How MP3 Will Break the Record Companies

Downloadable digital music will profoundly change the entire structure of the music business.
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Let's dig back into the downloadable digital music market once more, for a look at this phenomenon from another perspective. I wrote about the "MP3 mania" first here in May, initially in a couple of

columns about the marketplace and the players, then again last week on the

MP3.com

(MPPP)

IPO, the

outlook for

Liquid Audio

(LQID)

and what I see as

e.Digital's

(EDIG)

prospects. The technology side of this is pretty interesting, but technology isn't what the MP3 phenomenon is really about.

The technological side will sort itself out: We'll get one dominant format, probably, plus a couple of niche-market formats promoted by what will soon enough be fading companies. It's still early, I think, to pick the ultimate winner in terms of a specific stock. But it's not at all too early to look beyond the transient technological issues to the much bigger, longer-term issues of how MP3 and downloadable digital music in general are going to shake the immense recording industry. And the opportunities and risks that presents for investors.

Initially what I'll call here the "MP3 market" -- for the purposes of this column only, consider that synonymous with "the downloadable digital-music market" -- will be about

portable

music: downloadable tunes you can stick in some kind of hang-it-on-your-belt-sized device you carry with you. The market will also, obviously, include downloading tunes to PCs' hard disks, already a huge activity worldwide, if also a profitless one -- or worse! -- for the record companies.

As MP3 moves out of those fat but still niche markets into home stereo components designed from the ground up to download, store and play MP3 (and probably other digital-music-format) files, and into devices you can install in your car's dashboard for tunes on the road, the MP3 market is going to get bigger and bigger, eventually transforming and largely replacing the current CD-centric music-distribution system. CDs in their present form will be around for a long time to come. But they'll be a

lot

less important.

The recorded-music business has evolved on a fairly regular basis through several formats, from Edison's cylinders, to 78-rpm records, to 33-rpm LPs, to cassettes and eight-track cartridges, to CDs. CDs have been with us for almost 20 years now, and for the past several years the record industry has been looking for The Next Big Thing, that inevitable

next

format that will supersede the CD. That's clearly downloadable digital music -- but they never thought it would be anything like that, anything so ...

intangible

. They thought it might be digital audio tapes, which the recording industry feared and so killed; then they thought it might be the Minidisk, which they also feared but which has pretty much choked itself to death, despite

Sony's

(SNE) - Get Report

perfervid promotions.

Now we have MP3 exploding around the world, and it absolutely terrifies the record companies. Let me let you in on a little secret: It's not just the threat of mass piracy via MP3 that freaks the record companies, but their clear and growing sense that downloadable digital music is going to fundamentally change the structure of the music business, to their profound disadvantage. Dinosaurs in their death throes thrash around and stomp smaller creatures left and right -- but they do eventually disappear into the ooze. And that's where record companies, at least as they're structured today, are headed.

Because with our newfound ability to buy (or, yes, steal) music in the size chunks we want, when we want, without middlemen, powerful new avenues of distribution are going to appear.

One of the most fundamental changes, upon which nearly everyone in the music industry agrees -- if only quietly,

sotto voce

and fearfully, in the case of record-company executives -- is that MP3 is going to -- in fact, already may have -- brought about the rebirth of the single. The notion that we'll go on buying CDs with one tune we love, two or three that are OK, and a lot of filler material no one (including, often, the recording artists themselves) cares much about, is nuts. Yes, albums will still exist, but the singles market will overwhelm them.

Consider at least one aspect of the economics of this change: If record companies are used to selling $15.95 albums, recorded on CDs, but suddenly find demand has shifted to 99-cent singles, downloaded, how do they support their bloated, overpaid staffs and organizational structures?

And how does a

Tower Records

or a

Virgin

meet their huge expenses when they're used to marking that $15.95 down a couple of bucks for the first two weeks, then pushing it back up to 16 bucks for the rest of its shelf life? How do 99-cent sales, even if we do buy music at "record stores," begin to replace $12-$16 sales?

It gets even better (or worse, depending on your view). Consider some possibilities for music distribution, ca. 2002:

  • Artists set up Web pages and sell fans singles downloads of their new cuts for 99 cents.
  • Those artists offer "collections" (read: albums) as digital downloads for $10.
  • Those artists allow fans to buy annual subscriptions for, say $20, which allows them unlimited downloads for a year.
  • Those artists allow you to subscribe in advance for their new releases, sending you an email with a new tune every month. (Think about the ad-revenue possibilities of these sites. What would a million banner impressions a month on a Rolling Stones e-commerce/downloadable music site be worth? To heck with Budweiser underwriting Bruce Springsteen tours ... what about Budweiser buying out all the available banner slots on a Springsteen download site for six months?!?)
  • Kiosks appear in malls and elsewhere -- no reason whatsoever for them to be in "record stores" (remember them?) -- where those without a fast connection to the Web just stick their pocketable digital-music playback devices in a slot, swipe their credit cards and get new tunes or collections of tunes downloaded to them.

Note that in each case, the transfer of a physical good to the buyer was eliminated.

Note that all the busywork of CD distribution -- from pressing, or "burning," discs to sticking them into jewel boxes to boxing them up to shipping them to warehouses to shipping them to distributors to shipping them to record stores to putting them out in bins -- is all gone.

What do you think that's going to do to costs? And as a result, to prices? And to demand?

Some will say that new artists will be poorly served by this change, that without the record companies' huge A&R operations and budgets, devoted to finding the next big stars, musicians won't get noticed, heard or played. Phooey. The record companies have been cutting A&R budgets and artist-development funds for years -- and sites like MP3.com are already doing a better job of promoting unknown musicians than any record company is today.

Think about this for a few minutes and you can come up with another half-dozen ways downloadable music will revolutionize distribution, moving it from the physical realm to the Net. Think about opportunities for making money in this brave new world. Think about who's gonna get absolutely killed in this new era.

Understand now why the record companies hate MP3 so much?

Dinosaurs, indeed. Big, dumb, ugly ... and going down.

Jim Seymour is president of Seymour Group, an information-strategies consulting firm working with corporate clients in the U.S., Europe and Asia, and a longtime columnist for PC Magazine. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. At time of publication, neither Seymour nor Seymour Group held positions in any securities mentioned in this column, although holdings can change at any time. Seymour does not write about companies that are consulting clients of Seymour Group, or have been in recent years. While Seymour cannot provide investment advice or recommendations, he invites your feedback at

jseymour@thestreet.com.