Universal vs. Apple?

According to reports in the Wall Street Journal (subscription required) and New York Times, Universal is pressing for new terms as it renews its contract with Apple. Until the contract negotiations are worked out, Universal will offer songs "at will" through the service, meaning it can yank them at any time if they don't come to an agreement.

Universal is the largest record label in the world, accounting for about 26% of all recorded music sales (according to the company). It has also been, along with Sony BMG, one of the most aggressive about protecting its business in the face of the digital onslaught: the company signed a revenue-sharing deal with YouTube in October 2006 after making thinly veiled threats of a copyright infringement lawsuit, and sued MySpace in November 2006 over copyrighted material that allegedly appears on the site.

Most relevantly, Universal signed a deal with Microsoft in which Universal gets a cut (a little more than $1, according to unconfirmed news reports) of every Zune sold. Microsoft had no choice but to sign the deal: to launch as a credible competitor to the iPod, Microsoft had to have an online store, and it had to have music from all the major labels in that store. (Otherwise, the reviews would have been even worse.)

Who's in the driver's seat for this particular negotiation? On one hand, Universal's suffering from the falloff in CD sales--down 15% this year, according to the latest SoundScan report--and is counting on digital sales to make up some of the gap. In 2006, according to the company's annual report (warning: big PDF download), Universal earned 477 million Euros from digital sales, or 9.5% of its music revenue. The company doesn't reveal how much of that comes from iTunes, but it reported 300 million song downloads, and 100 million ringtone downloads, so it's safe to estimate more than half that revenue--at least 200 million Euros--comes from iTunes. And the proportion is increasing--in the first quarter of 2007, 15% of Universal's revenue came from digital music.

So if the two companies can't reach an agreement, Universal loses a small but notable portion of its revenue today--not a good thing in an industry that's already faltering--but more important, closes off probably the most important distribution channel for digital music.

Apple, on the other hand, earns most of its music-related revenue from sales of the iPod, not from digital downloads. (Most estimates suggest that Apple earns only 10% of the revenue from each download, with the rest going to the record labels, publishers, and other parties.) A Forrester Research study last December, although widely misinterpreted as showing iTunes sales collapsing, did in fact show that people only buy about 20 songs per iPod--the vast majority of music on people's iPods comes from other souces, particularly CDs. In other words, the iTunes Store is more of a checkbox feature to sell iPods than a major component of Apple's business.

Even so, losing access to the catalog of the most popular record label would be a pretty big hit to absorb. So although Universal has more to lose, it's already in the midst of a major business transition, and might be more willing to take big risks--like abandoning iTunes. That's why Apple has to negotiate.

One possibility: Apple might follow in Microsoft's footsteps and offer Universal a per-unit iPod (and iPhone?) payment, in exchange for Universal following in EMI's footsteps and offering DRM-free versions of some of its songs. Apple could sell those songs for a higher price to make up for the per-unit payment. Except, it's not yet clear that the lack of DRM and higher bitrates are compelling enough to convince users to pay the extra 30 cents--sales of some DRM-free EMI tracks on iTunes have risen, but it's early days yet.

If the two companies can't reach a deal, perhaps Universal will sell DRM-free MP3s through Amazon.com's upcoming store. MP3s can still be played on the iPod, although the lack of integration with the iTunes application makes downloading slightly more complicated. And if--big if--the Zune ever takes off, Universal's already positioned to earn some money from that product.