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Digital Music: Apple Shouldn't Sing Solo

By Alex Salkever With 50 million songs sold as of mid-March, 2004, Apple's iTunes Music Store (iTMS) owns more than half of the music-download business. Apple (AAPL) execs note proudly that the iPod now rakes in more than 50% of the total revenues in the digital-music-player sector. Macheads offer these numbers as proof that the music battle is over -- and that Steve Jobs has won.

Not so fast. Wal-Mart (WMT), the world's largest retailer, fired a shot heard across the Internet on Mar. 24, with the launch of its own online music store, with 88-cent downloads -- 11 cents cheaper than Apple. If anything, this competition is just starting: Now-legitimate Napster has an online music service, Virgin is getting into the business, and Sony (SNE) is set to enter later this year (see BW Online, 3/10/04, "Virgin May Show Apple a Thing or Two", and 3/1/04 "The Nine Lives of Napster").

BATTLING THE WORLD? In this context, the fight over digital-music standards could be crucial to Apple's future. It has bet heavily on the Advanced Audio Coding (AAC) standard, which it claims is a huge improvement over the older and much more popular MP3 standard. Apple has incorporated AAC as the primary standard in its iTunes software.

Naturally, Microsoft (MSFT) sees the future of music differently. Redmond is pushing hard for music software and device makers to adopt its Windows Media Audio as a primary standard. Falling in line with Microsoft are Apple's music-player competitors -- Samsung, Dell (DELL), iRiver, and Creative Technology (CREAF), among others. Like the iPod, these boxes will also play files encoded in MP3 and WAV, among others.

The music-download sites competing with Apple -- including MusicMatch and Roxio's (ROXI) Napster service -- also use WMA. While Sony's upcoming service is expected to adopt its own digital music standard, most of Sony's digital devices can play WMA files and allow customers to buy from all the other sites on the Web.

So yet again, it's starting to look like Apple against the rest of the world. True, Apple's deal with Hewlett-Packard (HPQ) to build HP-branded iPods puts one of the biggest PC players in Jobs's corner. But pushing a standard that stands apart from everyone else in the computing and digital-device world may prove to be short-sighted.

GROWING COMPETITION. If Apple really wants to boost AAC, it would allow other device and software makers to license Apple's own FairPlay digital-rights-management (DRM) system. DRM is computer code bound to each downloaded track or album that carries instructions on how the music may be used. For example, FairPlay allows unlimited CD burns of single tracks but doesn't allow songs bought through iTMS to be played on other devices or to be traded on file-swapping networks. While anyone can use AAC -- it's an open standard, after all, and widely available for licensing -- FairPlay puts a barrier between Apple and the rest of the online music community because iTMS downloads can play only on iPods.

That may sound like a good way to lock customers in. For a while, I thought so. But the announcements of new online music stores keep coming. And Napster's parent company has raised revenue guidance for its online music sales to $5.5 million, from the $3 million range, for the quarter concluding at the end of March. That translates into a run rate of 5 million or so songs per quarter, which is an improvement -- but still a far cry from Apple's music sales, which are in the tens of millions of dollars worth of songs each quarter.

Jobs himself recently acknowledged that Apple could miss its target of 100 million iTMS songs sold by April. Add up these discordant factors, and the competition for iTMS could start to stiffen in 2005. Apple may wind up isolated with a standard nobody else is using.

WARY OF REDMOND. It doesn't have to be this way. Apple could still guide digital-music standards for years to come -- and create a more open, competitive marketplace that will ultimately benefit everyone -- except Microsoft. How? By letting go of FairPlay and trusting the market -- as well as its own ability to make killer consumer devices.

While Apple's competitors have embraced WMA, they hardly relish the thought of their business becoming heavily dependent on another standard that Redmond controls. I asked several of Apple's competitors in both music hardware and software if they would like to license FairPlay and include AAC as an optional format. They indicated that it's something they would be very interested in.

Apple's AAC/FairPlay combo already owns the largest share of the music-download market. If music players from other outfits could use iTMS, then customers could move back and forth from one brand to another. True, that would mean less of a lock for Apple's iPod. But it would be a big boost to iTMS revenues.

MULTIPLE PERMUTATIONS. By allowing competitors to leverage the already popular AAC/FairPlay combo, Apple would give them a strong alternative to WMA. Apple might lose out a bit in the short run. But it would be far more likely to prevail over the long haul if it allowed these natural allies into the fold. If Apple truly believes it can make the most innovative music players and software, then it has little to worry about from competition. Standards barriers that ghettoize Apple's music efforts pose a far greater long-term risk.

This would fly in the face of Apple's long-standing belief that the way to create the best user experience is through tightly integrated hardware and software. However, Apple has already made a version of iTMS to work with Windows machines. True, iTMS for Windows has to play nice with only a single piece of hardware -- the iPod -- right now. But it still needs to contend with the multiple hardware and driver permutations that make up the complicated WinTel landscape.

One last point. By most accounts, iTMS is the smoothest, best online music store around. While Jobs & Co. doesn't make any profit from the store yet -- it's a loss leader for the iPod -- Apple could end up making boatloads of money if iTMS becomes one of the handful of default players and stores for what will clearly be a multibillion dollar market.

SOFTWARE, NOT HARDWARE. That's where the long-term opportunity lies. I'd bet customers would pay a premium for a really good music player now. And they'll pay for worthwhile content on the Web going forward, be it music or sports or access to specific news sites. But beyond hardcore Apple aficionados, they won't pay premium prices for hardware or devices for very long into the future. There isn't a single type of electronic device that hasn't suffered from shockingly rapid price devaluations.

Right now, customers seem ready to shell out for the iPod's cool cachet. That might even hold up for two years or so: The Sony Walkman lasted a number of years before competition heated up. But ultimately, the rest of the market will catch up enough to become more competitive. Already, iRiver's players, in particular, are getting kudos from reviewers (see BW, 3/29/04, "Taking On iPod"). And when device makers start to catch up, Apple will be in a stronger market position if it still controls the software, rather than the hardware.

I know. This stands Apple's traditional business model on its head. But the impossible already happened when Apple started building products for Windows. I'll take the margins on software over those for hardware any day. And I would take a smaller share of a much bigger digital-music pie over the prospect of facing down Redmond and everyone else in what could turn into a really rough music war. Salkever is Technology editor for BusinessWeek Online. Follow his Byte of the Apple column, only on BW Online

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