The debate over DRM has raged since the inception of digital music and the growth of Apple (AAPL) and its iTunes Store. Even Apple's head Steve Jobs wrote a letter discussing DRM on Apple's website. Apple's first partner into the DRM-free world was EMI (EMIPY.PK) and together they launched iTunes Plus. An additional service for music that gave customers better quality tracks that were free of restrictions. These tracks could be played, burned or used anywhere, virtually on any device.
Universal has shunned the online music juggernaut that is iTunes and its 70+% market share. It has chosen to partner with Real Networks (RNWK), which has its well known Rhapsody service starting to gain some momentum in the space. The stock jumped off its 52-week low today finishing up 7% on the news. Before we jump on the Rhapsody bandwagon, investors need to consider that this 6-month Universal test is available also to online stores run by Best Buy (BBY), Wal-Mart (WMT), Amazon (AMZN) and Google (GOOG). While some of these big net names don't exactly offer complete online music services to consumers you can see that the biggest name is missing. Apple Inc.
Contract renewal negotiations fell apart between Universal and Apple some time ago and it was clear then that Apple's firm demands were not met with smiles. Reportedly during the talks, Universal wanted changes to pricing and Apple wanted to keep the same pricing simplicity and get rid of DRM completely. It seems Vivendi's Universal unit holds a big grudge. However, if DRM-free music is truly the wave of the future it wont be long before iTunes is back in Universal's good graces. With CD sales down sharply quarter after quarter and digital sales, although growing, failing to compensate, its only a matter of time before shareholders become unhappy with the fact that the biggest music distributer in the world excluded the most powerful online music store in the test.
The question investors have to ask now is whether the 6 month test period is enough for any competing service, such as Real's Rhapsody, to gain any traction against iTunes simply because of DRM-free music? The same songs will still be available through iTunes just packaged with digital rights management. Will this be enough to lure people away from the iTunes store and into competitor online music stores, where they can buy individual songs, put them back into the iTunes media management software and load them onto their iPods? Based on market trends it doesn't appear very likely.
iTunes music sales have always been a low margin business for Apple as its been said that of each $0.99 track almost $0.70 goes to the record label and the rest covers network and advertising costs. What Apple's profit machine feeds off of is sales of iPods and Mac Computers. So for Apple shareholders is this a big deal? Well, yes and no. It isn't a big deal being shut out of the DRM-free test by Universal, however if this strains the company relationships further and Universal decides to pull songs from iTunes that could provide a significant blow to Apple's music business. Universal does sell about 1/4th of the world's music.
Anything Apple loses in the online music business will most notably be picked up by Real's Rhapsody, which would have a positive effect on shares of Real Networks. However, the online music business is still very low margin and Real as a stock I would not recommend based on this DRM-free test alone.
The music trends are clearly forming to a purely digital age with freedom and sharing being at the forefront of consumer minds. With that will come more DRM-free offerings, which will spur further music player sales. The product everyone seems to still want is the iPod and the company making that particular gadget is none other than Apple. Those executives at Universal better start to mend fences soon because not working with Apple in online music is a severe mistake, with the iPod still on the consciousness of virtually every music consumer on the planet.
Disclosure: author is long AAPL.
