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Apple's Chain Reaction

The iPod maker's string of retail stores are an underrated part of past and future success.

Updated from 7:27 a.m. EDT

According to conventional wisdom,


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resurgence is due almost entirely to the popularity of the iPod.

But the company's success lately may have as much to do with something more prosaic: Apple's rapidly expanding chain of retail stores.

The stores have given Apple the chance to showcase its products, and not only the iPod but also its line of Macintosh computers. The stores may be a significant reason Apple has

gained share in the computer market.

The company's retail strategy is "an important part of Apple's success," says Crawford Del Prete, senior vice president of research at industry consulting firm IDC. "Clearly, Apple's products are experiential in their nature ... they're something people want to go and touch. That's something the stores provide."

But if the stores have boosted short-term sales, they may weigh on long-term results. That's because retail-chain growth inevitably tends to slow as stores age.

Apple's stores are still relatively young on the whole, but that likely will change in coming years as future store count slows.

"Growth does tend to level out," says Craig Johnson, president of retail industry consulting firm Customer Growth Partners. "Nobody's totally immune from it."

Apple's strategy for its retail stores perhaps takes on a greater importance after the company and


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terminated their iPod reselling agreement last week.

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Though H-P was responsible for about only 8% of iPod unit sales last quarter, it did provide a larger retail distribution network that Apple will have to replace through other channels.

People have had their doubts about Apple's stores from the onset, something that inevitably drew comparisons to



failed store effort. Gateway closed its retail division last year as part of an effort to cut costs.

In contrast, Apple went in the other direction, as the company showed again last month when it

reported second-quarter earnings. In the most recent quarter, Apple's retail division garnered $555 million in sales, up 106% from the same period a year earlier and far outpacing the company's overall sales growth.

And that wasn't just a one-quarter fluke. Last fiscal year, sales through Apple's retail stores jumped 91% to $1.19 billion. The division posted a $39 million operating profit last year after showing a $5 million operating loss the year before.

Much of that growth can be attributed to expanding the store base. The company now has about 120 stores, up from 86 at the end of last fiscal year and just 65 at the end of fiscal 2003.

But Apple's retail success isn't just a factor of more stores. The company also is selling more products through these stores. On average, Apple's stores posted about $5.3 million apiece in revenue in the company's just-completed quarter, up 56% from the same period a year earlier.

The benefits go beyond just raw sales and income figures, analysts say. Apple launched the stores at a time when other retailers were cutting back on shelf space they had devoted to Apple products, or had stopped carrying them altogether.

Apple launched the stores to develop a "high-quality buying experience" it believes is "critical to attracting and retaining customers," the company said in a recent regulatory filing.

The company didn't provide comment for this story.

But the stores not only have opened new channels for Apple's products, they've also acted as a billboard for the company, extending its brand. Further, they've given customers a chance to test the company's products, an important factor, particularly in the computer arena, because Apple's wares are so distinct from those of its competitors.

"This allows them to reach out to consumers who may not normally or necessarily be interested in Apple," says Tim Deal, an analyst with industry consulting firm Technology Business Research.

On the other hand, the stores have not been an unqualified success. The stores division showed an operating loss until last year, and even then, much of the operating income would have been erased by depreciation and amortization charges.

Costs also have jumped from leasing new properties and building storefronts from raw space, although the growth in retail revenue has outpaced those costs so far.

But the longer-term costs may be more of an issue. The company has been able to show such rapid growth from retail partly because of the relative youth of its stores; more than half the stores are less than two years old.

Typically, in the retail industry, individual stores show their greatest sales growth in the first four years before that growth starts to tail off, notes Johnson. On a broader level, as Apple's stores age, those older stores will become an increasingly larger portion of the company's overall store base, further weighing on the company's retail growth prospects.

Apple's ability to maintain its retail growth also may be hit by other trends. The company so far has focused on putting stores in affluent communities and in high-end malls.

But it soon will run out of such desirable locations, according to analysts. The company may find that it either has to slow down expansion or put stores in less-favorable areas.

"I don't expect them to blanket the entire U.S. or Europe," Del Prete says. "In the absence of being able to open a lot of stores, the growth will slow down.

Additionally, Apple operates in the electronics area, in which price cuts are the norm. In sectors in which retailers have more pricing power, they can increase sales simply by bumping up prices.

Apple, however, may find that harder to do: The company recently cut prices on its iBook line and it has repeatedly slashed prices on its various iPods.

Retail sales growth "is very tough to sustain over time, particularly in a deflationary environment," says Jay McIntosh, a retail analyst at Ernst & Young.

While the retail stores are likely helping sales of the iPod, the company as a whole -- and the retail segment in particular -- has become dependent on those sales for growth, notes Johnson.

Should iPod sales cool, the company will need to find another hit product despite how hot its retail stores have become.

The danger, says Johnson, is that Apple could become like

Sharper Image


, whose results have lived and died by the success of its Ionic Breeze air filters. After sales of the product fell off, so did the company's shares, Johnson notes.

No one expects Apple to be in the same ditch as Sharper Image any time soon. As long as the company can continue to unveil new, hot products, Apple stores will help push its growth, analysts say.

"There's a lot of risk there. It's a different business than manufacturing," say McIntosh. "If you're a manufacturer that has a unique product, if you're an innovator, that would give you an edge."