PC Industry in 2007

The personal computer (PC) market is bifurcated with the top four vendors HP, Dell, Acer and Lenovo commanding 50% of worldwide PC shipments. The next two biggest players Toshiba and Apple capture only 4.1% and 2.6% market share respectively. Using an average of the top four vendor's financial performance as a proxy for the PC industry, ROA and ROS on aggregate is 6% and 5% respectively putting them in line and below the overall economic average. An analysis of the industry forces according to Michael Porter's model would indicate that value creation is hampered by high buyer power and high supplier power while value capture is often difficult given the high level of rivalry and the increasing commoditization of PCs. However, Apple's line of Macs has been able to buck the trend of falling ASPs (average selling price has fallen 8% since 1999) and consistently been more profitable than its rivals earning 35% gross margins vs. 19% for Dell and 24% for HP. This intra-industry difference is due to consumers' higher willingness to pay (almost 40% higher net sales per unit) as further discussed below as well as Apple's strategy to not participate in the low-price volume segments of the PC industry.

Apple Inc's Competitive Advantage

(i) Apple Design

Apple has been well ahead of the curve from a design perspective, with the company placing a large emphasis on style as far back as the early 90s with the launch of the first generation iMac. Apple figures out what consumers will most want from the devices and engineers the devices to serve those wants and it does so reliably (Apple is well known for the reliability of its Mac OS and customer focus). HP and Dell have both undergone a “de-commoditization” strategy validating Apple's decade long strategy although neither HP nor Dell has been as successful. As consumers gravitate towards notebooks from desktops, Apple's design strategy will increasingly pay more dividends with consumers becoming more style conscious as devices become more portable.

(ii) Ownership of Software

Apple's high quality bundled software creates a more inelastic demand for its hardware as those accustomed to Apple's ease of use and interfaces are unlikely to purchase another PC when it's time for an upgrade which creates a recurring hardware venue for Apple. This is unlike the Microsoft-based PC world, where similar experiences can be found across virtually all vendors. Apple's proprietary software is a key differentiator as it is the only major hardware vendor that can provide a fully integrated solution to consumers. As users become more familiar with and accustomed to Apple's software (such as Macintosh OS X and iTunes) and user interface, it increases customer loyalty making them less likely to switch to a Dell or HP.

(iii) Product ecosystem

The strength of Apple is its ability to create Apple-Centric ecosystem where all its products and functionalities are inter-connected. For example, the Mac operating system (OS) is not available on non-Apple PCs, and while iPods can connect to non-Apple PCs, the only software management option is Apple's iTunes (i.e. iPods cannot synch with Windows Media Players and iTunes cannot synch with non-Apple mp3 players). Apple has further expanded this strategy into its distribution by launching a network of retail Apple stores that again promote the entire Apple user experience. This tactic of controlling the user experience from hardware design to software applications, services and point of purchase are keys to Apple distinguishing itself from its competitors.

(iv) Apple Brand

Apple has mastered the technique of using its brand as leverage into new consumer electronic markets witnessed by the interest that surrounds any potential new product launches and the hype is usually all positive. Apple does an outstanding job of integrating new products into the existing ecosystem, where Apple was once a computer company, the release of the iPod has expanded the company into media and entertainment, and the iPhone has done the same into mobile communications. This creates the so-called halo effect where consumers who try one Apple product become more likely to try another. The halo effect can have significant impact on Mac sales if purchases of other Apple products then try Macs instead of PCs. In summary, Apple has managed to buck many of the negative industry forces by positioning itself mostly in the consumer PC market and converging computing with entertainment and communications. Apple's tight control of its value chain (hardware, software, applications and retail distribution) differentiates its user experiences and its ecosystem approach raises the competitive/switch barriers allowing it to charge premium prices relative to the industry.

Mac Share of World PC Market

While easily forgotten today, with the successes of the iPod and iPhone, Apple's history is deeply rooted in personal computers since the company's inception in the mid-1970s. In the 20-plus years since, the Mac has become an accepted member of the PC industry with strong appeal to educational and creative professional markets, but limited adoption in the broader PC market. The primary reason for Apple's limited market share is its adherence to using Apple-only products, which limits interoperability with other software programs (although Macs have been able to run Microsoft Office beginning in 1997). However, in recent years, Apple has opened up with the compatibility of iPods and iTunes on Window-based devices and the availability of the Windows operating systems on Macs could be drivers for market share gain. A simple calculation shows that by gaining an additional 1% of the world's PC market, Apple could add $1.3B to its operating margins (currently at $4.4B at the end of 2007).

Industry Change

Innovation drives market share in most industries and this is especially salient in the PC industry. Quite often the efforts have revolved around making computer components smaller but more powerful with the ultimate goal of making computing ubiquitous no matter where the user is. With the first PC displacing the “mini-computer” in the '80s, to the advent of the laptop and now netbooks gaining in popularity, computers marketed today are becoming more compact as soon as the technology and economics allows it. Going forward, the miniaturization and the eventual gutting out of the PC will continue first with more universal adoption of the smart-phone as its functionalities converge with those of the PC's, to the eventual migration of software and application online removing the need for processing and memory hardware that are currently used in PCs.

Wireless as a computing platform and digital convergence

Consumers bought 1.1 billion handsets in 2007 compared with 269 million PCs worldwide. While tradition wireless users have simply been utilizing their handsets for voice conversations or for SMS, a number of industry dynamics are coming together that have changed consumer usage of wireless handsets. The combination of advanced wireless handsets, advanced 3G and mobile WiFi and numerous mobile applications it allows significant opportunity for wireless and handset providers to drive mobile multimedia content. With decreasing cost of processing power, storage, display technology and battery technology handset, vendors are creating smart-phones that have the computing and storage power similar to a PC just a few short years ago. Additionally smart-phones are equipped with a substantially larger full color screens that enable far superior viewing characteristics relative to traditional wireless handsets. Although wireless networks are slower than many consumers may like, wireless carriers across the world are upgrading their networks to 2.5G and 3G technologies that allows immense data transfer. A second cross current sweeping the industry is the increasing trend towards digital convergence (the ability to transfer all forms of digital content from the Internet, to home entertainment centers and to portable devices) culminating in cloud computing where all software and application are stored and accessed online. Customers will be willing to pay a premium for the benefit of seamless integration of various products, particularly as devices grow in complexity and the performance benefits become more pronounced.

Can Apple shape the change

The handset vendors are likely to be the biggest beneficiaries at the early stage of this architectural change similar to how PC vendors were the first obvious beneficiaries of the growth in the personal computing market. Early success stories created from this trend include RIM and Apple. In previous upgrade cycles, consumers chose their wireless phones primarily on the form-factor and price of a mobile handset, software applications and features although important were generally viewed as secondary functions that were nice to have but not critical to the purchase decision. Indifference was largely due to the lack of sophistication as mobile games were limited and music consisted of low quality ringtones. In today's market, the technological architecture underlying mobile handsets is finally catching up to meet the needs of more sophisticated software applications. Consumers and professionals alike can now browse the Internet, e-mail colleagues and friends, play the latest racing game and listen to music and watch video all from a single device and there is no device that does it better than the Apple iPhone. The iPhone has changed the dynamics of not only the smart-phone market but also the broader handset industry with its sleek design and intuitive user interface and excellent performance of its touch-screen software. The ability to effectively integrate software applications into mobile handsets in a manner that is intuitive to the end user will provide a critical factor and a huge value propositions for end users. Also while digital convergence is still in an emergent phase Apple is well positioned to capitalize on the trend. Apple already has a number of the pieces in place, including being the sole hardware vendor with a proprietary operating system (Mac OS X), market leading portable video device (iPod) as well as other nascent complementary product offerings (AppleTV). Apple's digital environment sets the company apart from its competitors as it can provide hardware and software that is more seamlessly integrated. Apple's iTunes will likely be at the epicentre of this convergence as it syncs multiple devices and holds access to Apple's enormous customer base.

Macs: Beginning of the end? (Maybe not)

While the disruptive technologies borne out of smart phones and cloud computing has the potential to change the core assets of the PC industry, it does not necessarily mean PCs are destined for obsolescence at least not anytime soon and not in its entirety. However, it does mean innovation in the PC market that will capitalize on these trends. Apple has been a frontrunner with the release of the ultra subcompact MacBook Air that has minimal hardware requirements perfect for cloud computing as well as the iPhone which is fast becoming the industry standard for smart-phones. Furthermore, the continued proliferation of iPhones creates a ready-made installed base of new Apple consumers who could be converted to Mac purchasers in the short term. If Apple does meet its 10 million target in its first year of sales (highly likely given preliminary sales data) and making an assumption that of the 10 million 50% are non-Mac users, a 30% penetration of this non-Mac iPhone base would turn into 1.5 million additional number of Macs sold. Using the simple earnings accretion calculation as above this would lead to an incremental gain of $735 million in pretax income which would surely increase as iPhone adoption accelerates.

Macs still drive revenue and GM

Although the iPhone garners the most attention from investors and the media given the long term impact on the company's results, Macs continue to be the main growth driver at Apple. Mac's still account for 43% of total sales and its gross margin is in line with corporate gross margin (both at 35%). Looking at its suite of products, iPod margins are below the corporate average (30-35%) and the iTunes business is a loss leader used as a reverse razor and blade strategy. While iPhone gross margins are the highest (around +45%) its revenue and margin contribution is minimal given iPhone sales is 1/10 that of Macs. Central to Apple's ability to drive above industry growth comes from its reinvestment of “excess gross margin” into aggressively priced products and emergent technologies such as AppleTV so if Apple divested its PC unit, it would cut off a significant source of funding. In order to succumb the high initial cost curves associated with new product introductions Apple needs to retain the steady cash flows generated from Mac sales.

Recommendations

(i) Short term: Focus on core products

Premium products = stable and attractive gross margins. The growth strategy for Macs should continue to be sell well designed and premium products that provide a great user experience. As a premium product provider, Apple maintains a healthy gross margin (30% +) and emphasizes high-quality product design over cost-saving measures. Apple has made necessary trade-offs by eschewing the low-end portion of the market and focuses only on the middle and high end segments. Geographically, Apple's market share is strongest in North America. The company still has opportunity for further penetration within the US market and it should continue its retail strategy that broadens the availability of Mac products. However, the low hanging fruit over the next decade may lie in it's under penetration in markets abroad offers a significant opportunity (such as non-Japan Asia and Latin America). A more aggressive push into international markets could be a source of growth primarily driven by high volume sales of core products (portable computers, desktops, iPod) supplemented by strong-selling new products (i.e. iPhone) which transition over time to become core products.

(ii) Medium term: Continue to invest in software and application

While Apple generates its earnings and cash flows from selling devices, the software and applications it builds for its devices are crucial. Specifically the unique features of the Mac OS, the simplicity of iTunes, and the innovation of the App Store are all part of what holds together the Apple ecosystem. iTunes is one of the key Apple products for driving the halo effect. It is the software that connects devices within the Apple ecosystem and by controlling software Apple is better able to integrate applications that matter most to its customers. By delivering added value and differentiating itself, Apple may be able to buck the overall decline in PC sales through market share gains. With the technology shift into cloud computing gaining traction and the high capital expenditure required for development, Apple would benefit from alliances with infrastructure cloud companies such as Cisco as well as on the application side with Microsoft and Google. Apple should learn from its mistakes in the early 1980s when it lost significant market share by closing its operating system to outsiders.

(iii) Long term: Emphasize culture of risk taking

To ensure that it continues to create innovative designs and content, Apple must emphasize its culture of risk taking and be unafraid of expanding new markets even at the risk of cannibalize existing products. While the PC accounts for more than 40% of current sales and overall industry PC sales growth still stand at low single digits, it is not unthinkable that smart-phones can ramp up faster than desktop connection as more users connect to the internet via their phones than the desktop PC within the next decade. The PC cycle is entering its mature phase while mobile computing is still in its early stages and Apple is currently leading the charge in mobile innovation. It must continue to develop its application ecosystem, push the envelope on R&D, and enhance user experience even at the expense of cannibalizing PC sales because otherwise new entrants will. Apple has had a history of disrupting markets and creating new ones and this has to continue especially if it transforms itself to a consumer electronic company.

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