iTunes 10th Anniversary: Leading From the Front

After years as the only meaningful game in town, iTunes is facing the kind of game-changing competition it once presented to Tower and HMV. Can Apple innovate fast enough? And is iRadio the answer?

So what can Apple do for an encore in the music business?

After reinventing and restructuring the music biz with the iTunes Music Store during the last decade, iTunes remains far and away the leader--but now there are serious questions as to whether Apple is still a leader in innovation as the download growth tails off and more consumers mull committing to convenient paid subscription services. The doubts have mounted especially after Apple ceded smartphone momentum to Samsung and saw its profit margin and share price fall. CEO Tim Cook has debuted a string of product updates that were incubated before the 2011 death of Steve Jobs. A few very public missteps--such as Apple's release of a half-baked maps app--have added to the murmurs that the company has lost its mojo.

During the last 10 years, Apple, arguably the most innovative company on the planet, has run the biggest music service in the world. Apple effectively created today's legal market for digital downloads and still owns roughly a 65% market share. Now companies like Google and Amazon are striving to re-create the same hardware/software/service ecosystem that helped turn Apple into the world's most valuable corporation.

Apple is hardly sitting idle as streaming services reshape digital music. The company is in negotiations with record labels for an Internet radio service that one label source describes as "an evolution of iTunes" rather than a Pandora-like service. While the service would be tightly integrated with the iTunes store--labels are said to want the service to encourage download purchases--it represents a step away from the transaction-based services for which Apple is known. The service would generate revenue from not just incremental downloads but also advertising, most likely through its iAds mobile advertising division. Rights holders will participate in a revenue-share deal.

The Web radio service's greatest asset could be its reach. Sources say labels are negotiating global licenses that will expand the service well beyond the U.S. market. Apple has already launched iTunes stores in 119 countries, but few of them have an Internet radio option on par with what Apple could bring to market. Pandora, which has 200 million registered users and 70 million monthly active listeners, has a large lead in the United States. The rest of the world is wide open.

But Apple also needs larger innovations in hardware and software to fend off competitors. Some of Apple's lucrative smartphone business has been eroded by South Korean electronics giant Samsung in recent years. Samsung's share of the global smartphone market grew to 21.1% in fourth-quarter 2012 from 4.3% in first-quarter 2010, according to IDC, and topped Apple's 20.3% share--although Apple had a lead in smartphone profit share, 30.7% to 20.4%. Those two factors helped drag down Apple's share price below $400 from a high of $705 in September and erased more than $269 billion of market capitalization.

The music business has an immediate cause for concern if Apple is no longer the innovator it was during the second Jobs era (1997-2011). One major-label executive says 48% of consumers who buy a piece of the ­company's music at iTunes don't return the next year. "The whole iTunes ecosystem is based on new people going into the walled garden. If that ever stops, then the growth will grind to a halt."

Another person within the same company says some iTunes customers will return not in the second year but in the third year. One possible explanation for these infrequent purchase habits is iTunes' gift cards. A music fan who buys gifted downloads may be less likely to return than regular customers. Another explanation could be some consumers changing credit cards (thereby changing the numerical identifiers attached to each purchase).

Downloads won't keep people inside the walled garden as effectively as in the past. The digital download market is past its high-growth years and now faces increased competition from streaming services that provide an alternative to ownership. U.S. track sales were down 1% through March 31, eight percentage points lower than the pace a year earlier, according to Nielsen SoundScan. Album downloads' rate of growth has fallen to 10% from 17% a year ago.

Radio could be a partial solution. Apple is prepping an Internet radio service for launch this year that should boost iTunes' download sales, encourage iCloud usage and help Apple take market share from competitors like Pandora and iHeartRadio. Some people believe Web radio could be a steppingstone to an on-demand music subscription service that will help Apple evolve beyond the download market.

Apple is still an innovative company but hasn't showed any signals of its ability lately, BGC Partners analyst Colin Gillis says. The ongoing debate over Apple's role as an innovator in the post-Jobs era "has some credence [because] we've been in such a product vacuum in 2013," Gillis says. But he thinks people should wait and see what happens this year: From wearable computers (think smart wristwatches) to TV, Apple is rumored to be working on products that would open up new markets.

Apple's momentum has certainly slowed from the hectic pace that saw it release a series of mobile products starting with the iPod in 2001, and the products that Jobs left in the pipeline prior to his death are on the market. Now the company is filling in the gaps in its product line. By offering a range of computing devices, Apple is aiming to be a one-stop shop for consumers.

In addition to its big innovations--the high-priced smartphones, tablets and computers--Apple innovates in small ways that enhance its ecosystem. These apps, services and stores complete the Apple experience, generate more revenue and, in some cases, help fend off competitors. One example is Mastered for iTunes, a type of download that has been mastered with software that brings out maximum character and clarity when played on iTunes. Improvements to the iTunes platform allow labels and distributors to update metadata, get albums live and react to the marketplace in real time.

A steady flow of small innovations has helped the sales growth of digital albums: audiovisual bundles, digital booklets, the iTunes LP format and pre-orders that give the customer a track at the time of purchase. While CD prices are dropping, these innovations have pushed prices of deluxe albums well beyond the $9.99 standard price point. "Some things work better than others, but it's remarkable how the iTunes team has continued to innovate over the years," says Thomas Hesse, president of corporate development and new businesses and chief digital officer at Bertelsmann.

Executives universally hail the success of iTunes' Complete My Album feature, which allows customers who have purchased tracks from an album to upgrade to the complete album with a single button. No other download store offers this feature. One executive calls it "the single biggest tool" at the iTunes store. "We've been telling other guys out there they need to do it," the executive says. "It's been years. We told Google before they launched it was the No. 1 thing they needed to have. We say the same to Amazon."

But Apple hasn't innovated in other areas, BGC's Gillis says. Voice recognition software Siri lags behind Google Now, Google's intelligent personal assistant. ICloud hasn't yet lived up to its potential. Mobile advertising unit iAds has "fallen flat" as the minimum ad buy reportedly dropped to $100,000 from $1 million. And then there's Ping, the social network within iTunes that lasted only 25 months. "For all this cash they're sitting on, there's plenty of areas where they could beef up their efforts."

Apple's billion-dollar music question is how to embrace streaming while maintaining dominance in downloads. Jobs was famously disinterested in the concept of renting music for a fee, instead opting to sell downloads that consumers could keep in a permanent collection. Although Jobs didn't shy away from developing hardware that cannibalized existing Apple products--the iPhone cut into sales of the iPod, for example--Sony Music Entertainment chairman/CEO Doug Morris says that harming iTunes weighed on his mind. "We talked about subscriptions, Steve and I, 100 times," he says. "He was very indecisive about it. If he had really gone after the sub business, he felt it would have destroyed iTunes."

Apple need not worry about on-demand streaming upstarts Spotify, Deezer or Beats Electronics' upcoming service for now. NPD Group VP/senior industry analyst Russ Crupnick says Apple doesn't need to offer a cutting-edge service to succeed. "You don't need to be super-innovative for the mass market, which is what Apple is going for."

Indeed, music subscription services aren't yet a mass-market product. At the end of 2012, the biggest subscription service in the world, Spotify, had roughly 4 million subscribers. Other digital subscription services are far more mainstream. SiriusXM Satellite Radio has 23.9 million subscribers. Netflix has 25.1 million digital video subscribers.

But Internet radio, like radio in general, is a mainstream product and very popular with young listeners. Americans ages 13-35 spent 23% of their listening time on Web radio in fourth-quarter 2012, up from 17% a year earlier, according to NPD Group. Half of them listened to Pandora or Clear Channel's iHeartRadio, while just 9% listened to the free version of on-demand service Spotify.

Apple's Internet radio service, expected in late summer or early fall, can help keep people within the iTunes/iCloud/iOS walled garden. It should sell more downloads, too. Sources say labels, not content to earn just performance royalties from Apple's Internet radio service, have been pushing the company to include features that encourage listeners to purchase tracks. "Everybody is wary of having a super Pandora on the loose," one executive says in reference to the Web radio leader that uses a compulsory license and doesn't negotiate with labels for content.

Ultimately, Apple's competition isn't Spotify, Pandora or other music services: It's the handful of big companies that create ecosystems like its own. Google and Amazon offer cloud storage and services to complement their hardware and, in Google's case, mobile operating system.

These ecosystems are the gateways to music stores and services. Apple has seamlessly paired iCloud with iTunes so consumers can store music remotely and access songs from multiple devices. Warner Music Group executive VP of digital strategy Stephen Bryan believes iCloud creates a reduced-friction buying experience that "will significantly expand the potential of iTunes." When a person buys a digital track on an iPhone, "you know it will always be available to you," he says. "You don't have to worry about where it's stored."

Digital World Research analyst Paul-Jon McNealy believes there are only a handful of companies that come close to matching Apple in user-interface design and consumer credit card and personal information: Google, Microsoft, Amazon and Facebook. He also ranks Samsung fairly high as well. Other companies like Sony and LG tend to have inferior user interfaces, he says. "Anybody outside of those five companies is generally struggling to do both of those things well, and that can be the South Korean companies or the Japanese companies."

"They are very interesting," Sony's Morris says of Samsung. "More than Google, they have adapted to the culture. If you look at their ads, they're copying what [Jobs] did. Their ads are brilliant. Their styling is beautiful."

Apple needs to roll out new products. The performance gap has closed as Amazon, Google and Samsung have put out improved products that come at lower prices. "As the performance gap gets smaller, the price gap becomes more meaningful," Gillis says. Samsung doesn't have the ecosystem to compete with the other companies, but Google and Amazon can sell hardware at or near cost to generate post-sale revenue. Google gives away its Android operating system so people will use its search engine, maps app and other revenue-generating services. Amazon uses its Kindle tablets to encourage the sale of digital and physical goods.

Markets change quickly and what may have looked like a competitive advantage can erode quickly. Samsung took just a couple of years to grab an estimated 30% share of smartphone profits. "Markets naturally mature," Gillis says. "That's what happens. This is where the innovation will need to come through."