Hell Freezes Over for Apple, Part One

Last week (October 16, 2003, to be precise) Apple launched the long-awaited PC version of its much lauded, and so far, very successful iTunes subscription-based music download service. The launch was accompanied with plenty of fanfare in the mainstream press for a variety of reasons, not the least of which is that iTunes is something of a revelation for the music industry in the sense that it actually gives music fans what they want: legal downloadable music with limited restrictions in an easy-to-use and understand package. Moreover, the fact that Apple released an iTunes for the windows-based world was seen as a shift of strategy on the part of Microsoft-hata Steve Jobs, a fact that Apple’s marketers cleverly manipulated to their own advantage, advertising iTunes for the PC with the great tagline, “Hell Freezes Over.” Financial and industry analysts also praised Apple for this move, because although iTunes has been a success thus far—selling roughly 13m tracks at $0.99 a pop since its launch—its “Apple-Only” distribution strategy meant that the market for it was rather limited. (Apple’s machines comprise roughly 3% of the PC market, according to this article, whereas Windows PCs are a vastly larger market, meaning much more potential iTunes subscribers.) Even musicians had eagerly chimed in on the perceived greatness of Apple’s move, with Bono—of U2 fame, no less—stating that Apple’s move to PCs was an occasion for him to “kiss corporate ass”, which is something that he doesn’t “do for everyone.” (Excepting the producers of the Tomb Raider soundtrack, that is.)

However, despite the fact that iTunes is clearly a solid service—we just downloaded it, and it looks like a typically well-designed Apple product—it’s less clear whether or not it will be a boon for Apple over the long-run. The logic behind iTunes appears to be an attempt to be twofold: one) create a relatively profitable new sales channel (online music) and two) sell more iPods. However, after carefully considering the situation, we’re not so convinced that Apple’s foray into the wild world of digital music is a great bet for its shareholders. Not only is Apple’s position as a leader in the arena of digital music downloads looking less tenable as new competitors enter the market, both the markets for online music distribution and MP3 players looking like their headed toward destructive price-based competition that will only hurt Apple’s bottom line.

Let’s start by examining the market for digital music, and Apple’s position within it. Up until now, there has been very little competition for iTunes. In fact, when Apple launched the service in April, its competitors included such lackluster services as Rhapsody (an overly complicated, poorly-executed Real Networks/major label service that had failed to catch on), and popular peer-to-peer services like KaZaa or Grokster, where users could download music for free, but only at the risk of incurring the RIAA’s wrath and possible lawsuits. Little wonder, then, that when Apple launched an easy-to-use service, with an extensive catalog (200K plus songs at launch, approximately 400K songs to date) that it was able to capture the lion’s share of the market for fee-based downloadable music.

However, as has happened time and time again—consider as it did with GUIs, user interface, and hey, even MP3 players—iTunes revealed Apple’s skill in being to get a product and service just right, only to have its design choices quickly copied by competitors. Admittedly, the first service to copy Apple—BuyMusic.com htt kinda sucked—but newer services, particularly MusicMatch.com make downloading music on a PC just as easy—if not better—than iTunes. For example, not only does MusicMatch feature the same pricing scheme as Apple ($0.99 a track/$9.99 an album), it features a highly similar, very intuitive interface, and vastly superior editorial content (piping in album information and using collaborations from the All Music Guide, which is easily the most comprehensive source of music info on the web). Moreover, MusicMatch currently features the same number of songs as Apple’s iTunes service, and offers more esoteric or obscure content, which is a boon for music consumers like ourselves, who tend to avoid most of the mass market stuff sold on iTunes. All of these factors make MusicMatch a potentially better option than iTunes for music fans.

Although MusicMatch might not be able to best iTunes’—despite having what we think is a better product, the company is much smaller than Apple—it is merely the tip of the iceberg of in terms of the competition that Apple is about to face. Consider this: in the next few months, the following competitors will be entering the market for digital music: Microsoft, whose bottomless pockets give it the ability to fight a protracted price war, Dell, which plans on launching a service to support a line of MP3 players it announced mid-September, Amazon.com, whose extensive customer data and large amounts of site traffic make it easy to recommend and cross-sell music direct to users, and a revitalized, subscription-based Napster service, which has the advantage of a recognizable brand-name, with plans to have twice as many songs available for download at launch. Clearly, while Apple may have had a captive market to sell to in the Mac world: mac users had virtually no choice when it came to downloadable music—the PC world is shaping up to be a much different battleground. As a plethora of new entrants—each with a roughly identical product (music downloads from the same array of artists) enters the music download marketplace—competition on price will likely occur as each download service tries to gain market share at the expense of their peers.

The likelihood of price competition is compounded by the fact that any would-be players in the music download arena—iTunes included—faces razor-thin profit margins. Due to the fact that there’s effectively one source for content in this industry, artists and recording labels, with many potential buyers (each new download music service) gives content suppliers—labels and artists who control the rights to their music—substantial power over download services (it’s estimated that record companies collect as much as $0.35 per song downloaded). Meanwhile, marketing, administration and technology costs for each service are relatively high (and will likely remain so, as long as competition in the music download market continues to increase). Consequently, of the $0.99 you’re paying for each music track you download, ultimately less than $0.10 ends up as profit for a music download service, according to industry analyst Charles Wolf of Needham & Co.

Given the competitive forces of the online music download world, the key to long-term profitability seems, put simply, get big, fast and become the dominant player in the category. By achieving a pre-eminent position in the music download position, a firm like iTunes could theoretically demand better terms from content providers in exchange for providing them access to their audience, giving them a lower cost structure than competitors. Additionally, a leading position could also create a virtuous cycle for a player that would be very difficult for competitors to match—a leading player could demand exclusive rights from specific artists or labels who wanted to sell digital versions of their songs, which in turn would increase the customer base of a service, which would thereby give a download service greater clout to demand exclusivity from their artists, and so on.

In order to achieve this scale, and hopefully insulate themselves from competition, online music firms are using a combination of several different tactics. Some of these tactics include extensive marketing and advertising to build awareness, trying to secure as larger library of music than that of competitors or paying content producers to provide content exclusively to a specific service in order to encourage fans to use that service rather than competitors. Additionally, firms are also trying to compete by offering fans different levels of access or permission with respect to the songs they purchase or download: some firms offer generous rules on the number of times a specific track can burned to a CD, or alternatively, offer more liberal rules on the types of devices—computers, MP3 players, CDs—that the song can be played upon. (These “rules” are all enforced by technology-based copy protection.)

Apple’s strategy for iTunes appears to be twofold: aggressively outspending its smaller competitors—MusicMatch and Roxio’s Napster— in terms of advertising and marketing, while trying to sign artists to iTunes-exclusive digital distribution deals, either by luring them with Apple’s brand (the Rolling Stones) or by simply paying them for this exclusivity (Dr.Dre, the Eagles). These tactics are relatively smart for Apple right now—as it has significantly more cash and current assets than these competitors—it can easily outspend them or force them to spend more to gain traction. Furthermore, since it has a much larger market share than either of these rivals, it can spread these costs in a way that its smaller competitors can’t. Apple’s aggressive moves in these areas clearly highlight its desire to quickly build up an unassailable lead in the online music domain, and hopefully shield it from larger entrants—e.g. Microsoft or Dell—who could easily afford to outspend Apple in terms of advertising and marketing.

However, while Apple is doing well with utilizing marketing and signing artistis to exclusivity deals to support iTunes, the biggest flaw in Apple’s iTunes strategy is this: whereas other services like MusicMatch allow users to download music they’ve purchased to whatever device they’d like, no matter who it’s manufactured by, Apple is currently only allowing music from the iTunes store to be downloaded to iPods. This seems to put iTunes at a considerable disadvantage relative to its competitors—although it’s true that the iPod is the most popular MP3 player on the market, it should be noted that the iPod only has 31% of the MP3 player market. (And when you factor in the fact that the majority of iPod owners are also Mac owners, iTunes share of the market for Windows users with MP3 players is probably significantly smaller.) In other words, competitors like MusicMatch or forthcoming services from Microsoft and Dell have a huge potential leg up on iTunes when it comes to trying to gain share in the digital music market. The market for online digital music is still up for grabs meaning that Apple’s iTunes has yet to gain the market share that would enable it to sign up most artists or label to exclusive contracts, which is the one area that Apple could truly differentiate itself from its competitors in. Moreover, since iTunes’ competitors are roughly equivalent in terms of the service and features they offer users, the much greater flexibility that they offer users should help them steal share from Apple.

So what’s behind with Apple’s decision not to go the whole hog when it comes to providing iTunes users the same flexibility as competing services? We suspect that a large part of it comes from Apple’s desire to hedge its bets, given the current uncertainty of who will emerge as a leader in the online market world (or who will enter it), the tight margins associated with digital music download, and the she and the tight margins of the online music world and the profitability of its iPods. Apple likely recognized that it would be extremely to generate significant profits in the digital music market without maintaining a near-monopoly position in the marketplace. Consequently, one way to compensate for the riskiness of entering the digital music marketplace was to use the iTunes service as a means of hopefully selling more iPods, which have played a pivotal role in Apple’s success over the last two years. (It was recently revealed in a press conference that iPod sales were responsible for $12.1m of Apple’s net income last quarter [roughly 25% of its profits].)

We’re surprised that so many analysts see Apple’s use of iTunes as a “Trojan Horse” with which to increase iPod sales as a “good thing” or a “win-win” for each product. While there’s no disputing that the iPod is a great product, given its small market share (31% of MP3 players) we still can’t see how it allowing users to download from iTunes to iPod will enhance iTunes position in the marketplace. Furthermore, although the iPod is currently the leader in the world of MP3 players, it’s also relevant to ask whether or not it will be able to maintain this position in the face of much improved, and significantly cheaper products from competitors like Creative and IRiver, which threaten to erode the iPod’s profitability to consumer electronics product levels. (As we’ll discuss tomorrow in more detail, the iPod’s continued success is by no means a certainty.) Our best guess right now is that Apple hopes to somehow use iTunes as a means of insulating the iPod from price competition and vice-versa. While such a strategy sounds great in theory, it will be very hard to pull off successfully in a competitive marketplace. We’ll have more on this tomorrow.