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Apple buying Beats could radically transform the digital music business

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There are still many unknowns about Apple’s (S AAPL) reported acquisition of headphone maker Beats Audio, but one thing is already certain: The deal, if it goes through as reported, is going to be a game changer for digital music.

News of Apple’s negotiations with Beats broke Thursday, and we have learned very few actual details since, save for the fact that Beats co-owner Dr. Dre seems to be a happy man. Reports do indicate that Beats Music, which launched as a Spotify competitor earlier this year, will be part of the $3.2 billion package. That has led to two interpretations of the deal: Some people think it’s all about digital music, while others argue that Beats Audio with an estimated $1.5 billion in hardware sales per year is, at least for now, the crown jewel.

I’d argue both are true. For Apple buying Beats is all about hardware, and it will transform the digital music business to a point where pure-play music services won’t survive as viable competitors anymore. The present world of music subscription services may be dominated by Spotify, with Deezer, Rhapsody, Beats, Rdio and others all shooting for second place. The future will be dominated by Amazon, (S AMZN) Apple and Google, (S GOOG) with Microsoft (S MSFT) and possibly Samsung trying to break into the big leagues as well.

Spotify: From IPO to acquisition target

The current king of paid music streaming is Spotify, which some estimate will surpass 10 million paying subscribers this year. The company executed very well on its international expansion, bringing music subscriptions to 55 countries, and effectively using ad-supported streaming as a way to get people hooked. But that growth has also been incredibly expensive, leading to Spotify raise more than $530 million in funding, and needing more money to actually boost its customer base in highly competitive markets like the U.S., where growth has been stalling.

Spotify planned to go public later this year for a fresh influx in cash, but that IPO is now looking a lot less likely. Not only has the climate started to shift against tech IPOs in recent weeks, the impending announcement of Amazon’s music subscription service also cast some doubts on Spotify’s IPO story.

Amazon is reportedly looking to bundle music subscriptions with its Prime service, which means that an estimated 30 million Prime subscribers will have access to music that Spotify is trying to sell them for an additional $10 a month. Reports indicating that Amazon is about to release its own mobile phone, which would presumably come preinstalled with the music service, further cast doubts about Spotify’s ability to compete in the U.S.

Now add Apple to the mix, with its ability to reach millions and millions of phone and tablet users, as well as a marketing budget that dwarfs Spotify’s efforts, and you end up with a scenario that could make potential investors very wary of the music service’s stock. Instead, I’d expect that companies like Google and Microsoft are crunching their numbers right now to see how much they’d be willing to spend for Spotify — and Spotify’s investors may decide that a multi-billion dollar exit before Apple fully takes control of Beats may be the best scenario.

The rest of the field: ready to be reshuffled

Speaking of Google, Amazon and Microsoft: News of Apple’s acquisition of Beats must have sent the digital media departments in these companies into high gear. Amazon has been working on its streaming service for some time, Google delayed the long-rumored launch of a YouTube music service multiple times.

But with Apple now getting its hands on a Spotify competitor, one should expect that each of these players is looking to accelerate their own efforts to try to preempt Apple’s entry into the subscription music market. This could mean that Amazon and Google will finally reveal their own services in the next few weeks.

It could also mean that other big players, including Microsoft and Samsung, will look to grab a piece of the action before it’s too late. Samsung has been trying to figure out what to do with its media services, with recent experiments like Milk pointing towards more of an ad-supported model. Microsoft has been trying to get traction for Xbox Music by taking it beyond the game console, but thus far, there is little evidence that this has worked.

It’s very likely that these companies are now looking to make their own acquisitions to bolster their portfolios. Rhapsody with its 1.7 million paying subscribers worldwide could be a good match for Microsoft. Deezer may be interested to a company with international ambitions as well. And a company like Samsung that doesn’t have a compelling subscription offering of its own may jump in and even pick up a smaller player like Rdio on the cheap, if only to continue its move towards ad-supported music.

Digital music: the thing you get when you buy something else

I expect all of these changes to happen fairly quickly. Twelve months from now, the digital music world is going to look very different. Instead of startups trying to convince consumers to spend $10 for music per month, it will be dominated by big companies trying to convince consumers to buy their devices and buy into their platforms.

Digital music will become a value-add. It won’t exactly be free — licenses are still expensive — but it will increasingly be bundled with other products and services, and come with long-lasting promotional offers meant to convince you to buy phones, headphones, data plans, or in the case of Prime, all kinds of stuff.

The good news for music labels is that bundling works, if done right. Muve was able to get more than two million subscribers by simply adding the price of their music subscription to everyone’s phone bill. It’s just that their bundles targeted the “wrong” consumers for a world in which AT&T partner Apple is buying AT&T partner Beats.

Muve isn’t the only company that came up with the right model only to see others succeed with it. The pioneers of digital music may finally see their vision of mass consumer services become a reality in the near future — but chances are that these very pioneers and their startups won’t be part of that future anymore.

20 Responses to “Apple buying Beats could radically transform the digital music business”

  1. Roy K

    Music is sticky and it’s a great hook to keep users engaged in this attention economy. So whether Google or Apple have existing mediocre streaming services is not the point – the point is that these behemoths have a ton of cash on their balance sheets and they’re willing to spend it to compete for users to stick around in their ecosystems. I agree with Janke that all the big players (including someone like Facebook, I might add) could consider Spotify a target, simply because it’s got the users. Sure, assignment clauses will have to be negotiated. But all the labels want alternatives to Apple so they would rather see Spotify survive under a bigger sponsor than to see it implode on its own.

    If you look back at the music retail business, pure play music stores (like Tower, HMV) gave way to mass retailers like Walmart and BestBuy, who sold Music as a loss leader to get people to buy higher priced gadgets. It’s the same effect now, except the upsell is for one kind of OS or another. So whether streaming loses some money (and true, economics are not great fundamentally because people don’t want to pay for music anymore) will probably end up being another business case line item offset by effects like user retention / time spent / etc.

    ps, I personally hate that Apple did this – I don’t think this kind of goofy brand clash acquisition (“Apple Beats by Dre”…?) would never have occurred under Jobs. But so it goes.

  2. Joe Cerra

    I agree with many of your points but not the final one, that digital music is what you get when you subscribe to something else. Those 10M subscribes on Spotify tell you that consumers are willing to pay for these services. Even with competitors, such as iTunes Match / Radio, Rdio, etc, I think music is one of those things premium products where many will pay a premium price to use the platform / service they choose, driving demand for subscriptions.

  3. daniel harvey

    Spotify will never be an acquisition target because of their licensing deals. If they’re acquired by anyone it will be to kill them outright not build on their success as a result.

  4. Tom Goodwin

    While this one of the best pieces I’ve seen about the Apple move, it neglects a few things.

    1) No company in the history of mankind has ever come close to turning a profit from streaming. It’s a weird business where as revenue grows, losses grow proportionally.

    2) The bundling model has been around for years, everyone has tried it from handset makers to operators to console makers, to retailers. Nokia alone has tried music streaming about 3 times since 2006.

    • Ted T.

      I agree, and this is why Beats/Apple are a good match: both depend on hardware sales to make the actual profits, something most of their competitors in the music business have no answer for.

  5. toukale

    I don’t think this is the case. While streaming will be the future fact is if apple were to launch a streaming service now they would kill their download business instantly. Yes, downloads music is down but it’s still a big business for apple in the tune of billions per year. Why killed that by introducing a money loser in the meantime. It’s no big secret that everyone in the streaming business is losing money, from spotify to pandora and everyone in between. So according to you apple should killed their successful download business and introduce a money loser in the meantime.

    The way I see it is Beats give apple a chance to have their cake and eat it too, like facebook did with instagram. Beats should be left alone since they are already on all the platform as a way for apple to keep their toes in the streaming business while still able to keep making their billions in the downloads business. It’s an added bonus that the hardware part of beats is making money. It will also help them bring onboard two music executives in their quest to get better licensing deals with the labels.

  6. Janko I think it might be time to check your biases as this post reflects you might just have a dose of the overconfidence effect

    • Yes, it does, but there is no indication that a ton of people are using it. And it hasn’t prevented the company from working on a second, YouTube-based service, so it may also not stop them from buying a service with a large user base.

  7. Oletros

    You post is assuming that license agreements are transferrable with the purchase.

    By the way, Google has its own streaming service