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.

Posted by Matt Percy | Permalink | Comments (1) | TrackBack

Hell Freezes Over For Apple, Part I

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.

Posted by Matt Percy | Permalink | Comments (2) | TrackBack