iTunes Store a greater cash crop than Apple implies?

Posted:
in iPod + iTunes + AppleTV edited January 2014
Although Apple has repeatedly said that its iTunes Store operates at "just above break even," a thorough analysis of the service's economics suggests it turns a profit roughly in line with the company average, with recent events paving the way for even greater gains.



Based on per-song cost estimates, the ubiquitous iTunes service generates an operating profit of at least 10 percent, and possibly as much as 15 percent, according to PacificCrest's Andy Hargreaves. The analyst on Monday released a detailed report on the subject, in which he informed Apple investors that the economics of iTunes could soon serve as a boon for the company's bottom line.



A breakdown of per-song fees



"For each $0.99 song, we estimate that Apple pays $0.70 to major labels, which own over 85 percent of the market, and $0.60 to $0.65 to independent labels, which drives an average price per song of approximately $0.69," he explained. On top of that, of course, are Apple's network fees, transaction fees, and general administrative expenses associated with operating the iTunes Store.



Hargreaves calculated the network fees at $0.05 per song, which includes the delivery fee, and the hardware and software to facilitate delivery. "Operating expenses are likely less than $0.05 per song, based on the relatively small number of employees we believe work on iTunes," he wrote.



Then, of course, there's the transaction fee -- or royalty paid to credit card companies each time a sale is processed -- which Hargreaves argues is "the primary reason iTunes profitability has not been higher historically." However, he notes hat Apple has recently adopted a number of measures to limit those fees, such as managing a weekly sweep of its credit card transactions, broadly distributing gift cards, and by encouraging larger transactions through services such as "Allowance."



Therefore, the analyst believes the iPod maker is now forfeiting only around $0.10 per song per song to credit card firms, compared to as much as $0.25 per song when iTunes first launched. "Going forward, we expect Apple to continue improving its payment schemes to cut down on transaction fees and improve the profitability of iTunes," he added.







Based on those cost estimates per song, Hargreaves arrived at the 10 percent margin estimate. Applying that estimate to the $1.2 billion in revenue that iTunes is expected to generation in fiscal 2007, he believes the service will generate $0.09 to $0.14 in earnings-per-share for Apple.



DRM-free tracks present incremental profit opportunity



Perhaps even more compelling, according to the PacificCrest analyst, is the incremental profit opportunity presented by the Cupertino-based firm's joint announcement with music label EMI to start selling DRM-free tracks at an approximate 30 percent premium.



"Consumers desire for mobile content drove the explosion in digital music and the growth of iPods. However, consumers became enamored with the quantity of music that the iPod enabled them to access, and sacrificed quality, in our view," he wrote in the report. "Going forward, we believe that consumers will expect mobility and will increasingly look for higher quality as the next step in improving their music experiences, particularly as consumers increasingly use iPods and iTunes as a source of content for home and car stereos."



Hargreaves cited sources who suggest that the economic split between EMI and Apple is likely to remain constant for the higher-quality, DRM-free songs that begin to crop up on iTunes starting next month. Since the songs will retail for $1.29 rather than $0.99, he estimates Apple to receive $0.09 of incremental gross profit per song. While delivery fees should double due to the larger file size of higher-quality songs, the analyst has assessed those network costs at $0.02 or less per song.



Assuming that half of EMI tracks purchased through iTunes will be of the higher-quality DRM-free tracks, Hargreaves estimates the move could generate approximately $24 million of incremental revenue, and just under $6 million of incremental profit for Apple in a year. In his note to clients, the analyst acknowledged that those numbers may seem insignificant, but said they would grow quickly if other labels followed suit in offering the DRM-free tracks.



A subscription model could add $900 million in revenues per year



Another source of incremental iTunes revenue could arrive in the form of an iTunes subscription service. According to the report, Apple has already developed and is capable of launching such a service but has thus far found no compelling reason to do so. However, Hargreaves believes that an increase in competitive offerings and pressure from iPhone mobile carriers could force Apple add the service within the next 18 months.



"Carriers are in the unique position of having a network that can deliver music, a captive customer base of billions of people, and ubiquitous devices that are capable of playing music," he wrote. "We expect approximately 1 billion music-enabled phones to be sold next year. As network speeds increase, battery life on cell phones improves and storage grows, we believe that music offerings from carriers will become extremely viable competitors with iTunes."



However, the analyst believes an iTunes subscription service could prove to be beneficial to consumers while helping to monazite the iPod install base, rather than simply representing a defensive move on Apple's part. Based on a customary 50/50 split of a $10 to $15 monthly subscription charge between Apple and the labels, the iPod maker could see $900 million in added revenue should such a service penetrate to just 10 percent of its iPod base.



Keep an eye on April 28



Hargreaves in his report hinted that some of the aforementioned changes could arrive sooner than later. He notes that Apple launched iTunes on April 28, 2003 and that it typically negotiates one-year contracts with the labels. "As a result, we believe that the company is currently in renegotiations for its current contracts. Apple will likely maintain its firm grip on digital music in the near future, regardless of whether changes to iTunes are included in the current round of negotiations," he wrote. "However, 80 percent of music is still purchased in physical form, which suggests that the digital music market is still young. If Apple intends to keep its hold on digital music over the long term, we believe it will eventually have to become as innovative with iTunes as it has been with its hardware."



Apple priced at $130 a share



Hargreaves maintains an outperform rating and $130 price target on shares of Apple for PacificCrest.
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Comments

  • Reply 1 of 41
    I wonder how much more it costs for iTunes to offer 256 kbps music instead of 128kbps. Also, anyone know how many songs an iPod can hold that is filled with 4 minute songs at 256 kbps?
  • Reply 2 of 41
    Probably holds roughly half as many at 128k?
  • Reply 3 of 41
    Well people are saying 256kbps isn't twice as good as 128kbps so I was just wondering what the exact number was, but thanks.
  • Reply 4 of 41
    wallywally Posts: 211member
    Subscriptions just don't make sense for music. Apple is pushing for DRM-free tracks and succeeded with EMI's deal - adding a subscription model now would mean putting DRM back in.... no thanks... now a movie-rental service would be a good idea...
  • Reply 5 of 41
    irelandireland Posts: 17,623member
    They should make a few Euors too if they ever get Movies and TV Shows into Europe.
  • Reply 6 of 41
    mr. hmr. h Posts: 4,728member
    What a load of fluff. Isn't it obvious that he sat down and cooked up some reasonable-sounding numbers to end up with a nice round 10% operating profit margin?
  • Reply 7 of 41
    porchlandporchland Posts: 478member
    The cost model makes me wonder when Apple is going to get into the label game. Why give up $.70 cents every time someone downloads a John Mayer song when you can sign John Mayer, significantly improve margins and farm out the CD rights to someone else?



    Apple has a tremendous promotional engine. Sign an act, put them in an iPod commercial, promote them on the iTunes podcast, iTunes, Apple.com, etc. Pick the right artists, and Apple could have an instantly viable label.
  • Reply 8 of 41
    g5mang5man Posts: 91member
    Quote:
    Originally Posted by Porchland View Post


    The cost model makes me wonder when Apple is going to get into the label game. Why give up $.70 cents every time someone downloads a John Mayer song when you can sign John Mayer, significantly improve margins and farm out the CD rights to someone else?



    Apple has a tremendous promotional engine. Sign an act, put them in an iPod commercial, promote them on the iTunes podcast, iTunes, Apple.com, etc. Pick the right artists, and Apple could have an instantly viable label.



    The problem arises when 80% of the songs are still purchased via CDs. Apple has great negotiating power for digital music, but trying to become a label is stretching it.
  • Reply 9 of 41
    Quote:
    Originally Posted by pazimzadeh View Post


    Anyone know how many songs an iPod can hold that is filled with 4 minute songs at 256 kbps?



    My wife's iPod Shuffle (1 GB) has approximately 3 hours of music on it. All of it is 256 kbps.
  • Reply 10 of 41
    noirdesirnoirdesir Posts: 1,027member
    Quote:
    Originally Posted by pazimzadeh View Post


    I wonder how much more it costs for iTunes to offer 256 kbps music instead of 128kbps.



    According to the report, the costs associated to 'physical' delivery of the song are around 5 cents for the 128k songs and 7 cents (two cents more) for the 256k songs.
  • Reply 11 of 41
    dimmerdimmer Posts: 7member
    Well, he's way off the mark on the transmission costs, didn't include the credit card processing fees (apple charges per purchase, not waiting for a $10 price to be hit) and "forgot" that iTunes delivers around 10 previews (30 seconds each) for each sale. Nothing exists in a vacuum, Pretty sloppy work.



    If Apple were to offer a higher bitrate it would be 192kbps - with AAC it is impossible to tell the difference with the human ear of anything above that. I didn't run the test myself, but it's out there: try google.
  • Reply 12 of 41
    MacProMacPro Posts: 18,306member
    Back on topic.



    Wow, good news for Apple's stock.
  • Reply 13 of 41
    mr. hmr. h Posts: 4,728member
    Quote:
    Originally Posted by digitalclips View Post


    Back on topic.



    You what? Which posts have been off-topic?



    Quote:
    Originally Posted by dimmer View Post


    Well, he's way off the mark on the transmission costs, didn't include the credit card processing fees (apple charges per purchase, not waiting for a $10 price to be hit) and "forgot" that iTunes delivers around 10 previews (30 seconds each) for each sale. Nothing exists in a vacuum, Pretty sloppy work.



    Good point about the previews. But you must have missed this bit from the report:



    Quote:
    Originally Posted by AppleInsider


    Then, of course, there's the transaction fee -- or royalty paid to credit card companies each time a sale is processed -- which Hargreaves argues is "the primary reason iTunes profitability has not been higher historically." However, he notes hat Apple has recently adopted a number of measures to limit those fees, such as managing a weekly sweep of its credit card transactions, broadly distributing gift cards, and by encouraging larger transactions through services such as "Allowance."



    Therefore, the analyst believes the iPod maker is now forfeiting only around $0.10 per song per song to credit card firms, compared to as much as $0.25 per song when iTunes first launched. "Going forward, we expect Apple to continue improving its payment schemes to cut down on transaction fees and improve the profitability of iTunes," he added.





    Quote:
    Originally Posted by dimmer View Post


    If Apple were to offer a higher bitrate it would be 192kbps



    Obviously you missed the major news from EMI and Apple at the beginning of the month that Apple will be offering non-DRM tracks at 256 kbps AAC from EMI, starting in May. Apple said that by the end of the year, 1/2 of the store content will be available in this form; implying that other labels, major and independent, will join EMI in removing DRM and upping quality.
  • Reply 14 of 41
    Quote:
    Originally Posted by dimmer View Post


    Well, he's way off the mark on the transmission costs, didn't include the credit card processing fees (apple charges per purchase, not waiting for a $10 price to be hit) and "forgot" that iTunes delivers around 10 previews (30 seconds each) for each sale. Nothing exists in a vacuum, Pretty sloppy work.



    If Apple were to offer a higher bitrate it would be 192kbps - with AAC it is impossible to tell the difference with the human ear of anything above that. I didn't run the test myself, but it's out there: try google.



    Actually, the iTunes store will consolidate purchases within a given time frame. They don't wait for $10, but if you buy a song or two today then purchase a few more the next day, chances are good they'll be one charge on your card. I'm not a big iTunes purchaser, but I've seen it happen on my limited purchases.



    As for the 192kb/s, well I would have to imagine it depends which human ear is listening. Maybe the average person can't tell the difference, but what is average? It's also probably a bit like frame rates in video. The human eye can only perceive so many frames per second yet more frames beyond that limit still increases the perceived quality of the video.
  • Reply 15 of 41
    jeffdmjeffdm Posts: 12,946member
    Quote:
    Originally Posted by dimmer View Post


    Well, he's way off the mark on the transmission costs



    Right, but I don't think transmission costs are nearly that high.



    Quote:

    , didn't include the credit card processing fees (apple charges per purchase, not waiting for a $10 price to be hit)



    The article doesn't mention a $10 boundary. I'll have to check my agreements, but I think $0.01 per track on card charges would be about a $3 average transaction. Apple does wait a little bit though, I don't think it is weekly, but I've seen them wait a couple days. If they can consolidate charges, then their costs per track goes down a lot.



    Quote:

    If Apple were to offer a higher bitrate it would be 192kbps



    What do you mean? Apple already announced a 256kbps rate. Have you missed the EMI deal announcement?
  • Reply 16 of 41
    Quote:
    Originally Posted by Porchland View Post


    The cost model makes me wonder when Apple is going to get into the label game. Why give up $.70 cents every time someone downloads a John Mayer song when you can sign John Mayer, significantly improve margins and farm out the CD rights to someone else?



    Apple has a tremendous promotional engine. Sign an act, put them in an iPod commercial, promote them on the iTunes podcast, iTunes, Apple.com, etc. Pick the right artists, and Apple could have an instantly viable label.



    'Cause Apple Corps LTD. would probaly sue -- again
  • Reply 17 of 41
    jeffdmjeffdm Posts: 12,946member
    Quote:
    Originally Posted by Wally View Post


    Subscriptions just don't make sense for music. Apple is pushing for DRM-free tracks and succeeded with EMI's deal - adding a subscription model now would mean putting DRM back in.... no thanks.,



    Put the DRM "back in"? From what I remember of the deal, EMI tracks will be offered in both DRM/128 and non-DRM/256 variations, so it's not as if Apple is completely eschewing DRM.
  • Reply 18 of 41
    eaieai Posts: 417member
    Hes just picked a load of fairly random numbers that seem possible, I don't really think this should be considered very accurate. Theres no sources quoted, no real research, its just him saying "well, things must be cheaper than they were, lets say its about 10% now"...
  • Reply 19 of 41
    Quote:
    Originally Posted by JeffDM View Post


    Put the DRM "back in"? From what I remember of the deal, EMI tracks will be offered in both DRM/128 and non-DRM/256 variations, so it's not as if Apple is completely eschewing DRM.



    It's just letting the consumer decide.
  • Reply 20 of 41
    dimmerdimmer Posts: 7member
    Quote:

    Obviously you missed the major news from EMI and Apple?



    Nope, I didn't: but that's one deal with one label. Not everyone. Apple are free to do what they want, ans there is a customer mindset that 256 is better than 192 when it's not. That said, the file sizes are roughly the same (because digital sampling above 192 using AAC will always produce the same result).



    Quote:

    I don't think transmissionscosts are nearly that high.



    You'd be surprized. I don't think Akami is used for iTunes any more, but when they were in the picture, well let's just say that would be a great deal.
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