Hell Freezes Over For Apple, Part the Second

Yesterday we talked about the challenges Apple’s iTunes faced—razor thin margins, likely price competition due to the raft of new competitors entering the market—and briefly assessed the wisdom of Apple’s desire to use iTunes as a “Trojan horse” with which to spur iPod sales. (See this article for to hear the official Apple position on this decision.) Today, we’re going to subject the iPod to the same rigorous scrutiny and analysis, in order to argue that while the iPod is indisputably a cool product, it’s highly unlikely that it will be able to retain its present levels of profitability. We’re confident in this assumption for two reasons. First, Apple’s success in the market for MP3 players has attracted a wide array of large and small manufacturers who are gearing up to compete on the basis of cost, which will likely trigger a price war in this industry. Secondly, Apple no longer has the exclusive rights for the key resource fuelling the iPod’s success—an ultra-small, 1.8 inch hard-drive for Toshiba—a fact which will enable a variety of competitors to easily knock-off the iPod’s innovative design.

There are three main types of MP3 players available on the market: flash-based MP3 players, CD-based MP3 players and hard-drive based players. Flash-based MP3 players—like Creative’s Nomad Muvo NX—
tend to be extremely small in size (think slightly smaller than an cigarette lighter) and fairly durable, making them ideal for, say, jogging or working out at the gym. However, their small size and durability comes with the tradeoff: these players typically can’t hold too much music (roughly 2.5 hours on a 128 MB player) and moreover, if you’re a hardcore audiophile, the sound quality of these devices tends to be closer to tape than to CD. They tend to be priced in the $100-$200 range. Although these devices have a future, their relative lack of functionality, and easy-to-replicate technology (most of these devices now run off of USB drives) mean that these devices will probably fall substantially in cost over the next year or two with competition, making it very difficult to generate profits selling these items.

CD-based MP3 players—such as the Panasonic SL-CT800 —are essentially MP3 players that are capable of playing MP3s directly off of a CD. Where’s the fun in that, you ask? MP3 CDs are advantageous inasmuch as they can contain as much as 720 MB worth of music in MP3 form—e.g. about 15 hours of music per disc—as opposed to conventional CDs, which play about 74 minutes. Secondly, MP3-based CDs are customizable, enabling users to create 15 hour mix tapes for themselves and their friends! The downside is that these devices tend to be large and cumbersome, with plenty of moveable and breakable parts—just like real CD players! Additionally, while 15 hours of music sounds like plenty of music, it isn’t enough to accommodate most users CD collections. Consequently, CD-based MP3 players aren’t a particularly compelling long-term product to manufacture.

The most popular segment of the MP3 market—and the market that the iPod dominates, with 31% market share—are hard drive based MP3 players. Hard drive based players have been around for a few years—ever since Creative launched the 6 GB Nomad Jukebox in the summer of 2000—and were initially appealing to hardcore music fans who needed a way to lug a large music collection around the world with them. (Early hard-drive based MP3 players could hold as much as 120 hours of music—a pretty impressive amount.) However, these early players sounded much cooler than they actually were—they suffered from atrociously short battery life (about 2.5hrs to 4hrs), were very large and bulky (making them inconvenient for travel or use on the go) were fairly fragile (if dropping a CD player was bad, imagine dropping a hard-drive!), and suffered from overly slow and cumbersome interfaces. Even despite these limitations, there was a fairly receptive market for a hard-drive based MP3 player, and a fair number of users shelled out $300-$500 for the early versions of these devices, eager to fill them up with MP3s from their collections and other unnamed online sources.

Apple was one of the first significantly big and reputable firms to see the possibilities of hard drive-based MP3 players. Recognizing the fact that there was a market willing to part with a significant chunk of change for what were then relatively mediocre products from the likes of Archos, Creative and Rio, Apple decided that it could capture substantial market share by launching a similarly priced, but well-designed product. Rather than using the conventional hard-drives that its other manufacturers like Archos or Creative used in their devices, Apple used an exclusive Toshiba-made hard-drive that was inifintely smaller, lighter and more power-efficient than anything then available on the market. This drive enabled Apple to create the iPod, which was “smaller than a deck of cards,” (meaning that it was easy to move) housed in a stylish white casing (making it a fashion accessory, rather than geek chic), and offered vastly longer battery-life (thereby giving credence to the claim that hard-drive based MP3 players really could let you take your entire music collection on the go). (If you’re interested in learning the whole design history of the iPod, DesignChain.com has a great article on the subject here.)
At the same time as it was improving the hardware, Apple excelled on the software side, incorporating an extremely easy-to-use interface (interface design being one of Apple’s consistently strong points) for the iPod, and allowing the iPod to play Apple’s proprietary AAC music file format, which was far and away the best sounding digital music file-type available. All of these factors combined to ensure that the iPod was easily the best product to hit the market. And even better for Apple, it would be extremely difficult (at least initially) for competitors to copy, since Apple had managed to sign an exclusive deal with Toshiba to ensure it would be the only manufacturer to build MP3 players with the all important hard-drive which enabled the iPod to be another “insanely great” Apple product.

The rest, as they say, is history. The iPod was launched in the spring of 2001 (you can read a chronological history of the product here) and was an immediate hit. Since then, its importance to Apple has only increased: according to Apple’s most recent quarterly report (Oct 15 2003), the iPod contributed approximately $121m to Apple’s revenue in the 3rd quarter of 2003. Moreover, because Apple had exclusive rights to the Toshiba hard-drive that made the high-quality of the iPod possible, it could price the iPod at a premium far greater than competitors (a 20GB Creative Zen costs $242, compared to $388 for a 20GB iPod—you can compare them here– in other words, the iPod is about $150 more than an average MP3 player in the market), making it a disproportionately significant to Apple’s net income. (It’s estimated that the iPod contributed as much as 25% of Apple’s net income last quarter.)

While competitors couldn’t copy the style and features of the iPod at first, they eventually began to close the gap. Creative launched the aforementioned Zen a year or so ago, and has gradually been able to get it into an iPod-sized casing. Rio launched the ultra-light and small Nitrus, and although the device offered less storage than the iPod (1.5GB, or about 30 hours of music), it featured much longer battery life (up to about 10 hours). Meanwhile, high-end Japanese MP3 player and geek fetish object manufacturer iRiver recently launched a 15 GB player—the iHP-120—at the same price point as the 20GB iPod, but with one critical difference—its machine plays for a staggering 16 hours (as opposed to the iPod’s six), is more durable than the iPod, and simply looks damn cool. Thus, it looks increasingly likely that Apple may have created a market—generating awareness for the sophistication and usefulness of well-designed hard-drive based MP3 players—only to find itself competing in a price war with firms who’ve skillfully copied most of the benefits of the iPod. And a price war certainly seems to be what Apple’s competition desires: read this comment from Creative’s President, Craig McHugh: "We've been positioning our products to [cost] 30% less than a competitive iPod.”

Meanwhile, the device that facilitated the iPod’s creation—the Toshiba hard drive we mentioned earlier—is now off of its exclusivity deal. (Read this Business Week article for complete details.) meaning that the only uncopiable feature of the iPod is now publicly available to competitors. This fact appears to have motivated bigger players like Dell and Samsung to get in the marketplace—now that they can use Toshiba’s ultra-thin and small hard drive technology (Makes you wonder if Toshiba will capture all the value in this game, huh?) , they can create a machine to rival Apple’s and potentially dominate the competition given their—particularly so in Dell’s case—low-cost manufacturing capabilities.

Given the surge in competition and the loss of one of the key resource that’s driven the iPod’s profits for the last few years, Apple launched its online music store to help try and spur iPod sales. As we discussed yesterday, songs purchased via iTunes can only be played on iPods, and the goal of making iTunes iPod only primarily seems to be to provide the iPod with something that its competitors can’t copy. In short, what it seems Apple is trying to do is create barriers to entry—get so many people to buy iPods instead of competitors products, that those owners will be forced to go iTunes-only for their music fix online. Ideally, this will create a network effect, where each person buying a track on iTunes will be forced to purchase an iPod to play the song, and vice versa, to the point where Apple’s current market share in the MP3 market—31%—grows to the point where Apple has locked up the digital music market.

Accomplishing this goal—becoming the OS of digital music, in effect—requires two things: time and money. The problem for Apple is that it has an abundance of neither. Although Apple can pour a ton of money into a great advertising campaign in an attempt to build awareness, and hopefully send iPod sales into the stratosphere, in a few short weeks, Dell will be on the market with its iPod knockoff. Moreover, it’s unlikely that Microsoft will be willing to cede the opportunity to control digital file distribution—which would be the result of iPod winning the digital music game, thanks to the fact that iTunes sells downloads in Apple’s proprietary AAC format. While Apple has some cash on hand (about $3.4 billion in cash and cash equivalents, and another $2.6 billion in its remaining current assets), it has nowhere near the amount of cash Microsoft has ($42+ billion and counting), meaning that it would have a hard time spending its way to control of the market, something that Microsoft could easily do.

So what should Apple do? We’re not so certain if they can do anything, to be honest. While we’d love to see them win—we have to admit, that over the course of writing about Apple and the iPod for the last week or so, we’re really impressed with how cool the iPod is. (Does that mean we’d buy one right now? Probably not—we’re, uh, eagerly anticipating the price competition that will occur over the next few weeks to pick up an iPod at a more Apple-shareholder unfriendly price.) Some quick thoughts before we jet on out of here for the weekend: Apple could sell the manufacturing rights for the iPod to somebody who could make a go of it (e.g. Dell) in a price war, and try to sell as much as they possibly can at the lowest price as possible. While Apple would lose the short-term revenue from the iPod (which we’d guess is gone, anyways), they might get the long-term benefit of owning the digital standard for media files (which could be worth way more, anyways). However, this strategy of allowing a third-party to manufacture something was tried once before by Apple in the 90s with the Mac, and failed dismally—there’s probably some cultural resistance to doing this @ Apple. Secondly, Apple could sell the AAC format to Microsoft, and try and convince Microsoft to use the far-superior AAC format over WMA as the de facto file sharing device on the Windows OS. This would mean that Apple would forgo the long-term revenue from AAC, but could make its money as a manufacturer of superior, well-branded MP3 players. Although a deal with arch-enemy Microsoft seems unlikely, who knows? We kinda like the idea, and besides, hell’s already frozen over once.