"Nearly a year later, not much progress has been made, contributing to the struggles of digital music stocks."
Morningstar.com
Profits of Digital Music Are Still Far Off
By George E. Nichols
When I visited the digital music landscape last July, I bemoaned the chief obstacle to success: the lack of legally available music from popular artists. Nearly a year later, not much progress has been made, contributing to the struggles of digital music stocks.
I also lambasted market leader MP3.com (Nasdaq: MPPP - news) as a poor investment vehicle, since enthusiasm for the stock was propped up by many misconceptions. Now, the stock is down 85% from its IPO peak.
Although MP3.com CEO Michael Robertson deserves credit for creating a business before music industry executives even knew how to spell MP3, his jihad against the music labels alienated MP3.com from the gatekeepers that control nearly 90% of popular music. The company has been mired in so much litigation that shareholders may be wondering if MP3.com is a Philip Morris in the making.
MP3.com has settled litigation with two of the major labels so far, and it gained some access to their popular music, an important breakthrough. Nevertheless, the labels remain distrustful of MP3.com and are choosing to back other companies, including ArtistDirect (Nasdaq: ARTD - news), Listen.com, and MusicBank.com.
Beyond its legal problems, MP3.com still doesn't generate strong commerce revenue and is increasingly dependent on advertising. For the first quarter of 2000, e-commerce revenue constituted 3.8% of net sales, a sharp decline from 15.9% during the same period a year earlier. Ads, however, are dependent on eyeballs, and MP3.com's traffic growth is stagnating.
For MP3.com and the rest of the industry to take off, music labels must make their popular content available in digital format, which they have been in no hurry to do. This new business model is a radical departure from their expertise in building relationships with traditional music retailers, like Musicland (NYSE: MLG - news), and radio stations.
The labels (and artists) don't want to move online until copyright security can be guaranteed. However, it is practically impossible for digital-rights management companies like Intertrust (Nasdaq: ITRU - news) and Reciprocal to come up with technology that is both hacker-proof and user-friendly.
I visited the home pages of major labels and found downloads for sale only at Sony (NYSE: SNE - news). But the company's effort is half-hearted so far, with the music of only 39 artists available for download. Consumers can buy vinyl LPs from 106 Sony artists. Also, these downloads are being sold at an exorbitant $2.50 per song.
So it's no surprise that music fans embrace black-market exchanges, including those facilitated by the Napster file-exchanging software. Despite the dearth of digital music commerce revenue, the popularity of MP3 continues to skyrocket, thanks to the proliferation of free, illegal files. A recent study showed that 57% of college students surveyed are at least weekly users of Napster, and dozens of colleges have shut down Napster access after music downloads began to clog their networks. Other programs, such as Gnutella, allow users to freely exchange files of any kind. The labels have little control over this, so they need to focus on offering downloads for sale soon, even if they aren't guaranteed a perfectly secure environment.
Because the digital music market is still in its infancy, it's tough to be sure who the eventual winners will be. If you're willing to stray beyond struggling pure-play digital music stocks like Liquid Audio (Nasdaq: LQID - news) or Emusic.com (Nasdaq: EMUS - news), some notable names are America Online (NYSE: AOL - news), Sony, and Sandisk (Nasdaq: SNDK - news). All of these companies will benefit from the rising popularity of digital music, and they generate healthy cash flow today.
The combined Time Warner/AOL is shaping up to be a giant in this market, as my colleague Pat Dorsey pointed out. AOL owns popular digital music software and Time Warner (NYSE: TWX - news) is home to one of the largest catalogs of pop music. The only other tech-savvy music label worth looking at is Sony. In addition to its stable of pop music, the company sells a portable MP3 player that uses flash memory. Manufacturers of flash memory are scrambling to keep up with demand, thanks to the boom in portable devices. Sandisk is a major player in this industry. Sandisk flash memory resides inside 78 models of MP3 players, as well as in a forthcoming cell phone that plays MP3s.
Regardless of who benefits, the digital music marketplace has developed more slowly than originally anticipated. There definitely is strong demand; a recent survey showed that many users would be willing to pay $15 monthly for Napster-like services. But the market will develop only as fast as the $38 billion recorded music industry can take its baby steps toward digital music.
George E. Nichols can be reached at george_nichols@morningstar.com.
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