Digital Music Unplugged: MP3 Takes Center Stage

Previously loved only by techies and music freaks, MP3 is now attracting music industry heavyweights and VCs.
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SAN DIEGO --

MP3.com's

(MPPP)

IPO today will go down as a watershed in the annals of new media: Not only is the highest-profile digital music company throwing its coming-out party, but all doubts about whether the Internet will shake up the music world should be snuffed out. For those who want a piece of the digital music action, now is the time to face the music.

In 16 short months, the digital music industry has moved to center stage. Back in March 1998, when MP3.com incorporated, the music downloading movement was a subterranean world dominated by college students, software engineers and geeky musicians. Since then, the technology has blossomed into one of the most closely watched corners of the Internet industry. In recent months, Wall Street has heard the tremendous promise of distributing music on the Net.

Nowhere was this more apparent than at this year's

MP3 Summit

, organized by MP3.com. At last year's debut San Diego conference, the several hundred who gathered were largely geeks and pirates with the odd intellectual-property lawyer. This year, the scene looked more like an investment conference cum trade show: Venture capitalists scoured the hallways and courtyards for promising investments, polo-shirted marketing flacks trumpeted the newest hardware gewgaws and youthful CEOs deflected the press with those magic words, "quiet period."

The rapidly changing landscape made for some odd juxtapositions. There sat rapper

Canibus

beside music industry bigwigs on a panel called "Artist Econ 101." Investment bankers in the audience applauded rapper

Ice-T

-- the same Ice-T whose "Cop Killer" record was yanked by

Time Warner

(TWX)

for controversial lyrics -- when he proclaimed, "There's money to be made in putting up buildings and tearing them down."

The commingling of revolutionary and capitalist rhetoric is what this scene is all about. Digital music is in the kind of chaotic flux that makes everyone but the complacent happy: Creative types love the utopian possibilities, while Wall Street sharks salivate over the investment opportunities. It's the same kind of environment that Web portals were in three years ago and e-commerce two years ago.

"Anyone realizes that when there's a massive restructuring, there's a lot of money to be made," says summit attendee Steve Steinberg, a technology analyst of several prominent hedge funds.

New Battlegrounds

Even though digital music presents a huge investment opportunity, it's no sure thing.

Ostensibly, the biggest risk threatening the digital music industry is the inevitable format wars that erupt when a powerful technology emerges. Some feel all the kvetching over standards misses the point. To begin with, many MP3 proponents admit that it will be replaced by a superior compression technique. Bob Kohn, chairman of

Emusic.com

, an online aggregator and retailer of digital music, has said that his company will sell music in any format that consumers want. Like all other wars in the past, the war over downloadable music formats will eventually settle. For investors, the real battle is the struggle for content.

"The battle is more analog," says

Internet.com

analyst Steve Harmon. "It's over who owns the artist's content because anyone who owns that content can distribute it on any platform."

That's why some online retailers are inking deals to license the digital content of independent record labels. This is the case with

Musicmaker.com

(HITS)

and with Emusic.com, which is aggressively striking deals with indie artists like

Frank Black

and indie labels like

Rykodisc

.

But while arguments rage over which technology will emerge as the standard for digital music, it's clear things couldn't have gotten this far without MP3. MP3, or Moving Picture Experts Group-1 Audio Layer 3, compresses music and video to send it over the Net with respectable fidelity. And what makes MP3 a nightmare for a record industry dreading piracy is one of its strongest points -- its status as a nonproprietary open standard.

MP3 has been embraced on a grassroots level as a brand representing a more democratic future than the one offered by the oligopolistic music business. Record companies, hardware makers and retailers alike are waking up to the power of MP3 and similar technologies to transform the packaging, distribution and marketing of the $35 billion music industry.

Forrester Research

estimates that digital downloading will add $1.1 billion to the U.S. music industry by 2003. And current research projects that digital distribution will account for 2% to 5% of prerecorded online music sales by 2002.

"Music is the obvious killer app of broadband," says Lawrence Kenswil,

Universal Music's

head of e-commerce.

Indeed, digital music is the next e-commerce battleground. On one side, established media powerhouses like

America Online

(AOL)

,

Amazon.com

(AMZN) - Get Report

and Universal Music are vying for a position in the market. On the other side, pure-play upstarts like

Liquid Audio

(LQID)

, Musicmaker.com and MP3.com are moving quickly to raise and invest money in an attempt to become the

next

new media powerhouses.

The Long and Short of MP3 for Investors

The sense of turmoil in the music industry represents an opportunity for investors looking to get in on the ground floor of something big before it explodes.

In the same way that portals realized they needed a community and a broadband strategy, online media companies are realizing that they need to position themselves for the emerging market in digital music.

RealNetworks

(RNWK) - Get Report

purchased

Xing Technology

, the leading developer of MP3 encoding software. Universal Music and

Sony's

(SNE) - Get Report

Sony Music Entertainment

say they intend to sell music via download before the end of the year. And

EMI

, the No. 3 record company, took a 50% stake in Musicmaker before that company's IPO this month.

Expect more old media and new media companies to target innovative technology companies that can expedite their entry into the market. Conversely, expect more Internet start-ups to strike deals with music companies in order to get access to content.

"The

Net represents the future of the music business," says Mark Hardie, a Forrester analyst. "While it's small now, the biggest area of growth is going to be in figuring out how to capture digital delivery as a profit center and not go the way of piracy."

The technology is prompting change at retailers, too. This month, Amazon.com has carved out an area on its site for digital downloading, featuring songs in MP3 format and Liquid Audio from artists such as

David Byrne

,

Robert Cray

and

Randy Newman

.

barnesandnoble.com

(BNBN)

, which expanded its music site this month, is likely to follow Amazon's move. And this week,

CDNow

(CDNW)

announced that it will be launching a store this September that sells secure downloadable music and custom CDs.

This widespread restructuring creates investment opportunities to go long or short. Hedge funds say they are honing in on both promising investments and shorting possibilities unearthed by the emergence of MP3. The best shorting opportunities, says Hardie, can be found in the bricks-and-mortar consumer electronics retailers, which don't understand the new technologies, and in the first-wave e-commerce retailers, which have been slow to embrace downloadable music.

More significantly, digital music is a test case for the future of all digital media. What's happening in the music world is likely to transform the way books and videos are sold. The advent of digital books that can download text online, the means to deliver video content on demand and the blurring of lines between streaming media and downloaded files all set the stage for a significant shift in the way entertainment content is consumed. And companies that emerge as the leaders in digital music will have a strong lead when other media open up to digital distribution.

"Lessons learned in

music will probably be applied to the other media," says Bruce Joseph, a prominent copyright lawyer with

Wiley Brine & Fielding

.

One risk investors face in the burgeoning market is getting killed by backing the wrong horse. The answer to that, says Harmon, is classic investment wisdom: Diversify your portfolio.

"It's early in all these different areas," says Harmon. "Do you play one or the other? You can bet on two to three others and hope that the one win makes up for the other two losses."

What is your attitude toward investing in the digital music market?

Are you kidding me?

Watching from the sidelines.

Dipping my toes.

Swinging for the fences.