Is Apple Leaving Money on the Table? Part Two

Mmmm. Apple Flavored Money.

In Part One of this series on Apple, Inc.’s earnings potential, we looked into how Apple was playing in the multi-billion dollar home theater business. Consumer Electronics (not including laptop and desktop computers) is a massive multi-billion dollar a year industry. Apple, of course, made a splash with the iPod and iPhone product lines, but it is conspicuously underplaying its potential role in the living room with the underpowered Apple TV.

And yesterday, Apple delivered better than expected earnings of $3.38 Billion on revenue of $15.68 Billion for their first quarter of FY2010 which ended on December 26 (their financial year is about 3 months and 5 days ahead of the calendar year). “If you annualize our quarterly revenue, it’s surprising that Apple is now a $50+ billion company,” said Steve Jobs, Apple’s CEO. It’s kind of a stretch to annualize the Holiday shopping quarter. But if does that keeps up, Apple will soon crack the top 10% of the Fortune 500. They’d be even higher if the Fortune 500 were ranked on earnings instead of revenues.

It’s wonderful news for Apple shareholders. But, I believe it could be even better – perhaps $1 Billion better with very little effort and almost no R&D. So in this part, we’ll take a look at the long forgotten and once failed tactic of licensing the Mac OS to clone manufacturers.

The first cloning attempt

In 1995, under the direction of then CEO Michael Spindler, Apple licensed the Mac OS 7 operating system and Macintosh ROM code to independent hardware makers in an attempt to increase the market share of the Mac OS. The first and largest manufacturer of Mac Clones was Power Computing Corporation, which sold their products exclusively through mail order. Other clone makers included UMAX, Motorola, and Tatung. It ended in a spectacular mess.

While the Power Computing Corporation was financially successful – selling over $100 Million in its first year of sales – much of that success was believed to come at the expense of Apple. Instead of expanding the Mac market to new customers, Power Computing and other cloners siphoned off customers from Apple. The licensing revenue from the cloners wasn’t enough to offset lost hardware profits. Apple’s fortunes sank precipitously. BusinessWeek, The Wall Street Journal, and other media outlets starting writing obituaries for Apple.

Sensing doom, Michael Spindler tried to sell Apple to Sun Microsystems (which was kicking ass at the time as “The Dot in Dot Com”). Before the sale could be completed, Spindler was ousted and Gil Amelio became the CEO for a famous 500 days. During Amelio’s 500 days he undertook a massive and expensive, but needed restructuring of Apple. And he began talk within Apple to unwind the clone business.

As the clone activity was going on, Apple was running into serious delays while developing their desperately needed next generation operating system  - nicknamed Copeland, which would have been given the moniker Mac OS 8. Deciding that the Copeland project was doomed, Apple started looking to acquire a new operating system. After having past up an offer to purchase the BeOS from Be, Inc. (a company founded by Apple alumni Jean-Louis Gassée), Apple found Steve Jobs’s NeXT. Jobs came in as an advisor and on Gil Amelio’s 500th day forced Amelio out and took control of Apple. In 1997, Jobs then proceeded to terminate all Mac OS licensees and buy Power Computing out for $100 Million. Apple famously then proceeded to try and break into the low end computing market formerly ceded to clone makers with the popular iMac – the computer that single handedly saved Apple.

Fast forward to today

Apple is making tons of money. Naysayer Michael Dell – who once said Apple should close shop and liquidate – is experiencing problems of his own with his namesake company. Dell still makes good money, but Wall Street isn’t kind to companies whose earnings are declining. As such, with a market capitalization of $26.57 Billion, it’s value is only 1/7 that of Apple’s.

If the rumored Apple tablet to be announced tomorrow lives up to its expectations, then Apple will have found yet another way to grow its earnings though a new market segment. Of course, it’s open to debate as to whether there’s really a large consumer demand for tablet computers or if a tablet can create a new market segment with no cannibalism against Apple’s notebook computer line. That all depends on the tablet’s design. Knowing Apple’s desire to surprise, we can expect that an Apple tablet will set itself apart from existing tablets on the market from Lenovo, Toshiba, and other’s which are so far just notebook alternatives.

But I digress, the Apple tablet is a topic which we’ll analyze after it is announced.

Anyway, today Apple is the sole manufacturer of computers that run the Mac OS X operating system (and iPhone OS, which itself is a variation of Mac OS X). There are no clones. For a brief while there were the unauthorized clones from Psystar Corp., but the courts have shut that down for now.

But is Apple missing out on accretive revenue? I argue, “Yes.” And I think it can be done in a way that avoids the problems Apple experienced in the 1990′s.

Where’s the low end?

When the iMac first came out, its goal was to provide a low cost, entry level Macintosh that could compete against low priced Wintel PC’s. At that time, the average PC price was edging below $1300. Low end computers, comprising 30% of the market were heading under the $1,000 mark. Apple went to the average with the flashy iMac, pricing it at $1299. Within a year, the base iMac hit the $999 mark. After the iMac moved to use LCD flat panel monitors, it’s price rose, but Apple introduced the education oriented eMac which maintained the $999 baseline.

However, as we entered the 21st century, average PC prices continued to decline. However, the baseline iMac and eMac, didn’t keep pace with the decline. In response, Apple introduced the Mac Mini in January 2005 starting at $499 (now $599). The Mac Mini proved to be popular, but it wasn’t a complete system. It was sold as “BYOMKM” – “Bring Your Own Monitor Keyboard Mouse”. The target audience was initially PC users wanting to replace their PC with a Mac – just plug in the old monitor, keyboard, and mouse. So, not really a low end computer since purchasing a bundle of low cost third party accessories would probably add about $250 to that cost.

Let’s sum that up in present day terms. Money’s tight. You’re heading off to college with the savings you built up mowing lawns and working as a caddy at the local golf course. Take a Mac Mini at $599 ($580 at Amazon). Let’s say it’s about $150 for a reasonable low end monitor. Then add $16 for a a very cheap and crappy keyboard and mouse. That brings the Mac Mini price to about $746.

A Mac is a nice, easy to use and maintain computer. But you need to save money for text books and other college essentials like beer (the campus borders parts of Canada where the drinking age is only 18 ). But let’s see if we can find something cheaper.

Dell’s Inspiron Zino HD, which looks like a Mac Mini knockoff starts at $249 – half the price of the Mac Mini. OK, it doesn’t include WiFi or a dual core 64-bit processor. But we can add those things in as well as a monitor, keyboard, and mouse. So, a fully configured Zino HD with 18.5″ monitor, keyboard, mouse can be had for a total of $579 (Oh, and that includes an HDMI output. And you know how much that means if you read Part One). That’s a $167 difference vs the Mac Mini. You can argue that the price difference is worth it since there are still other technical differences. But if you’re budget is limited, it’s not.

The price disparity becomes even greater on notebook computers. The cheapest MacBook computer is $999 ($955 at Amazon). Head over to Dell and we see notebooks starting at a staggeringly low $299 for the Inspiron Mini 10. For something somewhat comparable you can customize an Inspiron 15 for $579. Again, you’re not getting the same caliber components for the price, but there are some customers that are OK settling for less.

So basically, Apple is missing out on the budget constraint crowd that’s willing to settle for less. But they don’t have to.

Apple clearly wants to avoid the cheaper, low-margin, high-risk market segment. They’ve stated this strategy before in their earnings conference calls. And that’s not a bad idea. It’s paid off. But with the proper licensing agreement they can off-load the risk to companies that are willing to take that risk without risking their high-end market. And by focusing on licensing only, they can turn the low end market into one of high margins.

OK, how? Well, you create a license that restricts the Mac OS to only low end computers. There’s a number of ways to do this.

1. Set a price threshold: The Mac OS may not be offered on systems whose total cost before including a monitor exceeds so many dollars – say $400.
2. Set a CPU limit: The Mac OS may only be offered on systems using a specified list of low end CPUs. As newer and faster CPUs come on the market, they can update that list to include processors that Apple no longer users
3. A system certification program: Perhaps the easiest way to translate into legalese. A company wishing to license the Mac OS must have Apple’s certification for each model that will include the Mac OS as an option. The company will submit to Apple the technical specifications of the base model along with all customizable options. If it looks good, it gets Apple’s blessing. And Apple gets a licensing fee in return.

How much revenue could possibly come in?

Well, let’s do some hypothetical math. Apple sold 3.36 million Macs during Q1 2010. The Gartner Group released preliminary numbers estimating that Apple took 7.5% of the PC market. If that number holds up, then the PC market as a whole was about 44.8 million units for the quarter.

Market research firm NPD provides some even more interesting numbers in a report from mid-2009. In it, NPD estimates that while Apple’s market share is under 10%, it is actually a startlingly high 91% amongst computers costing more than $1,000. For Apple, that basically means every model except the Mac Mini. So, below $1,000 and Apple is probably looking at less than 1% market share. Average selling prices for PC’s are $569 for laptops and $489 for desktops – Apple offers literally nothing at or below the average.

But though cloning they can get into the below average market.

If the 91% number hasn’t changed – most likely Apple’s market share has increased further. That puts the sub-$1,000 at about 41.2 million units.

Interestingly, Microsoft started an ad campaign, dubbed “Laptop Hunters” to challenge Apple’s “I’m a Mac” ads. But Microsoft’s ads seemed to aim low – poking fun at Apple’s prices. Since Microsoft makes their money by selling OS licenses to PC manufacturers on a per unit basis, they probably don’t care too much about average selling prices. So, unlike Apple, they’re more than happy to be the king of the low end. (I wonder if PC manufacturers were as happy to see ads championing PC prices over quality.) We can probably assume that Microsoft launched the ads to try and prevent some of their budget conscious customers from defecting to the Mac.

So let’s say that Apple creates a low-end licensing program. What if they can capture 5% of 41.2 million cheap-o units that were sold in the past quarter. Next let’s say that Apple only charges a low price of $50 for the license. That would translate into about $103 Million in new revenue – and it would be almost all profit since the clone makers are doing all of the work.

Of course, $103 Million at 5% is probably a low ball number. How many times have you heard people say that they want a Mac, but want something cheaper? Low end licensing could get the ball rolling and market share increasing over time. They could very quickly be looking at over $1 Billion in additional profits as that 5% low end share goes to 10% and higher.

The Psystar Saga

Now were does this leave Psystar – the company that tried to sell unauthorized Mac clones? Psystar says they are appealing the ruling that stopped them from selling their product. It’s a long shot, but what if they win? It might just crack the whole market open – including Apple’s bread and butter high-end business. That’d be good for customers, but terrible for Apple shareholders. Perhaps a better option would have been for Apple to take the high road and negotiate a settlement with Psystar giving them a license to sell low-end clones which would only add to Apple’s earnings.