Daniel Eran Dilger
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Universal vs Apple in the iTunes Store Contracts

Universal vs Apple in the iTunes Store Contracts
Daniel Eran Dilger
When reports surfaced that Universal Music Group, the world’s largest music label, refused to resign its existing deal with Apple’s iTunes Store, there were private schadenfreude celebrations held in many closets.

Anti-Apple pundits briefly rejoiced at the prospects of a cataclysmic collapse of iTunes, something that they’ve been predicting and even, on occasion, pre-announcing as already having occurred in a test of their increasingly faulty powers in advancing self-fulfilling prophecies.

In reality however, the high priests of FUD got it wrong. Universal wasn’t pulling out of iTunes, despite the panicked headlines that suggested as much. Instead, the label was demanding a more favorable contract with Apple. Here’s why the big labels find themselves in such a position, and why they want contract leverage.

[Forrester Research: Epic Terror of iTunes and Apple TV]
[The Danger of DRM]
[Analysts fail to predict Apple’s success with iPod]


Music Labels Lose Track.
Universal and the other record labels were slow to recognize the online music business. Since the invention of music recording, the labels have been building a business that revolved around physical reproductions of music recordings.

The only change that the labels really needed to keep up with was the advances in recording technology, from the phonograph to the 8-track and cassette to the CD. Each generation of consumers were introduced a new format, and were were expected to replace their existing music library with a modern, new physical version.

After the CD however, things didn’t go as the labels expected. Various new post-CD formats were thrown out, only to fail in the market:

• Sony’s MiniDisc, the compact CD.
• Phillips’ Digital Compact Cassette, the CD equivalent to tape.
• Sony/Phillip’s joint Digital Audio Tape.
• DVD Audio and SACD, the next generation of high definition CDs.

How could music buyers be expected to repurchase all the music they owned if there were no new format to force the move? The CD, originally invented back in 1982 and fully mainstream by the early 90s, continues to be the most popular retail format today, despite the existence of higher definition options.

[Apple TV: Using DVDs and other Video Sources]


Entering The Digital Realm.
A new physical successor to the CD–hoped for by the music industry as a white knight leading it into a new promised land of album sales–not only failed to materialize, but the CD itself opened up and released its audio data into independent digital files no longer bound to the disc media.

Suddenly, music executives found their business model of selling music etched into plastic at risk. The MP3 music files users were creating from CDs were not only more convenient, but could also be copied around in bulk, shifting the relatively minor record counterfeiting business into a casual distribution system that dwarfed the legitimate music business.

By 2000, the music labels were in full panic. The Napster online music sharing network began demonstrating the consequences of treating commercial music as a communally shared idea rather than a protected production guarded by the institution of music labels.

[Is Piracy Really Killing the Music Industry?]


Napster and the Musicians.
Top musical acts quickly recognized that widespread sharing of their productions would destroy their music business. Metallica, Dr. Dre, and Madonna complained to Napster after finding their music in wide distribution, commonly in advance of its commercial release on CD.

The music industry relies on scheduled releases of music to create anticipation. A major function of the music labels is to promote new music by generating awareness of upcoming releases. When services like Napster leaked music out, the hype machine that advertised big acts–and subsequently sold their music to the widest possible audience–fell flat.

At the same time, services like Napster helped smaller indie acts which didn’t already have a promotional engine pushing them to the public. In 2000, Radiohead–which had never been in the top 20 in the US–suddenly shot to the top of the charts with its otherwise obscure album Kid A, which hadn’t had much radio airplay and hadn’t released any tracks as promotional singles.

The reason Radiohead could top the pop charts from out of nowhere was that millions of Napster users had been exposed to the group’s music.

Three years later however, Radiohead was disappointed to find its Hail To The Thief album on Napster prior to its commercial release, because the album had been leaked from a stolen bootleg of an unfinished version.

The High Cost of Free.
Free distribution of music helps new acts gain recognition, but bypassing the labels’ established promotional system–with its release embargoes, marketing expertise, and exacting quality control–had drawbacks as well.

Musicians and their label promoters aren’t the only contributors to the music industry. The labels also rely on retailers to sell their promoted albums. Without retail sales, the labels have no reason to exist.

That’s why the record labels were outraged by the recent decision by Prince to hand out free copies of his latest album bundled with newspapers in London. Prince was paid directly by the newspaper, but the labels feared two consequences:

• First, that distribution of a free CD would erase the perception of the value of music CDs in general.
• Second, that music distributed outside of the existing profit chain would marginalize the labels themselves.

[Prince Points the Way to a Brighter Future for Music – Wired]

The Label Middlemen.
The labels work hard to set the highest price possible for albums, because they take the majority of album revenues. The more labels ask for the music they represent, the higher their own profits are.

As middlemen, the labels pay the artists royalties on the productions side, and allow retailers a markup on the distribution side. It’s their business to make sure everyone is content with that arrangement, because without artists or retailers, the labels have no job.

However, the labels’ pricing behavior seems to assume that the market for music is not subject to change, but that every new hike in price can only boost their bottom line without risking any significant drop in demand.

As CD prices push toward $20 per album however, consumers have begun to spend their discretionary cash on alternatives: movies, video games, and other forms of entertainment.

The other demand problem for the labels has been the ubiquitous nature of unauthorized music distributed on the Internet. With an infinite supply of counterfeit music, the labels are pitted against plummeting demand while they also price their product out of the legitimate market without any regard for reality.

The Pinch on Music Retailers.
High music prices are not only bad for consumers, but also for the traditional music retailers. The percentage of profits that retailers can earn drops as album prices rise. As the demand for overpriced albums also drop, music retailers lose their sales volumes as well.

The labels have also skewered traditional music stores by attempting to blow out volume sales through big box retailers, who now consume the mass market demand for music by offering albums as a loss leader to bring consumers into their stores.

Music retailers are left to compete with low volume, low profit, high priced music. That has resulted in the high profile death of a number of music store chains, and leaves the remaining retailers to struggle along as knowledgeable providers of music in an industry now dominated by loss leader big box volume sales.

[Did iTunes Kill the Record Store?]


The Point Behind Apple’s Music Business.
Apple, like any other music retailer, only makes a minor profit on music sales. Like the traditional music stores, Apple wants to sell music in volume at prices that stoke an ongoing demand for music from repeat buyers.

Like the big box retailers however, Apple does not necessarily have to earn a sustainable profit on music sales, because Apple only sells music for two reasons:

• First, to create interest in and around its hardware products, where it earns its real profits.
• Second, to ensure that commercial music is available for and compatible with its Mac and iPod platforms.

Before opening the iTunes Store, the music industry hoped to standardize upon Microsoft’s Windows Media architecture, which if successful would have resulted in all commercial music requiring playback support from Microsoft.

However, Microsoft never released its latest Windows Media Player DRM for any platform outside of its own Windows, and made no consistent provision for burning WMA protected music into a format that could be used on other systems.

Had Windows Media gained traction, Mac users would not have been able to use commercial music at all, just as Microsoft’s Direct X helps prevent any real market for cross platform gaming.

[Steve Jobs and the iTunes DRM Threat to Microsoft]


Windows Media: the Labels’ Next CD.
After physical successors to the CD all failed to gain traction, the music industry invested its hopes in Microsoft’s plan to deliver a virtual heir to the CD within the digital realm.

Rather than delivering music permanently etched into plastic, Microsoft developed a DRM architecture that promised to allow the labels to distribute virtual albums locked down to silicon instead.

In addition to preventing casual copying in the same manner the read-only CD originally did, Microsoft’s Windows Media DRM also introduced a subscription media business model that could allow the labels to sell and then later revoke access to digital music files after a certain number of plays or a given time period.

Unlike the already DRM-heavy failures of MiniDisc, SACD, and DVD-Audio, Windows Media was software based, so that even if it were ever cracked, Microsoft could later adjust its system in a software update and potentially wipe out playback of any suspected counterfeits.

Suddenly, the simple nature of the album had turned into a complex, highly policed architecture where music would only play when, where, and how Microsoft and the labels decided it would be allowed. This was great for the labels and for Microsoft, which would now have new monopoly leverage over any potential competitors to Windows, including Linux and Apple’s Mac.

In theory, it would also be ideal for artists and retailers, as both would be guaranteed a cut of the action; no music would play anywhere without Microsoft’s approval, and counterfeiting would theoretically stop. The problem for hopeful WMA partners was that there was never any action to cut.

[The Two Faced Monster Inside Zune]


The Failure of Microsoft’s WMA.
New music players designed to work with WMA would eventually only play WMA files, gradually obsolescing MP3 files and even the CD.

That would require consumers to repurchase all their music just as they had replaced their LP albums with CDs a generation prior, subsequently guaranteeing fat profits for the labels, artists, and retailers. WMA promised choice among hardware players and music retailers, but really only delivered one choice: Windows Media.

As Microsoft labored to release its WMA system, Apple began offering an alternative: the iPod. It was designed to work with the CDs users already owned, and didn’t introduce any DRM restrictions.

The iPod also offered a more elegant hardware choice than any of the WMA partners, but even more distressing for Microsoft was the fact that it offered an alternative to its WMA music stores.

[Why Microsoft Can’t Compete With iTunes]


The Rise of Apple’s iTunes Store.
Apple’s Steve Jobs repeatedly tried to convince the labels that their music business desperately needed a workable online strategy, not a DRM-heavy system that Microsoft was working to deliver by following the failure of MiniDisc, SACD and DVD-Audio in software.

It was only after the failure of WMA stores to deliver any meaningful sales–a problem created by the CD-friendly iPod itself–that the labels cautiously decided to sign up to deliver their music to Mac users in the iTunes Store. Apple demonstrated a promising market for low cost online music at a set 99 cent price.

[Steve Jobs: The Rolling Stone Interview – Rolling Stone]

Napster, having been shut down as a file trading service and then reopened as a WMA store, scrambled to advertise that the iPod would cost $10,000 to fill up with 99 cent songs from iTunes, whereas a WMA player could be filled with a subscription of WMA DRM songs for just $15 per month.


The problem with that logic was that consumers realized Napster was charging users $180 per year for music that they could no longer listen to the moment they stopped paying.

With the iPod, users didn’t have to buy anything to listen to their own music. The iTunes store was offered as an optional service. Those interested in the convenience of online sales could buy from its increasing catalog of albums, and were assured that anything they did buy could be burned to a standard CD for playback in a car CD changer or any other standard player, or even ripped back into a form that could play on other digital music players.

The result was rapid adoption of Apple’s far less restrictive system, and the subsequent establishment of Apple as the third largest music retailer in the US, behind big box loss leader music retailers Wal-Mart and Best Buy.

[How FairPlay Works: Apple’s iTunes DRM Dilemma]


Apple’s iTunes vs Labels’ Market Pricing
That gave Apple enormous market power as a music retailer, not just because it was selling a large portion of the labels’ music, but also because it represented the future of all music sales: the online business. Its larger competitors were only selling large volumes of CDs, and only as a loss leader.

Universal’s refusal to resign its original contract wasn’t a sign that it wanted to drop the only retailer who had managed to develop a workable online business model. Like the other labels, its job is to represent both artists and retailers, so it serves Apple, not the other way around.

What Universal was chafing against was Apple’s efforts to drop music prices. The labels had already failed to introduce so-called “market pricing,” an effort led by industry simpleton Edgar Bronfman Jr. While presented as a way to offer back catalog albums at a lower price, the real intent of Bronfman’s market pricing is to drive up the cost of digital albums in the same way the labels earlier drove up the cost of CDs.

Bronfman’s “raise prices to monetize demand” logic had been a core reason why CD sales had tanked and why many music retailers had been driven out of business. Jobs insisted that music prices in iTunes stay where they were to drive demand for online music and create price stability in the online market.

[Where is the iPod Killer? Edgar Bronfman Jr.]

Apple’s Music Contracts.
Jobs won that argument because his contracts with the music labels reserves the right for Apple, as a retailer, to set any price it wants. If Apple wanted to raise the price of music, its contracts allow it to, and if it wants to drop prices, its contracts with most labels allow it to do that, too.

Anyone can sign up to be an iTunes label and submit their own music to Apple for sale. Because of the work required to serve as a label, several groups supporting independent music offer their services as an iTunes label to musicians. They reveal that their contracts with Apple stipulate that Apple can sell music at whatever price it decides. The royalties artists are paid are directly proportional to the price Apple sets.

Prices haven’t changed in iTunes however, indicating that Jobs wasn’t just blowing hot air when he insisted that stable prices would drive demand. It turned out he was right, and sales through iTunes have grown by leaps and bounds.

The only change in pricing has been Apple’s deal with EMI to offer higher bitrate tracks without DRM for a 30 cent premium.

[Will Steve Jobs License Apple’s FairPlay DRM?]


The Threat of Real Market Pricing.
The labels also know that were Apple to change music prices in general, it wouldn’t be to raise them. It’s in Apple’s own interests to consistently maintain competitive prices and to even offer lower prices than retail CDs in order to incentivize online sales.

That gives Apple the power to deal out a devastating blow to Wal-Mart and Best Buy, playing their own game against them by calling their loss leader bluff.

Apple recently introduced “the Next Big Thing,” a promotional campaign offering 40 full albums from mainstream artists including Digitalism, LCD Soundsystem, and Peter Bjorn and John, for $6 – 7 each.

No wonder Universal and other labels are freaking out. Like Prince, Jobs is making money distributing and popularizing music at increasingly lower prices, and earning enough money to continue doing it.

At the same time, the labels are increasingly dependent upon Apple, the only company selling any significant amount of their music online, and increasingly, a large proportion of all of the music they represent.

Universal can only demand the right to offer some of its albums exclusively to other retailers first, in the hopes of scalping consumers with high CD prices before ultimately making it available for Apple to sell at volume incentivizing prices in iTunes.

[The Next Big Thing – iTunes]

Why Zune Had to Die for Microsoft’s Sins.
After Microsoft’s Windows Media DRM architecture fell from grace, the big labels quickly realized that Apple’s iTunes was the only game in town. Universal hoped the promised Zune would change that, and restore its power as the outfit calling the shots in the music industry.

Microsoft was left with so little clout after the failure of WMA that even Universal had the leverage to charge Microsoft royalties for each copy of the Zune. If it could rival the iPod, the Zune could restore the labels’ lost nirvana of a music industry dominated and policed by the label-friendly but consumer-hostile WMA.

Fortunately, consumers didn’t express any faith in Microsoft’s latest volley of promises after it willingly tortured its past partners and customers by casting its existing PlaysForSure program into the bonds of eternal darkness.

Microsoft is not a good god, even to its own faithful.

[The Microsoft iPod-Killer Myth]
[Zune vs. iPhone: Five Phases of Media Coverage]
[iPod vs Zune: Microsoft’s Slippery Astroturf]
[iPod vs Zune: A Buyer’s Guide]
[Strike 3: Why Zune will Bomb this Winter]
[Ten More Myths of Zune: Part 2]
[Ten More Myths of Zune]


Universal’s Do or Die Ultimatum.
Universal can’t walk away from Apple, because it knows that all of its music is going to be on the iPod whether or not it dances with iTunes; the only question is whether Universal will get paid to deliver its music through iTunes, or whether it will turn its back on the future and struggle to sell overpriced CDs.

Either way, Universal’s music will end up in iTunes playlists, legally at a fair price, or illegally via file traders.

That’s the real threat of market pricing, a reality the labels’ cartel hasn’t had to deal with in the past. Increasingly, the big labels will cease to matter, because their job is to promote artists and sell music, and Apple is doing a better job of that itself.
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