Commentary: How to Milk an Apple

Going by the numbers, Apple Computer Inc. (AAPL ) appears headed for trouble again. While CEO Steven P. Jobs engineered a remarkable comeback after retaking the helm in 1997, one-time expenses, such as plant closures, have pushed the company into the red for two quarters running. For the one ended Dec. 28, Apple reported a net loss of $8 million on revenues of $1.47 billion, vs. a profit of $38 million a year ago. Worse, Apple's share of the U.S. PC market is hovering around 3.5%, according to IDC analyst David Daoud. That's down from 13.4% a decade ago and 4.2% in the year after Jobs returned.

But fear not, Mac faithful: Apple may never again pose a threat to Microsoft Corp. (MSFT ) and its PC allies, but its niche is safe. In the $160 billion PC market, a 3% market share should be enough to fund Apple's research-and-development push. So long as Macolytes keep paying Apple's high prices, its 28% gross margins should far exceed PC rivals--especially if it keeps expanding its portfolio with non-PC products such as the iPod MP3 music player. "The battle for market share ended 10 years ago," says UBS Securities analyst Don Young. "But there's a place in the PC world for an innovation leader."

That's good news for consumers. Apple continues to be the trend-setter for the PC industry, which has been far more focused on cost-cutting than on innovation. In recent years, Apple has drawn crowds of copycats with its AirPort wireless networking gear and its flat-screen iMacs. Now, Jobs is sparing no expense on the R&D front. Even as revenues fell from $8 billion in fiscal 2000 to $5.7 billion in 2002, Apple's R&D outlay surged from $380 million to $446 million.

The new products keep coming. At the Macworld convention in early January, Jobs unveiled two snazzy new notebooks. More important, the company introduced iLife, its suite of video, music, and photography software that allows anyone to give home movies professional gloss--innovations that almost surely will end up in Wintel PCs.

Nothing will come easy for Apple, however. It is rapidly losing its grip on the education market, a former stronghold. As school districts opt for cheaper Wintel PCs, Apple's share in education has dropped from 21.5% in 1998 to 12.7% in the third quarter of 2002, says IDC--and few see a turnaround. Fourth-quarter sales of Power Macs to creative types fell by 27% from the year before, in part because of a delay in the introduction of critical desktop publishing software from Quark Inc. and by a rising gap between Intel Corp. (INTC ) chips and the PowerPC chips inside Macs.

Jobs has compensated by selling more computers to consumers. According to IDC, Apple's share of the U.S. consumer market jumped from 2.2% in 2001 to 3.9% in the first three quarters of 2002. In part, that's because of the rollout of 51 Apple retail stores and the six-month-old "Switcher" ad campaign aimed at persuading PC users to buy Macs. Roughly half of the people who bought Macs in Apple stores last quarter had never owned one before. That's roughly 23,000 new customers. However, no one knows how many Mac owners switched to PCs.

Over the next year, Apple may get a boost in the professional market. When Quark releases its software, many design shops will need to upgrade to Macs that include the year-old OS X software. The same goes for small-business owners who want the first Mac upgrade of Intuit Inc.'s QuickBooks accounting software since '95. And advance orders for Apple's two new laptops are brisk, say retailers.

Finally, Apple is moving beyond the Mac. It begins selling the iLife software suite, for $49, on Jan. 25. And the iPod has been a huge hit for two years now, with no slippage (page 111). Despite a hefty $299 to $499 price tag, Apple sold 216,000 of them in the last quarter of 2002. It's by far the leader in this growing category.

Jobs hasn't convinced everyone on Wall Street that the spending is wise. Besides R&D, he's pouring big bucks into his retail outlets. This year, Apple will spend $77 million, even though the stores aren't profitable. But those critics miss the point. Jobs needs to keep dreaming big when it comes to innovation. That's how Apple can turn 3.5% of the market into a winning formula.

By Peter Burrows

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