Apple buying Beats could radically transform the digital music business

There are still many unknowns about Apple’s (S AAPL) reported acquisition of headphone maker Beats Audio, but one thing is already certain: The deal, if it goes through as reported, is going to be a game changer for digital music.

News of Apple’s negotiations with Beats broke Thursday, and we have learned very few actual details since, save for the fact that Beats co-owner Dr. Dre seems to be a happy man. Reports do indicate that Beats Music, which launched as a Spotify competitor earlier this year, will be part of the $3.2 billion package. That has led to two interpretations of the deal: Some people think it’s all about digital music, while others argue that Beats Audio with an estimated $1.5 billion in hardware sales per year is, at least for now, the crown jewel.

I’d argue both are true. For Apple buying Beats is all about hardware, and it will transform the digital music business to a point where pure-play music services won’t survive as viable competitors anymore. The present world of music subscription services may be dominated by Spotify, with Deezer, Rhapsody, Beats, Rdio and others all shooting for second place. The future will be dominated by Amazon, (S AMZN) Apple and Google, (S GOOG) with Microsoft (S MSFT) and possibly Samsung trying to break into the big leagues as well.

Spotify: From IPO to acquisition target

The current king of paid music streaming is Spotify, which some estimate will surpass 10 million paying subscribers this year. The company executed very well on its international expansion, bringing music subscriptions to 55 countries, and effectively using ad-supported streaming as a way to get people hooked. But that growth has also been incredibly expensive, leading to Spotify raise more than $530 million in funding, and needing more money to actually boost its customer base in highly competitive markets like the U.S., where growth has been stalling.

Spotify planned to go public later this year for a fresh influx in cash, but that IPO is now looking a lot less likely. Not only has the climate started to shift against tech IPOs in recent weeks, the impending announcement of Amazon’s music subscription service also cast some doubts on Spotify’s IPO story.

Amazon is reportedly looking to bundle music subscriptions with its Prime service, which means that an estimated 30 million Prime subscribers will have access to music that Spotify is trying to sell them for an additional $10 a month. Reports indicating that Amazon is about to release its own mobile phone, which would presumably come preinstalled with the music service, further cast doubts about Spotify’s ability to compete in the U.S.

Now add Apple to the mix, with its ability to reach millions and millions of phone and tablet users, as well as a marketing budget that dwarfs Spotify’s efforts, and you end up with a scenario that could make potential investors very wary of the music service’s stock. Instead, I’d expect that companies like Google and Microsoft are crunching their numbers right now to see how much they’d be willing to spend for Spotify — and Spotify’s investors may decide that a multi-billion dollar exit before Apple fully takes control of Beats may be the best scenario.

The rest of the field: ready to be reshuffled

Speaking of Google, Amazon and Microsoft: News of Apple’s acquisition of Beats must have sent the digital media departments in these companies into high gear. Amazon has been working on its streaming service for some time, Google delayed the long-rumored launch of a YouTube music service multiple times.

But with Apple now getting its hands on a Spotify competitor, one should expect that each of these players is looking to accelerate their own efforts to try to preempt Apple’s entry into the subscription music market. This could mean that Amazon and Google will finally reveal their own services in the next few weeks.

It could also mean that other big players, including Microsoft and Samsung, will look to grab a piece of the action before it’s too late. Samsung has been trying to figure out what to do with its media services, with recent experiments like Milk pointing towards more of an ad-supported model. Microsoft has been trying to get traction for Xbox Music by taking it beyond the game console, but thus far, there is little evidence that this has worked.

It’s very likely that these companies are now looking to make their own acquisitions to bolster their portfolios. Rhapsody with its 1.7 million paying subscribers worldwide could be a good match for Microsoft. Deezer may be interested to a company with international ambitions as well. And a company like Samsung that doesn’t have a compelling subscription offering of its own may jump in and even pick up a smaller player like Rdio on the cheap, if only to continue its move towards ad-supported music.

Digital music: the thing you get when you buy something else

I expect all of these changes to happen fairly quickly. Twelve months from now, the digital music world is going to look very different. Instead of startups trying to convince consumers to spend $10 for music per month, it will be dominated by big companies trying to convince consumers to buy their devices and buy into their platforms.

Digital music will become a value-add. It won’t exactly be free — licenses are still expensive — but it will increasingly be bundled with other products and services, and come with long-lasting promotional offers meant to convince you to buy phones, headphones, data plans, or in the case of Prime, all kinds of stuff.

The good news for music labels is that bundling works, if done right. Muve was able to get more than two million subscribers by simply adding the price of their music subscription to everyone’s phone bill. It’s just that their bundles targeted the “wrong” consumers for a world in which AT&T partner Apple is buying AT&T partner Beats.

Muve isn’t the only company that came up with the right model only to see others succeed with it. The pioneers of digital music may finally see their vision of mass consumer services become a reality in the near future — but chances are that these very pioneers and their startups won’t be part of that future anymore.