SharkJumping

A special thanks to Forbes.com for featuring this blog on their site today here.

The Web 2.0 show was in town this week, which was a great time to catch up with a number of former colleagues in the digital music business.   The consensus was "Thank god we're no longer in that sector", and now the #37 reason occurred this week with the by Universal Music that it would share in the hardware revenue from the sale of the new , and would look to strike similar deals with other hardware manufacturers - the next question is whether they will demand a $1 royalty for each of my children since they have ears which can hear music and a brain which can store it - or would that be $2 since they each have two ears?

I understand that in a capitalist society the labels are just maximizing returns wherever they can, but this deal is the slippery slope to Hell for all other players in the category.  Walt Mossberg from the WSJ reviewed the Zune earlier this week and pointed out that it didn't have UMG music - well, I guess they got what they wanted by holding out longest. 

As I have pointed out in other posts (here), the music business is what I personally term a serial monopoly where any digital provider in the space must have at least all 4 labels to be competitive since you can't substitute Eminem (UMG) for Norah Jones (EMI).  This is a key test of supplier dominance, unlike in oil where Saudi crude and Texas crude are relatively similar substances.  That gives unprecedented supplier leverage to the labels, although the formerly Republican DOJ didn't agree when we argued that 4 years ago in a private anti-trust case.  That dominance is a huge part of the reason that I started Meez since we control our own content, with the ability to license-in amazing trademarks such as Major League Baseball and National Hockey League where it makes sense, but it's not required to have them to make the business work.

So now hardware manufacturers will have to pay flat per unit royalties to labels (aka the "Label Tax"), whether or not the consumer purchaser ever buys a track from that label.  If that label deal is not struck, then the label's content will not be available to the manufacturer's store, and since everyone is going vertically integrated these days (Apple iTunes, Sony Connect, Real Rhapsody/SanDisk, Microsoft Zune), it gives the labels even more power over the channel.

I could go on and on about the flaws in paying labels for hardware, but we'll keep it short

1. Why pay labels for hardware if they are already getting paid for each download?  Paying on software sales directly matches royalty payments with who generated the sales, vs me buying an MP3 player, but using it solely for my own collection or with eMusic.  The users have to pay a higher price in the end for a service they may never use.
2. How will hardware vendors possibly decide who gets which share of the Label Tax they will now be obliged to pay?  Having been in these discussions multiple times, the smaller labels are not going to accept a significantly smaller payment than UMG, even if their overall market share is much smaller.  And what happens to the next tier of labels - how do they get paid, or is this only for large labels?
3. How do artists and publishers get paid their share?  Since we have no idea how to match the UMG payment with any type of usage, how will a label accurately apply it across an entire artist roster, or even harder, across the various publishers, many of which are not even part of Universal?  You could base it on digital sales, on physical sales, on catalog sales, etc., but there is no way to make it match actual consumption since the Label Tax isn't based on consumption - it's a flat fee payment to get the rights to offer songs in a service.  Some people would call it "tying", but that's a complex Anti-Trust term :)
4. Where does this new Tax stop?  I joked about taxing my children, but does this levy extend to cell phones, recordable CD-ROMs, RAM chips, new game consoles, any device which can record audio, etc?   I think in reality, it extends as far as labels can exert leverage - what this means is that if you are a manufacturer interested in offering any type of music service, then you should now be either prepared to pay an extra fee yourself, or find a digital provider with the rights to offer it to your hardware, and let them take care of the tax.

There are other strong reviews of this issue including a good one here at Beta News.  The end result is that it simply points out how difficult the digital music business can be due to supplier leverage, and how insane VC's need to be to invest in the sector since there is no reason to believe this new levy will stop at a few dollars - like an intelligent parasite, the tax will increase enough each renewal period to suck all of the margin out of the business, but not enough to kill the host. 

The big test will be when the Apple deals come up for renewal - the labels talked a huge game last time about how they were going to force Apple to a higher price last year, and all quickly backed down when push came to shove.  Any Apple investors will need to note this in the risk column as they look at the next few years, but this will also affect other suppliers such as XM/Sirius, Motorola, etc., although it's a larger part of Apple's business than any other company. 

What's funny about the entire process is that services were the traditionally profitable part of the media sector used to sell lower margin hardware (E.g. game consoles, phones) - then the labels made the service part unprofitable, but Apple was able to make it up in hardware.  I think we're running out of high margin drivers for anyone but the labels, who continue to drive alternative revenue sources.  This is a great development if you're a Warner Music or EMI shareholder, but not so good for the other members of the digital music value chain.