Is the Music Fading for Apple?

Here's why the torrid gains from iPod sales may become a thing of the past. Is there something new in the pipeline to stoke growth?

By Sarah Lacy

As Apple Computer prepares to announce third-quarter earnings July 13, there's a growing sense even among the company's most avid fans that the iPod party is ending. Yes, some analysts are predicting a quarterly revenue number slightly higher than Wall Street's consensus of $3.3 billion, but few are predicting any new blowouts.

That's not to say the $13 billion computer innovator won't turn in an impressive quarter. Just hitting the $3.3 billion revenue target would amount to a 60% increase year-over-year from 2004. And the next two quarters should also give investors reason to cheer, thanks to the usual boosts from back-to-school computer sales and holiday shopping.

Some even think the revelry can continue well into this decade. SG Cowen, for one, issued a report on June 12 pointing to what it called a "halo" effect from iPod sales. The theory -- a favorite among Apple (AAPL ) boosters -- is that the iPod's success will slowly but inexorably convince PC users to switch to Macs and other Apple products.

Based on a survey of 1,400 consumers, SG Cowen expects Apple to increase its U.S. market share to better than 6% by 2008, from 3.7% today. Apple's new crown jewels -- the iPod family of digital-music players -- hold 76% share in a market with sales of $4.5 billion in 2004.


  Still, the consensus among analysts is that iPod sales compared to the previous quarter will be flat, at roughly 5 million units. From a device that has boosted Apple's revenues 148% since 2001, signs of a plateau are clear.

Come January, 2006, Apple investors had best beware. With every passing quarter, the company that set the music world on fire with the iPod is in greater need of an encore, most analysts who cover the company believe.

Computers likely won't pick up the slack. Mac sales are expected to grow 26% in 2005, then slow to just a 6% pace in 2006, according to Goldman Sachs. And iPod's sales growth is expected to cool from a sizzling 234% in 2005 to just 18% in 2006.


  "We take a look at the market research, and MP3 player growth is basically going to be halved or worse. We take a look at Apple's market share, and they've got the biggest target on them," says Megan Graham-Hackett, computer hardware analyst for Standard & Poor's Equity Research.

Indeed, Wall Street already seems to be factoring a slowdown into Apple's stock price. Shares closed at $38.24 on July 12, up 0.37%. But that's still down some 16% from a February high of $45.44. The only investors still beaming over Apple's prospects these days are those fortunate enough to have purchased the stock two years ago. Its price has posted a very impressive 400% gain since 2003.

Even if a halo from iPod sales casts its glow on other Apple products, as SG Cowen predicts, the company will still have to show some of its old razzle-dazzle, with the kind of innovative designs and features that have wowed customers in the past, says Richard Chu, managing director for SG Cowen and author of the study.


  "Consumers [who] are saying they're likely to buy a Mac are influenced by the presumption that they'll do more interesting things," Chu says. Simply put, it's what everyone has come to expect from Jobs & Co. -- and not getting it would be a bigger disappointment than any earnings miss.

In truth, innovation has been a mixed bag for Apple of late. Several analysts expect third-quarter upgrades to boost sales for its newest operating system, Tiger. Goldman Sachs, for one, thinks Tiger sales could have boosted revenue by as much as $50 million.

But Apple's forays into lower-cost versions of its popular products haven't been as fruitful as expected. Sales of the $99 iPod Shuffle have weakened recently, while those of the more expensive iPod Mini remain strong. Similarly, sales of $500 Mac Mini computers are weak, but sales of iMacs are still robust.


  The fact that the more expensive Apple products continue to sell well certainly helps profit margins and is a tribute to the loyalty of Apple's customer base. But these trends also suggest that Apple still is having a tough time tapping into a larger, mainstream audience. Chu says he'll be listening closely to what Apple says about inventories during the July 12 conference call. "I'd like to hear them say that inventories are at normal levels," he says.

No matter what the rest of 2005 brings, Apple expects growth to slow in 2006. "The bet is, Apple comes out with a new product that reignites growth. But [the growth consensus for 2006] is still around 19%, not the 60% we're expecting this quarter," S&P's Graham-Hackett says. Of course, 19% for a tech company is nothing to sneeze at. But it also underscores an old law of physics: What goes up, eventually must come down.

Lacy is a reporter for BusinessWeek Online in the Silicon Valley bureau

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