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How Apple, Inc.'s Watch Opportunity is Asymmetrical

By Evan Niu, CFA - Sep 24, 2014 at 8:11AM

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If the Apple Watch fails, it will get a lot more attention than if it succeeds. That's because Apple Watch is a symbol.

Source: Apple.

Apple ( AAPL -1.17% ) has been talking about its product halo effect for over a decade, where the purchase of one product encourages the purchase of additional Apple products within the ecosystem. The first significant instance was the iPod helping sell Macs, even after Apple brought iTunes to Windows.

Well, the halo effect isn't always symmetrical, and the Apple Watch may be the company's most asymmetrical device when it comes to selling other Apple products like the iPhone. If the Apple Watch fails, Apple will get a lot more attention than if it's a blowout success. 

No one would buy an iPhone just to get Apple Watch
Much like many other OEMs entering the smartwatch market, Apple is tethering the Apple Watch to the iPhone for numerous critical functions such as GPS and Wi-Fi. Apple says the upcoming wearable will require an iPhone 5 or later, and has not detailed if any functions will be available on a stand-alone basis. In some ways, the Apple Watch will be an extension of the iPhone, and as such the iPhone will help sell the Apple Watch.

Unfortunately, that's unlikely to be true the other way around. The Apple Watch doesn't have any killer stand-alone functions, so it doesn't seem that many potential customers will rush out to buy the device and then go out and buy the required iPhone on top. The Apple Watch is more of an accessory for the iPhone, and as such it will not help sell iPhones.

That's not to say that the Apple Watch doesn't have a strategic place within Apple's product lineup. As Apple has grown its overall portfolio over the years, each product has incrementally strengthened the overall halo effect and made Apple's platform increasingly stickier. Apple Watch could do the same, even if it doesn't help drive iPhone sales.

A numbers game
There's also a financial aspect to how the Apple Watch's opportunity is asymmetrical. Looking at traditional valuation metrics, Apple is cheap by just about any measure.

Valuation Metric

Value

Price / Earnings

16.3

Price / Sales

3.4

Price / Free Cash Flow

16.3

Source: Reuters.

The S&P 500 is currently trading at 19.8 times earnings, a notable premium compared to the Mac maker. While Apple has long traded at a discount to the market, it's arguably not priced for much future growth. This is why some Street analysts, such as Morgan Stanley's Katy Huberty, have called Apple shares a "free option" on future innovation. Any option trader can tell you that option payoffs are asymmetrical.

To be clear, Huberty's characterization was in early 2013 and she estimated at the time that shares were priced for negative earnings growth. Apple has recovered since then and is now flirting with all-time highs again, but you'd still be hard pressed to find anyone that considers Apple shares expensive.

However, if the Apple Watch ends up falling short of expectations, chances are that shares would get severely punished. On the flip side, the Apple Watch is unlikely to be a financial game-changer for Apple in the near-term.

For instance, if Apple sells 20 million units at an average selling price of $500, that would translate into $10 billion in revenue. That theoretical sum would easily make the Apple Watch the most successful smartwatch in the market, but it would also represent less than 6% of incremental upside to Apple's current trailing-12-month revenue base of $178 billion. Most would consider 20 million units an unquestionable success, but the point is just that its impact would still pale in comparison to the sheer size of the iPhone business.

If this proves true, there's only one explanation for this asymmetry, ignoring all immediate financial considerations.

One more thing...
When Tim Cook unveiled the Apple Watch, using Steve Jobs' iconic "one more thing" line for the first time, he also said it marked the "next chapter" in Apple's story. That's in part why the company chose the same venue where Jobs had unveiled the original Mac three decades prior to host its September 9th event. Cook wanted to underscore the significance of the unveiling.

Apple Watch is a symbol.

It's now been just over three years since Cook become CEO. In that time, skeptics have wondered if Apple's ability to innovate died with Jobs. Investors may also recall reports that Jobs left the company a 4-year product pipeline. It hasn't been quite 4 years, but Cook did confirm that Apple Watch development began after Jobs' death. This is why the Apple Watch is so important, because it symbolizes Apple's ability to innovate (or the perceived lack thereof) in the post-Jobs era.

Cook has never been a product guy, and the Apple Watch is decidedly his baby. The reality is that Cook doesn't need to be a product guy, because Jobs made Apple a product company. Still, Cook will inevitably be judged by the success or failure of Apple Watch.

Apple Watch represents the first major product category that Apple has entered post-Jobs. If its performance falls short of expectations, criticism regarding Apple's ability to innovate will intensify, and investors could lose confidence in the company's future. If it succeeds, we've already discussed how it won't transform Apple's overall business, and it's a bit premature to be optimistic about all the stuff Apple is working on that hasn't even been rumored yet.

Even though Apple has had its fair share of flops over the years, a possible Apple Watch flop would be significantly overweighted, for better or for worse.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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