Although the deal has not yet been formally announced, Apple (NASDAQ: AAPL ) is still expected to acquire Beats Electronics at some point in the near future. Much has already been written about the purchase -- its potential to bring a level of fashion to Apple's future wearables, Beats co-founder Jimmy Iovine's music industry experience -- but what I find most interesting is what it says about Apple's iTunes business.
Apple's total iTunes revenue is growing, and at a rapid pace, but the model on which the business was built -- music downloads -- could slow. Streaming services are clearly the future, and though acquiring Beats should help Apple break into that business, it still poses a major challenge.
Downloads give way to subscriptions
Industry music downloads slipped 5.7% on an annual basis last year, according to Nielsen. Consistent with those figures, Asymco estimated that Apple's iTunes Music sales declined about 14% in 2013.
It's possible that a lack of quality music may have weighed on iTunes' sales last year (arguably, fewer must-have songs were released in 2013), but the growth of music subscription services cannot be discounted. Spotify, the leader in that business, now has 10 million paying subscribers, up from just 5 million 17 months ago.
iTunes and the ecosystem
That's a problem for Apple, at least in terms of its ecosystem. Apple's customers are notoriously loyal, partly because the company makes great products, but also because Apple makes it difficult to leave. It's possible to port a large iTunes catalog to Android or another rival operating system, but the process is far from straightforward.
Someone who has purchased a bunch of music through iTunes, then, is likely to remain an Apple customer, consistently buying a new iPhone every two years. The idea of the sticky ecosystem has been championed by bulls such as hedge fund manager David Einhorn, who has consistently argued that this property of iTunes makes Apple unlikely to suffer the same fate as the once-dominant phone giants that preceded it.
But a customer who switches to Spotify, or some other similar subscription service, is device agnostic. In fact, the very appeal of these subscription services is that they allow their customers to access music from anywhere -- just about any Internet-connected device can access Spotify, no matter the manufacturer.
Apple is less likely to retain its customers
In acquiring Beats, Apple will get access to its own streaming service, along with a team of music industry veterans who can help it negotiate contracts with musicians and labels.
Although Beats' subscription service trails Spotify in terms of total subscribers, it's still relatively new. Apple's engineering expertise could improve Beats Music significantly, much like it transformed SoundJam MP into iTunes.
But even if Apple were to eventually offer the premier streaming music service, and go so far as to restrict it to the iOS platform, it would be worse than having a robust iTunes business. Switching between music streaming services is easy; losing access to a catalog of songs that one has invested hundreds, perhaps even thousands, of dollars in is far more difficult.
It remains to be seen if Apple will actually go through the acquisition, and, if it does, what it will do with Beats Music. But Apple's interest in a streaming music service -- and, more broadly, the growth in the larger sector -- is a disturbing sign for the long-term strength of its ecosystem.
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