In the world of poker, freerolling is a very good thing. The term typically refers to a situation where you have potential upside with no possible downside, usually if you're currently tied with an opponent but have a draw to improve your hand for the win.
As it turns out, Apple (NASDAQ:AAPL) investors are currently finding themselves in this situation in more ways than one, considering that current prices are effectively assigning a zero value to several highly likely innovations that Apple potentially has in store on the horizon.
The glass is totally empty
Earlier today, Morgan Stanley analyst Katy Huberty was out with a bullish note. According to her company's proprietary pricing tool, she estimates that investors are currently pricing in long-term earnings-per-share growth of negative 4%, which is a tad overly pessimistic to say the least. Huberty believes investors are expecting "significant share losses and/or margin contraction," even as the company is expected to grow its top line by 14%.
Specifically, those figures are based only on Apple's existing product lines, and if there's one thing investors know about Apple, it's that it likes to create new markets for itself.
Two new categories
There are now two rumored products potentially up Apple's sleeve. The first, of course, is the mythical Apple TV set that has yet to see the day of light. More recently, though, is speculation that Apple is working on a smart watch, which has naturally and unofficially picked up the iWatch moniker. After talk began last year, just this month both The New York Times and The Wall Street Journal have corroborated reports that the iPhone maker is experimenting with such a device.
Wearable computing certainly seems to be the next big thing, with Google (NASDAQ:GOOGL) moving first with Google Glasses, even though it's far from commercially viable yet. Big G's initial concept video from last April is quite compelling and seems to be an obvious progression of where computing will go.
Tim Cook has reiterated on numerous occasions that Apple continues to have "intense interest" in the TV space and thinks the company can contribute a lot to that industry.
These are where Apple investors are currently freerolling.
Free option = freerolling
Using language more familiar to investors, Huberty calls the stock a "free option on Apple innovation," particularly when it comes to inevitable "expansion into new segments," such as an iWatch or iTV.
If an iWatch grabs an attach rate of 20% of the 500 million active iTunes accounts, investors could be looking at an incremental $10 billion to $15 billion in revenue. Eventually, Huberty estimates that Apple could sell 50 million units per year for an average selling price of $200 to $300. As far as the bottom line is concerned, Huberty thinks such a device would add up to $2.50 to $4 per share in earnings.
Turning to the possible iTV, Huberty is modeling for an extra $17 billion in annual revenue based on a more conservative 10% attach rate among iTunes account holders. That figure is based solely on a U.S. rollout of an Apple smart TV, which could translate into additional earnings per share of $4.50 for the year based on an average selling price of $1,300. As the iTV rolls out to the rest of the world, the business could generate up to $68 billion in sales and tack on $18 per share in annual earnings.
When you combine those two new potential product categories, we're talking about incremental revenue opportunities of $78 billion to $83 billion after everything is said and done.
This is all before we even consider other possible catalysts for Apple, such as upcoming product refreshes, expanded iPhone distribution with larger carrier partnerships such as China Mobile (NYSE:CHL), or the possibility that the company is preparing to boost its dividend and give more cash back to shareholders.
Huberty assigns bull case, base case, and bear case price targets of $980, $630, and $400, respectively, over the next year. Seem like a pretty favorable risk/return ratio, if you ask me.
Besides, who would say no to a free option?