Apple Death Knell #39: iPod Won't Save Apple
March 18th, 2004

I received a ton of e-mail on this one: Money Magazine has published a damning report on Apple's operations under the get-to-the-point title, "Why iPod Won't Save Apple." We are entering it in the Apple Death Knell Counter (ADKC) as Death Knell #39.

The piece, authored by self-professed former Mac user Stephen Gandel, says that the success of the iPod is only covering up problems at Apple, specifically falling sales of the Mac.

Mr. Gandel says that Apple's profit margins have fallen through the floor, down to about 1% in 2003, from almost 10% as recently as 1999, saying:

But behind the hype and buzz surrounding the iPod and Jobs, there are problems stewing at Apple. Its core computer business, which still accounts for 70 percent of the company's sales, is withering. Apple sold just over 3 million computers in its last fiscal year, which ended in September -- 900,000 less than it sold in fiscal 1996, the year before Jobs returned.

Meanwhile, Apple's share of the worldwide personal-computer market has shrunk to 2 percent from 3.2 percent five years ago. What's more, despite their soaring sales, iPods are depressing profitability because of their lower profit margin.

The result: While Apple's sales of $6.2 billion last fiscal year were nearly unchanged from 1999, profits plummeted 90 percent to $69 million, from $601 million four years ago. It's unclear what Jobs can do or plans to do to turn around Apple's fortunes -- he refused to talk to MONEY about its future.

Of course, what he doesn't say is that this is because Apple has been investing in R&D. I don't want to get too far off the point, but it seems most Wall Street analysts and mainstream pundits and journalists don't get that the iPod rocks because Apple spent a boatload of money developing it. It wasn't produced by gnomes working in a magical Gnome Cave; it was produced by people, very talented people who cost money.

The same thing is true for Mac OS X: Apple has the best operating system in the world, and got it despite the fact the company sells in a year a tiny fraction of what Microsoft sells in a month. Also, Apple sells Mac OS X for as litle as a thirdof what Microsoft charges for Windows. Mac OS X Server is even less expensive when compared to server licenses for Windows. Despite this price difference, and volume difference, Mac OS X is a remarkable OS. It costs money to do that.

Without the quality of Mac OS X, it is reasonable to say that Apple's sales would be very much in the toilet.

The G5? Developing the new Power Mac line cost money. From the case design, to the industrial design, it costs a lot of money to make products like that. Without the G5, Apple would have sold far fewer Macs in the past 9 months than it did.

The iTMS? That cost a lot of money to develop. From the software to the man power required to load the songs and information into the iTMS database, it all costs lots of money; and let's not forget the licensing negotiations with the five major labels. Oh, and the rest of the world. Think about how many executive and attorney man hours have gone into those negotiations. Without the iTMS, Apple wouldn't be selling as many iPods, and the iPods do make a profit.

iLife costs money, too. Apple sells the software for US$49, and used to give it away. It costs a lot of money to develop and maintain iLife. It is my opinion that iLife helps sell Macs. Furthermore, I think that GarageBand itself is going to sell Macs to musicians once word gets out. (Hint: I would like to see Apple market GarageBand.)

Then there is all the other money Apple spends developing new technologies that we haven't seen yet. Apple's R&D spending has drastically increased, to be sure, but that is why the company has such wonderful products that, in the eyes of the Stephen Gandels of the world, won't save the company.

The reality is, in my never humble opinion, those very products, such as the iPod, are exactly what saved Apple in the very dark period of transition we have witnessed for the past several years. Although the costs of developing those products have hurt Apple's short term profits, they made profits possible where others in the industry had losses. For those keeping score at home, praising the fruits of R&D while damning the R&D is what we in the biz call an oxymoron.

Even more important is the fact that Apple's R&D investment is money that no other PC vendor is spending. Dell spends a bit of R&D on figuring out how to use 2 or 3 fewer screws in each machine (something at which Dell is the absolute master), or perhaps to cut the number of chips on its motherboards (which definitely costs real money, too), but the company is not developing new classes of products, or even new products. Dell instead is in the business of tiny evolutionary changes in existing products, which costs a lot less money to develop.

Yet Apple and Dell are the only two major PC vendors to turn a profit, even if, as Mr. Gandel later points out, Dell's profits are enormous compared to Apple's.

Microsoft definitely invests in R&D. Heck, the company spends more in R&D than Apple grosses, which is ironic considering the fact that the only good products to come out of Big Redmond are from the Mac Business Unit. Note, too, that despite these heavy R&D investments, the company also makes more in profit in a single quarter than Apple grosses in a year.

Such irony.

So, back to this article in Money: Mr. Gandel is missing the big picture when it comes to Apple, but that doesn't mean he is entirely wrong. His point about Apple's market share is one that has recently been concerning me more and more.

I had thought that the G5 would spark a new buying spree of Macs due to pent up demand, a buying spree that might well feed on itself as rising market share brought in even more new customers. I also think that iPod/iTMS success will eventually bring in new customers to the Mac platform.

The G5 has so far proven not to be the sales booster I had hoped. I am currently inclined to think that even if the technology going into the G5 requires the high price Apple is charging for the G5, that it is a price the market is simply unwilling to pay. The proof is in the pudding on this one, and the fact is that G5 sales have been lower than expected.

As for the effect of the iPod and iTMS, the jury is still out. Mr. Gandel, however, is ready to write the latter two products off, in terms of building sales for the Mac. From the article:

Part of the motivation to develop the iPod and digital media software is to drive computer sales. But so far that hasn't worked. In order to make the iPod a success, Apple had to make it compatible with Windows-based PCs. So there is no reason for an iPod lover to buy a Mac.

Out of the hundreds of people who were waiting outside Apple's SoHo store in the cold to buy an iPod, I could find only one whose positive experience with the music player led him to buy an Apple computer. The majority of the people, many of whom were there to buy their second or third iPod, owned Windows-based PCs and had no intention of switching to a Mac.

That's a bit of writing trickery. Mr. Gandel notes there are hundreds of people in line, and implies, without actually saying so, that he asked them all if they would buy a Mac. Well, my guess is that he didn't ask them all, or he would have said as much, but even if he did, it's hardly a scientific sample on which to base a far-reaching conclusion that the iPod won't bring in new customers.

By his own observation, "most" of the folks in line were Windows users, and they were all heading into an Apple Store. Is it reasonable to think that not one of those folks was going to check out a Mac while they were in the store? No.

Speaking of stores, Mr. Gandel also criticizes the Apple Stores as being a money-losing venture. That was true in fiscal 2003, which ended in September, as a whole. What he fails to mention is that Apple actually turned a profit from retail operations in the September quarter iteself, as well as the profit Apple made on retail operations in the December quarter (Q1 of 2004). In other words, the most recent trend for the Apple Stores is that they make a profit, making his look at only the annual loss a selective look.

He also notes that Apple claimed the US$5 million loss as effectively being an advertising cost. US$5 million in a year to bring in many tens of thousands of Windows users into an Apple Store? Mr. Gandel himself saw hundreds at just one Apple Store on a single night! I call that a raging success, and that's ignoring the profit Apple is actually now turning out at its retail stores.

Note, by the way, that he cites claims from an Apple retailer suing Apple who claims Apple is charging unfairly low prices to its Apple Stores for product.

That may be true, but as TMO columnist and curmudgeon John Kheit pointed out to me, if Apple was charging high prices to its Apple Stores, people like Mr. Gandel would probably claim it was an attempt to inflate profits for Apple's manufacturing operations and/or write-off non-existent losses for questionable tax gains. It's a no-win analysis.

Another strange point is criticism Mr. Gandel lays at Apple's feet regarding its cash holdings:

And Apple's earnings would have been worse had it not been for US$4.8 billion the company has in cash and short-term securities. In fact, the cash hoard made more money last year than Apple's operations -- which lost US$1 million while the computer maker booked a US$69 million gain on interest income.

First of all, Apple turned a profit on operations in one or two quarters in fiscal 2003. While that year-end loss of US$1 million is important, it is being taken out of context. We have to look at who else besides Apple is making a profit in the PC business, which is again Dell, and only Dell. When every other PC vendor is losing far more money than Apple, is it a reasonable criticism to complain about a US$1 million loss from operations?


Indeed, Apple is to be applauded for its success from operations when it is also spending so much in R&D. That Apple is also able to turn some profit from its cash holdings is icing on the cake, and don't forget that Apple has built those cash reserves from cash flow from operations. In other words, Apple is able to make money indirectly from its operations by managing its cash flow well, and that's a very legitimate form of profit stemming directly from operations.

Plus, Mr. Gandel is being highly selective in his criticism. Remember that US$600 million he lauded from 1999? Much of that profit came from enormous interest returns on its cash holdings at the time (it was at the height of the tech boom, when returns were at unsustainable highs), as well as the sale of some of its investments in ARM and Akamai. If its interest gains from 2003 aren't legitimate profit, why hold up 1999 as being so successful?

All in, Mr. Gandel's assessment of Apple has a couple of good points (weak Mac sales being the most important), but the rest of it selective, inaccurate, and selective. Indeed, it's just another Apple Death Knell.

Speaking of which, I have unearthed some more Death Knells from the past. I'll be adding those to the ADKC in the near future.