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How iWatch Incremental Earnings Could Return Apple To The $700 Stock Price

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Apple is rumored to be working on a smartwatch, dubbed the “iWatch” in the media.  I have written that an iWatch launch is unlikely this year, and I have also written that an iWatch would be important for Apple.  Should Apple introduce this product, it would add incrementally to earnings.  But more importantly, those incremental earnings would have outsized impact on the stock price.  Why?

First, consider the impact on earnings of an iWatch launch.   To consider the best case scenarios, I assumed that Apple could charge $300 for an iWatch (twice the Pebble watch price), earn gross margins of 40% and net margins of 25%.   I looked at two scenarios:  first, the iWatch could follow the adoption curve of the iPhone and, second, the iWatch could follow the adoption curve of the iPad.

If these assumptions are correct, and they are most likely aggressive, then the iWatch could add $0.43 to $1.55 EPS in the first year, $1.25 to $3.78 EPS in the second year.

(These are approximations, of course, because more accurate estimates would depend upon which quarter it would be introduced, etc.  By looking at four quarters, the intent is to smooth out those effects to get a rough approximation for this analysis.)

Today, earnings estimates for Apple for FY 2014 are $43.70 and earnings estimates for FY 2015 are $46.45.   Clearly, an iWatch launch, even with aggressive assumptions, will not have the earnings impact that the iPhone or iPad had for Apple.  Apple earned $3.17 total for the four quarters before the iPhone launch, and earned $5.11 total for the four quarters after the iPhone launch, an increase of 62% (EPS calculated on former accounting practices, shown for illustrative purposes that EPS improved after launch).  Apple earned $11.78 total for the four quarters before the iPad launch, and earned $25.26 total for the four quarters after the iPad launch, an increase of 114%.

However, the launch of an iWatch could still have meaningful impact on Apple’s stock price even with a smaller impact on earnings.  How?  The launch of a new product category for Apple would meaningfully impact Apple’s P/E multiple.

First, the overwhelming reason cited for Apple’s stock demise from over $700 to today’s mid $400 levels is the changed perception of Apple from a growth stock to a value stock.  Investors lamented the lack of innovation and catalysts for growth in Apple’s future.  An iWatch introduction would change the perception of Apple and the multiple investors would assign to it.

Second, Apple’s current Price/Earnings multiple on a trailing twelve month (TTM) basis is 10.6x.   When Apple introduced the iPad in April 2010, Apple’s Price/Earnings TTM multiple was 20.2x.  By WWDC in 2010, Apple’s Price/Earnings TTM multiple expanded to 23x, more than double today’s multiple.   By the end of 2010, Apple’s price/earnings TTM multiple settled to 21x.  When Apple introduced the iPhone in January 2007, Apple’s price/earnings TTM multiple was 33.4x and rose to 38.5x at the end of June when the iPhone was released.  By the end of 2007, the multiple increased to 50x.  Product launches in the past have enabled Apple to earn much higher Price Earnings multiples than they have today.  (Historical P/E multiples source:  YCharts)

Third, if Apple were to introduce the iWatch in the beginning of FY2014, a $700 stock price target would equate to a Price/Earnings TTM multiple of 15.5x to 15.9x, based upon a iPad or iPhone adoption curve, respectively.  For FY 2015, a $700 stock price target would equate to a Price/Earnings TTM multiple of 13.9x to 14.6x, based upon an iPad or iPhone adoption curve, respectively.  For Apple to trade at these multiples is not out of the ordinary.  Apple traded in these ranges as recently as in the fourth calendar quarter of 2012, and higher historically.

Creating a new product category is essential for Apple to break out of its current trading pattern.  The market generally has lost its confidence in Apple to innovate and has punished Apple by leaving it in the Value Stock bucket.  A new product category would change investors’ mindsets and give Apple a Price Earnings multiple more deserving of a growth company.  In this manner, the incremental earnings that a new product category, like the iWatch, could generate would help propel the stock back to previous levels.