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Online Music Hitting False Notes

Troy Wolverton

The online music business is booming, but is anybody making real money at it?

If you're doing the actual selling of music -- or music subscriptions -- to consumers, the short-term answer appears to be not much. Competition, marketing expenses, a faulty business model, slow-changing consumer attitudes and the use by some companies of music as a lure to sell other goods and services have all conspired to keep the business largely in the red.

And that's not likely to change anytime soon, no matter -- or arguably because of -- how many millions of songs Apple Computer (AAPL Quote) sells through its iTunes music store, analysts say.

"It's a long-haul business right now," says Aram Sinnreich, managing partner of Radar Research, a Los Angeles-based consulting firm. "It will be at least three years before anyone can make a serious profit selling digital music," largely because of the hold that Apple has on the market.

And even then, Sinnreich says, making money will require some serious changes in the way consumers are buying online music.

"Nobody will ever make money from selling 99-cent downloads" as Apple does through iTunes, he says. "There's not a margin in it."

Regardless of what's happening on the bottom line, though, companies are certainly seeing huge growth in digital music sales. The Recording Industry Association of America, for instance, estimates that the U.S. retail market for digital downloaded songs and albums grew to $503.6 million in 2005 from $183.4 million in 2004. The RIAA estimated that U.S. consumers spent another $421.6 million on ring tones and other mobile music content last year and some $149.2 million on music subscription services.

(The organization did not have estimates for prior-year ring tone or subscription sales, meaning that according to the RIAA's data, they effectively grew from a base of $0).

This boom has contrasted sharply with the overall music industry, where retail sales fell about 0.6% last year to $12.27 billion.

At Apple in particular, iTunes revenue is becoming increasingly important to the company's overall sales. The company groups iTunes song sales with sales of iPod accessories. In the first quarter, that unit tallied $491 million in revenue, or 8.5% of the company's overall sales, up from $177 million, or 5% of the company's sales, in the same period a year earlier. Apple has sold more than 1 billion songs through iTunes; citing data from Nielsen SoundScan, Apple CEO Steve Jobs has said that iTunes accounts for more than 80% of the total U.S. market for digital music sales.

That success to date has had some investors and financial analysts salivating at the company's prospects, giving yet one more reason to be bullish on Apple's shares.

But they may be getting a bit ahead of themselves. While Apple says iTunes is operating in the black, financial analysts generally estimate that the store is marginally profitable at best.

And even that performance seems to be a rare exception. Napster(NAPS Quote), which operates a rival online music services, is losing considerable money each quarter. Another rival, RealNetworks(RNWK Quote), has been consistently losing money on its actual operations, which exclude gains from investments or legal settlements, the company's real money makers of late. And few analysts think Yahoo!'s(YHOO Quote) music service, which is charging a bargain basement price of $5 a month for a subscription, is operating in the black either.

The problem digital music vendors face is that they haven't figured out a business model that works, analysts say. The industry is reminiscent of the early days of e-commerce, when everyone and his brother rushed in to set up a Web store but nobody had figured out how to turn a profit.

Selling downloads a la carte isn't a profitable business, because for every 99-cent song (like Apple sells), stores have to pay the music labels 65 cents or more, according to analysts' estimates. Add in marketing and technology costs, and the margins start to become very slim.

Many analysts see subscription services as the long-term future for the business, because they offer greater margins and recurring revenue. Indeed, Chris Gorog, Napster's CEO, estimates that the margins for subscription services are "four times" greater than those for individual downloads.

But today's subscription services aren't compatible with the iPod, which is by far the most popular digital music player. And Apple has shown no signs of losing its lead in the digital music player market or any interest in making iTunes subscription-based music -- or opening the iPod to other music services.

The iPod's success is holding back subscription services "to a tremendous degree at this point," Sinnreich says.

But other analysts say that's not all Apple's fault. Even if selling songs one-by-one online isn't great for music vendors, it's the method consumers are most familiar and comfortable with. Apple has made much of the idea that iTunes allows consumers to own, not rent, music, and that message has resonated with consumers who for years have been buying CDs and, before that, LPs and tapes.

For subscription services to take off, it's going to "require far more consumer education and changes in behavior compared to how they have traditionally purchased music," says Ross Rubin, an analyst with industry research firm NPD Group.

Some analysts believe that there's little future in merely selling songs -- or even subscriptions to digital music. Profitable companies will be those that defray costs in other ways, who use music to lure in customers for other services or products, or who see music as an incremental, not primary, revenue source.

Apple, for example, uses iTunes to support sales of iPods -- not the other way around. Cellular network providers are already making considerable incremental profits off ring tones, analysts say.

If so, the online world could end up looking a lot like the offline world, where music store companies have been closing and consolidating in recent years. In their place, most music CDs are now being sold through general or electronics retailers such as Best Buy (BBY Quote) or Wal-Mart (WMT Quote), companies that often use discounted CDs to lure in customers to buy other products.

MusicNow, the digital music service from Time Warner's (TWX Quote) AOL unit, is profitable, says Neil Smith. But that has a lot to do with being able to defray marketing costs across AOL's huge user base, he says. And selling subscriptions to MusicNow is just one piece of a larger strategy of marketing music and music-related content, he says.

At this point, the companies that make money on digital music "won't be the pure-play music companies," says Smith. "If history is any guide, the only people that make money [in music] are the [music] labels."