Apple’s streaming music problem

“People want to own their music,” Steve Jobs said. “The subscription model has failed so far … never say never, but customers don’t seem to be interested in it,” he told an interviewer in 2007. Were he alive today, Jobs might be rethinking that stance: Customers are interested; some 20 million paid for music subscriptions last year. Meanwhile, an estimated 80 million tap into “freemium” streaming services such as Pandora and Slacker. A decade after the iTunes Store opened and changed the way people buy music (it will pass the 100 billion downloads mark this year), another technological shift is transforming listening habits — and in many cases causing music fans to pare down their dependence on Apple.

What happened? Spotify, the Swedish music service that came to the U.S. in 2011, helped invigorate the subscription model with its comprehensive library of music (you can listen to what you want, not what a digital deejay serves up). But the real revolution stems from the rise of the smartphone, a.k.a. the always connected music player. Listeners don’t need to own music anymore; they can use their phones to pluck their favorite tunes from the cloud for about $10 a month. (Apple faces something of an existential threat here too. As Android phones proliferate and people access their music via subscription on those devices, part of the appeal of the iPhone — the Apple ecosystem, including iTunes — diminishes.)

While Apple’s business model isn’t hugely dependent on music sales — it mainly needs to keep selling more devices — the iTunes unit is a substantial operation. Asymco analyst Horace Dediu estimates that iTunes is a $17-billion-a-year business that costs $5 billion to run. Overall operating margins are growing, thanks to app sales, but Apple basically breaks even on music and video sales because of high publisher payments. And music sales simply aren’t keeping pace with other iTunes fare. Dediu says video and book revenues rose 90% last year — music grew just 10%.

Indeed, the days of big growth in downloads is long gone. Consider what is happening in Sweden, where Spotify has been offering its streaming service since 2008. Only one in 10 Swedes downloads music, compared with three in 10 Americans.

So will Apple embrace the subscription model? In early March, Apple CEO Tim Cook and products chief Eddy Cue reportedly paid a visit to Jimmy Iovine, a music producer who now runs headphones company Beats, known for the Beats by Dre headphones. They apparently wanted to check out a subscription-music service Beats has in the works, codenamed Daisy. A few days before Cook’s field trip Fortune reported that Google’s unit will launch a subscription-music service.

For Apple, which declined to comment, the logistics of altering the way it sells music may be easy. The company already has relationships with music labels, and it is less expensive to stream music than fulfill millions of micro-transactions. “The infrastructure is paid for; bandwidth is now cheaper,” Dediu says. “It’s just flipping a switch.” But reversing a course set by Steve Jobs? That switch is harder to make.

This story is from the April 08, 2013 issue of Fortune.

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