The Fall of Music Downloads

After learning to live with less profitable digital sales in the post-CD era, the music industry is getting hit again. Downloads of songs to iPods, computers, and other devices have stalled, researcher Nielsen SoundScan reports, growing just 0.3 percent this year. Even worse for music companies, an earlier digital moneymaker, ringtones, peaked in 2007 at $714 million and have since fallen 24 percent, according to the latest data from researcher SNL Kagan. "Digital downloads are clearly becoming a mature part of the business," says Howard Bass, a senior partner at Ernst & Young who advises entertainment companies. "The question is how quickly the music industry can adopt a new digital strategy."

The number of music enthusiasts using iTunes, (AMZN), and other digital music stores has leveled off at about 40 million people, market researcher NPD Group reports. Audiences increasingly are turning to ad-supported streaming sites such as Pandora. While growth in downloads may pick up this year, Pricewaterhouse-Coopers says, it won't be enough to keep the overall industry from shrinking. U.S. sales of all kinds of recorded music—CDs, downloads, and other formats—will fall to $7 billion in 2012, or a bit more than half their level in 2005, before climbing slowly, according to PWC. "The days when people were building their digital collections or might hear a song and buy digitally are diminishing," says Russ Crupnick, an analyst at NPD.

The major labels are scrambling to come up with alternatives. The industry's leaders, Universal Music and Sony Music Entertainment, are among the backers of Vevo, an ad-supported streaming website. No. 3 Warner Music Group (WMG)wants new acts to sign what the industry calls "360 deals," which generate revenue from music, merchandise, and concert sales. All the big labels have licensed songs to subscription services such as Rhapsody and Rdio. The problem is those services are far less profitable than sales of individual tracks. "It could take 200 streams to make up for a single download," says Robb McDaniels, chief executive officer of INgrooves, which distributes music online.

To squeeze more money from downloads, the big labels last year persuaded Apple (AAPL) to raise prices from 99 cents to $1.29 for the newest hit tunes. Warner in February said the higher price may have contributed to slower growth in downloads last year, though its overall digital music revenue grew by 12 percent in the quarter ended in March. Universal says revenue for its stable of artists such as U2, Justin Bieber, and Lady Gaga fell by 1.7 percent in the quarter ended Mar. 31, largely a result of weak ringtone sales.

One area that continues to grow at a troubling rate is pirated music. "This isn't a mature market, it is a market that's getting pirated," contends Strauss Zelnick, former chairman of Columbia Music Entertainment. Still, Zelnick concedes that value-minded consumers who might have spent money to download their tunes have gone elsewhere. "When disposable income is tight," he says, "a lot of them would rather spend for things like video games that can't be pirated."

The bottom line: As digital downloads slow, the music industry is scrambling for a strategy to keep revenues rolling in.

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