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Digital Music's New Battle Hymn

Over the past 10 weeks or so, Microsoft (MSFT) and America Online (AOL) have engaged in intense, multifaceted negotiations. They've labored to reach a deal covering everything from what the default Web browser will be for AOL's proprietary online service (currently, it's Microsoft's Explorer) to creating connectivity between the competing MSN and AOL instant-messaging systems.

But during the weekend of June 17, the negotiations took an acrimonious turn over a surprising sticking point -- digital music. The issue, AOL spokespeople claimed, was a Microsoft demand that the company remove competitor RealNetworks' (RNWK) media-player from AOL's ubiquitous client software (see "A Real Threat to Microsoft?").

That confrontation underscores the new realities of digital music -- tunes that are distributed via the Net instead of on a store-bought CD. Upstarts such as Napster and (MPPP) may have forced the pace of technological change and brought the idea to public awareness, but suddenly, the fight over the future of music on the Net -- and perhaps of the music industry itself -- has shifted to the industry's giants. "The muscle is lining up," says Doug Camplejohn, CEO of digital-music-subscription company MyPlay. In fact, Camplejohn sold out to publishing and music powerhouse Bertelsmann in May for just shy of $30 million.

INEFFICIENT. The draw of digital tunes is seemingly irresistible. Although consumers spend $38.5 billion a year on music worldwide, according to the International Federation of the Phonographic Industry, it remains an inefficient business, where the vast majority of products never make money. By taking advantage of the Internet and new digital formats, record labels and technology companies alike think they can improve margins and broaden their markets in much the same way that pay-per-view and video rentals significantly expanded the movie business (see "Q&A: EMI's Digital Music Maven").

With that prize in mind, over the past year the five largest record labels have either browbeat or bought out challengers that tried to woo paying customers away from free music on the Net. With the help of their trade organization, the Recording Industry Association of America (RIAA), the Big Five music labels have sued a host of Internet radio and streaming-music sites in an increasingly aggressive display of legal bravado. The RIAA has also won legal rulings that reduced the once-mighty Napster to near insignificance by forcing the company to screen copyrighted songs from its free file-trading system.

In April and May, meanwhile, the kings of the music establishment announced their own music-subscription businesses, to be launched sometime in the coming year. PressPlay (formerly called Duet) is backed by Sony (SNE) and Vivendi Universal (V), while MusicNet is backed by AOL Time Warner, EMI (EMIPY), Bertelsmann, and RealNetworks, which will also provide the technology platform. MusicNet will likely be built around a streaming-music model, but PressPlay hasn't yet revealed its plans.

CAPITULATION. Both groups say they'll license their system and content to third parties, a clear reaction to veiled threats of antitrust action from the U.S. Senate. However, exactly what subscribers will get from either system remains unclear -- including the details on which titles will be available for download or streaming access.

Napster itself has already signed up as a MusicNet customer, a further capitulation after it agreed last November to accept $50 million in financing from Bertelsmann in return for warrants allowing the media giant to buy a chunk of the file-trading company.

Microsoft, which has created an increasingly popular media player and a proprietary music-file format, clearly intends to crash the party. Redmond has said it hopes to offer a music-subscription service to its MSN customers, but it's likely to have trouble coming to terms with the big labels. "Microsoft is too big. It is a potential competitor of even the record labels. So there may be some resistance [from the Big Five] to adopting Microsoft's technologies," explains Matt Bailey, a senior analyst at digital entertainment consultancy Webnoize.

SCRAMBLED SIGNAL. While the jockeying by the various contenders has yet to play out, the future of digital music is coming into much clearer focus. For instance, negotiations between the warring parties are inching toward a resolution of intellectual-property and royalty conflicts involving Internet radio. Those talks cover a wide range of services, ranging from simulcasts of regular radio programs via the Internet to Net-only stations that focus on a specific genre to highly interactive programs of streamed music where listeners can sample and select songs and even set up personal playlists.

Thus far, Internet radio has failed to make money for anyone (see "Web Radio Pioneers Sing the Blues"). But most analysts believe that the lure of fine-tuned programming should prove strong over time. And advertisers could well take a liking to the medium's ability to precisely target audiences on a geographical or demographic basis. Other recent deals point toward a broadening of the industry's retail model -- away from one built around CDs and toward selling a wider array of goods and services.

Take the agreement that Andrew Rasiej's Digital Club Network and Sony Music Group penned on May 31 to beam concerts by Sony artists from 60 clubs around the country. Rasiej believes this is a sign that Sony is starting to embrace the new medium's marketing possibilities -- and that Webcast productions could enhance the value of music-subscription services. "Live concerts have always been promotional tools, and now they can be used more easily," he says.

BURN YOUR OWN. Music retailers are also adopting new strategies to take advantage of digital products (see "Facing the Digital Music at Record Stores"). Many are shifting the emphasis in their product lines away from CDs and toward more expensive audio and movie DVDs. The DVD format offers superior fidelity and longer playing times, which is spurring sales of concert videos, says Tom Thirkell, chief financial officer of Value Music Concepts, a Marietta (Ga.) chain with stores in 24 states and annual sales of $48 million. Thirkell's company, like other music retailers, has launched an online sales offensive that allows him to compete with the retail giants.

To make CDs more appealing, the labels are experimenting with ways of letting customers burn them their own. On June 5, Roxio announced that it had struck a deal with Big Five label EMI to create tools consumers can use to make their own disks. Roxio makes the top CD-burning software and is a favorite of music pirates (though the company contends the pirates represent a minority portion of its business).

EMI is clearly motivated by overwhelming customer interest. Roxio CEO Chris Gorog claims that 100 million consumers will have a CD burner by yearend. Many of them are using the technology to create their own musical mixes by burning MP3 files from their PCs onto CDs. This type of mix-and-match capability is something that labels have provided in only limited measure until now. "Consumers have spoken loudly that they know how to use that technology and would like to use it," says Jay Samit, senior vice-president for new media at EMI, who adds: "There are many value propositions that we can offer with CD burning."

REPULSIVE RESTRICTIONS. Music fans shouldn't mistake all these moves for an unambiguous embrace of all-you-can-eat music-subscription services, allowing free run of label catalogs. MusicNet has indicated that it will use copyright-protection software to prevent subscribers from burning CDs of tunes that are streamed over the service. In fact, many analysts expect the first round of new services to be so restrictive as to repulse many consumers. The labels themselves freely concede that they have no idea what consumers will pay for -- and how much they will pay. (What about you? Take our digital music poll, and let us know.)

Furthermore, a battle looms over standards for digital-music formats. The older MP3 format has dominated the consumer market until now, largely because of Napster and other free trading systems. That could change with Napster's decline, as it becomes harder for average Web surfers to find the MP3s they want. Both RealNetworks and Microsoft are offering technologically superior file formats and streaming-media systems with strong antipiracy measures and much better playback quality. As the ultimate victory of VHS over the higher-quality Beta videocassette illustrates, the more popular standard is most likely to win -- but which one will it be?

The record labels surely haven't embraced the MP3 format, and they'll likely exclude it from their new subscription services. That could contribute to confusion over which standard works best and under what conditions. And that could poison the consumer's experience.

"WRONG LESSON." "Do we really expect the sales guy in the store to understand that the portable player he's selling only handles a Windows digital-rights management system with a handful of subscription services?" asks Sean Ryan, the CEO of streaming-music company "People are thinking the trend [toward all-you-can-eat subscription services] is going to happen faster than it is going to. They have learned the wrong lesson from Napster." Fans of second-tier musicians may be particularly frustrated if, as some analysts expect, smaller Web sites devoted to independent bands disappear as more and more traffic migrates to established musical entities.

Accordingly, Ryan and others think it could be a few years before middle-level musicians figure out how to use the Web as their primary sales channel, outside the galaxy of the big labels. Likewise, the big labels, Microsoft, RealNetworks, and others may need up to five years to develop viable models for online distribution.

That's no surprise. Big shifts in media distribution usually take a few years to develop. But with fears receding that the music business music will be devoured by the Internet, it appears that many of the players with the power to make this transition happen are finally willing to sing along. By Alex Salkever in New York

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