It was good news when Apple announced the end of DRM on
iTunes Store music. And variable pricing sounds like a good opportunity for
consumers, but is it? The problem with business deals is that most of
the details are hidden from the public. To find out the truth, we have
to ask a few questions about motivation, limits, and trends.
I see a few facts in the deal worth pursuing. How much more are the
parties expecting to earn? What are the limits on the profitability?
Who is stuck with the costs? What changes will increase a company's
profits?
Estimating Costs
Since no one is talking, we'll use some old facts and basic
assumptions to piece things together. My first assumption is that the
recording industry will maintain its licensing fee as a fixed
percentage regardless of price structure. It will continue to make
70%
of the selling price. This leaves it free from all the operating
costs (network connection, servers, customer complaints, credit card
charges, etc.); Apple has to carry all of these costs.
While it gives the recording industry freedom from operational
expenses, it allows Apple to increase its profits as it reduces these
expenses. This is a fair tradeoff in risks between the two parties.
The next assumption is that if the recording bit rate is the same
and the song length is similar, then operating cost is constant for any
of the three tiers of song prices. I'm guessing this at 13¢ per
track.
The unknown variable cost is the promotions/advertising costs. Some
of this may be paid by the industry out of its licensing fees. I will
assume Apple will spend its own chunk of money as it chooses to promote
sales and/or artists. Apple has the additional benefit of promoting its
iPods at the same time. Apple will control this spending to increase
the store's profitability, but at the end of the day an average amount
will be spent.
Breakdown of Expenses
|
Sale Price
|
69¢
|
99¢
|
$1.29
|
|
fixed cost
|
0.13
|
0.13
|
0.13
|
|
advertise
|
0.02
|
0.05
|
0.05
|
|
license fee
|
0.48
|
0.69
|
0.90
|
|
profit
|
0.06
|
0.12
|
0.21
|
Old One Tier Pricing Model
|
Songs Sold 2008
|
Recording Industry
|
Apple Inc.
|
|
99¢
|
2,000,000,000
|
$1,380,000,000
|
$240,000,000
|
The remaining money is profit. The recording industry will make more
on $1.29 songs, and so will Apple. They will both have a financial
incentive to increase the sale of these songs more than the lower
priced songs. for this reason, I am going to assume that Apple will
spend more on advertising the 99¢ and $1.29 songs and less on the
69¢ tracks.
The next claim by Apple is that more songs are going to be sold at
69¢ than at $1.29. That is great - with a large back catalog there
are probably tons of songs that can be discounted. People have burned
many of these songs from their old CDs, but now they can be lazy and
buy them again for a reduced price. Don't you just love a free
market?
Just because more songs are available for 69¢ doesn't mean they
are the most popular. Apple has been tracking purchases for the last 6
years. A few days searching through its database will tell you what
songs to sell at a given price to maximize revenues. Once Apple starts
tiered pricing, it will gain additional buying habit information on
consumer preferences. forget everything else going on; this database
alone will be worth millions of dollars once it is compiled. (I can
envision Apple selling access to this database as part of future
negotiations.)
Guesstimated Breakdown if More 69¢
Songs Sold than $1.29 Songs
|
Songs Sold in 2008
|
Recording Industry
|
Apple Inc.
|
|
Sales
|
Profit
|
Profit
|
|
69¢
|
800,000,000
|
$384,000,000
|
$48,000,000
|
|
99¢
|
700,000,000
|
$483,000,000
|
$84,000,000
|
|
$1.29
|
500,000,000
|
$450,000,000
|
$105,000,000
|
|
2,000,000,000
|
$1,317,000,000
|
$237,000,000
|
To me it's clear that the harder to sell songs will be discounted,
while the moderately popular ones will be priced higher. The most
popular will be priced at the two highest levels depending on the
maximum overall profitability, e.g., some will sell significantly
better even if priced lower, thereby making the discount worthwhile. I
assume discounts will be used to spike demand for particular
artists.
Guesstimated Breakdown if More $1.29
Songs Sold than 69¢ Songs
|
Songs Sold in 2008
|
Recording Industry
|
Apple Inc.
|
|
Sales
|
Profit
|
Profit
|
|
69¢
|
500,000,000
|
$240,000,000
|
$30,000,000
|
|
99¢
|
700,000,000
|
$483,000,000
|
$84,000,000
|
|
$1.29
|
800,000,000
|
$720,000,000
|
$168,000,000
|
|
2,000,000,000
|
$1,443,000,000
|
$282,000,000
|
The variable pricing works better today because the sales model has
been proven, consumer buying habit data has been collected, and the
size of the back collection is large enough that differentiation is
meaningful. If you pick the wrong songs to price at 69¢, you could
potentially loose money relative to the flat 99¢ pricing.
Apple has been disciplined in its business dealings to grow from 100
million song per year to 2 billion (a 20x increase) in six years. That
consistency in focus says a lot about its business skill in
negotiations. It also shows that the record industry has a larger
interest in variable pricing to inflate its profits.
At the end of the day one thing is clear: every penny counts. In
fact, I would gladly take just one cent on every song sold for one
year. The extra $20,000,000 would look great sitting in my bank
account. With huge earnings possible over every single penny, it's easy
to see why the change in pricing structure was not done quickly. These
were serious negotiations that no one could afford to walk away from
without fighting for every advantage possible.
The breakdown of the NBC and UMG negotiations in 2007-08 showed that
it was much better to drop iTunes than risk establishing precedence
that could cost them billions later as the iTunes power continues to
grow.
Make no mistake about it, iTunes will continue to grow. It has
weathered competition from satellite radio, subscription services,
other proprietary formats, file sharing, and DRM-free sales from other
large distributors. NBC didn't come back because it likes Apple, but
since no other solution has proven as effective, it had to get back in
the game in order to play.
The question now is how will the recording industry continue
justifying its 70% cut? It is producing fewer records and CDs to supply
the retail stores. Apple is doing a lot of work with promotion, and it
can see that the best way to expand profits is to leave the recording
industry out. Why not sign more independent artists and pay them twice
their usual royalty? Apple would still more than double its profits in
the deal. I think recording executives are going to have to start
working harder for their pay in order to stay relevant in the new
marketplace.
While I admit that my numbers are mostly guesswork, they have a good
feel to them. We know that Apple spends millions on advertising both
iTunes and iPods, so 5¢ per download may be high at $100 million,
but that's within a total advertising budget of
$486 million. Profitability of the iTunes Store was originally estimated to be
around 10% back in 2003. I'm sure Apple has figured out how to reduce
its expenses, so this number has probably grown over time. Still, Apple
does say that the iTunes Store affects its margins, so that means
profits are well below 30%.
As a basic overview of the whole market, I am confident that the
scale of these numbers is reasonable. What I am missing is the very
complicated business arrangements that make it happen, what penalties,
how songs are picked for the different tiers, when promotions can start
and end, etc. There are plenty of inside details that would be fun to
hear about to see how these high stakes gamblers have played their
cards. Until I get promoted to the boardroom, I'll just have to satisfy
myself with dreams of earning one penny off every song sold.
