We maintain that what you see offline vs. the Web will remain different due to economics (ads on the webs are still paltry next to offline advertising after all) and what you see on the Web vs. wireless will remain different mainly due to technology. The cell phone, after all, has the computing power of a computer in 1995. Great. I wasn’t doing much back then online, apart from waiting for a page to download.
But media is going digital. This does not mean that newspapers, magazines, TV, radio or billboards will vanish, it just means that it will change. But what about music?
When Five Becomes Four… and Four Becomes Three?
Last year Sony (SNE) merged with BMG. And this year, EMI is being courted by both private bankers and WMG. In fact, the day after EMI shareholders accepted an offer from private bankers for $4.7B and be taken off the markets, the EU conditionally approved Vivendi Universal’s acquisition of BMG Music Publishing, after the music publisher agreed to sell off parts of its catalog, according to this post by Paid Content.
EMI, by the way, lost $568 million in 2006.
As of 2005, here was the breakdown in terms of market share around the World:
Clearly, EMI and WMG are the smaller players… and their market caps reinforce that:
- WMG = $2.49B
- EMI = $4.34B (bought by private bankers)
- Universal is part of Vivendi (we all know that disastrous story, with the Bronfman family knowing it too well).
- BMG was a part of Bertelsmann, and is now a 50%-50% joint venture between German-based Bertelsmann and Japan’s Sony. Looking at that pie chart above, for those keeping track, as of 2005, the market shares were 13.83% for Sony and 11.78% for BMG.
BMG/Sony merged partially to save money, their merger was to lay off 2000 employees and save them $350M each year. Over the years, the record labels had gotten large, fat in fact, and the digital revolution simply exasperated matters.
When EMI loses $568 million in a year, you know the industry is just getting ready for a shakeout. And much of the preparations have to do with merging to strengthen the base and weed out redundancy. The smaller labels range from marginal valuations to $36M, for example, in the case of Sanctuary.
An Apple A Day…
Of course, leading the charge on the digital side is none other than Steve Jobs and Apple (AAPL), who recently sold its 100 millionth unit of iPod. I’ve long said that Shawn Fanning and Napster have proven over time to be poodles compared to the grip that Steve Jobs has on the music industry and to a much lesser extent (for now), the movie industry by selling Pixar to Walt Disney (DIS) and becoming its largest individual shareholder.
It’s important to note that Apple makes practically all of its revenue in music off the hardware (the iPod) and not “software,” the music. Keep in mind that digital media is the new software, in our perspective. The software component is sold via iTunes, Apple’s radically successful music store.
Clearly, things were changing. In fact, by end of 2005, iTunes was outselling Tower and Borders in the US, according to NDP Group. In other words, we don’t expect a deceleration of things, but an acceleration of this shift.
While Apple’s revenues have grown $14B in 2005 to $19B in 2006. Much of that comes from computers, sure, but at $1 a song, having sold 2B songs, there’s $2B in revenues that Apple remits largely to the labels.
Analysts at IDC found that Apple made - as of 2005 - a healthy 35 percent to 40 percent profit on each player sold, and stands to make even more from ITunes music purchases and expected drops in flash memory pricing.
A quick “behind the envelope” estimate pegs revenues (from the launch of iPods in October 2001) at:
Average of $250 per iPod x 100M units = $25B in sales since 2001 for Apple.
The profit on these, at the 35% margin level is a whopping accumulated profit $8.75B since 2001 for Apple.
When you consider that Apple’s net income in 2005 and 2006 were $1.3B and $1.9B respectively, you see the valuable contribution the iPod makes. iTunes, alternatively, don’t add much to the bottom line; or at least, not as much.
Of course, the 2B songs sold on iTunes come from all major record labels and the independents, but considering that all of the independent labels and WMG boasted respective market shares of 18% and 15% respectively (as of 2005), there can be an interesting argument made for Apple to consider buying WMG and a bunch of independent labels.
And yes, this does not mean that WMG and the indies represented (18+15=) 33% of the 2B sold, but such an acquisition of the smaller labels would not cause an antitrust issue, would in fact boost competition and add a lot of value to Apple’s bottom line.
How Much Would Owning the Music Add to Apple’s Bottom Line?
Say the percentage of WMG and indie songs sold is actually 25% (and not 33%), that represents 500M songs, which at $1 would help retain $500M in profits for Apple… this is just one scenario in light of EMI being bought recently and the biggies being too large… but given the pessimistic horizon, who knows, maybe Vivendi would sell Universal Music Group at the right price.
It would also give Apple a way to increase its leverage in negotiations for revenue share with the majors, no?
Of course, this is not something that Apple only can do, Microsoft (MSFT), who launched the Zune in 2006 and has since sold 1M units could also make the move. We’ve argued that MSFT should get into the content space (again) and could do so my making acquisitions of record labels, which in an increasingly digital media landscape is not only a bad corporate strategy but would give it an edge over Apple and a shot in the arm of its Zune unit.
I'm not sure whether MSFT or AAPL will actually do this. But given the stakes, it’s not a bad idea. After all, cash is king but Apple and MSFT have respectively $12B and $35B. The firm’s P/E is 35 times and 22 respectively. Using the example above where a company buys the indies and smallest major record label for about $3B would add $500M in profits, which would in turn add 500M x 35 P/E = $17.5B in market value for Apple and $11B for Microsoft (at a P/E multiple of 22).
At today’s prices, Apple is worth $101B - crossing the mythical $100B valuation mark - so this is in fact a 17% spike in market value. Microsoft weighs in at $300B, and for them, such a move would yield an increase in value of 3%… but in MSFT’s case, it would catapult them in a much stronger position, since their larger war chest would allow them to make a run for a handful of indies and a major record label that is larger than WMG, be it Sony BMG (25% market share) or UMG (31% market share).
All of a sudden, the idea of owning the rights to the songs becomes more and more palatable, no?
AAPL vs. MSFT 1-yr chart: