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The music industry

Music's brighter future

Oct 28th 2004
From The Economist print edition

The internet will eventually be wonderful for music buyers, but it is still
a threat to today's dominant record labels

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"DIRTY pop with wonky beats and sleazy melodies" is how the Sweet Chap, aka
Mike Comber, a British musician from Brighton, describes his music. The
Sweet Chap has no record deal yet, but he has been taken on by IE Music, a
London music-management group that also represents megastar Robbie Williams.
To get the Sweet Chap known, last year IE Music did a deal to put his songs
on KaZaA, an internet file-sharing program. As a result, 70,000 people
sampled the tracks and more than 500 paid for some of his music. IE Music's
Ari Millar says that virally spreading music like this is the future.

It may indeed be, and nimble small record labels and artist-management firms
will certainly get better results as they find ways to reach more people via
the internet. But the question facing the music industry is when that future
will arrive. And the issue is most urgent for the four big companies that
dominate the production and distribution of music-Universal, Sony/BMG,
Warner and EMI (see chart 1). So far they have been slow to embrace the
internet, which has seemed to them not an opportunity but their nemesis.
Rather than putting their product on file-sharing applications, they are
prosecuting free-download users for theft. They have certainly been
struggling: sales of recorded music shrank by a fifth between 1999 and 2003.

Today, there is more optimism. In the first half of this year, global
physical unit sales of recorded music rose, albeit by a tiny amount. The
industry claims that file-sharing has stabilised thanks to its lawsuits. The
number of music files freely available online has fallen from about 1.1
billion in April 2003 to 800m this June, according to IFPI, a
record-industry body. That said, internet piracy is rampant, and physical CD
piracy continues to worsen.

But big music's attitude towards the internet has changed, too. Over the
past four years the big companies have come a long way towards accepting
that the internet and digital technology will define the industry's future.
Thanks to Apple and its enormously popular iPod music players and iTunes
download service, most music executives now believe that people will pay for
legal online music. (Although they have mushroomed, legal online downloads
account for less than 5% of industry revenues.) The big companies are trying
to work out how they can harness the internet. Consequently, they are having
to rethink their traditional business models.

Music



IE Music did a deal with KaZaA to promote the Sweet Chap. Apple's iTunes
music store, RealRhapsody, Sony's Connect and MSN Music Store are some of
the paid-for rivals to free P2P networks. The New York State Attorney is
investigating whether Sony BMG Music Entertainment, Universal Music Group,
EMI Group and Warner Music Group bribed radio stations. IMPALA, a trade
association representing independent music companies, will challenge the
EU's decision (see also background) to allow the merger of Sony and BMG.






In the physical world, the big companies have the advantage of scale. In
addition to marketing clout, they own a large back catalogue of music that
can be repeatedly reissued. They are also bolstered by music-publishing
businesses, which collect royalties on already published songs used in
recorded music, live performance, films and advertisements.

Historically, the majors have controlled physical distribution of CDs. Yet
that barrier to entry will erode as more music is distributed on the
internet and mobile phones. Artists can, in theory, use the internet to
bypass record firms, though few have yet done this. The principal reason
most have not is that they need marketing and promotion, which the majors
also dominate, to reach a wide audience.

The majors have a tight hold on radio, for example, by far the most
effective medium for promoting new acts. (Perhaps their lock is too strong:
Eliot Spitzer, New York's attorney-general, is investigating whether the
companies bribe radio stations to play their music.) Could the internet
challenge them on this too? So far, bands have not been launched online. But
that could change, and there is already evidence that data derived from the
preferences shown on illegal file-sharing networks are being used to help
launch acts.

Much will depend on whether the majors choose to address a problem that is
just as important as piracy: these days they rarely develop new artists into
long-lasting acts, relying instead on short-term hits promoted in mainstream
media. That has turned off many potential buyers of new music. In future,
using the internet, the industry will be able to appeal directly to
customers, bypassing radio, television and big retailers, all of which tend
to prefer promoting safe, formulaic acts. That could give the majors the
confidence to back innovative, edgy music. But much smaller independent
labels and artist-management firms can do the same, offering them a way to
challenge the big firms head on.

Even in the physical world, the big firms are struggling to maintain their
traditional market. Supermarkets have become important outlets, but the
likes of Wal-Mart stock only a narrow range of CDs, choosing to shift
shelf-space away from music in favour of higher-margin DVDs and videogames.
That is a symptom of another headache for all music firms: they face ever
more intense competition from other kinds of entertainment, especially among
the young. In theory, then, digital technology offers the majors an escape
hatch. With infinite space and virtually free distribution online, every
track ever recorded can be instantly available to music fans. Of course,
smaller firms will be able to do the same thing.



Where did all the music go?
According to an internal study done by one of the majors, between two-thirds
and three-quarters of the drop in sales in America had nothing to do with
internet piracy. No-one knows how much weight to assign to each of the other
explanations: rising physical CD piracy, shrinking retail space, competition
from other media, and the quality of the music itself. But creativity
doubtless plays an important part.

Judging the overall quality of the music being sold by the four major record
labels is, of course, subjective. But there are some objective measures. A
successful touring career of live performances is one indication that a
singer or band has lasting talent. Another is how many albums an artist puts
out. Many recent singers have toured less and have often faded quickly from
sight.

Music bosses agree that the majors have a creative problem. Alain Levy,
chairman and chief executive of EMI Music, told Billboard magazine this year
that too many recent acts have been one-hit wonders and that the industry is
not developing durable artists. The days of watching a band develop slowly
over time with live performances are over, says Tom Calderone, executive
vice-president of music and talent for MTV, Viacom's music channel. Even
Wall Street analysts are questioning quality. If CD sales have shrunk, one
reason could be that people are less excited by the industry's product. A
poll by Rolling Stone magazine found that fans, at least, believe that
relatively few "great" albums have been produced recently (see chart 2).






Big firms have always relied on small, independent music firms for much of
their research and development. Experimental indies signed Bob Marley, U2,
Pink Floyd, Janet Jackson, Elvis Presley and many other hit acts. Major
record labels such as CBS Records, to be sure, have signed huge bands. But
Osman Eralp, an economist who advises IMPALA, a trade association for
independent music companies in Europe, estimates that over 65% of the
majors' sales of catalogue albums-music that is at least 18 months old-comes
from artists originally signed by independents.

In the past, an important part of the majors'R&D strategy was to buy up the
independent firms themselves. But after years of falling sales and
cost-cutting, the majors have little appetite for acquisitions, and now rely
more on their own efforts.

What Mr Levy calls music's "disease"-short-term acts-is not solely a matter
of poor taste on the part of the big firms. Being on the stockmarket or part
of another listed company makes it hard to wait patiently for the next
Michael Jackson to be discovered or for a slow-burning act to reach its
third or fourth breakthrough album. The majors also complain that the radio
business is unwilling to play unusual new music for fear of annoying
listeners and advertisers. And while TV loves shows like "Pop Idol" for
drawing millions of viewers, such programmes also devalue music by showing
that it can be manufactured. Technology has made it easy for music firms to
pick people who look good and adjust the sound they make into something
acceptable, though also ephemeral.

The majors could argue that they can happily carry on creating overnight
hits; so long as they sell well today, why should it matter if they do not
last? But most such music is aimed at teenagers, the very age group most
likely to download without paying. And back-catalogue albums make a great
deal of money. The boss of one major label estimates that, while catalogue
accounts for half of revenues, it brings in three-quarters of his profits.
If the industry stops building catalogue by relying too much on one-hit
wonders, it is storing up a big problem for the future.



A new duet
There are signs that the majors are addressing the issue. Universal Music
and Warner Music are starting up units to help independent labels with new
artists, both promising initiatives that show that they are willing to
experiment. Thanks to the majors' efforts in the last few years, their music
has already improved, says Andy Taylor, executive chairman of Sanctuary
Group, an independent, pointing to acts such as the Black Eyed Peas
(Universal), Modest Mouse (Sony), Murphy Lee (Universal) and Joss Stone
(EMI).

And yet even if they can shore up their position in recorded music, the big
firms may find themselves sitting on the sidelines. For only their bit of
the music business has been shrinking: live touring and sponsorship are big
earners and are in fine shape. In the past 12 months, according to a manager
who oversees the career of one of the world's foremost divas, his star
earned roughly $20m from sponsorship, $15m from touring, $15m from films,
$3m from merchandise and $9m from CD sales. Her contract means that her
record label will share only in the $9m.

In 2002 Robbie Williams signed a new kind of deal with EMI in which he gave
it a share of money from touring, sponsorship and DVD sales as well as from
CDs, in return for big cash payments. Other record firms are trying to make
similar deals with artists. That will be difficult, says John Rose, former
head of strategy at EMI and currently a partner at the Boston Consulting
Group in New York, because many artists, and their managers, see record
companies less as creative and business partners than as firms out to profit
from them.

Artists' managers will resist attempts to move in on other revenue streams.
Peter Mensch, the New York-based manager of the Red Hot Chili Peppers,
Shania Twain and Metallica, says "we will do everything and anything in our
power to stop the majors from grabbing any share of non-recorded income from
our bands." Mr Mensch says that one way to fight back would be to start his
own record company.

Independent labels are also gunning for the big firms. For one thing, they
are fighting to stop further consolidation among the majors because that
would make it even harder for the independents themselves to compete for
shelf space and airplay. IMPALA will soon take the European Commission to
court for allowing Sony and BMG to merge earlier this year. But the small
firms are also optimistic that they can grow at the expense of their big
rivals. The majors are cutting back in smaller markets and dropping artists
who lack the potential to sell in lots of countries. That leaves a space for
the indies. For example, Warner Music Group is thought to be readying itself
for an initial public offering in 2005 and, as part of cutting costs in
Belgium, it dropped artists this year. Among them was Novastar, whose
manager says the group's latest album has so far sold 56,000 copies in
Belgium and Holland.

The more the majors scale back, the more the market opens up. People who
have left the big firms are starting up new ventures. Emmanuel de Buretel,
previously a senior manager at EMI, is about to launch an independent record
label called "Because", with help from Lazard, an investment bank. Tim
Renner, formerly chairman of Universal Music in Germany, will soon set up a
music internet service, a radio station in Germany and possibly a new record
label.



In the material world
Meanwhile, the majors are trying to plot their move to digital. Making the
transition will be tricky. Bricks-and-mortar music retailers need to be kept
happy despite the fact that they know that online music services threaten to
make them obsolete. It is still unclear what a successful business model for
selling music online will look like. People are buying many more single
tracks than albums so far. If that persists, it should encourage albums of
more consistent quality, since record companies stand to make more money
when people spend $12 on a single artist than if they allocate $2 to each of
six bands. Or it could mean that the concept of the album will fade.

Online pricing is unstable too. It is likely that download prices will vary
in future far more than they do now. Apple forced the industry to accept a
fixed fee per download of 99 cents, but the majors will push for variable,
and probably higher, prices. Online prices will have an impact on prices in
the physical world, which are already gradually falling in most markets. But
the result of all these variables might be structurally lower profits.

Edgar Bronfman junior, chairman and chief executive officer of Warner Music
Group, expects that paid-for digital-music services via the internet and
mobile phones will start to have a measurable impact on music firms' bottom
lines as soon as 2006. The new distribution system will connect music firms
directly with customers for the first time. It will also shift the balance
of power between the industry and giant retailers. Wal-Mart, for instance,
currently sells one-fifth of retail CDs in America, but recorded music is
only a tiny proportion of its total sales.

The best distribution of all will come when, as many expect, the iPod or
some other music device becomes one with the mobile phone. Music fans can
already hold their phones up to the sound from a radio, identify a song and
later buy the CD. At $3.5 billion in annual sales, the mobile ringtone
market has grown to one-tenth the size of the recorded music business.

But can paid-for services compete with free ones? The paying services need
to put more catalogue online if they want to match the file-sharing networks
with their massive music libraries. And it is still unclear how much
"digital-rights management"-technology that restricts how a music download
can be used-people will tolerate. Another key issue is interoperability:
whether the various new devices for playing digital music will work with
other online stores. Apple's iPods, for instance, work with iTunes, but not
with Sony Connect or Microsoft's MSN Music Store. Too many restrictions on
the paid-for services may entrench file-sharing.

Out of the more than 100 online music sites that exist now, a handful of big
players may come to dominate, but there will be specialist providers too,
says Ted Cohen, head of digital development and distribution at EMI. iTunes
is like the corner store where you buy milk and ice cream, he says, but a
customer does not spend much time there. Real Networks'Rhapsody, on the
other hand, charges a monthly subscription in return for unlimited streaming
music and gives descriptions that lead people to new artists. Recommendation
services like these, as well as people sharing playlists, will eventually
make the internet a powerful way to market music as well as to distribute
it.



Jiving with the enemy
In September, according to comScore Media Metrix, 10m American internet
users visited four paid online-music services. The same month another 20m
visited file-sharing networks. The majors watch what is being downloaded on
these networks, although they do not like to talk about it for fear of
undermining their legal campaign.

Online music might truly take off if the majors were to make a truce with
the file-sharing networks. The gulf between the two worlds has narrowed now
that the industry sells its product online and allows customers to share
music using digital-rights management. As for the file-sharing networks,
"the other side is more willing to talk and less adversarial," says an
executive at one of the majors in Los Angeles.

Music industry executives say that Shawn Fanning, founder of Napster, the
first file-sharing network, is working out how to attach prices to tracks
downloaded from such services, with a new venture called "Snocap". Mr
Fanning tried to make the original Napster legal back in 2001, but the music
industry decided instead to sue it out of existence. Sam Yagan, boss of
eDonkey, currently the most popular file-sharing network, says he had
meetings with three of the four major labels last summer about how his
network could start selling their music alongside free content. As IE
Music's experiment shows, that is not an impossible dream. Music executives
may not have the confidence yet to make a deal with their arch-enemies. But
eventually they have to get bolder. It seems clear that the only way for the
majors to stay on top of the music industry into the next decade is to take
more risks-both technological and creative-than they have done for a long
time.