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Wednesday, May 24, 2006, 04:00 pm PT (07:00 pm ET)

iPod: how big can it get?

That's the title of a detailed research report on Apple Computer's iconic digital music players, in which analysts for Credit Suisse weigh the iPod's recent success against that of Sony's Walkman in the '80's and '90s in order to depict the player's overall opportunity for further growth.

Despite the iPod’s overwhelming popularity, the firm says investors are becoming increasingly concerned with its growth opportunities, competitive pressures, slowing product introductions, and the law of large numbers.

It estimates Apple's current iPod worldwide penetration rate of the consumer PC installed base to be a mere 10.3 percent, assuming only one iPod is tied to each personal computer. With nearly 90 percent of potential market share remaining and Apple's defensible competitive position, the firm believes the iPod will eventually surpass Sony's magical sales mark of 309 million Walkman and Discman players by the year 2009.

"For comparison, it took Sony over 10 years to sell 50 million Walkmans, while Apple reached the same milestone in half the time despite lower market share and stiffer competition," analyst Robert Semple wrote. "Incidentally, Apple’s ability to pull-through additional revenue from accessories and music downloads has enabled it to effectively expand its opportunity."

The analyst says Apple's shipments are currently tracking at approximately twice Sony’s comparative pace, despite the iPod having lower overall market share. He said, "the biggest difference between the two products remains the use of open standards, with Sony effectively delivering an industry standard product while Apple remains proprietary."

While history has shown that closed systems like the iPod are rarely prosperous for prolonged periods, Semple believes Apple to be an exception. Because consumer electronics are not expected to become as large of a commodity as personal computers, he sees Apple's competitive position as sustainable for the foreseeable future.

"We do not believe Apple can be unseated from its leadership position by attacks on the individual segments of its music business, be it iPod or iTunes," Semple said. "Rather, we believe there will need to be a complete solution offering seamless integration between the hardware and software."

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The only potential competitor to meet such a challenge would be Sony, he said. Despite the electronic maker's uncertain music strategy, it's the only other company with the ability to offer the complete package of a music player, software interface, and personal computer.

Another factor that could fuel further iPod grow is an accelerating rate in which consumers are replacing their iPods with newer models. "Based on our estimate for the current iPod lifecycle to be 1.5 years, down from over two years, we believe the company will still be able to deliver attractive growth despite a decline in the number of new iPod users each year," Semple added. "The key takeaway is that if any company can accelerate its product replacement cycle, it becomes less dependent on new user penetration for growth. accelerate the replacement."

The analyst forecasts iPod units to grow 32 percent this year and 24 percent in 2007, despite an actual decline in the number of new iPod users each year. He estimates that between now and the year 2009, Apple’s iPod installed base penetration of the worldwide consumer PC installed base will gradually scale from 10 percent to 20 percent.

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When iTunes and accessory sales thrown in, Semple calculates the actual impact to Apple from the average sale of a single iPod to be $253 of revenue and $61 of gross profit — or total gross margin of 24 percent. On an individual basis, he believes Apple makes a 22 percent profit on iPods, 15 percent on iTunes and 60 percent on iPod accessories.

For each incremental one million iPods that Apple sells, Semple says the company generates and additional $253 million in sales and 3 cents in earnings-per-share. "The bottom line remains that Apple’s financial results are highly leveraged to iPod sales and we believe Apple is still in the early stages of product adoption," he wrote.

Looking ahead Credit Suisse, says flash-based players will drive overall market growth, as NAND flash costs are expected to decline approximately 50 percent per year, allowing digital music player makers like Apple to double storage capacity. The increased in storage and lower costs should enable additional functionality enhancements, such as photo and video on a smaller form-factor and competitive retail price points, the firm said.

Credit Suisse maintains an Outperform rating on Apple shares with a price target of $90.