over the iWatch's potential for mass adoption.

The iWatch would achieve faster, more extensive mass adoption were it to be subsidized. Although Apple estimates that subsidization now accounts for "only" about a quarter of iPhone sales, subsidization was even more crucial in the iPhone's mass adoption early on. After all, the iPhone has always cost a pretty penny, and if some consumers do not notice this, this fact can be attributed entirely to carrier subsidies.

As a consequence, I believe that the question of subsidization is essential to any responsible estimate of iWatch mass adoption and earnings potential. Of course, much depends on the capabilities of Apple's wearable device. What these will be only time will tell, but let's assume for the sake of argument that Apple introduces a wearable that has multiple, well-executed capabilities involving advanced sensors, as suggested by Apple's recent "hiring spree" in the area of medical technology and sensors. Such features are likely to include non-invasive measurement of glucose, heart rate, blood pressure and respiration. Let's also suppose that the iWatch will include something unexpected or difficult to execute, like the ability to contact emergency services if the user needs an ambulance. Suppose the iWatch is something along these lines: who might subsidize such a device?

I consider three options for iWatch subsidization. Although they pose significant challenges, I believe there is a distinct possibility that the iWatch will be subsidized to some extent for at least some customers. This should give investors faith in the iWatch's staying power if and when it does indeed materialize.

The Importance of Subsidization

Carrier subsidies have been central to the rapid mass adoption of the iPhone. At the same time, they have not yet played a significant role in the development of the iPad. The two segments also differ in relative size, with June quarter revenues of $19.8b for the iPhone and $5.9b for the iPad.

The first reason for the greater role of subsidies for the iPhone compared to the iPad is that the average iPhone is more expensive than the average iPad. Consumers find it much easier to pay out of pocket for the iPad, and for most people going without a smartphone is much more difficult than going without a tablet. As a consequence, the iPhone represents a more significant and necessary purchase for the customer, and makes him or her more amenable to taking a subsidy against signing a contract.

It is also much easier to monetize iPhone subsidies than iPad subsidies. Given the iPhone's heftier price tag, iPhone subsidization is much more likely to attract or retain customers than iPad subsidization, which does not bring as much benefit to the average consumer. Additionally, it is also easier to monetize via data plans for the iPhone, since the iPhone's ability to access the internet in all places is much more vital to most people than the iPad's ability to do the same. In fact, many people simply buy the Wi-Fi only iPad.

How would a potential iWatch fare on the subsidization front? Let us consider three possible sources of iWatch subsidies:

1. Insurance Providers

At least one analyst - Cowen & Co.'s Timothy Arcuri - has speculated that health insurance providers may subsidize the iWatch on the grounds that it would make users more health conscious and thus lower healthcare costs. Although this is a plausible way in which society might benefit from the iWatch, it is not obvious that insurance providers would be able to effectively monetize these benefits given that many will only accrue in the long term. It seems unlikely to me that insurance providers would be able to convince customers to sign contracts that last for five years or a decade. Additionally, given that buying health insurance is much more serious, complicated and expensive than buying a cell phone plan, iWatch subsidization may not attract many new clients or help retain many existing ones - especially if the iWatch is not terribly expensive.

However, it is possible that insurance providers like UnitedHealth (NYSE:UNH) and Aetna (NYSE:AET) could monetize the iWatch in a manner different from the one suggested by Timothy Arcuri. First, the iWatch could play a major role in early detection and diagnosis of common health issues like diabetes and high blood pressure, and thus lower healthcare costs even in the short run.

Second, an iWatch that could accurately monitor and track its users' activities and habits may allow insurance providers to offer different price tiers for those users who maintain healthy habits and those who do not. This could not only significantly improve margins for insurance providers, it also could provide monetary incentives for healthy behavior that could be adequately monitored and enforced. This could potentially change the way people behave in significant ways - and sounds very much like what Tim Cook has suggested is the gold standard for wearable technology: wearable technology that significantly changes the user's behavior.

Of course, insurance providers could subsidize the iWatch even if it did not directly improve profitability. After all, some insurance services do subsidize the purchase of medical equipment like blood glucose monitors. An iWatch that could non-invasively and constantly monitor the user's glucose levels could be subsidized to some extent just for that function - especially since the cost of strips for glucose monitors can add up over time. The same applies to an iWatch that watches blood pressure or contacts emergency services if the user has a heart attack.

Such subsidization is likely be limited to those with serious health problems, but that is by no means a small number. The American Diabetes Association estimates that 29.1 million Americans had diabetes in 2012, and the Center for Disease Control and Prevention estimates that 67 million Americans suffer from high blood pressure. These markets could be enormous.

Whether the happy outcome of insurance provider subsidies actually materializes will depend on insurance providers' ability to monetize provision of the iWatch. As a consequence, insurance provider subsidies are likely to be limited to existing coverage for medical devices and what insurers can monetize in a couple of years (which may not be much).

2. Pharmaceutical Companies

The iWatch could bring major benefits to pharmaceuticals. First, it could help pharmaceuticals in closely tracking detailed medical records over time for patients using some given drug. Combined with big data analytical techniques, such unprecedented datasets could drastically improve diagnosis and drug prescription while significantly reducing the incidence of side effects.

Similarly, large amounts of data on drugs may help pharmaceuticals better understand how they work, and thus potentially speed up the process of drug discovery in the long term.

Big pharmaceutical players like Pfizer (NYSE:PFE), Novartis (NYSE:NVS) and Gilead (NASDAQ:GILD) may well be eager to utilize the iWatch toward these ends, perhaps even to a degree where they are willing to subsidize it. Such subsidization also is likely to be limited to those with significant or chronic medical issues, although as I have mentioned, this number is quite large.

3. The Federal Government

I discuss the federal government separately because it operates in a different environment and faces different incentives than other healthcare players like insurance providers and pharmaceutical companies.

The federal government provides a great deal of medical coverage through Medicare and Medicaid, including for durable medical equipment. An Apple that could break into this market could very well see skyrocketing iWatch sales. However, Medicare does currently require that covered medical equipment should normally not be of much use to the perfectly healthy, so coverage of an iWatch is not a given. Nevertheless, policies, their interpretation, and their implementation can change, so the potential for iWatch coverage under Medicare and Medicaid is real.

However, partnering with the federal government can be quite difficult, and comes with its own set of unique problems. First, partnering with the federal government can be quite difficult due to cumbersome legislative and bureaucratic processes. In addition, once such a partnership is achieved, the federal government's size can often give it a great deal of control over partners, and Apple may not want that. Finally, partnering with the federal government and Medicare and Medicaid may not be a good move for the Apple brand, especially given how politically charged such government decisions can be. Even then, OpenSecrets.org reports that Apple spent more than $3m in lobbying efforts in 2013, so you never know what might happen.

Again, coverage under Medicare and Medicaid is likely to be limited to those with serious or chronic medical conditions.

Conclusions

Subsidization is likely to be one of the central questions that determines the speed and extent of the mass adoption of Apple's iWatch. This, in turn, will determine the extent to which the iWatch is able to affect Apple's enormous top and bottom lines. I expect that Apple and Tim Cook are quite aware of this fact, and they may well have something in the works on the subsidization front.

I have considered three players in the healthcare space who have at least some incentive to subsidize a health-centered wearable device. Any entity that subsidizes the iWatch for large numbers of people must be quite large, and I think among such large entities, insurance providers, pharmaceuticals and the government are most likely to have any interest in subsidizing the iWatch. The specific dynamics surrounding these players are also likely to vary from country to country, so iWatch subsidization prospects should also vary internationally (just like iPhone subsidization).

If Apple elects a partner that subsidizes the iWatch in exchange for certain kinds of user health data, it will also need perfect execution with respect to ensuring the safety of user medical records. However, these problems exist with or without the iWatch or iWatch subsidies, given the upcoming release of the Health app and HealthKit developer suite. Similarly, apps' ability to utilize Touch ID will pose similar data security concerns. Apple has done well so far, but a slip on this front could be extremely harmful to Apple's brand and sales.

I believe that any iWatch subsidies will initially be limited to those with significant medical concerns. These are not small numbers, so investors (and patients) should rejoice at such a development, even though primarily non-medical consumers may find themselves a little disappointed.

Only time will tell how well Apple monetizes the many social benefits that mass adoption of a wearable health monitor could yield, but I expect that Apple is hard at work trying to make iWatch subsidies a reality given the many benefits they could bring to patients, healthcare providers, pharmaceutical companies and society at large. Success on this front may improve annual iWatch profits by several billion dollars and could offer Apple a decisive advantage over competing wearables from Samsung (OTC:SSNLF) and Sony (NYSE:SNE).

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.