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How far can Apple ride the iPod craze?
The company's iPod music player has become a cultural phenomenon. But competitors are circling, and Apple's PC business continues to lose market share.
By Robert Walberg
Apple's (AAPL, news, msgs) metamorphosis from struggling PC company to consumer electronics heavyweight would make Kafka proud.
Three years ago, the company was on the brink of extinction, as its share of the PC market continued to dwindle and its stock sold pretty much for cash-on-hand, or about $11 per share. Today, thanks to the huge success of its iPod digital music device, the company is the envy of the tech world and the stock is trading at its highest level in four years.
But that steep stock price ought to cause some concern among investors. If it doesn't, perhaps the fact that competitors are aiming for iPod's market share will. Then there's Apple's PC problem -- its market share continues to fall, and computers still make up most of the company's sales. For investors, this means it makes more sense to buy an iPod than Apple stock.
But for now, however, Apple is sizzling.
In its most recent quarter, the company sold more than 2 million iPods, a stunning 500% increase over the year-ago period. Heck, only 2.7 million digital music devices were sold worldwide in 2003. Apple is experiencing huge demand for its product and continuing to build market share. According to NPD Group, the company owns 92% of the U.S. market and over 60% of the global market, both considerable increases over year-earlier figures.
Apple has succeeded where others, such as Sony (SNE, news, msgs) and Digital Networks' Rio, have failed (so far) for two principle reasons: - The music industry backs iPod. First and foremost is iTunes, managements coup to line up the music industry behind its product. Consumers go to iTunes to download millions of songs from a wide variety of artists for 99 cents per title. Apple directs a share of that money to the music industry, which previously saw the Internet as largely a place where people swapped stolen songs. In short order, iTunes, like iPod, has become the worlds leading source of online music.
- Add-ons designed just for iPod. Second, management has built an entire suite of add-ons designed solely for the iPod. The add-ons bring higher profit margins than the core product, and they help to establish brand loyalty. The idea here is that once a consumer invests enough money in headphones, speakers, carrying cases, etc., they wont be quick to switch to a competing, non-compatible product, even if that product sells for a few bucks less. Based on the market share numbers, the idea appears to be working.
Only direction for market share -- lower
Of course, one problem with the iPod's market share is that it pretty much has only one way to go -- down. In the end, the iPod is nothing more than an enormous marketing success. Sure, it was groundbreaking at first. But today you can find a number of similar products from other leading PC and consumer electronics companies, most at equal or better prices. The company's iTunes and add-on strategy are likely to keep iPod No. 1 for years to come. Still, its tough to sustain a near monopoly in a commodity-based business.
In consumer electronics, as in the PC industry, price is a key component in determining market share. So new entrants will try to steal share from Apple by offering similarly equipped products for less. Within the past month, no fewer than five companies -- Archos, Creative Labs, iRiver, Virgin Electronics and Dell (DELL, news, msgs) -- have introduced new portable music players to compete with iPod. Samsung, Sony and Rio Audio are also in the mix.
Apple answered with a new U2 iPod and with its newest line, iPod Photo. The latter can store up to 25,000 wallet-sized digital pictures, as well as up to 15,000 songs. It comes with either 40- or 60-gigabytes of disk storage and is priced at $499 to $599, or the high end of the market. The former is another example of Apples marketing prowess. The U2 iPod is a 20-gigabyte version that comes with a black case and a red click wheel instead of the traditional all-white design. It also offers consumers a digital compendium of U2s songs through iTunes for $149 instead of 99 cents per song. Expect more bundling in the future.
But if management falls into the same trap with the iPod as it did with its computer business -- thinking its product superior and worthy of a higher price -- modest, if not substantial, share erosion will occur over time. If nothing else, profit margins will certainly be compressed. CEO Steve Jobs recent comment that the iPod is a cultural phenomenon should give shareholders pause.
And don't forget
Of course, this brings us to the other problem confronting Apple: its computer business. Amidst all the hype that is iPod, investors have lost sight of the fact that computers still represent the bulk of revenues -- 52.4% in the fourth quarter, in fact.
Apples management hopes that its PC business will benefit from the iPod craze, as the digital music player draws more consumers to the company and its products. Unfortunately, what management calls the halo effect has yet to kick in, as the most recent data available on PC share shows Apple continuing to lose ground at home and abroad.
According to Gartner Inc., Apples worldwide market share in the third quarter fell to 1.8% from 2.1% for the same period a year earlier. Domestically, the companys share slipped to 3.2% from 3.6%. The data also show that unit growth fell 5% from the previous quarter compared to a 9.8% jump for the competition.
Product transition and component shortages contributed to the weak showing, but these factors cant mask the simple fact that Apple has steadily lost share in the computer market for the last decade. The company still has its loyal followers, especially in the graphic design and entertainment industries. Schools also remain a key source of PC-related revenue. However, the notion that the iPod will spawn a new generation of computer customers looks to be nothing more than hyperbole at this time.
The reality at Apple is that its consumer electronics business is taking over. With research firm IDC predicting that the digital music player business will grow to over 25 million units sold in 2008 from roughly 3 million units sold in 2003, its just a matter of time before Apples iPod revenues match its computer sales. In the most recent quarter, iPod revenues equaled 23% of the $2.3 billion total.
Out in front
For now, with iPod dominating the fast-growing digital music business, the immediate future is bright. Sales and earnings over the next few quarters should continue growing at a double-digit pace, or far faster than the competition. But with tech heavyweights Dell and Microsoft (MSFT, news, msgs) chiming in, the competitive landscape is getting more treacherous.
Meanwhile, Apple no longer trades for cash on hand. With its recent surge to new high ground, the stock trades at roughly four times cash and an eye-opening 45 times estimated fiscal 2005 earnings of $1.24 per share. Even backing out the near $14 per share in cash, the stock trades at 31 times earnings. One reason for the premium multiple stems from the fact that the company has handily beaten estimates for the past two years. But at these multiples, theres no room for disappointment, real or perceived.
Maybe thats why insiders have been busy selling stock during the recent iPod-related surge. According to Thomson Financial, six insiders sold 1.35 million shares for between $38.61 and $47.73 each. It's some of the strongest selling since early April, though the stock held up nicely during the selling and turned higher afterwards. Even so, if insiders dont see value in the stock, why should the rest of us?
Its tough to bet against a company seemingly doing everything right, and theres no real reason to at the moment. The iPod business remains strong, the PC-side should get a short-term lift from the new iMacs and an operating system upgrade cycle, and the company's retail store concept will benefit from new openings.
But current multiples suggest that most of that good news is already factored into the share price. So it's unlikely the stock will climb much further.
At the time of publication, Robert Walberg neither owned nor controlled shares in any equities mentioned in this column.
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