Business Matters: If iTunes Is Still Breaking Even, It Could Cost $1.3 Billion Per Year To Run
Business Matters: If iTunes Is Still Breaking Even, It Could Cost $1.3 Billion Per Year To Run

In Apple's impressive fiscal second quarter numbers, iTunes may not have created much revenue but its value to the company is certainly more than the financial statements indicate.

Apple's second quarter revenue was $24.67 billion, its 83% increase the largest year-over-year increase in company history. Net profit of $5.99 billion, up 95%, was also a second quarter record.

Hardware unit sales were astonishing. Apple sold 3.76 million Macs during the quarter, a 28 percent unit increase over the year-ago quarter. It sold 18.65 million iPhones (up 113%), 9.02 million iPods (down 17%) and 4.69 million iPads and could not keep enough in stock.

And then there's iTunes. Its revenue of $1.4 billion was up from $1.1 billion in both the previous quarters.

But when it comes to music and entertainment, their value to Apple cannot be seen as a line item on a financial statement. Even though iTunes - music, video, apps - accounts for a small portion of Apple's revenues, its value to Apple is far greater.

In the last quarter iTunes comprised just 5.7% of the company's revenue. Much of its recent growth is probably coming from app sales. The 10 billionth app was downloaded - not sold, but downloaded - from iTunes in January of this year. In January 2010, iTunes had its three billionth app download. So clearly there is a lot of app growth happening.

But music and apps are worth far more than $1.4 billion/quarter to Apple for three main reasons. First, iTunes creates some degree of customer captivity. In a world where consumers are able to switch from browser to browser and device to device, iTunes and Apple's mobile devices are a good reason to become and remain an Apple customer. Second, iTunes adds value to the most expensive and higher margin hardware that makes up Apple's strong financial position. Consider this: Apple's 31.9% operating margin in the last quarter was better than the 30% cut it takes on download sales (which doesn't even taken into consideration the cost of running and promoting the iTunes Music Store).

Third, and most recently, music and entertainment create a bulkhead between Apple and the competition. Any efforts to develop a cloud music service are a competitive reaction to the music and app strategies of other companies. If Apple can protect a small fraction of its mobile market share - both mobile phones and tablet devices - its efforts to bring iTunes into the future will have paid off handsomely. A cloud music service could quickly bring in hundreds of millions of dollars, but it could help protect billions of dollars of high-margin revenue elsewhere in the company.

By the way, during the Q&A portion of Wednesday's earnings call one analyst asked about Apple's cloud music plans. Chief Financial Officer Peter Oppenheimer deflected the question and said only that "very confident" about iTunes now and in the future.