Online Music: Rewriting The Score

It won't be easy to move listeners who buy single tunes to subscription services

For years, many music execs have argued that offering online subscriptions is the best way to sell digital music. But, so far, Apple Computer Inc. (AAPL ) has called the tune. The maker of the iPod music player has trounced all comers by selling more than 400 million songs through its iTunes Music Store. Meanwhile, Napster (NAPS ), AOL (TWX ), and RealNetworks (RNWK ), which all offer subscriptions, have been left behind.

Now, it appears, Apple could get its first serious competition. On May 10, Yahoo! Inc. (YHOO ) unveiled its Music Unlimited service, at the introductory price of just $60 a year -- a third the price of existing services. And BusinessWeek has learned that mighty Microsoft Corp. (MSFT ) is waiting for the right moment to strike with its own low-cost introductory offer. "When you see us move into the space," says Rob Bennett, senior director of MSN Entertainment, "you'll see us try very similar things."

So can these online behemoths make subscriptions mainstream? It won't happen overnight. For one thing, changing consumer behavior -- renting, not buying music -- will take some doing. Also, it's hard to make money on new types of subscriptions that allow folks to download tunes to portable players, at least at Yahoo-like prices. That means subscription rates may remain higher than most people are willing to pay. Then there's the iPod: The most popular player doesn't work with existing subscription services. Compatible players will have to get a whole lot cooler before people start buying them. Says Jupiter Research (JUPM ) analyst David Card: "There's only one device that matters, and you can't use it with Yahoo's music service."

That said, the subscription model has plenty of appeal. So long as fans pay their monthly bills, they would get unlimited access to a million-plus songs -- and be able to play them on their PC, on the road, or, with some home-networking gear, on their stereo. And the music labels would have a powerful means to build a steady stream of recurring revenues from anyone who has a Net connection. Says David Goldberg, vice-president and general manager of Yahoo! Music: "Subscription services will replace the entire music purchasing experience."

To get there, some obstacles will have to be cleared. Consider the Apple issue. Since the company makes nearly all of its music profits from the iPod, it has little incentive to create a subscription service -- or to make iPods compatible with those that exist. Simply put, there's not enough demand. While the number of subscribers to services from RealNetworks' Rhapsody division, AOL, Napster, and others rose from 750,000 in 2003 to 1.5 million in 2004, iPod sales zoomed from 4.4 million in fiscal 2004 to 17.2 million this fiscal year and are expected to hit 22.2 million in '06. That's why Apple says it has no plans to join the subscription fray for now -- though insiders believe Apple could easily roll out its own service.

The big question: Can anyone make money selling subscriptions at Yahoo's attractive price? Yahoo wouldn't discuss the economics of its Music Unlimited business, but several industry sources say the business model probably isn't sustainable. These people say the online providers typically pay the music labels about $6 per person a month for a subscription that allows users to listen to music only on their PCs. The service in turn typically charges users $10 per month. After expenses such as the cost of server infrastructure and credit-card fees, that leaves a profit margin of about 30%.

That's the good news. However, for subscriptions that allow downloads to portable players -- which most people are likely to want -- the fee to the label increases to about $8. That's why RealNetworks and Napster charged $15 per month before Yahoo came in with its $7 offer. Yahoo does have special advantages; since it can easily market to its 176 million registered users, acquisition costs are low. Also, Yahoo already has in place much of the costly infrastructure needed to deliver this service to customers

But industry insiders say it's unlikely those pluses are enough for Yahoo to make money on its current music subscriptions. That's why many believe it will be forced to raise rates. "[They] need volume, [and] when [they] get it, the price will come up," says Amanda Marks, executive vice-president of Universal Music Group's (V ) eLabs digital distribution unit. Yahoo hasn't ruled out future price hikes.

Moreover, the labels may be in no mood to help. Many music execs believe Yahoo is charging too little and could get consumers hooked on unsustainably low prices. "The labels are very sensitive to the devaluation of music," says RealNetworks chief strategy officer Richard Wolpert. Says another digital music exec: "The music industry wants to get people hooked on subscriptions and then increase prices, just like the cable-TV guys do."

Clearly, it's early days for the online-music industry, which still represents just 2% of total music sales and likely won't get much beyond 12% by 2010, says Jupiter. Indeed, despite the iPod's success, most people fill their players with songs from CD collections. The average iPod owner has purchased just 25 songs or so via iTunes -- a couple of CDs' worth. If downloads haven't changed the way most people get music, perhaps subscriptions will. Yahoo and MSN are counting on it. But they've got a ways to go before they give Apple CEO Steven P. Jobs a reason to turn up the volume.

By Peter Burrows, with Ben Elgin, in San Mateo, Calif., and with Ronald Grover in Los Angeles, Jay Greene in Seattle, and Heather Green and Tom Lowry in New York

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