Apple and the Music Industry

Last week’s post on YouTube and Viacom got some great comments. If you get a moment go read them. Ram Medury brings up the case of VAS content providers in India, who get a small fraction of the revenues. The rest is kept by the Indian mobile service provider. Senthil says that it’s about the quality of the content. If the content is compelling it will pull in the dollars. Also, Robert Young at Gigaom has a very thought provoking post on the subject of Google and old media companies.

Onward ho! As promised, this week I take up another interesting space where the “Content vs. Distribution” battle is being played out – digital music.

AAPL vs EMI

The chart above indexes the growth in the value of Apple and EMI plc since March 2002. EMI is one of the big four music “labels”, the others being Universal, Warner and Sony. The difference in the market cap growth for Apple and EMI, two companies who essentially eat out of the same plate (the music industry) is astounding. AAPL has grown by 600%, while EMI has lost market cap. EMI is now in merger talks with Warner Music.

Apple isn’t all about music, but their growth in revenue, earnings and market cap, in the last 4 years has been all about the iPod. The chart below shows you how closely correlated they are. Incidentally, it took me 10 seconds to pull this chart together on the Gridstone platform. Try doing that with anything else out there. Short commercial break now ends.

Apple Rev, EPS, iPod Rev

What makes the iPod so successful? There is no question that the iPod is a design marvel. I own two iPods myself and I love its looks and usability. But the iPod also owes its commercial success in large part to the near absence of competition.

Apple’s iPod and iTunes together are a closed system. iTunes doesn’t work with other portable music players and the iPod doesn’t work with other digital jukeboxes. The songs you download from Apples music store cannot be played on portable music players other than the iPod. You can however, convert your CDs into mp3 and play them on your iPod.

The reason this is a closed system is something called DRM (Digital Rights Management). The music you download from Apple store comes wrapped in software which implements the rights you have to that music – to play it on upto 5 computers and any iPod. The DRM is there because the music companies insist upon it. Pirated music is the number one reason why music sales have been dropping year after year.

DRM essentially is the glue that binds the “closed system” together. Apple’s DRM called “Fairplay” is proprietary to Apple. There are many industry commentators that have been calling for DRM free music. Steve Jobs also supports it, oddly. But there is no doubt in my mind that DRM free music is bad for the iPod.

Let’s look at the competitive dynamics of the digital music industry with DRM. In order for the DRM to work, the system needs to be a closed one. An industry standard DRM is unlikely to emerge simply because it is not in the interest of its leading players. So what does it take to be a player in this closed-system-DRM-based industry?

For one, you have to be an electronics manufacturer, since you have to make your own portable music players. That cuts the field down quite significantly. Second, you need to have the software development capability to come up with a DRM and an online music store. Third, you have to have the industry credibility to get the four major music labels to sign up with you. If you lose one of them, your customers are going to have a sub-optimal experience.

As you can see, the bar is quite high. Not surprisingly, today there are very few players of any significance. Microsoft and Sony have closed systems. Yahoo Music tries to get by without a player. Undoubtedly, with a 70% + market share, the 800 pound gorilla in this industry is Apple. They not only have a gigantic market share, they have pricing power.

Without DRM, or with a DRM standard, the market would be a whole lot more competitive. The music distribution business would be sundered from the music player manufacturing business. Many more players would jump into the fray leading to accelerated innovation and lower prices. The consumer would have more choices. One choice that they don’t get to exercise today would be to a really cheap portable music player that would play legally downloaded music. More competition would certainly impact the iPod – first its margins, then its market share. Although, it might expand the market size and Apple might still come out ahead.

And what of the music labels? Certainly, piracy and casual file sharing is hurting their prospects. But their insistence on DRM is puzzling. Their music is out there on CDs without any DRM protection. There is no sense in closing the stable door after the horse has bolted. Maybe they see something that we don’t. But any which way, it must hurt a lot, that a distributor of their music has created more market value than the top four music labels combined.

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11 Responses to Apple and the Music Industry

  1. Pingback: Musicians Online » Apple and the Music Industry

  2. Surya says:

    This was a great read, came to know about DRM which sounds like self destruction software.

    Walmarts market cap is bigger than P&G, so the content versus distribution debate has relevance in the hard world also. About the proportion of value(Content : Distribution) in the soft world, I totally agree that distribution channel seems to be ruling except for Microsoft excel on top of microsoft vista combo.

    Music lovers have benefited from MP3 and I am sure that my generation will not pay for music except for live concerts. So Musicians have to work more and do more live concerts which is again good for the listerner. Steve Jobs is sitting on the fence, but the iPhone looks like a home-run.

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  3. lrd says:

    The only people complaining about DRM are:

    1) People who have a distained for Apple and Apple products;
    2) People who for years have been waiting for the day that Apple folds up shop and simply goes away- maybe those nasty Mac vs. PC commercials don’t help;
    3) People with platform envy because they’ve bought the wrong product.

    Everyone else, like myself, couldn’t care less which player you have which MP3 player you own. And this is probably 95% or more of the people.

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  4. Ory@google com says:

    Your comment that more players would lead to accelerated innovation and lower prices. This may be true in general but let’s not forget that Apple is the leader here. Do you really think anyone could out innovate Apple or offer lower prices for the quality Apple offers.

    Apple is a man among boys in this situation and the competition has proven itself inferior and incapable. Apple is at the top of their game and their attention to detail withstands even with their music player domination.

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  5. brotherStefan says:

    This article seems constructed upon some terribly tortured logic. Just because iTunes and iPod accommodates one flavor of DRM (to the exclusion of other flavors) does not make it a closed system. It seems the only people complaining about Apple’s “closed” system are those that have no personal experience with it. 95% of the content stored in my iTunes (and played on my iPods) did not come from the iTunes music store. Nor is the other 5% (purchased from the iTunes music store) somehow “locked” and unavailable to be played on my car or livingroom sound system (or on a clunky disc-based portable mp3 player). If anything, Apple’s supposedly “closed” system allows me to listen to old 8-track and vinyl collections in a way that was physically impossible more than 5 years ago.

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  6. Basab says:

    Ory, most people would agree that more competition drives greater innovation and lower prices.

    BrotherStephan, 5% of 1000 songs is 50 songs that I would have bought from iTunes store. Those songs won’t work on any other player. That’s a $50 switching cost for me. That’s what closed systems do. Raise entry barriers for competition and raise switching costs for consumers.

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  7. brotherStefan says:

    Basab,

    So, it seems to me that you should be complaining about the closed system YOU have chosen to use. Correct me if I’m wrong, but I don’t recall seeing any turntable (or reel-to-reel, or cassette) aficionados complainig that their choice of player will not accomodate Apple’s (or any one else’s) DRM.

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  8. brotherStefan says:

    BTW, with regard to those iTunes purchases…

    Each was made available for play in my livingroom and/or car CD player in less time than it took to download the selections. I just fail to see what the “lock-in” is. It is certainly less restrictive than with any previously available analog media — after all these years, I’m still unable to get any cassette to play on my turntable.

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  9. mark says:

    You said “But there is no doubt in my mind that DRM free music is bad for the iPod.” I think you’ve got it very wrong.

    1. First, people buy iPods for the easy-to-use, seamless, well-designed system that it is. The iTunes store is not a driver for the purchase. The store is convenient, but most people fill their iPods from their own CDs and from piracy. So the iPod would continue to sell on its own merits even if you could buy songs from elsewhere or play iTunes-bought songs on other players (which you might still not be able to do without DRM as very few players offer the underlying AAC format used by iTunes).
    2. Second, you infer that iPod owners would buy from another store instead of the iTunes Store. But why would they? What do any of the other stores offer that iTunes doesn’t? eMusic, whose non-DRMed songs work on the iPod, outsells the other stores. It’s not subscriptions as those won’t work without DRM. iTunes is the 800lb gorilla of music stores. They’d be very few iTunes sales lost.
    3. Third, getting rid of DRM would free Apple of the expense to maintain and the liability to protect the FairPlay DRM. In addition, the presence of DRM and its required keys complicates innovations in iPods, iPhones, and iTunes. For example, wireless or LAN sharing would become much simpler without DRM.
    4. Finally, Apple believes more people would download music instead of buy CDs or piracy if there was no DRM involved. If true, the market would be larger without DRM, and iTunes would likely be the major beneficiary of such demand (since it is arguably the most comprehensive and easiest to use store, and most people are already familiar with it).

    DRM free music is good for the iPod.

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  10. Basab says:

    Mark, there are two separate issues here. One, that seems close to many peoples’ hearts here is the idea that the iPod is far and away a better designed portable player than anything else in the market. I actually agree with that but hasten to add that that is not the crux of the article. The second issue, which is, is that the iPod has benefited from an industry structure that has lower competitive intensity than it would have without DRM. If that were to be removed, there would be more competition. It may be better for the consumer, but not for Apple.

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  11. Vivek says:

    Is AAPL’s Market-Cap unjustified ?

    Closed or NOT, let’s look at the Business angle:
    What is a Record label ? A record label is a brand associated with the marketing of music recordings and music videos.

    Do you buy the Music for the Record label brand ? Do you buy a book because it comes from a certain publisher ? Do you remember the label of your favorite song ? Or the artist ?

    So essentially the Record label provides (1) Marketing muscle (billboards, promo’s) and (2) Distrubition (Tower Records, Target, …) to the Musician. In the old days, it was a MUST to have a Distribution channel to reach so many stores in the US, and across the world. In a sense, this was a Supply-Chain problem.

    Apple has solved the Supply-chain problem. Apple is buying Music from the Record labels just like Target, but doing a lot better job.
    – Give Consumers the option to buy only the songs they like
    – Indie labels, Artists can get distrubition at ITunes
    – You can get your obscure song, which the Store can NOT carry (the long tail …)
    – No Inventory, No carrying cost
    – Take the Music with you … to your Gym

    It has changed the Music buying & listening experience fundamentally (read value creation). It is paying the Music industry 70 cents for every song that it sells. W/out Apple the Music Industry would be in a worse situation.

    In Summary, AAPL is doing a lot better job as a “conduit” between you and the Artist than your old record label and Tower Records, and all the other APPL wannabe’s – that’s why the rising market cap for APPL and decreasing for the label.

    Google and YouTube is another story … in another post.

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