Surviving the Digital Music Avalanche, Part 1

It's clear that music on the Web has made a ton of money for a few lucky investors. Less clear is how the players themselves plan to thrive.
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It's clear that the interest in downloadable digital music (let's call it MP3 for short) has moved waaaay beyond just the online buffs, the rave-music crowd and the high-school and college students who are the most fanatical downloaders -- three groups with a lot of overlap.

TSC

readers' prolific response to my

columns in

May on the MP3 phenomenon came from people with a wide range of musical interests, over a three-generations-plus range, with a long list of personal agendas. Some just want to make sure the flow of "free music" continues unobstructed. Some want to revolutionize the system, whacking those evil old record companies, performance-rights organizations, record stores and trade groups (principally the

Recording Industry Association of America

, or RIAA). And some ... well, some just want to figure how to make some money on this.

As I wrote then, it's way too late in the game for efforts intended to stuff the MP3 genie back in the lamp to have much chance of succeeding. Too many copies of

WinAmp

,

RealJukebox

,

MusicMatch

and other key MP3 recording, conversion, download and playback software tools are out there already in too many PC users' hands. More, with literally billions of music CDs already floating around --

every one of which can be copied, duplicated and distributed pretty much however the copier wishes

-- efforts such as the copy-protection schemes proposed by the

Secure Music Download Initiative

, the recording-industry group trying to get the genie back in that lamp, have a decidedly uphill battle ahead of them.

An impossible battle, most would say. So the focus has shifted to the future: to what can be done with recordings not yet released, with songs not yet written, performed or recorded, to keep them from falling into the MP3 morass.

Meanwhile, there is frantic activity among producers of digital music tools, both hardware and software, to produce code and devices that accommodate some form of this oncoming copy protection, while also allowing their users to hear, record and pass along present-day MP3-standard music.

In those columns (which I immodestly suggest newcomers to MP3 might want to read before continuing here, as a kind of survey of the MP3 situation), I made some of the arguments for and against controlling digital-format music. And I went through a list of some of the companies active in this area.

It's time for an update.

This week,

MP3.com

(MPPP)

went public; as I

wrote Tuesday, I expected an over-the-moon IPO for the company -- and wasn't disappointed. The stock was priced at 28 (already bumped up twice by underwriter

Credit Suisse First Boston

from an original opening-price range of $9 to $11) and soon hit 105 -- almost the quadruple I'd predicted -- before falling to earth for a close Wednesday night at 63 5/16. That made for a 126% opening-day run-up -- not bad, not bad at all.

At least, not bad for the people who have gobs of MP3.com options and for those who, somehow, got some shares at the offering price. ("Friends and family" take on a whole new meaning here.)

For those who bought from, say, 50 on up -- whether they bailed as the air ran out and MP3.com came down from 105, or held -- the question is going to be when and if MP3.com can ever make a dime. The valuation at Wednesday's close -- about $4.2 billion -- sounds great, but if you look at what it's going to take to produce an interesting return on this investment, it gets downright scary. It isn't just that MP3.com isn't making money today, but that making money looks nearly impossible with the company's business plan.

Still, with a $4.2 billion market cap, MP3.com has awfully cheap currency to use to buy other companies, so maybe it'll succeed in buying someone else's revenue streams . . . which

do

eventually produce profits.

MP3.com's Web site -- its only business -- offers unknown artists a chance to post their music for the immense Web audience to sample; More than 100,000 songs have been published so far on the site. If a visitor likes a few cuts of an artist's work, MP3.com will sell him or her a semicustom audio CD of the work at a bargain price, from $5.99 to $10. Artists aren't compensated for the songs downloaded (in .MP3 format, of course) from the site, but do get a 50% royalty from CDs of their work sold by MP3.com.

This is a great public service and a lot of fun for visitors to MP3.com, who can prowl through and hear almost immediately a lot of new music. (The range is relatively narrow -- MP3.com posts mainly pop, rock, hip-hop, rap and electronic music -- but there are also some jazz, classical, chamber, choral and other tracks for old fogeys like me.)

I like MP3.com. I'm glad it exists. I download music there. I just can't figure how it's going to make anything like serious money. Indeed, I think MP3.com may well become the poster child for Web businesses that "enjoy" such high market caps, after spectacular IPOs, that they are forever burdened by those market caps, unable to produce anything like a decent return on that capital. (Not to be a hypocrite, if I were an MP3.com insider and held a few hundred thousand options at pennies each, I don't think I'd feel burdened by that market cap at all. After all, those investors who paid $60, $70, $80, $90 a share knew what they were doing, didn't they? Or, at least, were supposed to?)

Liquid Audio

(LQID)

has also been much in the news this week. After its July 9 IPO closed at 36 1/2, it had drifted down to 29 7/8 by Tuesday. The combination of press from this week's

Jupiter Communications

Plug.in conference in New York and the razzmatazz over MP3.com's IPO Wednesday nudged Liquid Audio back up to 30 5/8 Wednesday.

Liquid Audio works another corner of the downloadable music business. It produces a "player" -- the Liquid Music Player, a free, downloadable software package -- that allows computer users to listen to tunes recorded in Liquid Audio's compressed digital format. Needless to say, that format is not compatible with .MP3 -- or anything else. (It is, however, a high-quality format, also producing files typically smaller and thus faster to download than .MP3 files.)

Liquid has formed a relationship with

Amazon.com

(AMZN) - Get Report

in which Amazon posts Liquid cuts drawn from some of the hot CDs it's selling on the Amazon site. Go to Amazon this week and you'll find about 30 tracks available for download for free, in Liquid Audio format, from name-brand artists such as Cheap Trick, Emmylou Harris, Randy Newman and Santana. Those tracks expire after a fixed period, so you can enjoy them only for a while: Amazon intends these, of course, only as a preview, hoping you'll buy CDs with tracks you sample and like.

While all the Amazon cuts are available as Liquid Audio tracks, read the fine print and you'll notice that many artists insist their work also be made available on the site in .MP3 form. Those artists know .MP3 is absolutely the dominant format and want their work to get the widest hearing.

Liquid Audio has demo deals with

Capitol Records

and

Dreamworks SKG

. And it uses

Dolby Labs'

Advanced Audio Codec, which leads to its high audio quality. It's even come around to supporting .MP3 -- and soon, the latest entrant,

Microsoft's

(MSFT) - Get Report

Windows Media 4 format -- in the Liquid Music Player.

I like the quality of Liquid Audio playback. But it's a distant second standard behind .MP3. I suspect Liquid won't be around a few years from now, or at least won't be very prosperous, as the downloadable-music world coalesces around a single standard ... and that standard isn't going to be Liquid Audio. Indeed, even if the market embraces more than one standard, I think Liquid Audio isn't likely to make the short list.

So I'm not excited right now about Liquid Audio as an investment. But I could be wrong: This gorilla of a business is only now beginning to emerge from the mists, and six months from today it's possible -- likely, even -- that it'll look very different than it does today.

Tomorrow: A close look at e.Digital (EDIG) , one of the most-discussed and potentially explosive companies in the downloadable-music market.

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.