Case study: The success of the Ipod raises the licensing question for Apple . . . again.

Introduction[1]

This case study explores the rise of the Apple Corporation. The Apple iPod is one of the most successful new product launches of recent years, transforming the way the public listens to music, with huge ramifications for major record labels. More than 50 million MP3 players are expected to be sold in 2005, over a third more than last year. Cell phones have long been regarded as the most credible challenger to MP3 players and iPods. The launch of digital download services via cell phones illustrates the dramatic speed of convergence between the telecoms and media industries, which many observers expect to usher in a new era of growth for cell phones. Users are willing to pay more for additional services and many analysts predict that cell phone handsets will eventually emerge as the dominant technology of the age, combining personal organisers, digital music players and games consoles in a single device. Indeed, Microsoft founder Bill Gates has predicted that cell phones will supersede the iPod as the favoured way of listening to digital music.

Apple and the iPod

For those not yet fully plugged into digital music listening, MP3 is an acronym for MPEG layer 3, which is a compressed audio format. A compression ratio of up to 12 to 1 compression is possible, which produces high sound quality. Layer 3 is one of three coding schemes (layer 1, layer 2 and layer 3) for the compression of audio signals. By using this format of compression, a normal audio track is compressed to 3 to 4MB of size and therefore facilitates the transfer of audio files via the Internet and storage in portable players, such as the iPod, and digital audio servers.

The remarkable success of the iPod music player has propelled Apple back into the FT500 ranking of global companies.  This marks a return of the technology company to the ranks of the world's top companies after falling out of the list in 2001. Its shares have risen five-fold in the past two years, valuing the company at $34bn (£19bn). Apple, founded (in 1975) 30 years ago by Steven Jobs, who is now chief executive, has seen its fortunes ebb and flow. Mr Jobs has achieved a transformation since his return to the company in 1997 after leaving 20 years ago after a dispute with John Sculley, who was then Chief Executive (Coggan, 2005).

Historically Apple is a computer company and its core customer base today is only about 8 million active users; in a world of 400 million Windows users. Apple has always understood that its core franchise was very closely connected to the core computer franchise. Consumer electronics products, for example, are sold through different channels and they have different product life cycles. Making the transition has been extremely hard. What made the iPod transition easier is that the iPod began as a PC peripheral, even though it is ultimately a consumer electronics product. Eventually, Apple recognized that the iPod could not be limited to the Mac and it had to become a PC peripheral as well. The move into the PC market enabled Apple to access a much broader market than its core customer base.

Apple’s iTune Music Store web site

Apple’s success with its iPod is helped by its iTune Music Store Web site, which offers consumers the ability to digitise all their CDs as well as download new music at 79p per song. This site has sold over 50 million songs since its launch in April 2003, bringing considerable revenue to Apple (Durman, 2005). The site is universally regarded as being simple and fun, it is also offers a legal way to add music to your library. To import songs into iTunes, you simply insert a CD into your computer and click Import CD. iTunes also compresses and stores music in AAC — a format that builds upon state-of-the-art audio technology from Dolby Labs. It also offers users the ability to select different audio formats. iTunes lets you convert music to MP3s at high bit-rate at no extra charge. Using AAC or MP3, you can store more than 100 songs in the same amount of space as a single CD. iTunes also supports the Apple Lossless format, which gives you CD-quality audio in about half the storage space.

The rise and fall and rise of Apple Corp Inc.

Apple computers began in 1977 when Steven Wozniak and Steven Jobs designed and offered the Apple I to the personal computer field. It was designed over a period of years, and was only built in printed circuit-board form. It debuted in April 1976 at the Homebrew Computer Club in Palo Alto, but few took it seriously. Continual product improvements and wider technological developments including microprocessor improvements led to the launch of the Apple Macintosh in 1984.

The Macintosh computer was different, because it used a mouse driven operating system, all other PCs used the keyboard driven system known as MS DOS (Microsoft Disc operating system). Early in the 1980s Microsoft licensed its operating system to all PC manufacturers, but Apple decided against this approach opting instead to stay in control of its system. The 1980s was a period of dramatic growth for personal computers as virtually every office and home began to buy into the PC world. Slowly Microsoft became the dominant standard, not because its technology was better, but largely because its system became the dominant standard. As people bought PCs so with it they would buy the operating system: MS Windows, hence it became the de-facto dominant standard. The Apple operating system was only available if you bought an Apple PC. Consequently Apple’s market share plummeted. This was also the time when Steven Jobs quit Apple after disagreements with other members of the board. Interestingly in 1986 Steven Jobs became involved in another new venture: Pixar Animation Studios, of which he is now Chairman & Chief Executive Officer (see Illustration 1.1). By the mid 1990s Apple had grown to a $12 billion company twice the size of Microsoft; but Microsoft was powering ahead on the back of the launch of Windows it would soon become the $40 billion firm it is today (Schofield, 2005).

Illustration 1.1: Pixar Animation Studios

Pixar Animation Studios eventually became the Academy-Award winning computer animation pioneer. The Northern California studio has created six of the most successful and beloved animated films of all time: Toy Story (1995); A Bug's Life (1998); Toy Story 2 (1999); Monsters, Inc. (2001); Finding Nemo (2003); and The Incredibles (2004). Pixar's six films have earned more than $3 billion at the worldwide box office to date. Pixar's next film release is Cars (June 9, 2006).

In 1993 Apple launched the Newton; its first completely new product in many years. Indeed, it represented Apple's entry into (and perhaps creation of) an entirely new market: Personal Digital Assistants (PDAs). The PDA market was barely present when the Newton was released, but other companies were working on similar devices. The Newton Message Pad featured a variety of personal-organization applications, such as an address book, a calendar, notes, along with communications capabilities such as faxing and email. It featured a pen-based interface, which used a word-based, trainable handwriting recognition engine. Unfortunately, this engine had been developed by a third party, and was notoriously difficult to use and was partly responsible for the product’s failure.

In the mid 1990s Apple’s future in the computer technology industry looked bleak, with a diversified product portfolio and a low market share within the PC market of only 3%.  Many were therefore surprised when Steven Jobs returned to the company as Chief Executive in 1997. He quickly set about culling many product lines and much of its operations and decided to focus on only a few products including the new looking imac. This coincided with the economic boom in the late 1990s and allowed Apple to generate cash very quickly. This provided revenue for the development of the iPod, which was launched in 2003.

Figure 1: The rise and Fall of Apple Corp. Inc.

iPod dominates Mp3 market, but competition is fierce

In 2005 triple-digit sales growth for Apple's iconic digital music player sent the company's share price soaring more than 200 per cent in 2004. The challenge for Apple, however, is how to maintain the success of the iPod, especially with its indirect impact on sales of its PCs: most notably the imac and its Notebook range of portable PCs. Apple could continue to cut prices, but this would mean smaller margins. Another option would be product developments such as iPods with new capabilities and functions, such as a handheld computer, satellite radio, wireless e-mail capability and a phone. Such a move, however, would seem counter-intuitive for Apple, which has a reputation for simply designed and easy-to-use products (Morrison, 2005). In actual fact Apple began fighting the competition in the MP3 market by cutting prices and improving the product. In 2005 it launched lower-priced versions of its best selling iPod digital music player with significantly improved battery performance. However, at the same time a potential big threat in the form of Sony Electronics announced a new, low-price, high-performance digital music player under its Walkman brand.  Since October 2001, when Apple first launched its iPod, it has slowly reduced the price and improved the performance of the product. The design and styling have significantly contributed to Apples success with its 50 per cent market share for MP3 players. Competitors including Dell, Creative Technologies and Rio have launched many rival players, most cheaper and offering better battery performance. Yet it seems the iPod has an iconic status that is proving difficult to attack.

IPod Patent battles

Despite the success of the iPod Apple continues to fend off challenges to the propriety of its technology. In August 2005 Creative Technology, the Singapore maker of the Zen digital music player, suggested it was considering a legal battle with several digital music manufactures including Apple Computer, alleging that the US company’s popular iPod and iPod mini music players use Creative’s recently patented technology. Creative was one of the first companies to market digital music players in 2000, but the company’s devices have been overshadowed by Apple’s popular iPod product line. Apple has shipped over 40m units since introducing the iPod in 2001, dominating the US market.

Apple has extensive experience of fighting patent infringement cases and understands that such legal battles can take many years to settle. Its own battle with Microsoft over infringement of its operating system technology was eventually settled after eight years without a satisfactory outcome. It may be better for Creative to seek royalties from Apple, as patent cases can drag out for many years and are highly unpredictable.

An interesting twist to the patent fraud case is the increasing use of Apple iPods by industrial fraudsters who use them to download vast quantities of corporate information either to sell to rivals or to support their own start-up operations. Anti-fraud experts have warned that the machines, along with other music players, that boast hard drives with up to 20Gbytes of memory, could become widely used by employees to fool security officials and breach data security rules. In one case a recruitment agency found much of its client database had been copied to an iPods's memory and used to defraud the firm. Staff who have been given the sack or missed out on promotions are the most likely to turn to this type of fraud. They may be supported by criminal gangs who use employees as insiders to extract information, but in these cases they are more likely to be disgruntled employees who want to punish their employer. The National Criminal Intelligence Service points out that fraud cost £14bn last year (Inman, 2005).

The rise of Apple as a lifestyle brand.

At the centre of Apple’s recent success is the emergence of Apple as a lifestyle brand rather than as a technology company. Apple is very keen for instance to reinforce its California heritage. Every iPod comes with the words designed in California. Also, it may have been a subtle move, but remaining friendly not just user-friendly but friendly as opposed to the unfriendly giant Microsoft may be helping to increase the brand’s appeal. It maybe that people at last have become tired of Microsoft and efficiency and effectiveness and now are searching for something different. If Apple can capitalise on the success of the iPod and translate this into increased market share of the PC market this will truly signify a dramatic turn around for the firm in the PC industry.

To reinforce the idea of a lifestyle brand one need look no further than the huge increase in accessories for the iPod. It seems cool-conscious iPod buyers cannot get enough of carrying cases, adaptors, microphones or software, these accessories give consumers the edge as they take their iPods on the road, into classrooms and onto the street. Indeed, the road provides a big growth opportunity for Apple and the iPod. The challenge for Apple is whether it can establish the iPod in the in-car entertainment market by becoming the product of choice for those wishing to move effortlessly from home-to-car-to-sidewalk without any interruptions to listening, simply by plugging and unplugging your digital music player.  Apple has already worked with BMW to offer an in-car adapter that allows users to plug their iPod into the car stereo.  Car-stereo makers Pioneer, Alpine and Clarion have all unveiled adaptors that will allow iPod owners to wire music players directly to their car stereos and to use the stereo controls to play iPod-stored music. Furthermore, Japan's Nissan and a handful of European luxury carmakers said they would begin selling cars with iPod-compatible stereo systems. Still notably absent from the iPod club are the big automotive players: Japan's Honda and Toyota, as well as the big three US groups.

The licensing question returns to haunt Apple

Since Apple launched the iPod in 2001, doubters have said it was only a matter of time before Microsoft and its hardware partners developed a cheaper industry-standard music player that would relegate Apple to the fringes of the market; just like Microsoft did with Windows. Few forget how Apple's refusal to license its technology contributed to its demise in the personal computer market and critics say the company appears determined to make the same mistake again. A key issue for Apple is whether it can sustain the huge premiums that it earns with the iPod when Dell and others begin entering the market with much lower priced product offerings. Also, Apple is running into the same challenge as it experienced with the Mac of selling a proprietary solution. That is, music on the iPod cannot play on non-Apple devices. This time around, however, Apple is allowing HP to resell iPod. It's their first small step into trying to get into the mass market. It could be a fundamental change in strategy, if they were to pursue it aggressively. On the other hand, if they pursue their iPod licensing strategy like they pursued their computer operating system licensing strategy, which means selective licenses to small number of players, then they will still run the risk that they will continually get downward pressure on price by competitors like Dell, and greater availability of options by customers using Microsoft software. Leading to a repeat of the Mac problem. Essentially, just like the mid 1980s, there is a standards war; just as there was between VHS and Beetamax. There is a proprietary standard with iTunes, and there will be alternative standards pushed by Microsoft, Real Networks, and others. One can still detect an Apple orientated approach to growth rather than one driven by absolute growth. For example, iTunes, was initially available only on the Mac. This was meant to drive Macintosh sales, and then six or nine months later Apple would bring out a Windows version. The problem is that it gave competitors six to nine months to bring out Window's products, which creates a more competitive environment. Some analysts argue that if Apple had really been thinking in terms of breaking away from Apple users and its heritage, it would have started out on Windows and come to Macintosh later like everybody else in the world. But, critics argue that is not the way Apple thinks. There are clearly advantages when developing a new product to target the 400 million market and then target the total Apple user and ex-users market of 25 million. But there are also advantages of doing it the Apple way.

If Apple doesn't open itself up and make sure that it becomes the dominant standard, it could end up becoming the niche product again that makes it a little bit less attractive for users. Apple may be able to learn from Sony’s experiences. For although Sony lost the VCR industry standards battle it did win huge market shares with its Walkman. Sony drove the Walkman into a mass audience by drastically bringing down the price. Apple may be able to do this successfully with the iPod, but it has never been very good at very high volume manufacturing at very low costs. But, it maybe that the iPod is becoming the dominant platform in MP3 players just like Microsoft did with its Windows Operating System.

Cell-phones: the new threat

In 2005 Vodaphone and Orange introduced their own downloading services. Sony-Ericsson has also launched its first Walkman Cell-phone, and Nokia and others are producing their own music phones. At present most music phones have limited stereo capacity, but this will inevitably change. The key question is whether consumers prefer their music on their cell phone or their iPod. Consumers can already download music to their cell-phone, but the cost is almost twice that compared to Apple’s itunes. There are other limitations too. A song bought from Orange Media Player will be lost if the consumer switches to another network provider or changes SIM card. Nor can the song be played from a computer. Nonetheless, the inexorable shift from separate devices to a single hand-held device appears to be gathering momentum (see Figure 2). In particular 3G cell-phones will also offer the capability to download high-speed data over the airwaves including television pictures. The 3G handsets may be destined to become mini-TVs allowing consumers to watch sporting highlights and other entertainment, including games.

Figure 2: The future hand-held device will probably incorporate many separate devices

To try to combat the threat from cell-phones Apple has established a strategic alliance with its long-time partner Motorola, which will enable Motorola cell-phones to incorporate itunes technology. Late in 2005 Motorola put its ROKR E1 in the shops announcing it as the first cell-phone compatible with itunes.

Conclusions

The success of the Apple iPod has been remarkable by any measure. It has surprised Apple’s competitors but moreover it has surprised market analysts and investors, who had largely believed Apple was a niche player in the computer world. To be successful in the mainstream mass market is unusual for Apple. Many people recognise the Apple brand, but far fewer buy its products. Take the imac; this iconic stylish PC was universally praised for making the desktop PC an attractive product rather than a dull grey box. Yet, when one analyses sales of the imac they are tiny compared to other PC manufactures such as Dell and Hewlett Packard. The imac is clearly different from other PCs and customers have to pay a price premium for this, but few are willing to pay twice as much for a machine that ends up doing much the same as any other PC (mac users would understandably argue at this point saying that the Mac operating system is far superior to Microsoft’s Windows, but to most consumers who are not computer literate a PC is a PC). Profit margins are extremely small for PCs; this is why it is difficult for Apple to produce any revenue from the imac despite its success. Indeed, it is the iPod, which has delivered the cash for Apple. Apple has been here before, twenty years ago in fact. The success of the Apple Mac in 1984 delivered piles of cash for Apple and a rising market share of the growing PC market, yet it was Microsoft who emerged the winner largely because it licensed its operating system to all PC manufacturers, whereas Apple decided against this approach opting instead to stay in control of its system. Microsoft has gone on to be the dominant software company in the world. In 2005 Apple’s iPod is the leading digital music player, but should it licence its successful iPod technology? There are certainly lots of automobile manufacturers that would like to offer in-car iPod music players. There are cell phone handset manufacturers that would like to incorporate iPod music players into their products. And there are many electronic companies such as Sony, Sharp, Cannon and others that would be able to develop digital music players using iPod technology. It may be that Apple feels the technology, in this case the software, is an integral part of the physical product and that to separate the aesthetics of the music player from the software would damage the iPod brand. Leading to a commoditisation of the digital music player market and an overall decline in the iPod. Furthermore, margins are relatively good for Apple and licensing the technology would surely mean increased competition and reduced margins.

Apple, perhaps best known for its Macintosh computers, has relied on the iPod and sales of music from its iTune online music store to make up for its lack of market gains in the highly competitive PC market. It is necessary to remind students of business that ultimately this is about money and Apple was twice the size of Microsoft in 1995 and since then has largely failed to deliver growth for its shareholders. Indeed, Apple has not performed well compared to the overall stock market and a dollar invested in 1992 would only be worth 79 cents today. It made a lot of cash during the last years of the technology boom (2000), and because Mr Jobs did such a good job of streamlining the company it was able to hold on to that cash. But, fundamentally, the growth is flat. The core business of PCs continues to shrink, with iPod and iTunes driving its current revenue growth. While eye-catching, the iPod still has only a relatively small impact on Apple’s overall fortunes. But, the rapid growth in the portable music business means that the iPod contributed around 40 per cent of the revenue growth in 2003, compared with the same period a year before and offers huge growth potential.

Questions

1. Explain how the iPod is helping Apple achieve increased PC sales.
2. What are the potential benefits and limitations of licensing the iPod software to other MP3 manufacturers?
3. The iPod is facing fierce competition from all quarters: Sony, Dell and other electronics firms as well as cell-phone makers who are incorporating MP3 players into their devices. How can Apple compete?
4. What about longer-term success? How can Apple influence future technology developments or establish strategic alliances to ensure it is a dominant force in the new hand held device that will incorporate both cell phone and MP3 player?
5. Can Apple adopt a “BMW strategy” (BMW strategy is to target high premium segments) for the PC market and MP3 market?
6. What are the advantages and disadvantages of the Apple approach to launching a new product at Apple users first and then the larger Microsoft Windows users second?
7. The launch of the iphone in 2007 helps answer Apples strategy decision on competing with cell phones, but what about licencing, can it licence the iphone? Should it?

References

Phillip Inman P (2005) Fraudsters use iPods to steal company information, Guardian, June 14.

Coggan P (2005) iPod's popularity fires Apple back into FT500 ranks, Financial Times; Jun 11.

Morrison S (2005) Wall St wants Apple to raise iPod volume FT.com site; Jul 12.

Schofield J (2005) Microsoft gets creative to stave off its midlife crisis, Technology Guardian, Guardian, Sept 29, p9.

Durman P (2005) A second bite of Apple, Sunday Times, Business, September 25, p5.