AUGUST 27, 2002
SPECIAL REPORT: CAN APPLE KEEP ROLLING?At Apple, It's One Step Forward...
Every time Steve Jobs & Co. appears to have things going its way, something -- like a PC industry stuck in a slump -- seems to slow it downSome Apple aficionados will remember it as the night of the Jaguar. On Aug. 23, a line of customers snaked out the door of the Apple Computer store on University Ave in Palo Alto, Calif., the heart of Silicon Valley and a keyboard's throw from the garage where the two Steves founded the company in 1976. The buzz was palpable as the faithful queued up to buy early copies of Jaguar, the latest iteration of Apple's OS X operating system, hours before the official release on Aug. 24.
The upgrade, they believed, would dramatically improve the performance of the slow original version of OS X, the first Apple (AAPL) operating system to be based on industry-standard UNIX software. And they looked forward to Jaguar's new features, such as an enhanced e-mail program, better support for peripheral devices, and most important, network compatibility with Windows PCs.
Their enthusiasm belied a market truth, however. Web sites that sell Jaguar had already started offering rebates or lower prices to lure buyers of the $129 software package, which controls a Mac's basic functions. That seemed odd, considering that demand for Jaguar should be highest the day after its release. The explanation seemed to show up on Internet message boards, where plenty of Macheads griped that Apple was charging far too much for what they saw as too little added value.
OFFSETTING FACTORS. That tug of war between positive and negative momentum seems to be par for the course at Apple these days. It's furiously cranking out improved products, such as this year's enhanced iMac, the upgraded version of OS X, and a new iPod MP3 music player that for the first time works with non-Apple PCs (see "iPod: A Seed for Growth?"). Yet these initiatives are being more than offset by the generally weak PC market, the effects of which at Apple are being exaggerated by its sliding share of the education market, one of its key strongholds (see "Mac's Slipping Class Rank").
Add it all up, and the forces of negative momentum seem to have the upper hand for now, causing Apple's sales to fall 3% in its fiscal third quarter, which ended June 29, while profits fell 47.5%. Its stock, too, has taken a drubbing. Still, the $6 billion company clearly has ample staying power, which $4.3 billion in cash on hand sure helps (see "A Good Time to Pick Apple's Stock?").
However, with competitors circling in every key market, from Dell in PCs to Toshiba in MP3 players, Apple finds itself mired in a situation that demands only sure moves and no major errors -- and that seems to contradict CEO Steve Jobs's bold claims that Apple could innovate its way through a downturn.
A QUICK COOLING. Behind that boast was a presumption that the new iMac and OS X -- combined with a $50 million marketing campaign that urges Windows users to switch to Apple -- would lure scads of Windows converts and increase Apple's PC market share, which is stuck at about 3.5% in the U.S. Eight months after that plan was set in motion, it seems clear that it'll take a lot longer to succeed -- and a lot more effort.
For proof, look at the latest iMac. Right after its January introduction, sales soared so high that Apple couldn't keep up, thanks in part to component shortages. Then demand cooled off -- so quickly that in the third fiscal quarter, Apple sold only 1.5% more iMacs than it did the quarter before.
Analysts attribute that partly to the poor overall PC market, since if fewer consumers are buying computers, the odds that Apple can win hordes of converts shrink. In fact, Apple sold fewer PCs in its most recent quarter than it did in the same period a year earlier -- 808,000 vs. 827,000 -- a decline that tracks with the 4.6% falloff in worldwide PC sales in 2001, only the second annual drop in the industry's history, according to consultants Gartner Group.
FEWER FEET. That trend reflects ominously on Apple's new retail strategy, which is built around a slew of new stores it plans to open this year, bringing the total to 50 by December. For a time, the idea looked golden, with sales at the initial 29 outlets reaching $70 million on foot traffic of about 5,000 people a week. Enthusiasm has waned, though, and as of the fiscal third quarter's end, sales were $61 million at 31 stores, and foot traffic slid to 3,500 as the stores' novelty apparently began to wear off.
Those numbers still beat the pants off Gateway stores, which are lucky to get 700 visitors per week. But according to an Apr. 22 research note from veteran Apple watcher Charles Wolf of Needham & Co., Apple has been converting only 0.9% of non-Mac visitors into Mac customers. (Wolf owns Apple, and Needham makes a market in its shares.) It would take only a 2% conversion rate to boost Apple's market share in the home market by 50%, Wolf believes.
Now, with slower traffic through the stores and flagging sales, Apple's outlets may be losing their impact even before the 50-store buildout is complete. "We believe that Apple is making a big mistake in expanding its retail presnce and...increasing its fixed-cost base," wrote Merrill Lynch analyst Steve Fortuna in a July 17 research note. (Merrill makes a market in Apple shares and does investment banking for Apple.)
OVERBLOWN CLAIMS? That could be a valuable insight, given the reception for OS X, the first Apple operating system that's built on an industry-standard platform -- the same Unix software that runs the majority of Web servers. Even Mac users aren't upgrading to OS X in numbers that investors or analysts were expecting. So far, Apple has managed to convert only 20% of its 25 million customers to OS X.
Far from impressing the market, Jobs's claim that this is the fastest conversion to date for an Apple operating system has earned him the derision of critics. Apple executives declined to be interviewed for this article.
Another claim for OS X seems overblown: that its Unix backbone would provide Apple entre to corporations that shied away from its old proprietary operating systems but have used Unix for years. At least, few signs so far indicate that Apple will make significant inroads in big companies, outside of existing toeholds in graphics departments and biotech companies. Compared with such disappointments, the success of the stylish iPod music player -- with a 7% share of a booming market but only $100 million in annual sales -- is too modest to make much difference.
MORE MASS NEEDED. All of which raises the question: What should Jobs do next? Apple's disappointing third quarter raises the possibility that the long tech slowdown may have robbed the company of the important sales pop that traditionally has attended highly regarded new products, such as the latest iMac with its 17-inch flat-panel display. In fact, Jobs himself says he doesn't expect much of a PC industry rebound for six to nine months. Needham's Wolf predicted in a July 17 note that the home market won't rebound for another year.
Wolf also believes that Apple will find itself constrained by slow growth of broadband Internet access in the U.S., where only 13 million homes have high-speed connections. Wolf theorizes that this is hardly enough to create the critical mass needed to inspire content providers to offer a next generation of interactive, Web-based content -- offerings that many sites will use a Mac to prepare.
Indeed, a particularly dire situation for Apple is the state of its PowerMac professional line. Apple's most profitable product, with margins of 30%-plus, these powerful machines are a favorite of graphics professionals and biotech companies. PowerMac sales plunged 21% in the third fiscal quarter vs. the previous year, largely reflecting continued weakness in the graphics and advertising market.
WAITING AND WATCHING. A worrisome question for Apple is whether this problem is cyclical or systemic. This month, it released a new line of PowerMacs that represent a significant upgrade. All boast dual-processor systems that make them run faster. With the publishing and advertising businesses still in a funk, however, demand isn't likely to materialize for at least another quarter. The real question, though, is what happens then?
Graphics pros hardly need the additional power and speed to run their existing software. Additionally, many remain unwilling to pony up for a new operating system plus accompanying software upgrades. "Since Apple is charging the same for this update whether you've bought the previous ones or not, the lack of features relevant to my work means I can afford to wait and see how technology unfolds over the next couple of years," says Allan Guyton, chief designer at American History Co. in Fredericksburg, Va.
Guyton can take this chance partly because some big third-party software providers haven't yet updated their products to run with OS X. For instance, Quark, which makes production software for publishers, has yet to release an OS X version, so its customers see no reason to upgrade to OS X or to buy a new Mac.
A HOT PRODUCT. The same is true for Mac users of Adobe Photoshop -- just about anyone who uses a Mac for graphics work. Although Adobe has released an OS X version of Photoshop, "I think that some of the third-party plug-ins have lagged behind," says Rich Siegel, CEO of Bare Bones Software, whose products run on Macs. He says for serious Photoshop users, that's a stumbling block to upgrading. Siegel, who praises OS X and Jaguar as necessary steps forward, believes the largest factor impeding Mac sales remains the economy.
So, if Apple is looking for corporate purchases, it may be better off concentrating on selling its new Xserve server -- a hardware and software combination that can run in the Windows, Apple, or Unix environment. As a come-on, Apple has wisely offered $999 licenses that will allow an unlimited number of networked devices to use the software. In fact, Xserve might end up as Apple's hottest commercial product for the near term because systems administrators who already support Macs on their networks can seamlessly integrate a powerful and cost-effective Xserve in relatively seamless fashion.
Some IT honchos still question whether Xserve can truly deliver the high performance and reliability demanded by big companies. But for the most part, the reviews have been positive. "Apple has really done its homework in that regard," says IDC research vice-president and server analyst Jean Bozman.
JAGUAR'S LURE. One place it needs to do more homework is in schools. According to education tech tracker Quality Education Data, Apple has steadily lost market share in the K-12 market over each of the past two years. Though Apple still has the largest installed base of computers in primary and secondary schools, it's eroding at an alarming rate -- from 37% of the market in the 1999-2000 school year to 26% at the moment.
During the past quarter, according to IDC, Apple may have arrested the decline. And some school officials believe that Jaguar's ability to more easily fit into a network of Windows computers could help schools keep Apples in their classrooms. With its new eMac line for schools, plus laptops that offer wireless connectivity, Apple is working feverishly to hold onto what it has.
"We are ramping up right now to get our team trained in OS X. We know we will always buy Apples here," says Marie Scigliano, the director of technology at the Palo Alto Unified School District, which uses a mixture of Macs and Windows PCs.
UNDERMINED. Apple can take some other steps that fall into the category of blocking and tackling -- or common sense. For instance, Jobs has alienated some outside developers who create software for Apple customers by undercutting them. Witness the fate of Karelia, a small California software company that Apple cited at MacWorld last January for its innovative Watson software. That plug-in, available for $30, turned the Sherlock search engine that's included with Apple's operating system into a nifty advanced Web-search tool that could easily gather and customize information.
As a reward for this innovation, Apple redesigned Sherlock in Jaguar to do much what of Watson originally did. That cut off Karelia a mere eight months after it was declared a hero of the Apple realm. The message to developers: Look out for yourselves.
Jobs has also alienated Microsoft with his snarky "Switchers" ad campaign in which Apple converts comment on how much better life is with a Mac than with a Windows PC. That particularly bugged Microsoft managers who point out that only 300,000 copies of its Office V.X software have sold to Apple customers, well short of the 750,000 it had expected to be purchased by the July MacWorld. "Sales of Office are a good indicator of sales of PowerMacs, because the professional users tend to buy it," says Tim McDonough, the marketing manager for Microsoft's Macintosh Business Unit.
Should Microsoft get frustrated with the pace of sales and decide to yank its Apple version of Office in a few years, Apple could lose many of the customers who depend on it.
HOLDING ITS OWN. None of this means Apple is in trouble or even in particularly hot water. Rather, for the time being it has settled into a mode that makes it the BMW of computer companies. In fact, it's no small achievement for Apple to hold its own while other PC companies lose ground to Dell -- whose market share has climbed five points, to 27%, in just the last year, according to IDC.
To his credit, Jobs has methodically eliminated many of the barriers that relegated Apple machines to the fringes of computing. For example, the Rendezvous networking technology built into Jaguar will make it easy to have mixed home networks of PCs and Macs. As for its troubles in retail, Apple has reacted quickly by shifting to a mix of smaller stores with lower overhead to lower fixed costs such as rent.
"For them to have done as well as they have in the market that we are in is a testament to their abilities," says Brett Miller, an Apple analyst with investment bank A.G. Edwards. (Miller owns no Apple stock, and Edwards hasn't done investment banking work for Apple, but it does make a market in Apple stock.) That's the bright side of Apple's current situation, the one that reflects positive momentum.
"REASONS TO BE NERVOUS." Not far in the background, however, the old worries about negative momentum are lurking, the ones that focus on how few of Apple's product lines are clicking, and how hard it will be for the company to break out of its market-share box. Those are "definitely reasons to be nervous about Apple," says Mornginstar analyst Joseph Beaulieu. "Throughout its history, the company has failed to deliver on its promises time and again."
And so, despite all his accomplishments of the past several years, Jobs still finds himself trying to win over those who doubt that Apple can ever be more than a niche player. Same old worries, Steve, just a different year.
By Alex Salkever, Technology editor for BusinessWeek Online
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