iTunes now better than break-even

Asymco analyst Horace Dediu is out with a new report estimating that iTunes, which Apple has long stated it operates at a break-even level, may now be doing quite a bit better than that.

One big reason for the improved finances, Dediu notes, was the decision to roll Apple Software into iTunes for reporting purposes. While gross revenue from software still trails behind music at iTunes, the margins on those products, which include iLife and iWork, as well as Final Cut Pro and Logic Pro, are much higher, raising iTunes’ overall gross profit ratio.

But another big factor, according to the report, is the sheer economies of scale Apple has achieved in music, video and apps.

“What is known as iTunes today has quintupled in seven years,” Dediu writes. “Although cost of content sales are likely to have been preserved as a ratio (about 30%) the vastness of transaction volume (estimated at 23 billion item transactions in 2012 alone) implies that there are some significant economies of scale.”

Looked at another way, he adds, “at break-even the cost of operating iTunes stores would be about $3.75 billion,” given its current gross revenue.  “It’s hard to imagine this level of operational expense for digital content.”

Dediu estimates Apple is reaping a 1 percent operating margin on iTunes music, and 2 percent on apps. Overall, he estimates iTunes is contributing $150 million in earnings.  Not bad for a break-even operation.

And maybe not the end of it, either. I’ve long believed there is a theoretical limit to the upside from Apple’s inverted razor-and-blades business model. Unlike the classic Gillette strategy of breaking even or even losing money on razors to create an installed base to support ongoing sales of blades, Apple currently breaks even on the blades (i.e. iTunes content) to help drive sales of the razors (Apple devices).

That strategy requires a certain pace of device innovation, however, both to develop new device categories (the iPad) and to maintain a sufficient lead over competitors in existing categories to be able to command a price premium. Should that pace ever slow, Apple would become more dependent on content sales to sustain its overall margins.

One reason Apple may be letting operating margins at iTunes creep up now is that it sees that day coming.