iTunes Chugs But Label Accountants Hate Pure Profit

By Richard Menta 4/17/05

What is so wonderful about iTunes for the record industry is that their share of the revenue from this venture is pure profit. How you ask? That's simple to answer.

iTunes does not sell a physical product, it sells downloadable digital copies of a recording. There are no CDs and CD cases to manufacture. There is no shrink wrap process or warehousing costs for a product you can hold and feel. There are no union truck drivers to deliver the product to stores across the nation. Overall, there are no manufacturing costs and no distribution costs.

Richard Menta

Yes, there are the server and bandwidth costs for iTunes, but the record industry does not pay for any of that. That comes from iTunes share of the profits. The record industry receives somewhere between $0.65 and $.85 per song file (different sources quote different numbers). The rest goes to iTunes who picks up the tab for everything. This includes digitizing a million songs into the ACC format.

What does the record industry supply for its significant cut of the pie? They supply one thing, permission.

That my friend is a great business model. A new income stream not just generated from existing material, but without any added costs of delivery for the content holder. For all relative purposes it is pure profit.

Accountants HATE pure profits. They hate it because their company pays more tax on pure profits. Without any costs to write off, Uncle Sam will take a bigger portion of it.

Their solution for this is simple and it leads directly to where I am driving to if you give me another moment.

A very high percentage of the material on iTunes and Napster and the other services out there were created before there ever was an iTunes. This music was developed for distribution on Shellac 78, Vinyl 33 1/3, 8-track, cassette and CD. The studio costs, the marketing costs, the A&R costs, the costs for the music video, etc. were all spent to propel sales of these physical products.

None of it is yet spent on the digital downloads, which is a new element to record industry sales machine.

Company accountants, those fellows in the back office with the ties, need to do their jobs. By a simple stroke of the pen they can solve their little pure profit dilemma to protect more of the company's assets.

As download sales are still a relatively tiny element of the record industry today it is very easy for the accountants to shift on paper a percentage of costs used to develop the physical product to the digital product. Doing this eliminates the appearence of pure profit and thus associated tax liabilities.

Showing a loss

But what if the accountants show more than a lower profit? What if they show a loss?

Because the revenue generated by paid downloads is so relatively small it will be quite easy to apply enough cash to show a loss. For example, instead of separating the costs for marketing of paid downloads from the marketing costs for promoting CDs the accountants can do something else. First, they will take all of the total marketing costs and combine them under one heading "Marketing". From there a percentage of those total marketing costs are charged against paid downloads.

And what is that percentage? Within reason, whatever the accountants deem acceptable. If paid downloads make up 3% of total revenues, then it is reasonable to use 3% of total marketing costs. In reality no marketing money may have actually been spent to market paid downloads directly. Furthermore, CD marketing is very expensive and 3% of total marketing costs can exceed the total revenues brought in today by paid downloads. The end result is the appearance of a loss.

This loss is only on paper, but it offers quite a few advantages. It is legal, it is good for the tax return and it is good for normal business.

It is also useful to industry executives who are trying to raise the $0.99 cent price tag that has become standard on the paid download services.

Raising Prices

Record executives are frustrated with Apple CEO Steve Jobs. As CNET recently reported Jobs has refused the industry's demand to raise prices on the songs he sells on iTunes. As iTunes holds 70% of the market Jobs holds most of the cards and this has left the record industry feeling they have lost control on their own products.

Showing a loss on every song could be useful in wrenching some of that control back.

Very soon - and after the label accountants start applying more development and marketing costs to digital downloads - some record executive may make a declaration. This declaration will be that the record industry loses $0.50 on every song that is purchased on iTunes, Napster, Real, Walmart Online and others. The executive will then say the industry can no longer operate on a loss and must raise prices.

This manufactured loss will be echoed by other record executives. It will be spun and fed to the press as a fact. On the books it technically will be a fact.

iTunes recently sold its 350 millionth song. At $0.50 a song executives can claim they lost $175 million from iTunes alone. The reason they priced digital singles SO LOW initially, they will claim, was to stimulate the market against the likes of KaZaa, Grokster and others. Frankly, I think prices are presently too high, but that argument is for discussion another time.

Keep in mind that this accounting is legitimate as there are real costs beyond the stamping and delivery of a product. For future records a percentage of the studio production and marketing costs will automatically be applied directly to paid download sales, costs that a nascent industry is not yet mature enough to cover.

Showing a $0.50 loss can prove advantageous in other ways. It can be played before Congress as another reason why free file sharing must be stopped as file sharing prevents the industry from selling downloads for a profit. This same argument can also be played before the courts in future litigation.

The only element that might prevent the record industry from doing exactly what I described is Wall Street. The Street likes to see growth and paid downloads are a new source of growth for the record industry. Stunt the apperance of growth and the company stock may take a hit on valuation.

Still, paid downloads are a new area and investors are still hedging on it. There are other distractions too. Right now investors are more concerned with the Supreme Court Case of MGM v Grokster, which will propel record and movie industry stocks if the decision goes the media conglomerates way.

I must admit that all of this is only speculation. There is no evidence that in these Sarbanes-Oxley Act times the record industry is going to do what I described. But when one speaks of a young industry the tempation is always there to look into that crystal ball and make predictions on the future. None of us are clairvoyant, if we were we would all be at the race track. Still, I have this creepy sense about it all, most of it coming from knowledge of the record industry's past reputation and the many allegations on how they work their books.

I'll just say that if any of what I stated above comes to fruition in this post-Enron world I won't be surprised.


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