Online Music Singing the Contraction Blues

What was once a minor buzz about strategic moves in the online music sector is now hitting a crescendo over whether a shakeout is looming and which companies will be left with all the chips.

With the bigger players — Microsoft , AOL , RealNetworks , Apple and
Sony Music — all putting their cards on the table, the hedge-betting has
set tongues wagging about possible acquisition deals coming down the
pike.

RealNetworks set the train in motion with its minority
investment
in Listen.com, which runs Rhapsody, a competitor to
Real’s own MusicNet. Within days, Pressplay backer Sony acquired a minority interest in MusicNet, a clear sign of things to come.

RealNetworks declined details on its Listen.com investment but
well-placed sources tell internetnews.com the cash-for-equity
transaction included an option for Real to buy the company outright and
analysts expect that deal to be the first in a series of acquisitions that
will leave
the fee-based music services in the hands of a select few.

Greg Lee, research associate at Raymond James & Associates, is impressed
with Listen.com’s Rhapsody service,
which offers custom radio stations for $4.95 per month and a $9.95 monthly
plan that allows unlimited streams and access to burn songs for 99 cents.
Yet, despite being what he described as a “top-shelf service,” Lee doesn’t
believe Rhapsody can survive the inevitable shakeout.

‘Forget the service, it’s about marketing’

“This business is about marketing. Getting the content and the licenses
has become easier and easier
but, unless you have that marketing power of an AOL or an MSN, it’s really
tough to companies like Listen.com and FullAudio,” Lee explained.

Like Listen.com, FullAudio has integrated a strong radio
hook
in its revamped MusicNow service, which hawks unlimited tethered
downloads and streamed songs for $9.95 per month.

For Chicago-based FullAudio, the likely buyer would be Microsoft, a
company it already has a tight
relationship
with. Once RealNetworks uses its buyout option on
Listen.com, industry watchers say Microsoft will then acquire FullAudio. Pressplay, which is co-owned by Sony and Universal and had distribution deals with Microsoft and Yahoo would remain a competitor.

That scenario would leave MusicNet in the hands of AOL and Sony;
Listen.com as a RealNetworks subsidiary, FullAudio as a Microsoft-owned entity and Pressplay as a Sony/Universal initiative. All would have the
five major record labels
(including Sony) as minority stakeholders.

Confused yet? Right, that’s exactly the state of play until all the
hedging of bets plays itself out,
analysts explained.

FullAudio chief executive Scott Kauffman declined to comment on the
likelihood of Microsoft gobbling up his company. “We’re a venture-backed
company and our job is to build asset value for our investors. We’re ten
days into launching a new service and that’s our priority. As we start to
build a roster of consumers who first sign up and then renew their
membership, we’ll create a very attractive business,” Kauffman told
internetnews.com

But, because FullAudio’s MusicNow service is exclusive to Microsoft
Windows Media Player, and with the software giant’s public mission to turn
the Windows XP operating system into a full-scale multimedia entertainment
platform, it’s a logical bet FullAudio is already being courted by
Microsoft.

‘Contraction is inevitable’

Jupiter Research digital music analyst Lee Black agrees contraction is
inevitable. “Can Listen.com or
FullAudio survive for another year? No. They need to have that powerful
distribution arm. They both have
compelling features and they’re both selling at an acceptable price range
but it has not quite panned out
because they don’t have that portal backing,” Black said.

“The struggle is to sign up customers. They already have the licenses
and the technology infrastructure. The struggle to get customers will be
tough without a portal partnership. Portals come with a huge amount of
traffic and loyalty. And, portals come with integrated billing, which is
crucial,” he added.

Raymond James & Associates’ Lee agreed. “If the product is great and no
one knows about it, it’ll
eventually fade away. They really can’t compete with MusicNet and Pressplay,
which are marketed on AOL and
MSN. If AOL is running advertisements throughout their network and put a
big ad on the AOL main page for MusicNet, how can Rhapsody or FullAudio
compete with that?,” He argued. “They (AOL) have the money to subsidize
with free trials for a while so that’s tough to beat. That’s why I believe
contraction is inevitable.”

FullAudio’s Kauffman dismissed any suggestion that his MusicNow service
is devoid of any marketing muscle, pointing out its close association with
Microsoft’s WMP as one area where the service has a big-name outlet. “We
market through channel partners, Microsoft being one of them. We have all
the marketing muscle of those channel partners, including EarthLink,” he
said. FullAudio provides the backend technology that powers EarthLink’s
digital music service.

“Our marketing costs, in many respects, are shared with our channel
partners,” he explained.

Lee is unconvinced FullAudio can survive the shakeout. “My estimate is, a
year from now, we’ll see everything being centralized. There will be about
three or four big music services, all owned by the bigger companies,” Lee
said. Even the new entrants to the market, like Apple with its planned
service for Mac users
, will be brand-name firms with a built-in
marketing arm.

“Apple is in an unique position. They have a rabid fan base of Mac users
who will purchase their music subscriptions just because it has the Apple
brand,” Yankee Group analyst Ryan Jones said in a recent interview.

Even Roxio Inc., which is planning a legitimate
comeback
for the Napster brand, already has a user base available with which
to market the service. The company is a big player in the CD and DVD burning
software market, and would build a marketing plan marrying software to
services.

Don’t rule out Roxio from the buying spree, Greg Lee
warned. “It’s a possibility
that Roxio will be busy on the acquisition front. They can slap the Napster
name on any of the existing
services and create something big. The Napster brand is very valuable. It’s
a name people associate with
music downloads,” he added.

“Roxio has a decent amount of cash on hand. If they really intend to get
a service out there, they would acquire someone just to get the necessary
licensing deals.”

Is the price right?

While the labels and services are sticking to the $10 per month price
point running alongside 99 cent per song downloads, some analysts are
questioning whether that’s a comfortable price for consumers.

AOL’s relaunched MusicNet is offering 20 streams and 20 downloads for
$3.95 per month and an $8.95 per month plan for unlimited tethered
downloads. A pricier $17.95 per month option on the AOL service will allow
users to burn 10 songs to a CD. Pressplay, by comparison, also offers radio
stations and unlimited tethered downloads for $9.95 per month in addition to
song downloads that allow for CD burning.

But that price tag is still out of the reach of the music fans they’re
targeting, according to consultant Kurt Hanson, publisher of the popular RAIN newsletter. “I’m not convinced
that adults are sold on a subscription model for music purchases. Clearly,
there’s a segment of young people that have embraced that model but the
target market isn’t rushing to sign up, especially at those price points,”
Hanson said.

At $1.00 per song download, Hanson argues it’s cheaper to go to a retail
store and pick up a CD that comes with all the frills like lyric sheets and
album covers. “When I buy a CD, I have the right to put it on my hard
drive, on a playlist and I can even take it in my car. If I buy the digital
download, it’s the same price but I don’t get the opportunity to burn it
unless I pay extra. The pricing is similar but they’re offering less
value,” he argued.Hanson believes the labels must concede further on pricing and make it
“significantly lower” if they expect adults to be reaching for their credit
cards at the online music services.

Greg Lee agrees. “I expect more tweaking with the prices. We have seen
that people aren’t readily willing to pay 99 cents to download a song.
(The labels) are ignoring the fact that song download is available for
free, even if it’s illegal,” he said. Like Hanson, Lee argues that the
current pricing structure works out to the same as walking into a retail
store and picking up a 20-song CD. “There has to be a volume discount or a
package to hook buyers. That price just isn’t going to fly,” he argued.

Barely breaking even

The problem for the music services is that the record labels control the
pricing. For instance, sources say, the licensing deals are structured to
ensure the labels as much as 78 cents for every $1.00 song downloaded and
burned. The subscription services, which must cover bandwidth, storage and
other overheads, are finding it tough to breakeven, even at $1.00 per song.

The licensing deals are sometimes tiered in a way that the music services
pay as much as 78 cents on the $1.00 download on newer tracks and a little
less on older songs. The weighted average is between 73 cents and 78 cents
per song. When the services price the download/burn at 99 cents each,
they’re lucky to eke out 2 pennies per track, one insider explained.

Because of that, the subscription services aren’t rushing to adopt the
download-and-burn model, preferring to concentrate on hawking the on-demand
listening option.

FullAudio’s Kauffman refused comment on the licensing terms set by the
labels but conceded the download/burn model hasn’t taken off. “Our target
audience has not shown a high tendency to burn songs. That’s not a key
driver in the market,” he explained.

Some believe the labels are content to keep the price high and wait out
the ongoing litigation against the illegal file-sharing services which offer
free alternatives. With the well-chronicled victory over Napster and
similar lawsuits against Kazaa before the courts, the thinking is that the
recording industry is willing to spend big until the P2P networks are
outlawed.

The labels are gambling. They’re waiting out the eventual demise of the
‘illegals’ and pushing the development of the subscriptions services
simultaneously. If they lower the prices on the music services and the
illegal networks disappear, it will be tough to increase the prices. They
might end up undercutting themselves,” Lee said.

“If consumers get comfortable with, say, 25 cents per song, it’ll be
impossible to get it back
to a buck. I think the labels are dragging their feet to protect their
interests.”

Still, Lee believes the labels must concede on a price break. “The $1.00
per song price tag is excessive. I think it has to be less than 50 cents if
they are to attract critical mass. I’d be interested in the results of the
Rhapsody 49 cents-per-song promotion with Lycos. I think you can get the
volume if you price it attractively.”

Jupiter Research’s Black disagreed, noting that research showed the
$10/month 99 cents per song price had gained traction with consumers. “If
someone’s been downloading a lot of free stuff, of course they will expect
the price to be less. But, $1.00 per song is right there in terms of what
consumers are comfortable with,” he said.

“On or offline, $1.00 per song is typically a decent price. People pay
$1.00 for a ringtone. It’s still only a buck,” Black said.

Instead of just slashing prices and killing the golden goose, Black
suggested the music services might want to offer creative bundling. “You
don’t want to lower your price but you can keep it at $1.00 and sell two or
three downloads for that price. Keep the price point high, but increase
volume,” he said.

Amidst the disagreements over pricing and strategies, the analysts all
agree music subscription will be a game only for the big boys. “When you
have such a small group of players, there’s a lot of shuffling
that can go on behind the scenes. That’s what we are going through now. I
think it’ll all clear up within a year,” Black said.

When the music stops, it’ll be a case of who’s able to grab the last
remaining chair.

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