If ITunes Won't Be Profitable, What's the Point?

by Diane Bullock, Minyanville staff writer

When Apple AAPL got into the music business in April 2003, the company didn’t actually expect to make money at it. The iTunes store launched with only “break-even” ambition as far as Cupertino was concerned, merely acting as a hook for the real profit center: The iPod.

So much for self-fulfilling prophecies. Five years in, iTunes had unseated Wal-Mart WMT as the country’s leading music vendor and assumed the top spot in the global market by 2010. Last year’s sales hit $13.5 billion, with Apple generating up to 15% operating margin on gross revenue while commanding 64% of the world’s online music sales.
Now, as Apple takes its next bite out of the music industry with the upcoming iTunes Radio -- launching as soon as September -- “aim low” is, once again, the M.O.

For starters, while hugely popular, the music-streaming business isn’t particularly lucrative. In fact, it’s downright depressing. Even given Pandora’s P 70 million faithful users and Spotify’s 24 million, both services continue to post net losses in the tens of millions -- crushed in large part under the weight of hefty licensing fees.

But Apple is not only undeterred by the costs of acquiring music rights, it’s ready and willing to pay more. A lot more. More than twice Pandora’s rates, more.

The obvious business model relies on ads. iTunes Radio subscribers will hear audio ads every 15 minutes and see video ads every hour. (iTunes Match users get the service ad-free.) Apple’s partnerships with top-shelf brands like McDonald’s MCD, Nissan (OTCMKTS, Pepsi PEP, and Procter & Gamble PG are said to “pay anywhere from high single-digit millions of dollars to tens of millions of dollars for a year-long advertising campaign exclusive within their respective industries.”

Of Apple’s net ad revenue, record labels will take 15%, plus $0.0013 per song play in the first year. These figures are reported to increase to $0.0014 per song play plus 19% of net ad revenue in subsequent years.

So why does it seem an iTunes Radio profit isn’t making Apple’s priority list? Other than iOS 7, the service isn’t tethered to a major product launch that counts on a symbiotic relationship the way the iPod was teamed with iTunes and -- to a lesser extent -- the App Store helped sell the iPhone.

Apple’s move into Internet radio isn’t really about Internet radio at all. Instead, it’s about keeping its users from other Internet radio products. If Apple can provide this in-demand service to its iOS faithful, they won’t be tempted to stray and find themselves in the open and exciting arms of threateningly hip startups. Being all things digital means the cult of Mac won’t have to worry about defectors bolting for the door.

“Music streaming is one of many elements Apple is attempting to tie together so that it can have the most comprehensive entertainment offering in the industry,” says Bill Kreher, an Apple analyst at Edward Jones. “The addition of iTunes Radio enhances the overall ecosystem.”

What will likely make Apple's offering decidedly compelling for Internet radio consumers is that most of them already have an iTunes account with a library full of digital music purchases and uploaded CDs from which the streaming service will allow them to draw. iTunes Radio is pre-installed on any iPhone or iPad running iOS 7, included in iTunes for OS X and Windows MSFT, and available on the Apple TV. Simply put, it’s a brilliantly built-in customer base.

It’s also not a stretch to see how iTunes Radio could reel in existing Pandora, Spotify, and even Google Music GOOG subscribers who still use iTunes -- out of convenience alone. An opportunity to de-clutter our devices of one less app and remember one less password really starts to up the ante.

So much for self-fulfilling prophecies.

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