the Business Doc: Seven Reasons Apple's Watch Will Dominate

Apple Inc.
$126.56
Change: +0.96 - +0.76% 4/10/2015 2:12am EST

It's possible critical factors about the Apple Watch have escaped Wall Street's attention. Of one thing I am certain: the iWatch may not seem a great success today, but it will eventually change the way we use smart devices to communicate.

The Taptic Engine

Everyone knows the iPhone can be set to vibrate. But many people are unaware they can create a custom vibration pattern for each person in their contact list. The phone then vibrates that contact's unique signature upon receiving an incoming call. Haptics allows subtle buzzes on the skin to serve as alerts. Apple calls its tactile haptic alert system taptic.

This technology never took off with the iPhone. That's because people carry their phone in a pocket where vibrations are insulated by clothing. When not on our person, the phone sits plugged in on a desk away from us where we're immune from its vibrations. One of my aggravations is that I still occasionally miss important calls or alerts because I can't detect the phone when I'm at a noisy event or when I need it muted.

Imagine instead if you wore your iPhone next to your skin. Every buzz or vibration would be instantly felt. I know I would love having a unique signature for priority events I need to be alerted. Because touch would instantly signal me, I'd be alerted even if the environment was noisy or I'd muted the device.

There are times that I've anxiously awaited a call and had my phone in my pocket where I can feel it through my skin. Occasionally I've found myself recalling my call or alert and thought about the phone. Startled, I suddenly realize that my phone is ringing!

I predict that over time we'll become attuned to these various interruption codes. Early reports from reporters bear this out. I also predict that as we become more comfortable with taptics, we'll relegate these alerts to our subconscious. I'll sense an incoming alert and quickly glance at the watch to determine if it needs my attention. If not, I'll never promote the task to my consciousness. I foresee the time where I check my watch history and surprise myself that I received an alert I rightly ignored.

Reasons:

Taptics. Where the iPhone failed, the Watch nails it. We'll receive every taptic alert whenever we wear our watch. A wrist device buzzing or tapping us will easily break us out of our daily fog and tune us into a situation that demands our attention. And we can use it regardless of the environment. Taptics will become the new way we communicate.
Social proof. The naysayers predict the Watch will be worn by geeks and tech first adopters. But once it catches on with celebrities and trend setters, it will increasingly become a status symbol of the rich and famous.
The Veblen Effect. As people buy more of certain products, they become more valuable to the market. This is contrary to the laws of supply and demand and works only for extraordinarily coveted items. However, the iPhone enjoys luxury status - the more iPhones sold, the more desirable they become. I believe the Watch will attain a similar standing.
Jewelry. Apple is launching the Watch as a fashion accessory, not just a tech device. One of the reasons the iPhone enjoys such phenomenal success is because of its elegant design. It just looks sharp. Where the iPhone is almost jewelry, the Watch actually is jewelry. The device generated moderate acclaim among the fashionistas at the prelaunch in San Francisco earlier this month, and as it reaches mainstream acceptance it will transform geek into chic and benefit from the market forces of fashion with the early adopter appeal of technophiles.
Accessories. The Watch will feature various bands, crystals, and cases allowing the look to be altered to suit all occasions and further cementing the device as an ever-present fashion accessory.
Software Watch Faces. Wear a conservative watch to work, a chic tech style to a boys' night out, and an elegant analog style to dinner with a significant other. The user can change the watch face based on personal taste and the occasion- from Mickey Mouse to a trendy Applesque version.
Profit Potential. Apple has introduced three lines: the Sport economy model; the Watch mid-line; and the luxury Edition. The guts are identical inside. What differs is the material the case is made out of. As I show below, this positions Apple for a huge financial windfall.

Could Apple's stock hit $175 by the end of the year

(Ed. Note: It hit 182 by eoy and enjoyed a 5:1 split. As of Mar 2021 it's at split-adjusted 600)

As of Thursday, April 9 2015, Apple closed at $126.56. To hit $175 it would need to gain $50, a 40% increase. This past year the stock has already risen 70% making Apple the world's largest company by revenue. However, the stock has plateaued this last month, retreating from its previous high of $133, and many financial pundits believe we're heading into another recession. Am I crazy making such a bold prediction?

The iWatch is being viewed as the next step on the evolutionary path of miniaturization of the iPhone much like the Nano was a miniature evolved iPod. It's stylish but we've come to expect elegance from Jonathan Ive's design team. Most analysts I've talked to think the iWatch will suffer a lukewarm entry and then gradually gain market share. They say its audience will have three attributes: the consumer must be an existing iPhone user, be tech savvy, and have disposable income. They claim this triple-screen severely limits the reach of the iWatch and therefore its contribution to profit. I disagree.

It's Apple's marketing strategy that could launch their financials into orbit. Let me explain.

Apple is releasing three tiers of iWatch: the Sport for $350; the Watch for $550; and the Edition for $10,000 or $17,000 depending on whether one chooses gold or rose gold. The watches are the same except for the materials used to manufacture the housings. The most expensive Edition uses a gold composite; the mid-tier Watch uses stainless steel; and the economy Sport uses alloy. The inner workings are identical as is all circuitry and firmware. All three have the same functional capability.

Why is this significant? Since the inner workings will be the same, the only cost difference is in the materials. Adding just the difference in cost of raw materials to the economy model, we can quickly see how much profit Apple builds into the more expensive versions.

But gold costs a lot, you say. Well, Apple isn't actually using what the rest of us call gold; it's a metal-ceramic composite the company patented last year that cuts the gold by more than half. So whereas 55 grams of 18kt gold cost $2,115, the the composite drops it to as low as $872.

The Edition that carries a price tag of $10,000 costs $872 materials + the Sport iWatch at $350 = $1,222 that Apple is selling at 10K. That's $8,788 of profit, a whopping 88% profit margin.

But wait. Our calculations don't take into account the profit already embedded in the Sport version. The company would only make 88% if the Sport is priced at breakeven. In fact, Apple is routinely lauded for its sky high profit margins. Analysts estimate 28% of that $350 is profit. So this boosts the margin on the Edition to over 90%.

The $17,000 rose gold version increases it even further to 95%+. And as scale ramps up, per unit costs shrink which further swell Apple's coffers.

The Bottom Line

The analyst's consensus of watch sales for 2015 is 22.5 million units. However, the range varies so widely - from 8 to 41 million units - the results border on speculation and invalidate the survey. If 10% of iPhone owners buy one, sales will be 30 million. According to Nikkei, Apple is ramping up production for 36 to 60 million units per year. Apple is confident of their new product and has historically undershot demand in a launch. 20% of people I've spoken with say they'll buy one so let's consider the figure of 10% to err on the safe side. There are dozens of models with varying prices, so this is an oversimplification but here are the financial results:

Apple expects 50% of units will be Sport, 37% Watch, and 13% luxury Edition versions. The respective sales on Sport, Watch, and Edition are 15M, 11.1M,and 3.9M.
At profit margins of 29%, 53%, and 89%, average price point without extras is $1,677.63
Gross revenue of 30 million units is gross profit of $39.4 billion on revenue of $50.4 billion

Apple’s revenue ending Q3 of 2014 was gross profit of $70.5 billion on revenue of $183 billion, a 39% gross profit margin.

Given our model, the Watch adds $39.4 billion gross profit, 80% of the profit the entire company generated in fiscal 2014. This would also bring Apple’s gross margin up to 47% for the entire company.

If Apple hits these numbers, the stock would fundamentally be valued at another 60% of the current $125 price or $195.

It'll be interesting to see if Tim Cook announces the early numbers for the Watch and then see the stock price response if they forecast success. In the meantime, I'm long Apple calls and Apple stock. And I just preordered my Sport Watch.

Do you agree? Gonna buy a watch or are you holding out? Leave a comment and let me know. Until then,

profitable business All!