Apple Computer's innovation, business model, and industry influence

Apple Computer

About the Company

Apple Computer, Inc. is a Silicon Valley company based in Cupertino, California, whose core business is computer technologies. Apple helped start the personal computer revolution in the 1970s with its Apple II and shaped it in the 1980s and since with the Macintosh. Apple is known for innovative software and hardware, such as the iMac its iPod digital music player and the iTunes Music Store.

Apple has been criticized for their vertically integrated business model, which runs against the grain of much of the perceived wisdom of economists, particularly for the computer industry. However, the company is profitable. Other criticisms have included that it has been very personality driven, especially in the two different eras of Steve Jobs' tenure; some even regard it as being a cult, or at least having cult-like features. From a technical standpoint, Apple has also been criticized for having a closed and proprietary architecture with the original Macintosh, and a "not invented here" syndrome against adopting open standards.

However, that trend has been largely reversed with Mac OS X, and the company now has an official policy of adopting open industry standards where they exist. Apple has now used industry standard hardware technologies for many years, which has helped to lower prices significantly. Many Apple technologies have become industry standards where no former standard existed, e.g. ZeroConf network configuration, FireWire, etc. Other technologies, invented elsewhere, only gained wide industry acceptance after Apple adopted them, including 3-1/2-inch floppy disks, SCSI, USB, Wi-Fi and, of course, graphical user interfaces. Mac OS X itself is now based on an open source kernel and core operating system called Darwin. Apple also uses an open source HTML rendering engine in its Safari web browser.

Some third-party developers are also critical of the competing factions within Apple themselves, illustrated by the perception of an ongoing rivalry between the developers of Cocoa, which came from NeXT, and those of Carbon, which came from Apple. This rivalry is seen as counterproductive and unnecessary by many developers.

Apple's retail initiative has had a mixed reception. They have been considered a success in raising awareness of the Apple brand. Retailers have suggested that the Apple-owned retail stores have preferential treatment when receiving Apple hardware, and therefore receive limited stock product earlier, and at lower prices - an accusation that has been officially denied by Apple.

Financial Health/Revenue Growth

On April 13, 2005, Apple announced second quarter results and they were quite strong. "The Company posted a net profit of $290 million, or $.34 per diluted share. These results compare to a net profit of $46 million, or $.06 per diluted share, in the year-ago quarter. Revenue for the quarter was $3.24 billion, up 70% from the year-ago quarter. Gross margin was 29.8%, up from 27.8% in the year-ago quarter. International sales accounted for 40% of the quarter's revenue." An examination of these results indicates that the music business appears to be the strongest part of Apple, and could be the key to maximizing shareholder value. The Power Mac product, which includes the Xserve product line, was the weakest over the past year and could indicate that this area should receive less emphasis in order to increase shareholder value.

Apple's management has been working to reduce the company's expenses, eliminate inefficient product lines and restore a reasonable margin or return on each piece of computer hardware that is sold by Apple. This necessitates a reduction in market share and sales revenue in the short-term, in order to reap the benefits of greater efficiencies, better products and larger margins in the long-term. It does not mean that management is writing-off any markets or are disinterested in revenue growth, it means rather that they are more interested in solid financial fundamentals than they are interested in short-term sales and immediate profits. In the last fiscal quarter Apple was able to once again establish gross profit margins above 25%. This is a tangible sign that the company is poised for efficient growth and better financial health.

Cash Flow

This stock's price/cash flow ratio is normal compared with those of both the broader market and other stocks in its industry. Price/cash flow is similar to price/earnings, except that cash flow, which is the money available to be distributed to investors, is substituted for earnings. When purchasing a stock, a low price/cash flow is generally preferable to a high one, though one also needs to take into account the company's growth prospects.

Cash Flow (Values in millions of $ except per share values.)

Cash Flow table with Five Columns of Quarterly Data

Cash Flow

30 Sep 2000

Reclassified

29 Sep 2001

Net Income/Starting Line

Depreciation/Depletion

Deferred Taxes

Non-Cash Items

Changes in Working Capital

Cash from Operating Activities

Capital Expenditures

Other Investing Cash Flow Items, Total

Cash from Investing Activities

Issuance (Retirement) of Stock, Net

Issuance (Retirement) of Debt, Net

Cash from Financing Activities

Foreign Exchange Effects

Net Change in Cash

Cash Interest Paid

Cash Taxes Paid

Efficiency

Most stocks in the computer equipment industry have seen steadily growing revenue and impressive earnings growth over the past three years. This stock has also seen steady revenue growth over the past three years, with its results over the past year being particularly impressive. Like its peers, this stock's earnings per share have grown at a very high rate over the past three years. Note that this stock's sustainable growth rate is quite a bit less than the rate at which its earnings per share have grown. That means that the company will probably have to raise additional capital from outside sources at some point if it continues to grow at its current rate. Apple currently has no long-term debt.

As Apple recently touted the sale of the 500 millionth song by its iTunes music store, reports emerged that the company could be close to adding video features to iTunes and its iPod music players. The growth of iTunes over its two-year history underscores Apple's dominance in the online music market. When Apple reported its third-quarter results July 13, the company cited data from Nielsen Soundscan that gave the company 80% of the market for legally downloaded songs. Apple also said the latest reports from NPD Techworld gave its iPod 75% of the market for MP3 players, and the company posted iPod sales of $1.1 billion for its third quarter. With the iPod offering music and photo capabilities, speculation has grown that Apple could be on the verge on releasing a video-playing version of the iPod. The Wall Street Journal reported that Apple has held discussions with the major recording companies about selling music videos through the iTunes music store. Such a move would necessitate the release of a new iPod that plays videos. Analysts have said that Apple's iPod probably has about six months of growth ahead of it before the MP3 market begins to show signs of maturity and reaches a plateau. The company, according to those analysts, will need a new hit product by early next year.

Comparison - Dell v. Apple

Dell, Inc. is a computer-hardware manufacturer based in Round Rock, Texas. The marketplace perhaps associates Dell Computer most with the personal computers it designs, manufactures and sells for home and office use, but Dell also operates in the enterprise computing market with servers, data storage devices, network switches and computer cluster lines. Personal digital assistants, software and peripherals (including printers) round out Dell's product offerings.

As of 2005, Dell, Inc. had become one of the world's most visible companies. In February of 2005, Dell appeared in first place in a ranking of the "Most Admired Companies" published by Fortune Magazine. Dell incorporated as a Texas corporation in 1984 with a capitalization of $1,000, the minimum allowed by Texas law. Dell stock trades on the Nasdaq stock exchange in New York under the symbol DELL. As of 31 December 2004 the company had a market capitalization of $104.69 billion.

In its fiscal year ended 28 January 2005 Dell made a net profit of $3.32 billion on revenue of $49.2 billion. These figures represent 26% and 19% growth respectively over the previous fiscal year.

Dell Financial Ratios

Ratio

Short-Term Liquidity

Current Ratio

Acid Test

Days Sales in Receivables

Operating Performance Ratios

Operating Profits to Sales

Net Income to Sales

Dell sells all its products, both to the consumer and to corporate customers, using a direct sales model. Unlike Apple, Dell neither operates retail stores nor sells products through other retailers or resellers. Dell Inc. does, however, showcase its consumer-oriented products at kiosks in major malls. The sales staff at the kiosk may assist customers in ordering a product for shipment to their home. The Dell direct business model, which eliminates the middleman, has a reputation for its speed of sale-to-delivery of the company's products. Dell builds computers to order and this keeps its inventory costs low. Customers pay for product items before Dell builds those items, and this gives Dell a negative cash conversion cycle.

Dell currently ships Windows XP as the operating system (OS) of choice for most of its new computers, but it also offers Red Hat and SUSE for servers. Certain computers get sold "bare-bones" with a FreeDOS disk included in the box. On Dell's Windows machines, the manufacturer bundles a large amount of software. Some have accused Dell of shipping spyware and claim that its technical support team have instructions not to support its de-installation. Dell openly supported offering Apple Computer's upcoming Intel version of its Mac OS X operating system, but to this point Apple has stated the OS will only run on Mac machines.

Dell advertises heavily on television, on the Internet, in magazines and in newspapers, using constant "special offers" to encourage sales. A popular, widely parodied television and print ad campaign in the U.S. In the early 2000s featured young actor Ben Curtis playing the part of "Steven" - a cocky, and lightly mischievous blond-haired kid, who comes to the assistance of bereft computer purchasers. Each television advertisement usually ended with Steven's phrase: "Dude, you're gettin' a DELL!" During the past few years, Dell commercials have featured three "Dell interns" who learn about the company and show off Dell products, services and employees.

The PC industry operates on much thinner margins, which is why it takes so long to imitate. While Dell spends one percent of revenue on Research & Development (R&D), Apple spends four to five percent on R&D. Apple has a lot more capacity built into its business model to play with industrial design and to get it right than a Dell or a Gateway.

Profitability

Over the long haul, this company has posted results that are some of its industry's best, although the company's net profit margins - another key profitability measure - have been average compared with other companies in its industry.

Apple Financial Ratios

Ratio

Short-Term Liquidity

Current Ratio

Acid Test

Days Sales in Receivables

Capital Structure & Long-Term Solvency

Net Worth to Total Debt

Net Worth to Long-Term Debt N/a N/A2

Net Worth to Total Assets

Return on Investment

Return on Total Assets

Return on Equity Capital

Operating Performance Ratios

Gross Margin Ratio

Operating Profits to Sales

Net Income to Sales

Asset Utilization Ratios

Sales to Cash

Sales to Accounts Receivables

Sales to Working Capital

Sales to Total Assets

Market Measures

Earnings per Share

Average Price/Earnings Ratio

Through the 1990s, personal computers based on Microsoft's Windows operating system began to gain a much larger percentage of new computer users than Apple. As a result, Apple fell from controlling 20% of the total personal computer market to five percent by the end of the decade. The company was struggling financially under then-CEO Gil Amelio when on August 6, 1997 Microsoft bought a $150 million non-voting share of the company as a result of a court settlement with Apple (Microsoft has since sold all Apple stock holdings). Perhaps more significantly, Microsoft simultaneously announced its continued support for Mac versions of its office suite, Microsoft Office, and soon created a Macintosh Business Unit. This reversed the earlier trend within Microsoft that resulted in poor Mac versions of their software. However market share continued to decline, reaching three percent by 2004.

In October 2001, Apple introduced the iPod, a portable digital music player. Its signature was the incredible amount of storage space, initially five GB, enough to hold approximately 1,000 songs, compared to the 20-30 songs of Flash-based players of the time. Apple has since revised its iPod line several times, and on October 26, 2004, Apple released a color version the iPod which, can not only play music, but also show photos. As of November 2004, the iPod boasted a 87.3% market share among hard-drive-based players, according to NPD Group. On April 29, 2005, Apple released Mac OS X 10.4 "Tiger" to the general public.

In October 2001, Apple introduced the iPod, a portable digital music player. Its signature was the incredible amount of storage space, initially 5 GB, enough to hold approximately 1,000 songs, compared to the 20-30 songs of Flash-based players of the time. Apple has since revised its iPod line several times, introducing a slimmer, more compact design, Windows compatibility (previous iPods only interacted with Macintosh computers), AAC compatibility, storage sizes of up to 60 GB, and easier connectivity with car or home stereo systems. On October 26, 2004, Apple released a color version of their award winning iPod which can not only play music but also show photos. As of November 2004, the iPod boasted a 87.3% market share among hard-drive-based players, according to NPD Group.

Apple has revolutionized the computer and music industry by signing the five major record companies to join its new music download service, the successful iTunes Music Store. Unlike other fee-based music services, the iTunes Music Store charges a flat $0.99 per song (or $9.99 per album). Users have more flexibility than on previous online music services. For example, they can burn CDs, including the purchased songs (although a given play list can be burned to CD a limited number of times), share and play the songs on up to 5 computers, and, of course, download songs onto an iPod.

The iTunes Music Store commercial model is one-time purchase, which contrasts with other commercial subscription music services where users are required to pay a regular fee to be able to access musical content (but are able to access a larger volume of music during the subscription). The iTunes Music Store was launched in 2003 with 2 million downloads in only 16 days; all of which were purchased only on Macintosh computers. Apple has since released a version of iTunes for Windows, allowing Windows users the ability to access the store as well. Initially, the music store was only available in the United States due to licensing restrictions, but there were plans to release the store to many other countries in the future.

In January 2004 Apple released a more compact version of their iPod player, the 4-GB iPod Mini. Although the Mini held fewer songs than the other iPod models at that time, its smaller size and multiple colors made it a difficult find on store shelves after its debut. In June 2004 Apple opened their iTunes Music Store in the United Kingdom, France, and Germany. A European Union version opened October 2004 (actually, a Eurozone version; not initially available in the Republic of Ireland due to the intransigence of the Irish Recorded Music Association (IRMA) but eventually opened Thursday January 6, 2005.) a version for Canada opened in December 2004. On December 16, 2004, Apple sold its 200 millionth song on the iTunes Music Store to Ryan Alekman from Belchertown, Massachusetts. The download was the Complete U2, by U2. Just under three months later Apple sold its 300 millionth song on March 2, 2005. On May 10, 2005, the iTunes Music Store was expanded to Denmark, Norway, Sweden and Switzerland.

The iTunes Music Store was launched in 2003 with 2 million downloads in only 16 days; all of which were purchased only on Macintosh computers. It is a one-time purchase, which contrasts with other commercial subscription music services where users are required to pay a regular fee to be able to access musical content. Apple has revolutionized the computer and music industry by signing the five major record companies to join the iTunes Music Store. Unlike other fee-based music services, the iTunes Music Store charges a flat $0.99 per song (or $9.99 per album). Users have more flexibility than on previous online music services. In January 2004 Apple released a more compact version of their iPod player, the 4-GB iPod Mini.

On January 11, 2005, an even smaller version of the iPod was announced, this one based on flash memory instead of using a miniaturized hard drive. The iPod shuffle, like its predecessors, proved so popular that it sold out almost immediately, causing delays of up to four weeks in obtaining one within a single week of its debut. This is despite the fact that critics had gawked at the lack of LCD screen in the Shuffle, a norm in almost all current flash memory-based mp3 players. As of May 2005, it has captured a majority of the flash-player market, nearly 60%.

Future Performance recent development that could have a large impact on shareholder value is the report that Apple is in talks to use Intel Corp. chips in its computers. Wall Street was buoyed by the report because such a change could be the biggest shift in the Mac's makeup since it came out in 1984, and could make the machines less expensive. Apple and Intel have held talks in the past about coming together on creating a personal computer, but this recent report stated that Apple will agree to use Intel chips in Macintosh computers at some unspecified date, a development that was viewed with a healthy dose of skepticism by veteran industry analysts who have heard this rumor before. The largest obstacle between Apple and Intel is the incompatibility between the two different chip architectures in their current products. Apple's Macintosh computers are based on the PowerPC instruction set developed by current Apple supplier IBM and former supplier Motorola. Intel's chips use the x86 instruction set, which has provided the operating orders for Windows-based PCs since the 1980s. Software developed for one architecture does not run on the other architecture without a software emulator that usually slows performance dramatically. Therefore, if Apple were to switch to using x86 chips, it would have to get all of its Mac-friendly software partners to port their applications to a version of Mac OS based on the x86 architecture.

Apple's main motivation for moving to x86 chips would be to lower its costs or gain access to technology that it doesn't think IBM will have in the near future. And since Apple is unlikely to compete directly against Dell anytime soon, it's more likely that the company is worried about IBM's road map. A more likely scenario would involve Apple and Intel getting together to build a video-player iPod based on one of Intel's

XScale processors. The software development involved in moving the iPod product to XScale would not be as difficult as a PowerPC-to-x86 transition.

Apple appears to be moving forward with its stable of products. Earnings for 2004 were vastly improved over the two previous years and results for 2005 have indicated that this trend is continuing.

Quoting Merrill Lynch analyst Steve Milunovich in response to the threat posed by Yahoo!'s introduction of a subscription-based music download service, "the Apple story is about more than iPods. Although we think the iPod franchise is safe for at least the next year, the driver of the stock increasingly will be Mac sales. Management sees more evidence of the halo effect. We model a conservative 15-20% sustainable growth rate for Mac revenue.' Mr. Milunovich concludes by reiterating his Buy rating on the stock, with an objective of $51 per share." Certainly Apple seems to be posed to take advantage of its product line and grow the company because of its strong financial position.

As well as the transition to Intel microprocessors, 2006, or shortly thereafter, will see the arrival of Apple's next version of Mac OS X, Mac OS X v10.5 "Leopard." This is expected to provide for a smoother transition to the Intel chips, although they will run on present day PowerPC processors as part of their intention to continue PowerPC support for some years to come. Steve Jobs also stated during his keynote address at the World Wide Developers Conference 2005, that the use of Mac OS X will continue well into the next two decades.

Recommendation

Apple appears to be moving forward with its stable of products. I would certainly invest in this company. The liquidity ratios are excellent and there is no long-term debt. Earnings for 2004 were vastly improved over the two previous years and results for 2005 have indicated that this trend is continuing.

The operating ratios could be better, but they are improving. The product line is outstanding.

Apple's growing iPod success and the oft-mentioned iPod "Halo Effect" that could boost Mac sales as reasons for optimism. Apple is well positioned to capitalize on the large digital music opportunity with arguably the industry's most complete and integrated stack of hardware, software, and service.

The iPod + iTunes is positioned to be as successful in the digital music space as the Sony Walkman was, even with a similar flood of competitors entering the space. Apple could eventually ship as many as 85 million iPods, a 14-fold increase over the 6 million units shipped to date. That number is arrived at as 25% of the 340 million CD and cassette Walkman devices that Sony has shipped since 1979.

Apple's long history as an innovator in the computing industry is evidence of the company's vision going forward. Apple pioneered the first mainstream use of a computer mouse, computer HDD, pictures and icons "look and feel" graphical user interface (GUI), LCD flat panels, mainstream laser printer, FireWire (1394), WiFi, AirPort technology (co-developed with Lucent/Agere), iPod HDD-based music player, first successful online music download service, and the first platform for Microsoft Word and Excel office productivity software.

Apple's success in the digital music space represents a good opportunity for Apple to re-accelerate its core hardware business including iMac G5, PowerMac G5, iBook, and PowerBook G4. Non-Macintosh users are enjoying the benefits of the unique and easy-to-use Macintosh interface through Windows and iPod versions of iTunes and QuickTime. Moreover iPod is driving increased traffic to Apple Retail Stores. This combination could lure more users to the Macintosh platform.

Many analysts have said that the vast army of competitors using Microsoft's proprietary music format will eventually eclipse the iPod. While the iPod's lead may eventually be chipped away by those competitors, the company can still maintain its overall lead. Furthermore, Apple has room for growth in international markets.

Similarly, there is little threat to the dominance of the iTunes Music Store from Microsoft's Janus subscription service or the other music download services. Apple would be able to counter by either introducing an iTunes portable subscription service, something Apple could implement within a year if it decided to go that route, or by making the iPod compatible with music services other than iTunes. In addition, there are potential new revenue streams from increasing sales of Xserve, Xserve RAID, Mac OS X server, and SAN file system software.

Apple has a strong balance sheet, which Apple can increase through its strong cash generating capability. Although some analysts see a slowdown in the computer industry, Apple should continue to thrive because of its product mix. "Though demand is still healthy, computer makers have to overcome aggressive pricing in the second half." She has issued a "hold recommendations on... Apple Computer. Our recommendations reflect the relatively favorable industry fundamentals we project for the second half of 2005, as well as our price-to-sales and discounted cash flow analyses." There are also recurring revenue and replacement purchases of iPod and iTunes from a growing iPod user base. In short, I would definitely give Apple a buy recommendation.