A Bitter Apple Replay?

By Alex Salkever Apple reported blowout earnings on Oct. 13, based largely on eye-popping sales of its iPod hard-drive music player. In the fourth fiscal quarter ending Sept. 25, Apple (AAPL) sold 2 million iPods -- a 500% increase over the same period last year. Executives boasted during the conference call that the iPod owns 65% of the U.S. overall retail market for music players and 90% of the market for hard-drive music players.

Those execs also said the online iTunes Music Store holds 70% of all paid-music downloads worldwide. It's ironic that in this moment of triumph for Apple CEO Steve Jobs, the greatest challenge yet to Apple's online music dominance is emerging.

This week, Microsoft (MSFT) announced a marketing campaign designed to exploit iPod's most obvious weakness. Dubbed "Plays for Sure," Redmond's campaign seeks to provide consumers with a guarantee that any audio- or video-playback device labeled with those words will play any content file purchased legitimately from Microsoft or licensees of its Janus digital-rights management (DRM) technology.

THE MAC BLUNDER. The campaign is a guns-blazing broadside at Apple and its own FairPlay DRM system. (Although a third party originally built the technology, Apple spokespeople have confirmed that Apple now owns the FairPlay trademark and technology).

One of the most common complaints about Apple and FairPlay is that songs purchased from the iTunes Music Store can be played only on an iPod. Apple has thus far refused to license FairPlay to other online music services or device makers. Count on Microsoft to put up beaucoup marketing bucks to push its own music standard as one that's more versatile and gives consumers more choice.

Sound familiar? Many computer-industry analysts believe Apple made a fatal error when it decided not to license its proprietary Macintosh operating system to other computer makers. Apple wanted to own the whole chain -- including software and hardware. Microsoft focused on the software alone, believing the more licensees, the merrier.

Clearly, Bill Gates's tack proved superior. While Apple crows about a $5 billion cash hoard, Redmond is sitting atop a bounty 10 times that size and can't give it away to shareholders fast enough. According to tech trackers IDC and Gartner, Apple's market share in the PC sector remains in the low single digits.

GROWING CROWD. Are Apple and its enigmatic CEO bringing about a doomsday déjà vu with their steady refusals to let others partake in the iTunes juggernaut? That seems to be the case. Given its dominant share of the digital-music market, Apple might believe it has no need to worry. That line of thinking is also familiar -- and equally dangerous.

More than ever, standards matter in the tech world. They're the only way to ensure universal compatibility -- which consumers clearly want -- in fragmented markets. While Apple wins accolades for its beautifully designed, tightly integrated products, its insistence on total control could make continued domination of this market much harder.

For starters, there's the competition -- and I don't mean Microsoft. A gaggle of iPod pretenders -- from Virgin Electronics, Dell (DELL), Rio, iRiver, and Sony (SNE) -- have hit or will be hitting the virtual and physical shelves. And many of these iPod wannabes look pretty good. Some have neat features the iPod doesn't. Virgin's 5-GB player has two headphone jacks for easier music sharing and a built-in FM tuner. Rio's 5-GB player has battery life twice as long as that of the iPod mini. Sony's new Walkman offers video playback.

VULNERABLE MARGINS. Competition could also come in the next couple of years from the cell-phone market. Samsung has already announced a phone that incorporates a one-inch hard drive with capacity similar to that of the iPod mini. Apple has acknowledged that phones could become music devices by signing a deal with Motorola (MOT) to install iTunes music software on Moto handsets. But Motorola holds only 15% of the worldwide market, and many other phone makers are planning similar music moves, apparently without Apple's assistance.

Taken collectively, these products might eat into Apple's hard-drive player dominance in the U.S. and the major developed markets. No, it won't happen overnight, considering Apple's dominance and its chunk of all music player sales. But the competition is definitely catching up in terms of usability and looks. With price-cutting set to heat up as fresh entrants pile in, Apple should expect to see iPod margins continue to fall.

So rather than just earn money on each iPod, Apple would do better to make the cash on the software it installs on many, many players -- or perhaps earn boatloads of dough from its music store, should that venture truly become one of the top vehicles for selling music.

REDMOND'S PATIENCE. Then, there's Microsoft. If past is prologue, Apple should expect a relentless marketing attack tightly integrated with offerings from Windows PC makers. Moreover, time is on Microsoft's side. The digital-music-player market is still nascent. The prices remain high and penetration low. Apple may have the lion's share of business right now, but the market will grow quickly.

That could give Microsoft, a patient adversary, plenty of time to catch up in the music-software and DRM standard businesses. Sure, Apple has partnered with one of the two biggest PC makers, Hewlett-Packard (HPQ), to sell iPods. But that's not an exclusive deal, and HP could easily strike deals with other music-player makers or, as it originally planned, come out with its own.

Microsoft will probably make a steady stream of improvements in its media-player software. Will it ever match Apple in ease of use and elegance? No -- but who cares, really? Many consumers are more than happy with something that's good enough, and cheap.

WINDOWS OPENING. While I don't think Microsoft software is as usable as software from Apple, it's clearly not unusable. For Apple to assume that Microsoft isn't up to creating software that's "good enough" smacks of the same blundered logic that led Jobs & Co. astray a decade ago.

Apple could easily avoid an unpleasant redux. First, it already has built a version of its iTunes music-jukebox software for Windows PCs. Likewise, Windows users who buy iPods can also buy downloads from Apple's iTunes Music Store. The key thing here: Apple has already dipped its toe into the Windows software waters and found it feels good. By some estimates, as many as 60% of iPod buyers are Windows users. So Apple already has shown it can compete in the Windows market.

Allowing other Windows-compatible music players to sync up with iTunes and play copyright-protected songs purchased from the iTunes Music Store wouldn't be a huge jump. Of course, Jobs would be forced to cede a little more control. But he already started doing that by building iTunes for Windows.

GIVE NOW, TAKE LATER. Second, this time around the device makers are wary of Redmond. Many admit off-the-record that they don't want Gates to do with music players what he did with the PC operating-system market. Further, industry insiders admit that Apple's software is the best in terms of ease of use and design.

If Apple licenses FairPlay, it could sacrifice some sales and profits from its iPod line in the near term. But over the long haul, sowing the seeds of mass adoption of its DRM standard and its iTunes music software will help ensure that Apple's own future hardware offerings aren't marginalized. Jobs should sacrifice some of control and integration to make sure Apple has a seat at the table -- and a say in cutting up the larger, more lucrative digital-content pie. Salkever is Technology editor for BusinessWeek Online. Follow his Byte of the Apple column, only on BW Online

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