A bridge to the future of the iPod

More than six years into the iPod era, Apple still stands atop the music player landscape. But what comes next?

Apple is at a crossroads in the evolution of the product that arguably saved its bacon. Without the iPod fueling Apple's profits and investments, we probably wouldn't have spent the past year talking about Apple's surging Mac business or its game-changing iPhone.

After years of double-digit gains, iPod growth has finally trailed off. The market is arguably saturated: do you know anyone who wants to take their music on the go who hasn't bought an MP3 player? But at the same time, the iPod is undergoing a bit of a revolution: it's morphing from a simple music player to a full-fledged computer.

Apple has sent clear signals that it thinks the iPod Touch and the iPhone are the future of its iPod business. It considers the Wi-Fi-enabled iPod Touch "a new type of device," Greg Joswiak, Apple's vice president of worldwide iPod and iPhone marketing, said when Apple unveiled a higher capacity iPod Touch in February.

But that doesn't mean the whole world is ready to step up to a more sophisticated device like the iPod Touch: lots of people just want to play their tunes and watch their shows on the go, and don't want to break the bank to do so. While Apple is taking sure steps toward evolving the upper echelon of its iPod product line, what should it do to keep its iPod cash cow going into the next decade?

Look to the clouds. IaaS (iPod as a service) will thankfully never catch on as a buzzword, but Apple could bridge the gap between today and the future by bundling regular iPods with services, adding wireless as fast as possible, and bringing OS X down into a new generation of iPods as soon as Moore's Law lets it happen.

Coming back to earth
At some point last year, iPod growth began to slow. Year-over-year unit growth dropped from 50 percent during the 2006 holiday season to just 5 percent growth during the 2007 holiday season. But revenue growth remained steady, at 18 percent during the 2006 holiday season and 17 percent during the same period in 2007.

That suggests that people are making the jump from older iPods to newer models, a trend backed up by our recent iPod survey. The iPod Classic (defined as any generation of video-playing iPod) is the day-to-day music player for 31 percent of respondents. Fifty-two percent of all respondents have owned one or two iPods, and 34 percent bought their first model in 2003 or 2004.

But 60 percent of same respondents indicated that the iPod Touch would be their next iPod purchase. And 68 percent said given their choice of possible music player/cell phone combinations, they most want the iPhone. This kind of "trading up" to the starting price of $299 for an 8GB iPod Touch--or the $499 32GB model--helps Apple offset the slow growth of the basic iPod models with stronger revenue and profits from the iPod Touch while it adds a whole new source of cash with the iPhone.

Both the iPod Touch and the iPhone are much more than just music and video players: they can get online, send e-mail, and will soon be able to run a host of officially sanctioned games and applications.

As chips continue to get smaller, more powerful, and cheaper, it stands to reason that Apple could beef up the other versions of the iPod, the Shuffle and the Nano, with additional capabilities and features. Certainly, it will be able to keep increasing the amount of storage available on each device, the single largest request of MP3 player shoppers who responded to our poll. Wi-Fi capability was the second-most desired trait in a future iPod.

At some point, the MP3 player market looks like it will diverge into at least three businesses: a low-end commodity business cranking out tiny standalone audio and video players for very specific tastes, the high-end portable computing business, and some third category that packs as many computing features of the iPod Touch that can fit, at the time, within $50 of a $199 price band.

This three-headed monster appears some ways off. At the moment, there doesn't appear to be any competitor making meaningful gains at Apple's expense, even in the low-end market. That suggests people are still buying their MP3 players based on design, brand identity, and the need for more storage.

If that changes, however, Apple probably doesn't want to spend a lot of effort on a low-margin commodity business. The iPod brand is easily the strongest in the portable music player world, but as the low-end of the market spreads out into countless niches (think USB drives), Apple would have no real advantage over other consumer electronics companies that know how to crank out widgets in huge volumes.

Also, basic mobile phones are growing more and more capable of handling simple music playback, said Ross Rubin, an analyst with The NPD Group. And at some point, the ability of manufacturers to add more and more capacity will outpace the growth of the average individual's personal music library, he said.

The iPhone and the iPod Touch are the kind of innovative high-margin products that Apple likes to have. In a crowded marketplace, you need to find some way to differentiate yourself, and Apple has traditionally focused on making high-end products with great design that are easy to use.

At your service
Something is going to have to fit in between the commoditized MP3 players you might find one day in Walgreens or 7-Eleven and the iPod Touch. As Apple waits for the advances in chip technology needed to bring larger screens, more capacity, and wireless capabilities into power-constrained devices, it can start offering services to increase the attractiveness of lower-priced iPods, Rubin said.

Just a combined 13 percent of our survey respondents said they are considering an iPod Shuffle or an iPod Nano for their next iPod purchase. It's great for Apple that so many people want the iPod Touch, but that's leaving an awful lot of people on the sidelines who want a music player but can't justify spending $299. One thing the company could do is finally drop its long-standing opposition to a subscription model and start selling iPods in conjunction with such a service, Rubin said.

Apple has long maintained that people want to buy music, rather than rent it. However, that might not always be the case, as people are starting to get used to the idea of "cloud computing," where much of your data is stored by a third party.

And as more and more people buy iPods for video as well as music, such a subscription service makes more sense. Apple is now offering TV and movie rentals through iTunes, and could extend some sort of similar packaging to music if the demand was there. I think most of us have made enough hasty music purchases, only to grow sick of that song or album after a week, to consider a try-before-you-buy type of service from Apple.

Apple has a bit of a luxury in this area that it doesn't have in the Mac or iPhone market, in that it enjoys a dominant position from which to make its next move. The company seems to be in a similar position to when it introduced the iPod Nano, killing off its most popular product in the process. It had a killer design with the Nano, but had to make the tough decision to abandon its best-selling product.

Now, with the iPod Touch and the iPhone, Apple has a set of very compelling products that threaten its best-selling category. When recently asked if the iPod Touch would cannibalize iPhone sales, Apple COO Tim Cook said he'd rather Apple cannibalize Apple than someone else.

More capable mobile phones might take the less-profitable low-end, but Apple needs to make sure it keeps the meaty part to itself. Service-oriented iPods mixed with handheld computers might be the best way the keep the iPod gravy train going.