iTunes: Apple’s overlooked weapon

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Compared to Apple‘s (Nasdaq: AAPL) massive iPhone business, iTunes is seemingly negligible  But that’s no reason to deny iTunes’ significance. Among other digital stores, iTunes stands out as a major player. As the war for digital content continues, Apple may indeed face challenges, but a few advantages should help iTunes remain strong in the future amid increasing competition.

Apple’s iTunes and iCloud networks are getting stickier
The network effect is probably one of the strongest competitive advantages a company can have, as recently noted by Tim Cook at the Goldman Sachs Technology and Internet Conference: “We’ve found a huge correlation of people getting into Apple and buying their first product and then buying another product.” This is partly due to Apple’s strong network effect in which the relevance of its digital stores (iTunes and Mac App Store) become more useful and relevant with every additional user gained. The more iTunes is used, the more interested developers and major studios will be in adding content to the platform.

With the world’s largest a la carte digital store integrated seamlessly with its hardware and software, Apple’s offering is both compelling and “sticky.” iTunes has a whopping 500 million iTunes accounts. Plus, over the last several years, the iTunes experience has been enhanced with the addition of the Mac App store and iCloud. iCloud’s ability to seamlessly transport content between one device to another with incredible ease adds tremendous strength to iTunes’ offerings. Already, iCloud users have grown from 85 million to over 250 million in fiscal 2012.

iTunes’ solid growth and substantial size
Horace Dediu of Asymco recently reported numbers that really put iTunes’ growing size into perspective:

  • It was only two years ago when Apple’s iTunes business surpassed its iPod business in revenue. Now, in the company’s first quarter, iTunes revenue was 72% greater than iPod revenue. And based on Dediu’s estimates, iTunes is also more profitable.
  • iTunes is on track to surpass Apple’s Mac business in 2013. In fact, when Apple’s iTunes and accessories (including Apple TV) revenue are combined, Mac sales are dwarfed in comparison, representing just about half of the combined segments.
  • Over the past two years, Apple’s iTunes business has averaged an annualized growth rate of 30%, avoiding seasonal volatility.

To put things into further perspective, when Apple’s fourth quarter iTunes and accessories revenue are combined, revenue surpasses sales of every major phone vendor except Samsung.

Due to reporting standards, it’s difficult to estimate Samsung’s mobile phone sales, though according to a Gartner report, the company sold 107 million units during the fourth quarter — more than double Apple’s.

What does all this mean? As the absolute size of iTunes grows, investors might need to spend more time valuing Apple’s iTunes segment in terms of its business prospects as opposed to viewing it simply as an extension of Apple’s ecosystem that strengthens the company’s unique selling proposition.

Taking notice
Of course, Apple’s success hasn’t gone unnoticed. As noted by Google (Nasdaq: GOOG) CEO Larry Page in the company’s fourth quarter 2012 earnings call, its entertainment hub, dubbed Google Play, is “on fire.” Page cites “tremendous” growth in the “big bet,” launched May 2012. During the fourth quarter the company signed deals with Time and Warner Music Group. Now the company provides content from all of the top music labels, magazine publishers, and Hollywood film studios.

Likewise, Amazon.com (Nasdaq: AMZN) is gaining momentum in its Prime Instant Video service. Amazon CFO Thomas Szkutak reports that the percentage of Prime customers who are watching videos through Prime Instant Video is “up dramatically year over year.” With access to over 200 million customer accounts (up significantly from the year-ago quarter’s 164 million accounts), Amazon’s existing paid relationships should enable continued growth in Prime Instant Video.

Then, of course, there is Netflix  (Nasdaq: NFLX) and its 33 million subscribers, 10 million of which were gained during fiscal 2012 alone. The viability of its subscription model versus iTunes’ a la carte approach gives Netflix a clear advantage. Plus, the company has a solid track record of successfully negotiating deals with major content providers. 2012 marked a year of many significant content deals for the company — most notably its deal with Disney, bringing the company’s studio films to Netflix domestic streaming in 2016. Then, of course, there are the Netflix original series, which are already proving to be quite a success.

Suffice it to say, competition abounds.

Foolish takeaway

Companies are doing whatever it takes to create a compelling ecosystem. In this regard, the fight for consumers’ digital content purchases is a key battle. While it’s tough to tell who will come out the strongest in 2013, I’ll make two predictions:

  1. iTunes’s scale and stickiness will enable Apple to end the year with an even stronger digital store.
  2. The consumer will benefit substantially as tech giants fight for digital store market share.
This means two things for investors. First, a thriving iTunes with solid prospects is just another item to add to my thesis that at 10.6 times earnings, Apple is undervalued. Second, the battle for the living room is just beginning; keep a close eye on the key players involved.

 

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The Motley Fool’s purpose is to help the world invest, better. Click here now for your free subscription to Take Stock, The Motley Fool’s free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead.  This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

A version of this article, written by Daniel Sparks, originally appeared on fool.com.

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