All Eyes On Apple

Will the gray light of January cool the world's hottest company?

This promises to be a joyous holiday season for Steve Jobs and the incandescent Apple. Over the past year, the company's numbers have been stunning: Sales are up 24%, earnings up 75%, margins topping 30%, stock price up 146%. The popularity of the iPod and its snazzy young cousin, the iPhone, has lifted other Apple products, helping boost market share in personal computers in the United States from 2% a few years ago to 8% this past quarter, with Apple leapfrogging Gateway to take third place behind Dell and Hewlett-Packard. The latest upgrade to Apple's operating system—Leopard—is getting strong reviews, in contrast to the indifference that greeted Microsoft's new Vista OS. Apple's market cap is now north of $160 billion; 18 months ago, the crew in Cupertino, California, was worth a mere $60 billion. This $100 billion increase alone equals the combined value of Motorola and Sprint-Nextel.

Yet this is also a dangerous moment for Apple. In a way the company has never seen, the barbarians are massing at the gates. From hardware to software to services, major competitors with serious R&D and marketing budgets are laying siege to the House of Jobs. As Apple moves into new markets, it has made powerful new enemies, some working in concert. Nokia, for example, is banding with telecom companies to offer its own touch-screen hardware in an effort to sway subscribers from the iPhone and Apple's exclusive partner, AT&T. MP3 players from the likes of iRiver, Microsoft, SanDisk, and Toshiba are getting slicker all the time, targeting the iPod at a fraction of the cost. Vivendi Universal scuttled a long-term licensing deal to offer its music on iTunes and is talking with other music companies about building a download store of their own. Likewise, Amazon has created its own iTunes antagonist, Wal-Mart has been low-balling its way into the market, and subscription music sites such as Rhapsody are spending mightily to win consumers over to vast Web-based music catalogs available for a flat monthly fee. Even the tree ­huggers are coming after Apple, threatening to sue under a California consumer-protection statute if certain allegedly toxic chemicals aren't removed from the iPhone.

Recognition of these threats has led in some circles to wariness about Apple as a stock, which as of this writing hovers at $185 a share, near its all-time high. "In a perfect world, our computer model would set Apple's stock at about $135," says Steve Hach, a senior analyst at forecaster ValuEngine Inc., which ranks Apple in the "bottom 33%," largely due to an "unattractive" market-to-book ratio and market valuation. "Apple is far more overvalued than Google, Intel, or Microsoft." Arnie Berman, chief technology strategist at Cowen & Co., points out that Apple and Google are trading at the same P/E ratio, which has never happened before. Apple has been bid up in "paroxysms of excitement over the 'mobile Internet,'" Berman contends, and its shares have "benefited from a powerful hype cycle." The company's soaring valuation led the Jacob Internet Fund to chop its Apple position recently to 1% of assets under management from 2.5%. And Morgan Keegan analyst Tavis McCourt wonders about Apple's long-term prospects. While the company's pace of innovation has been "incredible," he says, its competitors are "also getting better." What's more, "the iPod business is maturing. Apple stores are packed, but they have been for two years now. This may be the last holiday season of substantial year-to-year growth for the iPod."

It's weeks before Christmas, and all through the house, there's an iPhone, a touch screen, and no need for a mouse. But Jobs, the "brilliant," "visionary" "genius" with a knack for creating "insanely great" consumer products, may well be wondering whether next year will be different. Merry Christmas, Steve. Enjoy it while it lasts.

Let's state the obvious: Apple isn't going under. Its customers aren't going to flee in droves. The company has an unmatched record of building lust-worthy products, and the strong momentum that Jobs and company are riding is unlikely to dissipate anytime soon. Jobs certainly won't let it go without a fight.

But none of that will stop a growing number of adversaries from doing all they can to pare Apple down. Nor does it dim­inish the fact that at $185 a share, its stock is far more vulnerable to a stall or even a fall than it was when it was $50 cheaper. The company has built up expectations that will be by no means easy to satisfy. You don't have to be a contrarian investor to see that Apple's 2008 may be a good deal tougher than 2007, especially when you consider that it introduced three new products this year (iPhone, touch-screen iPod, and Leopard), a hard pace to match going forward.

The question isn't whether Apple will survive but how it will evolve. Jobs declined to speak with us for this story, but on the eve of the iPhone's debut, he deployed a simple metaphor to chart Apple's future: "We've got two strong legs on our chair today," he told USA Today. "We have the Mac business, which is a $10 billion business, and music—our iPod and iTunes business—which is $10 billion. We hope the iPhone is the third leg on our chair, and maybe one day, Apple TV will be the fourth leg."

In essence, Jobs was describing a hermetically sealed system, the central premise of Apple's business model: If a customer buys one Apple device, she'll buy two, three, even four more—at a premium price—rather than dilute the experience with other brands. In an age increasingly defined by interoperability and technical collaboration, Jobs still refuses to license Apple's operating system. He won't allow music and videos downloaded from iTunes to be played on other MP3 players. He won't permit music downloaded from competing stores to play on the iPod. And in enforcing his exclusive deal with AT&T for the iPhone, he went so far as to disable or "brick" the device of anyone who dared "jailbreak" it for use with another carrier, or who downloaded third-party applications for features Apple hadn't built in. Today, there are an estimated 250,000 iPhones that haven't been hooked up with AT&T, and even Apple's COO, Timothy Cook, assumes they have been unlocked and attached to ­another carrier. That means almost 20% of iPhone customers want the hardware but not the closed ecosystem built around it.

Apple has thus far ridden this exclusionary strategy to riches, power, and glory. But what does Steve Jobs know that Albert Einstein didn't? Einstein posited that a closed system would become stagnant over time. Indeed, Apple, back in the 1980s when it was still Apple Computer, experienced as much when its closed-software approach for personal computing doomed it to tiny market share. Today, the question looms: Has Jobs hit upon a formula that insulates Apple from stagnation? Or will the road ahead unmask a vulnerability in Apple's business model?

Asking Forgiveness

Gorgeous as Apple's products are, people aren't buying them for their inherent technological superiority. For half the price of a Mac, you can pick up a PC that does pretty much the same thing. There are MP3 players that produce superior audio to the iPod. The iPhone has Wi-Fi and a beautiful touch screen, but the phone itself is middling, as is its cellular network. Even the security of Apple's operating system, a theme the company returns to frequently, is overstated: As most hackers will tell you, it's security-by-obscurity, a function of tiny market share, not inherent uncrackability. The CIO at one major Silicon Valley company told us that Apple's vulnerability on this front made it unlikely that he would ever switch. (See "iPhone Insecurity" for one security expert's sobering experience with the iPhone.)

No, it's the interface—the user's interaction with the devices—and the exquisite wrapping that have separated Apple products from the great unwashed. And give Jobs his due: He brought the personal computer to market, after all. He has an unerring eye for design and functionality. There's an intuitive humanity to his machines, and that has helped Apple forge an enviable bond with its legions of fans.

But when you get down to it, the Apple phenomenon is as much about fashion as it is about technology. You might say that Steve Jobs is the Marc Jacobs of computers (minus the heroin), betting the house his products will be, season after season, cooler than anyone else's. Yet fashion is, by definition, fickle. Lose the buzz, and you've got trouble. And for the first time in years, there are signs that Apple is not infallible and that Jobs's reservoir of goodwill with his followers is not bottomless.

When he unveiled the iPhone last January, Jobs predicted he'd sell 10 million of them by the end of 2008. And he sold 270,000 in the first two days. But it took 72 days to unload the next 700,000, according to Silicon Alley Insider—a rate that would have left him about 40% short of his target a year from now. To prime the pump, Jobs sliced $200 from the phone's sticker price only two months after it went on sale, a cut so large and so early that, along with the Apple cultists who'd stood in line for hours to get theirs, even Steve Wozniak criticized his Apple cofounder in public. Jobs quickly issued an "iPology," along with the offer of a $100 Apple Store credit. (The chit can't be used for iTunes.)

Soon another miscue roiled the Apple base: the now infamous "patch" that disabled any iPhone tricked out with unauthorized third-party applications. Again, the cult hollered—and the influential gadget blog Gizmodo went so far as to revise its iPhone review, urging readers not to buy it until Apple changed course. Users vented their frustrations online, "calling for Jobs's head," says Jason Chen, Gizmodo's senior associate editor. Jeremy Horowitz, editor of iLounge, an Apple-centric blog, said the debacle produced "more 'angry Apple customers' posting comments and complaints than ever before."

Suddenly, the company that could do no wrong could do no right. Jobs felt compelled to send out another communiqué, this time announcing that an Apple-approved iPhone platform for third-party developers would arrive in February of 2008. (No word yet on whether Apple will charge for the applications.) "I'm thinking his hand was forced," Chen says, "and he was getting tired of all the bad press." The general perception was that Apple was maximizing short-term profitability at the expense of customer satisfaction. It was acting—shudder—like Microsoft.

Phone Alert

The less mystique Apple holds for its customers, the more susceptible they are to temptation. Already a slew of technology companies are lining up to woo the faithful. As McCourt, the Morgan Keegan analyst, points out, "Each SanDisk generation of MP3 players is getting closer to iPods; the handset manufacturers are arguably making more impressive music-enabled handsets than the iPhone; and try out a new HP laptop with imbedded Altec Lansing speakers—it's half the price of a MacBook, with a far better audio experience. HP and Dell are getting better at consumer marketing—still not Apple, but this will change too."

Samsung already sells a touch-screen phone. So does Motorola. Sprint has a touch-screen phone that runs "thousands" of third-party applications, whereas Verizon not only peddles a touch-screen smartphone but also is road-testing VCast Mobile TV, which offers real-time TV broadcasts. Rumors abound about Google jumping into the mobile market with a low-cost "gPhone" platform (just be prepared for a barrage of targeted ads). And the king of search has banded together with Apple foes such as Dell, HP, Microsoft, and Samsung to form the White Space Coalition to push the Federal Communications Commission to open up part of the broadcast spectrum. If successful, Americans would be able to use any Wi-Fi-enabled device to access the Web anytime, anywhere, and at zippy speeds—a direct threat to AT&T and Apple, which have a five-year exclusive contract.

But Apple's biggest hardware threat may arrive from overseas. While Apple will be happy if it can sell 10 million iPhones by the end of 2008, Nokia, based in Finland, sells some 400 million handsets a year and controls almost 40% of the worldwide market. That's more than Motorola, Samsung, and Sony Ericsson—its three arch competitors—combined. Nokia, no slouch itself as an innovator, had an even better last quarter than Apple, with profit zooming 85%. And the company knows how to defend its turf: Three years ago, when Motorola's Razr began to gain on them, the Finns came back with a barrage of phones with MP3 players and cameras, and Motorola faded away. Now Nokia is about to roll out a touch-screen cell phone that does the iPhone one better. It's "haptic," meaning there is a physical pulse and feedback when the user taps the screen.

Nokia has at least two other major advantages. First, where Apple's five-year deal with AT&T is exclusive, Nokia's cell phones work with all the major carriers, a basis for huge scale reminiscent of the Microsoft-Intel partnership in the 1990s that almost destroyed the old Apple Computer. Second, Nokia's gear works with the faster 3G networks that are the standard across Europe. The iPhone is not 3G (there are rumors a 3G iPhone will be announced at MacWorld in mid-January), but Apple is looking to Europe for much of its future growth. That technical hurdle could be compounded by the anti-trust issues also confronting the company abroad—the makings, potentially, of a nasty conundrum.

In short, pretty soon the market will be glutted with smartphones with touch screens, real-time TV, MP3/video players, cameras, GPS, and digital recorders. And the one thing all of these manufacturers have in common is their willingness to work in a world where open platforms, collaboration, and social networking are becoming ubiquitous—not just in consumer contexts but as key components in corporate plans as well. If Apple chooses to remain apart, its leverage as an innovator will need to be powerful enough to counter the sheer scale of its competitors and their willingness to work together.

The iTunes Storm

Jobs's entire chair strategy, built around the iPod, iPhone, Mac, and AppleTV, depends not on the company's personal-computer business but on the iPod, which has become the engine of the empire. Apple has sold more than 110 million of the devices, and their popularity has radiated the much-discussed "halo effect," boosting sales of its computers, which in the first three quarters of 2007 contributed 41% of Apple's sales, up from 36%. This synergy, in turn, trickles down to other products such as software and Wi-Fi routers.

It's worth remembering that Apple lost money in 2001, the year the iPod was introduced, and had smallish profits in 2002 and 2003, when iTunes was created and the iPod took off. In other words, the iPod's success didn't come solely from elegant, simple, novel design, but also from the fact that the iPod and iTunes appeared together and, essentially, in a vacuum. The market in MP3 players was small at the time, and there were few legal ways to obtain music for them; Jobs was able to exploit both factors in taking control, then cemented that position by making iTunes available to Windows users. Today, Apple commands about 70% of music downloads.

The iPod-iTunes pairing was the product of a historical moment that may never be reproduced. It was an ideal closed system:an utterly new music machine and something exclusive to load into it, something very hard (or illegal) to obtain otherwise. The device and the service together became the basis of a subculture, an iPod aesthetic. The perfect business storm they generated allowed Apple to build a near-monopoly.

But if iTunes is the driver for iPod sales (which, in turn, boost Mac sales), then Jobs's chair sits on a floor he doesn't own. The content that launched the iPod isn't his. And now the music industry is striking back.

Leading the fight is Vivendi Universal. The world's biggest music company has already decided not to extend its licensing agreement with iTunes, although it hasn't yet pulled its music. (The disagreement centers on price and control: Jobs wants to keep downloads at 99 cents, while music executives want variable pricing so they can charge more for new releases.) Universal has also announced a five-month pilot with other online music retailers, including Wal-Mart and Best Buy, to sell music that can play on any player. Universal is reportedly in discussions as well with Sony BMG Music Entertainment and Warner Music Group—together they'd control more than three-quarters of the music sold in the United States—to create an industry-run subscription supersite called Total Music.

Such subscription services have to be especially unsettling for Apple. "A subscription-based model à la Rhapsody or Napster lets a music consumer do something unthinkable in the physical world: have access to 5 million songs," says Morgan Keegan's McCourt. "Likewise, the music industry makes about $10 a month on a Rhapsody/Napster subscriber versus $1 to $2 a month on an iTunes subscriber, so if they were rational—no guarantee—they would help push subscription services."

Video Download

The music skirmishes are simply a precursor to the impending battle over video, where the digital download market for films and TV shows is still in its infancy. The mobile-video audience grew by more than 30% in 2007, to 8 million, according to M:Metrics, a market research firm. That sounds an awful lot like the heat around the MP3 phenomenon back when the iPod was introduced. The difference is, an iTunes for video will never happen. The Web is already awash in video and there are plenty of devices to play it on. What's more, Hollywood saw what Jobs did to the music industry and has no intention of ceding similar control. NBC has decided not to renew its iTunes contract in favor of Amazon and, with News Corp., has formed an online video venture called Hulu. At the same time, other movie and TV executives are exploring options for distributing their wares, and Wal-Mart is partnering with all six major Hollywood studios to sell movies and TV shows. Whoever wins in the end, the crush has begun.

The fourth leg on Jobs's chair, AppleTV, is naturally dependent on the evolution of the video market. Before he rolled out the new box, which links your computer to your TV, Jobs called AppleTV the "missing piece" in Apple's product line. After it flopped, he referred to it as a "hobby." That was likely more an attempt at damage control than a true description of Apple's hopes for the device, especially if you consider that AppleTV was built around the video boom in the same way the iPod was conceived around the MP3: as a branded conduit between the Web and the consumer. It's a critical part of Apple's closed delivery system. Jobs sees your living room as his next big growth opportunity, with the iPhone serving as the remote control for your entire life—the hub connecting your stereo, computer, and television. But if there isn't an AppleTV at the heart of that system, what, exactly, will the iPhone control?

Jobs may well be cooking up an improved iteration of AppleTV. But the fact is, this time he isn't creating the next cultural phenomenon, but racing to catch up to it. Without the kind of exclusive content partnerships he had with the iPod—and here he's arguably behind Microsoft's Xbox franchise, TiVo, and the video-on-demand and DVR offerings from cable giants such as Comcast and Time Warner —he has to rely on reputation and fashion alone to carry him through.

Open vs. Closed

Apple is at a moment of choice: If it can stay hot and produce breakout couture hardware indefinitely, it can hold onto its closed model, elite pricing, and huge margins. In many ways, the world would be a prettier place if it did.

But in an age of convergence and simplification, customers are ever more insistent that computers, phones, TV, and music systems work together. For them, being "open" isn't about sharing patent information or computer code but about compatibility and seamlessness, from the phones in their pockets to the movies playing on their flat screens. Now that the race for an end-to-end system has begun in earnest (significantly, it doesn't look all that different from the race to own the desktop years ago), Apple needs either to win that race outright, or to get comfortable with being simply part of the solution. Winning outright is a very tall order, of course. It means coming up with a self-contained system so beautifully functional that a critical mass of consumers are willing to enter that world and never leave. But the viability of AppleTV is an open question, and the iPhone may never be the $10 billion market Jobs anticipates.

So what if Jobs has built only a two-legged chair? The iPod and Mac may be great businesses but not enough, in all likelihood, to meet the giddiness currently reflected in Apple's stock price. And clearly, some Apple watchers are expecting gravity to assert itself over the coming years. The 23% annual earnings growth Wall Street analysts are predicting for the company is an excellent number for most mortals, but far from the 150% growth rate Apple has delivered in each of the past five years. Actually, it's basically identical to the forecast for the personal-computer industry as a whole.

Jobs may have to accept that Apple's next wave of growth—or energy, as Einstein might have put it—depends on syncing up his products and platforms with those of his competitors. Apple was already forced to open up the iPhone in order to enter the French market, and the recent deal Microsoft struck with the European Union suggests that a transparent philosophy will win out permanently across the continent, where much of Apple's expansion plan is centered. Yet there are risks, too, in tearing down this wall. If the company's success has flowed from the trendy, gleaming exclusivity of its machines, then diluting that quality could erode the very foundation of the franchise. This is the box Jobs is in. And it's a tight box—just sleeker, so far, than anyone else's.

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2 Comments

  • Robert "GRIFF" Griffith

    The power of Apple's innovations in design & marketing are briefly shown in this excerpt of a presentation that I did for a Chamber of Commerce Marketing Expo enttitled "How to Move from bland to Brand to GRAND": http://www.THINK-TANK.com/pres....

  • Leslie Levy

    Actually, I think this misses the most important problem facing Jobs. He could take over Disney anytime. Would that be a good move for him?