Discussion essay paper

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Robin Chapman, Robert E. Hoskisson

Arizona State University

“This will go down in history as a turning point for the music industry,” said Apple Computer CEO Steve Jobs. “This is landmark stuff. I can’t overesti- mate it!”1 Jobs was referring to the April 2003 debut of Apple’s iTunes Online Music Store, the first legal online music service to have agreements with all five major record labels. Although initially available only for Macintosh users, iTunes sold more than 1 mil- lion songs by the end of its first week in operation. Not only did iTunes Discussion change the nature of the music industry, it also added greatly to Apple’s revenues by way of promoting the purchase of the iPod—a por- table digital music device that can store downloaded iTunes songs. In 2007, Apple controlled more than 70 percent of the digital music market,2 and its net income was $3.5 billion (see Exhibits 1 and 2). Jobs hopes further that the success of iTunes will flour- ish with the launch of Apple TV and iPhone in 2007. In May 2007, Apple was named by BusinessWeek as the most innovative company for the third year in a row. Apple’s focus on innovation has helped it main- tain a competitive advantage and marketing prowess over other industry players that have historically been much stronger than Apple.3 However, Apple must beat the competition on a number of levels. iTunes faces stiff competition from new and existing online music and video download services both legal and illegal. Discussion The iPod, Apple TV, and iPhone all face the threat of lower-priced rivals and possible substitutes. Apple’s innovative ability and the quality of its mar- keting strategy will likely determine the outcome of the company’s foray into the music, mobile phone, and video-on-demand businesses.

Early Company History On April 1, 1976, Steve Jobs and Stephen Wozniak began the partnership that would eventually become Apple Computer. Both electronics gurus, Jobs and Wozniak had known each other since high school and had worked together previously on other projects.4 In early 1976, Wozniak had been working on combining video monitors with computers. His idea was to invent a user-friendly computer that ordinary consumers could buy. Wozniak, who worked for Hewlett-Packard (HP) at the time, decided to approach his employer with his idea. HP, however, did not see a future for personal comput- ers (PCs) and soundly rebuffed him. At that point, Steve Jobs told his friend Wozniak that they should go into business together and sell computers themselves.5

Their first computer, the Apple I, was built in the garage of Jobs’s parents (see Exhibit 3). Known as a “kit computer,” the original Apple consisted merely of a cir- cuit board and did not even have an exterior casing. It was intended to be sold to hobbyists only. Jobs called the computer an “Apple” in honor of his days working at an orchard while seeking enlightenment—and because nei- ther he nor Wozniak could come up with a betterDiscussion name.6 The Apple I received mixed responses from hobbyists, and the duo decided it was time to expand the market for personal computers by building a more attractive and useful machine, the Apple II.7

Growth After taking on new partners to fund expansion plans, the company officially became Apple Computer, Inc., in early

C A S E 1 4 Apple Computer, Inc.: Maintaining the Music Business While Introducing iPhone and Apple TV*

* This case is intended to be used as the basis for class discussion rather than to illustrate effective or ineffective handling of an administrative or strategic situ- ation. We appreciate the previous input on an earlier case focused only on the music industry by Jeff Berrong, Marilyn Klopp, Max Mishkin, Jimmy Pittman, and Adrian Ray under the direction of Professor Robert E. Hoskisson.

Apple Computer, Inc., by Robin Chapman and Robert E. Hoskisson. Reprinted by permission of the authors.

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1977.8 Within months, the recapitalized company intro- duced the Apple II, the first computer to come with a sleek plastic casing and color graphics.9 Annual sales increased dramatically to $10 million, and the company began to grow quickly in size, adding thousands of employees.10 On December 12, 1980, Apple became a public company. On the first day of trading, its share price increased from an initial $22 offering to $29.11 By the end of the year, Apple reached $100 million in annual sales.12 The fledgling com- pany, however, soon faced some experienced competition.Discussion

In 1981, IBM released its first personal computer. IBM’s sheer size ensured its domination of the young PC mar- ket. Steve Jobs realized that Apple would have to move fast in order to remain a viable company. Over the next few years, the company released several new computer models, most notably the Apple III and the Lisa. Neither of these models sold particularly well.

In 1983, Jobs recruited Pepsi-Cola CEO John Sculley as Apple’s president and CEO. Jobs hoped that this change would bring more structure and

Exhibit 1 Consolidated Statements of Cash Flows

(In millions)

Three Fiscal Years Ended September 29

2007 2006 2005

Cash and cash equivalents, beginning of the year $ 6,392 $ 3,491 $ 2,969

Operating Activities: Net income 3,496 1,989 1,328

Adjustments to reconcile net income to cash generated by operating activities:

Depreciation, amortization, and accretion 317 225 179

Stock-based compensation expense 242 163 49

Provision for deferred income taxes 78 53 50

Excess tax benefi ts from stock options — — 428

Gain on sale of Power School net assets — (4) —

Loss on disposition of property, plant, and equipment 12 15 9

Changes in operating assets and liabilities:

Accounts receivable, net (385) (357) (121)

Inventories (76) (105) (64)

Other current assets (1,540) (1,626) (150)

Other assets 81 (1,040) (35)

Accounts payable 1,494 1,611 328

Other liabilities 1,751 1,296 534

Cash generated by operating activities 5,470 2,220 2,535

Source: Apple’s 2007 Fiscal Year 10K, www.apple.com/investor.

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13 Apple’s biggest computer achievement, the Macintosh (Mac), was released. After initially opposing it, Jobs had person- ally taken on the task of developing the Mac, which became the first PC featuring a graphical interface and a mouse for navigation. Apple first presented the now-famous Macintosh computer with a riveting January 1984 Super Bowl commercial. The memorable commercial featured an Orwellian 1984 world filled with stoic human zombies, all watching a large-screen image of “Big Brother.” A young woman rushes into the room and dramatically destroys the screen. Apple used this 1984 imagery to depict IBM’s computer dominance being destroyed by the new Macintosh.14 With features that made the Mac easy to use for pub- lishing and a marketing strategy that concentrated on universities, the new computer sold very well, push- ing Apple’s fiscal 1984 sales to an unprecedented $1.5 billion.15

Shake-Up By 1985, however, Jobs and Sculley began to disagree over the direction they wanted the company to take. After Jobs’s attempt to remove Sculley failed, Jobs left Apple in May to start his own new business, NeXT Computers. Meanwhile, Microsoft benefited from Apple’s poor negotiation of a contract that cleared the way for suc- cessive versions of the Windows operating system to use graphical user interface (GUI) technology similar to that of the Mac. With this agreement, “Apple had effectively lost exclusive rights to its interface design.”16

In 1990, Microsoft released Windows 3.0, the first universal software that could run on nearly every PC regardless of the manufacturer. Although Apple’s world- wide sales had reached $7 billion by 1992, Apple soon found itself fighting an uphill battle against the move- ment toward standardized software. More and more businesses and consumers wanted compatible operating

Exhibit 2 Apple Computer, Fourth-Quarter Fiscal 2007 10Q Report

Net Sales (net sales in millions and unit sales in thousands)

Three Months Ended

12/29/07 12/30/06 Change

Net Sales by Operating Segment:

Americas net sales $ 4,298 $ 3,521 22%

Europe net sales 2,471 1,712 44%

Japan net sales 400 285 40%

Retail net sales 1,701 1,115 53%

Other segments net sales (a) 738 482 53%

Total net sales $ 9,608 $ 7,115 35%

Unit Sales by Operating Segment:

Americas Macintosh unit sales 841 625 35%

Europe Macintosh unit sales 705 491 44%

Japan Macintosh unit sales 91 70 30%

Retail Macintosh unit sales 504 308 64%

Other segments Macintosh unit sales (b) 178 112 59%

Total Macintosh unit sales 2,319 1,606 44%

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Net Sales (net sales in millions and unit sales in thousands)

Three Months Ended

12/29/07 12/30/06 Change

Net Sales by Product:

Desktops (c) $ 1,515 $ 955 59%

Portables (d) 2,037 1,455 40%

Total Macintosh net sales 3,552 2,410 47%

iPod 3,997 3,427 17%

Other music-related products and services (e) 808 634 27%

iPhone and related products and services (f) 241 — NM

Peripherals and other hardware (g) 382 297 29%

Software, service, and other sales (h) 628 347 81%

Total net sales $ 9,608 $ 7,115 35%

Unit Sales by Product:

Desktops (c) 977 637 53%

Portables (d) 1,342 969 38%

Total Macintosh unit sales 2,319 1,606 44%

Net sales per Macintosh unit sold (i) $ 1,532 $ 1,501 2%

iPod unit sales 22,121 21,066 5%

Net sales per iPod unit sold (j) $ 181 $ 163 11%

iPhone unit sales 2,315 — NM

(a) During the third quarter of 2007, the Company revised the way it measures the Retail Segment’s operating results to a manner that is generally consistent with the Company’s other operating segments. Prior period results have been reclassified to reflect this change to the Retail Segment’s operating results along with the corresponding offsets to the other operating segments. Further information regarding the Company’s operating segments may be found in Notes to Condensed Consolidated Financial Statements at Note 7, “Segment Information and Geographic Data.” (b) Other Segments include Asia Pacific and FileMaker. (c) Includes iMac, eMac, Mac mini, Mac Pro, Power Mac, and Xserve product lines. (d) Includes MacBook, iBook, MacBook Pro, and PowerBook product lines. (e) Consists of iTunes Store sales, iPod services, and Apple-branded and third-party iPod accessories. (f) Derived from handset sales, carrier agreements, and Apple-branded and third-party iPhone accessories. (g) Includes sales of Apple-branded and third-party displays, wireless connectivity and networking solutions, and other hardware accessories. (h) Includes sales of Apple-branded operating system, application software, third-party software, AppleCare, and Internet services. (i) Derived by dividing total Mac net sales by total Mac unit sales. (j) Derived by dividing total iPod net sales by total iPod unit sales.

Source: Apple Company, 2007 4Q Form 10Q, hwww.apple.com/investor, 22.

Exhibit 2 Apple Computer, Fourth-Quarter Fiscal 2007 10Q Report (Continued )

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systems, but the Macintosh still ran exclusively on Mac OS, a system not available to other computers. By 1993, Apple’s board of directors replaced Sculley as CEO. Apple moved through two CEOs over the next five years.

During this time, Apple partnered with IBM and Motorola to produce the PowerPC chip, which would run the company’s new line of PowerMacs, allowing it to outperform computers powered by Intel microproces- sors.17 Despite this and Apple’s attempts to reorganize, losses mounted in 1996 and 1997. In December 1996, Apple acquired NeXT, with the plan of using its technol- ogy as the basis for a new operating system. After being gone for more than a decade, Jobs returned to the com- pany he had originally cofounded with Wozniak.

Jobs’s Return One of the first problems Steve Jobs moved to fix was the ongoing dispute between Apple and Microsoft over the Windows graphical user interface (GUI). Microsoft not only paid an undisclosed amount to Apple, but also made its Office 98 suite compatible with Macintoshes.18 Jobs then proceeded to change the company’s sales strat- egy in 1997 to encompass direct sales—both online and by phone. In a flurry of product releases, Apple intro- duced the new generation of PowerMacs, PowerBooks, and the highly anticipated iMac and iBook, which were less expensive computers aimed at the low-end com- puter market. After an entire year without showing a profit, the first quarter of 1998 began three years of prof- itable quarters for Apple.19

Jobs stated that he wanted to transform the com- pany by making the Mac “the hub of [the consumers’] digital lifestyle.” To do this, Apple introduced iLife in 2002, a software suite including applications such as iPhoto, iMovie, iTunes, and eventually the iPod. With the advent of Napster and peer-to-peer music sharing, Apple saw a way to capitalize on the emerging trend of cheap music downloads by creating a legal online music distribution network. iTunes would be the key to exploiting this market. Once downloaded by way of iTunes, music could then be transferred only to an iPod (due to encryption). With iTunes, Apple has quite possibly revolutionized the distribution of music and hopes to do the same with the distribution of movies on demand. Similar changes may be expected with the iPhone in the mobile or smartphone industry segments and with Apple TV in the mobile media and set-top box industry segments.

iTunes: Apple’s Online Music Store Apple ventured into the market of legal downloads with the introduction of its iTunes Music Store.20 iTunes offers downloads at a specified price without requir- ing a subscription or monthly fees. Originally offered

Exhibit 3 Select Apple Product Releases

1976 Apple I

1977 Apple II

1980 Apple III

1983 Lisa

1984 Macintosh Graphical user interface (GUI)

1986 Macintosh Plus

1987 Macintosh II

1991 Macintosh Quadra PowerBook 100

1994 PowerMac 6100

1997 PowerBook G3

1998 iMac

1999 iBook

2001 iTunes iDVD iPod

2003 iLife suite iTunes 4 (online music store w/200,000 downloadable songs)

2004 iPod Mini eMac iPod (Click Wheel) iPod (U2 Special Edition) iPod Photo

2005 iPod Shuffl e iPod nano iPod color iPod with video

2006 MacBook Mac mini

2007 Apple TV iPhone

Source: www.apple-history.com.

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exclusively on Apple’s own Mac, iTunes can now be installed on PCs as well. The idea behind iTunes was to provide a solution to the illegal pirating of music and software from rival sources such as Kazaa.

iTunes offers its users a selection of more than 6 mil- lion songs, with new songs continually added.21 Titles are from just about every genre of music. Users can perform a search by type of music, artist name, or title of track or album. Each song available can be previewed with- out making a purchase. Purchasers have the option of purchasing an entire album or single songs. Each song is $0.99, and a complete album starts at $9.99. Downloads can be made not only to a Mac or PC, but also directly to an iPod. All new song additions are encoded in AAC format, which many say is superior to MP3, although iTunes does still carry the MP3 format on some of its older selections.

Once songs are downloaded, they are stored as a digital music library. As this collection grows, this list of songs can be arranged in many different ways. Songs can be arranged by personal rating, artist, or genre. This feature allows for a customizable playlist for playback or burning to a CD.

In addition iTunes offers a collection of more than 10,000 audiobooks ranging in price from $2.95 to $15.95, including many different language lessons. Also avail- able are downloadable versions of public radio shows. Gift certificates are also available in different denomina- tions and can be sent electronically through e-mail.

As previously mentioned, in its first week of exis- tence, the number of downloads from iTunes surpassed the 1 million mark. This feat is amazing considering that at the time of iTunes’ introduction, the download service was available only for the Mac. In addition, at that time, Mac users comprised less than 5 percent of U.S. computer users.22 When iTunes became available for use on the PC, sales increased even more rapidly. iTunes PC downloads reached the 1 million mark in three days, less than half the time it took for the Mac ver- sion. But the success of iTunes is not measured in num- ber of downloads sold per day or week, since after pay- ing royalties, Apple makes only approximately 10 cents per song. iTunes is simply used as a means to boost the sale of iPods, iPhones, and Apple TVs, which generate a substantial profit per sale. For example, the iPod has been labeled “the profit machine” for Apple, as it tends to produce a 50 percent profit margin, per unit, before marketing and distribution costs.23

iTunes, iPod, iPhone, and Apple TV iPod For music lovers, the iPod is the greatest invention since the Walkman. With up to 160 GB of storage, it allows users to carry up to 40,000 songs or 200 hours of video wherever they go.24 There are currently four different iPod styles: the iPod shuffle, iPod classic, iPod nano, and iPod touch. iPod owners can purchase accessories such as the armband, the radio remote, and the uni- versal dock and remote to make using the iPod even more enjoyable. In 2007, with more than 100 million products sold, the closest competitor to Apple’s iPod had only 8 percent of the market share, leaving Apple with the vast majority. While others are seeking to sim- ply duplicate the complementary and innovative rela- tionships between iPod and iTunes, Apple continues to innovate with new products such as the iPhone and Apple TV.25 (See Exhibit 4 for more details about the iPod products.)

iPhone In first-quarter 2007, Apple launched its “revolutionary” product, the iPhone. The iPhone combines three con- cepts popular with consumers: a mobile phone, a wide- screen iPod, and an Internet communication device. The iPhone brags “an entirely new user interface based on a large multi-touch display and pioneering software,” which users can control with just their fingers.26 The iPhone’s default Internet browser will be Apple’s own Safari,** but it is open to other software as well.27 The iPhone allows for 8 hours of talk time, 24 hours of audio playback time, and 10 days of standby time.28 Apple sold 1 million iPhones less than three months after this prod- uct was available to consumers. Apple expects this trend to continue during 2008 and to reach sales of 10 million iPhones, stealing 1 percent of the mobile phone market share.29

Apple TV In addition to the iPhone, Apple also introduced the Apple TV in 2007. With this product, Apple intends to revolutionize the Internet video industry, as it did with the music download industry. Users can download movies and TV shows via the iTunes online service or via YouTube as well as view digital photos and home videos.30 Some negative hype claims that the Apple TV will be a flop just like the Apple III and the Power Mac

** Safari is Apple’s Internet browser that was introduced in 2003. It is part of Apple’s strategy to gain more market share by having both hardware and soft- ware products. Apple suggests that Safari is the fastest browser available. It blocks pop-up advertising and has a built-in text reader that reads the site pages aloud. In addition to being the default browser for the iPhone, it is the default browser for the iPod Touch and the Mac computer. Safari’s user share was esti- mated to be 6 percent in early 2008. (P. Festa, 2003, Welcome to the browser jungle, Safari, CNET News, www.news.com, January 7; 2008, Wikipedia, http:// en.wikipedia.org.)

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unpopular include the following:

Users are not able to download a movie from iTunes • directly to their TV; they have to download it to their PC first. It requires an HDTV, but the movies that can be • downloaded are of such low resolution that the pic- ture looks fuzzy and old-fashioned. It has no DVD drive. •

Steve Jobs announced at the Macworld Conference & Expo in January 2008 that the upgraded version of Apple TV will allow owners to order movies directly from the TV rather than having to download to the PC.31 Also, critics do compliment the fact that the Apple TV plays a slideshow of digital photos.32

The price to rent a movie using Apple TV is $2.99 for library titles, $3.99 for new releases, and $1 extra to view the movie in high definition.33

One key component that must be in place to have good media content for the three products mentioned is the relationship that Apple has with each of its media and phone service suppliers.

Service Suppliers: iTunes, Apple TV, and iPhone iTunes iTunes has agreements with all five major record labels (BMG, EMI, Sony Music Entertainment, Universal, and Warner Bros.) as well as more than 200 indepen- dent labels. These agreements allow iTunes to sell the music owned by these labels and pay the record label each time a song is downloaded. This deal is consid- ered a reseller agreement, meaning that Apple is not licensing content from these labels, but rather buying it wholesale and reselling it to consumers.34 Apple gets to keep its share, while the portion the label receives must be divided among many parties including artists, producers, and publishers. Labels earn approximately 70 cents per song sold on iTunes. This figure may seem small, but it is still greater than losing money to the millions of illegal downloads that nearly crippled the music industry.

The revenues for record label companies have been dropping in the past year due to tough market condi- tions, and Apple has introduced a strategy that may help increase revenues by at least a small percentage. It has already contracted with EMI to make its entire catalog available to iTunes’ users in two formats, the traditional download option, which includes the Fair- play digital rights management (DRM) software and DRM-free versions. The DRM software limits the

number of times a song can be copied, which decreases the quality of the song. The DRM-free versions would deliver greater quality music but would require a higher price tag. iTunes will start the DRM-free songs at $1.29 per song versus the traditional $0.99 per song. Other record labels may enter into the same agreement with Apple depending on how successful this strategy is with EMI.35

NBC recently cancelled its agreement with Apple to provide its TV shows on iTunes due to pricing disputes. Walt Disney Studios previously offered its new releases, and Paramount, Metro-Goldwyn-Mayer (MGM), and Lionsgate allowed older library titles to be purchased on iTunes, but the supplier agreements have changed with the launch of Apple TV.36

Apple TV Apple did not have an easy time finalizing with movie studios contracts that will allow Apple to sell movies on iTunes for use on the iPod and Apple TV. Not only were the studios concerned about losing significant revenues from the sales of DVDs and Blu-ray discs, but some studios urged Apple to require a watermark on digi- tal video for it to play on its devices. Their concern is heightened given the pirating experienced in the music download business. One movie-studio executive said, “Our position is, if you want our content, you have to protect our business.” Apple, however, responded that it trusts its consumers not to play pirated movies.37

The limited number of movie downloads available on iTunes would significantly diminish the success of Apple TV. Thus, Apple’s CEO was persistent in his negotiations with the movie studios. Jobs announced at the Macworld Expo in 2008 that Apple had reached agreement with each of the following major studios: Twentieth Century Fox, The Walt Disney Studios, Warner Bros., Paramount, Sony Pictures Entertainment, MGM, Lionsgate, and New Line Cinema.38 Despite NBC’s issues with Apple concerning TV shows, Universal Pictures (owned by NBC and General Electric) has agreed to allow Apple to rent its movies via iTunes.

The supplier agreement between Apple and the movie studios is that new movies will not be available for rent until 30 days after the DVD is distributed. Within a 24-hour period, customers will be able to watch a film as many times as they like once the movie is started. Movies that are downloaded but not started will not be available for viewing after 30 days.39