Digital Entertainment: The Future Of Music: Industry Transformation Is Just Getting Started

Looking to replace lost revenue from the decline of CD sales, the music industry is slowly realizing that digital distribution is its destiny.

The result is that labels are transforming themselves from vendors of physical goods to licensors of digital media. But this reinvention will take some time, as each new digital channel remains in a formative stage.

While MP3 player sales have skyrocketed in the past year, this growth has yet to spur equally dramatic increases in digital music sales.

According to Fulcrum Global Partners, there were more than 25 million MP3 players in the United States at the end of third-quarter 2005, compared with 6 million in the same quarter last year. About 20 million of these were iPods.

However, at the same time, Fulcrum estimates the average number of annual music downloads per iPod has actually decreased from 25 to 15 per user.

Meanwhile, some labels—Sony BMG and Warner Music Group in particular—are preparing for a showdown with iTunes over the now-standard 99-cent-per-track fee.

Labels want a flexible pricing model, where new releases from top acts would cost more than 99 cents and more obscure catalog titles would cost less.

Apple Computer CEO Steve Jobs replied by calling the labels "greedy."

Subscription-based music services like Napster, Rhapsody and Yahoo Music Unlimited have even greater problems with the wholesale rates the music industry charges.

Executives say the high rates that labels charge are bleeding them dry, leaving very thin profits to fund the necessary marketing and educational campaigns needed to drive sales further.

To be fair, the profit margins for subscription services are better than à la carte sales. According to various estimates, subscription-service profit margins are about 30 cents on the dollar, while à la carte sales generate only 5 cents on the dollar.

But the problem is that subscription services are a tougher sell, often requiring expensive advertising campaigns to educate potential customers and convince them to try something new.

"The monthly subscription-service business is actually pretty profitable, if you don't have a lot of marketing dollars sunk into subscriber-acquisition costs," says Gary Rudin, VP of marketing and business development for MusicNow, which America Online recently acquired as its default music service.

After all is said and done, these services are keeping only about 10% of the monthly fee that end users pay. Additionally, newcomers to the subscription space face new pressure from publishers for higher rates than those grandfathered in for the existing services.

Given these concerns, all have taken steps to expand or reinvent their business models to find additional revenue streams.

Napster, which recently reported about 450,000 subscribers, announced that early next year it is relaunching its Web site to better monetize the 2 million unique visitors it receives every month. Currently, the site exists only as a place to download the Napster service client. Plans are to expand that to include a more multitiered service that contains advertising.

Meanwhile, Yahoo's free music portal is already completely ad-supported and offers Internet radio, music videos and music news. The Yahoo Music Unlimited service is the only extension for which it charges.

Yahoo, which has yet to announce its subscription numbers, recently raised the fee for the portable subscription option to $12.99, citing "economic realities."

Despite all this, Rhapsody remains the leading subscription offering. Its parent company, RealNetworks, has several subscription-based music services in addition to Rhapsody, and recently reported its total subscriber base for all is 1.15 million. The company does not report Rhapsody subscribers separately.

Real is expected to launch a significant subscriber push in the wake of a landmark $761 million legal settlement of its lawsuit against Microsoft.

The agreement calls for Microsoft to integrate the Rhapsody service into its MSN search, instant-messaging and music store services. Rhapsody essentially becomes MSN's default subscription service, just after MSN broke off negotiations with the music industry for a music service of its own.

As the subscription market continues to struggle for an audience, another competitor is joining the fray: peer-to-peer services pursuing a label-authorized model.

Once a target of legal challenges from the Recording Industry Assn. of America, iMesh has reinvented itself as a "legitimate" music service. It offers access to some 15 million unlicensed tracks through direct file trading from other people's hard drives. The company tapped MusicNet to operate its licensed music service, where users can pay either 99 cents per track or $6.95 per month for access to 2 million label-owned songs.

Other such former "illegitimate" P2P services as LimeWire and eDonkey are struggling to follow. However, the decentralized nature of these networks makes it difficult for some providers to establish controls, such as filtering technology.

In fact, several reports have surfaced that the filtering system iMesh uses is not airtight, with several licensed tracks slipping through the system for users to obtain as unprotected MP3 files.

Technical limitations are not the only concerns that remain over whether commercial P2P services can attract and/or retain users. Their original appeal was their access to free music. With that lure removed, P2P setups like iMesh have to add more value to convince users to stay.

However, the P2P faithful remain confident that the community elements of their services will win out.

"The churn rate of our services is 1.5% per month," iMesh president Talmon Marco says. "That's very low. Verizon Wireless would kill for this kind of churn."

In the grand scheme of things, though, digital music is no longer restricted to Internet distribution. The number of digital channels is growing rapidly, and the music industry has high hopes for the growing popularity of wireless data services.

The number of ringtones downloaded in the past year has quadrupled, and the master-ringtone category is now the fastest-growing ringtone format. Ringback tones are slowly gaining traction, with labels and carriers retaining high expectations for their prospects.

Wireless operators are also selling full-song downloads. Sprint recently began selling full tracks that subscribers can download to their phones, with Verizon and Cingular expected to open additional mobile stores early next year.

But the realities of the mobile-music world limit price flexibility. Labels charge wireless carriers a higher wholesale rate than they charge online stores, immediately resulting in a higher cost.

Additionally, Sprint's service has a dual-delivery feature that sends one version of the purchased song to the mobile phone and another version to the PC. Music publishers say they are due their rate on each delivery method, even though there was only one sale.

Regardless of the rate, the carrier content business model differs drastically from that of Apple's iTunes. Apple breaks even on the cost of songs on iTunes and makes its money selling iPods. Wireless carriers, meanwhile, lose money on sales of their phones, which are subsidized, and make money on content and usage. By definition, the pricing will never match.

Another concern is whether consumers will accept an over-the-air delivery model, whatever the cost. The accepted method for putting music on a portable device is to transfer it from a personal computer, a process known as sideloading.

Research from NPD Group suggests 52% of consumers would prefer to sideload songs, while only 37% are interested in downloading over the air.

However, the music industry believes different consumers will use each service, so it remains unconcerned about the cost or usability disparities.

"We're looking forward to experimenting with these things," says Tom Ryan, senior VP of mobile and digital development for EMI Music Group. "We don't anticipate the same buyer of digital music on the fixed line will be the same buyer of digital music through the mobile phone over the air. Based on how that develops, there could be some interesting ways in how we set our strategy for selling through that medium." ••••