Why iPod Can't Save Apple The buzz around its wildly popular digital music box and swank storefronts mask a receding bottom line
(MONEY Magazine) – Manhattan, 5:55 p.m. on Feb. 20, and in five minutes Apple will begin selling the highly anticipated miniaturized version of its hugely popular iPod. Outside its SoHo store there is an anxious queue of trend-setters and gadget-philes that stretches for more than a big city block. Hundreds of people have been waiting as long as three hours in the cold to get their hands on a Mini. In SoHo, with its art galleries and designer boutiques, this Friday night the retail outpost for the PC maker is the place to be.
For Apple CEO Steve Jobs, these are triumphant times. The iPod is more than the most successful digital music player ever: It's a cultural phenomenon--on a par with Sony's Walkman--radically altering the way we buy and store music. Since returning seven years ago to the helm of the company he helped found in the 1970s, Jobs has said that innovation would lead Apple out of its funk. The iPod is the latest hit product to come from that decree, and it's bigger than Apple loyalists and shareholders could have hoped for. Even before the Mini shipped, customers ordered 100,000 at $249 a pop. Apple, in all, should sell nearly one billion dollars' worth of iPods this year.
This apparent success has lured many investors to jump on the Apple bandwagon. Its shares have risen 51% in the past year to a recent $23. If you love the company's products--and what's not to love about their ease of use and elegant design?--you might be tempted to buy Apple's shares. But behind the hype and buzz surrounding the iPod and Jobs, there are problems stewing at Apple. Its core computer business, which still accounts for 70% of the company's sales, is withering. Apple sold just over 3 million computers in its last fiscal year, which ended in September--900,000 less than it sold in fiscal 1996, the year before Jobs returned. Meanwhile, Apple's share of the worldwide personal-computer market has shrunk to 2% from 3.2% five years ago. What's more, despite their soaring sales, iPods are depressing profitability because of their lower profit margin. The result: While Apple's sales of $6.2 billion last fiscal year were nearly unchanged from 1999, profits plummeted 90% to $69 million, from $601 million four years ago. It's unclear what Jobs can do or plans to do to turn around Apple's fortunes--he refused to talk to MONEY about its future.
Of course, as the line outside Apple's 12,000-square-foot SoHo store grows, none of the company's problems seem to matter. Kevin Lewis, who has been waiting for three hours, declares, "The iPod Mini is the newest greatest thing." Scott Dercanin hopes that getting an iPod Mini for his wife will make up for missing Valentine's Day. Felix Petersen is risking missing his flight back to Berlin so he can own the first iPod Mini in Germany.
What's clear from seeing all these people spend their Friday night waiting on line to buy an iPod is that Jobs has made Apple au courant again. The question is whether the trade-off between buzz and the bottom line is worth it. In other words, should Apple's shareholders be any happier with Jobs' higher-profile, lower-profit Apple?
I grew up with Apple. My first computer was a IIe. When the Kolcuns became the first family on the block to own a Macintosh computer, with its compact design and point-and-click mouse, I remember thinking that my friend George was a little cooler than the rest of us. On my first day of college, my parents bought me a Macintosh. Everyone's did. A Mac, along with a boom box and a mini-fridge, was an essential dorm-room accessory. That was the last Apple PC I ever owned.
There is little mystery as to why Apple has gone from the company that created the home-computer market to a perennial also-ran in the PC business. For years, Apple's computers were more expensive and slower than their Microsoft-and Intel-enabled counterparts. With the Mac on a proprietary, incompatible operating system, many software makers chose not to produce applications for the computer, making it harder for Apple to sell its machines. The real question is how Apple survived at all. Most of the companies that challenged the Microsoft and Intel hegemony in the PC business have disappeared. Apple bucked the trend because for stretches of its history it focused on appealing to a price-is-no-object niche audience rather than slugging it out with the likes of Dell for the price-sensitive mass market.
In the past, Apple's profit and loss statement has suffered when the company went after the mass market. When Jobs ran the team that developed the original Mac, the driving motivation was to build a computer that was accessible to everyone, not just to those geeks who wrote software code. Its high $2,500 price, though, capped demand for Jobs' computer among the masses, and when he was ousted in the mid-1980s in a failed power struggle with then CEO John Sculley, Apple switched gears. Sculley realized Macintosh's strength was in graphics and heavily marketed the company's computers to professionals in the film, publishing, advertising and design industries. He also got Apple PCs into schools. Profits soared for the company in the late '80s and early '90s. When Sculley left in 1993, the goal at Apple once again became market share. New CEO Gilbert Amelio licensed the Mac's operating system to other PC makers, which rolled out cheap clones. He spent millions developing an operating system that would run on the Intel standard. But while Apple's sales rose, profits plunged. In 1996, Apple's operations lost $1.2 billion--its worst year.
Enter Jobs. He soon scrapped the bastardized operating system and cut off the cloners. He redesigned the Mac in startling colors and released more powerful and expensive Macs for Apple's core professional-user market. In fiscal 1999, Apple's profits hit $600 million. Jobs took his old company from its worst year to its best in 36 months.
These days Jobs wants to make Apple a broad consumer brand again. His view is that as all types of electronic devices--music players, cameras, camcorders--go digital, these gizmos will need to connect to a hub that manages and organizes this digital output. Jobs hopes that hub will be a Mac. To that end, Apple has rolled out a suite of software called iLife that organizes digital photos as well as allowing you to edit and produce home movies and mix your own music. And there are promises of more to come. "The products Apple will release over the next 12 to 18 months are going to blow the market away," says Eli Salzmann, co-manager of the Lord Abbett Affiliated fund (a MONEY 100 member), which, with a 4.3% stake, is Apple's largest outside shareholder.
Part of the motivation to develop the iPod and digital media software is to drive computer sales. But so far that hasn't worked. In order to make the iPod a success, Apple had to make it compatible with Windows-based PCs. So there is no reason for an iPod lover to buy a Mac. Out of the hundreds of people who were waiting outside Apple's SoHo store in the cold to buy an iPod, I could find only one whose positive experience with the music player led him to buy an Apple computer. The majority of the people, many of whom were there to buy their second or third iPod, owned Windows-based PCs and had no intention of switching to a Mac.
As for the iTunes music service, Apple makes little on downloads. Of the 99¢ it charges for each song, it has to pay the record labels 65¢. Another 25¢ covers the cost of distribution and credit-card processing. So even if you sell an impressive 30 million songs, as Apple claims, that adds up to only a paltry $2.7 million.
Jobs' other strategy to boost market share is Apple retail outlets. In 2001 he began opening company-owned Apple stores. The company now has 76 branches and expects to open another six by year-end. Jobs says Apple has no plans to become a retailer. The strategy is to open stores in high-profile locations to showcase Apple's products and demonstrate their central position in the digital media world. Apple calls the venture, which lost $5 million in 2003, a form of advertising. But so far the stores have done little to increase market share, and they could be bleeding a lot more red ink than Apple is letting on. Over the past year and a half, four of Apple's former authorized resellers have sued the company, asserting that its stores competed unfairly with them. Among their claims: Apple cuts sweetheart deals with its own stores to mask losses, such as charging them less for hardware and warranties than it does Apple's resellers. Tom Santos, one of the plaintiffs, estimates that Apple's stores would have lost as much as $80 million in 2003 had they been paying the same prices for inventory as the resellers paid. An Apple spokeswoman says the company won't comment on pending litigation. In the past, Apple has said that its own stores pay the same prices that resellers do.
This much is certain: Jobs' mass-appeal strategy has crimped the company's historically high profit margins. Apple's net profit margin is just 1%. That's down from 10% four years ago. And Apple's earnings would have been worse had it not been for $4.8 billion the company has in cash and short-term securities. In fact, the cash hoard made more money last year than Apple's operations--which lost $1 million while the computer maker booked a $69 million gain on interest income.
Even when you factor in Apple's $13 a share in cash and almost no debt, the company's stock, at a recent $23, trades at 20 times estimated 2004 earnings. Dell's shares, on the other hand, go for 26 times projected 2004 earnings--but its business is three times as profitable as Apple's. The company's supporters say current profits matter little because Jobs has proved time and time again that he can create new products and trailblaze markets. That may be so, but as Transamerica portfolio manager Chris Bonavico, who doesn't own Apple's stock, notes, "Apple will remain a company that is neat from a product and consumer standpoint but crap from an investor standpoint."