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Giving iTunes a careful listen
One million downloads a week sounds nice, but a close look at the numbers shows it's not justified.
May 27, 2003: 10:55 AM EDT
By Eric Hellweg, CNN/Money Contributing Columnist

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SAN FRANCISCO (CNN/Money) - When Apple Computer CEO Steve Jobs announced the iTunes music store and a new line of iPod portable digital music players on April 28, the press went into an orgy of fawning. Adjectives such as "revolutionary" and phrases like "Apple does it again" littered the media landscape.

But reporters weren't the only ones getting excited. Investors have jumped behind Apple's (AAPL: Research, Estimates) digital music service in a big way. Since April 28, the stock has shot up nearly 25 percent. And while many tech companies have enjoyed a rising-tide effect in the market lately, Apple's gains appear to be tied directly to its iTunes effort.

Exhibit A: When the company issued a press release on May 5 announcing that 1 million songs had been downloaded in one week, the stock shot up 11 percent in a single day, on trading levels five times what they were the day before.

It's a compelling story and, to some extent, a compelling product. But investors who are buying into the idea that iTunes will continue to sell at its current rate and become a real growth engine for the company are misguided.

I'm betting that this sales clip won't last, and I predict that, aside from a brief future blip when a Windows version is introduced, sales will eventually slow to a steady trickle. A respectable trickle, perhaps, but hardly a revenue stream worth the stock gains the service recently brought the company.

Behind the numbers

Let's look behind the numbers. The 1 million-songs-per-week numbers that were touted in press releases regarding weeks one and two sound big (curiously, Apple has no plans to release a sales total for week three), but upon closer inspection they're not terribly impressive.

Apple says that "more than half" of this song total was sold in album format, rather than as singles. Assuming a conservative 12 songs per album, and one album per person, we can calculate that 500,000 songs would satisfy 42,000 customers. Assuming a conservative five downloads per person for the remaining 500,000 songs, we come up with 100,000 additional users. That's fewer than 150,000 people using the service. (Apple refuses to comment on these numbers.)

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Based on these calculations, the download rate isn't as stunning as it first seems. And I think this rate actually represents a burst of activity that is largely the result of pent-up demand from the Apple faithful.

Of the other legitimate digital music services, only the tiny (but great) EMusic offers an Apple version, and only one major illicit file-sharing service, Limewire, is available for the Mac platform.

Most Apple users had to sit out the digital music revolution until the release of iTunes, causing an initial "oil well gusher of interest," says Phil Leigh of Raymond James & Associates.

Keep the gusher flowing

If the company is to make any decent money from iTunes, that gusher will need to continue flowing for the foreseeable future, since the service's profit margins don't come close to the healthy returns the company enjoys from its other divisions.

According to people familiar with the matter, for every 99-cent download Apple sells, the label takes 60 to 65 cents. With that remaining 34 to 39 cents, Apple must shoulder the infrastructure and marketing costs, leaving very little for the bottom line.

"This is a volume play," says P.J. Macnealy, an analyst with Gartner Group.

To be sure, Apple deserves credit for offering a music service that eclipses most of the previous legitimate programs in terms of ease of use -- and for selling digital albums at a price ($9.99) that's appealing to consumers. And the new iPod versions, also announced on April 28, will surely add some strong sales numbers to the 800,000 units already sold.

But investors who have added almost $1.5 billion to Apple's market cap since the iTunes announcement need to snap out of their Steve Jobs-induced trances and face the music.

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