Original URL: http://www.theregister.co.uk/2007/07/17/steve_gordon_apple_universal/

Behind the Apple vs Universal breakup

Taxing the hardware?

By Steve Gordon

Posted in Media, 17th July 2007 15:23 GMT

Column Earlier this month, Universal Music Group (UMG) - the world's largest record company with acts like U2 and Jay-Z - decided not to renew its contract with Apple's iTunes music store. Universal will continue to supply iTunes its vast catalogue but may cancel that supply at any time. In the company's own words, "Universal Music Group will now market its music to iTunes in an 'at will' capacity, as it does with its other retail partners."

This marks the end of intense negotiations between the two companies. The previous three-year deal between them ended last year, and a temporary one-year agreement also expired.

This article focuses on the reasons for Universal's course of action - and its chances of gaining income from hardware manufacturers.

Breaking Away

For years the major labels have complained about iTunes' price fix of $0.99 per song. They have argued that new releases should be priced higher than the more obscure tracks from older catalogues. Although EMI and Apple entered into an agreement to release EMI tracks for $1.29 each, these records are not protected by DRM. Universal, along with Sony BMG and Warner, have steadfastly refused to release non-DRM protected tracks.

Another underlying tension is that Apple has made a huge amount of money from sales of iPods - far more than the labels have made from iTunes. As of April 2007, the iPod had sold over 100 million units worldwide. This makes iPod the best-selling digital audio player series in history.

Analyst estimates for iPhone sales in its first weekend ran as high as 700,000 units, beating many investors' expectations, and some expect the momentum to continue. The iTunes Store has sold over 2.5 billion songs since its inception four years ago, as well as 50 million TV shows and over 1.3 million movies, making it the world's most popular online music, TV, and movie store. But the labels only make 70c off each track. This revenue pales in comparison to the amount of money Apple generates from sales of such devices whose purpose, in full (the iPod) or in part (the iPhone) is to store and play these tracks. The money is in the hardware.

Late last year, Universal successfully negotiated with Microsoft a $1 royalty for each Zune MP3 player sold. Unfortunately for Universal, Zune has not done much business due to serious design flaws. Things would have been a bit different if they could get a dollar from every iPod and new iPhone, too.

Steve Jobs says it is Apple's goal to sell 10 million iPhones in 2008, the first full year of sales. This means that the goal is to get one per cent of the £1bn strong mobile phone market. If Universal could negotiate £1 from every unit Apple plans to sell, it'd make $10m.

It is very possible that Universal intends to use the new "at will" deal to exert pressure on Apple to either replace the 99c fixed price with variable pricing or to agree to pay Universal a royalty on iPods, or both. Or as just discussed, Universal may wish to extend the royalty to any new products that play music, such as the iPhone.

Apple wields the bigger stick

As discussed, iTunes sales are not hugely profitable for the labels. But music sales have probably been even less profitable for Apple. For each 99 cent download they keep only approximately 30 cents. And out of that they must pay for bandwidth, promotion, and transaction costs. Their profit is probably minimal - if they make anything at all.

Even Steve Jobs admits that the iPod is not successful because of iTunes. By his own admission, the average number of iTunes songs in every iPod is just several songs. People fill their iPods with copies of their CD collection or from trading with friends, or through P2P services such as LimeWire.

iPod's success does not depend on iTunes, but rather the elegance of iPod's design and ease of use. For these reasons, if Universal retreated from iTunes, no one can reasonably anticipate that it would seriously hurt sales of iPods or iPhones.

Good idea - bad execution

I believe Universal is right in seeking a royalty on electronics sales. "Free music" is really not free at all. The electronics business, including Apple, is making a fortune from so called "free music" - because you need to buy a computer, blank CDs, and an MP3 player to enjoy the "free" music.

The Audio Home Recording Act already imposes a royalty on digital tape recorders, but not MP3 Players or computers. But when the AHRA was passed in 1992, the personal computer was only just making its debut in the US, and the MP3 player had yet to be imagined. So while the Act compensates copyright owners and artists for lost sales because of copying, the income generated by the levy has been negligible because AHRA does not apply to the new generations of technology, including personal computers and MP3 players.

So why hasn't the Act been extended to include this new generation of technology? The principal reason is that the major labels have not pushed for it. But wouldn't the record labels want to collect royalties from the manufacturers who are raking in money from sales of electronic equipment which is being used to acquire and listen to music without compensation to the labels?

Perhaps the main reason is the way royalties are distributed under the AHRA. The first third of royalties go to music publishers and writers. Then four per cent goes to side artists. The balance is paid 60 per cent to the labels and 40 per cent to the artists.

Maybe the record companies are afraid to push the extension of this Act to MP3 players and computers because they don't want to set another precedent of splitting proceeds on a 60:40 basis with the artists they represent. The standard artist royalty is only 10 to 15 per cent.

Moreover, under the AHRA the artists are paid directly. By targeting a successful individual manufacturer like Apple, Universal is aiming to recoup red balances (the amount it spends on production and marketing) on each artist's account. Most artists never recoup production and marketing costs so when the record labels collect money from their music, they "allocate" royalties to the artists' accounts but actually keep the money.

It is estimated that 235 million computers were sold throughout the world in 2006. If the labels collectively went after the electronics industry, consider the income it could generate from a significant royalty on the combined millions of computers, MP3 players, and MP3 capable cell phones sold each year.

If Universal, just one of four majors who collectively produce and distribute approximately 80 per cent of recorded music, could get $1 per Zune, the labels together may be able to get $4 to $5 or more for each computer and MP3 player, that could add up to an extraordinary amount of money that could compensate for lost sales due to "free music".

Since we have seen Universal's leverage against Apple is weak, it will probably never get any money from the iPod or iPhone. But if it sat down with the other major labels, the electronics business, and members of congress, it could work out a deal to extend the AHRA. And wouldn't getting 60 per cent of something be better than zero per cent of nothing?

Even if they actually had to pay the artists? ®