Apple's music lessons

Over the past few years, Apple Computer Inc. has flummoxed its critics and thrilled its user base by venturing into new territory with products like the iPod and its .Mac online service and chain of mall-based retail stores.

Apple has explained the new ventures as tactics to sell more Macintosh computers -- which, after all, is how the company makes most of its money.

But the decision to go further in the area of digital music -- first with a Windows version of the iPod and, by year's end, a Windows version of iTunes that will allow PC users to access the Music Store -- hints that a fundamental shift in Apple's strategy may be afoot.

Last week, analyst Charles Wolf of Needham & Co. in New York issued a detailed report examining the potential of the iTunes Music Store.

Wolf estimates that once Apple has the Windows version of iTunes in place, the store could capture 20 percent of the pay-per-download market.

This could translate to $600 million in annual revenue and $50 million to $60 million in operating income, nearly equal to Apple's $65 million in profit for the 2002 fiscal year.

But more intriguing is Wolf's speculation that the iTunes Music Store could drive sales of the popular iPod still higher, which he sees as "a major income opportunity."

Should this come to pass, and it appears that all the pieces are falling into place, then Apple could earn substantial revenue from a business only peripherally related to its sales of Macs.

In fact, once the service is available for Windows, the bulk of Music Store sales won't depend on Macs at all.

Apple already has set the precedent with the iPod. More than half of all iPods sold are to Windows users -- which, along with the launch of the iTunes Music Store -- helped propel sales of the portable music player to 304,000 units in Apple's just-announced earnings report for the third fiscal quarter.

In his June report, Wolf cited statistics from IDC, a research firm based in Framingham, Mass., that the iPod already holds 51 percent of the market for music players with hard drives. Imagine what would happen when Windows users can access the Music Store.

"Apple is abandoning its strategy of confining its software to the Mac platform," Wolf said in the report. He also upgraded his rating on Apple's stock to 'buy" from "hold."

"This overdue move will enable it to target its digital entertainment products and services -- starting with the iPod and iTunes Music Store -- at the entire market, not just the 5 percent Apple currently addresses," the report said.

Although it sounds like the "digital hub" concept run amok, the idea makes sense for Apple. The truth is, sales of Macs have been stagnant for years.

Even with such products as the 12-inch and 17-inch PowerBooks introduced earlier this year, the Power Mac G5s expected to ship at the end of August, and the evolving Mac OS X, Apple is -- more or less -- stuck with a very limited market.

The company's revenue hovers around $1.5 billion every quarter, with unit shipments ranging from 700,000 to 800,000. Both are down from just a few years ago, when the popularity of the original iMac helped Apple bring in more than $2 billion per quarter while routinely selling more than 1 million Macs.

Apple hasn't been alone in seeking to diversify from computer hardware. As it became clear that the days of rampant growth and fat profits would never return to the PC industry, all the major computer makers have been pursuing alternative strategies.

Gateway Inc., beaten down by price wars with Hewlett-Packard Co. and Dell Inc., found some success last year selling plasma televisions in its Country Stores. This year, the company, based in Poway, Calif., said it would remodel its stores and would start selling more consumer electronics.

Even industry leader Dell, with headquarters in Round Rock, Texas, recently dropped the word "computer" from its name to reflect its increasing focus on servers and storage systems -- areas significantly more profitable than selling Windows-based PCs.

Apple chose digital media as its avenue to diversification, capitalizing on its cachet among creative professionals of all stripes -- from graphic artists to musicians to filmmakers.

It's an area not only in which Apple can excel, but an area where it can leverage its trademark ability to integrate hardware and software. It's no accident that most of Apple's professional software products -- Final Cut Pro (video editing), Shake (video special effects) and the just-released Soundtrack (music composing) -- serve the creators of film and music.

All of this isn't to say, however, that Apple plans to stop making Macs; that day, most likely, is a long way off. But branching out into digital media delivery provides an opportunity to grow the company that it can't get by just making Macs alone.

And success in the digital media arena would help sell more Macs. During a conference call with analysts last week, Apple CFO Fred Anderson called the Music Store a "Trojan horse" that would lead to sales of more iPods. Windows users who purchase iPods then might be enticed to buy Macs, lured by the desire for the full benefit of Apple's integrated products.

But the iTunes Music Store and the iPod could be only the beginning. In the years ahead, the delivery of digital media holds great potential for Apple.

Apple European vice president Pascal Cagni generated a stir last week when the German magazine Berliner Zeitung asked him if Apple someday would offer movies for download. Though he couldn't directly answer the question because of Apple's policy of refusing to comment on future products or services, Cagni did call the suggestion "a good idea."

Whatever Apple's plans, delivering digital video would be a logical progression from the Music Store. Who better than Apple to sell digital video over the Internet?

Apple's QuickTime video technology already is used to stream many movie trailers. It has the infrastructure in place via the Music Store.

And one more critical piece of the puzzle: Widespread adoption of broadband Internet connections, necessary to transfer large video files -- is well under way.

In the August issue of Fast Company magazine, columnist John Ellis said that the Music Store owes part of its success to broadband Internet access.

He estimated that the number of U.S. households could reach 50 percent as early as 2005, making a digital video store a viable possibility.

"Everyone knows that 10 years from now digital-digital [the transfer of digital content over the Internet] will be a huge business," Ellis predicted. "The only questions now are how quickly we can get from here to there and, more important, who gets there first."

Apple has put itself in a strong position to become a major provider of digital content over the next decade. And in such a role, the Mac vs. PC issue will be much less relevant.

Of course, if Apple's digital services work better on a Mac -- and knowing Steve Jobs, they will -- it will serve to reinforce the Mac's image as the ideal platform for digital entertainment.

It all may sound far-fetched, but then five years ago so did downloading music over the Internet.

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