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It has been the conventional wisdom that while Apple (AAPL) makes a ton of money on iPods, it hasn’t generated a lot of profit from the iTunes music store. But Pacific Crest Securities analyst Andy Hargreaves yesterday morning suggested that the company’s operating profits from music downloads are about in line with the company average.

In other words, iTunes is generating some real profits for Apple.

Hargreaves estimates that in the September 2007 fiscal year, Apple will earn 9-14 cents a share from iTunes, generating operating profits in the 10%-15% range. His math looks like this:

  • Retail Price: 99 cents.
  • Wholesale cost: 69 cents.
  • Network fees: 5 cents.
  • Transaction fees: 10 cents.
  • Operating expenses: 5 cents.
  • Ergo: Operating profit per song: 10 cents.
  • He adds that his operating expenses estimate could be high, and that transaction fees are coming down over time, providing upside to his operating profit estimate.

    Meanwhile, Hargreaves says he believes Apple “has built and is capable of launching a subscription music service.” He says the company has had no compelling reason to launch such a service so far, but that increasing competition from cellular carriers and attractive economics for a subscription service “will drive Apple to launch its subscription service within the next 18 months.”

    Hargreaves predicts that 1 billion music-enabled phones will be sold next year (that seems like an astounding number, which implies that almost all phones next year will be music capable; most forecasts have the industry’s annual unit volume now running at about 1.1 billion phones).

    He says that the carriers’ music offerings “will become extremely viable competitors with iTunes,” offering an ability to download music anyplace, anytime. “The carriers post a competitive threat that will force Apple to [innovate] more in its iTunes service,” he writes. Hargreaves sees not only a subscription services but also personalization, tiered pricing and “more social aspects.”

    Hargreaves anticipates a subscription service would be priced at $10-$15 a month; 10% penetration of the iPod user base could add $900 million in annualized revenue, he says. Hargreaves also asserts that cannibalization of iTunes sales likely would be minimal, given that the average iPod customer buys only 20 iTunes songs a year.

    Apple yesterday was up $1.50 at $92.47.

    Source: Apple: Subscription Music Service Seems Inevitable