iTunes Store a greater cash crop than Apple implies?Although Apple has repeatedly said that its iTunes Store operates at "just above break even," a thorough analysis of the service's economics suggests it turns a profit roughly in line with the company average, with recent events paving the way for even greater gains.
Based on per-song cost estimates, the ubiquitous iTunes service generates an operating profit of at least 10 percent, and possibly as much as 15 percent, according to PacificCrest's Andy Hargreaves. The analyst on Monday released a detailed report on the subject, in which he informed Apple investors that the economics of iTunes could soon serve as a boon for the company's bottom line.
A breakdown of per-song fees
"For each $0.99 song, we estimate that Apple pays $0.70 to major labels, which own over 85 percent of the market, and $0.60 to $0.65 to independent labels, which drives an average price per song of approximately $0.69," he explained. On top of that, of course, are Apple's network fees, transaction fees, and general administrative expenses associated with operating the iTunes Store.
Hargreaves calculated the network fees at $0.05 per song, which includes the delivery fee, and the hardware and software to facilitate delivery. "Operating expenses are likely less than $0.05 per song, based on the relatively small number of employees we believe work on iTunes," he wrote.
Then, of course, there's the transaction fee — or royalty paid to credit card companies each time a sale is processed — which Hargreaves argues is "the primary reason iTunes profitability has not been higher historically." However, he notes hat Apple has recently adopted a number of measures to limit those fees, such as managing a weekly sweep of its credit card transactions, broadly distributing gift cards, and by encouraging larger transactions through services such as "Allowance."
Therefore, the analyst believes the iPod maker is now forfeiting only around $0.10 per song per song to credit card firms, compared to as much as $0.25 per song when iTunes first launched. "Going forward, we expect Apple to continue improving its payment schemes to cut down on transaction fees and improve the profitability of iTunes," he added.
Based on those cost estimates per song, Hargreaves arrived at the 10 percent margin estimate. Applying that estimate to the $1.2 billion in revenue that iTunes is expected to generation in fiscal 2007, he believes the service will generate $0.09 to $0.14 in earnings-per-share for Apple.
DRM-free tracks present incremental profit opportunity
Perhaps even more compelling, according to the PacificCrest analyst, is the incremental profit opportunity presented by the Cupertino-based firm's joint announcement with music label EMI to start selling DRM-free tracks at an approximate 30 percent premium.
"Consumers desire for mobile content drove the explosion in digital music and the growth of iPods. However, consumers became enamored with the quantity of music that the iPod enabled them to access, and sacrificed quality, in our view," he wrote in the report. "Going forward, we believe that consumers will expect mobility and will increasingly look for higher quality as the next step in improving their music experiences, particularly as consumers increasingly use iPods and iTunes as a source of content for home and car stereos."
Hargreaves cited sources who suggest that the economic split between EMI and Apple is likely to remain constant for the higher-quality, DRM-free songs that begin to crop up on iTunes starting next month. Since the songs will retail for $1.29 rather than $0.99, he estimates Apple to receive $0.09 of incremental gross profit per song. While delivery fees should double due to the larger file size of higher-quality songs, the analyst has assessed those network costs at $0.02 or less per song.
Assuming that half of EMI tracks purchased through iTunes will be of the higher-quality DRM-free tracks, Hargreaves estimates the move could generate approximately $24 million of incremental revenue, and just under $6 million of incremental profit for Apple in a year. In his note to clients, the analyst acknowledged that those numbers may seem insignificant, but said they would grow quickly if other labels followed suit in offering the DRM-free tracks.
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