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Apple Music Could Be on its Way to Better Profitability

Reports have been coming in recently that Apple (NASDAQ: AAPL) is looking to negotiate with record labels to lower royalty rates.

In this clip from Industry Focus: Tech, Motley Fool analyst Dylan Lewis and senior tech specialist Evan Niu explain where Apple Music fits into Apple's overall business, how much money the service brings in regularly, and how better contracts with record labels could juice the segment's profit.

A full transcript follows the video.

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Dylan Lewis: We talked about Apple Music a little bit before. I thought we should come back to it. There's some news that's recently come out about their cost intentions with the service, and looking to bring things down, maybe make it a little bit more profitable.

Evan Niu: Right. There have been reports that Apple is trying to negotiate lower rates with the record labels. Right now, reportedly, the record labels keep about 58% of revenue, which is easily the largest direct cost associated with the service. Which suggests that it has a gross margin of about 42%. Which is higher than the corporate average, so you can immediately appreciate it there from a profitability standpoint. But if they can get that licensing cost down even more while Apple Music is growing -- because I think that's a big piece of it, because they agreed to pay higher royalties. But if they can grow users, which the industry likes, then they have a better position to negotiate a lower percentage royalty take. And Spotify is supposedly around 55%, and dropped to 52% recently after some negotiation. So, it does seem possible that Apple can get a better deal, provided it can continue to grow subscribers. Both companies are growing pretty well, and they're kind of going in lockstep together. The whole industry is expanding, the industry for paid streaming subscribers is really growing, and Apple Music and Spotify are really driving that. But, as they keep growing, I think they definitely have a good case to take to the record label and say, "We're really helping your industry, give us a little bit of a better break on these royalties." That could definitely help profitability a little bit.

Lewis: We don't talk too much about Apple Music because it's such a tiny part of the company's business. What would this look like, in terms of the segment for them? How big is it right now? You hear that costs could come down from 58% to 55% or 52%. It won't be something that meaningfully moves anything for them, but it's a nice bump, right?

Niu: Right. Alone, I don't think it's a huge thing that's hugely important. But I think Apple Music is going to be a critically important piece to the overall ambition to double the services business over the next four years to about $50 billion. Right now, the services business overall is about $25 billion, and they want to grow that to $50 billion by 2020. There's lots of different levers they can pull to get there. But I think Apple Music is one of the most important ones within that portfolio of services that they're growing, and really putting more focus into.

Lewis: And I think right now, it's a $3 billion business, or something like that. Is that right?

Niu: Yeah, roughly, based on 27 million subscribers at a run rate of about $10 a month, that puts you in about $3.25 billion, roughly. But, obviously, that number is always moving as they're growing the subscriber base, and it's not clear how many people are on individual plans versus family plans. They actually just introduced a new pricing tier for a year-long subscription that gives you a little bit of a discount, it's $100 for a year as opposed to $120 for a year if you pay on a monthly basis. I think that also appeals to the users because they can get a little discount, and for Apple that gives them more visibility because now they have a year-long subscription. So, they definitely have a few things they can do.

Lewis: Still not a needle-mover for the company, but something to keep tabs on.

Niu: Yeah. I think it contributes to an important strategic element. But in itself, it's not a huge thing.

Dylan Lewis owns shares of Apple. Evan Niu, CFA owns shares of Apple. The Motley Fool owns shares of and recommends Apple. The Motley Fool has a disclosure policy.