Apple Faces Biggest iTunes Challenge Yet

After dominating the online music service business for over two years, Apple's seminal iTunes Music Store service is about to face it's biggest challenge yet. Unexpectedly, that challenge is not coming from Microsoft or its partners, but rather from the music industry that provided Apple with the contracts it needed to offer digital music to consumers. Apparently, the music industry is tired of Apple's pricing schemes and they'd like to see consumers pay more for newer songs, and less for older songs. Apple is resisting, for now. But the outcome of this battle will likely determine how quickly digital music sales grow in the near future.

To date, Apple's success with iTunes seems astonishing: As of early this month, consumers have purchased over 500 million tracks from the service, and the recent launch of iTunes in Japan saw customers there purchase over 1 million tracks in just four days. The company commands 75 percent of digital music sales, and, thanks to its successful iPod franchise (21 million units sold so far), it owns 80 percent of the MP3 player market as well.

Impressed? As it turns out, those figures are just a drop in the bucket compared to audio CD sales and, interestingly, portable CD player sales, respectively. Total audio CD sales in 2004 were over 3.5 billion units (for comparison, most CDs include 5 to 10 tracks). And total portable audio CD player sales last year alone were approximately 19 million units, and they're expected to hit almost 18 million units sold in 2005.

Put simply, music is big business. And with Apple creating a digital audio monoculture, the music industry is getting ready to fight back. Curiously, their plans are more in line with consumer needs that are Apple's. The music industry would like to see Apple make two changes. First, they would like individual song pricing to be variable. New songs, they say, could cost as much as $1.49, while old songs could cost much less than the 99 cents that Apple is currently charging for all songs, regardless of demand. Apple thinks consistent pricing is more important, despite the fact that music has always been sold at a variable per-track rate, based on demand.

Second, the music industry would like Apple to either embrace Microsoft's rival Windows Media Audio (WMA) format--which is used by all non-Apple online music services and MP3 players--or open up its own proprietary format--Protected AAC--to the competition. The music industry feels that the current bifurcation between WMA and Protected AAC in the market creates confusion for consumers and is, thus, slowing the adoption rate of digital music. This is the sort of confusion that slowed the adoption of personal video recorders in the early 1980's and recordable DVD devices over the past several years.

They actually have a point. But critics argue that the music industry shouldn't be messing with the sole successful digital music business model. And, after all, Apple is the company that jumpstarted online music sales. When CEO Steve Jobs first approached these companies two years ago, none of them had a digital music strategy at all, beyond trying to sue file sharing networks into oblivion.

Part of the issue is jealousy. Because Apple makes little or no money on music sold from the iTunes Music Store--70 cents of each sale goes to the record companies, while the rest is split between the artists and various marketing and licensing costs--the company is focused on using the service to bolster sales of iPods, each of which is sold at quite a premium. Record companies don't see a cent from the sale of iPods, which some find untenable.

Later this year, the recording industry has to renew its contracts with Apple. If they decide to boycott iTunes--an unlikely event, given its popularity--Apple will essentially have to close up shop because the company are its primary source of content. But Steve Jobs is known for his tough bargaining tactics, as ex-HP CEO Carly Fiorina is painfully aware. This time, my money is on Jobs and Apple to carry the day.

Meanwhile, Microsoft's challenge to iTunes and the iPod remains as ineffectual as ever. One of the key players in the MP3 space, Rio, recently announced that it was exiting the market completely, after losing tens of millions of dollars a year on the venture despite decent unit sales. Online music services such as Napster continue to languish with few subscribers, and the recent launch of Yahoo! Music Unlimited--which provides high-quality WMA-based songs for a surprisingly low cost--hasn't gotten much press. Microsoft continues to make promises about future services and devices, but thus far Apple simply dominates the market it jumpstarted. It's unlikely that will change any time soon.