Last week Steve Jobs presented a new version of the Apple TV device and announced that it would stream only rented content and that TV episodes would be available at a lower price point of $0.99. With these changes Apple addressed weak points in its video strategy, which had caused lackluster sales. However, while consumers may be pleased it seems that the lower price ponit is a point of contention with the television networks. So far only ABC and FOX have signed on to Apple TV, and many speculate that ABC did so since since Steve Jobs is on the board of directors for Disney while in FOX got the OK since Rupert Murdoch is interested in working with Apple on iPad projects that support Newscorp’s publishing business.

Ignoring political alliances, I wondered just what the floor price should be for an Apple TV rental. The blog TVByTheNumbers had a provocative post, hyposthesizing that on average broadcast networks make $0.80 in advertising per viewer during a one-hour broadcast show.

CPM of $25 = $0.03 per view x 32 spots = $0.80 per viewer per episode

I considered this $0.80 should be the benchmark by which a substitution view should be judged. I then set out to estimate the revnues other platforms created on a per viewer basis and compare. The revenue models accounted for the following factors:

• Revenue stream (advertising or user payment)
• Advertisements per episode stream (applicable only to Broadcast TV, Hulu and Hulus Plus)
• Viewers per episode stream (dependent upon the delivery screen)
• Viewings (greater than 1 if the episode has been purchased)

I decided to ignore advertising commissions and distribution fees, which could be a major factor for networks to estimate the benefit, or lack thereof, in distributing their shows via iTunes and Apple TV. At the end of this post are all the calculations for each of the platforms. The following graph summarizes the results:

Even with the higher CPM prices (cited in the Appendix) it seems that Hulu offers the lowest revenue per user. However, Hulu Plus’ dual revenue stream (similar to cable TV), which accounts for a $9.99 monthly fee as well as advertising, jumps the gap and manages to post the highest revenue per user, clearly the winning model. The per-episode purchase models of Amazon and iTunes also pose a decent revenue of $0.66 per viewer while Apple TV’s rental model comes in at a lower $0.50 per customer, which might be too low for certain networks.

As I mentioned before this price doesn’t reflect any distribution fees that Apple might take so the comparison for iTunes and Apple TV might not be accurate. I might also be ignoring other factors. For example, episode purchases through Amazon might have more viewers per episode than Apple iTunes since the Amazon service has more streaming options to televisions.

Another thing to consider is that although broadcast television may take in around an average of $0.80 per viewer during every hour of primetime, these viewers are also likely to continue watching the same channel, contributing to further revenue on the channel during the next show. They are also going to be exposed to TV spots promoting the network’s other content. These are benefits that would might be incurred towards a limited extent with Hulu (which does promote a network and its other content), but would be completely absent with Amazon and Apple. Therefore, there is a much larger set of intangible benefits to a viewer watching a show on a network, that can’t be simply accounted for in the subscriber, rental or advertising revenue of alternate platforms.

I want to also highlight that DVDs are sold after a television show ends, so this aggregate revenue stream doesn’t directly compete with a broadcast audience like Hulu, Amazon or Apple’s services, so it has a different set objectives of to fulfill; not so much to compensate for an audience which is not watching the show on television as helping pay for the production costs- typically a broadcast production only covers 50% to 75% of its costs through broadcast distribution; the rest has to be recouped through syndication and other sources like DVD sales.

Even though I do think these models are inherently limited in their ability to compare the platforms, I still believe the comparison illustrates well some of the factors that are involved in the pricing and negotiation of these deals, and indicate why the new Apple TV rental model is not currently accepted by CBS, NBC and other networks.

Appendix

For Hulu, I calculated the advertising based on a CPM of $63 since according to Wired their rates run about two to three times that of broadcast television. This sounds a bit high to me but it’s possible since the Hulu has better targeting, higher valued demos, and lower commercial skipping/avoidance than broadcast TV.

Hulu: CPM of $63 x 6 spots = $0.38 per viewer per episode

In the case of Hulu Plus I added the $9.99 monthly fee, divided by 18.8 episodes per month (this was estimated by taking the average monthly minutes per Hulu viewer by 47, 44 minutes of content plus six 15-second spots).

Hulu Plus: $9.99 monthly fee / 18.8 episodes = $0.53 in fees per episode + $0.38 in ad revenues = $0.91 per viewer per episode

Since Amazon, iTunes and Apple TV are strictly purchased or rented models, advertising was not part of equation. For Apple TV I assumed that an average of two viewers would watch each rented episode since it streamed to a television. In the case of Amazon and iTunes I assumed an average of only 1.5 viewers since their models could stream to computers that inhibited group viewing. I also assumed that content purchased via Amazon and iTuens would be viewed more than once.

Amazon: $1.99 purchase fee / 1.5 viewers / 2 viewings = $0.66 per viewer per episode
iTunes: $1.99 purchase fee / 1.5 viewers / 2 viewings = $0.66 per viewer per episode
Apple TV: $1.99 purchase fee / 2 viewers / 1 viewing = $0.50 per viewer per episode

The model for DVDs was similar to iTunes and Amazon, only substituting a $2.50 price per episode based on the retail price of $60 for a DVD set with 24 episodes.

DVD: $2.50 purchase fee / 2.0 viewers / 2 viewings = $0.63 per viewer per episode

An article today in the Financial Times mentions how Apple is supposedly pressuring TV networks to cut their episode pricing on iTunes in half, from $1.99 to $1. The price cut indicates that television sales have been lackluster. While exact iTunes sales information isn’t offered, it is known that Apple had accumulated sales of 15 million TV episodes in February 2006, 50 million in January 2007 and 200 million in October 2008. Based on this, in a recent in November 2009 I projected that Apple should have then reached sales of 86 million episodes.

I extrapolated the videos sold at December 2008 and 2008 on the speeds implied between official announcements. For example:

(200MM at Oct 16, 08 - 50MM at Jan 10, 07) = 150MM/645 days = 230K sales/day

50MM at Jan 10, 07 + (230K sales/day x 355 days) = 132.6MM sales at December 31, 2007

Utilizing this information I then calculated the average sales per user. Based on my calculations these average sales have dropped since 2007.

The bottom line is that Apple needs to rework its video strategy. The price cut attempts to address the issue. Why should iTunes customers pay $1.99 for a one-hour TV episode when they can spend the same amount for a game that they can play hours with? Apple understands that iTunes customers make this comparison, and that a TV episode, which is watched perhaps twice or three times, especially when repeat viewing require a user to store the video, taking up half a gigabyte of drive space, resulting yet another deterrent.

It’s also possible that Apple’s current roster of video platforms (iMac, MacBook, iPod Classic, iTouch, iPhone, Apple TV etc.) are simply not “fantastically great” enough for video watching due to portability (in the case of the computers) or screen size (in the case of the portable devices). Tomorrow Apple is presenting a new device, which could turn out to be the perfect device for video watching. It might finally convince iTunes customers to buy more TV episodes. It may also persuade Apple’s TV production partners to go along with the new iTunes pricing plan.

Apple has an impressive position in the music market. Through its iTunes store, the company currently has a 69% share of the U.S. digital music market and a 25% share of the total U.S. music market. Their position isn’t as strong however in the video market. This is especially apparent when you compare iTunes music and video sales on an average unit sold per user basis.

The iTunes store launched in early 2003 and by the end of the year it had almost 700,000 registered users. With the launches of the iPhone and iPod Touch, iTunes greatly expanded its customer base and they now reach over 100 million users.

The larger user base consequently led to accelerated musics sales. In early September total song sales reached 8.5 billion; they will probably surpass 10 billion in early 2010. (Update: Effectively, Apple reached the 10 billion songs sales point on February 25, 2010)

Looking at the average annual songs sold per registered user, iTunes initially had a very high amount- over 60 songs per user during its first year. This makes sense given that most of iTunes’ initial customers were early adopters of iPods and iTunes and probably hard-core music fans. After 2003 average song sales dropped off, but steadily grew back through 2007, until the user base ballooned (with the introduction of the iPhone and iPod Touch), resulting in another drop in 2008. However, the average has recovered between January and September 2009. Perhaps the latest wave of iTunes customers are becoming music customers.

As I mentioned beforem within video the picture hasn’t been as pretty. Total video units sold has been a fraction of average songs sold per customer. I thought that video sales would’ve picked up once more video-capable Apple devices were in the market (iPhone, iTouch, etc.) but that hasn’t been the case. Average sales per user dropped off in 2008, again, due to the increased user base, but video sales have not recovered like music. Rather there have been two sequential declines in average video units sold per user.

So is there a possibility that Apple will rectify its video position? Since April I have been speculating on the highly rumored iTablet. I believe that the device will be a multimedia marvel, revolutionizing gaming, digital magazines and digital video in particular, much as how the iPod affected the digital music industry. What was missing from my initial analysis was how Apple would need to couple its device launch with an evolution of iTunes, in terms of its video business model.

While iTunes does offer unparalleled access to content from many producers, it is easy to understand how many consumers might be stifled by its pay-to-own business model. An 45 minute standard-definition television episode on iTunes takes up about 450 MB of storage space. That is about 50 times more than a song. A song costs only half as much as the TV episode ($0.99 to $1.99). Therefore the real prohibitive cost to consumers from buying video content is disk space and not the purchasing price.

The logical solution for iTunes would be to implement a video subscription model. This week such a service was reported on at AllThingsDigital and Disney is rumored as being one the service’s early partners. Such an option combined with the “iTablet” would give Apple a much stronger customer offering for video, and would probably propel the company’s position within the market during the next few years.

The digital video market, being nascent, promising and hot, is the equivalent of a precocious young celebrity. They both attract a lot of attention, press coverage, and debate concerning which projects and relationships are worth pursuing. Of course, I have my own opinion, but just about digital video and not celebrities.

If you divide the digital video market by delivery methods (streaming or downloaded) and business models (consumer paid or ad supported), four sectors emerge.

Companies within the ad-supported streamed quadrant (upper left-hand corner) have received a lot of criticism lately for basically giving away for their content. Although YouTube attracts between 40 to 60% of total internet video streams the company places ads in only about 9% of these streams. Hulu has been somewhat more successful since it’s selling about 60% of its ad inventory, but the site has much less traffic, and runs only two minutes of spots per 22 minute program (a quarter of the standard amount on television). Hulu’s annual sales are running at about $120 million, a third less than estimates at the beginning of the year.

Unsurprisingly, there is much speculation about Hulu beginning a subscription service option, which would extend its presence towards the lower left-hand quadrant, along with the likes of Netflix and the “TV Everywhere” project currently being developed by Time Warner and Comcast. Such a business model might offer Hulu a greater revenue per viewer than what advertising currently yields, even at a high $50 CPM. Interestingly Amazon’s versatile Unbox service offers both paid streaming and downloaded options, placing it across both the lower left-hand and right-hand quadrants. Just within the paid downloaded quadrant iTunes is probably the biggest player.

Most of these companies do not yet have mobile video platforms. The only options seem to be YouTube, iTunes and Podcasts. Hulu may have an iPhone App in the works, but it seems to be on hold until their subscription service launches. This would leave Podcasts as the only mobile ad-supported downloaded service. It seems to me that this is an opportunity worth exploring.

Mobile video content has a strong value proposition. It offers portable viewing of video, anywhere and at anytime, and doesn’t require a network connection which can very unreliable or inaccessible in many situations. Mobile video also offers a higher level of viewer engagement than with television or computers where consumers can change channels or application windows. The only catch is that in order to make the most of this, you would have to “pause” or disable the fast-forward button during commercial breaks. Of course, the downloaded content would also have to an “expiration date,” as is the case with any video content, but this could be easily implemented with mobile devices just as Apple has restricted the length of time for viewing rented movies from its iTunes store.

I posted my idea for an ad-supported downloaded video on a recent article by Dan Rayburn concerning Hulu’s possible iPhone app, and how Hulu could opt for this route . His response:

Sure, it’s possible, but I don’t think likely as the consumer experience would suffer and the content would not be available instantly.

I respectfully disagree since consumers do want to be able to watch video content without relying on AT&T’s 3G network. Perhaps in the long term when mobile networks switch to 4G downloadable content would not offer the same value, but it remains to be seen how quickly mobile networks upgrade, and how data pricing plans also evolve. I also believe that consumers would be willing to temporarily cede their FF button in return for the right to see the latest episode of their favorite TV show anytime and anywhere. Viewers don’t mind sitting through the unskippable commercial breaks in Hulu and this proposition would be fairly similar.

The most important thing to remember is the immense market potential of mobile video. According to Nielsen, consumers currently spend about 3.5 hours per month watching video on a mobile device; that’s only 1.8% of the total time they spend watching video. Everybody is expecting this market to explode and the sooner or later a diversity of video options will be offered to satisfy a range of demands. Perhaps the downloaded ad-supported models won’t be the majority, but they will certainly be available. The only question is which companies will offer the service.

Today it was confirmed that Apple will be hosting an event on September 9 in San Francisco. The wording and design of the invitation indicate that the event will focus on music, most likely the iPod line and iTunes.

Last year’s invite clearly showed a thin iPod, hinting at the return to the “narrow form factor” in the fourth generation Nano, which was indeed presented at this event. The rumored announcements for this year’s event include:

• The Beatles library will be added to iTunes Store. This has been widely speculated since The Beatles remastered catalog is being released the the same day, but the event’s invitation mimics a song from The Rolling Stones; could this be a smokescreen?
• There will be adjustments to the iPod product line including an video camera functionality to the iTouch. Capacity upgrades are expected as always.
• Similarly, there will be price adjustments across the lineup.
• Finally, iTunes version 9.0 will be introduced. It may include new music bundling options and social features. A less likely subscription music service has also been rumored.

Regardless of exact proclamations the event is undoubtedly meant to support Apple’s iPod sales, which are normally strongest in the fourth quarter. This year however expectations are somewhat lower since iPod sales dipped recently in the third quarter, a first on a year-to-year quarterly basis. This is why I consider this year’s September event to be a quick reboot; a moment for Apple to reiterate its lead in the music sector, while buying the company some time to develop in other areas.

The iPod division, or segment, was the strongest contributor at Apple in 2006. Since then Mac sales have grown more briskly. Other segments have also consolidated themselves.

This all demonstrates how Apple, despite the iPod’s success, has not rested on its laurels and has developed its other products while diversifying its business interests. Apple has expanded from computer and software to music, video, mobile and gaming. Moving forward it will be interesting to see which new products and services Apple launches to further expand its stake in each of these sectors.

I personally believe that while a music subscription service would be quite challenging, a video subscription service would be a more natural market fit. Although Apple has done well with iTunes video sales, consumers normally rent access to TV shows or movies, rather than purchasing them outright. I am certain that Apple will eventually present a video subscription option in the iTunes store, perhaps within the next year. Gene Munster, an analyst at Piper Jaffrays, recently predicted that Apple launch an Apple TV set by 2011.

If the company does successfully move into music and video subscription services it could effectively become a media company, competing with the likes of Comcast, Netflix and Hulu. Apple is already leaves its digital music competitors in the dust. It is interesting to speculate how it would fare in the digital video sphere. I am sure the topic will be coming up in the months ahead, if information is finally revealed.