iPod, Therefore iTunes

Affiliates interested in offering digital music downloads should pay tribute to Apple for legitimizing an over-hyped and under performing market that was close to flaming out before it ever got off the ground.

Despite the continued existence of freely available music through peer-to-peer networks, Apple has sold more than 125 million songs through its iTunes online store since it opened in late 2002, according to the company.

Apple’s iTunes dominates the industry, representing 70 percent of all music files downloaded legally between December 2003 and July 2004, according to market researcher NPD Group. Napster, with 11 percent of the market, was the second-largest download seller, followed by MusicMatch, RealNetworks and Walmart.com.

But how long can Apple top the download chart? Analysts say Apple’s continued leadership of the non-free world of music downloads is largely tied to the success of the iPod, which is both asset and encumbrance for the Cupertino, Calif., company. According to Apple, the company sold 2 million of its industry-leading iPods during the quarter ending in September 2004.

Apple was able to grow and dominate its market because of the company’s product design skills and because consumers and the music labels felt comfortable with them, according to Mike Goodman, a senior analyst at the Yankee Group. Apple was the first digital music distributor to be fully supported by the recording industry, Goodman says.

“They were the first to have access to the (music) libraries needed to make a successful online music service,” he says. The company that offers the largest music catalog, as Apple does with more than 1 million tracks, has an advantage in attracting consumers, according to Goodman.

Apple is unique in selling both the songs and the music players, which gives the company an advantage, according to Goodman. “The iPod received the blessing of the youth as the coolest music player,” he says, adding that the iPod’s interface and ability to manipulate it with one hand distinguish it from the competition.

While other music download services try to eke out a living on the slim margins offered by selling songs for less than a buck apiece, Apple makes a hefty amount of its profit on hardware sales via the iPod, Goodman says. Apple is turning the model of selling razors to make money on razorblades on its ear because “iTunes exists to sells iPods,” according to Goodman.

“Apple will continue to lead as long as they continue to innovate with hardware,” says Tim Bajarin, president of analyst firm Creative Strategies. He says that with 92 percent of the hard disk player market, Apple has a large customer base ready to purchase music. “Because the iPod is one of the most elegant music players, people want to get out there and use it,” Bajarin says. “It’s viral.”

Orchestrating The Future

While these numbers are impressive for a market fractured by a variety of incompatible file formats and hundreds of generic portable music players, the market penetration has been small and the potential for growth enormous. Accord-ing to NPD Group, less than 1 percent of US households legally downloaded music in July of 2004.

The Yankee Group’s Goodman expects iTunes to keep humming along in the short term. Although he says the market will heat up through competition from new services developed by music seller Virgin and online portal Yahoo, “I don’t see [Apple’s dominance] changing in the next six to 12 months,” Goodman says. Because its dominant iPod portable device will not play most other file formats, Apple doesn’t have to worry about competition to iTunes today, he says.

Companies would have to either license Apple’s FairPlay digital rights management or reverse engineer it, as RealNetworks has done, to enable songs encoded in its file format to play on the iPod, Goodman says.

However, Goodman argues that iTunes may eventually have to outgrow the iPod if Apple wants to continue to grow with an expanding market. He says that only 30 percent of music downloads end up on hard disk devices today, so Apple is limiting iTunes’ potential reach.

Goodman is not convinced that tying a music service to a proprietary hardware device is the best strategy if viable iPod competitors are developed. “Over the long term, just selling to the iPod will not be successful.” Tracks can be downloaded to Macs or PCs through the iTunes Web site, but users cannot copy them to devices other than iPods.

Apple recently began to increase its hardware reach by creating more versatile iPods and agreeing to allow mobile phones to play iTunes. Apple hopes to attract a new audience with the recent introduction of the iPod Photo, which includes a color screen and can store up to 25,000 digital photos. Apple also licensed the iPod to Hewlett-Packard to sell to Windows users, and Motorola announced it would introduce handsets capable of storing and playing iTunes in mid-2005.

Network Competition

Every download seller has an affiliate program in place to try to increase the overall market by encouraging links from other Web sites. Apple launched its iTunes affiliate program in September with affiliate network LinkShare. The company provides tools that enable affiliates to directly link to single tracks and albums and will offer special promotions to encourage sales

According to Apple spokeswoman Liz Einbinder, the company pays a 5 percent commission on all sales stemming from affiliate leads. The company sends out checks 45 days after the month in which an affiliate accrues $25 in sales. Einbinder says the company does not disclose details about the number of affiliates who have signed up for the program.

Nathan Wright, who runs music Web site MonkeyCube.com, says it took about three days for Apple to approve him as an affiliate. “It was a very easy process,” he says. MonkeyCube made the cut because it does not include offensive content and has sufficient traffic with more than 800 unique visitors per day, according to Wright.

Wright says that while he did not earn any commissions through the first 60 days of being an Apple affiliate, he is happy to include links on his site to Apple products. “Apple has been a great brand and company to associate with. If I could chose any (music seller) to partner with, I’d choose Apple.

Michael Sullivan of FreshTuneage.com signed up to become an iTunes affiliate on the first day, but he says Apple wasn’t fully prepared to partner at the beginning. “They kind of stumbled out of the gate,” Sullivan says. Apple initially offered links only to the iTunes page, but set up a program for linking to individual tracks within a few days.

FreshTuneage also has links to buy albums on Amazon.com and CDBaby .com, says Sullivan. He is hopeful that readers will be attracted to iTunes because they can download tracks immediately instead of having to wait for CDs to arrive in the mail if they purchase from another of his partners. Sullivan also suggests that Mac enthusiasts such as himself might prefer to buy from iTunes instead of other services because of their passion for the brand. “There is some inherent snobbery,” he says.

So far no one has purchased any iTunes by clicking on his links, Sullivan says. He says the music reviews and news bloggers he has spoken with have not successfully converted their traffic into music download sales.

Music download competitor Buy.com pays 10 percent, a higher commission than Apple. And like Apple, Walmart.com also pays per track sold. MusicMatch, Napster and RealNetworks pay their affiliates based on their ability to locate new subscribers for their monthly fee services. RealNetworks offers incentives ranging from $2 to $11 for corralling new subscribers for its services, and MusicMatch offers bounties of $7 to $10.

The Yankee Group’s Goodman does not believe that the subscription model will be successful. “The negative backlash will intensify as consumers realize that when they end their subscription, access to their music goes away,” he says.

Goodman doesn’t expect Apple to launch subscription services. Streaming services won’t help them sell iPods since the devices do not directly connect to the Internet. “The rental model works for movies, but not for music,” according to Goodman.

The Early Innings

As the New York Yankees painfully discovered in 2004, even commanding leads can be surpassed, and Apple has a competitor that may prove as tenacious as the Boston Red Sox. Microsoft, which has its own protected music format and an unequaled bank account, has been upping the ante by developing a new mobile device platform and revamping its music service.

Microsoft recently rolled out the 10th version of its Windows Media software for playing audio and video files, and several hardware partners announced portable devices that can play them. Through MSN Music, consumers can download music videos, single tracks or albums from more than 3,000 independent labels. Microsoft updated its music service to better integrate with its Windows Media Player software that is included with all Windows PCs as well as 70 handheld devices, including PDAs and smart phones.

“There are far more devices that play Windows Media files” than iTunes, says Michael Gartenberg, vice president of research at Jupiter Research. “The challenge is for one of the [Windows hardware] vendors to come out with an iPod equivalent,” he says.

“In the marketplace now the digital distribution of protected music files is strongly determined by the device,” according to Gartenberg. “For now it’s the iPod, but it is hard to predict the future.” Digital music sales are expected to double to $270 million in 2004 and could reach $1.7 billion by 2009, according to Jupiter Research.

Gartenberg said that because portable audio players have penetrated only 5 percent of the American market, “discounting Microsoft or RealNetworks at this stage of the game would be extraordinarily foolish.” While iTunes is the leader today, “the online music offerings aren’t all that different in terms of content, selection and usage rights,” according to Gartenberg.

Microsoft has been less aggressive and forthcoming about its plans for teaming with affiliates. The company has a “preferred partner program” instead of an affiliates program. Spokeswoman Sarah Williams says the company does not provide financial information about relationships with affiliates.

Since Microsoft’s primary focus has always been selling software, the company may use its music service as yet another avenue for selling devices powered by Microsoft applications. The MSN Music service integrates links to download sellers Napster, Walmart.com and MusicMatch and CD site Amazon.com.

Microsoft has frequently let other companies compete in a nascent industry before pouncing on the opportunity, as it did with spreadsheet and word processing software. The company also has established a reputation for getting things right after the third or later generation of software, so the landscape could change, according to Goodman. “Microsoft is probably better off being out of the box late rather than early,” he says.

ITunes’ status as the download service front-runner will depend largely on the iPod’s dominance over devices manufactured by consumer electronics companies who often partner with Microsoft, so the pressure is on to continue the company’s initial success. As Goodman says, “In a market-share business, everything can turn on a dime.”

JOHN GARTNER is a freelance writer living in Philadelphia. He is a former editor at Wired News and CMP.