Online Music Hitting False Notes

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.