The Mighty Lure of Online Music

Even as the field gets ever-more crowded, the many players expect to make money by using their download sites to sell other goods

By Scott Kessler

It seems like everyone is in or is getting into the online music business. Apple Computer's (AAPL ) iTunes is the segment's leader. RealNetworks' (RNWK ) RealRhapsody and Real Player Music Store and Roxio's (ROXI ) Napster 2.0 are gaining traction (see BW Online, 3/1/04, "The Nine Lives of Napster")., EMusic, and Musicmatch are smaller industry players. In addition, we at Standard & Poor's expect Microsoft (MSFT ) to launch its online music service by June.

Amazon (AMZN ) and America Online (TWX ) are considering their options, and so is MTV. Record companies Sony (SNE ) and Virgin have indicated they'll join the fray this year. Even consumer giants Coca-Cola (KO ) and Wal-Mart (WMT ) have been experimenting with it.

Given this significant and increasing competition, can companies make any money in online music services? Perhaps, but just not in the ways you might expect.


  Apple has been leading the charge since it launched its iTunes Music Store in April, 2003, with much fanfare. iTunes sold over 30 million digital songs in 2003 at around 99 cents apiece. During the Super Bowl, Apple announced a promotion with PepsiCo (PEP ) to give away 100 million songs. iTunes is modestly profitable, but we think the greatest value in the service is that it drives demand for Apple's iPod music devices. It's helping Apple increase its market share in the MP3-player segment, and Jobs & Co. hopes its success will promote gains in the computer market as well.

While Apple developed iTunes internally, RealNetworks and Roxio built their online music offerings largely through acquisitions. RealNetworks bought in August, 2003, and Roxio acquired Napster in November, 2002, and Pressplay in May, 2003. Like Apple, both Real and Roxio use these services to promote their other offerings, which include products to create, deliver, and manage content. Roxio's online music division lost $15 million in the fourth quarter of 2003. RealNetworks does not disclose the profitability of its online music segment.

We expect Internet-oriented businesses such as, America Online, and Microsoft to use music-download offerings to enhance existing products and attract users to their Web sites and services. These three outfits already directly or indirectly sell a lot of music CDs, so enabling people to also buy songs digitally makes sense.


  Music downloads could also be used to supplement the current content and services (such as streaming radio) found on AOL Music and MSN's Entertainment areas. Microsoft would also probably benefit from increased use of its media software. The New York Post recently opined that the software giant has been quietly promoting the Napster 2.0 service, which employs a version of Windows Media Player.

We think record companies like Sony and Virgin will utilize their upcoming online music stores to better establish and develop relationships with their existing and potential customers. This will also make selling music more profitable because not only would they avoid paying for CD processing, packaging, and shipping but they would also be able to eliminate middlemen (and their take) from the process.

The reasons consumer outfits like Coca-Cola and Wal-Mart would offer online music services are a little less clear. Wal-Mart began testing its site in December, and Coca-Cola launched a Web service focused on Britain in January. We believe Wal-Mart's rationales are similar to Amazon's: Offering digital downloads would increase the ways a consumer could buy music from and drive incremental traffic and users to its Web site.


  In the case of Coca-Cola, which also has been working with Musicmatch in the U.S., we believe it's using digital music services to create interest and excitement around its brand, particularly with its core teenage consumers. Typically, soft-drink businesses are more creative and aggressive when it comes to advertising and marketing, and Coca-Cola's efforts in the online music area are indicative of this tendency.

Prominent partnerships between beverage makers and Internet music services also include PepsiCo with iTunes and Heineken with RealNetworks. We wouldn't be surprised if additional consumer-oriented companies began to pursue partnerships and offerings in the online music area to promote their own brands and products.

Although we believe music sales will continue to migrate online, digital downloads are already becoming commoditized. The real value of these services, in our view, is that they drive Web-site traffic and often stimulate use or purchase of associated offerings. Of the types of businesses exploring online music services, we believe the record companies could garner the most significant incremental benefit from increased revenues and lower costs associated with online music services.


  However, over the near term, we don't expect the record companies to be able to offer more than their own libraries of digital music, somewhat limiting their services' appeal. We also believe that business models predicated on free-standing online music services delivering significant profitability should probably be revisited, unless they have exclusive access to certain types of content.

To some extent, as a reflection of the fierce competition in this market, our recommendation on the stock of RealNetworks is 3 STARS, or hold. RealNetworks derived a notable 15% of its fourth-quarter 2003 revenues from online music. Still, we expect more participants to enter this area and that RealNetworks' offerings will become more commoditized.

Note: Scott Kessler has no stock ownership or financial interest in any of the companies in his coverage area. He's a registered representative of Standard & Poor's Securities, Inc. Other S&P affiliates may provide services to the companies under discussion.

Analyst Kessler follows Internet software and services stocks for Standard & Poor's Equity Research

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