Media is going digital, in case you haven’t heard. Today CBS bought music social network Last.fm for $280M. That’s not to say that it will all be online, for free, in an ad-supported model. We maintain that what you see offline vs. the Web will remain different due to economics (ads on the webs are still paltry next to offline advertising after all) and what you see on the Web vs. wireless will remain different mainly due to technology. The cell phone, after all, has the computing power of a computer in 1995. Great. I wasn’t doing much back then online, apart from waiting for a page to download.
But media is going digital, on that there’s no doubt. This does not mean that newspapers, magazines, TV, radio or billboards will vanish, it just means that it will change.
I’ve argued that software - increasingly open source or ad-supported and free - is being replaced by digital content in terms of profit potential: once you produce it, it’s all marginal profit. [See Is Digital Content the New Software?]
But, given that I’m the business of producing video and publishing text (as I am doing here), my focus has been largely on anything but music. So this begs the question, what about music?
When Five Becomes Four… and Four Becomes Three?
Last year Sony merged with BMG. And this year, EMI is being courted by both private bankers and WMG. In fact, the day after EMI shareholders accepted an offer from private bankers for $4.7B and be taken off the markets, the EU conditionally approved Vivendi Universal’s acquisition of BMG Music Publishing, after the music publisher agreed to sell off parts of its catalog, according to this post by Paid Content.
EMI, by the way, lost $568 million in 2006.
As of 2005, here was the breakdown in terms of market share around the World:
Clearly, EMI and WMG are the smaller players… and their market caps reinforce that:
- WMG = $2.49B
- EMI = $4.34B (bought by private bankers)
- Universal is part of Vivendi (we all know that disastrous story, with the Bronfman family knowing it too well).
- BMG was a part of Bertelsmann, and is now a 50%-50% joint venture between German-based Bertelsmann and Japan’s Sony. Looking at that pie chart above, for those keeping track, as of 2005, the market shares were 13.83% for Sony and 11.78% for BMG.
BMG/Sony merged partially to save money, their merger was to lay off 2000 employees and save them $350M each year. Over the years, the record labels had gotten large, fat in fact, and the digital revolution simply exasperated matters.
When EMI loses $568 million in a year, you know the industry is just getting ready for a shakeout.
And much of the preparations have to do with merging to strengthen the base and weed out redundancy.
The smaller labels range from marginal valuations to $36M, for example, in the case of Sanctuary.
An Apple A Day…
Of course, leading the charge on the digital side is none other than Steve Jobs and Apple, who recently sold its 100M unit of iPod. I’ve long said that Shawn Fanning and Napster have proven over time to be poodles compared to the grip that Steve Jobs has on the music industry and to a much lesser extent (for now), the movie industry by selling Pixar to Walt Disney and becoming its largest individual shareholder.
Hardware vs. Software
It’s important to note that Apple makes practically all of its revenue in music off the hardware (the iTunes) and not “software,” the music. Keep in mind that digital media is the new software, in our perspective. The software component is sold via iTunes, Apple’s radically successful music store.
The iTunes Revolution
From Apple:
- Apple sells 2B songs on iTunes, in 2007.
From SFGate:
- February 2006: Apple sells 1B songs on iTunes in 3 years.
From CNET:
- July 2005 - iTunes crosses 500M.
- January 2005 - iTunes crosses 250 million mark.
- December 2004: iTunes crosses 200 million songs sold.
- 2003: iTunes crosses the first 50 million songs after 11 months.
Clearly, things were changing. In fact, by end of 2005, iTunes was outselling Tower and Borders in the US, according to NDP Group. In other words, we don’t expect a deceleration of things, but an acceleration of this shift.
While Apple’s revenues have grown $14B in 2005 to $19B in 2006. Much of that comes from computers, sure, but at $1 a song, having sold 2B songs, there’s $2B in revenues that Apple remits largely to the labels.
Analysts at IDC found that Apple made - as of 2005 - a healthy 35 percent to 40 percent profit on each player sold, and stands to make even more from ITunes music purchases and expected drops in flash memory pricing.
A quick “behind the envelope” estimate pegs revenues (from the launch of iPods in October 2001) at:
= average of $250 per iPod x 100M units = $25B in sales since 2001 for Apple.
The profit on these, at the 35% margin level is a whopping accumulated profit $8.75B since 2001 for Apple.
When you consider that Apple’s net income in 2005 and 2006 were $1.3B and $1.9B respectively, you see the valuable contribution the iPod makes. iTunes, alternatively, don’t add much to the bottom line; or at least, not as much.
Of course, the 2B songs sold on iTunes come from all major record labels and the independents, but considering that all of the independent labels and WMG boasted respective market shares of 18% and 15% respectively (as of 2005), there can be an interesting argument made for Apple to consider buying WMG and a bunch of independent labels.
And yes, this does not mean that WMG and the indies represented (18+15=) 33% of the 2B sold, but such an acquisition of the smaller labels would not cause an antitrust issue, would in fact boost competition and add a lot of value to Apple’s bottom line.
How Much Would Owning the Music Add to Apple’s Bottom Line?
Say the percentage of WMG and indie songs sold is actually 25% (and not 33%), that represents 500M songs, which at $1 would help retain $500M in profits for Apple… this is just one scenario in light of EMI being bought recently and the biggies being too large… but given the pessimistic horizon, who knows, maybe Vivendi would sell Universal Music Group at the right price.
It would also give Apple a way to increase its leverage in negotiations for revenue share with the majors, no?
Et tu Microsoft?
Of course, this is not something that Apple only can do, Microsoft, who launched the Zune in 2006 and has since sold 1M units could also make the move. We’ve argued that MSFT should get into the content space (again) and could do so my making acquisitions of record labels, which in an increasingly digital media landscape is not only a bad corporate strategy but would give it an edge over Apple and a shot in the arm of its Zune unit.
Is Cash King?
Whether or not MSFT or AAPL will actually do this, I doubt.
ADDED LATER: In fact, Apple Inc. (the computer maker) can’t enter the music content business by way of a 1991 agreement with Apple (the fab four). Then again, in 2007 the two parties updated the agreement, so I can’t see why another addendum is out of the question, if Apple Inc. really wanted to enter the space.
Given the stakes, it’s not a bad idea. After all, cash is king but Apple and MSFT have respectively $12B and $35B. The firm’s P/E is 35 times and 22 respectively. Using the example above where a company buys the indies and smallest major record label for about $3B would add $500M in profits, which would in turn add 500M x 35 P/E = $17.5B in market value for Apple and $11B for Microsoft (at a P/E multiple of 22).
At today’s prices, Apple is worth $101B - crossing the mythical $100B valuation mark - so this is in fact a 17% spike in market value. Microsoft weighs in at $300B, and for them, such a move would yield an increase in value of 3%… but in MSFT’s case, it would catapult them in a much stronger position, since their larger war chest would allow them to make a run for a handful of indies and a major record label that is larger than WMG, be it Sony BMG (25% market share) or UMG (31% market share).
All of a sudden, the idea of owning the rights to the songs becomes more and more palatable, no?
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May 30th, 2007 at 2:12 pm
Fantastic! That kind of money… buys a lot of cowbells.
May 31st, 2007 at 11:19 am
Apple isn’t exactly allowed to enter the music business, with the whole Beatles-founded Apple Corps.
May 31st, 2007 at 12:06 pm
Thanks Cyrus… you are right:
“In 1991, the companies agreed to share the trademark of the term, Apple, but Apple Computer was forbidden to use the name in any use “whose principle content is music”.
But, the companies entered a new agreement this year:
http://www.apple.com/pr/library/2007/02/05apple.html
I do not see why Apple could not sign a new agreement… especially with its massive influence on music on upcoming generations.
This was more of a (hate the word) thought exercise… it’s a “what if” post and touches mainly on what a bit of financial engineering could do.
Alas, good eye. Will add a note in the post.
June 1st, 2007 at 11:19 am
I think you need to re-do the math on your valuation analysis - 500 million in revenue is not 500 million in profit. Check out the Ad-Supported Music Central blog at http://ad-supported-music.blogspot.com/
June 1st, 2007 at 11:35 am
Thanks Marc, but in a way it is:
1. Right now Apple gets 5% margins on iTunes, so it’s close to $0… paying it out to a plethora of stakeholders.
But,
2. We’re talking about digital content and not traditional media content. With digital, the idea is with digital there’s no packaging, no distribution fee, etc. etc. So in economic terms, marginal revenue derived from digital media approximates to 100% profit as volume rises.
June 1st, 2007 at 4:25 pm
froosh, you need to look a little deeper.
1. Apple’s 5% margin is after it pays all stakeholders,
2. You would be right if Apple gets an additional $500 million without the accompanying cost, but owning WMG brings the cost with it so $500 million is not marginal profit. It is additional revenue, not profit. The additional profit is probably more like $25 million.