(FORTUNE Magazine) – "My God, there really has been a genie locked in that bottle! Apple's innovation and creativity have been unleashed in a way that they haven't been in 20 years. Look at the results. This isn't a company about 5% market share; this is a company that is capable of competing with world-class competitors and achieving market shares of 65%, 70%, and even 90%."

Steve Jobs, the silver-tongued king of Apple Computer, is explaining how the world's opinion of his company has risen with the triumph of the iPod. We're in our third phone conversation, following up on a 2½-hour interview in the Apple boardroom a few days before. Jobs is obviously feeling good, and with good reason. Overnight, it seems, Apple has broken out of its box as a boutique computer maker and emerged as a force to be reckoned with in consumer electronics, music, and who knows what else. "The great thing is that Apple's DNA hasn't changed," he says. "The place where Apple has been standing for the last two decades is exactly where computer technology and the consumer electronics markets are converging. So it's not like we're having to cross the river to go somewhere else; the other side of the river is coming to us."

Apple's recent achievements, in fact, make it look as if it is walking on water. Its stock price, which languished during and after the dot-com crash, suddenly more than tripled last year. (It recently hit an all-time high of nearly $80 a share.) In January, Jobs crowed that Apple had posted the highest revenues and profits in its 28-year history for its fiscal first quarter ending Christmas Day. Propelled by sales of 4.6 million iPod portable digital music players, revenues zoomed by 74%, to $3.5 billion for the quarter, putting the company on track, by analysts' estimates, for a $13 billion 2005. Meanwhile profits more than tripled.

The DNA may not have changed, but the external transformation is dramatic. No longer is Apple's business limited to computers--though it did sell more than a million Macs last quarter for the first time in four years. Today the company's ever-expanding products encompass multimedia applications for creative professionals and consumers, the thriving .Mac (pronounced dot-mac) Internet subscription service, and a popular line of easy-to-use wireless networking gizmos to link computers and stereos and other devices in the home and office. And, of course, the iPod. The company has even become a player in retail with its 100 Apple Stores: chic glass and anodized aluminum temples that fuse fashion, technology, and reverence for personal creativity into something Jobs likes to call the "Apple user experience."

In his first extended interview since undergoing surgery for pancreatic cancer last summer, Jobs eagerly explains how Apple has pulled all this off and drops hints about where the company is going and how big he expects it to get. (For excerpts from the interview, see box.) But as the conversation unfolds, Steve doesn't talk about the next gotta-have-it gizmo or ultracool ad campaign or trendsetting industrial design. None of those, he says, is Apple's core strength or primary competitive advantage. Instead he's going to talk about software--the central strand that runs through all of Apple's success.

Steve being Steve, he's doing this partly because he's selling something. This spring, Apple will unveil Tiger, an update of its OS X operating system that, at $129 a pop, will generate hundreds of millions of dollars of high-profit sales. (More about Tiger later.) Even so, for Steve to credit software for Apple's success sounds so hopelessly dweeby, so Bill Gates, that it seems hardly worth muting your iPod for--until you consider the new business model it has helped Apple spawn. Indeed, the whole iPod phenomenon is, underneath it all, one big interwoven software creation. The iTunes jukebox that coordinates the mind-meld between your iPod and your Mac or PC is just the most obvious chunk of code. The iTunes Music Store, which accounts for 62% of all music download sales on the web, is likewise a software machine, purring away in both Apple's corporate IT systems and your computer. And the iPod itself, like the Macintosh, is a marvel of software engineering.

It's that prowess in software that is Apple's greatest hope for sustained growth as it dives into markets dominated by leviathans like Sony and Microsoft, and that could propel it into other realms of consumer electronics. As we'll see, software wizardry is how Steve brought Apple back from oblivion and even breathed new life into the Mac, which turned 20 years old the day we sat down to talk. Software, in a word, is the genie in Apple's multibillion-dollar hardware business.

Steve Helps Himself

Your typical corporate CIO must be wondering, "Why aren't there some nice new exciting applications for me?" Nothing has really changed in his world, while on the consumer side there's all this cool new stuff like iTunes and the iPod and iPhoto and iMovie. That's where the real innovation is now, and Apple is driving it.

-- BILL JOY, CO-FOUNDER AND FORMER CHIEF SCIENTIST AT SUN MICROSYSTEMS

Think back about just how irrelevant Apple seemed even two years ago. Its share of the personal-computing market had shrunk inexorably throughout the 1990s to a tiny 2%. It had slogged through nearly a decade of dwindling influence and financial pain. The consumer-oriented Mac couldn't run many of the programs that PC users--especially those in business settings--needed. Corporations, which buy the bulk of computers, were at best keeping a few Macs around to handle creative tasks like photo editing and document design.

By the late 1990s, Apple was making even its most loyal users doubt the point of sticking with the company. Its operating system was an unstable patchwork, and programmers were growing ever more reluctant to write for Macs or adapt their PC programs to run on the machines. Apple knew it needed help. It turned to a man who had started it all: Steve Jobs. Since being pushed out in 1986 of the company he had co-founded, Jobs had gone on to start another computer company, Next, and to take over what would become the animation powerhouse Pixar. Apple bought Next in 1997, and in came Jobs with a plan to remake the company with software.

But software takes a long time to build, and at first he had to scramble just to keep the place afloat. He pruned the product line in his first full year as CEO, causing revenues to sink some 15%, to $5.9 billion--little more than half of Apple's peak sales in 1995. One of his first moves surprised Apple partisans--he turned for help to his longtime rival Bill Gates. The two struck a deal under which Microsoft bought $150 million of Apple stock and promised to keep supplying Microsoft Office and Internet Explorer for the Mac, programs that made Apple's computers at least somewhat compatible with the PC world. (Microsoft's stake in Apple is now worth well over $1 billion.) At the same time, Jobs used hardware to create buzz. In 1998, Apple launched the iMac, a fun, jellybean-colored machine that--while little different internally from its predecessors--quickly became a fashion statement.

But in truth, he was using the Microsoft deal and the iMac to buy time. Jobs' big bet was on Mac OS X, a new operating system based on his work at Next. Unlike the old Mac OS, this one would be based on Unix, an operating system that had been poked, prodded, tested, and improved over decades by some of the largest companies and universities. He told Avie Tevanian, who led software development, and Bertrand Serlet, the head of the OS X team, to treat it as a moon shot. In 2001, after three years of labor by nearly 1,000 geeks, Apple delivered the software equivalent of a cross between a Porsche and an Abrams tank: an operating system with sleek, animated graphics and an abundance of useful and novel features built on top of industrial-strength code. OS X made it easier to write applications, made programs run better, and allowed for much easier plug-and-play of camcorders and other consumer products.

OS X gave Apple the foundation it needed to build new generations of machines. But to get most of its 25 million or so Mac customers to upgrade, Jobs needed sexy applications. As part of his deal with Gates, Microsoft had agreed to adapt Office and Explorer for OS X. Jobs had assumed that this vote of confidence would inspire third-party developers to come up with software for, say, editing home videos on a computer or managing photos or digital music. But a 1998 meeting in which Jobs asked Adobe Systems executives to develop a Mac version of their consumer video-editing program changed his mind. "They said flat-out no," Jobs recalls. "We were shocked, because they had been a big supporter in the early days of the Mac. But we said, 'Okay, if nobody wants to help us, we're just going to have to do this ourselves.' "

So Apple plunged into the OS X applications business. It bought a languishing project from web software company Macromedia, and in less than a year turned out two programs that capitalized on the iMac's ability to connect to digital camcorders: a video-editing program for professionals called Final Cut Pro and a simplified version for consumers called iMovie. Apple's Applications Software Division, which sprang from the project to become what is now a 1,000-engineer-strong group, has been on a roll ever since.

Consider iLife, a bundle of programs that comes free on every new Mac or can be purchased separately for $79. Its five applications turn the computer into a home studio: iMovie, iDVD (for recording movies, digital photo slide shows, and music onto TV-playable DVDs), iPhoto (for managing and touching up digital pictures and making slide shows), GarageBand (for making and mixing your own music), and the iTunes digital-music jukebox. iWork, aimed at people who like to make presentations and put out newsletters, is equally slick: It consists of a PowerPoint-like program called Keynote and a flashy word-processor/page-layout program called Pages.

The steady stream of software not only kept the buzz alive but also helped Apple create a tidy new line of business. Gradually users began to notice that the company was delivering truly innovative programs and continuously improving them. Today Apple gets people hooked with free online updates and then, every year or so, offers to sell them a full overhaul loaded with new features--and more and more users are willing to pay. OS X has already gone through four versions, named Cheetah, Puma, Jaguar, and Panther. It's a tactic that Microsoft and other software makers have tried with much less success--Windows users in particular have grown leery of the chronic computer crashes and conflicts between programs that its upgrades cause. Apple engineered ways to minimize such problems.

The upgrades also fuel Apple's computer hardware business, which still accounts for 60% of annual sales. Jobs sees applications like iLife as the centerpiece of his marketing strategy, which is to differentiate the Macintosh from Windows PCs by positioning it as a complete multimedia machine. Right out of the box, the Mac with iLife gives users (especially the creative types) everything they need for creating, editing, managing, and playing digital content. While comparable applications are available for Windows machines, matching what Apple initially throws in free costs hundreds of dollars, and the various Windows programs don't interact easily with one another. "Everyone in every corner of the software business could learn a lot from iLife," says Bill Joy, the legendary computer scientist, now a Silicon Valley venture capitalist.

Triumph of the iPod

I remember sitting with Steve and some other people night after night from nine until one, working out the user interface for the first iPod. It evolved by trial and error into something a little simpler every day. We knew we had reached the end when we looked at each other and said, "Well, of course. Why would we want to do it any other way?"

-- JEFF ROBBIN, LEAD SOFTWARE DESIGNER FOR ITUNES AND THE IPOD

The best example of how clever software plays the pivotal role in unlocking huge hardware opportunities for Apple is the saga of iTunes and its progeny--the iPod and the iTunes Music Store. Their lightning evolution demonstrates how, when the coders really get rolling and follow their noses, one technological breakthrough leads to another in a virtuous cycle that Jobs, the marketing whiz, can exploit to create "user experiences." It's how the iPod coalesced into the hottest product the media and electronics world has seen in years. And the delicious irony is that Apple's enormous success in digital music came out of nearly missing the boat.

"I felt like a dope," says Jobs, thinking back to summer 2000, when his fixation on perfecting video editing on the Mac distracted him from noticing that millions of kids were using computers and CD burners to make audio CDs and to download digital songs called MP3s from illegal online services like Napster. Yes, even Jobs, the technological visionary of his generation, occasionally gets caught looking in the wrong direction. "I thought we had missed it. We had to work hard to catch up."

He moved fast, ordering Mac hardware designers to incorporate CD-ROM burners as standard equipment in all Macs. But what about the "jukebox" software necessary to manage what could conceivably be thousands of songs on the computer? Windows PC users already had several jukebox programs to choose from, but only a handful of Mac developers were tinkering with them. One was a company called SoundStep, founded by a then 28-year-old software engineer with an MBA named Jeff Robbin, who had left Apple literally the month Jobs returned. His program, SoundJam, wasn't ready for market, but Jobs bought the company anyway, primarily because Robbin had impressed people while at Apple before.

The alacrity and breadth of what transpired over the next 13 months are hard to believe in hindsight. Robbin and a couple of other programmers started over from scratch and pounded out the first version of iTunes in less than four months. That was just in time for Steve to show it off at the annual Macworld trade show. The application simplified the importing and compression of songs, but more important, iTunes was a powerful and ingenious database that could quickly sort tens of thousands of songs in a multitude of ways, and find particular tracks in a trice.

Even before iTunes was out the door, Jobs, a music nut himself (he favors Dylan and the Beatles), recognized that although storing and playing music on a computer was pretty cool, wouldn't it be even cooler if there was a portable, Walkman-like player that could hold all your digital music so that you could listen to it anywhere? He asked Robbin to pitch in on the portable-player project, a much more complex undertaking that required not only modifying iTunes but also building a tiny new operating system for what was basically a miniature computer, and designing a user interface that could sort and navigate music files on it with the same sophistication as iTunes on the Mac. It was another crash project that yielded the iPod just nine months later, in November 2001.

Only after playing with iPod prototypes did Jobs and his geeks realize that the whole iPod "platform" was still missing something, namely an online store for buying downloadable songs. They knew there had to be an easier way to get music for your iPod and your computer than by laboriously "ripping" audio CDs into your computer. But talk about a software challenge: An online store would require building an e-business infrastructure that could automatically both serve up the songs and take care of billing and accounting for conceivably millions of purchases. Plus, they'd have to construct a "storefront," either as a website or preferably by modifying iTunes yet again so that the store was incorporated right in its screen. And then they'd have to persuade big record companies--firms like Sony and Universal Music were paranoid about downloads--to buy in to make the concept work.

Still, less than 18 months after the rollout of the iPod, Apple's iTunes Music Store opened for business in April 2003. "We had hoped to sell a million songs in the first six months, but we did that in the first six days," says Eddy Cue, the corporate IT specialist who led the project and is now a vice president for applications. In the meantime, Robbin's crew developed a version of iTunes for Windows PCs, expanding the potential market for iPods and the iTunes Music Store to, well, the entire world--as well as delivering a huge, huge ego boost. The company that had once begged to get PC software adapted to the Mac now found itself supplying some of the hottest software in the PC world. By the time Apple announced its financial results in January 2005, it noted that to date it had sold more than ten million iPods and 250 million songs.

Apple Casts a Shadow

Software is the user experience. As the iPod and iTunes prove, it has become the driving technology not just of computers but of consumer electronics.

-- STEVE JOBS

The crudest way to measure the impact of Jobs' software factory is by the numbers. He estimates that this year Apple will generate $1 billion in revenue from selling applications and updates, plus other software-related revenue generated by the iTunes Music Store and its .Mac online subscription service, which has 600,000 members. That's almost double last year's take and doesn't count the boost software provides by helping sell iPods and Macs.

More important than direct software sales are the growth opportunities Apple's "user experience" prowess might open up. Owning a 62% market share of the online music market, for instance, augurs serious sales growth. Even though that market is still in its infancy--downloads accounted for less than 2% of U.S. music sales in 2004--the iPod platform, for example, kicked in revenues of $1.4 billion in Apple's first fiscal quarter, nearly as much as it did in the previous four quarters combined. Merrill Lynch analyst Steve Milunovich predicts that the iPod business alone will hit $6.2 billion in fiscal 2006, roughly as big as all of Apple when Jobs took over. (Of course, the iPod's growth will eventually flatten as the devices lose their fad status. Yet the gadgets are so useful that it's easy to imagine them becoming as ubiquitous as the Walkman--of which Sony has sold 340 million.)

With the iPod and iTunes Music Store, Apple has changed the rules of the game for three industries--PCs, consumer electronics, and music. And as new as its influence is, Apple appears to have nothing to fear from major rivals. Its software skills have consumer electronics companies at a major disadvantage that could take years to overcome (see "Saving Face at Sony"). Says Nathan Myhrvold, former chief of Microsoft Research: "Once audio and visual experiences become a combined hardware-software-network thing, the consumer electronics guys are fish out of water."

Apple has cast a shadow over Microsoft too. Jobs likes to say that the upcoming Tiger version of OS X will have everything that Bill Gates and Microsoft are promising in Longhorn, the often delayed major upgrade of Windows, now due in mid-2006. "They copied the original Mac with Windows 95," Jobs gloats, "and now they're going to be copying us again." (Microsoft declined comment.)

We promised earlier to tell you about Tiger. The software's most notable feature is Spotlight (that's a Spotlight icon at the top of this page). It's Apple's entry in the race to deliver a hot new capability called "desktop search." The idea is to be able to automatically scan your computer's hard drive to find files, e-mail, documents, pictures, music, and the like, much as Google scours the Internet. Desktop search promises to free users from a major headache: having to remember how files and folders are organized and particular pieces of information are stashed. Google is at work on a similar product, as an add-on piece of software; Microsoft plans to integrate desktop search in Longhorn.

Tiger is also loaded with features that Apple has included just because they're cool. An icon called Dashboard unlocks a bevy of handy Internet-enabled applications called widgets--windows that pop up at the touch of a key to display movie listings, the weather outlook, stock prices, a dictionary, a currency converter, a language translator, and the like, and then melt away just as quickly so you can get back to your work.

When you look at the brief history of OS X, and hear software experts like Bill Joy call it the best operating system in the world, you begin to realize what a remarkable accomplishment it has been for Apple--not only to build it but also to migrate millions of users to something so radically different with relatively little pain, and to improve it so dramatically and with such regularity that it has turned the endless nuisance of software support into a profit machine. The technology is so solid that Apple is beginning to sell Macs into markets that never before would even consider them, like the military and university supercomputer centers. Most tantalizing of all is scuttlebutt that three of the biggest PC makers are wooing Jobs to let them license OS X and adapt it to computers built around standard Intel chips. Why? They want to offer customers, many of whom are sick of the security problems that go with Windows and tired of waiting for Longhorn, an alternative. And besides, Apple has buzz now, and Microsoft does not.

Regardless of whether OS X starts showing up in PCs, it looks like Apple, a company that has had its share of ups and downs over the years, has finally mapped out a durable growth path. Sales will likely reach the $13 billion mark this year, thanks largely to the updraft from the iPod and the new $99 iPod shuffle. But there also appears to be a swelling of demand for the Mac product line, helped by the new budget-priced Mac Mini. If Apple can double its personal-computer market share in, say, the next two years (which still wouldn't put much of a dent in the sales of other PC makers), it would be well on its way to becoming a $20 billion company. And that doesn't even take into account what else Steve might have up his sleeve. Apple now has more than $6.5 billion in cash, ample to fund R&D, which last year consumed about $500 million.

Jobs is always coy about where Apple technology might pop up next, but occasionally he'll drop hints. At the recent Macworld trade show, he declared 2005 to be the year that high-definition video hits the mainstream, and touted the HD editing capabilities of a new version of iMovie. He also notes that a new generation of Wi-Fi networking gear is in the offing next year, which will offer enough bandwidth to finally make it possible to stream high-quality video from Macs to TVs. (In the short term, look for Apple to use its wireless technology to let HDTV owners display slideshows of digital photos stored on their Macs.)

Jobs also talks about alliances that will expand Apple's influence. "We're partnering with Motorola for doing things on cellphones, partnering with HP on the iPod, partnering with car companies and with the record companies. And we definitely will be partnering more and more."

There is one immense uncertainty hanging over Apple, however. Last July, Jobs was diagnosed with a rare islet-cell neuroendocrine tumor on his pancreas. In most cases, pancreatic cancer quickly turns lethal. Fortunately, this particular type can sometimes be treated with surgery, and experts say the procedure has a relatively good five-year survival rate--approaching 50%. Jobs had part of his pancreas removed in late July, returned to work six weeks later, and has been cancer-free ever since. He says he's feeling better than ever.

That illness only serves to remind investors and fans how crucial Jobs is to Apple. Jim Collins, the management guru who wrote the bestseller Built to Last, calls him the "Beethoven of business." Jobs may not be a programmer or a designer or an engineer or an MBA, but he has matured into a shrewd business strategist. And his perfectionist's penchant for the aesthetics of the user experience is the DNA that makes Apple such a distinctive and creative enterprise. Apple has to hope this particular genie won't disappear.

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