News that major retailers are slashing prices on Apple (NASDAQ:AAPL) Watch suggests that a new Apple Watch 2 is in the works for a March-April release. The next Watch will probably be an "S" style revision with little external change. Instead, the important changes will be internal, a new processor and a FaceTime camera. These changes could set up the Watch to take on the role of "action camera" in the future, expanding its target market.

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Source: Apple

Watch Upgrade

Rumors to the effect that Apple Watch would get some form of update on its anniversary have been floating around for some time. These rumors will undoubtedly gain momentum now that the price cutting (of about $100) at retailers Target (NYSE:TGT), Best Buy (NYSE:BBY) and B&H has been noticed. Such price cutting typically precedes a product refresh, as retailers clear out old channel inventory to make way for the new model.

The timing is certainly appropriate as we approach the one-year anniversary of Apple Watch, which became available for pre-order on April 10, 2015. For the first few years of iPad, Apple released updated versions on an annual basis. It's reasonable to expect the same for Watch since it's necessary to maintain consumer interest and sales momentum.

What Apple may offer in a revised Watch 2 is open to debate. Tech Crunch's Matthew Panzarino has opined that "Apple might ship a minor revision of the Apple Watch that includes a FaceTime camera and not much else." This just shows the ongoing technical deficiency of so-called tech writers.

The addition of a camera means a whole new processor. And that is the major change that is coming to Watch 2. Apple's systems on chip (SOCs) typically include the interface for the cameras, such as the SOCs for iPhone. The SOCs also contain an Image Signal Processing (ISP) block that handles things like focal plane non-uniformity correction as well as control of exposure time and signal gain. Additional higher level image processing enhancement is performed in the SOC CPU as well.

So the SOC and camera are very closely tied together, and I think it's a foregone conclusion that Apple would replace the SOC rather than add in another chip just to handle the camera functions.

And the Apple S1 SOC needs to be upgraded for other reasons. Keep in mind that the S1 is itself a tiny, encapsulated circuit board with a number of discrete components, as shown in the images below:

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Source: Chipworks

ABI Research also has another even more detailed tear-down of the S1:

As discussed in AnandTech's excellent technical review of the Watch, the processor is fabricated on Samsung's (OTC:SSNLF) 28 nm process. This was probably done for cost, as this process node is very mature and low cost. But it's two full generations behind the latest 14-16 nm FinFET processes of Samsung and TSMC (NYSE:TSM).

The latest gen processors provide greater processing speed combined with lower power consumption and increased battery life. The latest Samsung Galaxy S6 and Apple iPhone 6s smartphones make use of these advanced processors.

AAPL surely realizes that it needs to move the Watch processor to the latest as well. The key deficiencies of the Watch are its limited (~1 day) battery life and relatively slow processor. So, at the very least, we can expect to see an "S2" SOC. It will probably still contain a number of discrete components, but fewer with the WiFi and Bluetooth modems integrated into the application processor to make it more of a true SOC.

Natural Extension

I've been saying for some time that I expect the communications role of the Watch to enlarge with each generation, so the addition of a FaceTime camera and FaceTime capability is a very natural next step. Here the question is whether the Watch will have a stand-alone WiFi capability. This would give it the ability to conduct FaceTime calls over WiFi without the need of an iPhone as an intermediary.

I'd like to see this capability in Watch 2, but it may not be in the cards for this generation. WiFi radios still cost a lot of power, and that's the key limiter. More likely, Watch 2 will still need to be wirelessly tethered to an iPhone.

But it occurred to me that there is a more interesting role for the camera to play in the Watch 2. That's the role of an action camera. The reader may be chuckling at this, but hear me out. The Watch Sport is already priced about the same as an action camera, and it's considerably smaller and lighter. It's relatively water proof, and there is hope that Apple will improve the "water proofiness" for Watch 2.

With the straps being so easily removable (compared to almost every other sports watch), I can see mounts being developed that fit into the strap recesses. Then, you could put the Watch 2 on a selfie stick or helmet mount. And the Watch is even smaller and lighter than GoPro's (NASDAQ:GPRO) HERO Session.

It also has a much better user interface as well as integration with the host of Apple services provided for iPhone, including automatic uploading and cloud-based distribution of photos and videos. So turning the Watch into an ultra portable, ultra compact, ruggedized sports camera seems like a really good application.

There are technical hurdles, of course. Probably, this first generation FaceTime camera may not be full HD (1080p) but rather Apple's usual "FaceTime HD" resolution of 720p. This will put most action camera users off for Watch 2, but Apple will probably get the idea by Watch 3 and offer 1080p.

Investor Takeaway

My main point about Apple Watch is that there's still a lot of capability to be exploited by AAPL in the Watch. The company has already made it clear that its whole product strategy is to push more and more capability into each product category. I have previously pointed to the iPhone communications functions as being the natural area to move into Watch. The Watch isn't a particularly good device for text communication, so FaceTime becomes a very logical path forward.

The general purpose of the camera is something that I'm sure Apple has already thought about, so we may see more rapid progress in that area than I'm expecting. In any case, the enlargement of functionality should translate directly into an enlarged TAM.

By my calculations, Apple sold about six million Watches in the December quarter. I estimate that Apple Watch's cumulative sales are at about 11 million through December for an average of about 3-4 million units per quarter. As a rough estimate, the addition of the camera and a faster processor is probably good for another one million unit sales per quarter, bringing the sales volume up to a four to five million average.

That's still not iPhone territory, but it's getting up to major product status since it's about the same as Mac unit sales. Assuming a very modest ASP of $300 (remember Apple sells through many retailers, so this is kind of a "wholesale" price), that amounts to $1.2-1.5 billion in added revenue per quarter.

This is very likely to grow with each succeeding generation. Apple has developed a mobile device that benefits tremendously from advances in processor fabrication, so it's positioned to become ever more useful. Apple's competitors will also benefit, but AAPL has the advantage of its Watch OS ecosystem and native Watch apps that its competitors cannot match.

The bright prospects for Apple Watch 2 (and beyond) should help allay investor fears about Peak iPhone. Apple is continuing to expand its hardware and software ecosystems. I remain long Apple and rate it a buy for investors with long-term (3-5 year) investment horizons.

Disclosure: I am/we are long AAPL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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