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Stock Strategist

A High Bar for Apple's New Products

Expectations are high for Tuesday's event, and the company has little room for error.

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All eyes remain on  Apple's (AAPL) event Tuesday, where it is believed the firm will introduce a larger-screen iPhone 6 (and possibly two), as well as an iWatch wearable device. We view much of Apple's runup--a 32% gain in the past six months, reaching all-time highs--as driven by tremendous anticipation for these products. In our view, the bar has been raised to the point where Apple has virtually no room for error, yet concerns around iCloud security and heightened phablet competition from Samsung's Galaxy Note Edge, which we think led to last Wednesday's 4% sell-off, may pose a couple of risks.

In our view, new features around the iPhone 6 (larger screens, sapphire-based displays, mobile payments) are well understood. Besides these features, we view the two main catalysts for iPhone 6 growth as Apple's partnership with China Mobile and changes in many U.S. wireless plans that allow for early upgrades.

We see a chance that iWatch will be priced higher than peers, while failing to offer all of the functions that have been rumored by many in recent months. We expect tight integration with iOS and a host of fitness features, but no medical features that would require Food and Drug Administration approval and relatively little processing power in order to preserve battery life. Thus, an iWatch may face skepticism at first, but as developer support, new features, and price reductions come in over time, we see it becoming a viable product that contributes incremental earnings growth. More important, an iWatch should add another layer of switching costs and enable the firm to hold on to its massive iOS user base in the long run.

December Quarter Will Hinge on IPhone 6
Looking at the iPhone 6, we think Apple will need to hit several key milestones over the next couple of months to placate investors and justify current stock prices. First, Tuesday's product introduction will have to include all of, if not more than, the widely rumored features and screen sizes, while offering no glaring omissions or room for disappointment. Second, Apple may need to deliver opening weekend sales (probably Sept. 19-21) far in excess of 9 million units sold a year ago. Apple reports opening weekend sales on a sell-in basis, which includes online and retail sales, as well as shipments to resellers and carriers to stock the retail channel. At this point, we'd guess that Apple would need to deliver opening weekend sales of at least 11 million units this year in order to justify the current share price. Presumably, the partnership with China Mobile should help Apple reach this target. We note that last year, Apple not only disclosed opening weekend sales but also updated its financial guidance for the September quarter, so we'll keep an eye out for a similar update this year as well. Finally, all eyes will be on the firm's earnings report in late October and especially its guidance for the December quarter. Given Apple's difficulty in generating outsize year-over-year iPad sales growth, and excluding any possible iWatch contribution, we would look to the iPhone as the primary source of any revenue forecast beat (or shortfall) from consensus expectations for the December quarter. We currently estimate that Apple will sell 60 million iPhones in the December quarter (versus 51 million a year ago), but suspect that consensus estimates are currently even higher. We could easily see a scenario where Apple sets all-time iPhone sales levels but fails to meet the expectations of investors and encounters a sell-off on "weak" unit sales.

Watching for an IWatch
One of the key takeaways from our research is a reminder that Apple's first-generation products (iPhone, iPad) were introduced with far less functionality than what we consider to be common features today. We anticipate the same, if not more pronounced, dynamic with an iWatch, given battery constraints. Rumors that the iWatch will be introduced in September but might not be available for sale until calendar 2015 raise our suspicions even further, as the company may need to cut out a couple of features in order to make the product ready for prime time. We think it is entirely possible that an iWatch won't be able to handle Siri or phone calls independently (at least right away), as the components needed to run these functions may be power hungry, but it may act as a Bluetooth-type device tethered to a nearby iPhone. We are also quite skeptical that an iWatch can measure serious health metrics like blood pressure, as the device may not hit the high quality requirements needed to meet FDA approval (or again, at least not in its first generation).

Ultimately, we expect an iWatch to offer various features, like calendar and text alerts and maybe even mobile payments, that are best suited for a device that is worn at all times (rather than a phone that might be left on a desk or in a purse), as well as fitness features (sleep cycle, pedometer, and so on) currently offered by wearables like the Nike FuelBand or Jawbone Up today. Although many are expecting a $200-$300 device, similar to competing smartwatches, we wouldn't be surprised if an iWatch were introduced at $399 or above. An iWatch may not hit the mainstream right away and reach hundreds of millions of customers in its first 12 months, but we certainly think it has a good chance to be a nice iPhone accessory that reaches a widespread audience in the intermediate term. Not only should it be additive to revenue and earnings, but the device should strengthen switching costs around iOS (which, in our view, is the source of Apple's narrow moat) as we suspect that iWatch owners would be increasingly less likely to switch away from iOS smartphones and tablets over time.

Sell-Off Reasonable
Regarding last Wednesday's 4% sell-off, not only do we think it is reasonable that investors begin to take profits in Apple after its 32% rise over the past six months (and especially given our view that the stock is modestly overvalued today), but the company certainly appears to be a candidate for a "buy the rumor, sell the news" type of sell-off heading into the event. We also believe that, in order to meet or exceed iPhone sales expectations, Apple will have to make massive market share gains in the United States against Samsung. The introduction of the Samsung Galaxy Note Edge, with an innovative side screen, may have raised some fears that Apple's share gains at the 5.5-inch segment of the market might not be a slam dunk after all.

Bad Time for a Breach
Finally, concerns about Apple's iCloud security, due to the theft of compromising celebrity photos, come at exactly the wrong time for the firm. Not only did this make tabloid headlines a week before the firm's most important product launch, but Apple has consistently touted the security and privacy of iOS at recent events and is widely expected to introduce a mobile payment platform that would require topnotch security for stored credit card data. Regardless of the truth around this incident and the reality of Apple's security measures, the perception that iCloud has security flaws has probably caused too much damage for Apple to repair immediately and is likely to be the elephant in the room at Tuesday's event.

We don't expect iOS users to depart the platform in droves because of this incident. Our concerns don't revolve around iCloud itself, but rather the contrast between this incident and the rumored announcement of a mobile payment platform at the event. Reports suggest that any mobile payment data will probably be stored in Apple's secure processor enclave (similar to Touch ID) within its A-series processors, rather than iCloud. Apple has also announced enhanced security measures around iCloud, and it intends to raise awareness around added security actions that users can take. However, the unavoidable headlines about the iCloud breach may cause some users to avoid, or fail to see value in, a mobile payment platform, as well as possibly cut back on the use of other iCloud services that may enhance Apple's switching costs. In turn, one of the key new features of the iPhone 6 may not be enough of a draw to help the company encourage users of older iPhones to upgrade to the new device, thus potentially creating a modest headwind that may cause Apple to fail to exceed the extremely high bar that's been set for iPhone 6 unit sales growth.

Brian Colello does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.