The Long and Winding Road … to Satisfaction

Apple’s announcement this morning for its iTunes music store is another earthquake for the music industry. While it resolves some issues, it leaves major ones unresolved.

In a press conference in London, Apple CEO Steve Jobs announced that one of the big four record labels, EMI, in May will make its catalog available for download without DRM. Consistent with Jobs’ call to abolish copy proection, this could help solve Apple’s regulatory hassles over its closed DRM system, or at least buy it some time. However, there were several major caveats:

• It costs more: the price per track goes up 30% in the US ($1.29 vs. $0.99) and 25% in the UK (99p vs. 79p); no Euro price is yet posted. For that you get no DRM and a higher quality (256 kbps vs. 128 kbps) track. Purportedly the prices for downloading entire albums remain unchanged, consistent with its new Complete My Album program.
• The songs are not in MP3 format, but (like other iTunes downloads) in AAC format — supported by the iPod, Zune, but not all MP3 players.
• EMI is the smallest of the big four, with roughly 10-15% of the industry. This is not their first experiment with DRM-free music, but it’s obviously the biggest.
• The downloads include all currently downloadable EMI artists — such as the Rolling Stones (on Virgin), Elton John (on Chrysalis) and Norah Jones (Blue Note) — but not the Beatles. Despite Apple Inc.’s earlier trademark settlement with the Apple Corps, Sir Paul and the rest of Fab Four are still holding out for a better offer.

The economics of the deal are interesting. Obviously there is no cost difference for encoding without DRM, and the incremental cost of inventory (or bandwidth) for the 256kbps songs is minimal. This means EMI will let Apple sell DRM-free music as long as it gets more money — gaining the price increase that the big four were hoping to achieve.

Today’s announcement shows yet again that Apple holds the keystone advantage in the digital download ecosystem. Apple has about an 80% share of US legal downloads, but the deal is worldwide. Apple wins in three ways:

• Everyone’s iPod now holds half as many downloads, necessitating an upgrade for those who use their iPod mainly for downloads.
• It gets to sell upgrades to more than two billion songs sold thus far, perhaps overcoming the speculated slowdown in downloads (or, more accurately, levelling off of growth).
• The DRM-free music may get iPod owners to buy more than 15 songs/year.

Also, Apple’s efforts could shift some industry attention from MP3 to AAC. While AAC is widely believed to have better sound quality, the real difference is the business model. Since both are heavily encumbered by patents, I’d consider neither to be a truly open standard. However, the AAC royalties are based on encoders and decoders with an annual cap of $250,000, whereas the MP3 royalties include both an upfront encoder and decoder charge, as well as 2-3% of the content price. Better still for Apple, as part of the MPEG-4 patent pool, it gets either an offset (or, if it’s lucky, a royalty-free cross-license) of the AAC fees for use of its own patents.

To check some details in writing this post, I went back to the MBA teaching case I wrote on digital downloads back in Fall 2002. The Big Six (Warner, Sony, Polygram, EMI, BMG, Universal) had become the Big Five in 1998 (with the Universal-Polygram merger) but not yet the Big Four (when Sony-BMG seemingly combined in 2004). CD sales had fallen for one year, but the trend was not yet established. At that point, Apple had released its iTunes music software (January 2001) and the iPod (October 2001), but the iTunes Music Store (now just the iTunes Store) was in the future (March 2003). Meanwhile of the download services announced by mid-2002, today only one (Rhapsody, now part of Real) is still viable.

In less than five years, Apple has transformed the industry, and despite efforts by the record labels to reduce Apple’s power and raise prices, they keep agreeing to Apple’s terms. Of course, the absence of DRM (for those who pay extra) means that iPod libraries can be migrated to Zune or Sansa MP3 players, a Walkman Phone, or any other portable music player. Apple seems willing to take the risk in exchange for a strategy of creating its own future.

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