By Will Swarts Published: August 24, 2006

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Creative Technology (CREAF)

Share price as of Wednesday`s close: $6.01

Share price now: $7.22

Percent change: 20.1%

Volume: 2.2 million shares, daily average 63,300

The News

The market pumped up the volume on Creative Technology (CREAF: 7.20, +1.19, +19.8%) Thursday after the maker of digital music players settled a series of legal disputes with Apple Computer (AAPL: 67.77, +0.46, +0.7%), owner of the dominant iPod product line. Shares of Creative jumped 20% in midday trading.

The Singapore-based company, whose brick-sized Nomad music player was a hit in the pre-iPod days, will receive $100 million from Apple in exchange for a license granting use of Creative`s patent for navigating music on a digital player. The out of court settlement also gives Creative entry into the lucrative market for iPod peripherals, currently dominated by Logitech International (LOGI: 20.49, -0.71, -3.4%), Griffen and Belkin.

The settlement has far-reaching implications for Creative, and should be a huge relief for Apple, which in a worst-case scenario could`ve been subjected to an injunction barring entry to shipments of iPods to the U.S. Apple currently has a 70% to 75% share of the U.S. digital music player market, according to the NPD Group, an independent research firm.

``Creative played relative hardball in terms of trying to stop iPods from entering the country,`` says Rob Enderle, an independent technology analyst and principal at the Enderle Group in San Jose, Calif. ``Were they to be successful for even a short period of time, ugly things would have happened with Apple. They would have lost more than $100 million a day.``

The deal was prompted, he says, largely by Apple`s realization that the navigation patent gave Creative a strong legal position, and that its countersuits weren`t likely to make much progress through the courts.

``Creative is very fortunate to have been granted this early patent,`` said Steve Jobs, Apple`s chief executive, in a joint statement with Creative. ``This settlement resolves all of our differences with Creative, including the five lawsuits currently pending between the companies, and removes the uncertainty and distraction of prolonged litigation.``

Sim Wong Hoo, chairman and CEO of Creative, said the settlement would add one-time earnings of 85 cents a share to the quarter ending Sept. 30.

The news prompted Carey Wong at OCBC Investment Research in Singapore on Thursday to upgrade the stock to Buy from Hold. Jonathan Ng, at CIMB-GK Research, also upgraded Creative`s stock to Buy from Hold after the settlement was announced.

The Analysis

While the news is terrific for Creative, whose stock price was down 60% since the start of 2005, the settlement has some unexpected consequences for its business. The most important of these is that despite its pioneering status as an MP3 player manufacturer, Creative`s move into making peripherals for its main competitor signals a major, if inadvertent, shift.

``Whether Creative knows it or not, it`s like announcing they`re going to exit the MP3 player market,`` says Enderle. ``You can`t make peripherals for somebody else`` and get market share with rival products, he adds.

While it`s a lucrative business, he says there`s a basic weakness in the business proposition Creative has struck.

``Apple`s been going into the peripheral market more themselves recently, and it`s tough to compete with the platform owner,`` Enderle says. ``They know what they`re going to build before they`re going to build it.``

Wong, the OCBC analyst in Singapore, wrote Thursday that it`s still going to help Creative`s bottom line. He raised his revenue forecast for fiscal 2007 2% to $1.3 billion, and boosted earnings estimates by 19.4%, to $143 million.

``We think that the potential for Creative to expand it travel speakers/docking systems and earphones business is huge, as the iPod-accessories business is literally a cottage industry in itself,`` Wong wrote.

The Bottom Line

Looking ahead, the digital-music-player landscape is about to be reshaped profoundly, and competitors will be doing all they can to peel away Apple`s dominant position.

Wong suggests that Creative`s settlement will help it work with Apple when Microsoft (MSFT: 25.73, +0.06, +0.2%) unveils its Zune player this fall. It will also address the threat from SanDisk (SNDK: 52.08, +1.43, +2.8%), which this year has tripled its market share of flash-memory based players, which compete with the iPod Nano line, to about 30% from about 9%, says Enderle.

SanDisk`s emphasis on partnering with Urge, the MTV subscription music service that charges a flat $14.95 monthly fee, and Microsoft`s indication it will offer a similar model may be the biggest threats to Apple`s proprietary iTunes model, which encourages users to buy music files.

``When you`re at the top of the market, you tend to peak and then all roads from there tend to lead downhill,`` Enderle says of Apple`s prospects. ``Everyone that plays in that market is aiming at Apple.``

However, detente between pioneer Creative and powerhouse Apple may lead to some as-yet unconsidered innovation, which is the only way to stay on top.

``Their market share can still be the leader, but it could go from 70% to 30%. That`s the kind of future Apple`s looking at,`` says Enderle. ``In consumer electronics, you have to come up with new and exciting products in what is an incredibly fickle market.``

In the absence of a market-altering invention, it looks like Creative has opted for an uncreative route to profits by deciding in essence that if you can`t beat `em, join `em.