Yahoo! Music the Latest to Fall on Apple's Sword

The online music subscription service market is shrinking.

The latest company to exit the market is Yahoo!(YHOO Quote), which has decided to move its subscribers to RealNetworks'(RNWK Quote) Rhapsody service.

The market shift underscores a point that Apple(AAPL Quote) CEO Steve Jobs has made all along -- namely that people like to own music and not rent it, a strategy that has paid off handsomely for the iPod.

Yahoo!'s exit leaves only three big players, RealNetworks, Microsoft(MSFT Quote) and Napster(NAPS Quote), remaining in the subscription music game.

Yahoo! said Monday it has partnered with Rhapsody, the digital music service from RealNetworks and Viacom's(VIA Quote) MTV Networks, to replace its music service with Rhapsody's.

In the next few months, Yahoo!'s music subscribers will switch to Rhapsody's digital music service. They will hold on to their existing pricing for a limited time before being charged a new fee. Yahoo! has claimed more than 25 million people visit Yahoo! Music a month, but only a fraction of them pay for the premium subscription service.

Yahoo! and Rhapsody also intend to partner on services like digital downloads -- a move that is unlikely to cause Apple to break into a sweat. Apple said more than 4 billion songs were downloaded last year from its iTunes store.

The deal sets the stage for a potential clash between the Yahoo!-Rhapsody service and Microsoft's Zune subscription product as Microsoft attempts to gobble up Yahoo!. Microsoft made a $44.6 billion, or $31 a share, unsolicited bid for Yahoo! last week.

"One of the problems with on-demand subscription services is that they haven't been able to go beyond a niche audience because most music lovers are on the iPod," says David Card, an analyst with Jupiter Research.

The RealNetworks-Yahoo! deal was about taking a competitor out, he says. "The marketplace is not very crowded now," says Card.

For Apple, the shrinking marketplace for music subscription services comes at a time when investors and analysts worry about the future of the iPod.

In the last quarter iPod sales grew 5% compared with 50% in the year-ago quarter, with growth in U.S. sales nearly flat. Apple has hinted that it will refresh the iPod line and turn it into a wireless mobile platform.

Apple shares closed down $2.10, or 1.6%, to $131.65 Monday. The stock is nearly 35% off from its 52-week high.

Last year, Apple also introduced music free of digital rights management. Since then Amazon.com has started offering DRM-free music in a move that some felt could eat into downloads from the iTunes store.

Yahoo Music's latest move shows Apple may have made the right bet. "Yahoo saw that all the major record labels have moved towards selling music without DRM, which makes it impossible to run a music subscription service," says Phil Leigh, senior analyst, with market research firm Inside Digital Media. "It also shows that the dominant player in the market is iPod and it has set the standards."

Cramer: Who Does Yahoo! Think It Is?

The Yahoo-Rhapsody deal also raises not just questions of potential competition in the future between Microsoft's Zune platform and the Yahoo-Rhapsody service but also Microsoft own strategy with the Zune.

"If the Microsoft-Yahoo merger is completed, we believe the integration of the two companies will be a lengthy process and competitive conflicts between Microsoft's online music store, its Zune digital media players and the Rhapsody service will likely emerge but over a longer timeframe," says Ingrid Ebeling, an analyst with JMP Securities in a research note. JMP makes a market in RealNetwork shares.