Tuning Up for the Online Music Business

Making a buck selling songs online will be tough, but a raft of sites are at the ready

For years, record companies squelched efforts to sell tunes online, for fear of Napster-style piracy. Now, suddenly, the floodgates are opening. Giants ranging from Dell (DELL ) and Sony (SNE ) to Amazon.com (AMZN ) and Wal-Mart (WMT ) are scrambling to set up Web music stores. So are a number of smaller players including -- yes -- a revived Napster, which is being relaunched by Roxio (ROXI ) Inc. this month. Also within weeks Apple Computer (AAPL ) Inc. will likely go ahead with the much-anticipated launch of its iTunes online store for Windows users. "Within a very short period," says Dell Inc. CEO Michael Dell, "the labels will want to be on as many music stores as they can."

With at least a dozen players likely to enter the market over the next few months, competition will be fierce. Just as the real world has everything from Wal-Mart to the indie record store, the new entrants are looking to carve out niches. Two classes of winners will likely emerge: those with sufficient scale to convert meager per-song margins into meaningful profits and those that use music to sell add-ons, be it hardware, subscriptions to online music magazines, or concert tickets. Says Jonathan Hurd, a vice-president with management consultant Adventis Corp.:"The ones that get the customer experience right will benefit -- but there are many ways to mess up."

To avoid that fate, the new services will largely mimic the business model Apple created for its popular iTunes site. Most will sell songs for 99 cents apiece. Users will be able to burn the songs to as many CDs as they want and play them on up to three PCs or mobile devices. Music execs hope that will provide listeners with the flexibility they crave while preventing mass copying and file-sharing.

TOUGH ECONOMICS. But even at 99 cents a song, making profits selling music online could prove tough. Under existing arrangements, 75 cents or so will go to the label, and credit-card processors will pocket another 5 cents. That leaves just 19 cents for marketing, technology, and all other costs. The rush for market share will almost certainly force services to slash prices -- and to find other ways to make money. Earlier this year, Listen.com experimented by charging 49 cents a song but ultimately retreated to 79 cents -- and only for those with a $9.95 subscription.

So why the rush to jump in? For hardware giants such as Dell, Sony, or Apple, the real money will be made selling music players. Dell is clearly counting on its online music offerings to create demand for its new player, the DJ, set to launch this month. And for Wal-Mart, which accounts for 20% of all music sold in the U.S., it's too big a market to ignore.

Smaller players are counting on selling premium content. For a monthly subscription of $10 or so, customers of Musicmatch Inc. and Napster 2.0 will get a range of perks -- say, exclusive recordings or the ability to easily buy a song heard on a Web radio station.

Whatever the model, getting downloaders to pay for online music will mean giving them sufficient control over their songs. Already, there are signs that the labels will be slightly less flexible with the vast Windows universe than they were with Apple; with 2% of the market, it was less of a piracy concern. Industry insiders say that to discourage users from sharing playlists of, for instance, dance or jazz tunes, EMI (EMI ) Group PLC has forced the services to reduce the number of playlists consumers can burn to a CD to five, for example. That's down from 10 at iTunes.

Other limitations could also give music fans pause. Many new songs won't be available, and acts such as the Beatles still won't be online. Different services, moreover, will use different technologies to ensure customers don't cheat on copying or downloading. Without standards, users will find their portable players won't play songs from every online service.

Still, a year from now, many kinks will be gone. The best services may match the elegance of iTunes, and prices will probably have dropped. That's the best news music fans have heard in a long time.

By Peter Burrows in San Mateo, Calif., with Ronald Grover in Los Angeles, Jay Greene in Seattle, and bureau reports

    Before it's here, it's on the Bloomberg Terminal.