If Apple's (NASDAQ:AAPL) iTunes, Software and Services unit were its own business, it would rank higher than No. 158 on the Fortune 500 based on its fiscal 2014 net sales. (Fortune ranks companies based on gross revenue, so it would actually rank much higher.) Last year was a pretty good year for the iTunes, Software and Services unit. Apple increased net revenue from the segment 13%, and it reached 10% of the company's total revenue despite a couple of headwinds.
The first was self-imposed. Apple started giving away OS X upgrades and the iWork software suite, giving up about $1 billion in potential revenue from sales of its software that would have gone toward the iTunes line item. The second, and more important headwind, is that fewer people are downloading music from iTunes (or any digital music store).
As more people move to streaming songs on-demand through services like Google's (NASDAQ:GOOGL) (NASDAQ:GOOG) YouTube and Sweden-based Spotify, Apple has been left behind. Apple's purchase of Beats Electronics last year gave it an established music service to add to its portfolio, but Apple has yet to do much to promote the music service that made super-fan Tim Cook buy the whole company.
A slow bleed
While Apple has the largest stake in the digital music download market, at around 60%, the amount of net revenue the company actually lost from the decline in music sales isn't much more than a rounding error on Apple's income statement.
Nielsen estimates that last year digital album sales in the U.S. declined 9% to 106.5 million, and single-song downloads fell 12% to 1.1 billion. Overall, I estimate the decline in album sales affected iTunes' net revenue by $16 million, while singles net sales declined approximately $26.7 million. Even if you triple that total decline to account for the rest of the world, it's less than $130 million. For reference, total iTunes revenue topped $18 billion in fiscal 2014, which ended in late September.
For a company that strongly associates itself with music, however, the slow bleed of music sales from iTunes could impact sales of its devices. Strong integration with iTunes helped sell the iPod last decade (and vice versa), and it helped sell the iPhone and iPad after that.
With streaming services offering a commoditized experience across every device (at least for each individual service), Apple doesn't hold an advantage over the competition any longer.
In fact, Apple is missing out on the newest growth market in digital music. Last year, Nielsen's says on-demand streaming grew 54% to 164 billion streams. That's why Apple needs to move to integrate Beats Music more closely with iOS, and leverage its large device footprint to beat the competition in streaming.
Apple can provide a user experience on iOS that differentiates Beats from the competition by allowing Beats to work with the operating system's apps and features like Siri, the lock screen, iTunes, or the Safari browser. Meanwhile, the competition has to play on top of the OS and work with whatever Apple is willing to give them.
Google is already winning
Google already pre-installs its most popular streaming service, YouTube, on nearly every Android device. The recent integration of YouTube with its premium music streaming service -- Google Play Music All Access -- gives Google a chance to sell every Android user (and most iPhone users) its music streaming service.
Still, Google doesn't do much to differentiate its service from the competition, even though it practically owns the operating system it runs on. Google doesn't really need to act on that, however, as YouTube has become the de facto source for music fans to listen to individual songs.
Google has nurtured the streaming music aspect of its video site, recently adding millions of new songs to the service when it introduced YouTube Music Key. Now Google offers a full-fledged ad-supported music streaming service on top of its premium service.
The opportunity for Apple
The number of paid streaming music subscribers continues to grow. Spotify has 12.5 million subscribers generating about $1.5 billion in revenue for the company every year. Apple's gross digital music sales are estimated to be around $3 billion.
Integrating Beats Music with iTunes and iOS could spur subscriptions to fend off the slow decline in music downloads. Apple could catalyze additional sign-ups if it could negotiate a lower price with record labels (which set the price floor on streaming services at $9.99 per month). Apple was reportedly trying to lower the price to $5 per month.
If Apple could attract 10% of the estimated 600 million active iOS device users to a $5-per-month streaming service, it would surpass the company's annual music downloads sales. There's still plenty of growth in the streaming market, and Apple has never been afraid to cannibalize its own products in the past, so the opportunity is definitely out there for Apple to take.