The Future Will Be Tiny ... and Integrated

In Finding Harmony in the World of Online Music, I wrote about RealNetworks' new Harmony Technology. (Incidentally, the final version is now shipping, and you can grab it at Real's Web site.) I mentioned that Apple Computer has taken umbrage with Harmony because Real is opening Apple's closed iPod system to music from non-Apple stores. My take on this battle is that Real never should have had to force Apple's hand and go its own way. Instead, Apple decided that Apple—and only Apple—could supply purchased music for enjoyment on the iPod. And Apple has pledged to fight Real and make its music incompatible through future iPod updates.

Two weeks later, I remain convinced that giving consumers a choice—in this case, a choice of online music stores—is ultimately the way to go. Choice has driven our free market society since the beginning. The concept is simple enough. However, some reader feedback has me questioning my views. Not that I'm backing down from my choice mantra. But it's become somewhat obvious to me (you know, after others pointed it out) that maybe we're missing the real point of this fight. Maybe Apple and Real aren't really fighting about music formats at all.

Today, two core products define Apple's music business: the iPod and the iTunes Music Store. The iPod, clearly, is hugely successful: Apple has sold millions of the devices, all at a healthy profit margin. Next to the Macintosh, the iPod falls a bit short financially, but I think it's only a matter of time before Apple is making more money from the iPod than it does from its computer business. When that happens, Apple will officially become a different kind of company altogether.

Meanwhile, iTunes has also seen some high-profile successes, but the service continues to be a financial deadweight. Although Apple has sold 100 million songs through iTunes and now boasts a catalog of more than 1 million titles, iTunes either loses money or merely breaks even, depending on who you talk to. No problem, Apple CEO Steve Jobs has said, iTunes helps sells iPods, so iTunes is doing its job. And that, ostensibly, is why Apple has railed against Real's Harmony technology: By offering customers a choice of music stores, some iPod owners might choose to go with a cheaper and more capacious iPod alternative, such as Dell's Digital Jukebox (DJ). And if that happens, the thinking goes, Apple's newly created empire could crumble.

I'm now positive that that thinking is wrong. Apple isn't fighting Real because of iTunes or the iPod. No, this fight is really about Digital Rights Management (DRM), the software code that controls the distribution of content you purchase online. Microsoft and Real got there first, with complete DRM platforms, but Apple's FairPlay DRM scheme—which the company uses to protect songs purchased from the iTunes Music Store—is arguably the most popular, assuming "popular" refers to unit volume. And if Apple is to have a future in digital music, FairPlay needs to retain its dominant position. Here's why.

As noted, Apple doesn't make much (or any) money on music purchased at the iTunes Music Store today. But as any company would with any potentially lucrative up-and-coming business, Apple is willing to take a loss on iTunes for the short term if it can use that time to establish itself as the volume supplier of both a DRM solution and a product that people want. Because if online music sales continue to grow—and let's face it, they will—Apple could suddenly find itself as the dominant distributor of a form of entertainment that's been making money for far longer than the computer industry. Currently, more than 500 million music tracks are sold each month in CD format, far outstripping the 11 million tracks sold online. If just half of those tracks were distributed digitally, and if Apple were to maintain its 70 percent market share, the company would be distributing almost 200 million music tracks a month. Eventually, of course, most music will be distributed this way. And Apple might find itself the Best Buy, Wal-Mart, and of online music—combined. In other words, Apple would have the clout and market power to demand a bigger piece of the pie. And it would start making money on iTunes. Big money.

But back to the iPod, which is currently the only non-computer device on the planet that can play back songs purchased from iTunes. (A recent deal with Motorola will eventually allow iTunes song playback on certain cell phones as well.) Apple knows that its iPod business is a short-term affair, despite its obvious and quick success. That's because the world is turning, undeniably, to tiny, integrated devices based on cell phones. Already, sales of camera-enabled cell phones have surpassed sales of digital cameras. And as you read this, a new generation of personal information manager (PIM)-equipped smart phones is killing the market for standalone PDAs. What's next? As soon as you add a low-voltage hard disk to a cell phone, you have an iPod replacement, and it will be Nokia, Motorola, and Sony Eriksson selling those devices—not Apple. But Apple knows that it will have to play in that world to continue being successful. Thus, its fledgling deal with Motorola.

Flash forward to 2005 or 2006. You'll be able to purchase a cell phone that will include an integrated camera/video camera; a 5GB-to-10GB hard disk for storing photos, movies, music, and any other data; and all the PIM functionality of today's PDAs. The phone will even work with Bluetooth-equipped keyboards and will likely run Microsoft Office-like productivity applications. You won't need a bunch of separate devices—you'll just want, and need, this one thing. And if Apple's plans to leverage its business today with the iPod and iTunes are successful, it will be Apple's FairPlay—and not Microsoft or Real's DRM schemes—that device makers will rush to support. And Apple will be the company—and not any other retail or online store—from which consumers purchase music. And that business will be worth hundreds of millions of dollars a month.

In other words, the Apple and Real fight will eventually affect all of us, whether we're into digital audio or not. This fight will someday be seen as the opening salvo in a war that could last for years and have ramifications far beyond what is now a pretty small market. And this fight isn't really about today, it's about the future. If Harmony succeeds, it has the potential to kill Apple's consumer electronics future and relegate the company to a has-been PC alternative. That's why Apple is so upset about this development.

As consumers, we shouldn't be concerned much with which company "wins." We should be more concerned about choosing the services and products we want based on quality, price, and other criteria that matter to us. But understanding the stakes involved is important because those stakes will guide the behavior of the companies that are positioning themselves to receive our hard-earned money.

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