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Innovation Mojo Boosts Apple’s Fair Value

We’re raising our fair value estimate for Apple after incorporating the impact of Apple Watch, but expectations for the firm remain too high.

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In our view,  Apple’s (AAPL) latest product introduction event was a success. Barring any execution missteps, the launch of two larger-screen iPhones, Apple Pay, and Apple Watch should put to rest any fears that Apple and its management team had misplaced their innovation mojo. News around the iPhone 6 and iPhone 6 Plus was mostly in line with our expectations. At this point, we remain comfortable with our estimates of 60 million iPhone unit sales in the December quarter, even though we realize that Apple’s current stock price likely bakes in even loftier expectations. We'll likely raise our fair value estimate to $93 per share as we incorporate financial estimates of Apple Watch into our valuation. Apple's narrow economic moat rating is unchanged.

Apple’s iPhone 6 and iPhone 6 Plus may emerge as two of the best smartphones on the market, as Apple continues to focus on the industry's premium segment. However, headwinds to future growth likely stem from low-end and mid-range competition from Android. Apple Pay looks interesting, and we’re pleased that Apple took great lengths to discuss security associated with this new service. We're much more interested in Apple Pay in terms of adding another valuable service that both enhances the user experience, and adds switching costs that promote customer stickiness. Apple could potentially earn incremental revenue from Apple Pay in the long run, but we don’t see it moving the firm’s revenue needle today.

Apple’s Watch lineup looks compelling. The devices have more functionality than what we would have expected, but we fear that the tradeoff might be poor battery life, which was not disclosed, and is our biggest concern for now. Prices starting at $349 seem reasonable, but we’re curious about the all-in cost once customers buy additional wristbands, which may be the real source of Apple’s profitability from the product, as well as pricing on the gold Watch Edition.

Growth drivers for the iPhone 6 should come from Apple’s partnership with China Mobile (even though China was not listed as one of the eight countries that will immediately get the iPhone on September 19), and changes in many U.S. wireless plans that allow for early upgrades. Beyond these factors, the rest of Apple's growth may need to come from market share gains from Samsung and others, as customers who left Apple for the lure of larger-screen devices may come back to iOS. We expect Apple to gain some market share in developed markets, but we can’t predict that such share gains are a slam dunk. Various industry reports generally indicate that Apple has the highest customer loyalty in the sector. However, loyalty metrics for Samsung devices and Android, in general, have been quite good, so we don’t see every premium smartphone customer trading in their devices overnight. Furthermore, the bear case for the iPhone over the past couple of years has been slowing growth at the high end of the smartphone market, as a greater portion of growth will likely come from lower-priced smartphones in the $100 range sold in emerging markets. We don’t think this dynamic has changed, or will change, regardless of whether Apple sells a phone with a 4.0” or 5.5” screen. These threats prevent us from being wildly optimistic that Apple and the iPhone will emerge as a winner-take-all in the smartphone space.

We remain comfortable with our call for 60 million iPhone units sold in the December quarter, but didn’t see any surprising iPhone 6 features that would move the needle on our forecast one way or the other. The biggest surprise was that the iPhones did not include a sapphire screen. This was contrary to the rumor mill leading up to the event, but it makes sense to us, as the benefits of sapphire (scratch resistance, but expensive and can crack under pressure) make much more sense for a watch screen than a phone (although we wouldn’t rule out the use of a sapphire screen in the phone in future models). We view the lack of a pricey sapphire screen as a benefit for Apple’s iPhone near-term gross margins, but likely providing some long-run gross margin pressure.

Regarding Apple Pay, we’re encouraged by the firm’s security efforts around credit card and financial transaction information, especially in light of the firm’s iCloud security problems from last week. Ultimately, we think Apple Pay could win some adoption right away. It remains to be seen how much easier it is for the average iPhone user to pay via iPhone or Watch, rather than pull out a credit card, and the true value of the service may come from in-app mobile purchases from companies like Target, Uber, and Panera (disclosed today). Further, security around Apple Pay, such as the use of TouchID and the creation of one-time numbers and dynamic security codes, may actually emerge as a key benefit of the service (despite recent iCloud concerns), as merchants such as  Target (TGT) and  Home Depot (HD) --whose credit card security woes are well-documented--will not receive actual credit card numbers for Apple Pay purchases.

In the short-term, it does not appear that Apple Pay will drive meaningful incremental revenue for Apple in terms of extracting a percentage of transaction fees from merchants, although the long-term potential for healthy revenue and profitability appears to be there. Yet we’re much more interested in Apple Pay in terms of switching costs, as meaningful Apple Pay usage among iOS customers could give users yet another good reason to remain with the platform in the long-term, and buy many more Apple devices over time. From the perspective of credit card networks, we don't think the technology--which essentially functions as a secure storage mechanism for payment data--is disruptive to the businesses of payment networks or card issuers, as it will allow customers to use a variety of payment options.

In general, our first impressions on the Apple Watch are favorable, but for now, we're containing our enthusiasm. We remain concerned about battery life and costs above and beyond the stated $349 starting price. Although we haven’t yet tried out the Digital Crown that allows users to scroll and zoom through the device, we’re encouraged by Apple’s innovative user interface, which could be a key differentiator from competing devices on the market.

We were correct in assuming that the Watch will need to be paired with an iPhone for significant functionality, as it incorporates a WiFi and Bluetooth chip, but no cellular chipsets or GPS. The device also doesn’t have a host of true medical features, such as blood glucose measurement. We think this would have been a long shot anyway, as it would have exposed Apple to FDA oversight. Still. there certainly could be such features incorporated in Watches in the distant future. Prices starting at $349 were modestly lower than what we anticipated, but we suspect that prices for the 18-karat gold Apple Watch Edition might be much higher. Also, the cost of additional watch straps may make the device a bit prohibitive for the mainstream, as we can easily see customers wanting to own several straps (steel for formal, rubber for Sport Band, etc.).

The Apple Watch unveiling pulls the rug out from under our earlier prediction for an Apple bracelet rather than a watch. However, the company solved any fashion and gender differences by building the Watch in two different sizes (38 millimeter and 42 mm) and offering different bands. By offering the Siri and Map features, the Watch offers greater functionality than what we would have expected. However, we fear that Apple chose a clear tradeoff in terms of battery life, as the firm didn’t disclose the product’s battery life at the event. At this point, we can only assume that battery life hits a bare minimum of 24 hours, which could deter many potential buyers. Re/code previously reported that the Watch wouldn’t launch until early 2015, so the delayed availability wasn’t a total surprise. The delay is reminiscent of the initial iPhone, which had a several month lag between announcement and availability. But we view it as much more important that Apple gets the product right, rather than early. We’re encouraged by the innovation incorporated into the Apple Watch, but all of this goodwill could evaporate instantly if Apple were to fail to execute in delivering a smooth, functional product.

Our revised fair value estimate of $93 now incorporates sales of an Apple Watch. We currently model unit sales of 15 million in calendar 2015, primarily to early tech adopters and those with disposable income. However, we don't see the Watch lurching into the mainstream right out of the gate. We use an average selling price of $450 for the device, which we consider to be the all-in cost of the cheapest Watch at $349 plus the price of two wrist straps, which we assume to be $49 each. By calendar 2018, we model 37 million units per year at a $350 average selling price, or ASP, as Apple will likely cut the device’s price in order to appeal to a more mainstream audience, especially as more apps developers, software and services is added to the Watch platform. We model a 35% gross margin for the Watch but we may be initially conservative, depending on the cost of the sapphire screen, in particular. In turn, we currently model that Apple Watch adds about 5% incremental gross margin dollars to Apple as a whole.

We also modestly adjusted our iPhone estimates, as we forecast higher gross margins in fiscal 2015 due to the lack of a sapphire screen in the iPhone 6 and 6 Plus, but shave a couple of percentage points off of long-term iPhone gross margins, reflecting our assumption that costlier components (either a sapphire screen or perhaps even more memory) are added to these devices ensure a premium user experience. We also lowered our iPad Mini unit sales estimates, as we suspect that the presence of a 5.5-inch iPhone 6 Plus will cannibalize some iPad Mini sales. Since iPhone gross margins are likely far superior to iPad, this is an advantageous tradeoff for Apple that the firm would likely welcome.

We view Apple’s product event as giving us greater comfort around its narrow economic moat and positive moat trend ratings. Barring execution missteps or a product flop, we view usage of Apple Pay and ownership of an Apple Watch as two items that should add significant switching costs to iPhone users, and make it extremely unlikely that such users would break away from the Apple ecosystem toward similarly priced, or even lower-cost, Android devices. We still recognize that no single piece of hardware or software will create strong enough switching costs to lock Apple users in forever, but we view Apple’s switching costs as having a Velcro effect, where many little hooks keep users attached to the platform. Just as digital music and perhaps media ownership may have far less of a "hook" today as it did in the mid-2000’s when iPod was in its prime, Apple Pay and Apple Watch may emerge as two strong hooks for Apple over time.

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Brian Colello has a position in the following securities mentioned above: HD. Find out about Morningstar’s editorial policies.