02 Feb 2004  Research & Ideas

Where Does Apple Go from Here?

Macintosh market share continues to decline, but the iPod and iTunes are hit products. Where does Apple Computer’s future lie? An interview with HBS professor David Yoffie.

 

Apple Computer knows how to make headlines. The company is celebrating the 20th anniversary of the Macintosh and is enjoying the fruits of its launch into the digital entertainment business. In its December quarter, Apple sold 730,000 iPods. And the iTunes music download service has sold 30 million songs since its April 2003 debut.

No wonder then that Steve Jobs was a recent BusinessWeek cover boy. But for longtime Apple watcher David Yoffie, the Max and Doris Starr Professor of International Business Administration at Harvard Business School, the jury is still out on prospects for the company's long-term success. And Job's track record is hit or miss, he says.

Take Apple's return to investors. Yoffie says that if you invested a dollar in Apple in 1992, it would be worth $.79 today. The S&P 500 over that same time would be worth about $2.75, or more than three times your Apple investment. "Now, obviously, the company is doing much better since Jobs returned to the CEO job; but having said that, it has not yet reached the value that it was in the early 1990s," Yoffie points out.

Yoffie, whose book Judo Strategy was an international business best seller, has studied and written about Apple for the last decade, generating several case studies. His latest case, Apple Computer 2004, co-written with research associate Debbie Freier, was recently published by Harvard Business School Publishing. Yoffie sat down with HBS Working Knowledge for an interview in his office on campus.

Sean Silverthorne: Let's start with Jobs and his track record at his second tenure at Apple. From what you have seen, what has he tried to do, what's he been successful at, and what has he not been successful at?

David Yoffie: Steve was spectacularly good at getting the company highly focused in his first couple of years. He got rid of a huge number of product lines. He streamlined the operations and he bet on a very small number of products. The combination of the early success of the iMac, the booming marketing in 1998 and 1999, and the streamlined cost structure allowed Apple to generate cash very quickly. So Jobs' first great attribute was extreme focus.

There is a window right now for a desktop alternative to Microsoft in many markets around the world.
— David Yoffie

Number two; he went back to creating sizzle and real brand substance, which Apple had lost under (Michael) Spindler and under (Gilbert) Amelio, neither of whom were marketers. They were both engineers' engineers, and they didn't have the kind of marketing sizzle that (John) Sculley had or that Jobs had before Sculley. He brought back the brand value that really had been gone.

The third thing he has done is that for the very first time Apple has a non-Macintosh product (the iPod) that has promise. Apple has tried many times, from the Newton to the Pippen, all of which failed. For the very first time they have created a new product category where there is a prospect of earning a real return.

Q: Why has Apple had such a difficult job growing beyond the Mac?

A: Apple is a computer company, and Jobs has always understood that his 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's ultimately a consumer electronics product. Although it took him time, Jobs ultimately recognized that the iPod could not be limited to the Mac and it had to become a PC peripheral as well. Once he made the move to the PC market, he created the potential to access a much broader market than his core customer base. The Apple core customer base today is only about 8 million active users, in a world of 400 million Windows users.

Q: So the 25 million Mac users Apple talks about are customers over time?

A: That's correct. There are roughly 25 million Macintosh users in the entire installed base. But in fact the real number of active users is something closer to 8 million, which is a tiny, tiny, tiny fraction of the real market for any electronic product. Historically, Apple was trying to sell to its installed base of Mac users, and that base has never been large enough to amount to a hill of beans.

Q: What do you think of what Jobs calls the BMW strategy for the Mac, where you sell a product at a pretty good profit margin to a core group of loyal users and you don't talk much about market share? (Market researchers pinpoint the Mac share at 2 to 4 percent of the overall PC market.) Is this a viable strategy for Apple?

A: Over the long run, no. There are two primary reasons for it. Unlike BMW, which can sell at an enormous premium relative to the core market, 200, 300, 400 percent, Apple's products, while still highly differentiated, have a very hard time selling at a huge premium relative to the core PC market. So problem number one is that PCs have been closing the gap with Apple and are much cheaper. As a consequence Apple continues to find pressure on its prices, which makes it harder for them to sustain a big premium over time. This is why Apple has barely generated any real profits out of its core Mac business in the last three years. Their huge cash horde (about $4.5 billion) was largely generated during the boom, and since that time, they've continued to lose share.

The second problem is related to the underlying economics of one of the core components in the Macintosh—the operating system. The last generation of operating systems cost about a billion dollars to develop. In fact Apple spent roughly a billion dollars to deliver OS X . They get to amortize that investment over 3 million annual buyers. Microsoft spends the same billion dollars to develop XP and they get to amortize that investment over roughly 120 million users a year. In order for Apple to even get something close to comparable economics, they need to get a huge premium. Steve's response is that they don't have to get Microsoft's economics. They can do much worse than Microsoft's economics and still have a good business.

The problem is that even at a four- or five-time premium to Microsoft, they still can't sustain that business model. The next generation operating system, the one that will ultimately replace OS X and XP, is probably going to cost $1.5 billion to $2 billion dollars. So, Apple's underlying economics will never allow them to support their next generation operating system. If (Microsoft's) Longhorn is ever successful, the pressure that will place on Apple will be enormous because Apple simply will not have the resources with 8 million active users to ever be able to support it.

Q: In the hardware and PC operating system business, then, is there a way for Apple to succeed long term? Obviously it will have to get more users.

A: Well, what do you mean by "success"? There are at least three different ways in which you can imagine Apple going forward; I'm sure Steve has more.

One is to say they're going to build their business off of the digital home, the iPod, iTunes, iPhoto, etc., and become more of a service and software digital home application company. The strategy going forward is going to be more like a consumer electronics company, making hardware and software, rather than being a computer company. The Macintosh will be the core businesses that they milk and then they will build these other businesses for the future. The question is, can they sustain the huge premiums they earn with today's iPod when Dell is coming in with much lower-priced products and other competitors are entering the market? They're also running into the same challenge of selling a proprietary solution. (Music on the iPod can't play on non-Apple devices.)

It's very interesting that Apple is allowing HP to resell iPod. It's their first baby step into trying to really get into the mass market and becoming more of what I would describe as a horizontal hardware and software provider rather than a vertical, turnkey hardware integrated software provider. It's 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 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. It's still unclear whether this will be a viable strategy.

Q: When Jobs returned to Apple, he pulled back on previous plans to license the Mac OS.

A: Right, he killed it. And today the iPod is still the BMW strategy of the MP3 player business. So the question becomes: will Apple sell the iPod to a broader base of customers? Can they do with iPod what Sony did with the Walkman? That's the unknown. The challenge is that Sony drove the Walkman into a mass audience by drastically bringing down the price. We don't know whether Apple will be able to do this successfully. They've never been very good at very high volume manufacturing at very low costs.

A second strategy for Apple is to really go back to the Mac OS licensing business and try and generate a large enough volume so that the economics of their operating systems business will make sense in the future. For many years I thought that Apple's OS business was dead because they lost and Microsoft had won. Today it's a little less clear again. The reason is that so many of Microsoft's customers are unhappy with Microsoft pricing, and there is a new willingness to entertain new concepts, new ideas, new products, that didn't exist before.

In my view, Apple has three critical advantages over anybody else in the markets they serve.
— David Yoffie

For example, we're already seen outside the United States that Microsoft is getting enormous pressure in places like Thailand, China, and India because people simply aren't going to pay the Microsoft tax. And today they're looking towards Linux, but Linux, as it is today, is not a good solution for the desktop. So there is a window right now for a desktop alternative to Microsoft in many markets around the world, and if Apple should decide to aggressively pursue that market it could be an interesting opportunity for them. That window may not exist for long since Microsoft is a very aggressive company and eventually they'll figure out that prices are going to have to get lower and they're going to have to be more aggressive.

The third option is that Apple says our real advantage is in application and industrial design. In my view, Apple has three critical advantages over anybody else in the markets they serve. One is they have an incredibly strong brand; two, they have been the best at industrial design, far better than their closest competitor, Sony; and third, they have been very good at delivering applications in the digital home space.

The third strategy is very different from the second, which is to (concede) we lost the operating system war, and instead leverage our brand, our industrial design skills, and our application base. This strategy would suggest that Apple give up on the Mac OS, become a Microsoft customer, and go after the consumer PC in a very big way. (Yoffie is a board member of Intel, whose chips power most PCs and who has tried to woo Apple as a customer.—Ed.)

Q: Consumer PC? So Apple would make consumer PCs on Windows, and not just morph into a consumer electronics company like Sony?

A: Well, in fact, it would be to do what Sony has failed to do. Sony has not been able to deliver a successful consumer PC. Vaio has simply failed. The question is, could Apple with its superior industrial design, its superior application set, and its strong brand, do what Sony has failed to do? It's a big question and I doubt very much that Jobs wants to go in that direction, but it certainly is a possibility that they could entertain.

Q: If we look at those three alternatives, it seems like from Apple's own initiatives it's heading down path number one: the digital home application and services company.

A: The number one is the path of least resistance because they can continue the BMW strategy for the Mac, which at a minimum breaks even, makes a little money, or loses a little money in any given quarter. The strategy funds their ongoing efforts to build their applications and their third-party hardware businesses like the iPods. Ultimately, the iPod by itself is not a business because they have to develop a whole suite of products that would go along with it.

Q: Do you think that's kind of what the iTunes strategy is, the first in a series of products that are built off of iPod?

A: It could be. The problem is that we're in a standards war right now, and there is proprietary standard with iTunes, and there are going to be alternative standards pushed by Microsoft, Real Networks, and others. 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 has always built its company historically on hit products, and the problem with a hit product strategy is that when it works, it's great, but because it's dependent on a big hit, when it fails it's miserable. It's a little bit like the movie business. In years when you have Lord of the Rings, life is wonderful. But in years when you have Hollywood Cop, it's miserable.

In the years in which Apple has missed or hasn't had hit products, life has been miserable.

Q: What kind of window would you give Apple going forward? How long can Apple continue to maintain this kind of flat-line growth while slowly depleting its cash surplus? How long before it has to click on the next big thing?

A: A long time. I wrote my first case on Apple in 1992. I predicted at that time that Apple was going to have serious problems. It was roughly a $12 billion company then, and the business was doing well. But what I kept on saying is that big companies with relatively stable cash flows take a long time to die unless they really screw things up badly. During the Amelio years it looked like they had screwed things up very badly because they hadn't had a hit for eighteen to twenty-four months, and they did shrink dramatically.

Even with Jobs back in the seat now for six years, they continue to shrink. So here we are now, twelve years later, and they've gone from $11 billion to roughly $6 billion in annual revenue. But they're not burning cash and they're cash-flow breakeven. They made a lot of cash during the last years of the boom, and because Steve did such a good job of streamlining the company they were able to hold on to that. But, fundamentally, they're still relatively flat growth. Their core business continues to shrink, with iPod and iTunes driving their current revenue growth.

Q: What do you think of Apple's mall store retail strategy?

A: I think of their retail strategy as part of their brand advertising. I guess I would say two things about it. One, it has had a positive impact on the brand. You do get people browsing through the stores. Despite what Apple says, the statistics suggest that there is no significant conversion of non-Macintosh users to Macintosh users on the basis of the stores. So, if you think of it as an investment in brand marketing, it has probably been a reasonable investment. However, I don't expect it will ever generate significant revenues or significant profits.

Q: Is that brand reinforcement enough to keep that retail strategy going?

A: The stores are very good when you have a hit product because they drive a lot of traffic. During a period like today, where they have this wonderful new hit product called the iPod, they're driving lots of traffic into their stores. If they go through a period when there are no hit products, the stores just become an anchor weighing them down. If you can tell me whether or not they'll have a string of hit products, I can tell you how long the stores will last. I think it's fundamentally dependent on those hits. It is not like a Disney store, for example, which at least historically didn't depend on hits to drive traffic. Apple depends on hits to drive people into those stores. When Apple has a new cool Mac or a new cool device like a new iPod, people want to see it, feel it, and touch it.

Q: Occasionally PC companies will try to bring Apple's design smarts to the Windows world, but just don't seem to have the same success. Is that a testament to Apple and Jobs?

A: There's something about the PC world that always surprises me. I would expect when Apple brings out a great product, you should get relatively rapid imitation (in the Windows PC market). But in fact, it usually takes eighteen to twenty-four months. There's an incredibly long lag between the time in which Apple brings out something and people finally bring out a product that really can compete effectively. Part of the explanation is that Apple is so small that hard-nosed business people say, "It's just a niche, you don't need to worry about it." And it's not until it gets a little bit of traction that people really start to take it seriously and then start to figure out how to imitate it. Job's big advantage is that most of his competitors don't take him seriously in the early stages of a new product launch.

Number two; really great industrial design is hard.

Q: And he has passion for it.

A: And he has passion for it, right. I did a study on Gucci and it reminds me a little bit of Gucci. Jobs has a passion and love of details like Tom Ford had at Gucci. Steve Jobs, in some ways, reminds me more of Tom Ford than Bill Gates or Michael Dell. There's nothing uglier than a Dell box. And they seem to make little effort to deal with it. Furthermore, the PC industry operates on much thinner margins, which is why it takes so long to imitate. Dell spends 1 percent (of revenue) on R&D, Apple spends 4 to 5 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.

Q: We talked earlier about the positives Jobs brought back to Apple upon his return to the company. What are his negatives? Is he holding them back in some ways?

A: The question is; will Steve Jobs ever break out of the BMW niche strategy? His whole world has been focused around creating insanely great products, which are fundamentally built around a tightly integrated, tightly controlled, closed environment. And for Steve to really get religion and to break out of that would require a new Steve Jobs, which we have not yet seen.

Steve Jobs in some ways reminds me more of [Gucci's] Tom Ford than Bill Gates or Michael Dell.
— David Yoffie

The fact that iTunes, for example, initially was available only on the Mac is an example of this tendency. Initially, iTunes was meant to drive Macintosh sales, and then six or nine months later they 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. If Steve had really been thinking in terms of the breakout strategy, he would have started out on Windows and come to Macintosh later like everybody else in the world. But that's not the way he thinks. Just to put yourself in the position of anybody else in the world devising the same product, the first thing you do is make it for the 400 million market and then you do it for the 25 million market. He does it the other way around. I think that Steve has blinders on that make it very hard for him to break out of this pattern.

There's the other obvious question. Can anybody really run two companies simultaneously, Apple and Pixar, in two different businesses without sacrificing something? Can you bring enough attention to both companies and really be running them? I doubt that anybody can really do that well.

Q: Do you see a synergy in the future between what Pixar does and what Apple does?

A: No, other than they're both creative businesses in some way, shape, or form, but Pixar is basically a movie studio, which relies heavily on creative talent and computers to build their products. They're not selling computers and software to large numbers of people. Today Pixar sells a single product to a single company, and there is no underlying synergy with Apple. There is nothing that is meaningful enough to make an argument that these two things can make a CEO better by virtually doing the two of them together.

Q: Why do we have this continuing fascination with Apple given its relatively small market share?

A: Well, partly it's the brand. And what does the brand stand for? The brand stands for cool, hip, cutting-edge products that capture people's imagination. Jobs is a CEO who has a flair for the dramatic, and also captures people's imagination. He is the rebellious part of the computer world. Like Bill Gates, he's another college dropout who is a self-made man, but he does it with much more flare than Gates.

Q: We certainly did lose interest in Apple when Amelio and Spindler were the CEOs.

A: Yes, there were no hit products, and it became a dull company. They were just doing the same thing, making incremental improvements. Now everybody is waiting with bated breath for what Steve Jobs is going to do next, and the hope is, it's going to be something great, insanely great. And sometimes it is, and sometimes it's not.

Q: You've taught Apple over the years. What's been the reaction of students to Apple cases? Are they interested in this company in ways that they aren't in other companies?

A: I've written several versions of Apple, and Apple Computer is usually one of the top ten selling cases at the Business School almost every year for the last twelve years. It captures the fascination of business students as well as the general public.

The interesting thing about teaching Apple is that when things are going bad, everybody says, "Of course." And when Apple is doing well and you begin to teach the same basic ideas and explain why it's not sustainable, there's enormous skepticism. I've seen the cycle now several times. When I first started teaching the case, things were going great and nobody believed me that Apple had problems. And then when Apple was going down, everybody said, "Yes, of course." We see these wonderful cycles in teaching where people tend to be swayed by the latest fad in the business press about Apple. I tend to see much more continuity, but students are often more susceptible to the latest whims, both executive and MBA.