D A V I D B . Y O F F I E

9-715-456 R E V : O C T O B E R 2 8 , 2 0 1 5

Professor David B. Yoffie and Research Associate Eric Baldwin prepared this case. This case derives from earlier cases, including: “Apple Inc., 2008,” HBS No. 708-480, by Professor David B. Yoffie and Research Associate Michael Slind, “Apple Computer, 2006,” HBS No. 706-496 by Professor David B. Yoffie and Research Associate Michael Slind, “Apple Inc. in 2010,” HBS No. 710-467 by Professor David B. Yoffie and Research Associate Renee Kim, and “Apple Inc. in 2012,” HBS No. 712-490, by Professor David B. Yoffie and Research Associate Penelope Rossano. This case was developed from published sources. Funding for the development of this case was provided by Harvard Business School and not by the company. Professor Yoffie serves as a director of HTC and Intel. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Copyright © 2015 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to www.hbsp.harvard.edu. This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.

E R I C B A L D W I N

Apple Inc. in 2015

On March 9, 2015, Apple’s CEO, Tim Cook, announced the Apple Watch, his first major strategic initiative following the tragic death of Steve Jobs, his mentor and predecessor. Jobs, of course was a legend: he had changed Apple from a company on the verge of bankruptcy to one of the largest and most profitable companies in the world. Four years later, Cook was trying to demonstrate that he could not only sustain Apple’s achievements in computers, MP3 players, phones, and tablets, but he could also take Apple to the next level.

By almost any measure, Apple’s performance in the prior decade had been stellar. As 2015 opened, Cook had reason to celebrate his own accomplishments. In the final quarter of 2014, Apple posted record profits of $18 billion, the largest quarterly profits in corporate history (see Exhibit 1). Spurred by the release of the iPhone 6, the iPhone shattered sales records, selling 74.5 million units in the 2014 holiday quarter. Sales were particularly robust in China, the world’s largest smartphone market.

The company’s momentum and stock performance was undeniable (see Exhibit 2). But there were also challenges in 2015. Smartphone competition was intense, especially in China, where new low-cost competitors such as Xiaomi were taking the market by storm. iPod sales had been falling for seven straight years. Even though Macintosh sales had grown faster than the industry in recent years, Apple’s share of worldwide PCs remained in single digits. Worse, the iPad had suffered a significant decline in sales, down 22% from Q4 in 2013. With sales of the iPod and iPad slipping, and those of the Mac remaining relatively small, Apple was increasingly dependent on the iPhone, which accounted for 69% of its revenue.1

The announcement of the Apple Watch led many to ponder whether Cook would successfully transition Apple to “his” company, or whether Apple would still live off of Steve Jobs’s legacy? Would the Apple Watch be another home run, similar to the iPhone, or would it become another niche product, like Apple TV? Cook had big shoes to fill, and he had to wonder: Had he made the right strategic moves to deliver on Apple’s daunting ambitions?

This document is authorized for use only by Mingxuan Xu ([email protected]). Copying or posting is an infringement of copyright. Please contact [email protected] or 800-988-0886 for additional copies.

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Apple’s History

Steve Jobs and Steve Wozniak, a pair of 20-something college dropouts, founded Apple Computer on April Fool’s Day, 1976.2 Working out of the Jobs family garage in Los Altos, California, they built a computer circuit board that they named the Apple I. Within several months, they had made 200 units and had taken on a new partner—A.C. “Mike” Markkula Jr., who was instrumental in attracting venture capital as the experienced businessman on the team. Jobs’s mission was to bring an easy-to- use computer to market, which led to the release of the Apple II in April 1978. It sparked a computing revolution that drove the PC industry to $1 billion in annual sales in less than three years.3 Apple quickly became the industry leader, selling more than 100,000 Apple IIs by the end of 1980. In December 1980, Apple launched a successful IPO.

Apple’s competitive position changed fundamentally in 1981 when IBM entered the PC market. The IBM PC, which used Microsoft’s DOS operating system (OS) and a microprocessor (also called a CPU) from Intel, was a relatively “open” system that other producers could clone. Apple, on the other hand, practiced horizontal and vertical integration. It relied on its own proprietary designs and refused to license its software to third parties. IBM PCs not only gained more market share, but also emerged as the new standard for the industry. Apple responded by introducing the Macintosh in 1984. The Mac marked a breakthrough in ease of use, industrial design, and technical elegance. However, the Mac’s slow processor speed and lack of compatible software limited sales. Apple’s net income fell 62% between 1981 and 1984, sending the company into a crisis. Jobs, who was often referred to as the “soul” of the company, was forced out in 1985.4 The boardroom coup left John Sculley, the executive whom Jobs had recruited from Pepsi-Cola, alone at the helm.

The Sculley Years, 1985–1993

Sculley pushed the Mac into new markets, most notably in desktop publishing and education. Apple’s desktop market was driven by its superior software, such as Aldus (later Adobe) PageMaker, and peripherals, such as laser printers. In education, Apple grabbed more than half the market. Apple’s worldwide market share recovered and stabilized at around 8% (see Exhibit 3). By 1990, Apple had $1 billion in cash and was the most profitable PC company in the world.

Apple offered its customers a complete desktop solution, including hardware, software, and peripherals that allowed them to simply “plug-and-play.” Apple also stood out for typically designing its products from scratch, using unique chips, disk drives, and monitors. IBM compatibles narrowed the gap in ease of use in 1990 when Microsoft released Windows 3.0. Still, as one analyst noted, “[T]he majority of IBM and compatible users ‘put up’ with their machines, but Apple’s customers ‘love’ their Macs.”5

Macintosh’s loyal customers allowed Apple to sell its products at a premium price. Top-of-the-line Macs went for as much as $10,000, and gross profit hovered around an enviable 50%. However, as IBM- compatible prices dropped, Macs appeared overpriced by comparison. As the volume leader, IBM compatibles were also attracting the vast majority of new applications. Moreover, Apple’s cost structure was high: Apple devoted 9% of sales to research and development (R&D), compared with 5% at Compaq, and only 1% at many other IBM-clone manufacturers. After taking on the chief technology officer title in 1990, Sculley tried to move Apple into the mainstream by becoming a low-cost producer of computers with mass-market appeal. For instance, the Mac Classic, a $999 computer, was designed to compete head-to-head with low-priced IBM clones.

Sculley also chose to forge an alliance with Apple’s foremost rival, IBM. They worked on two joint ventures, one to create a new PC OS and one aimed at multimedia applications. Apple undertook

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another cooperative project involving Novell and Intel to rework the Mac OS to run on Intel chips that boasted faster processing speed. These projects, coupled with an ambition to bring out new “hit” products every 6 to 12 months, led to a full-scale assault on the PC industry. Yet Apple’s gross margin dropped to 34%, 14 points below the company’s 10-year average. In June 1993, Sculley was replaced by Michael Spindler, the company’s president.

The Spindler and Amelio Years, 1993–1997

Spindler killed the plan to put the Mac OS on Intel chips and announced that Apple would license a handful of companies to make Mac clones. He tried to slash costs, which included cutting 16% of Apple’s workforce, and pushed for international growth. Despite these efforts, Apple lost momentum: a 1995 Computerworld survey found that none of the Windows users would consider buying a Mac, while more than half the Apple users expected to buy an Intel-based PC6 (see Exhibit 4 for shipments of PC microprocessors). Spindler, like his predecessor, had high hopes for a revolutionary OS that would turn around the company’s fate. But at the end of 1995, Apple and IBM parted ways on their joint ventures. After spending more than $500 million, neither side wanted to switch to a new technology.7 Following a $69 million loss in Apple’s first fiscal quarter of 1996, the company appointed another new CEO, Gilbert Amelio, an Apple board member.8 Amelio proclaimed that Apple would return to its premium-price differentiation strategy, but Macintosh sales continued to fall. In December 1996, Amelio announced the acquisition of NeXT Software (founded by Jobs after he left Apple) and plans to develop a new OS based on NeXT. Jobs also returned to Apple as a part-time adviser. Despite more restructuring efforts, Apple lost $1.6 billion under Amelio (see Exhibit 3). At one point, insiders believed that Apple was within 90 days of bankruptcy. To save the company, Jobs became the company’s interim CEO in September 1997.

Steve Jobs and the Apple Turnaround

Jobs moved quickly to reshape Apple. In August 1997, Apple announced that Microsoft would invest $150 million in Apple and make a five-year commitment to develop core products, such as Microsoft Office, for the Mac. Jobs abruptly halted the Macintosh licensing program. Almost 99% of customers who had bought clones were existing Mac users, cannibalizing Apple’s profits.9 Apple’s 15 product lines were slashed to just four categories—desktop and portable Macintoshes, for consumers and professionals. Tim Cook, hired by Jobs in 1998 after a career in operations at Compaq and IBM, was credited with streamlining Apple’s supply chain. In addition, Apple launched a website to set up direct sales for the first time. Internally, Jobs focused on reinvigorating innovation. Apple pared down its inventory significantly and increased its spending on R&D (see Exhibit 5 for PC manufacturers’ key operating measures).

Jobs sought to bring a new culture to Apple. While previous CEOs sought to broaden Apple’s products, Jobs believed deeply in focus. Apple had one of the narrowest product lines of any company of comparable size. Jobs also believed in extreme practices of secrecy, including a “closed door policy” in which key cards accessed only certain areas, and dummy positions for new hires until they could be trusted. Everyone knew that violation of Apple’s culture of confidentiality was grounds for termination.10 Employees reported that working with Jobs was rewarding, but often difficult. Jobs noted that “I don’t think I run roughshod over people, but if something sucks, I tell people to their face.”11 Jobs was especially fanatic about industrial design, simplicity, and product elegance.

This approach led to Jobs’s first real coup—the iMac—introduced in August 1998. The $1,299 all-in- one computer featured colorful translucent cases with a distinctive eggshell design. The iMac also supported “plug-and-play” peripherals, such as printers, that were designed for Windows-based

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machines for the first time. Thanks to the iMac, Apple’s sales outpaced the industry’s average for the first time in years. Following Jobs’s return, Apple posted a $309 million profit in its 1998 fiscal year, reversing the previous year’s $1 billion loss.

Another priority for Jobs was to break away from Apple’s tired, tarnished image. Jobs wanted Apple to be a cultural force. Not coincidentally, perhaps, Jobs retained his position as CEO of Pixar, an animation studio that he had bought in 1986. (Jobs sold Pixar to Walt Disney for $7.4 billion in 2006.) Through multimillion-dollar marketing campaigns such as the successful “Think Different” ads and catchy slogans (“The ultimate all-in-one design,” “It just works”), Apple promoted itself as a hip alternative to other computer brands. Later on, Apple highlighted its computers as the world’s “greenest lineup of notebooks” that were energy efficient and used recyclable materials.12 The goal was to differentiate the Macintosh amid intense competition in the PC industry.

The Personal Computer Industry

While Apple pioneered the first usable “personal” computing devices, it was IBM that brought PCs into the mainstream in the 1980s. But by the early 1990s, a new standard known as “Wintel” (the Windows OS combined with an Intel processor) dominated the industry. Thousands of manufacturers—ranging from Dell Computer to no-name clone makers—built PCs around standard building blocks from Microsoft and Intel. Growth was driven by lower prices and expanding capabilities. The overall industry continued to boom through the early 2000s, propelled by Internet demand and emerging markets such as China. By 2013, emerging markets accounted for nearly 58% of PC shipments.13 Growth in PC shipments started to slow after 2005 and tipped over into a 4% decline in 2012, followed by a drop of 10% in 2013, and 2.1% in 2014. Total PC shipments slipped to 308.7 million in 2014.14

Slowing revenue growth followed the slowdown in volume. Despite PCs that were faster, with more memory and storage, average selling prices (ASPs) declined by a compound annual rate of 8%– 10% per year from the early 1990s through 2005.15 The rate of decline in ASPs lessened between 2006 and 2014 to a compound annual rate of 2%.16 By 2014, the average profit margin for the major PC manufacturers was under 3%.17 The standardization of components led PC makers to cut spending on R&D to between 1% and 3% of revenue (see Exhibit 5).18 As contract manufacturing in Taiwan and China became popular, Asian firms took over responsibility for more innovations, such as industrial designs. The largest segment of the PC industry was laptop computers, which represented 56% of shipments in 2014.19 The growth in demand for laptops was linked to lower prices: the ASP for a portable PC had fallen to roughly $700.20

Buyers and Distribution

PC buyers fell into five categories: home, small and medium-sized business (SMB), corporate, education, and government. Home consumers represented the biggest segment, accounting for nearly half of worldwide PC shipments.21 While all buyers cared deeply about price, home consumers also valued design, mobility, and wireless connectivity; business consumers balanced price with service and support; and education buyers depended on software availability. In distribution, a significant shift occurred in the early 1990s when more knowledgeable PC customers moved away from full- service dealers that primarily sold established brands to business managers. Instead, larger enterprises bought directly from the manufacturer, while home and SMB customers started to buy PCs through superstores (Walmart, Costco), electronics retailers (Best Buy), and web-based retailers. At the same time, the so-called “white-box” channel—which featured generic machines assembled by local

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entrepreneurs—represented a large channel for PC sales, especially in emerging markets. White-box PCs reportedly represented about 30% of the overall market in 2009, and by 2012, white-box PCs accounted for half of all desktop PCs sold in China.22

PC Manufacturers

The three top PC vendors—Lenovo, Hewlett-Packard, and Dell, accounted for 51.1% of worldwide shipments in 2014 (see Exhibit 3 for PC manufacturers’ market shares). Industry leadership had shifted numerous times in the prior three decades, with Lenovo supplanting Hewlett-Packard (HP) as the market leader in early 2014. China-based Lenovo vaulted into the front ranks of PC vendors in 2005 when it acquired IBM’s money-losing PC business for $1.75 billion. The upward trend continued through 2014 when Lenovo’s worldwide share grew to 19.2%.23 Lenovo’s greatest strength was its dominant position in China, the fastest-growing PC market in the world, where it commanded a 35% share.24 Following a rough period after the acquisition of Compaq Computer in 2002, HP outsourced most of its production to Asia and dramatically lowered its costs. But HP’s attempt to maintain PC leadership came at a high price: after 2005, HP market share eroded, margins declined, and the board fired three CEOs.25 HP proposed spinning off PCs in 2011, recanted, then decided again to break up the company. HP held the number-two position in worldwide shipment market share at 17.1%.26

Dell held the third-largest market share, with 13.5% of worldwide PC shipments for 2014.27 Its distinct combination of direct sales and build-to-order manufacturing was popular in the corporate market for a decade. Yet when a boom in retail consumer PCs outpaced corporate sales, Dell was late to catch on. Founder Michael Dell returned as CEO in January 2007 and emphasized consumer-friendly products, reentered retail distribution, and pushed for international expansion. Still, Dell struggled with cost controls and poor margins. Faced with a declining share price and investor discontent, Michael Dell took the company private in a $25 billion deal completed in late 2013.28

Suppliers, Complements, and Substitutes

Suppliers to the PC industry fell into two categories: those that made products (such as memory chips, disk drives, and keyboards) with many sources; and those that made products—notably microprocessors and operating systems—that had just a few sources. Products in the first category were widely available at highly competitive prices. Products in the second category were supplied chiefly by two firms: Intel and Microsoft (see Exhibit 6 for selected financial information).

Microprocessors Microprocessors, or CPUs, were the hardware “brains” of a PC. Intel had held the majority of the PC CPU market since the 1980s. Despite competition from companies like Advanced Micro Devices (11.5% market share in Q4 2014), Intel remained the market leader with leading-edge technology, manufacturing scale, and a powerful brand, commanding over 88% of the market at the end of 2014.29 Performance of CPUs continued to double roughly every 18 to 24 months, but prices had dropped (adjusted for changes in computing power) by an average of 30% per year between 1970 and 2007. However, CPU prices had stabilized in recent years.30 In 2015, a few manufacturers were shipping PCs with ARM, a low-power, lower-performance, and lower-priced CPU that was used in smartphones and tablets, but ARM’s market share in PCs remained tiny.

Operating system An OS was the software that managed a PC’s resources and supported its applications. Microsoft had dominated this market since the IBM PC in the 1980s. Nearly 90% of all PCs in the world ran on some version of Microsoft’s Windows operating system at the end of 2014.31 Microsoft’s big hit in the new millennium was Windows XP. Introduced in October 2001, 17 million copies of XP were sold in its first eight weeks of sales. Developed at a cost of $1 billion, XP initially

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garnered for Microsoft between $45 and $60 in revenue per copy.32 However, the next three generations, Vista (2007), Windows 7 (2009), and Windows 8 (2012), met with mixed reviews, and each new generation of OS faced higher development, marketing, and support costs. In mid-2015, Microsoft planned to ship its latest update, Windows 10.

Application software, content, and complementary products The value of a computer corresponded directly to the complementary software, content, and hardware that were available on that platform. Key application software included word processing, presentation graphics, desktop publishing, and Internet browsing. After the early 1990s, the number of applications available on PCs exploded, while ASPs for PC software collapsed. Microsoft was the largest vendor of software for Wintel PCs and, aside from Apple itself, for Macs as well.33 Firms such as Google even offered productivity software (Google Apps) for free. PCs also benefited from a wide selection of content and a vast array of complementary hardware, ranging from printers to multimedia devices. The number of new, exciting PC applications had slowed considerably in recent years, as software developers increasingly focused on new devices, such as phones and tablets.

Alternative technologies Since the early 2000s, consumer electronics (CE) products, ranging from cell phones to TV set-top boxes to game consoles, started to encroach on functionality that was once the sole purview of the PC. For example, advanced game devices like Sony PlayStation 3 allowed consumers to watch DVDs, surf the web, and play games directly online, in addition to playing traditional video games. Another alternative to Windows and Mac PCs emerged with the introduction of Chromebooks by Google in 2011. Chromebooks were ultraportable laptops designed for web- browsing, e-mail, and other online or cloud-based activities. In essence, a Chromebook was a low-cost laptop with limited internal storage and a stripped-down operating system from Google, called ChromeOS. All applications ran inside the Chrome web browser. Over the next few years, Samsung, Dell, HP, Lenovo, and Acer introduced Chromebooks, which retailed for $199 to $349. Some analysts predicted Chromebook sales would surpass 9 million units in 2015.34

Of course, the most widely used alternatives were smartphones and tablets. With 1.3 billion smartphones and 230 million tablets sold in 2014, PC sales were suffering. While several industry insiders worried about the impact of digital devices on the PC industry, Jobs viewed all of these devices as part of an integrated strategy to deliver breakthrough user experiences.

The Macintosh and Apple’s “Digital Hub” Strategy

In 2001, marking Apple’s 25th anniversary, Jobs presented his vision for the Macintosh in what he called the “digital hub.” He believed that the Macintosh had a real advantage for consumers who were becoming entrenched in a digital lifestyle, using digital cameras, portable music players, and digital camcorders, not to mention mobile phones. The Mac could be the preferred “hub” to control, integrate, and add value to these devices. Jobs viewed Apple’s control of both hardware and software, one of the few remaining in the PC industry, as a unique strength.

Apple subsequently revamped its product line to offer machines that could deliver a cutting-edge, tightly integrated user experience. Thanks to creative marketing and several innovative computer products, such as the ultra-thin Mac Air, Apple became the third-largest PC vendor in the U.S., with a 13% unit share in Q4 2014.35 The company’s greatest strength lay in the premium-priced PC category; 91% of PCs priced above $1,000 in the U.S. market were sold by Apple.36 Globally, Apple’s market share had risen steadily since 2004, reaching 6.4% at the end of 2014, placing it fifth among global PC manufacturers.37

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Changing the Macintosh To accomplish his vision, Jobs made four important changes in the Macintosh. First, and perhaps most important, Apple introduced a new OS in 2001, the first fully overhauled platform released since 1984. The Mac OS X was based on UNIX, an industrial-strength OS favored by computer professionals. Analysts estimated that OS X cost Apple roughly $1 billion to develop. Second, since the early 1990s, Apple had built Macs with an IBM CPU, called PowerPC. In 2006, Jobs made a large investment to shift Apple to Intel chips. By the next year, the entire Macintosh line ran on Intel. With “Intel Inside,” Apple could produce thinner, lighter laptops as well as more powerful computers. The Mac could also natively run Microsoft Windows along with Windows applications. This capability potentially offset a long-standing disadvantage of choosing a Mac—the relative lack of Macintosh software.

The third element of the new Mac strategy was developing a proprietary set of applications, even though building programs such as the iLife suite required Apple to assume significant development costs.38 The final piece of Jobs’s puzzle was a new distribution strategy. The first Apple retail store opened in McLean, Virginia, in 2001. Apple not only wanted consumers to look at the eye-catching Macintosh designs, but also wanted people to directly use and experience Apple’s software. In 2014, the retail division—with nearly 450 stores in 14 countries—accounted for 12% of Apple’s total revenue.39 Observers viewed Apple’s retail strategy as a huge success: one analyst said that the company had become “the Nordstrom of technology.”40 Most analysts believed that the popularity of media products, such as the iPod, iPhone, and iPad, were critical to bringing consumers into the stores and exposing them to the Mac.

Moving Beyond the Macintosh

Apple’s shift toward a digital hub strategy was initiated by the debut of the iPod in 2001, followed by the iPhone in 2007, then the iPad in 2010. While the prospects for the Macintosh business had improved, it was the iPod that set Apple on its explosive growth path. Jobs’s focus for the iPod was simplicity: he said that “to make the iPod really easy to use—and this took a lot of arguing on my part— we needed to limit what the device itself would do. Instead we put functionality in iTunes on the computer. . . . So by owning the iTunes software and the iPod device, that allowed us to make the computer and the device work together, and it allowed us to put the complexity in the right place.”41

The historical economics of the iPod were stellar by CE industry standards. The iPod Nano, for example, had gross margins of around 40% in 2007.42 The biggest cost component for the Nano was flash memory, which could account for more than half of the bill of materials. Recognizing the importance of flash memory, Apple invested in several memory producers in order to secure output at the best prices, which made Apple was one of the largest purchasers of flash memory in the world.

Apple’s approach to developing and marketing the iPod became, over the initial and strenuous opposition of Jobs, more open than its strategy for the Macintosh. The iPod could initially sync only with a Mac, and Jobs wanted to keep it that way, reportedly declaring at one point that Windows users would get iPods “over my dead body.”43 The rest of Apple’s executive team pushed Jobs to change his mind, and he ultimately relented. Opening the iPod provided access to the vast market of Windows users, and sales only really took off after Apple developed a version of the iPod and the iTunes software that worked on Windows PCs in 2003.

iTunes Two features that differentiated Apple’s iPods were its iTunes desktop software and its iTunes Music Store, which opened in April 2003. The two, in combination, completed Apple’s vision of an entertainment hub.44 The iTunes store was the first legal site that allowed music downloads on a pay-per-song basis. Visitors could pay $0.99 per song for a title offered by all five major record labels

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