Apple, Inc

Case 1

October 2, 2008
BUSA 499
Prepared by: FiNoMo
Dr. Chung-Shing Lee
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Table of Contents

I. Executive

Summary……………………………………………………………………………………

………………………………3

II. Strategy

Identification…………………………………………………………………………………

…………………………..…4

 Key Issues and Problems

III. Strategy

Evaluation……………………………………………………………………………………

……………………………….4

 Industry Analysis – Porter’s 5 Forces

 Competitor Analysis – VRIO (Table 1)

IV. Strategic Option Development……………………………………..

………………………………………………………….9

 Option A

 Option B

V. Strategic Option

Evaluation……………………………………………………………………………………

…………………11

 Trade-Offs Between Options (Table 2)

VI. Strategy

Selection………………………………………………………………………………………

……………………………11
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VII. Strategy Implementation………..

………………………………………………………………………………………………12

I. Executive Summary

Apple Inc ignited the personal computer revolution in the 1970s with the
Apple II and since then has been reinventing and innovating not only computers,
but also other electronic goods. 1 According to the 2007 Annual Report, “the
Company is committed to bringing the best personal computing, portable digital
music and mobile communication experience to students, educators, creative
professionals, businesses, government agencies, and consumers through its
innovative hardware, software, peripherals, services, and Internet offerings.”
Apple’s objective is to leverage its unique ability to design and develop its own
operating system, hardware, application software, and services. The company
wants to be sure that its customers are offered new products and solutions with
superior ease-of-use, seamless integration, and innovative industrial design.
Besides personal computers, Apple capitalizes on the convergence of the personal
computer, digital consumer electronics and mobile communications by creating and
refining innovations. Some of the most successful products and services offered are
the iPod, iPhone, iTunes Store, and Apple TV. One of the company’s goals is to
effectively reach more of its targeted customers and provide them with excellent
customer service before, during, and after the sale.2

According to our research, we have specified that the main issue in the music
entertainment industry is piracy. More specifically, it is the illegal download of
music. A direct outcome of this issue is the iTunes program that was sold with
every iPod. With iTunes, Apple was able to protect its music by encrypting each
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audio file to make it compatible only with Apple iPods. This prevented the music
from being traded on illegal networks. 3

After detailed analysis of the Apple Inc, we have decided that to fight piracy,
Apple has one of the following two options. First, it would have the option of
increasing the DRM complexity (Option A) which would constantly require higher
skills to update the system. The second alternative would be to remove DRM
altogether (Option B) and allow users of players other than iPod to purchase the
iTunes.

We believe that Option B would be the best choice because after all it would
allow not just the iPod users, but all users of any players to buy iTunes, which would
be a great advantage to Apple.

By studying this case, we recommend for Apple to distribute DRM –free

music. First, DRM does not solve piracy, but rather sustains it and creates
opportunities for people to “break the code”. Second, if Apple abolishes the DRM
protection, its competitive advantage would increase through greater customer
satisfaction and loyalty. Next, DRM – free music would be more accessible to all
consumers. And finally, since the music bought through iTunes is safe (e.g. free
from viruses and corruption), users of all players would be rather encouraged to buy
from iTunes.

II. Strategy Identification

The case gives wind of several issues in the industry. The most significant

issue of all, regardless of the other problem areas is the existence of music piracy.

The outcomes of this are both the use of Digital Rights Management (DRM) in the

industry, and the industry itself. Legal digital downloads of music emerged as a

result of people downloading and sharing music online for free.

There also exist other key issues deducible from the case. First of all are

hackers, who are able to circumvent the DRM used by (e.g.) Apple in iTunes,

requiring Apple to constantly upgrade the protection on their digital music files4.

Secondly, we have competitors, such as RealNetworks, who were sued by Apple for

making their software compatible with their own, in an attempt to channel sales to
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their software, Harmony5. Finally, an emerging trend in the music industry,

unmentioned in the case, is that of self-sufficiency among established artists. Nine

Inch Nails6 and Radiohead7, for example, are both operating outside of the control of

a record label and releasing and selling music on their own, even going as far as to

giving it away for free8. This may suggest a shift in control from record labels to

artists.

III. Strategy Evaluation

Porter’s Five Forces:

Threat of Entry

How entry works in the industry of music entertainment, specifically, the

online music stores, is interesting. Basically, there is not great cost advantage to

the existing companies because it is not expensive to create an online music store;

the basic factor needed is the knowledge to create it. Economies of scale, which

explain that a firm’s costs fall as a function of its volume of production, are not true

for the online music industry.9 This is so because the music store owners have to

obtain the records that they would like from the record companies and then pay the

record companies a royalty for every song sold through their online store.

Product differentiation as barrier to entry is quite low because there is not

much that can be done to differentiate music – it is already different in itself. One

of the most common options would be the add-ons or extra options that come with

the music sold.

Cost advantages independent of scale as barriers to entry is also very low.

Compared with a pharmaceutical industry for example, where it takes decades to

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accumulate experience, not much experience or technology is required to sell music

online. There are also almost no government regulation as a barrier to entry.

The Threat of Rivalry

The threat of rivalry within an industry is determined by four factors. The first

is the presence of a large number of firms of a similar size. While the number of

competitors within the entertainment industry is numerous, Apple’s control of the

market (assuming they can sustain it) lowers the level of threat in this respect. The

second factor is the slow level of industry growth. The entertainment industry is

expected to grow fast10, meaning that the level of threat posed by rivalry remains

low in this respect. Companies have, however, tried often to gain market share by

going head-on against their competitors (a trait attributed to slow industry growth),

meaning that the situation is not as black and white as theory might suggest.

Thirdly, the threat of rivalry tends to be high when there is a lack of product

differentiation. This is true for the entertainment industry, in which the services

provided are very similar. Companies compete with various pricing strategies,

including iTunes’ 99 cents per song download and Napster-To-Go’s monthly fee of

$12.50 for unlimited access to songs11. The fourth and final factor that increases

rivalry in an industry is the abundant addition of production capacity. This, however,

does not apply to the entertainment industry12.

Threat of Buyers

This threat is extremely large. There are a large number of customers which

are all very price sensitive. It is easy for the buyer to switch to another product. The

buyer’s final decision lies in actually purchasing the product with constraints such

as the DRM systems or not. If the buyer do not have an Apple product, they are not
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likely to buy the product the way things are at the moment. This also increases the

threat.

The Threat of Suppliers

Suppliers in the entertainment industry can be classified both as the

recording artists and/or songwriters as well as record labels. The recording industry

consists of a number of firms, including many small, independent labels (making up

12.61% of the industry’s sales) and a few large companies known as the “big four”.

These are, classified by size – largest to smallest: Universal, with a market share of

31.61%; Sony BMG, with a 27.44% market share; Warner, with 18.14%, and EMI,

with 10.2%13. Companies in the industry are quite numerous, meaning that

entertainment industry firms have a lot of choice in where to source music.

However, the major contenders in the recording industry are very few and have a

lot of bargaining power in terms of regulations, as well as the price and availability

of the supply of their products. Just recently, the National Music Publishers

Association announced their desire to increase the royalty paid by Apple per

downloaded song from 9 to 14 cents, costing the company an additional $144

million. Apple’s response was a threat to close iTunes altogether, demonstrating the

sway of suppliers over companies in the entertainment industry14. Music, as a

product, is very unique, meaning that companies in the entertainment industry will

have a hard time challenging suppliers, and finding alternative ones. Apple,

however, has a very strong lead in the industry due to the popularity of iTunes and

its linked consumer electronics product, the iPod, lowering this aspect of threat from

suppliers, to an extent. Thirdly, the high threat of substitutes outside of music

(DVDs, movies, etc.) serves to lower the threat of suppliers. Finally, the threat from

upward vertical integration remains low. The case shows that iTunes is force to be
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reckoned with in the entertainment industry by sheer popularity. This is further

confirmed competitors’ futile attempts to take control15, 16

.

Because of the aforementioned rise in self-sufficiency among certain artists,

the threat of suppliers from the songwriter/artist side has become far more

pressing. Artists who value DRM-free digital music files may opt out of supporting

industry giants demanding that music have such encryption. Self-sufficiency also

means that the suppliers may set, not only the price of the product, but also its

supply; once again, due to the uniqueness of the music as a product, companies in

the entertainment industry have few choices to turn to if these suppliers decide not

to work with them. In the increased self-sufficiency of artists releasing music on

their own, we may already see a form of forward vertical integration. In terms of

substitutes, artists (at present) do not have to worry about the format that their

music is released. If, however, the popularity of digital media over the traditional

hard copy formats (CDs, vinyls, etc.) becomes far greater, artists not supported by

an entertainment industry firm will be negatively impacted. In its current state, the

threat of substitutes for the artists as suppliers is low, increasing threat from

suppliers in the entertainment industry. If the aforementioned potential situation

arises, the threat of suppliers may be grossly lowered17,18.

It will be interesting to see how far the self-sufficient artists’ control will extend. To

look at an extreme scenario, there is a chance that we may see companies in the

entertainment industry working with artists as the suppliers rather than record

labels. Doing so would create a positive image of supporting musicians for Apple,

potentially furthering their popularity. On the other hand, while removing some

problems (to the short-term benefit of artists and consumers), it may be creating an

entirely new one. The repercussion of such a move could be a war among
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entertainment industry giants for artists to be “signed” to digital music providers,

effectively shifting the battleground from one industry to another and creating all

new threats of rivalry and suppliers.

The Threat of Substitutes

The threat of substitutes is huge. There are several major substitutes such as

illegal downloading, buying CDs in a regular record store, download music to your

cell phone, and buying music videos. (DVD concerts) These are almost perfect

substitutes because it serves the same purpose, making music available to you

when you want to listen to it. There are also other substitutes like going to a

concert, listen to the radio, watching TV, watch a movie, or simply go to a

restaurant where they play background music. The availability of music makes the

threat major.

Apple’s growth in the past several years shows as evidence that if done right,

selling music online can be a very profitable business. One of the components

consumers use in deciding where to get their music is whether the music files are

protected with DRM or not. Currently, all music that Apples sells on iTunes is DRM

protected.19 We see that Apple positioned itself well in the music entertainment

industry and for the time being, needs to sustain its’ position. In the future,

however, as piracy increases and DRM secrets will continue to leak out, Apple would

do better by repositioning to the DRM-free music.

Table 1: VRIO Analysis

Resources and
Capabilities
V R I O Competitive Advantage

Brand/Name √ √ √ √ Sustained

Logistics √ X X √ Parity
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Design/Product √ X X √ Parity

Innovation √ √ √ √ Sustained

No Competitive
DRM √ X X X
Advantage

Customer Loyalty √ √ √ √ Sustained

The VRIO analysis shows that Apple’s competitive advantage is mostly

achieved through its brand, innovation, and customer loyalty, as well as

combinations of the three. The Apple and iTunes brands are both well respected

and trusted by consumers. Apple’s innovation with the iTunes/iPod combination is

another important factor; an innovative product, combined with a user-friendly, all-

encompassing service covering both a means to keep and organize music on one’s

computer as well as to purchase new music easily (i.e. through e-logistics) . Finally,

through their innovation and name, as well as the clever combination of hardware

and integrated software, Apple has been able to create a competitive advantage for

itself through customer loyalty.

Logistics (i.e. the means by which consumers are able to purchase music

directly onto their computers), while innovation, is neither a rare, nor inimitable

resource or capability for Apple. For similar reasons, the design of iTunes as a

product bestows them only with competitive parity, rather than sustained

competitive advantage. DRM, on the other end of the scale can be seen as valuable

to Apple and the music industry to the extent to which it works (until someone

hacks it), however, as is shown by the case, is not a rare capability, is highly

imitable, and is not organized in a way that would provide sustainable mitigation of

the problems it is trying to solve20.

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IV. Strategic Option Development

There are several strategic options the company can implement to solve the

key issue. One course of action could be Apple continuing their current course

hoping that hackers will not be able to crack the DRM systems that are already

in place. They fix it with small updates in the iTunes software. However, our

team has provided two mutually exclusive courses of action that we will base

this paper on:

Option A

The first course of action is to increase the complexity of the current DRM

systems. The case suggests that already in 2005, hackers had cracked the DRM

system and written software allowing the files the iTunes store to be shared freely.21

Since they already have been cracked several times, the encryptions have to be

made a lot more complex. If not, the whole point of having a DRM system

disappears. Unfortunately, history has shown that even the most complex

encryptions can be cracked. One example is the DVD. It was supposed to be

impossible to crack the code, but it was cracked within weeks of release. Piracy is

hindered only until next hack is made.

Option B

The second course of action is to remove the DRM system completely.22iTunes

are required by the record companies to have DRM systems on all the files they sell.

However, if iTunes sell 2 billion songs from their online store, the record companies

themselves sell ten times this amount. The funny part is that the record companies

themselves sell all of their songs without DRM systems on the songs. Research tells

us that the average mp3 player can hold approximately 1000 songs, but only 3% of

the songs are protected with DRM systems. When this is the case, why even bother
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having them in place? Removing the DRM system would also make the songs

available to customers who don’t own an Apple product.

Interestingly enough, a 2007 study conducted by the University of London at the

request of the Canadian government showed that illegal downloads of music did not

affect the legal music purchases. In fact, owing to the increased exposure gained

from allowing illegal downloading to happen, artists’ could see an increase in their

record sales23.

V. Strategic Option Evaluation

Table 2: Trade-offs of Options A and B

Option A Option B

Cost x √

Time x √

Quality (Customer x √

Satisfaction)
Choice x √

X = bad √ = good

Obviously, Table 2: Trade-offs of Options A and B show that Option B is the

better option of the two. First, the cost to implement a more complex system would
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require more resources which would have to constantly be improving. However,

without DRM security, there would be no cost at all. Second, The time that it takes

a consumer to find the record that they want would decrease without DRM security

which would also be more convenient since it will all be in one place (at iTunes).

Customer satisfaction would greatly increase without the DRM because consumers

would be able to buy music that is not just playable on iPods, but also on their

computer and other mp3 players. In the end of course, consumers would have

more choices and opportunities to control the music they own.

VI. Strategy Selection

First of all, since the DRM systems are a requirement from the record

companies, Apple has to convince them that having the DRM systems is not

preventing piracy. Apple then has to drop the DRM systems on their music files.

They key to succeed after dropping the DRM system is to launch a huge marketing

campaign letting people know about the removal. It should be clear to the public

that they can now use the music files purchased from iTunes on any device. This

will hopefully put pressure on the record companies as well to drop the systems.

Secondly, DRM-free versions of the songs should be uploaded free of charge for

the customers that have already purchased DRM protected songs. They now have

to upload the remaining library.

The main thing here is to market the DRM-free songs to the public. This is to

make sure the consumer knows the songs will work on any application when they

purchase from the iTunes online store. As long as Apple can convince the record

companies to shut down the DRM systems, implementing it should not create big

problems.
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VII. Strategy Implementation

DRM systems cause more problems than it fixes. There are always people who

are willing to put the time and effort to crack the encryptions. Keeping the

encryptions up to date is time consuming and costly as they always have to be one

step ahead of the hackers.

Removing the DRM systems is also another example of how to increase

customer satisfaction. The consumer can now play the songs he purchased on any

application he might chose. This leads to a competitive advantage through better

customer loyalty.

Removing the DRM systems also makes the music more accessible to

consumers. Many consumers are not purchasing songs online because of these

constraints. They seek other sources instead, including illegal downloading.

Considering that iTunes is the biggest online music store on the market, removing

the DRM systems should increase their market share significantly. People will be

encouraged to buy music off iTunes rather than download it illegally thanks to the

safety of using iTunes over free downloads. You get high quality files rather than

getting viruses and corrupt files.

ENDNOTES
1
Apple Inc Website. Support Center
http://www.apple.com/investor/
2
Securities and Exchange Commission. 2007 Form 10-K for Apple Inc.
http://www.sec.gov/Archives/edgar/data/320193/000104746907009340/a2181030z10-
k.htm#toc_de19701_2
3
Barney, Jay B and Hesterly, William S (2008). Strategic Management and Competitive Advantage.
Pearson PrenticeHall. p. PC 1-11
4
Barney, Jay B and Hesterly, William S (2008). Strategic Management and Competitive Advantage.
Pearson PrenticeHall. p. PC 1-9
5
Ibid. p. PC 1-12
6
Moulds, Josephine (October 2007). Nine Inch Nails Follows Radiohead and Dumps Label.
Telegraph.co.uk. Retrieved October 1, 2008, from
http://www.telegraph.co.uk/finance/markets/2817362/Nine-Inch-Nails-follows-Radiohead-and-
dumps-label.html
7
Radiohead’s ”In Rainbows”: Track-by-Track Preview (October 2007). Rolling Stone. Retrieved
October 1, 2008, from
http://www.rollingstone.com/news/story/16654550/radioheads_in_rainbows_trackbytrack_preview .
8
Ibid. Fans could choose from a variety of package options for the album, including a digital
download for which consumers could choose to pay what they wished, including nothing.
9
Barney, Jay B and Hesterly, William S (2008). Strategic Management and Competitive Advantage.
Pearson PrenticeHall. p. 41
10
The Global Entertainment Industry is Expected to Show an Annual Growth of 10% in the Next
Four Years and That Growth Will be Driven by China (August 2007). BNET Business Network.
Retrieved October 1, 2008, from
http://findarticles.com/p/articles/mi_m0EIN/is_2007_August_20/ai_n19452832
11
Barney, Jay B and Hesterly, William S (2008). Strategic Management and Competitive
Advantage. Pearson PrenticeHall. p. PC 1-12
12
Ibid. pp. 46 - 47
13
Cashmere, Paul (January 2007). Universal The Biggest Label of 2006. Undercover.com.au.
Retrieved October 1, 2008, from http://www.undercover.com.au/News-Story.aspx?id=1215.
14
Ramsay, J.T. (October 2008). Apple Threatens to Close iTunes. Comcast.net Music. Retrieved
October 1, 2008, from
http://www.comcast.net/music/blindedbythehype/2855/applethreatenstocloseitunes/
15
Barney, Jay B and Hesterly, William S (2008). Strategic Management and Competitive
Advantage. Pearson PrenticeHall. pp. PC 1-6 to 1-13
16
Ibid. pp. 47 - 49
17
Ibid. pp. PC 1-6 to 1-13
18
Ibid. pp. 47 - 49
19
Barney, Jay B and Hesterly, William S (2008). Strategic Management and Competitive
Advantage. Pearson PrenticeHall. p. PC 1-11
20
Ibid. pp. 76 - 92
21
Barney, Jay B and Hesterly, William S (2008). Strategic Management and Competitive
Advantage. Pearson PrenticeHall. pp. PC 1-6 to 1-13
22
Thoughts on Music, Steve Jobs, February 6, 2007
23
Moses, Asher (November 2007). Piracy Not Raiding CD Sales. The Sydney Morning Herald
(online issue). Retrieved October 1, 2008 from http://www.smh.com.au/news/web/piracy-not-
raiding-cd-sales/2007/11/06/1194118008817.html