Europe vs. Apple: Facing the Music

At some point, the company will need to address concerns about its iPod-iTunes DRM link. Will Apple eventually inch toward interoperability?

by Dan Carlin

When Norway's consumer protection agency filed a complaint last June against Apple (AAPL), the Cupertino (Calif.)-based digital music and computing giant barely blinked. After all, with sales booming around the world, how much damage could a small band of critics in a nation of 4 million people wreak?

Plenty, it turns out. The Norwegian Consumer Ombudsman continued to develop its case, which alleges that the exclusive link between Apple's iPod and iTunes music store violates Norwegian consumer law by preventing iPod owners from playing songs bought from other online services or listening to iTunes songs on rival MP3 players. "We want to make it very clear in Norway that their business isn't fair to consumers," says Torgeir Waterhouse, a senior advisor to the Norwegian Consumer Council, who is leading the Apple investigation.

Consumer Backlash

Now the mouse that roared is picking up supporters. On Jan. 25, the Dutch Consumer Ombudsman weighed in with its own concerns over what spokesman Ewald van Kouwen called "illegal practices" by Apple. That brings to seven the number of European countries that are looking into the iPod-iTunes connection, including France, Germany, Sweden, Denmark, and Finland (see BusinessWeek.com, 1/25/07, "Consumer Groups Wage War on Apple DRM").

The implications of a snowballing consumer backlash can't be lost on the digital music star, which sold nearly $9.6 billion worth of iPods and digital music in the fiscal year ended last September and got 40% of revenues outside the U.S. Indeed, the growing chorus of discontent—and the likelihood of a legal showdown in Norway—could have a ripple effect across Europe and throughout the digital music business.

Experts say Apple and its competitors, especially Sony (SNE) and Microsoft (MSFT), who could likewise be targeted for similarly closed business models, must take this David vs. Goliath battle seriously. "Apple is concerned about precedent," says Mark Mulligan, senior analyst with JupiterResearch in London. "There's a good chance whatever happens in Norway will be followed elsewhere in Europe."

EU Opposition

Indeed, the risk facing Apple is that the European Commission, which made waves with its antitrust case against Microsoft and could strike again against Intel (INTC), might step into the battle. "If Apple becomes the major hub between the consumer and the music industry, one could argue there's a need for Europe-level intervention," says Stefan Bechtold, senior research fellow at the Max Planck Institute for Research on Collective Goods in Bonn, Germany.

Such a move, were it to happen, could take five or more years, cautions Andrew Sheehy, the founder and vice-president at digital music consultancy Generator Research, in Newton Abbot, England. "Getting an EU-wide interoperability directive would be very difficult and time-consuming," he says. "Apple will try to string it out as long as possible." And if the matter made it to European court, Sheehy argues, "Apple would take them to the cleaners" because the legal underpinnings are weak.

Long before then, however, Apple must deal with Norway. By September of this year, the company will be required to show authorities there that it has begun modifying its digital rights management (DRM) system to comply with Norwegian law. If it does not, the Norwegian Supreme Court could order a shutdown of the Norwegian iTunes site. Or Apple, which declines to comment, could pull out of the market. "It's up to them to do the right thing," says Norway's Waterhouse.

Deconstructing DRM

The stakes are far greater than the tiny Norwegian market. If Apple agrees to modify its DRM policy under order, or avoids the situation by pulling out of Norway altogether, it may have to take the same steps to accommodate other European countries with strong consumer protection laws. With a combined population of nearly 200 million, the seven countries already examining the iPod problem represent a big, wealthy market. Indeed, in a report released last year, Credit Suisse Group (CS) analyst Robert Semple projected Apple could sell more than 309 million iPods in Europe by 2009.

That makes this a tough call for Apple, which has built its digital music empire on the seamless integration of the best-selling iPod and iTunes. Apple's FairPlay DRM system enforces the restriction that iTunes downloads can be played only on iPods and that iPods can't play songs downloaded from other paid services.

The close link has been a key to Apple's success, and the company is loath to weaken it in any way. "[Apple's] overwhelming market share is based in large part on its ability to lock people into that device," says Josh Bernoff, principal analyst with Forrester Research (FORR) in Boston. "Hell will freeze over before Apple gives up the secrets to its DRM system."

Apple's Options

Though it won't discuss the issue publicly, Apple quietly acknowledged the risk in its 2006 10-K. Noting that "certain countries have passed legislation or may propose legislation that would force the Company to license its DRM solutions so that content would be interoperable with competitor devices," Apple cautioned that such moves might lessen antipiracy protection for digital content and affect its licenses with suppliers. What's more, if the company were unable to devise alternative solutions in a timely manner, it "could have a materially adverse affect on the Company's operating results and financial position."

So far that risk hasn't spooked investors, who have driven up Apple shares 43%, to $85, since the Norwegians made their move last June. Some say there are obvious holes in the case—including the fact that tech-savvy consumers can disable its DRM simply by burning the songs onto a CD and ripping them back onto a computer. Analysts say Apple would marshal that and other arguments in its defense. Norway might have to settle for a compromise solution, such as a requirement that Apple more clearly disclose to potential customers that its products are not interoperable with rival offerings.

Changing Market

Norway and the EU aside, Apple may not be able to resist responding to market forces. Some major music companies have already discussed the possibility of selling non-DRM-protected MP3s directly on their own Web sites, which would put pressure on Apple to modify or eliminate FairPlay. And the growing strength of music phones and other alternatives to the iPod eventually may force Apple to modify its business model.

Until that happens, the erstwhile computer company will continue to make hay with its music bonanza—and Europeans will likely continue snapping up iPods and iTunes by the millions. The long-term outlook of Apple's digital music business in Europe may be darkened a bit by the prospect of heavier regulation, but the company's rapid growth isn't likely to be halted anytime soon.