Apple Music Might Become More Profitable for Apple, Inc.

The Mac maker is attempting to negotiate lower royalty rates.

Evan Niu
Evan Niu, CFA
Jun 24, 2017 at 11:00AM
Technology and Telecom

Overall, the music industry greatly appreciates what Spotify and Apple (NASDAQ:AAPL) Music are doing: reinvigorating the industry by increasing the propensity of users to actually open their wallets. For years, consumers were becoming a little bit too comfortable with the idea that music streaming should be free, provided they were willing to endure a bunch of ads. That potentially represented an existential risk to the industry if consumers lowered their value perceptions of music to such a low level. The fact that Apple Music only offers a paid tier represents a big step in the right direction -- one that is greatly appreciated by the record labels.

Last year was the music industry's best in two decades, with streaming services driving total sales. The last time sales grew this much, CDs were still a thing. Apple now reportedly wants a bigger piece of the action.

Apple Music on iPhones

Image source: Apple.

Record labels want more subscribers

Bloomberg reported last week that Apple is looking to renegotiate its licensing deals with the major record labels in order to keep a larger share of the revenue. The negotiations cover royalty rates for both Apple Music as a streaming service, as well as iTunes for music sales. The existing agreement expires at the end of the month, but will probably extend in its current form if new terms aren't agreed upon, according to the report.

Apple currently pays a more generous rate than industry leader and dominant competitor Spotify. Spotify was recently able to secure more favorable terms under the condition that it can continue growing paid subscribers; the company now has 50 million paid subscribers, while Apple Music has 27 million.

Chart comparing Spotify and Apple Music subscribers over time

Data sources: Apple and Spotify. Chart by author.

Record labels currently collect 58% of all revenue from Apple Music subscribers. Spotify was previously forking over 55% of revenue before successfully getting that rate dropped to 52% if it can maintain paid subscriber growth. Bloomberg's sources say that the record labels are open to accepting a lower rate under the same condition that Apple Music continues to grow paid subscribers.

The Mac maker originally agreed to higher rates since the record labels were worried that Apple Music would cannibalize iTunes sales; those concerns don't apply to Spotify, which doesn't operate a downloadable music store. There are still a handful of markets in the world like Germany and Japan where consumer preferences haven't shifted to streaming as aggressively as they have in the U.S., and record labels want Apple to encourage music sales via iTunes in these countries. The same is true of markets with poor cellular connectivity, since streaming performance can be inconsistent.

Apple Music is already more profitable than the corporate average

Based on 27 million subscribers, Apple Music is now a $3.25 billion business. If record labels currently keep 58% of revenue, which would easily be the largest cost, that suggests that Apple Music operates at a roughly 42% gross margin. The true figure would be slightly lower, as Apple probably incurs some other smaller costs directly tied to the service, but the licensing costs are easily the bulk of Apple Music's cost of revenue.

That margin profile is already higher than Apple's corporate average of around 39% last quarter. Seeing as how growing the services business is a key priority at Apple, in part due to the higher levels of profitability, any concessions that Apple can score from the music industry would go a long way as Apple Music continues to grow paid subscribers.