The Apple iPhone idis 619 Capstone Assignment By


Innovative Brand Reputation: Apple had a history of producing innovative products such as Macintosh and iPod through their Humane Engineering goals



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Innovative Brand Reputation: Apple had a history of producing innovative products such as Macintosh and iPod through their Humane Engineering goals
Quality Sales: Apple offers high quality pre- and post-sales support through its Apple Store. Apple “believes a high-quality buying experience with knowledgeable salespersons that can convey the value of the Company’s products and services greatly enhances its ability to attract and retain customers
Confidentiality: By having a very tight control in Apple’s development strategy, Apple is able to take its time to develop the product, and have total control of the announcement of the product.

Cost drivers:

Economies of scope – Apple tries to achieve economies of scope. For example, it first introduced iPod and then introduced lower versions of the product using the same technology. Similarly in personal computing side, Apple uses the same technology in the backend.

Vertical integration- Apple achieves vertical integration by developing its own operating system, hardware, application software, and services and strives to provide superior ease-of-use, seamless integration, and innovative industrial design

Lawsuits: Apple incurs costs from potential or current lawsuits such as consumers not being able to play purchased songs from iTunes across devices.

Resources and capabilities: (see Exhibit II (D) 4 – Part A (g) – VRIO Analysis for Apple)

Products and number of product markets served:

Apple’s products include Hardware (e.g. Macintosh line), Music Products and Services (iPod line, iTunes), Peripheral products (e.g. displays), Software products (e.g. Mac OS), and Professional Applications (e.g. video editing software)



II (D) 5: Compare firms using Value minus Cost (Willingness to Pay) framework

Please see Exhibit II (D) 5a for the WTP analysis. The Value portion for each of the manufacturers was calculated based on surveys that were sent to around 80 participants across a diverse demographic (different age groups, professions, social interests, etc.). A copy of the surveys are available in Exhibit II (D) 5c (Part A & B), and a graphical breakdown of V, P & C in Exhibit II (D) 5b. However, we faced some challenges in trying to ascertain the costs associated with smartphone manufacture. Most companies don’t break their costs down at this level of detail. Some do present relevant financial information for their mobile business unit but this wouldn’t be a reliable measure to perform an apples-to-apples comparison since some companies such as Palm and RIM focus almost exclusively on smartphones while others like Nokia and Motorola focus on a broad range of mobile handsets across multiple segments. We has also not been able to get any reliable information on what Apple’s cost structures related to the iPhone might look like. We did come across one reportli from iSuppli that tries to estimate what the input costs for the iPhone might be and estimate margins based on this. However, we haven’t considered this report for the V-C analysis since (i) it is a single data point from one analyst (ii) it doesn’t account for other costs that Apple will incur as part of its iPhone business including marketing costs, labor costs, etc. As a result, the WTP exhibit is primarily useful for two purposes: (i) to provide an insight into the type of value that customers attribute to these different handset manufacturers and their products (ii) get a sense of what margins Apple’s competitors in the smartphone space (if we were to assume that RIM & Palm’s data was indicative) are experiencing.



II (D) 6: Comparative Financial Analysis

Financial ratio analysis provides us an opportunity to quantify and analyze operational performance of the handset and wireless service industries. The financial analysis for the handset (Exhibit II (G) – Part A – Comparative analysis of handset manufacturers) involved the following categories of ratios and financial numbers which were closely analyzed over a period of five yearslii, dependent on the financial data available:



  • Liquidity Ratios-Current Ratio, Quick Ratio

  • Asset Turnover Ratio-Inventory Turnover

  • Financial Leverage Ratios-Debt Ratio, Debt-To-Equity Ratio

  • Profitability Ratios- Gross Profit Margin, ROA, ROE

  • Growth Rates and other operational ratios- Sales growth rate, Cost of Sales, Net Income growth rate, R&D/Sales

Apple has experienced unprecedented sales and income growth in years 2004 (33.38% and 68.27% sales growth and 285.51% and 399.25% in income growth over 2004 and 2005) on account of its portable digital music player iPod success, followed by the video iPod in 2005. But with the commoditization of iPod with its reduced iPod Nano price, low price iPod shuffle offering and increased competition from handset manufacturers with built in mp3 players in handsets, the sales and income in 2006 have shown a flattening trend. By successfully keeping its Cost of Sales increase, comparatively lower than its revenue growth, Apple has further strengthened its income growth. Apple displays favorable Current Ratio (averaged 2.72 over last five years), and Quick Ratio (averaged 2.69 over last five years) as compared to its competitors and also the industry standards, providing a favorable liquidity position. Looking at comparable firm, Motorola is a close second in these ratios to Apple, with Nokia close behind. RIM has higher liquidity ratios than Apple, Motorola and Nokia, although that can be attributed to its comparatively smaller firm size and fewer product lines, leading to lower inventory levels. Apple’s inventory turnover is an area of potential improvement for Apple. Although its inventory turnover is favorably much higher than the industry standards, it has been gradually declining over years, while the ratio for its competitors like Motorola, RIM and Palm has been increasing. Some plausible reasons for this decline could be Apple’s introduction of Intel-based Macintosh computersliii and increased store openingsliv. Also, Apple’s Debt to Equity (0.723 for Apple in 2006) and Debt Ratios (0.42 for Apple in 2006) are increasing although they are less than its competitors like Motorola, Sony, Nokia and LG, though RIM and Palm are better positioned than Apple for the same ratios. The increase is primarily driven due to increase in Accounts Payable and Non-current liabilities, year-over-year for Apple, indicating that Apple is increasingly funding its operations through Debt rather than Equity. These ratios are critical for long term solvency of the firm, are closely watched by the investor community and hence need to be paid close attention by Apple. Gross Profit Margins (average of 28.14% over last five years) for Apple are below the industry average (34.2%). Apple continues to strive for increased Gross Profit Margins over last five years improving from 27.9% in 2002 to 29% in 2006, primarily driven by increased sales. Motorola’s Gross Profit Margins which stand at 29.7% as of 2006, while Nokia is ahead of the two at about 35% gross profit margin as of 2006. RIM continues to enjoy the highest level of Gross Profit Margin at about 55.2% as of 2006, primarily driven by the worldwide expansion of its Blackberry handset which is now available over 160 networks in over 60 countrieslv.The growing gross profit margin attractiveness of the high end handset segment as shown by Nokia and RIM, may have been one of the drivers for Apple to enter this industry. The Return on Assets (average of 5.69% over last five years) and Return on Equity (average of 9.25% over last five years) ratios also are attractive for Apple as compared to the competitors and the industry (1.5% and 5.5% respectively for the industry). Again for Apple this has been due to the immense success of the iPod. Over 2006, Apple’s ROA has been reasonably flat (11.5% in 2005 and 11.6% in 2006), as income increases at the same rate as the assets, in line with its move to commoditize iPod. Hence overall, financially, Apple is strongly positioned in the handset industry to compete aggressively with its competitors like RIM, Palm, Nokia and Motorola etc., with the caveat that this favorable position has been achieved by Apple, primarily on account of its tremendous success with the iPod music and video player series.

II (D) 7: Implications

Apple has entered the highly competitive smartphone industry with its new offering, iPhone.. It is set to change the dynamics of the smartphone industry by creating a new consumer segment for smartphones. So far, smartphones were mainly used by corporate users to access office applications such as Email, web browsing and have the device integrated with cell phone. On the other end of spectrum are mainstream consumers who would like to have one device to play MP3 songs and to make calls. With Apple’s iPhone, it has integrated the two segments with its product offering and has designed the product to appeal to users for whom “Experience” matters most. Competitors such as LG Prada are already marketing mobile phones with the look and feel of an iPhone (although they lack many applications and OS integration that iPhone promises. Other competitors such as RIMlvi are increasing their offering in consumer space and for the business users (Pearl and BlackBerry 8800) and have a reach with 225 network carrierslvii who earn hefty profits on selling blackberry devices. RIM is also expanding its offering through additional network carriers worldwide. Palm is a close contender since its TREO is regarded as a feature rich product among consumers. However, its recent announcementslviii of exploring options and hiring a former Apple engineer send mixed messages and it is unclear if Palm will stay in the competition or quit. The industry is clearly evolving to offer cell phones with better user experience and feature rich products and competitors are trying to tie up complementary offerings. For example, a music company in Europe started offering its music through streaming audio directly into cell phones thereby freeing up the drag on revenues caused by credit card processinglix. So Apple has caused a shakeup in the handset industry and in the service provider industry in the way in which they offer services. Apple will meet stiff competition from RIM which currently holds 50% of smartphone segment and from Nokia and Motorola (who are traditionally market share leaders in handset industry) as they introduce smartphones to protect their market shares. If Apple Inc. is successful in developing a whole new consumer segment of smartphone users, it would have the first mover advantage and capture the market share while traditional players work on bringing a similar user experience to penetrate this new segment. Although RIM may still continue to be a leader in the enterprise smartphone business, since enterprises generally move slowly towards a new product due to switching costs, there may be a small segment of powerful players in the enterprise segment who may strongly recommend that iPhone be supported on their corporate networks. This will be a challenge for RIM as Apple gains entry into the enterprise market. Also, as Cisco and Apple settled their trademark dispute, they agreed to work together “in the areas of in the areas of security, and consumer and enterprise communications."lx This partnership with Cisco may further strengthen Apple’s ties in the enterprises. Apple’s exclusive partnership with Cingular (or the new at&t) may also open doors for new ways to share music, download music as Apple and Cingular continue to work closely to offer new product feature and service offerings to their consumers. Thus Apple is strongly positioned against competition with its strong product offering, and partnerships with Cingular and Cisco. Apple made a calculated judgment to unveil its iPhone 6 months before entering the market. This has helped created product and brand awareness and lot of speculation and hype about the product. As Apple studies the competition and strategic moves by competitors during this time frame, Apple gets to make the final call of what new “cool” features will be introduced in the first version of iPhone thereby taking the industry by a storm. Apple’s iPhone is driven by software, so adding new features is a comparatively smaller incremental effort. However, Apple has to live up to its expectations and brand image for the product to be successful.

II (E): Intra-Industry Analysis

II (E) 1: Strategic groups in the industry

Strategic groups in the smartphone manufacturer industry can be analyzed along two dimensions- Mobile Operating Systems (Exhibit II (E) 1a – Smartphone Operating System Adoption Landscape )and Features/Applications available on the phone.



Mobile Operating Systems (Exhibit II (E) 1b – Smartphone Industry Map)

Along this dimension, the smartphone devices are arranged according to the extent of their integration (tight, proprietary) with the mobile operating systems. The major mobile Operating Systemslxi are as follows:



  • Symbian: holds 72.8% market share and is supported by Siemens, Samsung, Sony Ericsson, Panasonic and Nokia

  • Linux: Open source operating system that holds 16.7% of the market and is supported by independent vendors of Linux as well as by smartphone manufacturers

  • Windows Mobile: from Microsoft, accounts for 5.6% market share

  • Blackberry OS: has 2.8% market share and has been developed in house by RIM

  • Palm OS: holds 1.8% market share and owned by Palm Source which in turn is owned by Access

  • OS X Tiger/Leopard: Apple’s mobile operating system, no market share at present

There are three subgroups within the smartphone producer industry based on the choice of operating system. There is some overlap among these categories, i.e. a device manufacturer may belong to more than one subgroup simultaneously.

  • No OS agenda: These are the companies that have not invested in operating systems development themselves, and use operating systems developed by other software vendors who are not their competitors in the device space. Motorola and HP are two examples of such companies: these companies normally use a version of Windows Mobile OS or a version of the Linux OS, although recently, there has been a shift towards Windows

  • Collaborative OS: These companies have formed alliances to jointly develop and promote a mobile OS. Linux and Symbian are examples of such a strategy. The use of Symbian is not limited to companies in the alliance – it can be licensed to other smartphone producers as well. Additionally, promoters of Symbian are free to use other independent operating systems like Windows and Linux.

  • Proprietary OS: These companies have developed their own proprietary operating systems. Apple, with its OS X Tiger Mobile OS and RIM with its BlackBerry OS are examples of such a strategy. These companies believe that a very tight integration between their devices and the software running on it provides more value to the customers than using 3rd-party operating systems.

Features/Applications

Along this dimension, the smartphone producers are arranged according to the relative strength and multiplicity of features and applications available on their smartphone devices. Based on this criterion, phone devices can be divided into the following three groups-



  • Low: Such features include web browser, camera and text messaging/SMS

  • Mid: Multimedia (video player, music player) and GPS in addition to ‘low’ features

  • High: push email, calendar, word processor, spreadsheet, security software, 3G+ compliance and Wi-Fi capabilities in addition to ‘mid’ features

Smartphone devices normally correspond to the Medium or High categories of features and applications. Exhibit II (E) 1 depicts the positions of various smartphones producers on these two dimensions. The strategic groups resulting from this analysis are as follows-

  • Group 1- Medium feature, very high integration

  • Group 2- High feature, low integration

  • Group 3- High feature, medium integration

  • Group 4- High feature, very high integration

  • Group 5- Very high feature, medium integration

  • Group 6- Very high feature, high integration

II (E) 2: Threats, Opportunities & Mobility Barriers of Strategic Groups

The following sections describe the particulars of these strategic groups, like size, threats, opportunities and mobility barriers.



Group 1- Medium feature, very high integration (e.g. Apple):

This strategic group is currently unique to Apple iPhone. Although the size of this group is presently 0 (since the launch of the iPhone is still about 3 months away), the iPhone aims to capture 1% of the worldwide mobile phone market. The threats to this strategic group, which may potentially cause the mobile phone subscribers to opt for other smartphones, are as follows-



  • Medium (not high) features and applications: The device is not 3G compliant, as most other smartphones are. This would cause slower device performance. The browser would be Apple Safari, and not the market leaders like Internet Explorer or Mozilla Firefox. Additionally, very few external applications would be available.

  • Investment in OS X: In-house investments would need to be made continuously in the operating system to keep it current relative to other mobile operating systems

  • Highly priced device

Opportunities for this strategic group:

  • Leverage the powerful brand - the strength of the iPod brand would arouse strong curiosity amongst mobile phone users and allow the iPhone to gain traction in the market

  • Move to group 4 or 6: Enhance speed capability, work w/ ISVs on porting other applications, particularly those of interest to corporate users

Mobility barriers: Movement across operating systems strategic groups (i.e. to high/very high feature, high integration) to capture additional customers, especially corporate customers, would require investments in software applications that work on its proprietary operating system OS X. The cost to develop such software in-house would be high. Apple does not possess a strong relationship with ISVs and so that option would require time and effort.

Group 2- High feature low integration (e.g. LG):

This group comprises companies that provide most features associated with smartphones but they have not invested in an operating system (proprietary or collaborative) themselves. These companies use commercially available ‘independent’ operating systems like Windows Mobile and Linux. The threats to these companies are –



  • OS stability issues: Windows Mobile, the most common OS for this group, is prone to frequent freezing and crashing

  • Application interoperability- Interoperability among the 3rd party applications that are used on these devices is unsatisfactory

  • The strengths of group 4, 5 and 6 companies

Opportunities for this strategic group:

  • Leverage in-house technological expertise to enhance the device features

  • Leverage the relationships with ISVs to enhance applications interoperability

Mobility Barriers:

  • The ‘top’ players of the market have gained a large market share and continue to innovate (enhance s/w and hardware capabilities) at a furious pace

Group 3- High feature medium integration (e.g. Motorola, Sony Ericsson):

This group is comprised of companies that provide features and applications similar to group 2, but have a higher level of integration (i.e. medium level) between the devices and the mobile operating system. These companies have a foothold in group 2 as well as group 4, i.e. their devices can work with multiple operating systems (collaborative like Symbian as well as ‘independent’ like Windows Mobile and Linux)



Threats to group 3:

  • Multiple bets- porting devices on collaborative as well as ‘independent’ operating systems may be perceived as a ‘confused’ and costly strategy

  • May hurt market share if the customer preference is for high integration

  • Intellectual property related issues: Since the promoters of collaborative mobile operating systems, like Symbian and Linux, are competitors of each other, there may be limits to how much technology they can contribute to the common OS effort, which may limit the quality of such operating system

  • Duplicated effort: Since Linux is already available as the open source OS to which these companies, other mobile device makers and the worldwide mobile device developer pool contributes, there is a concern that the resources expended on Symbian may be unnecessary From that standpoint, making devices to work with this OS may turn out to be a wasted effort

  • Low market share of Symbian in the US: although a market leader worldwide, Symbian has only 6% of the US market. The devices based on this technology may see lower growth in the US

  • Device adoption may be hampered due to higher number of mobile applications available for group 2 devices

Opportunities for group 3:

  • ‘Hedged’ bet- collaborative OS as well as ‘independent’ OS (Windows Mobile, Linux). This can be advantageous if the companies can adjust ‘the sails’ quickly if customer preference turns in one direction

  • Leverage the relationship w/ other groups via membership in Linux and Symbian efforts

  • Ability to pool in resources of multiple companies in the space, to design and develop an enterprise grade operating system

  • Potential of Symbian becoming an open, universal standard. This can enhance the adoption of group 3 devices

Mobility Barriers: This is the best group to be in from a mobility perspective, since these companies have invested in collaborative OS, and at the same time they have expertise in making devices that can work with ‘independent’ operating systems like Windows Mobile and Linux. These companies can easily switch to very high feature, low integration group.

Group 4- High feature very high integration (e.g. RIM):

This group is currently unique to RIM due to its proprietary BlackBerry OS and the BlackBerry device. It accounted for 53%lxii of the 5.2 million smartphones shipped in the US last year. Blackberry provides high features but lacks word processor, spreadsheet and PDF capabilities. The software on the BlackBerry is mostly proprietary and developed in-house.



Threats to group 4:

  • Unavailability of ‘standard’ applications

  • High costs of in-house applications development to keep up with the competitors with low H/W-S/W integration

  • Difficulty of integration of blackberry OS into Windows OS environment

  • Growth of Windows Mobile OS and its adoption by many major smartphone makers

Opportunities for group 4:

  • Highlight the superior performance of in-house apps

  • Leverage the brand penetration to upsell the next higher versions of the mobile devices

  • Participate in the industry consortia (e.g. Symbian, Linux) for promotion of industry standard operating systems and applications

Mobility barriers:

  • Strong competitors who span multiple strategic groups

  • Move to low H/W-S/W integration groups would require manufacturing devices compatible with ‘independent’ operating systems like Windows Mobile, and foregoing the proprietary advantage

Group 5- Very high feature, medium integration (e.g. Samsung, Palm):

This strategic group is comprised of firms that make feature- and application-rich devices, have invested in collaborative operating systems and at the same time support ‘independent’ operating systems as well. For examples, Samsung is part of the consortium supporting the Symbian operating system. It also supports Windows Mobile operating system on its devices. Since its divestiture of Palm OS as part of Palm Source to Access, Palm has moved from very high integration to medium integration. This shift is evidenced in Palm’s use of Palm OS for Treo 650 and Windows Mobile for Treo 700. In an interesting move, Palm has acquired the rights to a version of Palm OS (Garnet) from Access and has said it will continue development of Palm OS.



Threats to group 5:

  • similar to group 2

Opportunities for group 5:

  • Ability to move to group 4 and compete strongly with RIM by controlling a key aspect (OS) of a smartphone.

  • Availability of large (~20000) applications for the Windows Mobile OS

Mobility barriers: This group can move to either side of the H/W-S/W integration spectrum, and therefore enjoys that flexibility.

Group 6- Very high feature, high integration (e.g. Nokia):

This groups is comprised of companies that make feature- and application-rich devices and have also invested in a common mobile operating system (Symbian in the case of Nokia).



Threats to group 6:

  • Devices with in-house and proprietary operating systems that can integrate the software applications for better usability and performance

Opportunities for group 6:

  • Rising popularity of collaborative and independent mobile operating systems

  • Devices with Wi-Fi and cellular network interoperability

Mobility Barriers:

  • A move to low H/W-S/W integration group would require a shift of strategy and additional costs to port the devices on common operating systems.

II (E) 3: Other Competitive Dynamics

Disruptive Technologies

  • Push email technology

  • Dual mode technology: switching between cellular and Wi-Fi networks

  • Browsers tailored for the smartphone screen: Firefox Minimo, IE Mobile

  • RIM’s licensing of BlackBerry Connect service that lets Motorola, Nokia, and Palm smartphones receive BlackBerry push e-mail

  • Mobile device convergence – phone, camera, music player, video player, laptop

  • Expansion of cellular bandwidth and technologies like EV-DO

Standards

  • Linux standardization projects, e.g. LiPS, ALP

  • Symbian development by a mobile device maker consortium

Growing Market Opportunity/Industry Trends

  • 200 million smartphones expected to ship globally in 2009lxiii

  • Smartphones replacing laptops as the mobile computing device

  • Enterprise applications moving to the smartphone

  • Mobile versions of apps from ISVs- e.g. Oracle, Salesforce.com, SAP, Sybase.

Competitive Dynamics

  • Motorola and Nokia catching up w/ Palm in the prosumer smartphone market

  • Efforts to improve battery life

  • Partnerships with software developers-

    • Motorola’s attempts to encourage developers to build applications for Windows Mobile via its Fast Track Center web site which gives developers access to business and product development services from Motorola and its partners.

    • Motorola’s CanvasM, a JV with Tech Mahindra for custom wireless business applications

    • Palm’s Palm Developer Network, including Palm OS and Windows Mobile developers to offer technical, business, and marketing support and compatibility testing services

II (E) 4: The firm’s competitive position before and after the strategic move

Prior to its iPhone announcement, Apple had never been a player in the mobile phone maker industry. Apple’s claims to fame have been its Mac line of computers with its Mac OS operating system and user-friendly graphical user interface, and more recently, its iPod line of music players and the iTunes music download service. In the former, it was competing with other computer manufacturers like IBM, HP, Dell etc, and in the latter, its competitors are Creative, Rio, Sandisk, Rhapsody, etc. Of late, almost all major mobile phone manufacturers have begun to integrate a digital music player (MP3 player) in their devices. Although iPod was a huge success for Apple, this device convergence (of mobile phones with music playing capabilities) was posing a long term threat to Apple. The introduction of the iPhone provides a higher-end extension to Apple’s iPod product line and allows Apple to take on mobile phone manufacturers on their own turf. This widens Apple’s competitive landscape significantly. This seems to be a well thought-out and carefully orchestrated strategy on Apple’s part as evidenced by its name change to Apple Inc that was announced along with its iPhone introduction.



II (F): Threats and Opportunities Analysis

II (F) 1: Emerging threats and opportunities

In addition to those covered under six forces analysis and the macro environmental analysis, the following are the threats and opportunities for the smartphone industry-



Threats

  • High obsolescence rate for mobile phones, which requires frequent introduction of new devices. This increases the costs of developing, manufacturing and marketing of mobile phones in general and smartphones in particular

  • Entry of ‘regular’ mobile phone manufacturers into the smartphone industry and more claimants for the ‘pie’- this is evident from mobile phone makers like Motorola, Samsung LG, and now Apple that are entering the smartphone market

  • Consolidation in the service provider sector, US and worldwide – most mobile phone service providers are consolidating or merging with stronger parents. Such consolidation would allow the new, ‘big’ companies to demand higher price discounts, and therefore, would drive down the profit margins of the phone makers in general and smartphone makers in particular.

Opportunities

  • Large potential market size and low penetration of the smartphone industry provides profit opportunities for the device manufacturers as well as service providers

  • Opening of the consumer and prosumer sectors to the smartphone industry with falling and/or subsidized (mostly by carriers) device prices – this would help bring in relatively more price sensitive buyers into the smartphone market

  • Expansion of mobile internet bandwidth and connectivity technology – (3G, 4G technology) – as connecting to internet via smartphones becomes easier and the carriers provide higher speeds, the use of smartphones for personal as well as business use would become more widespread

  • Smartphone replacing laptops as the mobile computing device of choice for corporate users- this phenomenon will increase the usage of smartphones, and as a result, their sale

  • Emerging markets – most prominently India, China and Southeast Asia see more and more economic growth and as their internet and cellular telephony infrastructure expands, so will the use of smartphones. This will provide new avenues of growth for smartphone manufacturers

  • Proliferation of original design and manufacturer (ODM) companies – these companies allow smartphone makers to turn most of their fixed costs of design and manufacture of their devices to variable costs by allowing them to outsource these activities. This allows the smartphone makers to achieve greater cost efficiencies and economies of scale.

II (F) 2: Implications for strategy

The threats described above would limit the profitability of the smartphone manufacturers. However, the opportunities listed above would allow them to enter new markets and reach new users. This would necessitate the need on the part of smartphone makers to utilize the business strategy of mass differentiation while holding on to their advantages in their niche markets. For example, RIM's Blackberry smartphone devices have been targeted mainly at business users. However, of late, RIM has been making efforts to reach out to consumers by enhancing its user interface while still retaining its business user base by enhancing its corporate-friendly features.



II (G): Summary of External Analysis

The Industry analysis indicates that the handset industry in general is moderately unfavorable. However, the smartphone industry, a sub-segment of handset industry, is under penetrated. The competitor analysis indicates that handset manufacturers of smartphone industry concentrate their efforts on corporate users. Apple has found a segment within smartphone segment whose needs are not met by the current handset players. Apple has chosen to enter the consumer smartphone segment where it faces little or no competition in terms of the unique offering that it brings to the table. With the iPhone offering, Apple has positioned itself according to the needs to the consumer segment. However, consumers in general are price sensitive and Apple can initially cater to the needs to early adopters and tech-savvy consumers due to their technical expertise and high price point. During this phase, other smartphone competitors can use the cross-elasticity of demand to attract mainstream smartphone consumers due to their low price points. Our analysis indicates that all handset manufacturers (both general and smartphone) follow the leader and try to imitate their products and enter the new market segments and there is little differentiation between the existing products (Please see Exhibit II (G) – Part A for a comparison of the handset manufacturers). Apple is in a financially stronger position compared to its competitors. Its financial ratios fare better than competitors and industry standards.



III: INTERNAL ANALYSIS

Internal Analysis – Part A – Apple

III (A): Business Definition/Mission

In 1987, Apple’s goal was as followslxiv:

Our goal is to enhance our position as the innovator and premiere manufacturer of personal computer – the value leader, not the price leader. We intend to continue our strong sales growth worldwide. We will do this by concentrating on two key strengths:

Human Engineering – We build “friendly” products whose simplicity and ease of use make them natural extensions of their owners. First and foremost, we build computers for people.

Customer Service – We’ve created a worldwide network of servicing retailers, distribution sites, and technical support center unmatched in the industry. Our ability to provide product and support when and where our customer need them is critical to our success”.

Today, Apple’s goal is not much different from 1987 except it has extended its business from computers to digital devices. Apple wants to extend its Human Engineering into integrating today’s digital devices, and creating a Digital Lifestylelxv. This is reflected in Apple’s mission statementlxvi:

Apple ignited the personal computer revolution in the 1970s with the Apple II and reinvented the personal computer in the 1980s with the Macintosh. Today, Apple continues to lead the industry in innovation with its award-winning computers, OS X operating system and iLife and professional applications. Apple is also spearheading the digital media revolution with its iPod portable music and video players and iTunes online store, and will enter the mobile phone market this year with its revolutionary iPhone.”

III (B): Firm’s Management Style

Steve Jobs’ management style is reflective of the company’s management style – Apple is a very entrepreneurial and aggressive. Through various ex-Apple employee interviews with the media, we found out that Steve Jobs is a very tough boss to work for. He is a strong critique of product designs, due to the importance he places on the usability of their devices. The designers continue to work hard to improve their designs. Upon product completion, Steve Jobs would tell marketing that they have this wonderful thinglxvii. By motivating people through constructive criticism, Steve Jobs is able to get the best out of his employees. However, much of the Apple internal management details are very confidential. “Most of what Apple's engineers are fiddling with won't make it out of the lab, of course. Jobs himself will determine what does. Though he has ceded some control to trusted aides as he has matured as a manager, he still makes the final call on products” lxviii. Steve Jobs is fanatical about leaking company information. One of things that they tell new employees is “If you leak, we will find you, we will fire you, we will sue you and we will prosecute you”lxix. This culture seems to be reflected in employee behavior when we attempt to interview them. They simply refuse to give any information about Apple. "Apple has sued several suspected leakers or their abettors. Jobs also compartmentalized the company so that the vast majority of employees, even most managers, don't know what their colleagues are working on. Each product has several code names--a different one in each department. "Teams doing components have no idea what product they're for," says an Apple engineer. Jobs, former execs say, also has been known to plant false rumors internally; if they leak, he knows who talked."lxx



III (C): Organizational Structure, Controls and Values

III (C) 1: Firm’s organizational structure

Apple claims to be organized along functional lineslxxi (please see exhibit Exhibit III (C) 1). However, one of the direct-report to the Apple CEO is the Senior Vice President of iPod Division. This suggests that Apple has a Hybrid, Matrix or Network Organizational Structure. However, we do know that Steve Jobs has compartmentalized the company so that majority of the employees and managers don’t know what other groups are working onlxxii. This further reinforces Steve Jobs’ efforts in maintaining confidentiality within the company.



III (C) 2: Controls used to monitor/appraise employee behavior and performance

As advised by a former VP of Apple, the company has an "in your face" culture. Employees are expected to have "a lot of face time" with their managers. The managers monitor the performance of their employees very closely and hold them "really really accountable" . As an example, product managers are expected to provide precise customer requirements for products and features to the engineering team based on which products are designed. Also, they are expected to provide reasonably accurate sales quantity forecasts to the operations organization based on which products are manufactured. If the customers do not like the product or features and the sales forecasts are "way off", the product marketing manager could be fired.



III (C) 3: Firm’s organizational values

From Apple’s 1987 Value Statement documentlxxiii, we can see that they have retained most of their values to-date. These values are reflective of the innovative products and services that Apple is providing today.



III (D): Strategic Position Definition

III (D) 1a: Corporate Level – Firm’s business portfolio

Apple is in the following businesses: Macintosh Computers, iPod, other music related products, peripherals, software and services.

Apple’s core competence is leveraging its human engineering to deliver stylish and user friendly electronic products, and in effectively marketing these products.

III (D) 1b: Corporate Level – Firm’s Corporate Level Strategy

Please see Exhibit III (D) 1b for Apple’s 2006 revenue (in $ million) in its respective businesses. Although the Macintosh and iPod may be developed in isolation, the end product shows that there is tight integration between the software and hardware. And in the software area, it had to work on Macintosh, Window PC and iPod. So, the hardware development of iPod and Macintosh may be separated, but the software is the glue. This suggests that Apple’s corporate strategy is one of as ‘Related Linked’. Given the fact that the iPhone is an iPod with added mobile phone capability, its introduction will not change Apple’s Related Linked corporate strategy.



III (D) 1c: Corporate Level – Recent acquisitions, mergers or divestments

Apple believes in organic growth. According to jobs, “Software is the user experience” and Apple doesn’t like to depend on Independent Software Vendors to design that experience. As such there have been no major acquisitions in the past. For example, many of the applications developed by Apple were for MAC based applications that attempt to cater to the creative and entertainment aspects of the user community. As such, when Apple’s request to create a video editing program was rejected by Adobe systems, Apple launched its own project to create Final Cut Prolxxiv. Apple also ventured into the retail space and opened about 160 stores in USA, Canada, UK and Japan. Many times, people would walk into a retail store to buy an iPod, test drive other MAC products and would end up buying a computer to go with the iPod. Apple estimated that the foot traffic in its stores totaled 50 million in fiscal year of 2005. lxxv



III (D) 1d: Corporate Level – Recent alliances, partnerships or joint ventures

Apple has allied with Cingular as the sole service provider for the iPhone within the US. Please see Exhibit III (D) 1d-1 for the analysis of synergies between Apple & Cingular

As part of trademark settlement dispute over iPhone, Cisco and Apple have decided to work together in the areas of security, consumer and enterprise communications. Please see Exhibit III (D) 1d-2 for the analysis of synergies between Apple & Cingular

III (D) 1e: Corporate Level – Evaluate the firm’s business portfolio

Please refer to Exhibit III (D) 1e for Apple’s BCG matrix.

Apple’s Macintosh business has a minor share of the personal computer marketlxxvi while the market is slowing down in growthlxxvii. This puts Apple’s Macintosh in the Dog category (Exhibit III (D) 1e – Apple’s Business Portfolio Analysis using the BCG matrix). However, Macintosh generates 38% of Apple’s FY’06 revenuelxxviii. So the Mac is really a Pet. Apple’s iPod business had 28% market share of all MP3 players in 2005lxxix. It is expected that the MP3 player market will grow from 26.4 million units from 2004 to 700 million units in 2009lxxx. This puts the iPod in the Stars category. According to Steve Jobs, Apple wants to capture 1% of the mobile handset market by 2008. This is a relatively small market share. And the mobile phone market had grown 22.5% from 2005 to 2006lxxxi. Hence, iPhone is in the ‘Question Mark’ category. Although iTunes was originally created to fit into the iPod sales and offer a way to download music legally, iTunes was originally referred to as the “razor-and-blade” model with “variable element (iTunes) serving as the loss leader for profit-driving durable good”lxxxii. However, for iTunes to be profitable, it needs a large number of users of iPod and iPhone. iTunes fits well into the concept of scalability continuum where iTunes content is “Information intensive without labor intensive customization”. Media companies are rushing to offer their content on iTunes and size (in terms if media available) adds to the value of the network. Thus with iTunes, Apple has created a network effect and with more users of iPod and iPhone, iTunes will move from a ‘Question Mark’ to a Cash Cow.

III (D) 2a: Business Level – Define the generic business level strategy for each business

Apple’s business level strategy is Broad Differentiation. Apple’s goal is to be a “value leader, not price leaderlxxxiii” for “students, educators, creative professionals, businesses, government agencies, and consumers”lxxxiv. Apple can only provide value leadership through product differentiation. Although Apple has been trying to set Macintosh’s business level strategy to Broad Differentiation, it has traditionally been sold to mainly students and creative professional, which realistically put Macintosh’s business level strategy to be Focused Differentiation. The iPod and music related businesses are truly a Broad Differentiation business level strategy. By offering iTunes to be available on both Macintosh and Window PC, the iPod is usable by more diverse masses. The simple design of iPod, and easy access to large list of on-line music and other iTunes media content such as videos, audiobooks, TV shows truly differentiates the iPod from other MP3 players. The iPhone is intent to replicate the success of iPod and also address the concern that handsets with integrated MP3 player are eating away the market share of iPod and iTunes.



III (D) 2b: Business Level – Fit between business level and corporate level strategy

Apple’s strategy is to be 2nd to market and focus on enhancing the “user experience” of the products. Apple single mindedly focuses building easy-to-use products such as the MAC, iPod and now the iPhone. Apple’s fit between business level and corporate level strategy can be classified as a “Simple Consistency” fit.



III (D) 2c: Business Level – Change in business level strategy based on strategic move

Although Apple intends the iPhone to be a ‘Focused Differentiation’ product with its high price point and catering to users who want to have a converged device for the iPod, handset and internet communicator, initially, the iPhone is restricted to a limited group of users. The limitations are price and service provider. iPhone is relatively expensive compared to currently available handsets, and will be only with Cingular service. Apple may imitate its strategy of iPod and move from focused to broad differentiation with its iPhone offering as mainstream consumers start gaining interest in the product. Since Apple is defining a new customer segment in the consumer space of “consumer smartphones”, it will be at an added advantage if it quickly moves the iPhone from focused differentiation to broad differentiation and starts subsidizing the iPhone early on to gain market share in an already competitive handset industry.



III (D) 3a: Resources & Capabilities – Analyze to determine V-P, Value & cost drivers, etc.

Please see earlier section II (D) 3h for Apple’s value & cost drivers, etc.


III (D) 3b: Resources & Capabilities – How V-C will change based on strategic move

Although an iSuppli analyst estimates that 4GB iPhone would cost $246lxxxv, it is not clear what the real cost is since Apple has not sold any iPhones to add to its COGS. However, we do know that the 4GB iPhone will be sold for $499. According to Steve Jobs, today’s users have to buy an iPod and smartphone to get close to the features of iPhone. A 4GB iPod costs consumers $199, and an average smartphone with 2 year contract costs $299lxxxvi. So, Apple is pricing 4GB iPhone at $499 with 2 year contract. However, iPhone provides more value than a iPod and smartphone combined.


iPhone Values: Please see exhibit III (D) 3b – Part A


With the additional features and ease of use, iPhone definitely increases the buyer surplus (V-P).

III (D) 3c: Resources & Capabilities – Value Chain exhibit

Please see Exhibit III (D) 3c – Part A for the Value Chain Analysis for Apple



III (D) 3d: Resources & Capabilities – VRIO Analysis

Please see earlier section Exhibit II (D) 4 – Part A (g)


III (D) 3e: Resources & Capabilities – How is the firm retaining customers?

Traditionally Apple has retained its customers through a cult-like following. However, with the introduction of iPod, their customer segment has expanded rapidly outside of their cult followers. Apple is able to retain this new segment of customers through its excellent “human engineered” products and after-sale support. Apple seems to be able to retain customers through its excellent user interfaces. However, this is impeded by the relatively higher price of its products. Take the Macintosh computer for example. For a relatively similar performing computer, a consumer will pick a Windows PC. However, if the consumer had a chance to really use a Macintosh extensively, the superior user experience for would compel the consumer to stay with the Macintosh in spite of its higher cost. Therefore, to entice users to use the Macintosh, Apple focuses on educational institutes. Apple either donates or sells to educational institutes, where future computer users get their first exposure to computer. This builds on their positive experiences and promotes usage of Apple products. Starting with the iPod, Apple has also well understood its product life cycle and has continuously innovated its product lines to cater to a wider segment of customers.



III (D) 3f: Resources & Capabilities – Apply frameworks from other classes

Apple focuses on value-driven product development, rather than price leadership. Apple closely watches unmet market needs in terms of usability of devices and develops products to make complex tasks simple. It then charges a premium for these products and usually is successful at it, due to the convenience factor of its products as compared to the substitutes. Apple develops consumer products which compete on basis of their form and possession factors in terms of sources of utility framework. For example with the iPod, Apple introduced a slim version of a music player with lots of disk space and an easy-to-use interface. It soon became a fashion accessory to carry around when listening music and became a substitute phrase for MP3 players (possession factor). Although with the iPod, Apple started with a push strategy of product positioning, with the iPhone there seem to be more elements of pull than push, with a lot of curiosity driving the pre-launch demand for iPhone. This has happened due to the immense success with the product design of iPod and its mass appeal. Apple is also using analysts, partners, bloggers and its website as a means of promoting its product line and has pre-empted the competitors in the handset market with its innovative design and new features like touch keypad, visual voicemail and wide screen LCD format with its iPhone. It continues to use direct and distribution channels depending upon the product. If the product is sophisticated such as Macintosh computers, the product is sold through Apple Stores in addition to its online store, where there are knowledgeable experts that can demonstrate the value of the Macintosh. If the product is simple like iPod, which does not required technical experts, then they are sold through major retailers, along with its own Apple Stores and online store. Apple has also developed complementary platforms like iTunes for its consumer products like iPod, iPod Video and now iPhone, to provide exclusive content for its products driving their appeal for the end consumer. This also provides an incremental revenue stream for Apple in the long run and helps positions itself as a leading provider of consumer needs in music, video and wireless communication businesses, in terms of devices and content. An analysis of Apple’s strategy using the 4Ps framework shows that it develops products that exploit an unmet market demand, and prices the products based on the value proposition of these devices. Apple typically will price its product higher than competitors with comparable functionalities. This is because Apple believes its human engineering of its products adds additional value. To promote its premium values, Apple’s message from advertisements to its Apple Stores is “simplicity”. Its background for its ads and stores is just plain white. There are no flashy colors or a flashy environment. It is just plain white, which accents on the simplicity of its product solutions.



III (E): Financial Analysis

III (E) 1: Financial Analysis – Analyze performance over past 5 years

Please see section II D 6



III (E) 2: Financial Analysis – Conduct valuation using an alternative technique

Relative Valuation for Apple

Choice of Comparables

Apple, Inc. operates in multiple industries- digital music players (iPod), personal computers (Mac desktops and laptops), music download service (iTunes), Operating Systems (OS X) and with the announcement of iPhone, in the smartphone maker industry as well. Therefore, the following comparables, which are used for Apple’s relative valuation, represent all of these industry sectors-



  • Smartphones- Palm (PALM), Research in Motion (RIM)

  • Digital Music Player- Creative (CREAF), Sandisk (SNDK)

  • Personal Computers- Dell (DELL), Gateway (GTW)

  • Music Download- Napster (NAPS), CNET (CNET)

  • Operating Systems- Microsoft (MSFT)

Estimating Valuation Ratios for the Comparables

We have used four valuation ratios in comparing Apple with the comparable companies: Enterprise value to Sales, Enterprise value to EBITDA, Market value of equity to Book value of equity, and PE (price to earnings per share). Enterprise value is the adjusted market value of the firm, sometimes referred to as the true value of the firm. Enterprise value is obtained by adding debt to the market value and subtracting the cash and cash equivalents. To estimate Apple’s enterprise value in comparison with its comparables, we use the ratios Enterprise value to Sales and Enterprise value to EBITDA. The relationship between market value of equity to book value of equity is often used as a measure of how over or undervalued a stock is. The ratio of price to earnings per share (PE ratio) is mostly used to compare different companies to see how expensive they are as compared to their comparables. In estimating Apple’s market value, we use the ratios market value to book value and price to earnings per share. We have used Yahoo finance to obtain values for computing the valuation ratios (see Exhibit 2). The trailing twelve months data is used for sales, EBITDA and book value. Most recent quarter data is used for shares outstanding, debt, cash and cash equivalents.



Estimation of Enterprise Value and Equity Value for Apple

The enterprise value and equity value for Apple are calculated as follows: For each set of ratios determined for the comparables in Exhibit III (E) 2, the average is computed. This average value is then multiplied with the value of the denominator of the ratio for Apple, to compute the value of the numerator of the ratio.



Enterprise Value

The average for the ratio of Enterprise Value/Sales is multiplied with the Sales for Apple to estimate the Enterprise Value for Apple. Similarly, another value of Enterprise Value for Apple is calculated by using the average of the ratio Enterprise Value/EBITDA for the comparables and multiplying it with the EBITDA for Apple. The Enterprise Value of Apple is computed as the average of these two values.



Equity Value

The average of the ratio Market Value/Book Value for the comparables is multiplied with the Book Value for Apple to determine one measurement of the Equity Value for Apple. The average of the Price/Earnings (PE) ratio for the comparables is multiplied with the earnings per Share (EPS) to obtain an estimate of the PE ratio for Apple, which in turn in multiplied with the number of shares outstanding for Apple to derive the second measure of Equity Value for Apple. The average of these two values is determined to be the Equity Value for Apple.



Adjustments

The section ‘Adjustments’ of Exhibit III (E) 2 shows the median metrics for Revenue Growth, Projected EPS Growth (for 2007 and 2008) and Operating Margin for the comparables, along with the percentage by which these measures for comparables differ from those for Apple. We notice that, relative to the median for comparables, Apple exceeds the revenue growth and operating margin growth but trails in EPS growth. Subjective adjustments of 5%, -5%, -5% and 5% respectively are applied to these measures to arrive at a net adjustment of 0%.



Final Values for Enterprise Value and Equity Value for Apple

The Enterprise Value and the Equity Value for Apple computed above are increased by the adjustment factor of 5% derived in the previous section, to determine the adjusted estimates of these values for Apple. These computations are depicted in the table below.



VALUATION

BY COMPARABLES

ADJUSTMENT

ADJUSTED VALUATION

ENTERPRISE VALUE

$ 62,762 M

0%

$ 62,762 M

EQUITY VALUE

$ 62,130 M

0%

$ 62,130 M

Please see Exhibit III (E) 2 for detailed explanation of the comparable analysis



III (E) 3: Financial Analysis – Scenario Analysis (Exhibit II (D) 6 – Apple’s valuation using scenario analysis)

We used EVALlxxxvii to value Apple Inc. using DCF valuation under the following scenarios. The rationale for choosing the scenarios is given below. (Please see Exhibits II (D) 6, a-g for the scenarios below)



  1. Apple achieves a realistic goal of meeting 1% of overall handset market share (10 million units), corresponding iTunes sales go up and high end iPod sales are cannibalized - We selected this scenario as the base case scenario taking Steve Jobs key note speech as reference. In this scenario we assumed that Apple gets 1% market share in 2008 and 7% market share by 2015.

  2. Apple does not introduce iPhone - Here we have assumed a scenario where Apple does not introduce iPhone and iPod sales are cannibalized since cell phones are coming up with integrated MP3 players.

  3. Apple introduces iPhone and it is an exceptional success - In this scenario we assumed that Apple is successful in creating the niche market for consumer smartphones and that Apple can realize market share of 2% by 2008 and 14% by 2015

  4. Apple introduces iPhone and it does not live up to the hype created - In this scenario we assume that Apple’s iPhone does not live up to the consumer expectations from Apple and that the product is a failure either in terms of price or in terms of usability. In this scenario Apple gets only 0.4% of market share by end of 2008 and 1.5% market share by 2015

  5. Apple introduces iPhone but fails to add content to iTunes - Although iTunes incurs significant cost for Apple with majority of revenues going to music companies and credit card processing, iTunes will be profitable if there are large number of users on iTunes. Currently Apple’s revenues from iTunes are increasing in the order of 100%. If Apple fails to add content to iTunes, not only will it lose revenues (since scale drives revenues) but number of users of iPod and iPhone will reduce thereby failing to add new subscribers. For simplicity of the model, we have left the market share assumption as 1% by 2008 and 7% by 2015.

  6. Apple introduces iPhone but iPhone is commoditized - Apple commoditize iPhone from 2008 onwards and the average selling price with 2 year contract with Cingular is $299. This is a scenario if Cingular is successful in negotiating with Apple to reduce the price for new subscribers in order to gain more subscribers from rivals such as Verizon and T-Mobile.

  7. Apple introduces iPhone but fails to keep its COGS in control - In this scenario we have assumed that COGS increases tremendously due to processing fee while providing content on iTunes. COGS has been maintained at the current rate of 70% throughout the forecast horizon and beyond.

The summary of assumptions made for coming up with DCF valuation is given in Exhibit III (E) 3b. Weighted Average Cost of Capital (WACC): Broadly speaking, a firm uses either debt or equity to finance its assets. WACC is the average of the costs of these two sources of financing, each of which is weighted based on its respective proportion. WACC can be considered as the overall required return on the firm as a whole.

WACC = Re * E/V + Rd * D/V * (1 - T)

Cost of Equity: “A firm's cost of equity represents the compensation that the market demands in exchange for owning the asset and bearing the risk of ownership” lxxxviii. Cost of Equity is calculated using the Capital Asset Pricing Model (CAPM). Per the CAPM,

Cost of Equity = Risk-Free rate + Beta x (Market Risk Premium)

ke = rf + β*(rm – rf)

Computing Cost of Equity


Risk Free Ratelxxxix

rf

5.44%

Market Premiumxc

rm – rf

7.17%

Betaxci

β

1.4

Cost of Equity

ke = rf + β*(rm – rf)

15.48%

The WACC is taken as Cost of Equity since Apple Inc. has zero debt and we anticipate that Apple will continue to follow the strategy of having no debt in its books. Apple Inc does have some operating leases which can potentially be classified as long term debt and total minimum lease payments for the next five years and thereafter is given as $1154 millionxcii. Even if we assumed a conservative number of 5% as cost of debt, given the operating lease is $1154 million and market cap for Apple Inc. is 77 Billion, it has a very minor impact on the WACC. (WACC changes to 15.32% from 15.48% if we assume Debt). So all the valuations in different scenarios, we have used cost of equity as the WACC (15.48%).



The valuation of Apple under these various scenarios is given below


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