Apple's Front-Runner Challenge

Apple ( AAPL) has raced to the front of the digital music market with its iPod line. But some are wondering how long it can stay in the pole position.

"We're still at the very early stages of this transition" to digital music delivery, said Mike McGuire, who covers the online music market as a research director at GartnerG2. "The game ain't over by a long shot."

How the competition ultimately turns out should have big implications for Apple's stock over the long term. Its shares tripled last year as booming iPod sales -- now more than one-third of the company's revenue -- revved up the company's earnings -- and its potential prospects. The stock's run has left it trading at a sharp premium to rivals such as computer industry leader Dell ( DELL).

Should anything slow the iPod's momentum, Apple's stock -- which has been a momentum trader's dream -- could also begin to drag.

Apple's iPods held 82% of the market for hard drive-based digital music players last year, said Shyam Nagrani, an analyst at industry research firm iSupply. But the company likely will see its share slip in coming years, he said.

"There's no company in this world that can maintain 80% market share forever," Nagrani said.

Indeed, the iPod already faces serious challengers and the competition is likely to heat up in the near future. Last week, for instance, Dell rolled out a line of new music players that cost significantly less than similarly equipped iPods. Dell's announcement came one day after Apple unveiled several new iPod models and slashed the price of its top-of-the-line iPod photo.

In addition, earlier this year, Microsoft ( MSFT) showed its interest in the market at the CES trade show by touting a slew of new devices that use its Windows Media technology. And Sony ( SNE), one of the longtime leaders in portable music devices with its Walkman series, recently reorganized its digital music efforts to better compete with Apple.

While an increasingly crowded market of digital music players may pose a threat, other digital devices may be an even bigger challenge. Later this month, for example, Sony plans to release its PSP, which is billed primarily as a game machine, but it will also be able to play music and movies stored on a new DVD disc format or on its MemoryStick flash storage cards. Between the PSP's Japanese launch in December and the end of this month, Sony expects to ship 3 million of the devices, including 1 million into the North American market.

In contrast, Apple shipped 4.5 million iPods in its fiscal first quarter.

Similarly, mobile-phone handsets are becoming ever more powerful and popular -- and some handset manufacturers are starting to incorporate the ability to play digital music into their phones. Earlier this week, for instance, Sony Ericsson announced a new Walkman phone, which will be able to play MP3 and other digital music files.

"It's hard to believe that Apple dominance could just continue for the next few years when you see competitors come out and try to attack this franchise," said Rod Bare, an analyst at Morningstar. "We've seen the personal digital assistant go by the wayside as people adopt smart devices. Will the media player get sucked into that vortex as well?" (Morningstar doesn't do investment banking. Bare does not hold a position in Apple shares.)

The iPod also faces competition from older technology. Online music sales represent a small fraction of the $12 billion music industry. While carrying all your music around in a device the size of a deck of cards may be the hip thing to do, not everyone's buying it yet.

"There's still a lot of people who get their music on shiny plastic discs," noted McGuire. The transition to digital delivery of music is by no means a done deal right now."

Even if the bulk of consumers buy into downloading music instead of buying discs, the iPod may not continue to be the player of choice. Incompatible file formats may become more of a problem in the future, noted McGuire. Songs purchased on Apple's iTunes store generally work only on the iPod, which also won't play Windows media tunes in their native format. Microsoft is trying to play up these problems through its "PlaysforSure" logo, which touts the ability of consumers to play their Windows Media files on a variety of devices.

And while Apple's design -- with its signature click wheel -- has certainly played a role in the iPod's popularity, much of the device's success may have to do with the device being a fad, warn analysts.

"How music is consumed will continue to evolve," said trend watcher Irma Zandl, president of the Zandl Group consulting firm. "I doubt that the iPod will be the gadget of choice five years from now."

To be sure, Apple is hardly being passive. The company has repeatedly revamped its iPod lineup, introducing new models and targeting new segments. In January, for instance, the company rolled out its iPod Shuffle, a line of bargain-priced flash-memory players.

In addition, Apple has its own piece of the cell-phone market with an agreement to provide its iTunes service on Motorola ( MOT) handsets later this year.

And although the competition may be getting serious, many analysts believe they are still far behind in the race. While Dell and others may try to cut into Apple's lead through pricing, they're likely to have limited success unless they come out with more compelling products.

"The iPod's click wheel is superior to anything the competition can offer," said Tim Bajarin, president and principle analyst at Creative Strategies, a consulting firm. "I haven't seen anything from the competition that's strong enough for the contenders to bite into Apple's market share."

And some think that instead of simply defending its lead in the music space, Apple will go on the offensive and take its technology into other digital media markets.

"We're in the early stages of a revolution," said Steve Wallman, a hedge fund manager whose fund is long Apple. "I think Apple is poised to do well in that next phase. I think the iPod is simply a foreshadowing of what's to come."

But even if everything goes right, the company's stock valuation of about 35 times projected earnings for its next fiscal year still makes valuation an increasing concern, Bare said.

"It's tough to think of a company that firmly entrenched in the computer and consumer electronic business sustaining a valuation that's so high," he said, adding that his fair value for Apple is about $19, an extreme minority view considering the plethora of Wall Street price targets at around $50. The company's stock closed Wednesday at $44.12.

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