Margins, pressures lead iPod vendors to Microsoft Zune

If you’ve been following news reports for the past two months, you’ve most certainly heard about Microsoft’s Zune – the company’s first self-badged portable media player and most recent “iPod killer.” And you probably also know that pundits have already declared Zune dead in the water, months before its official release. Besides chiding it as a weird-looking iPod wannabe, writers have questioned whether its wireless and video functionality will even work properly, then pointed to its lack of iPod-beating features, plus Microsoft’s apparent inability to match Apple’s online media store, marketing, or cool factor.

But there are two factors the pundits have ignored: iPod retailers and developers. Strained by pricing and other pressures from Apple, these two key partners in the iPod’s growth are offering Microsoft greater support than anyone might have imagined two or three years ago. And for that reason, Zune may have a better-than-expected chance at grabbing market share in the 2006 holiday season.

Retailers: Apple’s Least Loyal Allies

Since Apple’s battles with retailers are fairly well-known, we don’t have to rehash them in detail: it suffices to say that Apple felt compelled to open its own international chain of stores to properly sell its products, and that it’s no surprise that the “official” Apple Stores both target highly competitive markets, and tend to be both first and best at stocking new Apple offerings. In addition to inspiring lawsuits by small but dedicated Apple computer resellers, which accused Apple of entering their markets in a predatory fashion, the company has enjoyed a less than ideal relationship with larger store chains. During a time when Apple’s iPods and computers are enjoying unparalleled popularity, these stores continue to aggressively push alternatives – and seek out other partners.

Consider Sandisk. Even if you’re a fan of the iPod, you have to wonder how a company without any audio background or reputation in the MP3 business could quickly come to have even decent market share, let alone a number two position ahead of Creative, Sony, and other better-known companies in the United States. The answer is simple: Sandisk has been backed by prominent American bricks and mortar retailers, receiving shelf space and impressive placement in weekly newspaper circulars, amongst other perks. In print and online, massive electronics retailer Best Buy finds a way to put Sandisk’s Sansas in as many photos as possible, next to and sometimes instead of iPods.

Why would a store try to push Sandisk players on people at a time when iPods are ultra-hot? Profits. Since Sandisk aggressively controls its costs by owning and licensing out the flash memory technology it uses, there’s a significant profit margin on Sansa players, which the company passes along to retailers. These stores would rather sell more units of high-margin players than more iPods, which despite their incredible popularity carry amazingly low retailer profit margins.

At this point, we need to take one step back and explain a few points which might not be obvious to average consumers: large bricks and mortar retailers are all about per-unit profits. It’s possible for a store to sell two different products for $300, one of which puts $10 of profit into the company’s pocket, while the other offers $50 or $100 in profit. The store doesn’t care whether the lower-profit item uses higher-quality parts that make it work or look better; it wants you to buy the one with the higher profit margin.

You might be surprised to learn that stores don’t make $100 on every 30GB iPod they sell – the actual number’s not even close. In fact, some stores claim that, when their overhead (total cost of employing people, paying rent, and so on) is taken into account, they actually lose money on every iPod they sell. That’s one of the reasons salespeople are told to push “replacement policies” and accessories all the time, a profit-enhancing annoyance which is obvious to consumers. It’s also the reason for a less obvious but even more aggravating set of practices: these stores actively push more expensive accessories over cheaper, equally good or better products. We have heard many stories on how certain stores won’t stock good, inexpensive products because they don’t want to cannibalize sales of their more expensive or just higher-margin ones.

Recently, the retailer story has become even more eye-popping. If you’ve been shopping online and offline recently, you’ve probably realized that – unlike online retailers such as Amazon.com – bricks and mortar store chains make every effort to sell products at their full “manufacturer’s suggested retail prices” (MSRPs), rather than offering discounts.  In fact, unlike online stores, which have unlimited shelf space, the bricks and mortar retailers are constantly trying to guarantee that every square foot of their shelf space is worth hundreds of thousands of dollars. As suggested above, these stores don’t want to offer you a good deal or see you buy the best product out there – they just want to make as much money as possible.

Margins, pressures lead iPod vendors to Microsoft Zune

How bad has this become? Best Buy actually does tests to see if it can sell various products for more than their MSRPs. Read that again. That’s why you’ll sometimes see iPod accessories selling at Best Buy for $5 or $10 more than Apple’s prices, or $20 more than Amazon.com’s prices. After Best Buy publicly purged the customers who came to the store looking for the “best buy” on products, it has focused on trying to sell to less savvy customers who want help and don’t know much about product features or pricing. Since the company operates a vast network of stores, it has surprisingly strong access to the nation’s electronics customers, and a disturbing ability to control prices. When possible – such as during the launch of a hot video game console – it tries to force customers to buy pre-determined “bundles” of hardware, software, and accessories, rather than selling the low-margin hardware with only the add-ons customers actually want. With Apple Stores nearby selling unbundled iPods at their regular prices, it’s hard for Best Buy to force customers to part with even more of their money than is absolutely necessary.

Margins, pressures lead iPod vendors to Microsoft Zune

Like a bigger, bolder version of Sandisk, Microsoft is tapping into these trends to try and see Zune succeed this year. With knowledge of the mistakes of companies such as Creative, iRiver, and Sony, Microsoft has already approached retailers with promises of the marketing support, profit margins and accessories the stores have been hoping for. While we have heard rumblings that Apple may be attempting to mend strained relations with these retailers, it’s unclear which products – iPods or their competitors – will receive the lion’s share of attention from these stores by the end of the year. Thankfully, official Apple Stores continue to spread across the world, guaranteeing that customers will have options even if Apple doesn’t win greater support from other retailers.

Developers: Apple’s Most Loyal Allies

Then there are the iPod’s third-party developers, who represent a considerably different story. Actually talking with these developers yields understanding that mere economic analysis cannot convey: just as is obvious from every year’s packed Worldwide Developer Conference (WWDC) events in San Francisco, these companies’ hearts are still with Apple. Many of the iPod’s accessory makers are long-time fans of Macintosh computers and other Apple products, and they entered the business as much to support Apple as to support themselves.

But their heads are increasingly turning towards Apple’s competitors. As previously noted on iLounge, Microsoft has already approached Apple’s partners to try and create an accessory ecosystem similar to the iPod’s – Sandisk has apparently done the same. Besides the fact that Microsoft and Sandisk have been acting friendly – a recent complaint developers have had about Apple – these companies have offered iPod accessory makers better licensing deals than Apple’s Made For iPod program, enabling them to take products originally developed for iPod use and conceivably make higher per-unit profits while selling them at lower prices.
Margins, pressures lead iPod vendors to Microsoft Zune

From what we understand, these developers are torn. On one hand, they have faced pressure on everything from product pricing and naming from Apple, and having forgotten Microsoft’s notorious history of bullying, they are happy just to be approached by people who appear to be friendly and interested in their products. On the other hand, they love the iPod, and would prefer to be developing products for Apple.

Though the results of Microsoft’s approach won’t be seen by the public for several months, we know that some of the iPod’s accessory makers are now also developing add-ons for Zune – one key to Microsoft’s ability to appeal to retailers, despite all the doubt that’s out there. We’ve also heard that others are working on add-ons for some other top-secret Microsoft product that’s apparently coming in early 2007, and unrelated to Zune.

As with the question of retailer support for Microsoft, it’s unclear whether these accessories will turn out to be great, or just big snores given whatever Apple and developers have planned for the near future. From where we stand, one thing is certain: the coming months will involve major surprises for everyone – consumers, developers, and retailers alike. We’re looking forward to seeing how it all plays out.

Are you? Do you think the iPod’s continued success is a foregone conclusion? Will Microsoft emerge as a serious contender this year? Or will Sandisk continue to maintain its number two position? Please add your comments and opinions below!

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