• The Apple (AAPL) Watch isn't as quick and responsive as a smartphone.
• However, this issue will likely be addressed through software and hardware upgrades.
• While the product category has a lot of promise, the Apple Watch has other costs pertaining to COGS and OpEx, which severely limits profit contribution over the next couple of years.
• Volumes would need to be ramped up to offset these costs, which limits the contribution to Apple earnings. On the other hand, it may provide some upward lift to revenues in key quarters.
• While I'm certain I'm on the exact margin impact, I don't view the product category negatively, as I believe that over time it will add meaningful shareholder value.

From my own experience with the Apple Watch, I felt that the device was pretty slow in comparison to an iPhone but was substantially quicker than comparable smart watches from Samsung (SSNLF) and various other OEMs. Of course, I'm not much of a technology reviewer and I'm just basing this off of my own personal experience, but I think very many of you can already validate what I'm thinking here.

Apple plans to address this issue by releasing a second-generation Apple Watch that will come with improved hardware, and will operate without sharing data with an iPhone. More specifically, the Apple Watch is slow because it has to communicate with the iPhone to display information on the device, so by removing that bottleneck, the performance will improve considerably from the first generation device.

For the most part, investors had pretty high expectations for the upcoming product category. It takes a while for new product categories to appeal to the mass market. In this case, the app developer ecosystem is relatively small and it will take some time for developers to create a unique experience away from smartphones and tablets. Needless to say, the Apple Watch has very compelling applications for health and fitness, and is useful for big data analytics.

I anticipate that these functions will be built upon going forward as Apple will continue to integrate various micro-electromechanical systems into the device, i.e. sensors. The inputs for an Apple Watch are different when compared to an iPhone because the device is strapped to your wrist, which can give users the ability to feed continuous contextual data into the device. This has interesting implications for app developers, but I don't think the development community has leveraged the differences in hardware between wearables and smartphones to a meaningful extent. However, that doesn't make me pessimistic but rather realistic about the long-term revenue ramp of the product category.

Also, profitability has been a key concern for analysts following the announcement of Apple earnings in Q3. Initially, analysts were anticipating that the Apple Watch margins would at least be similar to the Apple iPhone. However, after examining the accounting notes more carefully from Apple's annual report, there are other costs not factored into component cost breakdowns.

According to the Apple 10-K filing 2014:

Revenue allocated to the embedded unspecified software upgrade rights and the non-software services is deferred and recognized on a straight-line basis over the estimated period the software upgrades and non-software services are expected to be provided for each of these devices, which ranges from two to four years. Cost of sales related to delivered hardware and related essential software, including estimated warranty costs, are recognized at the time of sale. Costs incurred to provide non-software services are recognized as cost of sales as incurred, and engineering and sales and marketing costs are recognized as operating expenses as incurred.

When looking at Apple's accounting notes, cost of sales is also inclusive of the cost of servicing the device, warranties, and other unanticipated costs. More specifically, the company mentions unspecified software upgrade rights, which is basically a deferred cost that is recognized on a straight-line basis. In other words, Apple factors in additional costs not pertaining to hardware, which reduces the gross margin investors could realistically anticipate even as the Apple Watch is estimated to cost $84 per unit to make. Also, the operating expenditures are likely to be bloated because the development of a new product category is very resource intensive on both the hardware and software side. Therefore, the product category isn't going to generate iPhone like margins until the Apple Watch generates much more meaningful sales volume. Furthermore, it's likely that Apple will invest a lot of resources in terms of R&D, and SG&A to sustain unit growth over the next couple of years.

Currently, Apple doesn't break out Apple Watch shipment figures, however, estimates from IDC indicate that shipments in the second quarter of 2015 were approximately 3.6 million. If we assume that rate of adoption continues throughout the entire year annual shipments should reach 14.4 million. Assuming ASPs are around $500, we can anticipate revenue of $7.2 billion. But, as I have mentioned earlier, the initial cost of developing the device must have been pretty high, as the company doesn't anticipate gross margins to improve sequentially from Q3 FY 2015 to Q4 FY 2015.

Furthermore, Tim Cook mentioned on the Q2 FY 2015 Apple earnings conference call:

We're not going to guide to or give projections of gross margin outside of the current quarter. And so what we have right now, which is a situation, it's not surprising to us, we knew we would be here, is that the watch gross margins for the current quarter that we've included in the guidance that Luca's provided in the aggregate, are lower than the company average. And so that to us is intuitive that they would be. And so I think we must be just looking at it through a different lens than you are.

This all points to lower expectations on the product itself, but at the same time the category could add meaningful revenue growth in the next fiscal year. If Apple Watch volumes grow steadily, perhaps revenue from the category will exceed $10 billion over the course of FY 2016. That could mean the difference between meeting analyst expectations versus beating them, as analysts are anticipating revenue to grow by $11.53 billion between FY 2015 and FY 2016. If the addition of Watch volumes are included, and iPhone units continue to grow, Apple should sustain a solid top line growth rate. However, it would be flawed to anticipate high rates of profitability, based on the comments from Tim Cook in prior quarters, and based on the accounting notes in the annual report.

Source: Apple Stock Price data by Amigobulls

The stock is starting to recover due to the broader improvement in market sentiment. The stock is fundamentally undervalued, and various upside catalysts aren't fully priced into the stock. Investors can make a compelling entry point at today's pricing levels.

I continue to reiterate my buy recommendation and $136 price target for Apple. I anticipate the stock to reach my price target by December 2015 despite recent market volatility.

Cover Image Licensed from: adrianhancu / 123RF Stock Photo