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'98 Year In Review
December 17, 1998

Winner #1 -- Apple

by Louis Corrigan (TMF Seymor)
Up 155.7% as of 12/15/98

When Apple co-founder Steve Jobs returned to the helm of the maverick computer maker in the summer of 1997, the Mac faithful cheered. The stock briefly popped from under $13 to nearly $30. Then reality set in and the stock slid back to the $13 mark.

The company's market share had been eroding for years. It slipped again from 5.7% worldwide in 1996 to just 3.6% in 1997, with that number dropping to 2.6% in the December quarter. Its U.S. share dropped from 7.4% in '96 to 4.6% in '97 and 3.3% in the December period. This downward spiral resulted from the successful Wintel partnership that provided more user-friendly, Windows-based PCs that sapped Apple of its main competitive advantage. In response, Apple looked like a deer caught in the headlights: confused and scared.

The cockiness that had been the Mac-meister's trademark turned into denial and then simply despair. Morale was faltering; leading players were jumping ship. The place was a shambles. The company's product line was bloated and unappealing on a price/performance basis. In a consumer market moving below the $1000 price point, Mac loyalists were lucky to pay $1,500 for a slow, closeout model. Its famed marketing department had little to crow about. Its operations were disorganized, with too much inventory and not enough of what was selling, and too many units doing their own thing.

Meanwhile, the company's late move to license clones was backfiring as the clone-makers were stealing Apple's share of a contracting market. Also, Apple had long ignored many of its key software partners. As a result, those partners were beginning to back off from the Mac OS at a time when Apple was asking them to totally rewrite their software for a new Mac operating system called Rhapsody. The company was losing millions of dollars, and for good reason. As Jobs recently told Fortune in a fascinating interview, the situation was "[m]uch worse than I could imagine."

What a difference a year makes. In 1998, Apple's stock price has tripled thanks to a dramatic turnaround that Jobs has produced through a series of material and spiritual transformations. On the one hand, he quickly made a lot of tough decisions, including locking down continued software support from onetime arch-rival Microsoft (Nasdaq: MSFT) in what some loyalists considered a heretical move. Jobs also completely refocused the company on its core markets, beginning with the high-profit business market. On the other hand, he's used his considerable personal contacts and charisma to reinvigorate the company's culture. In short, he's made everyone believe that Apple will now survive. And nearly by fiat, it has. Since Jobs arrived, Apple has...

-- Put together a strong board of directors (including Oracle (Nasdaq: ORCL) Chair Larry Ellison) who are being paid only in options. For years, Apple's board had ineptly watched as the company fell apart.

-- Killed its too-little-too-late cloning strategy.

-- Scored much-needed support (in every sense) from Microsoft in the form of $150 million in cash plus a Mac-first Office 98 software suite.

-- Backed off Rhapsody, opting instead for simpler, more customer and programmer friendly updates of the Mac OS that should make it more stable for enterprise computing. The OS X coming in 1999 is expected to include the best features of Rhapsody but without the headaches. The company is also actively courting software partners, from mainstays like Adobe and Intuit to game makers like Eidos.

-- Killed its money-losing Newton unit as a prelude to potentially extending the Mac operating system into new handheld devices.

-- Reorganized Claris software, returning responsibilities for Apple's operating system to the parent. That was just one example of broader organizational consolidation.

-- Launched a build-to-order strategy and moved toward more standardized PC parts. That helped alleviate the excess inventories/parts shortages that have constantly plagued Apple.

-- Hired former Compaq (NYSE: CPQ) procurement/inventory manager Timothy Cook to serve as senior VP of worldwide operations.

-- Refocused its sales channels by ditching retailers that weren't committed to the Mac and opening up a direct sales channel via its revamped website.

-- Simplified its product offerings by dumping not just the Newton message pad but peripherals such as printers and focusing on performance. Its G3 Mac notebooks, for instance, are the fastest money can buy, addressing the needs of its core business market in publishing and design. That move bought time for the introduction of the cute teal-colored iMac, Apple's first real consumer hit in eons.

-- Highlighted its hot new products with a $100 million "Think Different" ad campaign that took direct aim at the slow-afoot, boring old Wintel beige box.

The iMac's success is indicative of the broader turnaround. The company sold 278,000 units in its first six weeks on the market, beating predictions that the company would sell 100,000 to 150,000 units during its fiscal fourth quarter. The iMac was the top selling desktop in superstores for August and September, according to ZD Market Intelligence. Meanwhile, International Data Corp. says Apple is now growing faster than the overall PC market, moving up to 5% of the U.S. market last quarter from 4.4% a year ago. Thanks to the iMac, 1,000 new software programs and upgrades, many for consumers, are now on the shelves.

But to appreciate the turnaround, you must look at how thoroughly Apple's FY98 results thrashed the analysts' estimates as well as the dismal FY97 numbers. Apple earned $1.95 per share before a one-time gain after losing $8.29 per share last year, including charges.

Qtr.

Sales

Y/Y

EPS*

FY97*

Est.

Gross

FY97

Q1 $1,578.00 -25.9% $0.33 $(0.96) $0.18 22.4% 18.6%
Q2 $1,405.00 -12.2% $0.38 $(1.42) $0.16 24.8% 18.9%
Q3 $1,402.00 -19.3% $0.50 $(0.44) $0.33 25.7% 20%
Q4 $1,556.00 -3.6% $0.68 $(1.26) $0.49 26.8% 19.8%
*Excludes one-time items.
Sales and Inventory in millions. Units Sold in thousands.

Qtr.

Units

FY97

Inventory

Q1 635 923 $400.00
Q2 650 602 $250.00
Q3 644 698 $129.00
Q4 834 652 $78.00
Inventory in millions. Units Sold in thousands.

Perhaps the most dramatic stat is Apple's shrinking inventories, which suggest it's finally got its operations cooking. The company finished Q4 with six days of inventory, less than the eight days worth reported by industry leader Dell (Nasdaq: DELL). Such stellar asset management has pushed Apple's cash hoard to $2.3 billion from $1.46 billion a year ago. Net of $954 million in debt, Apple has nearly $7.82 per share in cash.

Analysts expect Apple to earn about $2.40 per share for the year ending in September (range $2.00 to $2.90) and $2.74 (range $1.80 to $3.15) for the following year. It's not clear what tax assumptions are worked into those estimates. Apple's FY98 numbers benefited from a 6.1% tax rate (taxed at 35%, the reported $2.10 in total EPS would have been $1.24). While the iMac will cut into gross margins, Apple will start showing year-over-year revenue gains in the current quarter. Net of cash and debt, the stock trades at just 10 times the FY99 estimate.

With the most dramatic stage of the turnaround completed, investors have started to worry about Apple's long-term prospects for growth. Some have also highlighted PC Data's research showing that Apple's year-over-year unit growth has dropped after the iMac's hot intro from 65% in September to just 13% in October. Skeptics insist that the iMac at $1,299 is still too expensive as a consumer model and that's why Apple has introduced a novel financing program that will get you an iMac for just $29.99 per month over 67 months (total payment $1,992 based on 14.9% annual interest rate). Rumors have floated that Apple will drop the iMac's price to $999 to spur sluggish sales.

Yet, Apple still seems to have momentum, and the numbers look appealing for its key market segments. Apple reports that it has an installed base of 10 million consumers (17% market share), 6 million education users (44% share), and 6 million business users in the publishing/design segment (36% share). Of all new computers shipped, however, Apple is getting just 3% of the consumer market, 25% of the education market, and 27% of its niche business segment. With a total of just 2.76 million units shipped last year (not all of which were G3s or iMacs), Apple still has plenty of room to grow by selling to folks who had held off on a Mac upgrade, recapturing customers who have defected to Wintel and driving new sales among first-time consumer purchasers.

Crucially, market research conducted by Audits & Surveys found that 29.4% of iMac customers are buying their first computer. So the iMac is already reaching brand new consumers. Equally important, about 12.5% of iMac buyers are Wintel converts. Extraordinary!

While many had speculated that Apple would attempt to leverage its brand into some hybrid Internet/DVD type consumer electronics device, Jobs makes it quite clear in the Fortune interview that he plans to keep Apple focused on computers but to push for greater consumer appeal. "The whole strategy for Apple now is, if you will, to be the Sony of the computer business." Or as he says later, "[T]he computer revolution is still in its early stages. There's a lot of room for doing new and exciting things with the same basic product."

Jobs had tried to buy 3Com's (Nasdaq: COMS) PalmPilot but was rebuffed. Now, as Jobs' buddy Larry Ellison told Fortune, Apple will build its own "Internet information appliances with a Macintosh foundation." These devices might include palm computers or laptops selling for just a few hundred dollars. Part of this strategy involves exploiting Sun Microsystems' (Nasdaq: SUNW) Java.

As Jobs told Fortune, "If we have a fantastic Internet and Java platform that also happens to run core productivity applications like Microsoft Office, we've got something pretty interesting." Apple's control of the second most popular computer operating system during a period when the Internet seems to be constantly changing the competitive landscape means that it's perhaps uniquely positioned to revitalize the whole PC market in ways that go beyond mere innovative styling.

In the near term, Apple's stock depends on execution and iMac demand. Longer term, it depends on Jobs' ability to take the extraordinary momentum created over the last 18 months and use it to regain lost market share among Apple's core segments while finding new ways to play to Apple's competitive strengths. The fact that Apple remains the best candidate to become the Sony of the computer business speaks volumes about why the company remains an industry player with vast market opportunity despite having apparently lost the PC wars years ago.

Apple Company Information:
Trades on Nasdaq under symbol AAPL
Apple's Web Site (www.apple.com)
Current Quote
Apple's Chart

Other Related Apple Links:
Apple Message Board
How About Them Apples? -- Fool on the Hill, 8/11/98
Apple Polishes Its Image -- Fool Plate Special, 7/16/98
Daily Double -- 6/8/98
Apple's Fruitful Earnings -- Fool Plate Special, 4/16/98
Dueling Fools, 4/1/98
The State of Apple -- Fool on the Hill, 3/30/98


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