Napster Versus Apple?

Can Napster take on Apple in the digital music market? You have to be kidding, right? Apple has a market capitalization of $117 billion. It dominates the MP3 player market with its iPod. It dominates music downloads with its iTunes service. It recently introduced the iPhone to enormous amounts of free publicity. In contrast Napster just reported $32 million in revenues for the June quarter and has operated for years without a profit, burning through much of its once substantial cash reserves. When people want to pay for music downloads, they use Apple; when they don't want to pay, they don't subscribe for $15 a month for Napster's (or Yahoo's, or RealNetwork's) music library of 4 million tunes, they just get it for free (or steal it, according to the music industry). Napster had just 770,000 paid subscribers world-wide at last count.

But wait, maybe you should look at the Napster story. After all way back in 2002 Apple was a loser company with a stock worth well less than a tenth of what it is today. Its Mac line was languishing, its Newton PDA had been a failure; go back to 1998 and people were practically giving away Apple stock.

So what is the Napster story? Napster management understood that they were being shut out of most of the music download market partly because of the dominance of Apple's proprietary iPods, which will not allow music subscription services to run. They also understood that people, especially young people, will pay for music only to the extent it is a hassle to get it for free. So while they did fight for share in the MP3 player space, they concentrated on the future, which they saw as music-enabled cell phones. For those of you who have not been paying attention, these phones have been around for a couple of year's now with almost no media attention prior to the iPhone launch.

Napster has built its own infrastructure capable of allowing telecoms to enable music subscriptions, ring tone downloads, and yes even single-tune sales to download to cell phones over the wireless networks. Right now you can buy cell phones from AT&T and other carriers that have the option of subscribing to Napster. Major cell-phone manufacturers are building the capability of using Napster into at least some of their cell phone lines. Nine, yes 9, carriers around the world are working with Napster to compete with Apple iTunes.

So when it comes to music, it is not clear who is David and who is Goliath. You might consider Goliath to be the telecoms, with Napster as one weapon they hope to use to defend themselves against Apple.

This is unlikely to be a linear process. Remember that Apple did not invent the portable music player. It made a deal with the music industry to sell songs, then did great job integrating hardware and software. Apple fans spread the word about iPod / iTunes much more successfully than they proselytized for the Mac computer mainly because iTunes took much of the geek factor out loading up MP3 players. And yes, iPods were filled with music ripped from CDs or illegally downloaded. The number of songs actually sold by iTunes compared to the number of songs sitting in iPods today is quite low.

So I see two major scenarios, and people can only guess at how market share will be split between them. The Apple wins scenario is this: there have been 100 million iPods sold (my guess is that about 40 million are now broken, so 60 million are still in use). Starting as soon as a lower cost iPhone comes out, whenever these 60 million people either break their current iPod or their cell phone, they are going to buy an iPhone. Yep, that is 60 million iPhones that could sell in the next 3 years. It could become uncool to own anything but an iPhone. Three years from now an iPhone could conceivably be priced around $100. Another factor pushing this scenario: people who have actually bought iTunes will only be able to play them on iPods or iPhones, so they won't be shifting much to non-Apple products.

The other scenario is that the cell phone makers and telecom companies succeed in pushing their various versions of 3G, music-enabled cell phones. Perhaps the Apple brand is tarnishing; perhaps some new fad will jump to the head of the cell phone pack. Given that iPhones are not for sale except for in Apple stores and AT&T stores, to some extent this is bound to happen.

What Napster lacks so far is a fan base that will show friends how to use Napster-enabled music players and cell phones. Sales people at cell phone stores could fill this role, but it is not likely to be a priority for them.

An early indicator comes from Japan. At the Napster analyst conference Wednesday (see my summary), management reported that in Japan they already have more cell phone subscribers than traditional computer subscribers. They have a deal with DoCoMo, which is promoting and selling Napster-enabled phones. The numbers are low so far and at least the first month is free, but expect to see this add to Napster revenues in the December quarter.

I believe both Napster and Apple are set to prosper in the next few years. Apple is the safe bet, so the returns, while good, are not likely to be as significant as Napster's will be if it succeeds.

I own some Napster stock; I do not currently own Apple stock.