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I have to admit, the iPod has been one of those devices that has fooled me from the start. I never thought anyone would buy a $400 portable music player, and before you laugh at me, remember how you felt the day it came out. If you bought an iPod within the first few weeks of it being released (or at least would have if it was PC-compatible), you’re off the hook. If not, you were skeptical like the rest of the world.<\/p>\n
Oh how times have changed since then. iPod sales have far surpassed everyone’s expectations \u00e2\u20ac\u201d including probably some people at Apple \u00e2\u20ac\u201d and by the end of 2005, the device could see a market share of over 80%. Possibly well over<\/em> 80%. An entire book could be written on the rise of the iPod, and in some senses, an entire book already has<\/a>.<\/p>\n But I don’t want to get into any of that. It’s a huge hit. Bravo Apple. You are shaking up the world again… in a great, great way.<\/p>\n What I want to talk about is how this game will play out. How the rules will change when Microsoft puts both feet in the water. How sales will be affected when consumer tastes change. How new devices and new technologies will help, hurt, or kill the iPod. And most importantly, how Apple may attempt to defend its newfound position of power with a diversification strategy. The most shocking thing about Apple’s latest quarterly financial report is the raw amount of revenue brought in by the iPod as a percentage of the company’s total revenue. iPod revenue came at $1.2 billion while total revenue was $3.49 billion… if you subtract the iPod’s share, revenue comes out to $2.29 billion, meaning the addition of the iPod to Apple’s lineup essential grew the company’s top-line by 52%! That is huge. What’s even huger is what happened to the bottom-line. Due to off-the-charts iPod sales, Apple’s profit went from $63 million in the same quarter last year to $295 million in this quarter. This was particularly shocking to analysts (and myself) because it is generally thought that the iPod is one of Apple’s lower margin products. After running the numbers in my previous post<\/a>, however, it appears that that has dramatically changed. A reliable inside source has also confirmed that suspicion and informed me that iPod margins are quite healthy and have risen by at least 30% since the introduction of the original iPod. This, of course, is huge for Apple as they appear to have ramped up production enough to get much better deals on parts, labor, and everything else associated with the production of iPods. Additionally, since a lot of the R&D for the iPod occurred during the initial introduction of it, those costs are no longer part of part of the equation. Yes, there’s still R&D going on, but Apple has clearly hit the “margin sweet-spot” in this last quarter of sales.<\/p>\n Another interesting thing about this dramatic change in product mix is that given how poorly PowerMacs will be selling in the future (as compared to iMacs and Mac Minis), we should see the average margin of Apple’s CPUs diminishing below that of the iPod. I am a professional designer and I’d never buy a PowerMac again. It’s not a bad computer at all, but Apple has created such a powerful machine in the 20″ iMac that I really have no reason for more than that. If you edit video for a living, fine, buy a PowerMac, but for the majority of even Apple’s professional user base, I reckon the consumer machines are just fine. So what Apple now has is a situation where their high-margin product (the iPod) is supposed to convert you over to their low-margin product (the Mac). Who would have thunk it.<\/p>\n It’s a strange situation for sure, but it will not last. The fact is that the margins (and sales) Apple is enjoying on iPods right now are due to lack of competition in the space. Yes we know all there are a handful of other MP3 player manufacturers out there, but none have created the total experience that Apple has created. Apple also has not yet even begun to feel the Microsoft effect in this segment. That should change as well.<\/p>\n So let’s examine some threats facing the iPod over the next couple of years.<\/p>\n Love them or hate them, you have to respect Microsoft’s power to radically affect any sector of the tech industry. They are the most powerful company in the world today and more powerful, on a world scale, than most governments. They are also fiendishly good at spotting innovation and bending it in their own favor.<\/p>\n So what has Microsoft done to head off the iPod power surge? To no one’s surprise, it’s a software-based attack. Although Microsoft profits from hardware such as mice and keyboards, they’ve chosen (so far) to let hundreds of other companies build the players while they build the platform. Microsoft could easily build their own player, so let it be understood that if they don’t, they are betting that it is not a good idea for the long-term. They could even afford to build a player knowing<\/em> it wasn’t a good idea for the long-term, merely to head off Apple’s momentum right now. But they’re not… which means they don’t think they need to.<\/p>\n Instead, Microsoft’s plan revolves around the Windows Media Player, Janus DRM, and what’s known as the “Plays for Sure” initiative.<\/p>\n Many Mac users (and even Windows users) remember the Windows Media Player as a clunky, crash-prone, bloated piece of software which rarely acts as it is supposed to. Times, however, have changed, and the Windows Media Player has undergone more improvements than Quicktime and Real combined over the last few years. It’s nice looking now. It doesn’t crash as much. Its API is much<\/em> more robust than either Real’s or Quicktime’s. And most importantly, the WMV 9 video codec, at web bitrates, now looks better than Quicktime’s or Real’s. So after years of playing catch-up, Microsoft’s media player is now on par or better than the competition’s in many significant ways.<\/p>\n One of the ways the Windows Media Player is ahead is in comprehensive DRM. Apple uses the AAC format wrapped in its own FairPlay DRM and that’s great for music… but what about video? I can distribute a DRM’d audio or video file with all sorts of customized rights management on it if I encode with WMA\/WMV. Before you shake your head and start screaming about how DRM is evil, realize that it is a fact of life and it likely always will be. It’s the only reason you can even buy music or rent video online, and Microsoft is thinking big-picture with it. Any major movie studio can distribute a full-screen, full-length, high-quality DRM’d movie right now in WMV format and it’s small enough to fit on an SD card. Apple is nowhere to be found in this market right now, and unless they’ve got another iTunes-like coup in their pocket with the major movie studios, Microsoft will likely own this space within a year or two.<\/p>\n But Janus goes beyond just the Windows Media Player. It is a set of requirements that device manufacturers must adhere to in order to maintain in their role in the Microsoft ecosystem. For instance, every Janus-compatible device must have a secure clock. A secure clock ensures that the date on the device can’t be tampered with in order to circumvent DRM time schedules. Furthermore, Janus-compatible devices must follow the Windows Media API exactly how Microsoft prescribes it. This means, essentially, that the device is heavily biased towards using the Windows Media Player as the sole conduit to the computer. The end result? All commerce goes through Microsoft.<\/p>\n The third prong in the Microsoft attack is the “Plays for Sure” initiative. “Plays for Sure” is not really any different than the concept of Windows. If you buy software which is Windows-compatible, it will work on any computer which runs Windows. If you buy music labeled “Plays for Sure”, it will work on any “Plays for Sure” endorsed device. So you can already see the value in device manufacturers getting that endorsement.<\/p>\n With regard to the current state of the music market, the “Plays for Sure” initiative really doesn’t mean anything yet. Most consumers will say “If it doesn’t play on my iPod, it doesn’t play for sure”. What happens when Dell starts giving away improved music players with their computers though? What happens when non-Apple music players start doing more things like playing video and making phone calls? Once enough of these Microsoft-endorsed devices make their way into the market, “Plays for Sure” will start to matter a lot.<\/p>\n So, enough about Microsoft.<\/p>\n I was delighted at the release of the iPod Shuffle because it is the first iPod that I feel should not be integrated with a phone. I listen to all my music on a Treo 600 phone and the regular iPods give me little advantage over this besides a slightly nicer interface and better syncing. I tend to listen to music without touching the interface much so that part doesn’t bother me, and the syncing just takes a little longer with the lack of iTunes but I’m okay with that too. Besides that, the Treo kills the iPod in almost every other category. I can make calls. I can check e-mail. I can use Bloglines. I have unlimited capacity via SD cards. I can take pictures and movies. I have much better battery life. The list goes on and on.<\/p>\n While the cellphone is the going to be the primary music player of most people within a few years, the iPod Shuffle fills a slot the cellphone never will: the ultra-tiny, wearable device. I need my cellphone to have a certain amount of bulk in order to carry out all of the complex interactions I have with it, but I just need a wearable iPod to be as small as possible, whatever the sacrifice in interface.<\/p>\n The key here is that no one wants to carry two cellphone-sized devices around. Given that people will always have a cellphone, there are only two things that Apple can do: build their own cellphone and keep making the iPod Shuffle smaller. The cellphone will be the primary music-playing device with either a hard drive or a high capacity SD card, and the Shuffle will be the device you take with you only on the rare occasions when you don’t have your phone (usually during exercise or when traveling out of the country).<\/p>\n Some people question whether or not Apple wants to be in the cellphone business, but I think the question is not if<\/em> they want to make a cellphone but rather how they can negotiate the complicated landscape of cell carriers whilst turning a profit. Russell Beattie<\/a> put the subject best when he said:<\/p>\n “Steve Jobs has a mobile phone. I’m not sure which mobile phone it is, but he’s definltely got one. And he hates it. He curses at it every day. He hates it like he hated the original IBM PC. He hates how hard it is to add contacts and make calls and he cringes at the web experience and the Java games, if he’s even bothered to try them. He holds it in his hand during long trips and admires some things about it, but knows he could do it better<\/em>.”<\/p><\/blockquote>\n Palm has already proven that you can make a high-end device like the Treo 600\/650, sign deals with all carriers to support it, and turn a healthy profit in the process, so there is no reason to think Apple can’t do the same. In fact, the Apple brand has so much cachet right now that I would bet at least one carrier would bend over backwards to do a comprehensive deal with Apple.<\/p>\n And then there’s the ultimate end-around: Wi-Max. Robert Cringley wrote in an article several weeks ago<\/a> that Walmart or McDonald’s could cover almost as much of the country with Wi-Max as any cellphone carrier covers with GSM\/CDMA in a pretty short amount of time. An antenna on the roof of every store, a management system to gate access, and you’ve just created a next generation data and voice network. Is Apple watching this space for an entry point? Maybe.<\/p>\n
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\nLet’s start with a few things learned from Apple’s last SEC filing.<\/p>\nJust the facts<\/h3>\n
The Microsoft factor<\/h3>\n
The changing role of the device<\/h3>\n
Accounting for taste<\/h3>\n