Infotech Innovation

Welcome to Apple World

The company's partners gain brand hipness—but lose a little independence

STEVE JOBS HAD PLENTY of problems to contend with as he sauntered onstage for his first speech after return­ing to the top of Apple in 1997. He faced a shrinking market for his Mac comput­

ers, bloated costs, and a severe short­age of cash. But on that day, Jobs chose to talk to the Mac faithful mostly about another problem: Apple's growing isola­tion. Despite the company's reputation for making the world's finest PCs, very little software or add-on gear worked with the Mac. "Apple lives in an ecosys­tem, and it needs help from other part­

ners," said Jobs. "And it needs to help other partners."

To drive the point home, Jobs then did the unthinkable, inviting arch-nemesis Bill Gates to join him on stage via video-conference to announce details of a deal to forget any patent claims in exchange for $150 million, and ensure that Micro­soft Corp. continued to make Mac-com­patible versions of its ubiquitous Office software.

Today, that Apple Inc. ecosystem has morphed from a sad little high-tech shtetl into a global empire. Once known for de­fining the digital future but never fully capitalizing on it, Apple has been trans­formed into tech's most influential hit-

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Once known for defining the digital future but never fully capitalizir

maker. With Mac sales growing at three times the PC industry rate, more than 200,000 software makers, including gi­ants such as gamemaker Electronic Arts Inc. and fast-growing corporate supplier VMware, have returned to the Mac fold in the past year. Apple's online iTunes Music Store has become the world's third-largest music retailer after Best Buy Co. and Wal-Mart Stores Inc. A cottage industry of iPod accessories continues to blossom into something far more sub­stantial. Consider that by next year, some 70% of new cars will come with iPod connectors built in, and about 100,000 airline seats will have the same.

JOINING THE JOBS CLUB WITH THE JUNE 29 debut of the iPhone, Apple seems poised to extend its reach even further. A new flock of partners, from AT&T Corp. to Salesforce.com Inc., is waiting to jump on the bandwagon for the slick phone/Web browser/music player/camera. Sure, the hype prior to iPhone's launch bordered on ridiculous (Comedy Central's Stephen Colbert joked that the iPhone launch is the second most important event in human history, after the birth of Christ). But phonemakers such as Nokia and Motorola, and carri­ers like Verizon, are waiting nervously to see if Apple can remake the U.S. cellular business by determining what services consumers get and leaving the carriers out of the loop.

As long as Apple stays on its game, leading providers of everything from silicon chips to Hollywood flicks will feel pressure to strike deals to Jobs' liking. Apple can confer brand hipness on its partners. And its ascendence in markets like cell phones and who knows what else in the future—say, Apple-branded TVs—may impose a new focus on more consumer-friendly parts, software, and services. But to be part of the Jobs club, you give up a certain amount of inde­pendence on everything from design to identity to pricing.

In the process, Jobs is upending two decades of conventional wisdom about the nature of competition in digital mar­kets. Since the rise of Microsoft and In­tel's "Wintel" PC standard in the 1980s, the assumption has been that markets would be dominated by those that could set technical standards—say, Microsoft in operating systems or Intel in micropro­cessors—and then benefit as thousands

of others competed to build products on top of that "platform."

But Apple's strategy is far simpler: Focus on making the best product, and rewards will follow. In fact, Apple's new partners are signing up in spite of, rather than because of, Jobs' rules of engage­ment. Apple makes little pretense of building a level playing field, but rou­tinely picks favorites—such as Google for building mapping and video applica­tions for the iPhone. And rather than aim for the most partners, Apple focuses on attracting the best ones. As a result, the

Mac and iPod feel more like a gated, elit­ist community, with Apple keeping close watch over who gets in. "The notion of a platform is a very PC-oriented way of looking at the world," says Silicon Valley financier Roger McNamee. "Consumers just want a great experience. They don't buy platforms."

Consider how Apple changed expec­tations about portable music devices. There were plenty of MP3 players around before the iPod arrived in 2001. Now, if the iPhone works as advertised, it could similarly redefine the mobile-phone experience. As any BlackBerry or Treo owner knows, all of the 25 million smartphones sold last year offer similar capabilities, such as Web browsing and e-mail. But none has captured the heart of the mainstream consumer. And on paper, at least, the iPhone erases myriad frustrations faced by hundreds of mil­lions of phone users—from maddeningly

complex menus, to the inability to find a contact while on a call.

Spin it out a few years, and it's not hard to see why many companies want to be on Apple's side. Visitors to an Apple store can now sign up for an AT&T cellular package. In the future, who is to say they won't also be able to sign up for all the broadband and data services needed to make their Apple products work together, from iMacs to laptops to Apple TV set-top boxes to whatever is next (can you say: "I want my Apple iHomeTheater"?). That would play to Apple's strength—making the complex

TheAppl Ecosysten

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simple. "What you end up with is a kind of Apple archipelago—this cluster of islands in this big digital sea that are great places to hang out," says Paul Saffo of the Insti­tute for the Future.

Of course, Apple's products have to continue to delight—a real question for the iPhone, which doesn't even have a physical keyboard. But if Apple succeeds, it could raise itself and its ecosystem above the cacophony of industry giants now battling to "own" the digital con­sumer. The telephone and cable compa­nies try to take advantage of their control of customers' access to video, data, and voice content. Google Inc. and Yahoo! Inc. want to leverage the fact that they are the online concierge for millions of consumers. Apple comes at it from the device perspective: If it can control the S gadget you use to connect with all those ~ other platforms, it can control what you 2 pay (99<f a song, for example). 5

90 I BusinessWeek I July 9 & 16. 2007

m it, Apple is now tech's most influential hitmaker

There are lots of phone carriers and cable companies, each with fairly similar offerings. Google and Yahoo are pow­erful in their own right, but they can't totally control their destiny since Web users are a click away from using another search engine or portal. For now, though, Apple is head and shoulders above others in making the actual machines you use to pull up Web pages, music, TV shows, movies, and soon, perhaps, phone con­versations. Says David Sanderson, head of Bain & Co.'s global media practice: "We're moving from a distributor-driven

than hurt Mac sales, as some feared, this opened the floodgates on iPod sales by making the device usable by the 98% of computer users who ran Windows. An­other milestone came when the company switched from PowerPC processors made by IBM to Intel's far more popular chips. This made it possible for Macs to run Windows (an important insurance policy to many Mac newbies) and made it far easier for software developers to adapt their programs for Apple's products.

Consider the perspective of one big video-game producer, Electronic Arts.

Apple has the two things suppliers look for: big orders today and momentum. For example, Apple will buy 19% of all the NAND "flash" memory chips (a key component in the iPod Nano and in the iPhone) produced worldwide this year. Now it's making a big bet on touch-screens. And nearly a million software developers are creating programs for Apple devices, up 26% from last year.

Data: Apple Inc.. NPD Group Inc., iSuppli Corp.

c 1 ,-•: S I A $1 billion-plus industry of independently sold iPod accessories has sprung up, everything from toilet-paper-holder docking stations to shoulder-bag boom boxes. Apple says 70% of all 2007 U.S. car models are offering iPod connectivity. It is teaming up with six airlines to let passengers charge iPods and watch video on seat backs. More than 1,000 iPhone products are already being advertised.

Major TV networks, from Warner Bros, to CBS, Fox, and MTV, have sold about 50 shows through Apple's iTunes software in the past two years, for total sales of about $100 million. Also, some 2 million movies have sold in the past year. Apple has sold about 2.5 billion songs from labels including EMI, Universal, and Sony. It sells an estimated 80% of all digital music and ranks as the third-largest seller of music, in any format.

paradigm to a consumer-driven para­digm—and Apple gets consumers."

And not just any consumers, but those who will pay a premium. The Mac is gaining share despite an average price tag of $1,400, nearly twice that of the typical PC. iPod shoppers still paid an average price of $181 in May, 15% above other music players. The iPhone is even more audaciously priced. The $499 base price compares with an average $66 for a regular phone, or $160 for a smartphone such as a BlackBerry or Treo, says NPD Group Inc. analyst Stephen Baker.

THECOMPATABIUTY FACTOR NONE OF THIS WOULD have come about if Jobs hadn't had his epiphany about reaching out beyond the insular world of the Mac. The Office deal was a symbolic first step, but the real wake-up call came with the 2003 decision to do a Windows-compatible version of iTunes. Rather

In the early 1980s, about half of the people working at EA's Redwood City (Calif.) campus were Apple alumni. Yet EA stopped making Mac-compatible games later in the decade, when Apple turned its attention to corporate markets. EA co-founder Bing Gordon recalls his shock when Apple's then-CEO John Scul-ley said in 1987 that "there is is no home computer market." Says Gordon: "They were working so hard to get respect, the last thing they wanted was for people who wore suits to think of the Mac as a toy." Predictably, game sales on the Mac plummeted, making it even less worth­while for EA to make the big investments to adapt its PC games to run on the Mac's unique innards.

But because today's Intel-based Macs don't look much different from any Win­dows PC from EA's perspective, Gordon says it should be cheaper to churn out Mac games than, say, adapting them to

game consoles like the Sony PlayStation or Nintendo Wii. With the Mac rapidly gaining share with younger shoppers, EA has announced plans to release its new Harry Potter game and three other games on the Mac this summer.

Another rarely mentioned advantage is Apple's so-called developer program. Once iPod sales began skyrocketing in 2003, the company worked with makers of portable speakers, music-player cases, and other add-on gadgets. Now Apple is working on the most mobile platform of all. Since BMW first added an optional

iPod connector in the glove compartment of

„,,,. . .^ many of its 2004 mod­els, carmakers includ­ing Chrysler, Ford, and Honda have followed suit. General Motors Corp.'s 2008 Cadillac CTS will come with a center console that fea­tures the iPod's "rotate and click" interface, not only for pulling music off an iPod but also for playing the ra­dio or listening to CDs or satellite radio. "Ifs about getting to your music, not having to learn a new set of tricks to each service," says James Grace, the 27-year-old GM manager

who leads the project.

Apple may be even more aggressive in courting partners for the iPhone. On June 11, it announced that any Web 2.0 program designed to work with Ap­ple's Safari browser would work on the iPhone. That means such popular sites as MySpace, Digg, or Amazon.com will be able to adapt their services to take advan­tage of the device—say, by adding a vir­tual button on their sites so that iPhone users could actually place a phone call with a fellow Netizen, rather than just send an e-mail or instant message.

To be sure, many developers gripe that this approach is a far cry from letting them create applications designed from the ground up to work directly with the iPhone. Thats a privilege Apple has con­ferred on only a few partners, such as Google. But "it's a good first step," says Digg Chairman Jay Adelson, who expects Apple to become more inclusive as time

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goes by. "For now, it's a very strange kind of controlled system—because they have these insanely high bars [for reliability and user experience] that they want to hit."

Many partners won't wait for a formal invite. Despite doubts about the iPhone's usefulness to serious businesspeople, Salesforce.com plans an iPhone version of its sales management software. "Ifs not just about market share, ifs about showing what is possible and what is cool," says CEO Marc Benioff. And more than 150 developers have registered to attend an ad hoc "iPhone Developers Camp" in San Francisco on July 6, to trade ideas and create new applications.

But if the Apple orchard is growing, it is still no Eden. For those partners that make

the cut, Apple enforces a brutal perfection­ism. "The stereotype is that they're this loosey-goosey California company, but nothing could be further from the truth," says Gary Johnson, the former CEO of chrpmaker PortalPlayer Inc., which roared to prosperity by providing the electronic brains of the first generations of iPods. Johnson says that whenever a project fell off track or a part fell short of Apple's needs, its engineers were demanding "root cause analysis" and explanations within 12 hours. "You could pacify other customers by putting 10 engineers on a plane to see them. Not Apple."

'AN UNREASONABLENESS' WORKING WITH APPLE can be exhaust­ing. Johnson says the company almost never issued documents outlining its technical requirements, preferring to keep things oral to avoid a paper trail that might be leaked. And no supplier

was given a full picture of what exactly Apple was working on: Everything was on a "need to know" basis. "There's an unreasonableness," says Johnson. "Ifs as though your entire reason for being is to serve them." Yet he adds he has no hard feelings: "It wasn't a malicious thing. It's almost machine­like. You may have friendships or busi­ness relationships, but they don't really count." Johnson found that out on an April morning in 2006, when he learned that Apple had decided not to use a chip that had been under development for more than a year and that was expected to bring in half of PortalPlayer's sales. The company's stock crashed 50% when Johnson told Wall Street a few days later.

Video-content providers

aren't eager to duplicate the iTunes

experience and sell cheap fuel

for Apple players

Seven months later, it was purchased by Nvidia Corp. for $357 million—half of its peak market cap.

Suppliers of TV shows, movies, and other video content have their own rea­sons for being wary of joining the Apple ecosystem. They know what happened in the music industry. Jobs created a kind of reverse razor-and-blades model with the iPod, where Apple sells lucrative razors (music players) and the studios are stuck selling cheapo blades (music). Holly­wood so far has resisted Jobs' vision for placing movies on the iPod and iPhone. So far, only movies from Walt Disney Co. (where Jobs is the largest individual shareholder) and Paramount Pictures have licensed movies to iTunes. The 52 million TV shows and movies sold so far by Apple amounts to fewer than two videos per iPod.

This makes Apple's newest partner­ship with AT&T for iPhone service all the

more intriguing. Since the iPhone was announced in January, many observers have wondered if Jobs pulled another fast one, using his consumer cred to win unprecedented influence over the $140 billion cellular-phone business. Nor­mally, carriers in the U.S. control how cell-phones are priced and marketed, right down to deciding whether they will turn on capabilites built into the phones, such as wireless music downloading. But thaf s not how Apple rolls. Apple defined the 16 services that are highlighted on its home page, and users sign up for them via iTunes, not on AT&T's homepage or in its stores.

Has AT&T set itself up to be mar­ginalized? The carrier stands to steal subscribers from its rivals; CEO Randall L. Stephenson said on June 19 that of 1.1 million people who had inquired about the iPhone, 40% were not cur­rently signed up with AT&T. But analysts say Apple will earn a luxurious 35% gross margin on each of the $500 devices. AT&T is offering a $59 base plan for phone and data services—roughly $20 less than the cost for other devices. Be­sides taking a bite out of AT&T's margins, this could cause its other handset makers to demand sweeter deals, too.

But the real test will be whether Jobs can change the way consumers think about a phone. This is Apple's first entry into a preexisting mass market, and those other phone manufacturers can't afford to let him rewire things to suit Apple's strengths. Some already have rolled out cheaper products that, if not exactly as capable as iPhone, may be close enough. Will most consumers eventually choose to save money, even at the expense of a bit of elegance? History says they will, according to Harvard Business School professor Clayton M. Christensen: "The world always ends up thanking innova­tors for their cool products—but won't pay for them. There are forces of gravity at work."

Now there's a match-up worth watch­ing: Steve Jobs vs. gravity. •

-WithArikHesseldahl in New York

BusinessWeek .com

ONLINE: A slide show assessing the financial eco­system that's grown up around the iPod and Mac. How the iPhone stacks up against the Treo and BlackBerry. The spread of Apple designers to other industries. An interview with Bruce Tognazzini, Apple's first Human Interface Designer Go to businessweek.com/extras.

TELEVISION: To see the frenzy of consumers buy- u ing iPhones as they are released, watch our weekly a TV show, BusinessWeek Weekend. To see video 8 clips or find your local station and airtime by Zip « Code go to businessweekweekend.com. S

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