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Online Music's Elusive Bottom Line

Music retailer MusicLand has high hopes for its new music downloading Web site. Graze Music, which opened Nov. 16, sells songs, shows users where to buy concert tickets, and is aimed at luring customers to the outfit's retail stores or a separate site where they can buy a host of other products. One thing it won't be doing, says Robert Willey, a MusicLand senior vice-president, is make money.

His is among a growing roster of companies -- from brick-and-mortar retailers like Wal-Mart (WMT) to Web players such as Yahoo! (YHOO) and wireless-service providers including Sprint Nextel (S) -- that are piling into online music downloading (see BW Online, 10/27/05, "Sprint Races Into Mobile Music"). They're responding to the rising tide of buyers who want songs fast, easy, and over the Internet.

But like MusicLand, all face a vexing challenge: How to make music downloading profitable. It's one that's plagued retailers and recording executives alike since at least the early days of Napster in 1999. Now it's taking on added urgency.

PIRATES SURVIVE. The music-downloading market is crowding faster than ever. iMesh, a file-sharing company that shut down after it ran afoul of the recording industry in 2004, just launched a new, legal version of its service on Oct 25. Time Warner's (TWX) America Online pushed further into online music Nov. 3, when it acquired Web-based subscription service MusicNow from Circuit City for between $3 and $5 million, according to people familiar with the deal. Verizon Wireless is expected to debut its own music service next year.

Music labels are clamoring for a bigger share of sales, the cost of luring subscribers is on the rise, and compact disk sales are dropping -- about 7% a year.

And even after a decision by the U.S. Supreme Court effectively shut down file-sharing pioneer Grokster and left other downloading companies like eDonkey scrambling to find legitimate partners, there's still a host of underground programs like FrostWire that let users download .mp3 files for nothing. "At the end of the day, we're still competing with free," says Dave Goldberg, in charge of Yahoo Music Unlimited, a music subscription-service (see BW Online, 10/24/05, "A Hard Ride for eDonkey").

SLIM PICKINGS. So how does one make a buck selling songs online these days? Computer maker Apple (AAPL), the market leader, has a pretty good approach. Apple, which sells about 1.8 million songs a day at 99 cents apiece, has sold more than 600 million tunes since the debut of its iTunes music site in April, 2003. But even it has had mixed results. Sales of digital music have failed to keep pace with demand for iPod digital music players, according to Fulcrum Global Partners.

The number of songs downloaded per iPod recently has declined to 15 a year, as of 2004's third quarter, vs. 25 in the year-ago period. Apple also ekes out the slimmest of margins after compensating rights holders with a fixed percentage of the cost of a song (as high as 70 cents on the dollar, according to David Card at Jupiter Research) and paying credit-card companies processing fees for each transaction. It also faces pressure from record companies to switch to a more flexible pricing structure (see BW Online, 9/29/05, "Why Apple Won't Up-Charge Downloads").

Apple isn't the only one feeling the heat from labels, says Jonathan Potter, executive director of the Digital Media Assoc., a trade organization that represents companies with online music services, including RealNetworks, MusicNow, and Yahoo. "Every CEO of every online music company feels the pain every year when [record label] deals are up for renewal" says Potter.

RENT VS. BUY. Other players, such as Napster, Real Networks, and Yahoo, let users listen to an unlimited amount of music as long as they pay a monthly subscription fee. Napster, which charges $9.95 a month, saw a 150% increase in second-quarter revenue, to $23 million, but continued to lose money -- $13 million in that quarter.

Real Networks, which owns leading music-subscription service Rhapsody, saw $25 million in music-related revenue last quarter, but declines to say whether the subscription service is profitable. Analysts say Yahoo's 4-month-old subscription service is likely breaking even or in the black, since it was able to skip high marketing and customer-acquisition costs by targeting its millions of existing users. Yahoo Music General Manager Goldberg declines to break out revenues or profits for the unit.

Still, Yahoo's subscription model, where users can "rent" an unlimited number of songs that they can play from their computer as long as they keep up payments, may be the most likely path to success. "The subscription business can support much better margins" than Apple's pay-per-download model, says Card. "I think there is a real business there" at current subscription rates.

PICK YOUR PARTNER. In this model, the music service agrees to set aside a certain dollar amount per subscriber for the record labels, publishers, and artists. Then, that total kitty is divvied up depending on how many times users listen to each song. Profit margins can be between 25%-40%, says Matt Graves, a spokesperson for RealNetworks.

Regardless of the margin, services' success will ultimately rely on whether they can secure a large user base, say analysts. That puts large Internet companies with huge existing audiences of Web surfers at a big advantage. "AOL and Yahoo are both going to make a strong run here," says Ted Schadler, an analyst with Forrester Research.

Meanwhile, independents will need to seek partnerships fast. Rhapsody has sought partnerships, like with Internet-service provider Comcast (CMCSA), in hopes of boosting its exposure to users. Without existing clout, the smaller independent players make the risk of falling by the wayside. "It wouldn't surprise me to see Napster get bought." Says Schadler.

BEING THERE. In many cases, more companies may use the pay-per-download model as a marketing tool rather than as the basis for a full-fledged retail operation, say analysts. Companies say they still feel compelled to maintain a presence in online music, both to get a toehold in a growing market and give a complete product offering.

That's the plan for MusicLand. "It's about being where your consumer is, making sure we sell the types of products and services they buy," says Willey. And with consumers spending more time and money on the Web, any player that wants to sell music needs to be there, too -- whether they can make money from it or not.


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