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A Strategic Analysis

of

Apple Corporation

Timothy Pivovarnik

Jeff Shaver

Adam Siler

Richard Sterling

Dave Strubbe


EXECUTIVE SUMMARY 3

HISTORY OF APPLE 4

THE PC INDUSTRY 10

THE ONLINE MUSIC INDUSTRY 12

THE FUTURE OF APPLE 12

PERSONAL COMPUTERS – A SHIFT IN STRATEGY 12

APPLE IN THE LIVING ROOM 14

STRATEGIC ALLIANCES AND ENTERTAINMENT 15

EXTERNAL ANALYSIS 17

TECHNOLOGICAL ENVIRONMENT 17

Brand Awareness – Style at a Premium 17

Interoperability 18

Technology and the Digital Lifestyle 18


REGULATORY ENVIRONMENT 20

INDUSTRY ANALYSIS USING PORTER'S FIVE FORCES MODEL 21

WHICH EXTERNAL THREATS ARE MOST SIGNIFICANT 23

ADDITIONAL EXTERNAL THREATS 25

SECURITY 25

VERTICAL INTEGRATION OF COMPETITORS 25

VALUE CHAIN ANALYSIS 26

TECHNOLOGY AND PRODUCT DESIGN 27

PRODUCTION 27

SALES AND MARKETING 27

CUSTOMER SERVICE 28

LEGAL SERVICES 28

SWOT ANALYSIS 29

STRENGTHS 29

WEAKNESSES 30

OPPORTUNITIES 31

THREATS 31

FINANCIAL ANALYSIS 32

2ND QUARTER 2006 32

HISTORICAL PERFORMANCE 33

STOCK PRICE PERFORMANCE 34

PROFITABILITY MEASURES 35

LIQUIDITY AND LEVERAGE MEASURES 35

PRODUCT UNIT SALES 36

OPERATING SEGMENTS 36

MARKET VALUE ANALYSIS 37


PRO-FORMA INCOME STATEMENT 38

PROJECTED FREE CASH FLOW AND EQUITY VALUATION 39

STRATEGY 40

PRODUCT DIFFERENTIATION 40

STRATEGIC ALLIANCES 44

CONCLUSIONS 48

REFERENCES 49

Executive Summary

Apple Computer's 30-year history is full of highs and lows, which is what we would
expect in a highly innovative company. They evolved throughout the years into an
organization that is very much a representation of its leader, Steven Jobs. Apple made
several hugely successful product introductions over the years. They have also
completely fallen on their face on several occasions. They struggled mightily while Jobs
was not a part of the organization. Apple reached a point where many thought they would
not survive. When asked in late 1997 what Jobs should do as head of Apple, Dell Inc.'s
(DELL) then-CEO Michael S. Dell said at an investor conference: "I'd shut it down and
give the money back to the shareholders." (Burrows, Grover, and Green)

Well, times changed. Less than 10 years later, BusinessWeek ranked Apple as the top
performer in its 2006 BusinessWeek 50. Apple attributes their recent success to robust
sales of iPod music players (32 million in 2005). They are optimistic about the economies
of scope with media giants, such as Disney and Pixar. (BusinessWeek)

Apple rarely introduces a new type of product. Thus, instead of being the pioneer, they
are an expert "second mover" by refining existing products. Portable music players and
notebook computers are examples. Apple increases the appeal of these products by
making them stylish and more functional. They now appear poised to make significant
strides in the home computer market and to creating a total digital lifestyle whereby the
home is a multimedia hub.

History of Apple
Steve Jobs and Steve Wozniak founded Apple on April 1, 1976. The two Steves, Jobs and
Woz (as he is commonly referred to – see woz.org), have personalities that persist
throughout Apple's products, even today. Jobs was the consummate salesperson and
visionary while Woz was the inquisitive technical genius. Woz developed his own
homemade computer and Jobs saw its commercial potential. After selling 50 Apple I
computer kits to Paul Terrell's Byte Shop in Mountain View, CA, Jobs and Woz sought
financing to sell their improved version, the Apple II. (Linzmayer, 7-9)

They found their financier in Mike Markkula, who in turn hired Michael Scott to be
CEO. The company introduced the Apple II on April 17, 1977, at the same time
Commodore released their PET computer. Once the Apple II came with Visicalc, the
progenitor of the modern spreadsheet program, sales increased dramatically. In 1979,
Apple initiated three projects in order to stay ahead of the competition: 1) the Apple III –
their business oriented machine, 2) the Lisa – the planned successor to the Apple III, and
3) Macintosh. (Linzmayer, 14-5)

In 1980, the company released the Apple III to the public and was a commercial flop. It
was too expensive and had several design flaws that made for less-than-stellar quality.
One design flaw was a lack of cooling fans, which allowed chips to overheat. In late
1980, Apple went public, making the two Steves and Markkula wealthy – to the tune of
nine figures. By 1981, the Apple III was not selling well and Scott infamously fired 40
people on Feb 25 ("Black Wednesday"). Scott's direct management style conflicted with
the culture Jobs and Markkula preferred, and Scott resigned in July. Markkula stepped
into his position as CEO. (Linzmayer, 15-6)

In August 1981, IBM released their PC. Unimpressed and unafraid, Apple welcomed
IBM to the PC market with a slightly smug full-page ad in the Wall Street Journal. It
would not be long before IBM's PC dominated the market.

The Xerox Alto was the inspiration for Apple's Lisa. Apple employees were able to
examine the Alto in exchange for allowing Xerox to invest in Apple before Apple's initial
public offering (IPO). Apple released the Lisa in January 1983 and was notable for being
the first computer sold to the public that utilized a Graphic User Interface (GUI).
Unfortunately, the Lisa was not compatible with existing computers, and therefore came
bundled "with everything and a list price to match." (Linzmayer, 77) At $9,995 (over
$21,000 in 2005 dollars), the Lisa missed its target market by a wide margin.

Jobs attempted to control the Lisa project. Scott, unimpressed with the performance of
Jobs on the Apple III project, had Jobs head up the dog-and-pony show for the pending
IPO. Jobs, looking for a project to lead, inserted himself into the Macintosh development
team. Using his considerable influence, Jobs was able to procure the resources to produce
a computer that was faster than Lisa, used a GUI, had a mouse, and sold for ¼th of Lisa's
price. Apple introduced the Macintosh with great fanfare during the 1984 Super Bowl.
The Orwellian-themed commercial (directed by Ridley Scott, of ‘Alien' fame) portrayed
IBM as Big Brother and embodied Macintosh and Apple as freedom-seeking individuals
breaking away from this oppressive regime. The commercial was largely successful and
sales for the Mac started strong. However, Mac sales later faded. (Linzmayer, 76-93, 109-
14)

John Sculley left PepsiCo to join Apple in April 1983. He was famous for engineering the
"Pepsi Challenge", in which blinded testers tasted both Coke and Pepsi to unveil the
‘truth' of the taste of Pepsi. In response to lagging Mac sales, Sculley contrived the ‘Test
Drive a Macintosh' campaign. In this promotion, prospective users could take home a
Macintosh with only a refundable deposit on their credit card. While lauded by the public
and the advertising industry, this campaign was a burden on dealers and significantly
impeded the availability of Macs to serious buyers. In 1985, Apple tried to have
lightening strike twice with their ‘Lemmings' commercial during the Super Bowl. In what
was becoming Apple's typical patronizing fashion, this commercial insulted current PC
users by portraying them as witless lemmings, unthinkingly doing harm to themselves.
Although Jobs attempted to overthrow Sculley, the board backed Sculley. Jobs left Apple
to form NeXT computer. (Linzmayer, 143-5, 153-8, 207)

After Jobs left in 1985, sales of the Mac "exploded when Apple's LaserWriter met Aldus
PageMaker." (Linzmayer, 159) Apple dominated the desktop publishing market for years
to come. Under Sculley, Apple grew from $600 million in annual sales to $8 billion in
annual sales by 1993. Apple introduced Mac Portables in 1989 and the first PowerBooks
in 1991. By 1992, PC competition ate into Apple's margins and earnings were falling.
Sculley was under pressure to have Apple produce another breakout product. He focused
his energy on the Newton – Apple's introduction of the Personal Digital Assistant (PDA).
Despite Sculley generating substantial demand for Newton, it did not live up to the hype
due to it being severely underdeveloped. Sculley resigned in 1993 and Michael Spindler
replaced him. (Linzmayer, 158, 161, 183-96)

Spindler spent most of his time and energies on regaining profitability, with the end goal
of finding a buyer for Apple. Over the next several years, Spindler shopped Apple to Sun
Microsystems, Eastman Kodak, AT&T, and IBM. Meanwhile, Apple was unable to meet
the growing demand for its products due to supplier problems and faulty demand
predictions. To add insult to injury, Microsoft released Windows 95 with great fanfare in
1995. After significant quarterly losses in 1996, the board replaced Spindler with Dr. Gil
Amelio, CEO of National Semiconductor. (Linzmayer, 233-40)
Dr. Amelio tried to bring Apple back to basics, simplifying the product lines and
restructuring the company. One of Apple's most pressing issues at the time was releasing
their next generation operating system (code named "Copland") to compete with
Windows 95. Amelio and his technology officers found that Copland was so behind
schedule that they looked outside the company to purchase a new OS. Ultimately, and
somewhat ironically, they decided to purchase NeXT computer from Jobs. Naturally,
Apple welcomed Jobs back into the fold. The board became increasingly impatient with
Amelio due to sales not rebounding quickly enough. Apple bought out Amelio's contract
after just 1 ½ years on the job. (Linzmayer, 240)

Jobs eventually claimed the CEO position. Then, he cleaned house by revamping the
board of directors and even replacing Mike Markkula (who had been with the company
since the beginning). Jobs simultaneously put an end to the fledgling clone licensing
agreements (which created a few Mac clones) and entered into cross-licensing
agreements with Microsoft. On May 6, 1998, Apple introduced the new iMac, a product
so secret that most Apple employees had never heard of it. (Linzmayer, 289-95) The new
iMac was a runaway success with its translucent case, all-in-one architecture, and ease of
use. It brought Apple to a new market of users – those who had never owned a computer
before. Jobs further simplified the product lines into four quadrants along two axes:
Desktop and Portable on one, Professional and Consumer on the other. Apple completed
the matrix with the introduction of the consumer-based iBook in 1999.

The year 2001 was an important year for consumers of Apple products. Apple opened
their first 25 retail stores (totaling 163 stores in 4 countries as of May 2006). In
September 2001, Apple introduced the new iMac featuring a screen on a swivel.

The new iPods (portable music players) were a tremendous success. Apple sold so many
that Apple's dependence on Mac sales was significantly less. This was no small feat
considering that the 2001 iMac became Apple's best-selling product "by a long shot".
(Linzmayer, 301) Apple offered iTunes (a free application) to help their consumers
organize music on iPods and Macs.

In 2003, Apple expanded iTunes by 1) opening the iTunes music store to allow Mac users
to purchase music online and 2) expanding iTunes to Windows users. Sales of iPods
skyrocketed and currently provide the bulk of product sales to Apple. (Apple)
In 2005, Apple announced that it would start using Intel-based chips to run Macintosh
computers. In April 2006, Apple announced Boot Camp, which allows users of Intel-
based Macs to boot either Mac or Windows OS. This functionality allows users who may
need both OSs to own just one machine to run both, albeit not simultaneously.

The PC Industry

We can glean Insight into the history and composition of the PC Industry from its
eponymous title. In the late 1970s, as Wozniak and Jobs were starting Apple computer,
personal computers were an emerging product. The following chart (Reimer) gives an
overall view of the major market players since the mid-1970s.

By 1983, the market share of the Apple II fell to 8% while the PC had 26%. Market share
of Macintosh peaked at slightly more than 10% in the early 1990s and has since tapered
to between 2-3%. The IBM PC and its clones became the standard due to the success of
the open nature of the PC. This allows product developers to offer vastly more products
for the platform.

Some argue that not licensing the Mac OS was a mistake. Bill Gates and Microsoft were
encouraging Apple to license their OS in the early 1980s, because they were developing
software for Apple and had much riding on the success of the company. When Apple did
not license, Microsoft began developing their operating system, Windows. (Linzmayer,
169-75, 245-9)

The Online Music Industry

While Apple clearly dominates the online music industry, the battle for domination is not
over. Although digital music sales are growing rapidly, the Recording Industry
Association of America (RIAA) states that digital sales account for only 4% of all music
sales. (Borland) Analysts at Forrester (Bartiromo) and Gartner (Bruno) validate this.
Apple's sales are between 66% and 75% of downloads and 80% of music players.
(Bruno) Apple is part to a suit alleging monopolistic practices concerning their market
share dominance of players and downloads. (Grundner)

The other players in the download market are (the revised) Napster, Yahoo Music,
Rhapsody, and illegitimate file-sharing services. Portable music players competing with
the iPod include those made by Creative, Samsung, iRiver, and Sony. A major point of
contention between these services and player manufacturers is the control of a variety of
incompatible Digital Rights Management (DRM) schemes.

The Future of Apple


Personal Computers – A Shift in Strategy

Apple has historically taken a far different path than the traditional Windows and Intel
combination. Microsoft provides the Windows operating system to separate downstream
hardware producers such as Dell. Apple vertically integrated both the operating system
software and hardware completely under Apple. A consumer running Microsoft
Windows can choose from a myriad of systems based on the Intel processor, while a
consumer running Apple's OS X must purchase Apple hardware.

Apple is adjusting this strategy by migrating their microprocessors from IBM and
Motorola PowerPC to Intel. Analysts believe that the Intel-based Macintosh may be able
to run Microsoft Windows applications by the end of 2006. (Burrows)

In addition to switching processors, Apple positioned their computers as an immediate


option for the traditional Microsoft Windows user. With Apple Boot Camp, users may
now use Mac OS X or Windows on an Apple computer. (Sutherland)

Figure 1: Apple Boot Camp – Allowing Mac OS X or Windows


(http://www.eweek.com/slideshow_viewer/0,1205,l=&s=27287&a=175119&po=18,00.as
p)

By allowing users to run Windows on an Intel Mac, Apple reduced the switching costs
for traditional PC users. Apple may steal away customers that are willing to pay a
premium for a system that runs both Windows and Mac OS X.

Figure 2: IBM PowerPC Processor (http://itc.ua/img/ko/2003/50/proc5.jpg), Intel


Processor Core Duo / Pentium M (http://blog.pc-actual.com/blogpca/images/Intel
%20Pentium%20M.jpg)

Apple continues to retain a strategic option to license its technology to clone makers such
as Dell. Past attempts at licensing Apple technology (to IBM, Gateway, and others) failed
on accord of Apple's rigid demands. Many technology leaders (such as a 1985 letter by
Bill Gates to Apple CEO John Sculley) criticized Apple for keeping a closed architecture.
Apple cofounder Steve Wozniak criticizes this strategy, "We had the most beautiful
operating system, but to get it you had to buy our hardware at twice the price. That was a
mistake." (Linzmayer, 245-57)
Whether Apple would be willing to pursue this reversal of vertical integration is unclear.
Although such a move would cannibalize a portion of Apple's own hardware sales, it
would also provide royalty-based revenue that could approach $1 billion annually.
(Burrows) Jobs traditionally sided against licensing Apple technology. He referred to
Mac clone producers as "leeches" and he personally killed Power Computing (a Mac
clone producer) by terminating their license in 1997. (Linzmayer, 255)

Apple in the Living Room

Apple's iPod and iTunes are a powerful combination that fosters a network style of
increasing returns. (Barney, 124) By selling iPods, Apple increases the consumer demand
for music from iTunes. By placing more musical choices on iTunes (including less
popular songs that appeal to niche audiences), there is more demand for iPods. Apple had
70% of the legal music download market in early 2005. (Yoffie)

Apple is shooting for the digital living room of the future. For example, Apple just
released a "boom box" portable version of the iPod. This iPod (the iPod Hi-Fi) comes
with a remote control. Instead of forming a strategic alliance, Apple engineered the iPod
Hi-Fi and designed it with high-fidelity features. (Burrows) Apple is clearly trying to
develop a stronger core competency in the entertainment area.

Figure 3: The Apple Hi-Fi. (http://www.apple.com/ipodhifi/)

Apple may also release an Apple-branded cell phone and iPod combination device by the
end of 2006. (Burrows) This product would again position Apple as a "second mover"
responding to Palm's Treo and Verizon's VCAST technology.

Strategic Alliances and Entertainment

Jobs had the early strategic vision to complement computing with movie entertainment.
After founding NeXT, he personally acquired a majority interest in the young movie
company Pixar in February 1986. (Linzmayer, 219) Jobs went on to invest ¼ of his
personal wealth into Pixar.

In 1995, Pixar solidified its position within animated movies with the debut of Toy Story.
Grossing $358 million worldwide, it became the 3rd-largest grossing animated movie in
history. (Linzmayer, 222) After this success, Jobs took Pixar public and negotiated far
better terms with Disney. Later successes included Toy Story 2, Monsters Inc., and
Finding Nemo. Ironically, Jobs stated in the November 23, 1998 BusinessWeek, "I Think
Pixar has the opportunity to be the next Disney – not replace Disney – but be the next
Disney." (Linzmayer, 222-4)

The alliance between Pixar and Disney has tremendous potential for economies of scope.
As CEO of Apple and Disney's largest shareholder, Jobs is the strategic link between
Disney, Apple, and Pixar. Opportunities include combining the animated movie expertise
of Disney and Pixar, as well as sharing the content of Disney's ABC or ESPN networks
over Apple's digital offerings. (Burrows, Grover, and Green)

A current example of the fusion between Disney, Jobs, Apple, and technology is video on
the iPod. Disney's Desperate Housewives was one of the first television programs
available for purchase and download to the newer video-enabled iPod.
(http://www.apple.com/itunes/videos/)

There are concerns about whether these synergies will come to fruition. There are fears
that the personality and style of Jobs may conflict with Disney, and that Disney CEO Iger
could be "Amelioed" -- driven out of office by Jobs in a manner similar to how Jobs
drove Amelio out of the CEO post at Apple. (Burrows, Grover, and Green)

External Analysis

Technological Environment

Brand Awareness – Style at a Premium

Apple's products are trendy and stylish. After Jobs returned in 1997, Apple retained
designer Jonathan Ive to differentiate their computers from the typical beige box. Ive's
design of the iMac included clear colorful cases that distinguished Apple computers.
(Linzmayer, 295-6) Apple's iPod (with the trademark white ear buds and simple track
wheel) commands a 15%-20% premium over other MP3 players. (Yoffie)

Apple and Pixar limit the number of computer products and movies that they sell.
Product differentiation with focused quality and style also extend to the Jobs Pixar –
"Pixar's executives focus on making sure there are no ‘B teams,' that every movie gets the
best efforts of Pixar's brainy staff of animators, storytellers, and technologists." (Burrows,
Grover, and Green)

Figure 4: The Stylish Design of the iMac and Mac Mini


(http://www.apple.com/pr/photos/iMac/imacphotos.html

http://trad.org/technique/apple/iMac.jpg/view

http://www.divisiontwo.com/articles/MacMini2.html)
Apple positions its Macintosh computers as higher quality and higher price. HP, Dell, and
other PC manufacturers are pricing many systems under the $1,000 threshold. "Apple is
struggling to meet demand for its new MacBook Pro laptop despite a $1,900 price tag
that is nearly twice that of garden-variety rivals." (Burrows)

Apple has only recently entered the low-end (below $500) consumer market with the
Mac Mini. Although the Mac Mini is a base model with few features, it comes encased in
a very small and distinctive package. Apple portrays this computer as "Small is
Beautiful". (Apple) Likewise, the iPod Shuffle was Apple's first entry into the lower-end
($100 range) of flash-memory-based portable music players.

Interoperability

Although Apple competes directly with Microsoft for operating systems, the release of
iTunes for Windows in 2002 was a key strategic move. This decision expanded the
potential customer base to nearly all personal computer owners, even though Apple only
has 2%-3% of all personal computer sales. (Yoffie)

Conversely, Apple depends on Microsoft for a version of Microsoft Office. As the most
widely used office suite of applications, Macintosh users rely on Office to correspond
with companies that standardized on Windows. This is from a strategic alliance between
Apple and Microsoft after Jobs returned in 1997. (Linzmayer, 290)

Apple's iTunes service has a technological hook (asset specificity) to Apple's iPod.
Although versions of iTunes exist for both Apple and Microsoft operating systems, the
iTune's AAC file format prevents other portable music players (such as iRiver or
Samsung) from playing purchased songs. (Yoffie)

Technology and the Digital Lifestyle

Apple not only dominates the music player market, its iLife suite provides consumers
with easy-to-use software for music and video composition. With "podcast" a household
word, Apple's Garage Band application makes the recording of podcasts and music very
easy. (Boddie)

Figure 5: The GarageBand Music and Podcast Application


(http://www.apple.com/ilife/garageband/)

Regulatory Environment
While introducing new technologies, there is a persistent threat of legal action by
competitors. For example, Apple sued Microsoft in 1988 (settled in 1997 for an
undisclosed amount) for perceived similarities between Microsoft Windows and
Macintosh audiovisual works. (Linzmayer, 172-4)

Microsoft has generally been the focus for government antitrust charges (such as U.S. v.
Microsoft) (US DOJ, 2006). Both federal and state governments assert that Microsoft's
dominance blocked fair competition within the software industry. This is an advantage
for Apple, because its operating systems are a viable substitute for Windows.
Furthermore, Microsoft's continued support for Office for Macintosh reduces the
perceived level of market monopoly and abuse. (Linzmayer, 290-1)

Manufacturers will continue to trespass on Apple's intellectual property. For example, the
company tex9 released an open source music program called xtunes that was very similar
to iTunes. In 2002, Apple took legal action against tex9, who then altered the program
and renamed it sumi (pronounced, "sue me"). (Linzmayer, 300)

Legal threats can surface from somewhat unusual sources. Apple Corps Ltd. is the
London-based company that owns the rights to the music of the Beatles. Paul McCartney
and Ringo Starr recently sued Apple over the use of the Apple logo in iTunes, claiming
that it violated Apple's agreement not to produce music under an apple-based logo.
(Associated Press)

Research and development is a key component to Apple's sustained competitive


advantage. Apple is currently taking legal action against several popular technical web
sites for releasing proprietary product research. Sites such as appleinsider.com have
allegedly posted verbatim content from documents protected by employee non-disclosure
agreements. (McCullagh) Release of critical insider information could give Apple's
competitors a jump in producing rival products.

Industry Analysis Using Porter's Five Forces Model

Apple operates in two primary industries:

• Computing - Hardware and Software

• Delivery of Entertainment and Media

Apple has always been under intense competition within the computer, software, and
entertainment industries. "Looking to 2005...Every time that Apple had jumped into the
lead in a product category during the past two decades, it had had difficulty in sustaining
its leadership position." (Yoffie) We use Porter's Five Forces Model to understand why
Apple's industries are so competitive. (Barney, 78-98)

Figure 6: Porter's Five Forces Model (Barney, 79)


Figure 7: Summary of Industry Threats (Computer Equipment and Entertainment
Distribution)

Type and Severity of Threat Organization Examples

Entry – High Threat Verizon Streaming audio and video with V CAST.

Amazon On demand online services to purchase music (similar to iTunes).

GoogleThey make everything.

The "Next Google" New entrants with disruptive technology.

Rivalry – High Threat Microsoft Windows Operating System, Windows Media


Player for playing music and video.

Linux Competition to Mac OS X Operating System.

Napster, Rhapsody Online music sources – alternatives to iTunes Music Store.

Dell, HP, Lenovo Alternate sources for computer hardware.

iRiver, Samsung, Creative Small, stylish MP3 Players.

DreamWorks Animated movies.

YouTube.com Online video.

Substitutes – Moderate Threat XM, Sirius Satellite Radio for music.

XBox, PS2 Entertainment Media, Media and Music.

Various Internet Streaming Radio and Podcasts.

Music CDs, DVD-Audio and SuperAudio CD Alternative means to acquire music.

Broadcast, Cable, Satellite, NetFlix, TiVo, Theatres Alternative sources for video.

Suppliers – High Threat Motorola, IBM, Intel, Samsung Suppliers of


Processors and computer memory.

Microsoft Strategic Alliance / Supplier of Office for Mac.

The Big Five - BMG, EMI, Sony, Universal, and Warner Sources of music. Will they
raise prices and break the dollar per song model? Some in the record industry resent
Apple's distribution model. "Apple reaps billions from selling its hit music player, but
there are sparse profits from the songs being sold over the Net." (Burrows, Grover, and
Green)

Disney, ABC, NBC, CBS, Fox, Pixar, Sony Suppliers of Television and Movies. Will
they sign exclusive contracts with other online services? Note that this threat is reduced
for Disney / Pixar.

Buyers – Moderate Threat Consumers and Illegal peer-to-peer file sharing


Consumers share music using peer-to-peer networks without paying for music.

Distributors Apple retailers may pressure for lower prices or better terms. For example,
the release of the Apple Store in 2001 "infuriated longtime independent Apple retailers
that didn't appreciate Cupertino cannibalizing their sales." (Linzmayer, 300)

Consumer Attitudes and Behaviors Consumers or businesses may reduce spending on


personal computers or non-essential (potentially high elasticity of demand) music players
if they fear economic downturns.

Consumer Refresh Cycles Consumers and businesses may continue to use previous-
model iPods and Macs rather than upgrade to current iPods, iMacs, or OS

The total industry threat for the industry space that Apple occupies (computer equipment
and distribution of entertainment) is a high threat industry. Apple must continue to pursue
product differentiation (i.e. the style and ease-of-use of an iPod) and economies of scope
(i.e. offering ABC television shows on iTunes) to maintain their sustained competitive
advantage in this industry.

Which External Threats are Most Significant

• Computer Hardware and Software: Open Source software such as the Linux
Operating System and Open Office applications threaten both Apple and Microsoft. The
low (often, free) cost of the software may allow it to overtake Apple and Microsoft,
especially in developing markets such as China.

• Music Products: Major online retailers such as Amazon are considering entry into
the online music market. With a wide internet presence and a household name, Amazon
could present a formidable challenge to Apple. If the major record labels (Universal,
Sony BMG, EMI, and Warner) negotiate better terms with new competitors to iTunes,
Apple may be unable to provide some of the music content that they currently offer. The
major music labels dislike Apple's dollar per song pricing. They would prefer to earn
higher profits with "variable pricing". (Wingfield) With variable pricing, the most
popular songs would be greater than $1, and less popular songs would be less than $1.
Although the labels recently renewed their contracts with Apple, there may be provisions
that allow future changes in the pricing model. (Wingfield and Smith)
• Suppliers: The recent shift to Intel processors could present a significant threat to
Apple. With only two companies (Intel and AMD) producing Intel-compatible
processors, there is a strong potential for tacit collusion and oligopoly power between
these suppliers. Apple purchasing must now directly compete with HP, Lenovo, and Dell.
If shortages or exclusive agreements materialize, Apple could face problems with
obtaining raw materials. Apple should consider additional sources such as Advanced
Micro Devices (AMD).

Figure 8: CPU Market Share (http://www.pcpitstop.com/research/cpumfr.asp)

Additional External Threats

Security

Apple software, like all large software products, has security vulnerabilities that hackers
may exploit. A significant exploitation in the future could damage many businesses and
households using Apple computers. This would affect future customer purchasing
decisions. Apple enjoys a competitive advantage, because their OS X is mature and stable
due to its basis on BSD Unix. In fact, "computer security folks back at FBI HQ use Macs
running OS X". (Granneman)

However, the increased use of Apple computers is prompting hackers to target the
platform. In February 2006, there was documentation of the first known Apple OS X
worm. By using iChat instant messaging, it spreads to other users and deletes files from
their Mac computers. (Sophos) If Mac OS X becomes as wide of a target as Windows,
Apple's perceived differentiation as the more secure platform may disappear.

Vertical Integration of Competitors

Sony is an example of a competitor with a unique position against Apple. Sony Music
supplies Apple with many of the songs for iTunes. Sony also creates a version of the
Walkman portable music player that is a direct competitor to the iPod. (Hall)

Sony is attempting to vertically integrate forward directly to the music buyer. Sony
integrated their music system (Mora) into the Sony Walkman. Sony is exclusively
distributing certain songs on Mora. (Hall) Mora currently targets Japanese consumers. If
Sony can gain additional momentum (such as collaborating with other record labels),
their service could present a formidable challenge to iTunes in additional markets.

Figure 9: The Sony 20GB Walkman and Mora (only available in Japanese)
Sources: http://www.cnet.com.au/mp3players/mp3players/0,39036128,40002062,00.htm

http://mora.jp/

Value Chain Analysis

To determine where Apple developed distinctive capabilities, Porter's generic value chain
model provides a systematic framework for identifying Apple's utilization of resources.
Primary activities for Apple include Technology and Product Design, Production, Sales
and Marketing, Customer Service, and Legal Services.

Technology and Product Design

This component represents the true core (no pun intended) of Apple's capability. From
being the first platform to run an electronic spreadsheet (VisiCalc on the Apple II Plus) to
the first to establish a "digital lifestyle" hub (the Macintosh product lines), Apple's history
is rich with cutting-edge technology development. (Linzmayer) Apple drives to be the
best, no simply the first. The Apple operating system is universally regarded as more
stable and reliable than Windows, while the desktop publishing software bundles
(iMovie, iPhoto, iTunes, etc.) are the most comprehensive available to end users. Ives
best summarizes the entrepreneurial culture within Apple by saying that "it's very easy to
be different, but very difficult to be better." (Linzmayer, 301)

Production

Because Apple had long refused to license its operating system to external entities, the
bundled packages of Apple-developed hardware and software became the cornerstone of
Apple's production process. Apple achieved unparalleled performance via 64-bit
architecture, integrated distinctive styling with the multi-colored translucent iMac cases,
and redefined intuitive operation with the iPod. While every product introduction has not
been a success (Lisa, Newton, etc.), Apple treats component production as a natural
extension of the design process.

Sales and Marketing

We could simply title this section "Steve Jobs". Since his return as CEO in 1997, Jobs
personally unveils all new product introductions, reviews corresponding marketing
campaigns, and approves new product development guidelines. In a departure from their
turbulent history, Jobs "entered into patent cross-licensing and technology agreements
with Microsoft." (Linzmayer, 290) After years of unimpressive market share growth and
cannibalization of a loyal consumer base, the door to the expansive PC market was now
more accessible to Apple than ever before. Apple continued to command a market
premium for producing a "better mousetrap" throughout its history.

Customer Service

How has Apple retained substantial cash reserves during the explosive growth and
dominance of PCs worldwide? Apple created a virtual love affair with their customer
base by delivering technically superior products (iPods vs. other MP3 players, Macs vs.
PCs, etc.), and aggressively pursuing hardware and software updates. Apple integrated
their primary activities so well that it is transparent to the consumer where one activity
begins and the other ends. A perfect example of this is Apple's willingness to develop
software to run Windows XP on its new Intel-based iMac and then post it online free to
iMac users. (Wingfield) In such an environment, customer service merely becomes the
realization of receiving a little more than expected.

Although Apple employs many resources and capabilities to support their primary
activities (human resources, supply procurement, etc.), the most strategically relevant
would be Legal Services.

Legal Services

In a market climate of constant change and innovation, it is inevitable that the drive to
expand product and service offerings will subject Apple to patent and copyright
infringement claims. The dispute over the Apple logo on its iTunes Music Store, for
example, continues despite a previously reached settlement with Beatles' Apple Corps
Ltd. in 1991. (Dow Jones Newswires) While such litigation as Microsoft's Windows
infringement on Mac OS patents has been highly publicized, use of legal guidance to
drive acquisition versus internal development strategies for such products as GarageBand
and iMusic have proven highly valuable. (Linzmayer, 172-4, 250) Intellectual property is
sacred to Apple. There was a recent attempt to uncover the identities of internal "sources
who leaked confidential information about an unreleased product to online media outlets
in 2004." (Wong)

SWOT Analysis

Although participation in such activities may add value, they may not be a source of
competitive advantage. Ultimately, the value, rarity, inimitability, and/or organization
(VRIO) of an activity or resource determine its sustainability as a source of competitive
advantage. Within this context, we can identify a firm's strengths, weaknesses,
opportunities, and threats (SWOT).
Strengths

 Technical savvy – Product lines are easy to use and stable. Recent integration
with Microsoft products lines and Intel processors demonstrate ability and willingness to
adapt to a diverse customer base. (Mossberg) Such innovation, however, would not be
sustainable without a learning environment tolerant of mistakes. While the pure technical
expertise alone is not a valuable or rare resource, it becomes very costly to imitate when
it exists within the socially complex, entrepreneurial culture of Apple.

 Financial vitality – Cash reserves remained robust and stable despite stagnant
market share growth in the computer hardware and software arenas. Apple exploited this
by resisting market pressures to reduce costs, tightly integrating product packages, and
forming strategic alliances (i.e. securing the backing of all major music distributors in the
support of iTunes).

 Brand loyalty – The only way that Apple could maintain the financial vitality
described above is via a fanatical, almost cult-like, affair with its customer base. Such
brand loyalty is extremely costly and time-consuming to imitate.

 Steve Jobs – As discussed earlier, Jobs proved to be a vital component to Apple's


success. During his absence (1985-1996), Apple experienced the most turbulent
(financial and innovative) timeline in its history. Immediately upon his return, he
replaced most of the Board of Directors, pruned and focused the new product ideas, and
delivered seven consecutive quarters of positive earnings to shareholders. (Linzmayer,
289-99) As such, Jobs is certainly a valuable, rare, and hard to imitate resource that
Apple fully exploits.

Weaknesses

 Market share – Apple has historically been strongest in the US geographical and
educational vertical markets. With the educational market facing tightening budget
constraints and the US approaching a PC saturation point, Apple may need to burn cash
more quickly and succumb to market cost pressures on its products without a strategic
innovation, integration, or divesture.

 Steve Jobs – For virtually the same reasons Jobs is a strength, he is


simultaneously a weakness. The aggressive drive to bring innovative visions to life was
noticeably absent and painfully felt (especially by shareholders) during his departure. The
apparent absence of succession planning coupled with a lust for the limelight positioned
Jobs as Apple's single consciousness in the eyes of consumers and shareholders.

Opportunities
 Consumer electronics – With the startling success of the iPod and iTunes, Apple
entered the consumer electronics market. By expanding the iTunes concept to
downloadable mobile phone features and movies (podcasts), the door is now open to
develop new and potentially profitable strategic alliances with peripheral component
manufacturers (speaker, home stereo, etc.) and media transmission giants (Disney, TBS,
Verizon, etc.).

 PC hardware and software market growth – With cross-licensing of operating


system platforms in place, Apple entered the high-volume business environment
traditionally dominated by Windows-based PCs. The introduction of Intel-based
processors prompted businesses to replace PCs with iMacs. They did this to gain a level
of stability and reliability in their business applications that PCs failed to provide. An
example is Japan's Aozora Bank Ltd., who is replacing 2,300 PCs with iMacs.
(Wingfield) Apple must establish themselves as a credible player in business desktop
applications to overcome the "desktop publishing" stereotype.

Threats

 Legal risks – In a market that literally changes at the speed of thought, patent and
copyright infringement risks remain high. As long as operating systems and support
software packages continue to converge and remain relatively easy to imitate, present and
future lawsuits are inevitable. The Apple records claim against iTunes remains
unresolved.

 Competition – This threat occurs primarily on two fronts: PC hardware/software


and consumer electronics. For the same reasons discussed in the opportunities section, the
threat of imitability (cloning, pirating, etc.) increases. As relative newcomers to the
consumer electronics arena, will Apple retain a competitive advantage as they diversify
their offerings (speakers, home entertainment systems, etc.)?

Financial Analysis

2nd Quarter 2006

Apple's financial performance continued to strengthen over the last several quarters. In
the most recent earnings announcement, Apple reported significant growth in net
revenues driven by the strong performance of its iPod product line. Net sales for the 2nd
quarter grew to $4.36 billion, which is a 34% increase over 2nd quarter 2005 results. Net
income increased by 41% to $410 million. (Apple Reports)

The iPod product line continues to drive the financial performance of the company. In the
2nd quarter alone, Apple sold 8.5 million iPods, representing a 61% increase over the 5.3
million units sold in the 2nd quarter of the prior year. Mac sales showed slight growth of
only 4%. (Apple Reports)
Apple's year-to-date revenues total just over $10 billion and earnings total just under $1
billion. For the 3rd quarter, CFO Peter Oppenheimer stated, "…we expect revenue of
about $4.2 to $4.4 billion" which will push total sales above last term's annual numbers.
(Apple Reports)

Historical Performance

Although sales remained stagnant during 1998-2002, sales more than doubled since (see
graph below). This dramatic shift in performance is primarily due to the increase in sales
from the iPod product line.

(Apple Computer, 2005)

Stock Price Performance

Another interesting way to consider the financial performance is to evaluate how Apple's
stock price performed against the market and against its main competitors. As we see
from the chart above, Apple's performance has been inconsistent over the last 20 years
compared to the S&P 500. It also has not performed at the same level as its main
competitors, Dell and Microsoft. However, performance improved since 2003.

Profitability Measures

Apple substantially improved in its key measures of profitability in the last few fiscal
years. In terms of return on assets, return on equity and profit margin, Apple strengthened
financially and now has similar ratios to that of its competitors and the overall computer
hardware industry (see table below).

2003 2004 2005 Microsoft '05 Dell '05 Industry '05 S&P 500

Return on Assets 1.01% 3.43% 11.56% 19.75% 15.42%


11.98% 8.13%

Return on Equity 1.63% 5.44% 17.88% 28.56% 67.31%


36.61% 19.61%

Profit Margin 1.11% 3.33% 9.58% 31.57% 6.39% 6.36% 13.75%


P/E Ratio 33.89 22.63 18.51 26.32 22.09

In reviewing Apple's 1st and 2nd quarter 2006 earnings releases, gross margins dropped
slightly. Apple attributes this decline primarily to price pressures, especially in the iPod
product line. (1st Quarter 10Q) This will continue to affect performance over time.
However, Apple's ability to maintain the momentum it built in the marketplace will
control the speed with which erosion will occur.

Liquidity and Leverage Measures

Apple historically held very little long-term debt. The table below compares Apple's
liquidity measures to their competitors, their industry, and the general market. During the
period of strong financial performance, Apple accumulated cash. This strengthens
Apple's position should they choose to access the capital markets.

2003 2004 2005 Microsoft '05 Dell '05 Industry '05 S&P 500

Current Ratio 2.5 2.6 3 2.88 1.11 1.81 1.82

Quick Ratio 2.47 2.59 2.9 2.85 1.08 1.45 1.31

Product Unit Sales

In the last several years, there have been dramatic changes to Apple's product sales by
category. Apple breaks its unit sales into four primary categories: desktops, notebooks,
iPods, and peripherals. The graph below shows the product mix for Apple in 2002. Note
the domination by desktops and notebooks and the small contribution by iPods. (Apple
Computer)

When you compare the same graph for 2005, you see dramatic differences in the product
mix for Apple. The iPod sales now account for 32.5% compared to 2.5% for 2002. The
combined sales of computers (desktop/notebook) lost share, dropping from 79% to 45%
of sales. This drop merely represents a shift in Apple's product mix, not their global
computer market share (which remains stable in the 2-3% range). Meanwhile, sales of
peripherals (including wireless connectivity and networking solutions), remained stable.
(Hoover's)

Operating Segments

Apple breaks its sales into five "operating segments". The chart below shows the sales by
segment for each year 2002-2005. On a percentage basis, only the retail segment appears
to be outperforming the others. (Apple Computer, Hoover's)

Net sales in the retail segment grew to $2.35 billion in 2005. In the 1st quarter 2006, sales
growth continued in the retail segment to $1.1 billion (a 91% increase over the same
period last year). This increase was due to growth in the number of stores (from 101 to
135) and to a 41% same-store sales growth. (1st Quarter 10Q)

Although the retail segment was the only segment to realize growth as a percentage of
total sales, all of the segments had solid growth. In the Americas, sales increased 65%
and continued to represent approximately 47% of total worldwide sales. Sales in Japan
and Europe grew by 92% and 47%, respectively. (1st Quarter 10Q)

Market Value Analysis

We used Discounted Cash Flow (DCF) analysis to assess the appropriate equity value of
Apple. To complete this analysis, we developed a pro-forma income statement and
extracted free cash flow. We then discounted these cash flows using a calculated
Weighted Average Cost of Capital (WACC). Apple's WACC equaled their cost of equity
since they carry no long-term debt. We used the Capital Asset Pricing Model (CAPM) to
calculate the cost of equity.

CAPM consists of a risk-free rate, a market risk premium, and a company Beta. The yield
on the 10-year Treasury is the standard for a risk-free rate. To determine the market risk
premium, we used the average return that an investor would require for an investment
with average risk. (Higgins) We used data available online to determine Apple's Beta,
projected to be 1.46. (Google, 4/21/06) The below chart summarizes Apple's cost of
equity.

Cost of Equity/WACC Note Value

Risk Free Rate10 Yr Treasury 5.12

Market Risk Premium (Analysis) 4

Beta From Google 1.46

Adjusted Apple Risk Premium 5.84

Cost of Equity/WACC 10.96


Pro-Forma Income Statement

We made several key assumptions in compiling a pro-forma income statement. First, to


complete the estimate for the 2006 data, we merely annualized the earnings for the first
two quarters. We then projected a declining rate of growth in sales for the next four fiscal
terms of 30%, 20%, 15%, and 10%, respectively. We do not believe that the growth in
iPods is sustainable for the long-term. We also used the percent-of-sales method to
calculate cost of goods sold, research & development, SG&A, and interest. We applied
the 2005 tax rate for all future periods. As the table below shows, the mid-term earnings
growth is positive.

2005 Annualized 2006 2007P 2008P 2009P 2010P

Net Sales 13931 20216 26280.8 31536.96 36267.50 39894.25

Cost Of Sales 9888 14353 18659 22391 25750 28325

R&D 534 809 1051 1261 1451 1596

S,G,A 1859 2628 3417 4100 4715 5186

Operating Income 1650 2426 3154 3784 4352 4787

Interest Income 165 239 311 374 430 473

Taxes 480 705 916 1100 1265 1391

Net Income 1335 1960 2548 3058 3517 3869

EPS 1.57 2.31 3.00 3.60 4.14 4.56

Shares Out (000's) 848,612 848,612 848,612 848,612


848,612 848,612

Projected Free Cash Flow and Equity Valuation

We assume that Apple will continue without long-term debt. We also assume that there
will be no significant changes in capital expenditures and net working capital. Thus, free
cash flow will equal net income plus depreciation. Given WACC, we are able to discount
cash flows back using half-year PV factors (we are through the first half of 2006). We
calculated our terminal value using a perpetual annual growth rate of 7%, which is
slightly above the industry growth rate of 5.6%. (Datamonitor)

Free Cash Flows 2006 A2007P 2008P 2009P 2010P Terminal


Net Income 1960.00 2548.00 3058.00 3517.00 3869.00

Depreciation 239.00 310.70 372.89 428.86 471.78

Free Cash Flows 2199.00 2858.70 3430.89 3945.86


4340.78

WACC 10.96 10.96 10.96 10.96 10.96

PV Factor 0.9505 0.8565 0.7715 0.695 0.626 0.626

Terminal Value 109615.6

PV FCF 1862.98 2182.36 2359.25 2444.32 2421.99


68619.42

Sum of PV of CF 11270.90

PV of Terminal Value68619.42

FMV of Invested Capital 79890.32

Less Existing Cash Balance 8261

Intrinsic Value of Equity 71629.32

Given intrinsic equity value, we estimate the per share stock price. Given their particular
market condition, Apple appears undervalued (see table below).


Equity Value

Total Shares (000's) 848612

Value (000's) 71629000

Value/Share $84

Current Price (5/5/06) $71.89

Strategy
We can describe Apple's strategy in terms of product differentiation and strategic
alliances. In each of these strategies, we examine what Apple did historically and then
discuss alternatives for Apple's future.

Product Differentiation

Apple prides itself on its innovation. When reviewing the history of Apple, it is evident
that this attitude permeated the company during its peaks of success. For instance, Apple
pioneered the PDA market by introducing the Newton in 1993. (Linzmayer, 203) Later,
Apple introduced the easy-to-use iMac in 1998, and updates following 1998. (Linzmayer,
294-6) It released a highly stable operating system in 1999, and updates following 1999.
(Linzmayer, 297)

Apple had one of its critical points in history in 1999 when it introduced the iBook. This
completed their "product matrix", a simplified product mix strategy formulated by Jobs.
This move allowed Apple to have a desktop and a portable computer in both the
professional and the consumer segments. The matrix is as follows (Linzmayer, 297):

Professional Segment Consumer Segment

Desktop G3 iMac

Portable PowerBook iBook

In 2001, Apple hit another important historical point by launching iTunes. This marked
the beginning of Apple's new strategy of making the Mac the hub for the "digital
lifestyle". (Linzmayer, 299) Apple then opened its own stores, in spite of protests by
independent Apple retailers voicing cannibalization concerns. (Linzmayer, 300) Then
Apple introduced the iPod, central to the "digital lifestyle" strategy. Philip W. Schiller,
VP of Worldwide Product Marketing for Apple, stated, "iPod is going to change the way
people listen to music." (Linzmayer, 300) He was right.

Apple continued their innovative streak with advancements in flat-panel LCDs for
desktops in 2002 and improved notebooks in 2003. (Linzmayer, 301-2) In 2003, Apple
released the iLife package, containing improved versions of iDVD, iMovie, iPhoto, and
iTunes. (Linzmayer, 302) In reference to Apple's recent advancements, Jobs said, "We
are going to do for digital creation what Microsoft did for the office suite productivity."
(Linzmayer, 302) That is indeed a bold statement. Time will tell whether that happens.

Apple continued its digital lifestyle strategy by launching iTunes Music Store online in
2003, obtaining cooperation from "The Big 5" Music companies—BMG, EMI, Sony
Entertainment, Universal, Warner. This allowed iTunes Music Store online to offer over
200,000 songs at introduction. (Linzmayer, 302) In 2003, Apple released the world's
fastest PC (Mac G5), which had dual 2.0GHz PowerPC G5 processors.
Product differentiation is a viable strategy, especially if the company exploits the
conceptual distinctions for product differentiation. Those that are relevant to Apple are
product features, product mix, links with other firms, and reputation. (Barney, 266-71)
Apple established a reputation as an innovator by offering an array of easy-to-use
products that cover a broad range of segments. However, its links with other firms have
been limited, as we will discuss in the next section on strategic alliances.

There is economic value in product differentiation, especially in the case of monopolistic


competition. The primary economic value of product differentiation comes from reducing
environmental threats. The cost of product differentiation acts as a barrier to entry, thus
reducing the threat of new entrants. Not only does a company have to bear the cost of
standard business, it also must bear the costs associated with overcoming the
differentiation inherent in the incumbent. Since companies pursue niche markets, there is
a reduced threat of rivalry among industry competitors. A company's differentiated
product will appear more attractive relative to substitutes, thus reducing the threat of
substitutes. If suppliers increase their prices, a company with a differentiated product can
pass that cost to its customers, thus reducing the threat of suppliers. Since a company
with a differentiated product competes as a quasi-monopoly in its market segment, there
is a reduced threat of buyers. With all of Porter's Five Forces lower, a company may see
economic value from a product differentiation strategy. (Barney, 277-81)

A company attempts to make its strategy a sustained competitive advantage. For this to
occur, a product differentiation strategy that is economically valuable must also be rare,
difficult to imitate, and the company must have the organization to exploit this. If there
are fewer firms differentiating than the number required for perfect competition
dynamics, the strategy is rare. If there is no direct, easy duplication and there are no easy
substitutes, the strategy is difficult to imitate. (Barney, 281-7)

There are four primary organizing dilemmas when considering product differentiation as
a strategy. They are as depicted below.

To resolve these dilemmas, there must be an appropriate organization structure. A U-


Form organization resolves the inter-functional collaboration dilemma if there are
product development and product management teams. Combining the old with the new
resolves the connection to the past dilemma. Having a policy of experimentation and a
tolerance for failure resolves the commitment to market vision dilemma. Managerial
freedom within broad decision-making guidelines will resolve the institutional control
dilemma. (Barney, 294)

Five leadership roles will facilitate the innovation process: Institutional Leader, Critic,
Entrepreneur, Sponsor, and Mentor. The institutional leader creates the organizational
infrastructure necessary for innovation. This role also resolves disputes, particularly
among the other leaders. The critic challenges investments, goals, and progress. The
entrepreneur manages the innovative unit(s). The sponsor procures, advocates, and
champions. The mentor coaches, counsels, and advises. (Barney, 295)

Apple had issues within its organization. In 1997, when Apple was seeking a CEO
acceptable to Jobs, Jean-Louis Gassée (then-CEO of Be, ex-Products President at Apple)
commented, "Right now the job is so difficult, it would require a bisexual, blond
Japanese who is 25 years old and has 15 years' experience!" Charles Haggerty, then-CEO
of Western Digital, said, "Apple is a company that still has opportunity written all over it.
But you'd need to recruit God to get it done." Michael Murphy, then-editor of California
Technology Stock Letter, stated, "Apple desperately needs a great day-to-day manager,
visionary, leader and politician. The only person who's qualified to run this company was
crucified 2,000 years ago." (Linzmayer, 289)

Since Jobs took over as CEO in 1997, Apple seems to have resolved the innovation
dilemmas, evidenced by their numerous innovations. To continue a product
differentiation strategy, Apple must continue its appropriate management of innovation
dilemmas and maintain the five leadership roles that facilitate the innovation process.

Strategic Alliances

Apple has a history of shunning strategic alliances. On June 25, 1985, Bill Gates sent a
memo to John Sculley (then-CEO of Apple) and Jean-Louis Gassée (then-Products
President). Gates recommended that Apple license Macintosh technology to 3-5
significant manufacturers, listing companies and contacts such as AT&T, DEC, Texas
Instruments, Hewlett-Packard, Xerox, and Motorola. (Linzmayer, 245-8) After not
receiving a response, Gates wrote another memo on July 29, naming three other
companies and stating, "I want to help in any way I can with the licensing. Please give
me a call." (Linzmayer, 249)

In 1987, Sculley refused to sign licensing contracts with Apollo Computer. He felt that
up-and-coming rival Sun Microsystems would overtake Apollo Computer, which did
happen. (Linzmayer, 249-50) Then, Sculley and Michael Spindler (COO) partnered
Apple with IBM and Motorola on the PowerPC chip. Sculley and Spindler were hoping
IBM would buy Apple and put them in charge of the PC business. (Linzmayer, 250) That
never came to fruition, because Apple (with Spindler as the CEO) seemed contradictory
and was extraordinarily difficult in business dealings. (Linzmayer, 251-2)

Apple turned the corner in 1993. Spindler begrudgingly licensed the Mac to Power
Computing in 1993 and to Radius (who made Mac monitors) in 1995. However, Spindler
nixed Gateway in 1995 due to cannibalization fears. (Linzmayer, 252-3) Gil Amelio, an
avid supporter of licensing, took over as CEO in 1996. Under Amelio, Apple licensed to
Motorola and IBM. (Linzmayer, 253-4) In 1996, Apple announced the $427 million
purchase of NeXT Software, marking the return of Steve Jobs. (Linzmayer, 216) Amelio
suddenly resigned in 1997, and the stage was set for Jobs to resume power.

Jobs despised licensing, calling cloners "leeches". He pulled the plug, essentially killing
its largest licensee (Power Computing). Apple subsequently acquired Power Computing's
customer database, Mac OS license, and key employees for $100 million of Apple stock
and $10 million to cover debt and closing costs. The business was worth $400 million.
(Linzmayer, 255-7)

A massive reversal occurred in 1997 and 1998. In 1997, Jobs overhauled the board of
directors and then entered Apple into patent cross-licensing and technology agreements
with Microsoft. (Linzmayer, 289-90) In 1998, Jobs stated that Apple's strategy is to
"focus all of our software development resources on extending the Macintosh operating
system. To realize our ambitious plans we must focus all of our efforts in one direction."
(Linzmayer, 293) This statement was in the wake of Apple divesting significant software
holdings (Claris/FileMaker and Newton).

There is economic value in strategic alliances. (Barney, 370-84) In the case of Apple,
there was the opportunity to manage risk and share costs (Barney, 373-4), facilitate tacit
collusion (Barney, 374-5), and manage uncertainty (Barney, 378-9). It would have been
applicable to the industries in which Apple operated. Tacit collusion is a valid source of
economic value in network industries (Barney, 380), which the computer industry is.
Managing uncertainty, managing risk, and sharing costs are sources of economic value in
any industry (Barney, 380). Although Apple eventually realized the economic value of
strategic alliances, it should have occurred earlier.

The following are some comments about Apple's no-licensing policy. (Linzmayer, 245-9)

"If Apple had licensed the Mac OS when it first came out, Windows wouldn't exist
today."—Jon van Bronkhorst, Robertson Stephens analyst, San Francisco Chronicle,
August 8, 1994

"The computer was never the problem. The company's strategy was. Apple saw itself as a
hardware company; in order to protect our hardware profits, we didn't license our
operating system. We had the most beautiful operating system, but to get it you had to
buy our hardware at twice the price. That was a mistake. What we should have done was
calculate an appropriate price to license the operating system. We were also naïve to
think that the best technology would prevail. It often doesn't."—Steve Wozniak, Apple
cofounder
"If we had licensed earlier, we would be the Microsoft of today."—Ian W. Diery, Apple
Executive VP, Newsweek, August 29, 1994

"I am aware that I am known as the Great Satan on licensing…I was never for or against
licensing. I just did not see how it would make sense. But my approach was stupid. We
were just fat cats living off a business that had no competition."—Jean-Louis Gassée, Be
CEO and ex-CEO of Apple, admitting he made a strategic mistake

A strategic alliance can be a sustained competitive advantage if it is rare, difficult to


imitate, and the company has an organization to exploit it. If the number of competing
firms implementing a similar strategic alliance is relatively few, the strategy is rare. If
there are socially complex relations among partners and there is no direct duplication, the
strategy is difficult to imitate. (Barney, 384-9)

When organizing for strategic alliances, a firm must consider whether the alliance is non-
equity or equity. A non-equity alliance should have explicit contracts and legal sanctions.
(Barney, 390) An equity alliance should have contracts describing the equity investment.
(Barney, 392-5) There are some substitutes for an equity alliance, such as internal
development and acquisitions. However, the difficulties with these drive the formation of
strategic alliances. It is vital to remember, "Commitment, coordination, and trust are all
important determinants of alliance success." (Barney, 395)

Conclusions

We feel that Apple must focus on several key aspects to continue to grow and succeed.
They must continue a stable commitment to licensing, push for economies of scope
between media and computers, and become a learning organization.

Apple apparently made a commitment to licensing. Although it should continue, Apple


may want to consider other forms of strategic alliances. An equity strategic alliance may
offer Apple the opportunity to obtain additional competencies. An effective way for a
company like Apple to accomplish this would be in the form of a joint venture.

Apple should continue pushing the new line of media-centric products. Meanwhile,
Apple should not lose focus on its computers. Macintosh computers were 39% of Apple's
sales in 2005. (Burrows) This very innovative company exploits its second-mover
position. In the future, they will need to continue innovating to expand the boundaries of
both media and computers.

One persistent element of both competitive advantage and risk is Steve Jobs. He is both
synonymous with Apple's success and has a large equity interest in Apple and Disney. If
he were to divest his leadership position, the reaction of both the market and consumers
would be uncertain. Given his position within the organization as well as the history of
the company when he was gone, Apple must find a way to learn as an organization. This
will allow the company to withstand a departure by Jobs.

Based on the actions of the organization, we feel that the mid-term performance of Apple
will be strong. This period allows Apple the time to overcome their challenges if they
move swiftly. For this reason, we feel that they will continue to succeed and will continue
to outperform their peers.

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