Microsoft, again: Apple's old nemesis

By Evan Hansen
May 29, 2003, 4:00 AM PT

In a masterstroke of technological and marketing acumen, Apple Computer appeared to have seized the digital music industry last month by boldly creating its own retail download service.

The Macintosh maker, diagnosed being near death in the 1990s, seemed to have pulled off another miracle: Its iTunes Music Store sold 2 million songs in its first 16 days, dwarfing rival download services and drawing raves from Silicon Valley to Hollywood. Yet even before the initial euphoria could subside, the company began hearing familiar rumblings from points north--namely, Microsoft headquarters in Redmond, Wash.

"We've been working and have gotten a lot of traction in this space for a long while," said David Caulton, group manager for the Windows Media division, adding that Microsoft has no plans for a competing service. "We're still very comfortable with the strategy of enabling lots and lots of partners to build these things, rather than build a closed proprietary service on our own."

No one disputes the uncanny ability of Apple CEO Steve Jobs to identify consumer trends, and many see the Music Store as a positive step that will advance a sector of the entertainment industry that has been stymied by confusion, litigation and infighting. But just as it tries to expand beyond the confines of the computing business, Apple is finding that its future in digital music will depend largely on its old nemesis from the PC world.

Microsoft has lobbied the entertainment industry for years to endorse its Windows Media technologies as a way to secure digital distribution against online piracy, and its plan is quietly starting to pay off. Despite some reluctance from record label and studio executives, Microsoft has won a place for its products in nearly every corner of digital entertainment, from Internet music and video sites to home media centers, audio CDs and movie theaters.

"We think Apple's music service is a positive thing, but the reality is this: They're not the first to do it. We've been offering it for a year and a half with Pressplay," said Kevin Branigan, vice president of marketing at Diamond Rio, which makes a player that competes with Apple's popular iPod portable music device. "Microsoft did the work up front with Pressplay. Microsoft spent a long time lobbying manufacturers; that's the Microsoft way."

Few know that pattern better than Apple, which lost its fight for desktop computing to Microsoft long ago. So today, with an uncomfortable sense of deja vu, the Mac maker is facing a crossroads similar to one it encountered in the 1980s: whether to develop and promote technologies exclusively for Apple products or follow Microsoft's PC plan and work with as many partners as possible in hopes of becoming the music service used by all, regardless of software or hardware differences.

Apple has so far benefited from the music industry's reluctance to cede too much control to Microsoft. But the Mac maker will need to deal with Microsoft at some point, as a competitor or an ally, while the digital music business quickly evolves and various players begin taking sides.

Others waiting in the wings
"People are evaluating what's happening on the Apple side," a senior executive at one major record label said. "There are other companies with deeper pockets than existing download services, such as the big ISPs, big retailers and other players."

The most obvious threat to Apple would be a direct assault such as a Microsoft download service that undercuts the Music Store with better licensing deals and other incentives for the record labels, hardware makers and everyone in between. Microsoft could, for example, offer to run all the storage and distribution technologies for a major retailer such as Wal-Mart Stores while providing developer software for device manufacturers that would work with any format, perhaps initially for free to gain market share.

Such a scenario would seem particularly inviting for portable music player makers such as Rio and Creative, which compete with Apple's iPod and already support Microsoft's secure Windows Media Audio (WMA) format through the Pressplay music service in addition to free downloads that use the the MP3 format. Moreover, even though sources say the record labels are wary of Microsoft, the influential software company may offer them deals that are too tempting to resist.

"It's a tremendous opportunity for Microsoft," said Robbie Vann-Adibé, chief executive of Ecast, which makes download security technology. "Most likely we will see them partnering with others to get stuff done. It wouldn't be the first time Microsoft did something like that."

As underscored in its browser wars, Microsoft has a long history of doing whatever it takes to thwart anything it deems a threat to its technologies. And Apple's Music Store--as modest as it may seem, relative to the far-flung Windows empire--could easily be viewed by paranoid Microsoft executives as the first link in a chain of events that could ultimately result in significant competition, especially as both companies continue expanding beyond computing to digital entertainment.

It is just such thinking that has led Microsoft to take extraordinary measures in shutting out competitors, regardless of size. In aggressive strategies that have been subjected to unprecedented legal scrutiny, the company has used its considerable influence from its pervasive Windows presence to woo or pressure partners and competitors alike, from IBM and Sun Microsystems to Netscape Communications and RealNetworks.

The mere prospect of an icon on Microsoft's ubiquitous operating systems, media players or other products presents a powerful challenge for Apple, which has only a 2 percent market share of computers sold worldwide, according to industry researcher IDC.

"Microsoft has a lock on the desktop. If they ever want to run their own digital music service out of the Windows Media Player, they could own this," said Matt Rosoff, an analyst with independent research firm Directions on Microsoft. "It might make sense for them to partner with a retailer and offer them preferential space in the Windows Media Player. That would likely require any partners to use its Windows Media Audio format."

Even if Microsoft does nothing specifically to respond to Apple's service, many computing and music industry veterans argue that the software giant still has an advantage because it has already laid the foundation to make money through technologies necessary to buy, download and play digital music. Microsoft can profit from its "back end" infrastructure while leaving the headaches of operating a storefront to other companies, which may range from major Web portals such as Yahoo to retail chains such as Amazon.com and Sears, Roebuck.

"Microsoft makes a large percentage of revenues by selling software development kits (SDKs) for Windows Media Audio," Diamond Rio's Branigan said. "Every product ever made from every manufacturer using Windows will have to buy another SDK, and that's significant revenues for Microsoft."

Familiar pattern for Microsoft
That kind of toll-taker role is classic Microsoft, a company that has always sought to own the underlying architecture of any technology business, if not the product branding seen initially by consumers. Microsoft can then collect licensing fees from as many partners as possible--just as it has from PC makers for the Windows operating system--without paying for any licenses itself.

"Microsoft hates to license anything. They always fight for format dominance so they don't have to pay licensing fees," analyst Rosoff said. "The policy, which comes from the top of the company, is: 'We do not pay licensing fees. We collect licensing fees.'"

If Apple has a strategy for dealing with Microsoft, it isn't telling anyone; the company refused repeated requests for comment on this report. Any firm plans might be premature at this early stage anyway because so much depends on how successful the service becomes in coming months.

Record industry executives, calling the Music Store an "experiment," have agreed to initial licensing terms for just one year, according to several people familiar with the deal. That should be enough time to show whether legal services stand a chance of competing with free MP3s and file-swapping networks, the first and most important test for Apple and the labels.

Despite the hype surrounding the service's launch, it is not clear whether selling digital downloads is a lucrative retail business for Apple or any other company. Apple has not publicly discussed the licensing terms, but executives at other digital music companies said they expect its margins to be razor thin if the industry collects its standard rate of 60 cents to 70 cents per song.

After paying off the labels and music publishers, music retailers must still pay for a host of other services, including credit card transactions, bandwidth and storage for hosting and distributing the files, encoding and preparation of the music, customer support, marketing and staff. Some suspect that Apple's service may operate at a loss, at least in the short run.

"Retail is not a good business to be in," asserts Dave Goldberg, CEO of Yahoo's LaunchCast Internet radio service.

The size of the prize could have important consequences for Apple's long-term plan, particularly in determining how far it expects to expand into Microsoft territory--a necessary step if it intends to be anything more than a fringe player in the digital music business. The Music Store could be a powerful way to attract new customers to Apple's hardware if it just breaks even, but that might not be enough for the company to seek a broader role as a major digital storefront or back-end technology provider in the Windows universe.

Jobs has already said the company plans to offer a Windows-compatible version of its iTunes Music Store by year's end, and has begun advertising for at least one Windows software developer for the project. But Apple may be hard-pressed to bring its system for the Mac seamlessly to Windows.

The iTunes service uses the AAC audio standard, which claims to offer superior listening qualities compared with the MP3 format used for most free downloads, but it also uses a proprietary security system known as FairPlay. To competitors, that means Apple's system is not a truly open standard: If portable MP3 player makers decide to support AAC, for instance, Apple's tracks won't play on those devices unless Apple provides software that will support FairPlay.

"The problem with AAC is there are so many flavors it's unclear what the standard is," said Dennis Mudd, CEO of MusicMatch, a PC jukebox maker that teamed with Apple to provide Microsoft-compatible software when the Mac maker first introduced its iPod for Windows device. "That's got to get fixed."

Still, the technology has won some important endorsements, at least partly to keep Microsoft at bay for the time being.

AAC has the blessing of the Moving Pictures Experts Group (MPEG), a key industry standards-setting body that created MP3. AOL Time Warner plans to use AAC in its Internet radio service. MusicNet, an Internet music service backed by the record labels and RealNetworks, also is considering supporting AAC, according to MusicNet CEO Alan McGlade

"The problem is Microsoft has a monopoly, and once they win they can charge whatever they like," said Michael Robertson, who has squared off against the software giant in his role as founder of MP3.com and more recently as CEO of Lindows.com, a software company that offers a desktop version of the Linux open-source operating system that competes with Windows. "Media companies have been very wary of Microsoft for a long time."

Nevertheless, given the high stakes and myriad players in the music industry, business relationships can change 180 degrees overnight. Ironically, the splash made by Apple's Music Store may ultimately benefit archenemy Microsoft in the long run by raising mainstream market awareness about legal download services beyond iTunes in areas where Windows has powerful influence.

"MusicNet, Pressplay, Amazon, Yahoo, AOL, MSN--those are all going to be movers in this area," said Mike Harburg, chief technology officer at digital media company Loudeye. "Everybody's going to jump on this bandwagon."

The emergence of successful commercial services will play a pivotal role in establishing a new secure standard, which could inevitably benefit Windows Media Audio and other secure technologies. Such legal alternatives have been overshadowed in the past by the overwhelming popularity of free music services like Kazaa that use the MP3 download format.

"A few years ago, a variety of organizations had formats for secure digital downloads--RealNetworks, Liquid Audio, Microsoft, Sony," Ecast CEO Van-Adibé said. "That's more or less over. In the Windows marketplace, WMA is now a de facto standard for secure music."

That success could fuel new demand for Microsoft's Windows server software and push its monopoly in operating systems past the desktop to consumer electronics, from TV set-top boxes to portable music players and stereos.

"The market for digital rights management (DRM) technology for music is never going to make anybody rich. People are realizing that," said Larry Kenswil, president of eLabs, the new media and technology division of Universal Music Group. "Microsoft looks at the codec and the DRM as a means to an end, not as an end in itself."

News.com's John Borland contributed to this report.