Apple's iPod Problem

Chris Wysopal is the head of a four-iPod family. His wife and two kids all carry the pint-size nano music player from Apple (AAPL), while he uses a 2003-vintage device he got as a hand-me-down from his wife. But as much they love their iPods, the Wysopal family has no plans to buy any new ones in the foreseeable future. "They're all working, so there's no need to buy more," says Chris.

Strange as it may sound, Apple may have an iPod problem. The iconic music player cemented the company's reputation for innovation and fueled its financial success in recent years. But those days appear to be over. Legions of iPod owners see little reason to upgrade, especially with the rocky economy. As a result, some analysts believe this will be the first quarter since the iPod was introduced in 2001 that sales will decline from the year-earlier quarter. "The reality is there's a limited group of people who want an iPod or any other portable media player," says analyst Gene Munster of Piper Jaffray (PJC). "So the question becomes, what does Apple do about it?"

The iPod has been a powerful growth engine, helping to boost Apple's sales from $5 billion in 2001 to $32 billion in the fiscal year ended on Sept. 30. Growth for the music player franchise averaged more than 200% in 2006 and 2007, before falling to 6% in fiscal 2008. Munster expects the number of iPods sold to tumble 12% next year, to about 48 million units.

Apple's other businesses are healthy, with its iPhones and Macintosh computers selling briskly. But the decline of the iPod franchise means those other businesses will need to make up the difference as music player sales slide. That may prove particularly challenging as consumers cut back on their spending in the face of the recession. Wall Street has high expectations for the company, with analysts forecasting revenues will rise 15% next year, to $37 billion.

A number of institutional investors are selling their Apple shares. Oak Ridge Investments cut its stake in half, to less than 500,000 shares. "With the iPod maturing, the iPhone takes on greater importance," says David Klaskin, a portfolio manager with the Chicago investment firm. "But [the phone] is more expensive when you consider the cost of service." Apple shares have dropped more than 55% over the past year, to $92 each. The company declined to comment for this story.

Apple is working hard to keep the iPod fresh. The new flagship of the family is the touch, with the shape and large screen of the iPhone minus the phone capabilities. In one TV spot, Apple dubbed it "the funnest iPod ever" because it can play music and video, surf the Web, and handle computer games. The touch, which starts at $229, has been the most popular iPod product since July, says Stephen Baker of retail research firm NPD Group.

Meanwhile all of the iPod devices, save the screenless Shuffle, can play video. Apple has also developed new features for its iTunes music service, such as the so-called Genius that groups similar songs together in playlists. All of that work has kept Apple, with more than 70% of the U.S. retail market, far ahead of rivals, and that's not likely to change, according to NPD. Says Jupiter­media (JUPM) analyst Michael Gartenberg: "We'll continue to see an evolution in features, design, capacity, and price."

Perhaps the iPod's biggest benefit to Apple these days is in helping it sell Macintosh computers. People who use PCs with Microsoft's (MSFT) Windows operating system tend to be more likely to switch to Macs after they use one of Apple's music players, a phenomenon that has been called the iPod Halo Effect. Apple's share of the U.S. PC market has climbed to 9.1%, from 3.2% in 2003, according to market research firm IDC. "The iPod may be in decline, but it may not matter," says analyst Charles Wolf of Needham & Co. in New York. "The iPod may still be attracting Windows users to the Mac. And for Apple, that's pretty important."

Rough Times Ahead for the Electronics Industry