Apple will start selling Apple Watch in early 2015 and based off of my analyses, I estimate Apple will sell 20-30 million Apple Watches bringing in $11 billion to $17 billion of revenue and $0.70-$1.00 of EPS over the first 12 months on the market.

Apple Watch Addressable Market

Analysts are relying on various methods to arrive at Apple Watch's addressable market including surveys, prior Apple product launch sales trends, and current watch market data. I disagree with those methods since they contain significant issues or error-prone variables.

Surveys. Customer intention patterns do not correspond well with actual behavior.
Previous Apple Product Launches as a Proxy. My biggest issue with this method is that it ignores the passage of time and ecosystem changes.
Current Watch Industry Data. As Apple has shown over the years it is pointless to use existing pre-Apple industry market data as a proxy for future Apple sales.

I extrapolate Apple's addressable market for Apple Watch from iOS adoption rates. I use the share of iOS devices that upgraded to the latest iOS release by the end of the first full day after release as a proxy for Apple's most loyal customer base. I classify these users as a fair approximation of Apple's initial addressable market for an Apple Watch. Using a 2.4-year iPhone replacement cycle, I estimate there are approximately 400 million iPhones in use today. Since there are older devices resold or passed down to children and relatives, I would label the 400M data point as a base case estimate.

I consider a user that upgrades to the latest iOS release within the first full day after release as someone who is more interested in their phone and consequentially Apple. Why? These users are actively seeking out, and then upgrading, their iOS software which demonstrates an interest in their device or a willingness to try the latest software product. The steep adoption rate drop-off from iOS7 to iOS8 suggest there wasn’t much of an impact from Apple automatically sending a download notification to devices on the first day of a major software release this year. Exhibit 1 displays adoption rate estimates for the previous three iOS version launches.

Exhibit 1: Apple iOS Adoption Rates

Using the average between Mixpanel and Fiksu, I arrive at 13%, however Mixpanel has historically tracked closer to Apple's reported adoption rates, therefore I increased the 13% average to 15% to reflect a greater weighting for Mixpanel. I then multiplied that percentage by the 400 million iPhones out in the wild to arrive at approximately 60M core iPhone users that serve as a prime target to sell Apple Watch (which requires an iPhone 5, 5c, 5s, 6, or 6 Plus). It is important to note, as Apple VP Greg Joswiak said recently at the Code/Mobile conference, the Apple Watch is geared for everyone and not just those interested in technology. However, due to the requirement of owning an iPhone, I think 60 million is a fair estimate of the number of people interested in buying an Apple Watch from Day 1. Another variable is since adoption rates reflect iOS devices, there may be an impact from the same user upgrading all of his or her iOS devices at the same time. Considering the steep adoption rate drop off from iOS 7 to iOS 8, this impact doesn't worry me too much as I consider my 15% estimate to be a base case as there were many users who could not upgrade to iOS 8 on the first day because of a lack of storage.

Apple Watch Sales Projections

With my 60M estimate for the addressable Apple Watch market, I assume everyone in this group buys an Apple Watch over the first 12-18 months. Taking into consideration Apple Watch prices, a certain amount of time may be needed before a purchase is made therefore I backloaded sales into the second year to arrive at 20-30M units sold in Year 1 and 30-40 million units sold in Year 2.

Exhibit 2: Apple Watch Sales Projections

Apple Watch Average Selling Price Estimate

I estimate the Apple Watch average selling price (ASP) to be $563, as shown in Exhibit 3. While the $349 price for Apple Watch Sport has been announced, I included estimated selling prices for the other two watch collections. My estimates do not include additional Apple Watch band revenue. I am estimating a $7,500 estimate for a supply constrained Apple Watch Edition. I wouldn't expect much of a difference in demand moving from $3,000 to $7,500, so in order to maintain its exclusivity, I expect Apple to set a high price. The obvious risk to my logic is if Apple prices the Edition collection closer to $1500 and includes a viable replacement program, driving much more in the way of sales, but even then the ASP would only change by approximately 15%. I expect China to be a big variable when estimating Apple Watch Edition sales, but for now I am including a limited production schedule at least in the first few quarters of release.

Exhibit 3: Apple Watch Collection Breakdown and ASP Estimate

Apple Watch Sales and EPS Estimates

Exhibit 4 includes my estimates for a few Apple income statement line items. I estimate Apple Watch margins will come in less than iPhone, but higher than iPad with economics of scale adding a few hundred basis points of margin over time. Obviously this is an inexact science and watch accessories can help boost margin. Estimates reflect continued share buyback through 2016.

Exhibit 4: Apple Watch Revenue and EPS Estimates

Conclusions

I suspect Apple may have a hit on their hands with Apple Watch. Running with a 15% iPhone base penetration rate, I estimate Apple will be able to sell upwards of 60 million Apple Watches over the first 24 months on the market with more risk to the upside given Apple's strong iPhone guidance for this quarter. From an EPS perspective, Apple Watch can add between $0.70-$1.00 in the first 12 months after launch.

This report should be used to understand where I stand on Apple Watch especially when I discuss the product in my daily email, AAPL Orchard, or in other Above Avalon reports. Over the coming months, if new data becomes available, I will update my estimates accordingly. This report is not meant to be used as investment advice. Downside risks to my estimates include: Apple Watch supply issues and weaker-than-expected customer demand. Upside risks to my estimates include: Stronger-than-expected customer demand, especially in China. This report was produced by Neil Cybart on November 18, 2014.

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