iTunes increases wholesale payout for Independents

As I was researching iTunes’ margins for yesterday’s post, I stumbled across this interesting tidbit from Digital Music News. iTunes has increased its payout to independent labels from 65 cents to 70 cents on a 99-cent download. That doesn’t account for the fee collected by content aggregators, who are the primary channel through which most indies deal with iTunes.

Still, there’s a number of ways to read this development. iTunes is in an increasingly competitive situation and has the economic benefit of large and increasing volumes being spread across its fixed costs. That means an increase in its variable costs could be offset by gains in its operating margins. In other words, it’s the old “we’ll make it up on volume” strategy, minus the inventory baggage that dooms this strategy in the physical world.

The hard-core capitalists among us are bound to ask, “If sales are doing so well and you’re maintaining a dominant market share, why are you giving up margin instead of taking more of it?”

One answer: to starve existing competitors and to discourage new entrants. If iTunes pays out 70 cents, rightsholders will demand the same payout from iTunes competitors. Apple could be betting that such a payout will hurt its competitors more than it will hurt iTunes. And, given the arms race among major services to have the most comprehensive catalogs in digital music, it’s not as if a service can easily afford to pass on a deal.

Of course, the flipside is that iTunes may not have had a choice. With new services jumping into the market and Yahoo! signing partnerships with universities, wireless carriers and, most recently, satellite radio, perhaps this concession to labels indicates a realization by iTunes that it must take its competition much more seriously.

Should Apple open its music format?

This question comes up fairly frequently and usually accompanies every report on the latest growth rate of the digital music market. Apple’s failure to open its operating system is widely cited as the reason it lost the personal computing market to Windows-based PCs. Given the close relationship between iTunes and iPod, many pundits wonder if Apple is in the process of making the same mistake and expecting different results.

Here’s the quandary: Apple’s proprietary music format, AAC++, is sold only on iTunes. Those files must be converted to an format such as MP3 or WAV to play on something besides iPods, which remain far and away the dominant portable music player. Aside from open formats such as MP3 and WAV, the iPod plays no other file format.

Should Apple open the iPod to accept formats from services such as Rhapsody, Napster and others? Should iTunes open its file format to non-iPod markets?

iPods account for 92.1% of market for the hard-drive-based players, according to the NPD Group. But cheaper, flash-based music players have streamed in from all corners, leaving the iPod with a 30.2% share of the overall digital music player market. Meanwhile, the number of music services has tripled in the past year to 300. Each new competitor’s entry in the market gets splashy coverage by the domestic and international business and technology media, whose hype machines have been largely dormant since the dot-com bust of 2001.

Sales of iPods are driving sales for iTunes (and vice-versa) and there’s a not-to-distant relationship between iPod/iTunes and overall sales for Macs, the market share for which grew 34.8% to 2.5% overall in Q2 of 2005. That puts Apple in eighth place behind Dell, HP, Gateway and others.

Loren Loverde, director of IDC's Worldwide PC Tracker Program, told The Mac Observer:

“It seems they are seeing some real connection between the success of their online music business and the iPod and their PC business,” he commented. “It's hard to make that statement conclusively, but just based on the publicity that they've received from the music sector and the change in growth over the last couple of quarters, which has been quiet remarkable, it seems to coincide pretty well with the visibility of the music business. I think it's safe to say that there is some element of a halo affect.”

Let’s give it a quick Michael Porter test:

• Supplier Power: Given how completely iPod dominates the hard-drive-based market and iTunes’ towering sales, it’s hard to imagine that Apple is under the thumb of either hardware or content providers, although Apple’s deal with Intel could shift some of that leverage away from Apple. The current iPods use an ARM chip from Texas Instruments, but we can expect to see Intel inside future versions of the iPod line. Content owners, particularly major labels, claim to have been mortally wounded by file-sharing and piracy and thus are violently opposed to any format that lacks digital rights management and any format that lends itself to use on multiple devices (read: copying) makes them nervous. But, if anyone has exhibited leverage over content owners, it’s been Steve Jobs.
• Barriers to Entry: Not applicable. Not only has Apple entered the digital music and music player markets, it dominates them.
• Threat of substitutes: Sky-high. I’m not positing that Apple will succumb to them, but, with 300 music services and almost as many digital music players on the market (almost all of which are cheaper than their Apple counterparts), there doesn’t seem to be much to debate here.
• Buyer power: From a wholesale perspective, Apple’s eponymous retail channel is pretty good hedge in the event that relationships with other retailers of Apple products such as HP (whoops, not anymore, according to the WSJ) and Amazon go south. The bigger risk is with consumers, who face no shortage of substitutes (see above). Aside from adding a photo component and a U2 version, Apple hasn’t really introduced features or versions that aren’t already out there. The average price of a 20-gig digital music player is being driven down by Dell, Creative and a host of new entrants. By offering the same thing as everyone else, Apple has only its sleek brand by which to justify the premium that consumers pay for iPods.
• Rivalry: In terms of brand identity for digital music, Apple has a huge lead on its rivals that completely inverts the lead those rivals enjoy on Macs. As I mentioned, there aren’t many significant feature differences between their offerings, but each competitor’s closed format represents a barrier to entry for its rivals, notwithstanding Real’s efforts to sell music that plays on iPods.

Because iTunes is married to iPod and because both dominate their respective market, it’s not as if keeping the AAC++ format closed has represented much of a missed opportunity for Apple. If you’re an iPod owner, the only thing that would make you buy music anywhere but iTunes would be a service that offers cheaper files that still play on your iPod. If you're not an iPod owner, you can still convert iTunes files to play on your device.

In the eyes of Apple and its supporters, the iPod-iTunes relationship is akin to that of razors and razorblades or printers and ink cartridges. Conventional business wisdom avers that profits can only be preserved by maintaining the symbiosis between the two.

But what if a wedge gets driven into the iPod-iTunes relationship? What iPod starts losing share? Should iTunes address markets outside of iPod owners? Such a move would certainly orphan the iPod, although it would add value to an iTunes music file for which iTunes could charge a premium. That could stave off some of the commoditization of digital music, although, by making iTunes files directly playable on other devices, the iPod would be exposed to further price pressure.

But iPods add hundreds of millions to Apple’s top line, while iTunes has only contributed millions. Until something reverses that dynamic, it would be awfully hard for Apple to justify cutting out the knees of its largest absolute source of profitability and revenue growth.

iTunes collects 29 cents on a 99-cent download and is said to have 20% gross margins and 5-7.5% operating margins. Still, iTunes’ surging sales are expected to boost those margins as fixed costs are spread across increasing volumes, while operating margins on iPods are expected to fall below 10%. I suspect they could fall further as Apple gets squeezed between the price pressure and the supplier power wielded by Intel.

In the meantime, opening the AAC++ file format would only accelerate the inevitable. Apple should wring out as much profitability as it can from the iPod until profits from iPods and iTunes reach an inflection point. Only if such a point seems imminent (and that’s a big “if”) should Apple consider opening its music format.

Opening the iPod is a different matter. Apple has repeatedly slashed prices on the device and will likely do so again. It’s tempting to think that Apple’s brand can justify a premium for the device. But that same thinking is what cost the Mac almost all of its market share 20 years ago, when Apple’s refusal to license its operating system to other PC makers allowed Windows-powered PCs to flood the corporate, consumer and education markets.

Presently, iPod’s margins are under more pressure than its market share, although there's only so much margin Apple can cede before it loses share. Still, before it capitulates to accepting the file formats of iTunes’ competitors, it must look to other features to prop up the device’s margins. What features? That’s the topic of a later post, but battery life would certainly be at or near the top of my list.

Adding features could expose the iPod to broader competition from other handheld devices. To the extent that the iPod hems itself in from such competition or finds itself unable to compete, it may be time to consider opening the device to others services’ formats.

Similarly, if competitors such as Napster-to-Go showed they could consistently take share from iTunes, the iPod could be dragged down by iTunes. Blunting such an aftershock could require Apple to open the iPod to other services, as a turnkey device that plays other services' files would have more value to consumers in that context.

Legal Downloads Nearing a Tipping Point?

A report from the International Federation of Phonographic Industries showed that legal, single track downloads for the first half of 2005, 180 million, topped the total for all of 2004, which ended at 157 million.

Of course, illegal downloads still dwarf the legal variety, yet they rose a relatively paltry 3% from 870 million in January to 900 million in June.

The IFPI’s factsheet suggests that consumers' fear of lawsuits and annoyance with adware, spyware and viruses have blunted the growth of illegal downloading. That may be true, but it seems a little early to claim victory over illegal downloading. 3% growth is also the historical growth rate of the US economy, which could indicate that p2p services are simply hitting maturity.

The fact that illegal and legal digital music delivery are both still growing indicates that the overall digital music pie is still growing and thus neither side can claim definitively to be taking market share from the other.

As BigChampagne CEO Eric Garland told TechNewsWorld:

"Ultimately, we have to bridge the gap. Subscriptions look like a winning model," he said. "But consumers in our focus groups said that although they welcome subscription models, they will not stop downloading free MP3s. So they are willing to pay for music, but they still consider swapping files an important part of the equation."

What I found remarkable was the growth of legal download services, which have tripled to 300 in the past year.

There had been some expectation that consolidation and attrition would whittle that number down, but a countervailing force is the room for differentiation that exists for services. While major services such as iTunes, Napster, Yahoo! and Real's Rhapsody tout the 1 million-plus tracks that each have in their catalogues, other services differentiate by focusing on specific types of music, such as Christian, Indian, Indie Rock, etc., or by focusing on larger or more open file formats, such as lossless (FLAC, WAV, etc.), MP3 and DRM-less.

Going forward, I’m keeping an eye on subscription rates. As consumers move from music collectors to music samplers, I expect subscription services to occupy a bigger piece of digital music’s revenue stream.

Subscriptions to digital services are up sharply so far in 2005, according to IFPI, with a total of 2.2 million people now subscribed to music services globally. This is up from 1.5 million subscriptions estimated in the group's Digital Music Report in January.

What about the (i)Tunes, man?

In a report from today’s Wall Street Journal (subscription required), Apple has recently held discussions with major recording companies, seeking to license music videos to sell through its iTunes Music Store.

Like many people who follow digital content distribution, I’ve suspected that iTunes, which just crossed the half-billion mark for track downloads, exists to push sales of iPods, which have produced over $1 billion in quarterly revenue for Apple since Q4 2004. And vice-versa. This move certainly seems designed to push further into the stratosphere sales of iPods.

On the surface, this venture would portend no major technology hurdle, as iTunes is built on QuickTime and its last two versions have featured video playback. Similarly, iPods are now equipped with color screens to show album art, photos, etc.

But I am deeply skeptical of the iPod’s chances as a video playback device, for the following reasons:

1. Battery life. If you keep the backlight off, play low bit-rate songs (128 kbps), don’t shuffle, don’t flip back to memory – basically, hit play and don’t touch the thing again – you might, might get 12 hours’ life out of a brand-new iPod battery. Last month, Apple had to settle a class action lawsuit related to battery failures of its earlier iPod models. Now they're going to launch an iPod with the battery capacity to play hours and hours of video content? Doubtful.

2. Screen size. As anyone in the mobile phone industry will attest, the public’s presumed appetite for video content on 2 inch by 2 inch screens is looking more and more like a marketing myth. There’s only a handful of types of content that people are willing to squint at a handheld device for longer than two seconds to consume. Maps, directions, events in my area? Yes. Movie trailers and music videos? Not that I watch either, but, if I did, why wouldn’t I do so on the larger screen that accompanies the device on which I downloaded such content to begin with?

3. Functionality. Sorta overlaps with #2, but think about what you do with an iPod. You shop, tap away on your laptop, exercise, drive, powerwalk through airports and train stations and a whole lot of other activities to which listening to your iPod takes a back seat in terms of being your primary focus.

Indeed, video seems like a questionable offering for a service called iTunes. So, if it’s inconsistent with the name of the service and it isn’t going to sell more iPods, why is Apple interested in it? Because large numbers of people have already shown that they want it so bad that they’re willing to download it illegally, as they did with music. And, as it did with music, Apple wants to show video content owners that it can be every bit the vigilant technology steward of intellectual property that it has been for audio content owners.

Some may scoff that Apple’s FairPlay digital rights management coding has been easily cracked by software such as PlayFair, Hymn (which succeeded PlayFair following a round of cease-and-desist letters from Apple’s lawyers), DeDRMS and FairKeys. But the relatively small, but savvy cohort that uses such programs hasn’t come close to neutralizing Apple’s prowess at monetizing once-free digitally distributed content.

So, once again, Apple is looking to the lawsuits for its next market and is now locking in on the crowd that currently must download The Matrix or the last season of 24, The Simpsons, etc. on BitTorrent.