It took fourteen months but it finally happened last week. I began seeing Apple Watches on a daily basis. Just a few months earlier, it would have been rare for me to see someone wearing an Apple Watch. Something has changed. Despite the short amount of time on the market, the Apple Watch has been called everything from Apple's largest flop in decades to the next big thing after the iPhone. In reality, we actually know much more about how the Apple Watch has performed to date, and there is evidence Apple is still just getting started.
Something Changed at WWDC
Heading into this year's WWDC, Apple Watch expectations were at a low. The most recent comments from Apple management about Watch sales being focused around the holidays implied Watch sales had slowed somewhat materially in recent months. Developer interest and buzz around watchOS was lackluster, and recent price drops introduced questions about customer demand.
Things changed following Apple's WWDC keynote. It was clear Apple had no plans of slowing down with Apple Watch. More importantly, Apple was willing to make changes to Apple Watch software. As seen with the rethought user interface included in watchOS 3, Apple spent the past year studying how people were using Apple Watch. Friction points such as a clunky interface and little-used features, including Glances, were removed. Instead, Apple went back to the basics with a simpler interface and additional focus on Watch faces as the device's most valued real estate. (Additional thoughts from WWDC concerning watchOS 3 are available here).
Some people interpreted the changes found in watchOS 3 as evidence that Apple admitted it was wrong with Apple Watch. I disagree. That type of interpretation not only ignores everything that Apple got right about Apple Watch, such as Watch bands, but also ignores reality. Apple Watch financials portray a different story. Apple Watch's first year was not the disaster that many are now implying.
Apple Watch Financials
In terms of Apple Watch unit sales and revenue, we haven't been left as much in the dark as initially feared. While Apple has kept its official stance of not disclosing Apple Watch sales, management has not been shy about providing clues for reaching reliable Watch financial estimates.
Every three months during Apple's earnings calls, we have been given at least one major clue as to how Watch sales had fared. Here are the key clues that Apple management broadcasted on the past four Apple conference calls:
- July 2015: "The revenue from Other Products grew sharply [3Q15], up 49% over last year. The contribution from Apple Watch accounted for well over 100% of the growth of the category, and more than offset the decline of iPod and accessory sales...And to give you a little additional insight, through the end of the quarter, in fact the Apple Watch sell-through was higher than the comparable launch periods of the original iPhone or the original iPad."
- October 2015: "Sales of Apple Watch were also up sequentially [in 4Q15] and were ahead of our expectations."
- January 2016: "We set a new quarterly record for Apple Watch sales [in 1Q16], with especially strong sales in the month of December ."
- April 2016: "For some color on how we think about Apple Watch sales, we expect its seasonality to be similar to the historical seasonality of iPod, which typically generated 40% or more of its annual unit sell-through in the December quarter...unit sales of Apple Watch during its first year exceeded sales of iPhone in its first year."
In taking all of these clues into consideration, I have a high degree of confidence that Apple has sold 12 million Apple Watches to date. Exhibit 1 includes my Apple Watch revenue and unit sales estimates broken out by quarter.
Exhibit 1: Apple Watch Financials (Above Avalon estimates)
While these numbers are indeed lower than initial consensus estimates that came out when the Apple Watch was launched in April 2015, it would be incorrect to brush off a business that generated $6B of sales in its first 11 months.
Valuing Apple Watch Inc.
In an effort to better quantify how the Apple Watch is performing, we can value the Apple Watch business as if it were it a standalone company. One benefit of this exercise is removing the Apple Watch from the iPhone's shadow. Most financial metrics seem inconsequential when compared to the iPhone juggernaut.
Two items are needed to value a hypothetical "Apple Watch Inc.":
- Financial metrics
- Valuation framework
Given Apple's functional organizational structure, the company does not manage the Apple Watch as a separate division with its own profit/loss profile. While we can derive an estimate for Apple Watch gross margins, when it comes to estimating operating expenses, the calculations would prove less useful. Expenses such as salaries, retail costs, and even R&D are shared by Apple's broader product portfolio.
An alternative is to focus on Apple Watch revenue. This financial metric not only makes sense for measuring a product's success within a functional organizational structure, but also is something that we can estimate for Apple Watch with a fairly high degree of confidence.
When it comes to valuation, we can value Apple Watch Inc. by using a revenue multiplier. We take annual revenue and then multiple it by a certain ratio to obtain how much the market would be willing to pay for the right to own that revenue and future cash flows. This particular ratio can be obtained by using comparable company analysis. We look at how the market is valuing other consumer gadget hardware businesses.
Along those lines, I used three consumer tech hardware peers:
- Apple: Given the iPhone's share of Apple revenue and operating income, we can use Apple's current market valuation as a proxy for how the market is valuing the iPhone business. Apple currently sells at a 2.6x price/revenue ratio.
- Fitbit: Fitbit derives pretty much all of its revenue from wrist wearable hardware sales. This places the company as the most direct peer of Apple Watch Inc. Fitbit currently sells at a 1.1x price/revenue ratio.
- GoPro: GoPro serves as a good proxy for how the market is valuing a hardware company with slowing sales, increasing competition, and an unknown future. Things aren't looking good for GoPro although the company does appear to be making one last ditch effort to reinvent itself by hiring Danny Coster from Apple. GoPro currently sells at a 1.1x price/revenue ratio.
The interesting element found with these three peers is that each company is facing significant questions about hardware sales growth. While much has been said about GoPro's and Fitbit's issues, even Apple is expected to report a 15% decline in revenue in 2016. Accordingly, even if we assume Apple Watch revenue will decline over the next year (something that may be possible) this doesn't necessarily imply that the Watch should be rewarded a valuation multiple much lower than Apple, let alone Fitbit or GoPro.
As seen in Exhibit 2, I estimate that if Apple Watch was a standalone entity, it would be worth $10 billion. This estimate reflects a 1.7x price/revenue multiple, which is higher than Fitbit and GoPro's current price/revenue multiple. A higher multiple is justified due to Apple Watch's strength when it comes to appealing Watch bands, stronger customer loyalty, and deeper software and hardware integration. I am valuing Apple Watch in-line with Apple's enterprise value/revenue multiple. Even though the wearables category is much less established than the iPhone business, growth prospects remain quite attractive for the Apple Watch market in comparison to the mature smartphone industry.
Exhibit 2: Apple Watch Inc. Valuation Peer Analysis
Even if we valued the Apple Watch business as if it had the same future prospects as GoPro, we would still come out with a $7 billion valuation, which highlights the conservatism found in a 1.7x price/revenue multiple and $10 billion valuation.
Apple Watch Paradox
The preceding valuation exercise showcases the paradox that has engulfed the Apple Watch. While recent Apple Watch changes seem to imply that Apple management is pressing the reset button on the product, in reality, Apple already has a $10 billion Apple Watch business on its hands. This is even before all of the significant changes in watchOS 3 were unveiled on stage at WWDC. Rather than pressing a reset button, Apple is systematically going through the Apple Watch business to fix friction points that developed over the first year. All of this is being done to position the Watch for improved adoption and a valuation much greater than $10 billion.
There is evidence that Apple is still only getting started with Apple Watch. A closer look at Apple Watch bands reveal much potential and intrigue in terms of both technology and fashion. WatchOS 3 clearly positions Watch faces as a new kind of app for the wrist, which may represent the first genuine answer to the question of how to best interact with apps on the wrist. This could represent the beginning stages of an Apple Watch face App Store and a new stream of recurring revenue. I also think that Apple has major changes planned when it comes to Apple Watch collections, Watch case materials, and marketing. Apple's September keynote is shaping up to be an Apple Watch focused event. Add it all up, and Apple isn't walking or jogging but sprinting ahead with Apple Watch. We will likely look back at the weeks leading up to WWDC 2016 as the bottoming of Apple Watch expectations.
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