Slouching Toward Digital

Amazon may finally allow record labels to give iTunes a run for its money. But the e-commerce giant will also test the labels' tolerance for lower pricing's (AMZN) new music download service amounts to a grand experiment for record labels, many of which have agreed to sell their tunes for the first time without restrictions against copying and other digital rights management (DRM) protections. But Amazon's online store will also be a crucial test for just how flexible the beleaguered music companies are when it comes to pricing.

For the past several years, music executives have been desperately looking for a viable alternative to Apple's (AAPL) dominance in online music with its iTunes Music Store. Amazon, with its deep expertise in e-commerce, loyal following, and powerful brand, is exactly the kind of competitor that the music industry wanted. And unlike iTunes, where each and every song will continue to be priced the same, the new Amazon service is allowing the labels to have variable pricing. Most experts believe sales at the AmazonMP3 store, which opened Sept. 25, have been brisk and that Amazon is already the clear No. 2 in the market. Sony BMG's confirmation Jan. 7 that it will drop DRM for shoppers who buy music using gift cards for selected stores only increases the pressure for music companies to find new ways to sell downloads.

Record Labels Get Pricing Power

Being able to sell, say, a song off the new Alicia Keys album at a higher price than an old Bachman-Turner Overdrive tune is something the record companies have long wanted to be able to do on iTunes. But Apple Chief Executive Officer Steve Jobs has refused to budge, charging 99¢ per song (labels take home about 70¢ of that). While most songs now sell for 89¢ on Amazon, sources say, the record companies have the ability to vary what they charge the site—with two weeks' notice—in an arrangement similar to the wholesale rate card they offer bricks-and-mortar retailers. So the record companies can charge different rates for each song on an album, and Amazon sets the retail price. (Some record execs have said some wholesale prices are as high as 89¢ and that in order to stimulate sales, Amazon is choosing to forgo a profit on some songs).

Bill Carr, Amazon's vice-president for digital music, won't discuss terms of Amazon's contracts with the labels. But he says Amazon isn't running the business to be a loss leader: "Our business has to be profitable on Day One."

So far, the Amazon experiment seems to be yielding good news for labels. Besides the low prices, customers like the ability to get a wide variety of music that's free of antipiracy strictures that limit the type and number of devices they can play it on—especially after Warner Music Group (WMG) agreed to provide its catalog, sans DRM, in December. If Sony BMG follows suit as expected, Amazon will be the only site with music from all of the major labels that will play on an iPod, other than iTunes itself. Paul Verna, an analyst with eMarketer, says he thinks Amazon could easily grab a 20% share of the digital download market that's now dominated by Apple. Amazon hasn't released any numbers, but Carr says "we're really, really pleased with our early results."

Lower the Prices, Turn Up the Volume

The big question is, just how low are the record companies willing to go on prices? There has long been a school of thought in the industry that lowering prices substantially devalues music, and that's been anathema to music executives who see so much of their music downloaded and swapped for free.

But Amazon may present an opportunity to break from the entrenched thinking by selling tunes for much less and making up for it on volume. If iTunes broke the longstanding model of selling packaged music by letting consumers pick songs à la carte rather than forcing them to buy entire albums, then Amazon might be able to change the model on digital pricing. "There's a leap that needs to happen for the labels to adopt a pricing model that's more like the [music] publishing industry," Ali Partovi, CEO of iLike, told BusinessWeek in an interview late last year. Partovi's company is an online service that provides music recommendations and social networking for music fans. "Last century, publishers transitioned from selling sheet music to taking a smaller piece of a bigger pie [that is, getting a fraction of a cent when songs were played on the radio]. Publishers make a lot of money that way. The recording industry has had a lot of trouble making that jump. The leap they have to make is to agree to get a smaller share of a much bigger pie."

Says one top executive at a major Internet company's music division: The labels "have tried to build scarcity on the Internet, which is an oxymoron. They should say, 'How do we leverage the scale of the Internet? How do we get people everywhere listening to music?'"

Second-hand Sales: Pro and Con

To see the awkward position music labels are in, look no further than Amazon's own CD listings. Amazon's customers are increasingly turning to used CDs. Third-party sales by merchants across all Amazon products, much of those for used goods, now account for 32% of all the site's transactions. That's up from 19% in 2003. Just one example: On the Amazon page for Mary J. Blige's album Growing Pains, released Dec. 18, a new version sells for $7.99, but directly below it is a used version going for $6.45.

That steams the record labels, which don't make any money on sales of used CDs. The music industry can ill afford to have anything else pinch its faltering CD business. Album sales dropped another 15% last year, according to the most recent sales figures released by Nielsen SoundScan. That follows years of CD sales declines, which forced big retailers like Tower Records into bankruptcy and prompted other large chain stores to reduce the shelf space devoted to CDs.

Record executives decline to comment publicly about Amazon's new- and used-CD sales practices for fear of alienating their new partner for online sales. They say in private that Amazon should be extending a good-faith effort to the record labels by altering their policy to sell used and new together. "Nobody is happy about this but it's a little touchy right now with the new download store," says one executive. "You will begin to see a lot of pressure exerted on Amazon going forward," says another executive.

So far, Amazon's Carr says he has yet to hear any complaints on this score. "In my dealings with record labels over the past 12 to 24 months, it hasn't been brought up once. By and large, the labels are thrilled with us," he insists. He says Amazon is the only big retailer that has posted increasing CD sales for the labels in recent years, for a number of reasons. Unlike physical retailers that are trimming the size of their CD sections, Amazon carries all of the labels' inventory, from hits to obscure B-sides. And unlike Apple, it offers the music in either digital or CD form, which is still the biggest part of the market.

Carr goes so far as to insist that Amazon's used-CD business is good for the labels. He won't share specifics, but he says Amazon's sales of new CDs increased after the used business began to take off a few years ago. That's because it made the site more of a one-stop shop for music fans, who were exposed to new stuff as they trolled for used bargains. "Customers obviously want that choice [to buy used CDs]," Carr says. "If the only choice was to go to sites that only sold used, that obviously would not be good for the record companies."

Viewed as part of a bigger picture, the surge in third-party transactions at Amazon is just another sign of the enormous pricing pressure all media is facing. Some newly released DVDs, for example, sell for as low as $7 today. One reason may be that unit sales of DVDs fell nearly 5% in 2007, the first big decline since the format was first introduced in 1997, according to DVD sales tracker Adams Media Research. On the music front, Rich Greenfield, an analyst at Pali Research, says wholesale prices are coming down for CDs, thanks to the leverage being exerted by such big retailers as Wal-Mart Stores (WMT). But, he warns, music executives need to do more. "Cut prices or lose even more floor space," says Greenfield.

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