David and Apple

Does anyone possess a slingshot potent enough to slay this giant?

It's a classic b-school case. Consider a consumer electronics product where more than 70% of the units sold are manufactured by a single company. The market leader has proprietary software tying users to its hardware, and its product has unparalleled consumer recognition across all demographics. As a lesser player in that market, how do you effectively compete?

That's the question being asked by anyone in the digital music space who isn't Apple. Barely five years after Apple's entry into an already crowded market, iPod is practically a synonym for digital music player, and iTunes the most popular music download service in the world.

And it pays. Apple's Q2 2007 results blew past analyst forecasts, driven in part by US$1.689 billion in revenue from iPod players and US$653 million from other music-related services, up 24% and 35% respectively, year over year. In total, music accounted for 44% of Apple's revenue.

With numbers like that, it's not surprising that other companies want to play in Apple's sandbox. However, for the moment they're settling for crumbs. “Most MP3 manufacturers out there have decided to feed around the edges of the iPod market,” says James McQuivey, principal consultant at Forrester Research. “It's mostly a 'me too' product line.” Given Apple's success at giving consumers what they want, McQuivey says the key for competitors will be innovation.

One to watch is SanDisk, which began selling music players in 2004. SanDisk grabbed substantial market share, in part through offering product features iPod lacks, such as FM radio. But the core of its strategy — aggressive discounting — turns out to be relatively pedestrian. Its position as a major manufacturer of solid state flash memory for digital devices allows it to undercut competitors' prices on music players.

“The most costly ingredient in a flash-based MP3 player is the flash memory,” says Daniel Schreiber, SanDisk EVP and GM for audio/video. “We remove the middleman and pass that savings directly to the consumer.”

By 2006, SanDisk had secured 11% of the digital music player market — impressive compared to the single digit share of well-branded competitors like Sony and Microsoft (whose much ballyhooed Zune player hovers below 5% market share).

But it's not cheap memory alone that makes SanDisk a threat to the Apple juggernaut. Analyst Tawny Chen of NPD Research subsidiary Current Analysis West, says, “SanDisk is doing everything Apple isn't, like partnering with other music services, and offering features like FM radio and voice recording.”

In April 2007 the company introduced the Sansa Connect, billing it the first music player capable of wireless downloading (although Microsoft's Zune predated it, albeit with more limited wireless functionality). At the accompanying teleconference, SanDisk CEO Eli Harari described the new product as “pushing the envelope in terms of WiFi and music sharing.” Is this the new “killer app” for the digital music market? One Yankee Group analyst calls it “interesting, but not a game changer.” Until WiFi is more universally available in public spaces, says Josh Martin, wireless connectivity will be more of a novelty than a must-have.

Digital music players remain a small enough line of business for SanDisk that revenues aren't broken out (although overall, the company's fortunes have been battered by price volatility for memory). But according to Citibank analyst Craig Ellis, in 2006 audio players accounted for about 8% of total revenues. Current Analysis' Chen also notes that sacrificing revenue for market share worked for SanDisk in the flash memory market, and it may be pursuing a similar strategy for digital audio. The tight-lipped SanDisk declined to provide any details about its strategy.

But even low-cost hardware and wireless support may not be enough to wean consumers off their already considerable investment in iTunes. User-friendly software service is the other piece of the equation, and there are multiple rivals trailing Apple in that space, from Napster to Wal-Mart. Forrester's McQuivey feels that no download service can challenge Apple alone. “If someone is ever going to dethrone iTunes, they're going to have to be linked with a hardware manufacturer and a device that's just as compelling as the iPod experience.”

That philosophy may be driving the recent U.S. partnership between SanDisk and Yahoo Music, the most popular streaming music service in North America. Yahoo Music is differentiated from the iTunes model by its subscription service, where users pay a monthly fee to access all songs in the Yahoo library. But subscription services have been slow to catch on; a 2006 Ipsos Insight survey revealed that only 17% of music player owners had ever used them.

Digital music constitutes only a fraction of Yahoo's business and, as with SanDisk, those revenues aren't separately reported. Morningstar Analyst Larry Witt speculates that Yahoo may view digital music more as a way of rounding out its portal offering than a significant standalone business. “I don't think they're trying to make a serious push into taking out Apple,” he says. “They'd like this to take off … but it would take a lot of money, and frankly be very difficult.”

Most observers agree that Apple can probably rest easy for now. It would take a couple of years for any new music player to impact the market, not to mention that Apple almost surely has innovations of its own in the pipeline.

But where technology is concerned there no guarantees. The Yankee Group's Martin says, “It's going to be difficult to overcome what Apple is doing, simply because they have the best product out there today, and a cachet about them that's almost surreal. But it would be silly to say that no one could compete with Apple in the digital audio space, ever.”