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What's the Next Verse in Apple's Song?

If there has ever been a textbook example of how to turn a techie backwater into a mainstream market, it's Apple Computer's (AAPL) runaway success in the digital music business. When Apple unveiled its first iPod in Oct. 2001, the market was a smattering of little-known devices used mostly for playing songs illegally downloaded off file-sharing Web sites. That's one reason why the music labels agreed to CEO Steve Jobs' plan to sell their music for just 99 cents a song.

Besides, with Apple's anemic 3% PC market share, few record execs figured Jobs would be able to win over anyone other than his loyal base of Mac buyers. It would be a safe little experiment, letting music execs learn about the market while Apple picked up most of the tab.

Some experiment. So far, Apple has sold more than 22 million iPods and more than 500 million songs via its iTunes Music Store. Last quarter, Apple reported that 38% of its overall $3.5 billion in sales came from its music business.

RISK OF HISTORY REPEATING. And just as Jobs promised, Apple's success has been good for its music partners as well. Digital tunes now make up around 5% of total music sales -- and it may well be the labels' most profitable segment. After all, they don't need to press, ship, or take returns of physical CDs. The labels don't even have to pay for in-store marketing -- posters, end-cap displays, and the like.

But the problem with any hit-driven business is just that: If a company is going to maintain its momentum, it must have even bigger follow-up hits. And a growing community of people -- rivals, customers, investors, and even some of those record executives -- are wondering if Apple needs to leverage the iPod to come up with another platinum-selling digital music product.

This time, instead of a laid-back market with a few cash-starved startups, Apple is going to face off against a huge crowd of well-established competitors, each with new ideas about how to sell music. If Jobs lets any of them get too much of a head of steam, he risks a repeat of what happened in the PC industry: Apple set the tune with its original Mac but soon lost its market-share lead by refusing to change its initial approach.

OWN RATHER THEN RENT. So what is Jobs' next tune? Will he create an iTunes subscription service so customers can hear, but not own, any song they want for a monthly fee? Will Apple try to extend its audio dominance into the video realm, with products to let consumers watch music videos, TV shows, or sports clips?

Or, having turned iTunes into a virtual CD-rack for millions, will Jobs now try to create gear so people can listen to their iTunes and possibly other kinds of media in the living room? Perhaps Jobs will go even further and have Apple build its own home theaters and branded TV displays? And might Jobs break from past practice and license his technology to others -- say, to allow the iPod to work with rival services from the likes of AOL, Napster (NAPS), Real Networks (RNWK), and Yahoo! (YHOO)?

At this point, Jobs has expressed more reasons for not making these moves than for making them. He has long argued against the subscription model, saying consumers want to own rather than rent their music. He doesn't believe people want to watch movies on portable digital players' tiny screens. And he has said Apple can do more for its customers by sticking to its proprietary approach to developing products, rather than spending time getting them to work with less popular products from others.

LOW-END iPOD? Jobs seems to be betting that Apple's current course -- pushing more iPods and music sales on iTunes -- is the best one. That may sound less than imaginative for computerdom's top innovator, but the logic is powerful: For all the talk of other new-fangled approaches, Apple is the only company with millions of customers and a proven business model. And with just a 5% market share, Apple has plenty of headroom for growth.

Now wonder Jobs is moving aggressively to support that approach. In July, Apple added a podcasting directory to iTunes, immediately making it the place where many iPod users go to subscribe and listen to their favorite podcasts (see BW, 8/15/05, "Podcasts: David vs. Goliath").

What's more, on Sept. 7 a new plank of Jobs' plan will become apparent when he gives a much-anticipated keynote at the Moscone West conference center in San Francisco. It's widely expected that Apple will finally unveil a phone, made by partner Motorola (MOT), that can play songs stored in an iTunes music library.

According to one industry insider, the new phone will become the low-end model in the iPod product family, capable of storing up to 100 songs. That could appeal to current customers who want to have some tunes with them when they don't have their iPod or to millions of cell-phone users who want to give digital music a try without having to buy a separate gadget. Apple declined to comment for this article.

SHORTENED "HYPE CURVE"? And if the past is any guide, look for Jobs & Co. to have some other surprises up its sleeve. Among the obvious possibilities: A smaller version of the popular iPod mini that uses flash memory instead a hard drive, to store songs, or a version of the $99 iPod shuffle with a screen.

No doubt, Apple's announcements won't silence critics who say Jobs is leaving the door open to rival approaches. For starters, Apple has consistently said the new iTunes phone will not enable users to do "over-the-air" downloads directly to the phone. Instead, they'll need to sync it to their Mac or PC, just as they do with other iPods.

That's in contrast to carriers such as Verizon (VZ), O2 Germany, and Sprint Nextel (S), who are working with tech outfits such as Loudeye and MusicNet to unveil services that let consumers get songs sent directly to their cell phones. Even Cingular, which is expected to offer Motorola's iTunes phone, has plans to launch such a service, which will work with non-iTunes compliant phones.

"Over-the-air service is going to be critical to success [for digital music companies], and I don't think I'm the only one who realizes this," says Stan Sorenson, senior director of product management and marketing for Melodeo, a mobile music software maker. "The hype curve [on the iTunes phone] is going to be short on this one. People are going to say: 'I want the song I want now. Why can't I do that?'"

DOWNLOAD VS. SUBSCRIPTION. The problem for Jobs & Co. is unlike when the iPod was unveiled -- now, an army of rivals are working on a slew of new ways to get digital tunes. For example, Napster has teamed with satellite radio provider XM Satellite Radio Holdings (XMSR). They will launch an "XM + Napster" service in the fourth quarter, whereby XM subscribers that use an as-yet-unreleased portable player can mark songs they hear on one of the 150 channels. When the user next logs onto their PC, they'll be able to buy the marked songs from Napster's download store.

Many variations on this theme are in the works, all tied to helping consumers discover new music -- and therefore buy new songs. One small example: Manhattan-based NMK Inc. offers a service called 411-Song that lets callers of a special number hold up their cell phone to a song they like anywhere they hear it -- say, in a bar or in the waiting room at the dentist's office. Currently, the service tries to identify the song and, if successful, sends a link so the customer can buy a ringtone of the tune. As wireless networks improve and other bugs are worked out, consumers may be able to buy the actual song within the next year, says CEO Sunjay Galeria.

So far, Jobs isn't ready to sing any tune that calls for a subscription service. He has argued that until more people begin signing up for subscription services such as Real Networks Rhapsody or Yahoo's Music Unlimited, he'll remain convinced that consumers want to buy rather than rent their music. While many analysts think revenues from subscription services may someday surpass that of download stores, so far it's not a fair fight. The total number of paying members for all the subscription services is currently just a few million.

WITHHOLDING SUPPORT. Jobs refusal to apply Apple's might to develop the subscription market irks some of the company's music partners, who see it as a powerful -- and potentially highly profitable -- means to reach more consumers through digital means. And some record execs have other complaints, such as Jobs' insistence on selling songs for a fixed price of 99 cents each.

For example, Sony (SNE) executives have publicly expressed support for more variable pricing, enabling them to charge more for hot new hits and less for rarely sought oldies in the archive. "The market is starting to move towards greater differentiation," says Thomas Hesse, president of Sony BMG Music Entertainment's global digital business group. "Why should everything be the same price? No other market in the world works like that."

Some partners are also concerned about Apple's sheer dominance. Sony customers in Japan, for example, where Apple recently launched its iTunes Music Store, can't get music from Sony or Warner Music Group. Industry sources say while these labels made their catalogs available when iTunes launched in other locales, including the U.S., concerns with Apple's strength led them to withhold support in the Japanese market. Indeed, Sony has a major stake in a music service that was the market-share leader in Japan, although it was immediately eclipsed by iTunes.

SEEKING "A WEAKER NO. 1". So, some music executives were probably thrilled when iPod rival Creative Technology (CREAF) announced that it had captured a patent for the user interface of its Zen Micro music player. Since the patent may also apply to the iPod's famous interface, Creative could potentially seek hefty royalties from Apple.

And Craig McHugh, president of Creative's U.S. unit, aims to use the patent to chip away at Apple's reputation for being the industry's only innovator. "When people hear we have the patent that makes these devices so easy to use, who really is the inventive company? It could cause people to reevaluate what they think [about Apple]."

It's clear some music labels would prefer if Apple would let rival services such as Rhapsody and Napster work with the iPod, so Apple isn't the only one that can use that red-hot device to promote music purchases in digital form. Says one insider: "The labels would rather see a weaker No. 1 and a strong No. 2 and No. 3."

FACING A REBELLION. Jobs is betting his perfectionist, go-it-alone approach will do more to benefit consumers -- and judging from its loyal following, he's probably right in the short term. While there's no shortage of new rival products and services being introduced, Apple offerings stand out for their ease-of-use and slick designs. Throw in Apple's world-class advertising and its retail stores, where customers can get free hands-on training, and no rival can match Apple's ability to keep digital music on the fast track in the near term.

But could Jobs move more aggressively to take Apple beyond the iPod and iTunes? Many industry insiders think so and, furthermore, see the opportunity to take their slice of the pie as the market moves towards a far grander goal: A combination of services, including downloads, subscriptions, and various other methods, to let consumers get music whenever, wherever, and to whatever device they choose. "Consumers want choice," says Mike Brochu, CEO of Loudeye, which provides the e-commerce guts used by carriers including O2 Germany and Cingular.

Still, the choice most consumers are making remains Apple -- and it's sure to gain some extra momentum with whatever slick new products are unveiled on Sept. 7. But so long as Jobs remains on his current course, Apple could face a rebellion among partners and consumers who want more alternatives and more flexibility out of digital music's current king of the hill.

Depending on how you look at it, that leaves open the opportunity for Apple to blow its lead as it once did in PCs -- or for Jobs to make plenty of surprise-filled keynotes in the years to come.

By Peter Burrows Silicon Valley

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