The Apple Watch Is Proving To Be A Big Deal

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About: Apple Inc. (AAPL), Includes: FIT
by: D.M. Martins Research
Summary

The Apple Watch will likely do better than I expected at picking up the slack in revenue growth caused by a declining smartphone business.

I revise my Watch sales projections for fiscal 2021, and see the product category driving one-third of Apple's top-line growth next year.

I believe AAPL is still a bargain stock worth owning in a growth portfolio at its current valuation.

In the week of March 4th, market intelligence firm IDC published a report that made me even more optimistic about Apple's (AAPL) future growth prospects.

The research company disclosed that the broad wearable devices market has grown a sizable 31% YOY in 4Q18. Even more relevant, the smartwatch sub-category saw its market expand by an impressive 55%, with Apple's slice of the pie alone becoming about as large as all the other participants' combined. According to the independent researcher, "[the Apple Watch Series 4] has been off to a very strong start and IDC anticipates this to continue as more healthcare organizations and consumers adopt the latest device."

Credit: Apple

The news is crucial for Apple's growth aspirations, in my opinion. As the chart below suggests, smartphones seem to have definitively entered a period of (possibly secular) decline, as the product category reaches deeper into its mature lifecycle stage. Apple has been suffering more than others in the recent few months, with iPhone softness having been the main culprit in the company's nearly disastrous fiscal 1Q19.

On the device side of the business (i.e., excluding services and software), I have been counting on the Apple Watch to eventually pick up the slack in revenue growth driven by the smartphone business. The Cupertino-based company's wearable device has expanded its utility to consumers as well as its addressable market by adding (1) cellular capabilities with the introduction of the Series 3 version and (2) health monitoring applications with the most recent Series 4 model. As device makers approach a ceiling in terms of how much innovation they can introduce in handheld devices, I expect wearables to enjoy perhaps the same level of growth at scale that smartphones once did, a few years ago.

However, what I have been seeing lately in terms of smartwatch sales traction has exceeded my expectations.

Source: D.M. Martins Research, using data from IDC

What the recent news means for my projections

At one point in 3Q17, possibly still influenced by "expert opinions" on how much of a flop the Apple Watch had been as a new product category, I projected that the device could generate $11.8 billion in annual revenues by fiscal 2021. About one year later, I revised my estimates up to $16 billion on the back of encouraging metrics on the Series 3's performance.

Now, I make another round of revisions to better reflect what I perceived to be the improved opportunities in the smartwatch business. Notice here that I am purposely excluding AirPods and other wearable devices that Apple might release in the future from this analysis.

To start, I believe my previously estimated 20% YOY market growth rate in fiscal 2021 to be too low of a projection. I now think that 22% might better reflect the smartwatch environment, decreasing at a more modest pace of 25 bps per year. While smartwatch shipment increased an impressive 55% in 4Q18, I must be cautious not to extrapolate the outstanding results into future periods. I expect growth to be lumpy and driven by the successful timing of certain product releases.

Therefore, I revise my market growth projections upward for an estimated positive impact to sales of about $1 billion per year by fiscal 2021.

Then, I turn to market share. I had originally projected that Apple would reach peak market dominance at about 49%, and lose one percentage point of share per year to end up at only 44% in fiscal 2021. Today, I believe Apple is in an even better competitive position than I originally anticipated. While Apple is losing some ground to the smaller device makers that have been playing catch-up on the lower end of the spectrum, well-known brands that could give Apple a run for its money, like Fitbit (FIT), still seem to be less relevant in the space than many had imagined.

I now project that Apple will control 47% of the smartwatch space in fiscal 2021, for a positive impact to sales vs. my previous projection of roughly $750 million per year.

On the ASP side of the equation, I choose to maintain my projection of moderate improvement over the next few years, but without stretching my assumptions too thin. I understand that a scenario of tighter competition or a macro environment of less robust economic growth could put at risk Apple's pricing power. However, if history might serve as a guide, the company has been particularly competent over the years at protecting price premium on its devices very well.

Below are my revised Apple Watch sales estimates.

Source: D.M. Martins Research, using data from company reports

Notice that, per my projections, smartwatch revenue growth of about $3.2 billion in fiscal 2020 should amount to roughly one-third of Apple's total company consensus revenue growth that year. Not bad at all for a product category that might represent less than 5% of total sales today.

It is also worth noting that my estimates above could very well be overly de-risked, certainly compared to the much more aggressive projections disclosed by a few sell-side shops in the past months.

Final words

Although I called my readers' attention to the importance of the Apple Watch to the company's financial performance as early as September 2017, I did not expect the device to perform as well as it did in the 18 months that followed. I believe this is a great example of how I think Apple will be able to manage the slow decline in smartphone sales that I expect to take place over the next several years, as the market for this particular product becomes even more saturated.

Having said the above, I believe AAPL is still a bargain stock worth owning inside a growth portfolio at a current year P/E ratio of 15.9x and long-term PEG of about 1.6x (see graph below).

Chart Data by YCharts

Disclosure: I am/we are 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.