March 15, 2008

By ED CHRISTMAN

Research group NPD recently named iTunes the second-largest U.S. music retailer, and the company has just revealed that its store has passed the 4 billion download mark. So Billboard decided to crunch some numbers to see whether the conventional wisdom that Apple makes money from iPods—not downloads—still holds true.

While iTunes did not respond to a request for comment, its music suppliers think the store is making money on a cash basis, if not an accounting basis. Indeed, they say iTunes has told them its store is profitable.

The Cupertino, Calif.-based company announced it had sold its 2 billionth download Jan. 6, 2007; its 3 billionth July 31, 2007; and its 4th billion Feb. 27. As such, Billboard estimates that the store sold 1.7 billion downloads last year, and that of that amount, 940 million tracks were sold in the United States and 732 million were sold abroad, as the company operates stores in 21 other countries.

If all 1.7 billion downloads were counted at the U.S. price of 99 cents, they would equal $1.7 billion in revenue last year. But when it repatriates sales revenue from other countries, it likely enjoys a bump thanks to exchange rates. For example, in the United Kingdom, iTunes charges 79 pence per track download, but that equals $1.56, according to Web site oanda.com.

So when revenue is brought back to the States, Billboard estimates iTunes' music download revenue at $1.9 billion last year, which is in line with the $2.7 billion in revenue it reported during calendar year 2007 for other music-related products and services. Those consist of iTunes Store sales, iPod services and Apple-branded and third-party iPod accessories.

At a 30% profit margin, that equals $570 million in gross profit. But the company has expenses to consider. Last year, Apple overall generated $24 billion in sales. Its selling, general and administrative expenses were nearly $3 billion, and its research and development costs were $782 million. But it's hard to break out iTunes' share of that, as the download store accounts for only 8% of the company's overall sales, Billboard estimates. Plus, iTunes' expense structure likely differs from the rest of Apple, which is mainly a technology manufacturing company that makes computers, iPods, iPhones and accessories for its core products.

A more worthwhile comparison might be to look at Amazon's expense structure.

Amazon reported net sales of $14.8 billion for the year ended Dec. 31, 2007. Excluding its fulfillment costs for the physical product it ships to its customers, last year, the Seattle online store spent $344 million, or 2.3% of revenue, for marketing, while its technology and content costs came to $818 million, or 5.5% of revenue. Its general and administrative expenses came to $235 million, or 1.6% of revenue. All told, these are 9.1% of total revenue.

Since expense percentages are a function of revenue size, and with iTunes' 12.8% the size of Amazon's, if Apple spends at the same rate, its marketing costs would be about $45 million, its technology and content costs at $105 million and its general and administrative expenses at $30 million, for a total of $180 million. That would give iTunes an estimated operating profit of $390 million.


For another comparison, contrasting the two companies using Amazon's 1999 numbers, when revenues were $1.7 billion?almost the same as iTunes' revenue last year?it shows Amazon's marketing cost at $179 million at that revenue level, technology and content at $160 million and other expenses at $70 million, for a total of $409 million. That would give iTunes an estimated operating profit of $161 million.


In both instances operating profit doesn't count the depreciation and amortization costs of the technology infrastructure it built to open up for business, the overhead costs from parent Apple that it has to bear or taxes.


Yet, top distribution executives argue that Apple spends more on marketing the iTunes store than Amazon does. They also suggest that iTunes' technology costs are higher than Amazon's because all of its business has to go one extra step to provide for the download, in addition to supplying product information, placing purchases in a cart and getting credit card information.

Still, it seems that even with those higher costs, iTunes is now profitable on an operating basis.

But a top music executive says iTunes' margins "aren't that great because they spend a lot of money on advertising. I don't know what their variable costs are, but their fixed costs they are still amortizing." ••••

<byline>Additional reporting by Antony Bruno.</byline>

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