FTC Accuses BurnLounge of Being Pyramid Scheme

Burnlounge In what may not come as a surprise to some industry followers, the Federal Trade Commission (FTC) has filed a complaint in Federal Court alleging that digital music multi-level marketer Burnlounge is an illegal pyramid scheme - see article here, while you can download the actual FTC document here - 

MLM services need to have very high gross margins to support an actual operating business through multiple levels - I have personally never understood how a digital music business with 20-30% gross margins can support one level of retailer, let alone multiple levels, but I guess we're about to find out on June 19th when the hearing takes place.

Lala.com - Nuts - Bubble #2 is here

Lala_dot_com

was originally a way to swap used music CDs, similar to an eBay meets NetFlix, similar to PeerFlix.  They have been gradually moving in a digital fashion, and last week they launched a fairly aggressive move in the digital space, with the initial support of Warner Music and of some indie labels.

The basis of the service is a free, unlimited streaming service which encourages users to share playlists and then purchase the digital albums, which can be loaded directly to your iPod without using iTunes.  In addition, the program scans your hard drive and uploads the music it finds to the service so you can access it online.

I could further discuss the feature set and pricing model, but it's really not worth even spending the digital ink on it.  There is literally no logical business basis for this service, and we will look back at this as one of the signs of Bubble #2, just like College Club, Free ISP services, and other similar gambits were a hallmark of the last Bubble.

The reasons are clear:

  1. There is a very limited set of content for the service, with no reason to believe they will have a full set of content any time soon.
  2. iTunes/Apple has a history of blocking 3rd party systems which access their iPods - it doesn't stop the usurpers forever, but it makes for a difficult user experience, having lived through it at RealNetworks when we went through that process
  3. The prices for digital albums don't seem to be cheaper than on iTunes - in fact, a spot check of albums appeared to show that LaLa was actually more expensive than iTunes.
  4. The 3MB LaLa browser plug-in doesn't truly communicate to you what's going to happen - then it starts scanning your hard drive and uploading the information to LaLa, without making it clear what's going on.  Is happening as I write this note and is very irritating since it reminds me of the old P2P services.
  5. There doesn't appear to be any huge technology barriers to entry to their offering, which means that if the service actually became successful, the numerous other larger players would duplicate the model.
  6. Oh yeah - and the business model makes no sense.  Unless the labels are giving LaLa a break on royalty costs (which is presumably not happening), then the ongoing costs are $6-8 a month per registered user, or some similar type of usage based royalty.  Given that the digital commerce model offers providers like LaLa a 20% profit margin (including Apple at $1B in sales a year), the customer acquisition costs are going to be much higher than what the gross margin will be, even if we assume that users can be trained to purchase solely from LaLa given that it doesn't have a lot of content and appears to be more expensive than iTunes.

The running thesis is that LaLa has other ways to monetize the service, through advertising or other TBD sources, and that this is a way to ramp up interest (try LaLa.com in Quantcast to see how low the traffic appears to be) in the midst of a very competitive and low margin marketplace.  We haven't seen those initiatives yet, but given the smart investors and management team, I assume there is actually a better plan coming - however, in the current vein of the movement to keep the TV show Jericho or as used in the classic WWII Battle of Bastogne, the answer is NUTS.

Copyright Royalty Board Denies Appeal

The Copyright Royalty Board this week denied an appeal of their usurious internet radio broadcasting rate decision (see earlier post here), thus sparking a frenzy of lobbying attempts to get Congress to intervene, and causing digital radio broadcasting companies to consider other legal options.  The broadcasters have also started petitions, emailed their users about impending doom, and have aggregated it all at www.savenetradio.org.

After speaking with a few folks on the label side, I still get the idea that they are stunned by the decision to grant them their full demands and they are almost at a loss as to what to do.  The closest analogy is a salary negotiation - standard tactic is to ask for a larger salary than you believe you deserve since you know that the result will be something in the middle - in this case, the labels got everything they asked for, which realistically should mean the end of free Internet Radio as we know it today, pushing everything back to a paid model, unless it's truly a loss leader.

What's the lesson here?  Don't invest money into categories which can be changed overnight by government regulations, especially those lobbied for by much larger companies.  All of those investors in online gambling firms are feeling the same type of pain right now as anyone in the Internet radio biz.  The question really is "what type of music business would benefit from this big change?"

New CARP Rates - Another Reason I Don't Miss the Music Biz

Top_logo The Copyright Royalty Board last week released its ruling on Internet radio royalty rates for the next five years, and all it did for me was trigger brutal reminders as to why the digital music business is a terrible sector for anyone but content creators.  As a reminder, music labels are not paid directly in the US for songs played on the radio (publishers are) since it ostensibly contributes to sales of the music as a promotional vehicle. 

But the RIAA was able to insert a clause into the DMCA legislation which gave the labels the right to a royalty on Internet radio play, and the CRB determines the royalty rate in multi-year segments - it's a government statutory rate, similar to the 8.5 cents paid to publishers for every download or physical sale.

The 2005 rate was $.0007 per song, or roughly 1 cent per hour, assuming 15 songs per hour, although it can be more with a song skipping feature.  It doesn't seem like a lot, except that a company pays that fee PER USER (unlike broadcast) and still has to pay for bandwidth.  In addition, the Internet radio ad market is still nascent, especially since most radio advertising is local, and Internet radio doesn't have enough scale in any one market to make it worthwhile for the local car dealer to create ads (although it might change in time). 

Well the new rates are going to be far higher, moving steadily up to an amazing $.0017 per play by 2010, or 2.5X the current rate, which is somewhat higher the projected inflation.  And the new rates eliminated or reduced any type of exemption for smaller broadcasters.  Kurt Hanson has a good take on the ruling .

So who does this affect?  in the public markets, only Real () has a big enough Internet radio presence to be hurt, and it's still only a portion of Real's music business.  In the private markets, this could be devastating to popular radio services such as Pandora, Last.FM and Live 365 - and it will positively destroy the smaller players who have no chance of generating enough revenue to pay for the royalties.   

Hell is sometimes defined as "getting what you ask for" - well the RIAA and the labels just got it.  In the short run, this may be a revenue boost for labels and artists.  In the longer term, it just points out why no investor should put money into any music business which requires label licenses, and that's probably bad for the entire music sector. 

As a sidenote, the CRB might actually want to consider both sides of the argument next time it rules on similar issues, but just as in other political sectors, he who pays the most lobbyists wins.

Squeezebox/Rhapsody Review - Rocking

Sb3_front_500 I acquired a Squeezebox this month, which is a new Digital Media Adapter which allows a user to access digital music services without going through a PC client, as the older Rhapsody-Ready devices required.  The end result is that you get a pretty cool Music Unlimited experience without too much hassle, and without setting up a PC next to the stereo, which rarely passes the wife/partner test.

Logitech recently acquired Slim Devices, which produced the Squeezebox - this was a great purchase for Logitech, and I was surprised that one of the larger networking providers like Linksys didn't step up first for this team.  The resulting product reflects both the amazing technical chops of the dev team, as well as some of the continuing consumer flaws in the product and service of a smaller technical company.  It's a $299 small/attractive device which has Ethernet, Digital and Wi-Fi connections, as well as the usual audio plugs.

The absolute key feature here is that you can access Rhapsody and other music services like Pandora, Live 365, etc, without having the PC turned on anywhere in the house - it's a key move in the inevitable trend towards reducing the role of an actual PC download client in the music consumption process.  You need to set up an account at Squeezebox, which is irritating, but after that, it's really straight forward to set up and deploy music accounts.  There is no longer any connection to the PC, which solves a lot of the big issues involving the PC being turned off somewhere in the house when you want to listen to Rhapsody - in fact, you could just bring the device to any wi-fi connected area, and then access all of your music, which is pretty cool.

The other great feature is that Squeeze has integrated with a whole new set of Rhapsody API's, which go beyond typical MyLibrary functionality to allow user access to new editorial areas such as Search, Recently Added, Staff Picks, etc.  It's gone far beyond the usual playlist functionality to start to give much more access to the set top box vs just a small subset of the PC content.

On the other hand, this great new functionality is still stuck within a small LCD screen on top of the TV which most people can't see from more than a few feet away.  Unlike the much more expensive Sonos system, you still have to move forward to find and play your music, although Squeezebox still does a decent job of providing a basic interface.  The other big issue is a more systematic one - the Rhapsody system just cuts out too much once you average it over many hours - it's not a big issue for a couple of hours but when you really want the system to simply "always be on", it doesn't seem to work that way, although I may just have a lousy data ISP.

In general, the Squeezebox is a great mix of price, power, and functionality.  It's a full generation above the previous dumber, less functional, and harder to use boxes, and the non-PC functionality part is a HUGE step forward.  But at the end of the day, I'd recommend holding off another year before the Sonos or other more expressive functionality comes down to a lower price point since the current Squeezebox functionality is still a little too limited for a mainstream crowd.

Music Giants Review #2 - HD Music Service Still Not Ready

Clefclean100 I reviewed the Music Giants HD digital music service a year ago (here) and concluded that although it was intriguing, it just wasn't ready for prime time from an overall user experience.  Now the company has launched version #2, in conjunction with Windows Media Player 11 - unfortunately, the short answer is that I still can't recommend the service.  To recap, MG provides a lossless Windows Media music service which should produce a higher quality experience than the lower fidelity iTunes and Rhapsody music services.  The downloads are about 10X the size of an MP3, but still download quickly, with most albums arriving in less than 10 minutes on my office connection.

So what has changed in the last 12 months?  The first positive attribute is that there is no longer a 30MB separate MG client - now it's a relatively simple plug-in to WMP 11, and it's listed as a store in WMP 11.  The 2nd good thing is that the catalog has expanded a great deal - most major artists seem to have the bulk of their albums in MG, a big change from the previous year, and MG is making some moves in providing HD video downloads as well, primarily through HD Net.  The 3rd positive change is that MG has worked diligently with over 500 high end audio dealers, as well as high end stereo suppliers (e.g. Onkyo) to integrate into the very expensive music systems which would most benefit from a lossless HD audio experience.  Finally, the company has eliminated the $50 requirement to purchase any music, which should open up the experience to more users looking to experiment with high fidelity music downloads.

So why can't I recommend the MG music service?  The primary reason is because the consumer search and discovery experience simply sucks.  I rarely use that juvenile term, but you spend enough time with this user interface, and you would think time stopped over 10 years ago from a consumer experience - it's mind boggling.  There is NO concept of an editorial experience here - you can filter only alphabetically by album, artist or genre, and there is a limited selection of albums listed as New or Featured Releases on the first screen of a limited set of top level genres (20 genres vs 500+ in Rhapsody), in addition to some AMG album reviews buried deep in the album information where most people will never find them.  The search experience is mediocre, and there is no idea of "Related" or "recommended" albums, special playlists, popularity charts, user ratings or basically anything that would help a user filter the wide range of content.

Other issues are:

  1. The service doesn't work at all with Firefox, even on the basic web site
  2. You can only purchase music by the album, not by the track, thus defeating one of the true joys of digital music
  3. The video selection is terrible and overpriced - why are there no HD concert videos?
  4. There is an incredibly confusing experience between the WMP11 side and the MG side - I keep being told to upgrade my WMP on the MG web site, but if I call up the site through WMP, it works just fine.
  5. There is no concept of saving a user name/password, so you need to remember your information every time you log in, and the auto-remember function has been disabled.

Finally, the worst problem is that I have tested it over and over, and I still can't tell the difference between the HD downloads and the same Rhapsody or iTunes files.  This may change on a much higher end audio system than what I use (or with a more sophisticated end user than myself), but I've been A/B testing them today, it doesn't make a difference to me, although I could see why it might make a big marketing difference to folks buying a $10K+ audio system.

So I can't really recommend the Music Giants service, although I think there is definitely a good opportunity to address a higher end audience if MG can fix these issues before others enter the marketplace.

Zune/UMG - "Label Taxes" Arrive

ZuneA 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.

The Death of "Plays for Sure" - Long Post

Pfs I'm late to the party with this post, but after overwhelming evidence from every quarter, it's clear that Microsoft is putting Plays for Sure (PFS) to bed and replacing it with the Zune hardware and software combination.  So why do we care?

Well, the reason is that it concedes the online audio battle to Apple - it's officially over.  Why is that?  When PFS was up and running, there was a reasonable chance that the combined forces of the "Everyone but Apple" crowd would eventually dent the iPod/iTunes dominance with a series of differentiated devices and software services, all of which were transferable across this array of devices - thus the term, Plays for Sure.  The download model alone might not do the job, but the Janus/MS 10 subscription services would be a different factor, and the combined weight/range of alternatives would be enough to move users to the new systems.

Unfortunately it didn't happen.  Apple continued to have an 80%+ share in devices, as well as in downloads, and the Janus/MS10 functionality simply doesn't work well enough to be a good customer experience.  The array of MP3 players didn't match up to Apple's focused designs and great advertising, and the software/hardware integration failed to produce a good experience.  Try updating firmware on a PFS device, or watching it "time out" while trying to play a PFS song on an airplane - you will throw the device out the window.

So MS, building on its expensive but successful Xbox experience, decided to break away from PFS, and to develop its own integrated hardware/software solution, called Zune, slated to launch later this year.  On paper this made sense - tie the service and platform together, differentiate on features such as WiFi, and roll out aggressive pricing and cool hardware.

However, it causes HUGE sets of problems in the marketplace.  MS continues to maintain that PFS is a focus for them, but no one believes that, including the labels, who aren't necessarily happy about this development.  The MP3 player companies are totally screwed - they now need some type of integrated solution vs just plugging in a turnkey MS PFS system, so they're scrambling like wild, with SanDisk hooking up with Real, Toshiba doing a deal with MS for Zune, Nokia buying Loudeye, and the others all looking at Napster or smaller alternatives.  Since everyone is adding some type of "Secret Sauce" to the base PFS system, it's possible that none of the non-Apple music will play on other PFS devices.  Sony Connect is still being featured on the back of a milk carton ("last seen in 2003") while MTV URGE is soon to be a key player in a "Where Are They Now" special on VH-1.    And by the way, what ever happened to the well regarded MusicMatch once it was sucked in by Yahoo Music?  This overall scenario is like being on the set of Under the Rainbow, with midgets running everywhere while Apple rampages away on its way to $2B in download revenue in 2007, even though its hardware isn't that superior anymore.

And the Microsoft Zune?  Based on all known facts, there is no way the Zune takes any more than 5-10% market share, especially now that it looks like some of its vaunted next generation features such as WiFi are not really implemented in this version, and there is apparently no video solution, at least at launch.  So what did we get in return for MS creating the Zune? We blew apart the coalition, splintering the anti-Apple group, and weakening all of the players.  That's the end result of the the death of Plays for Sure. 

Next battle is in video, where again, Apple is taking a strong lead due to better hardware, good software integration, and great marketing.   The best bet is for the competitors to fight it out at the cell phone level, with Nokia and possibly RealNetworks (Wider Than deal) building potentially competitive solutions.

Napster Replacement Value?

150pxnapsterlogo Analyst Darren Aftahi of Think Equity put out an interesting report today calculating the value of Napster's assets in a M&A scenario since Napster has retained investment bank UBS to "look at strategic options" (meaning sell itself).  I agree with Darren that Napster is the most attractive M&A target out there today in digital music, and that there is a decent sized group of potential buyers, although I think a hardware maker will end up buying them vs a service provider.  Given Napster's $100M in cash, decent brand, $100M in revenue and 500K subscribers, $5 a share seems like a reasonable value, even if the economics of the digital music business are pretty rough.

However, where Darren's analysis breaks down is on the replacement cost of what he calls Napster's "subscription architecture", meaning the content library, the label deals, the customer/subscription management system, database, etc.  He places the replacement value on that piece at an astonishing $120-$145M, giving the stock another $3 in value, which is why he indicates there only 3 significant subscription providers, vs many music download providers.

That number just isn't right.  In the last few years, it has gotten substantially easier to build a digital music service, subscription or otherwise.  On the label side, the major deals are now pretty standard, and most of the indie deals can now be done through aggregators - that process has matured enough that it's almost become a rote process now if you know what you're doing.   On the content library side, there are a few people who have built one from scratch who could do it again, or you can use Musicnet to do so, which accelerates the process.  As to the "subscription architecture" part of it, that's just a fancy name for a consumer-facing media delivery system - it takes work, but there is nothing unique or impossible to understand about subscription music versus other media.  Finally, hardware, storage and bandwidth prices have plunged in recent years, and off-shore development is now a lower priced option in many cases.  And this time around, one could hire a team who has already built a music system, accelerating the entire process by skipping the known issues.

The end result is that a good team could now build a competitive Subscription Architecture for the US market in less than 12 months for less than $20M.  Now a new market entrant may not want to wait that long, or may want other aspects of Napster's assets, which is why I believe Napster has significant value, but let's not go crazy over-estimating what it takes to build one.  Plus in today's competitive market, I would build in other characteristics such as enhanced community, avatars (Meez), karaoke () or other user-generated content options in order to differentiate the experience, but it's simply not that hard.  What's hard is actually making money in the digital music business, which is why I believe there aren't that many providers anymore - they can get a better ROI in other parts of the digital media sector.

Listen.com - Where are they now?

Rob Reid, the founder of Listen, married a wonderful woman last night, so the old Rhapsody gang was mostly reunited for an evening here at City Hall, and it was good to see that everyone is doing well in their post-RealNetworks lives.  Here is a quick update of the Listen.com "where are they now?"

1.  Rob Reid - Chairman and founder - just got married, and has been living in LA working on a couple of great media ideas, as well as helping out a few companies like us at Meez.
2.  Sean Ryan - CEO - started Donnerwood Media 18 months ago, home of leading avatar service Meez, as well as popular casual game
3.  Dave Williams - VP Product - is CMO and GM of Games at , which was just purchased by Viacom last week for $200M!  Nice job
4.  Ranah Edelin - VP Business Development and Label Relations - now CEO and co-founder of karaoke and talent platform - recently named by Time Magazine as one of the top 50 websites on the Internet.
5.  Niranjan Nagar - VP Engineering - now CTO and co-founder of karaoke and talent platform - recently named by Time Magazine as one of the top 50 websites on the Internet.
6.  Tim Bratton - VP, New Technology - in typical brilliant but quirky Brattonian style, he's working on a series of cool technology ideas, but also took the time to purchase an RV park in Texas (see site here), which is already throwing off cash.  Might be our next offsite location...
7.  Zahavah Levine - Legal Boss - now General Counsel at , having gone from the frying pan into the fire, but YouTube couldn't have hired a better person for the job.

There are many other Listen alums scattered around the Internet, but it has been good to see everyone doing so well.  What is clear is that most of us appear to have abandoned the masochistic digital music business outside of the SingShot gang, which I think has found one of the few viable business models in online music.

SingShot named Time Magazine Top 50 Coolest Website

Less than 3 weeks after launching, Rhapsody alumni site (see my earlier post here) has been named by Time Magazine as one of the Top 50 Coolest Websites of 2006 (see article here).  Given that they're still in beta, and still have some great announcements and improvements coming later this year, it's a great endorsement of their service, as can be heard from some of the truly amazing singers on the site, as well as the future William Hungs...

It's also a great site for kids who are looking to sing, or just like reading lyrics on the screen.  Check out my godson Finn's rendition of London Bridge...

Or my 2 year old son Quinn's rendition of favorite song Twinkle Twinkle...(starts a little slow)

My SingShot Recordings

Online Karaoke platform just launched, run by two amazing former colleagues from Listen.com.  Check out a couple of of my pitiful recordings and then go record one of your own - it's a lot of fun for both adults and kids.  If you're over 21, I'd recommend having a cocktail first...

SingShot is also a great example of one of the few reasonably good business models in digital music, and it fits really nicely into the expanding social media and personalization wave, just like our avatar service Meez.

DMGI & HNDH - Market Finally Behaving

I posted about the IPO of Digital Music Group (DMGI) here and the reverse merger public offering of Handheld Entertainment (HNDH.OB) here a few months ago, making the point that the initial market valuations were insane by any rational measurement, and that realistically, neither company should actually even be public.  The good news is that the reality of their respective market positions has begun to sink in to the general investor community, driving down their share prices and market valuations, and restoring some of my faith in the free market.  The bad news is I wasn't able to short either company, but hopefully others were able to do so.

DMGI went public in February 2006 at $8.50 and quickly spiked above $10.  The company had revenue of $721K in Q1, with a loss of $414K, and it's growing quickly, although there is still no reason for it to be public since it's tiny and not even a market leader in its own segment.  The stock is now around $5.75 a share, and should realistically settle in about $3-4 a share, with the only reason there is even that floor is due to the amount of cash raised in the IPO.  The amusing thing is that the only analyst to cover the stock comes from FTN Midwest, the bank that took DMGI public, and even he has a HOLD recommendation on the stock.

Handheld Entertainment reverse-merged into a public shell in early March 2006. (couldn't they do a deal with DMGI's investment banks?)  The stock started trading day 1 at $7 a share even though the private investors had literally just bought stock at $2 right before the offering.  The stock has gone as low as $3.10, but is now hovering around $4.25.  A quick look at the numbers - Q1 was a $584K revenue quarter, at a negative GROSS margin of 3%, with 97% of revenue coming from Wal-Mart, and that the 10QSB states that "it's reasonably possible we will not be able to obtain sufficient financing to continue operations".  I'd say there is no possible floor on this stock since they have only 2 quarters of cash on hand at current burn - going to zero or fire sale.

Legal Disclaimer - I am a terrible personal investor, not a legally qualified analyst and this is a blog, not a research report, so don't blindly follow my advice - do your own research :)

Music Labels and Judge Patel - Courthouse Fun

Having followed the original Napster case quite closely, it was always interesting to see how Federal Judge Patel would rule on certain motions.  She often surprised both sides by issuing very wide rulings, some of which were late rejected by the senior courts, but this tendency made her courthouse a tough place to be since you never really knew what was going to happen.

Well, the music labels re-learned that lesson on Friday when Judge Patel ruled (Reuters link that EMI and Universal may have deliberately misled the US Department of Justice about how much information they had on competitor pricing policies in the digital music business, and she ordered them to turn over all related materials.  Without boring everyone with the details, this is related to the label-led creation of PressPlay and Musicnet as "independent" digital music companies in 2001, which we at Listen.com (and others) fought as a clear anti-trust violation.  Unfortunately, the DOJ political appointees cowered under their desks when it actually came time to finish off the action, so they dropped the case in 2003, but it now appears that the labels may not have been entirely forthcoming (yes, shocking, I know).

So the "Son of Napster" case continues along (the 3 labels suing BMG and Hummer Winblad for funding Napster), dragging everyone in its wake, and again pointing out why being a start up in the digital music business is not an attractive proposition, and showing why having Judge Patel is always worth the price of admission.  And the good news is that this action looks like it will continue to put pressure on the concept of the Most Favored Nation (MFN) clause, which is inherently anti-competitive, and yet still shows up in many label and publisher contracts - I would be wary of insisting on that clause going forward.

TubeMusic – Flawed but Interesting Digital Music Company

Continuing the trend of following small, public digital media companies (see earlier posts on Handheld/ZVue and Digital Music Group), I stumbled across TubeMusic this week. Tube’s () concept is pretty cool, which is to provide a music video service using the emerging multicast spectrum available from local television stations as they begin to broadcast in digital form. It uses spectrum given to the stations by Congress to offer more targeted programming, and new digital televisions and cable boxes should be able to receive the broadcasts. For more information, see www.multicasting.com. Local stations are hungry for more ways to reach their user base, and this potentially offers up interactive programming opportunities for a wide range of programmers, and better yet, it may fall under the broadcast “must-carry” rule, making sure any multicast programming is also carried by cable and satellite programmers. In addition, Tube is headed up by experienced music video executive Les Garland, who was a co-founder of MTV, so the team certainly knows music video.

However, as usual in these types of reverse-merger companies, the financial structure is a complete mess (see filings), and the valuation is probably way too high at $75M, given the early stage of the company and the missteps so far. Tube’s attempt to buy and build a large music studio have turned out badly outside of what appears to be a gain on the real estate itself, and there is almost no money in the bank, plus a lawsuit and other financial defaults.

So why is it interesting? Because the company has signed distribution agreements with 3 good-sized television groups in the last couple of months, giving it a potentially compelling footprint for a launch later this year. Yes, they paid dearly in stock for those deals, we're not sure when the technology will roll out in large quantitites, and no one knows the exact deal terms.  However, we’ve seen that music video programming is a very popular format, and everyone is looking for options beyond MTV, so I think it's worth  keeping Tube on the radar to see if  they can dig themselves out  of the current hole - but still too risky to invest in them.

DOJ Opens Digital Music Pricing Investigation

Having been through a similar and ultimately fruitless exercise three years ago, I don't think music labels exactly quiver at the announced DOJ investigation of their digital music pricing practices.  They generally just have their lobbyists back up the bank truck, dump their load, and then watch the DOJ political appointees scurry for cover as various key elected officials race to protect them

However, given that the DOJ has been shamed into it by the Spitzer investigation, it's possible they might even follow through a bit, hold some hearings, and even demand some documents before they let it whither away so that they can focus on new ways to wiretap citizens or how to track down every Google pornography searcher.  As discussed before in this post, I believe the more interesting overall discussion is the one concerning Most Favored Nations clauses (Wikipedia definition here), and not the one around overall pricing since the MFN clause negates the need for any pricing collusion, which even I can figure out without going to law school.

Google Music Humor Continues: Napster Rumor

Note - we appear to have a calendar publishing problem with Typepad, so this post actually appeared 2 days ago, not today.

On the heels of the mysterious Mosaic Theory concept of Google Tunes last week (rumor is that Tom Hanks may star in the lead role), we today had the "Google buys Napster" rumor, which was reported by the known investor newspaper The , as coming from analyst Kit Spring of the investment bank Stifel Nicolaus.  Luckily the free markets reacted insanely by driving up Napster's stock over 70% in a few minutes to almost $5, before settling back down to $3.91, still 25% above the previous day's close with a trading volume massively higher than normal - see Signs of Bubble 2.0. 

The good news is that we now know the names of a public investment bank and analyst we had never previously heard of (which happened to have done a stock offering for its own stock 2 days ago).  The bad news is that there were no facts or logic involved in this speculation since Google could make far more money around music rather than providing music itself.  The analyst made the argument that Napster was valued roughly at cash value, and the value of the subscribers was far higher, ignoring the debt involved, low operating margins, and significant operating losses in the business.  Google emphatically denied the rumor, and I can't find any financial reason to support the purchase theory, outside of the need to generate news. 

But the best related segment news is that Digital Music Group IPO appears to be on track, which is a guaranteed Seinfeld episode for at least a year, especially now that Gizmondo is in Ch 11.

DMGI Goes Public - Continues to Amaze

I have to say that I admire the chutzpah of the Digital Music Group guys, and their banks FTN Midwest, and I-Bankers Securities.  They absolutely jammed that future penny stock company public, raising $33M, and giving them 6 months to build a big enough story that the stock will hold up until the lock-up ends, or whenever they agreed to end it.  The next steps will be use the cash to attempt to roll up or aggregate other players in the space such as larger competitors The Orchard, IODA, DRA and Iris.  I would expect a flurry of deals in any case, and given that they have raised much more money than their competitors, it will be an interesting year.

As I have been absolutely clear in multiple previous posts, there is no possible rational way to value this company at anything remotely close to the current levels.  It is currently worth more than a company in a similar category, but one which generated $7M in revenue last quarter.  It's starting to approach the valuation of a digital music company with over $100M in the bank and a quarterly run rate of $24M.  As a comparison, DMGI's revenue was about $235K in Q3 2005.  Or another way to look at is that the independent digital music aggregation category is now worth over $1B, if you add up the revenues of the top 5 players, and apply DMGI's valuation metrics to all of them - clearly insane.

My guess would be the vast majority of the shares were sold to retail investors.  Given that the Shorts can start descending early next week, I think we'll see the Dogs Come Out.  And yes, I'll be personally there with them since there is rarely such an easy way to make money in a free market environment, but this is one of those opportunities if you can find shares to short.

Google Tunes: You Must be Kidding Me

Must have been a slow news week since various news outlets breathlessly announced the rumor that Google may launch a music download service within 6 months, supposedly called Google Tunes.  Bear Stearns analyst Robert Peck apparently speculated that this made sense given the explosive growth of iTunes site, and then indicated that this speculation was based on "Mosaic Theory", which must be somewhat akin to Scientology theory, based on the lack of rigorous analysis involved here, although Wikipedia shed some light on it here.

Given the problems with the initial launch of Google Video (recently apologized for by senior Google executives), why would a music launch make any sense?  We're looking at a business with 15% gross margins, no ability to differentiate content, a need to work closely with hardware to be successful (with overwhelming market share leader iPod not in that equation), and limited ability to monetize advertising around it - try reading a digital download contract and you'll understand what I mean.  Plus they would have to either work with a music aggregator like Musicnet or Loudeye (lowering margins to almost zero), or go through all of the pain of signing label deals, encoding content, adding metadata, etc.   Of all of the possible opportunities to expand business, why would Google choose this one rather than focusing on making a much better music/digital media search experience, and monetizing that at the high rate they do for other similar categories?

Now Google is the reigning web powerhouse, so do I think Google may toss out some early version of a product just to see what happens?  Yes, that's possible, based on what we've seen from Google Base, Video, Reader, Music Search, Talk, etc., but I would be astonished if the music download business was in their top 25 priorities for 2006 - and you simply can't do music as a side project and expect to be successful since it's deeply related to the hardware, content relationships and editorial, none of which are currently core strengths for Google.  Maybe I should have spent more time studying "Mosaic Theory" though...

Digital Music Group: CORRECTION

Upon receiving a note from the Chairman of Digital Music Group correctly pointing out a significant error in my market cap calculations, I need to issue a Correction to the previous post.  Given the complexity of the merger of Digital Music International and Rio Bravo to form Digital Music Group, I did not correctly take into account the elimination of the vast majority of the original Preferred Shares of Digital Music International when DMG was formed - therefore, the correct market value of the merged company is not $270M, but is approximately $75M.   The rest of the post still stands as to the overvaluation issues with the offering, but the ratios of valution to sales, and employee value to sales are clearly lower than in the previous post - I regret the error.

Digital Music Group IPO Inches Closer: Simply Mind Boggling Valuation

Correction:  the original post below did not correctly calculate the number of shares outstanding in the merged company of DMG.  The new market cap is actually closer to $75M, vs $270M, lowering the ratios described below, although not changing the overall thesis.

When I wrote about the S-1 filing of Digital Music Group in late 2005, I assumed that it was the last we would hear about it since it's such a ridiculous concept, even in today's increasingly bubble-like atmosphere.  However, amazingly enough, the IPO appears to be moving forward based on the recently filed . 

There is no point in completely rehashing the first post since nothing has changed to make this offering any less ludicrous.  However, we can at least look at the valuation justification now that they have released expected pricing.  At the median offering price of $9, this would value the company at approximately $270M, based on a total of almost 30M shares, fully diluted.  To put it in context, the average price to sales valuation paid for large, fast growth digital media companies has been approximately 5x sales - that would be JamDat, IGN, MySpace, etc.  That's a rich, but defensible valuation assuming market leadership, high growth and high gross margins.

So how does Digital Music Group stack up?  The revenue in the most recent quarter (Q3 2005) was $235K,  giving it an annual run rate of $1M.  Therefore, we're looking at an astonishing 270x Sales valuation with a gross margin of 39% for Q3.  Another metric would be valuation per employee - since DMG has a grand total of 12 employees, each one is apparently worth $22.5M+, a slightly higher number than you would find at most other companies :)  A final way to look at it would be to consider that in August & again in late September 2005 (just 4-5 months ago), the DMG Board of Directors decided that the fair value of the company stock was $.01 a share when it sold 775,000 common shares to insiders for the grand total of $7,750 - yet now the stock is $9 a share?  A more correct valuation would be in the $5-10M range, so avoid this one like the plague, or short it like crazy if possible.  There are too many other better investments in the private sector with larger, more established players such as IRIS, DRA, IODA, and The Orchard.

Other interesting tidbits in the filing are:

  • iTunes (which accounts for 92% of their revenue) pays them $.70 per single download and $7.00 per album, and that appears to be a standard rate in the industry.
  • In short term agreements with content owners, DMG pays the owner 80-85% of revenue
  • In longer term agreements, DMG pays the publishing royalties, and then pays 25-50% of revenue to the content owner, as well as advances to secure the rights
  • Peter Csathy, the former President of MusicMatch, is joining DMG's Board, as is John Kilkullen, the Publisher of Billboard
  • DMG has borrowed $500K on a $750K line of credit from a Director/Shareholder's company in order to fund the costs of the IPO
  • DMG has paid royalty advances of $1.150M as of 9/05, yet amortized only $10K of it in the last 9 months with another $50K now payable.  Luckily these deals are long term deals since this amortization is going to take a long time at anything close to the current rate.

Music Giants Review - Still Needs Work

I spent the day playing with the new high fidelity music service from MusicGiants.com, a company in Incline Village, Nevada, close to our house in Tahoe.   There was a recent article in the local paper about them and I was interested in trying it since their primary focus, lossless WMA 800-1100K bit rate songs from all 4 major labels, was at least a different approach than banging ones head against iTunes along with everyone else.

The short answer is that the concept is interesting, but the current implementation still needs a lot of work before I'd recommend it to anyone   You must download a 30MB client to access their service, which is strange since everyone else is going to web clients - I can't imagine what the other 20 megs of that client actually do.  You then must pay an annual $50 fee to use the service, all of which is credited to you the first year in music credits at $1.29 a track. I'm actually OK with that fee concept if the quality is much higher since I think there is a small but valuable audience which will pay for higher fidelity.

However, the editorial approach to the service is simply horrible - it's essentially a long listing of artists by genre, or just alphabetically by last/first name (they list by both, which is strange).  There are no popularity charts, no timely playlists/editorial or community features, and the search algorithm is close to useless unless you spell the name exactly right.  They use AMG content for editorial, which is always good, but the sole result within the product is a long bio of the artist, with no hot links to the genres or similar artists listed within the biography.  And I received an error message every time I started up, presumably related to the screen resolution ("unsupported DPI"), which meant that there were some minor graphical issues through out the product.  The overall player interface is clean, with some decent graphics, but is pretty confusing about what is actually in your library since there is no button or link to Your Music or Your Library, which is a tough interface problem for most users.

On the catalog side, it's fairly sparse, even if you just limit it to major labels since they say that they haven't gotten to the indies yet.  For example, there is no Bruce Springsteen, only one Chicago album (#17, which means they may have done some before that), only 2 Alan Jackson out of 11 on Rhapsody, only one Britney Spears album, and only 4 recent U2 albums (out of 14), etc., to randomly choose some big name artists.  So ignore the tag line about having all 4 major labels until they can significantly increase the catalog.

On the fidelity side, the player use a clever gauge to show the fidelity/bit rate of the songs you're playing.  The player automatically imported all of my MP3's (nice, but would be good if it told me that anywhere in the service) and listed them as "low fidelity" since they're either 128K or 192K, depending on where I acquired them.  I bought a couple of songs (Angels by Robbie Williams and Who's Gonna Ride Your Wild Horses by U2) which was a reasonable process, but only after I was forced to download an additional security upgrade from Microsoft - not quite sure why that extra step was needed, especially after it failed the first time.  Each song download took about 2 minutes on a DSL connection, which isn't horrible for a file 5x the size of a standard iTunes download.   The problem I had was when I switched rapidly between the Rhapsody file and the MusicGiants file, I couldn't tell the difference, even with nice noise-cancelling headphones.  I may not be a total audiophile, but I've spent a reasonable amount of time in the sector, and these mainstream songs are not worth paying to have at full fidelity, at least not with the recordings I was consuming - maybe Classical music or other types of genres make sense, but the thrust of this company is not in that direction.

So I'm now stuck with $47 worth of credit on a conceptually cool service which simply doesn't fit the needs of the vast majority of digital consumers without a large set of improvements.  MusicGiants needs to radically improve the catalog and overall interface, as well as work closely to integrate it with connected-stereo companies such as Sonos and Olive to make it available to those users with very high end audio systems, as well as with higher end WMA-compatible portable players to help them differentiate from iPods.   And at the end of the day, the problem is that as the majors look to increase overall digital music prices, MusicGiants will have to increase their prices, and without a signficantly better product, I'm not sure how big a market exists for them.  That having been said, if they can improve the product and conclusively show that their lossless approach is the right one, they  may be able to carve out a profitable niche, but my guess is that others will soon enter that category and just having higher fidelity is not a long term advantage vs larger established players.

SharkJumping: Year in Review

I started blogging in late July of 2005, primarily to understand the blogging phenomenon, especially after my wife consulted for blogging pioneer SixApart, and after I attended the Casual Games Conference in Seattle.  In that time, I have attempted to focus primarly on digital media, gaming, consumer technology, and a few other topics in hopefully related areas.  So let's do a very brief year-end summary:

  • Infinium Labs - home of the aptly named Phantom console - blogged about them here and here.  In the last 6 months, the stock has dropped essentially to $.02, they've replaced the CEO, and it's clear it's going to Zero...
  • - blogged about them here and here - my personal favorite, whose PR hack repeatedly emailed me asking "if I was part of the conspiracy against them".  Stock has dropped to 2.5 from 10 since my October post .  It's going to Zero...
  • Loudeye - a good group of employees in a bad business.   Stock has dropped to $.41 from $.80 since I blogged about them in August - will be sold for less than that at the end of the day - a victim of bad sector economics and a horrible Overpeer acquisition which they shut down last month.
  • Digital Music Market and Competitors - Apple continues to utterly dominate the category, with Real, Napster and others bringing up the rear.  Good news is that 75% market share brings incredible economies of scale to Apple in the player hardware business - Bad news is that the music labels still own the download category, and utterly control the economics.  RealNetworks and Napster will fight it out in the subscription business until Apple enters it in 2006, and all competitors will focus on the new web/ad-supported sector.
  • Ringtones/Dwango, etc. - An amazing global $5B+ business which outlasts the perpetual naysayers, and which delivers returns increasingly to music labels and to carriers vs the earlier outsized returns to aggregators such as Infospace, Moderati and Zingy, all of whose business models are starting to resemble the market dynamics of Sysco (that's the largest US food distributor, not the router company)
  • Casual Games - an unsung, but quickly growing entertainment category which is about to be hit by standard consolidation economics, with many current players being bought or going away, with the others being relegated to "lifestyle" businesses.  However, I believe the growth opportunities of this sector make it the most promising one of the entertainment category.  The reason I invested into Puzzle Pirates is because I believe they are a key break-out player in the category.
  • Next Gen Consoles - XBox 360 looks like a good box with a potentially phenomenal online business, but not a great software business since the initial games are weak.  PS3 won't ship until Q4 2006, but will have great games and mediocre online support.  Who knows what Nintendo Revolution will do, but their amazing success in Japan with non-standard games for the DS is a potential indicator.
  • Consumer Bubble 2.0 - yes, it's arriving, meaning valutions are increasing for these companies, but it doesn't mean they're all over-valued, just that there is too much investment cash in the category - these new entertainment firms will redefine what is currently a traditional linear media company.  E.g. if you're a newspaper company, what are you doing now as your current business inevitably declines?
  • Donnerwood Media - we will launch a kick-ass new entertainment category in Q1 2006

Thanks for reading Sharkjumping this year - 2006 is looking like a very fun year....

Sean

Music Download Price Fixing? Spitzer Subpoena Barking Up Wrong Tree

Had to republish to correct misspelling in the title...

 

NY State Attorney General Spitzer is 2 for 2 in the last few years going after the music labels for various legal offenses which everyone knew were occurring, but which no political or legal entity seemed to want to address.  The labels/retailers settled retail CD (funny plastic disks sold in retail stores for high prices) price fixing charges in 2001 stemming from an FTC investigation, and then settled payola (paying traditional radio stations to play music) charges earlier this year, refusing to admit guilt, but paying fines to make the charges go away.  So now it's back to what Spitzer must call the easy win trough with the latest subpoenas to the labels about price fixing in the digital music business.

Having lived through 3 years of these negotiations, ending about 15 months ago when I left Real, I strongly believe the labels all know what the other labels are charging for various digital media licenses - in fact, at Listen.com, we pursued a private anti-trust case against the major labels for a year over some of these issues, particularly their refusal not to favor their own entities vs others, and their seeming inability to stop trading information between themselves.   However, I'm not sure (I'm not an Anti-Trust attorney, but my mother was one, so I get to pretend) that they are necessarily colluding to set prices since, as has been discussed in various articles, the download prices are somewhat different from contract to contract, as are some of the business terms, and I believe it's generally due to different strategies favored by each label rather than a far reaching conspiracy.

So what's going on here?  Various news articles have stated that this round of subpoenas stems from Apple's issues with label statements that they will raise digital download prices, as I discussed here.  I would say that Warner and UMG are certainly signaling (MBA geek-speak for actions which indicate something to competitors) wildly that they will do so in 2006, both to see what the reaction is, and to make it clear to others that it's coming.  I'm not sure I would focus on that issue as a Conspiracy one since it's difficult to prove unless Spitzer just wants a settlement rather than actually go to court on something for once. 

To me, the more relevant issue in a music label deal is the "Most Favored Nations" (MFN) clause, which is almost unheard of in normal business practices not inhabited by what I term serial monopolies.  This clause is fought tooth and nail by every licensee, but is rarely changed by labels - it states that the label can not receive terms worse than any similarly situated supplier (e.g. other label).  I used to refer to it as the "Lazy Business Development clause" since it effectively saves labels from actually negotiating the terms  - they just claim MFN and do an audit once a year if they think a competitor is getting better terms.   That's a bigger anti-trust issue than spending time worrying if the actual cost of a download is within $.05 of another supplier since it really doesn't matter if there is an MFN clause since terms will naturally become similar in that situation, and there isn't really a need to collude on pricing.

I'm curious to see how it all plays out since Spitzer has more balls than the Federal Anti-Trust appointees we dealt with in our private case, but my assumption is that the best case result is yet another fine which gets chalked up to the cost of doing business in the music sector.  As I have said many times, the digital music business does not allow licensees any leverage since they need all 4 (soon to be 3) labels to launch a service, and the resulting financial terms are painful for those companies, Spitzer lawsuit or not.

Google Music Search - Listen.com Redux?

Google Music search launched today, and it reminds me a lot of the original Listen.com MP3 directory.  It's a sub-set of Google's general search available at http://www.google.com/musicsearch or just by typing any artist name into Google and then clicking on the "More Music Results for xxx".  The overall experience is a clever repackaging of the standard Google filters (site, images, news, groups), but also starts to add in the commerce part (Froogle) by offering direct links to both digital and physical retailers.  Google has similar sub sets of search available for movies and for financial stocks, so this continues a trend for them.

So what's interesting about this?  First is that it handicaps Apple's iTunes a bit since it does not have any web-only way to get to music content - you must download iTunes to access any music information.  Other more web-centric digital retailers should be able to take advantage of this, although the RealNetworks links, for some unknown reason, do not link to the web version of Rhapsody, but instead link to a decent artist information page at real.com which then forces you into a registration and download process.

Second interesting debate going on is whether Google is taking a referral fee from any of the retailers, and how they are deciding which retailers to list first, since one would assume there is much value in being listed higher, a la the Overture bidding system.  I've seen speculation on both sides today, but it looks to me like it's just taking a Froogle spider crawl and repurposing it for this service, so I assume the answer is no, and that it's not related to any type of business arrangement.  The only one I can't figure out is the RealRhapsody link, which looks technically to me like a feed was given to them, but I'm probably wrong and should stop pretending to be an engineer.

The original Listen.com MP3 directory was very similar to this vision, as is today's GoFish commerce service  We had an editorially reviewed and categorized directory of all of the legally available digital music, and we did deals with the leading search engines of that era to integrate the results, and then we shared the resulting commerce or ad revenue.  Unfortunately, there was almost no major label content legally available in those days, P2P Napster was dominant, and then the advertising business collapsed across the Internet, so we were forced to change the company to create Rhapsody.  In this case, times have changed enough that both the amount of digital content and the cost effectiveness of advertising and commerce links are coming together to make this type of experience a much better one. 

The key unknown is whether Google's immense reach begins to drive customer acquisition in the sector, which would push the sector even harder towards a web-centric approach, and does that affect Apple at some point?

Web Rhapsody Review - Nice Effort

4 years after Listen.com launched the original award-winning Rhapsody client, RealNetworks today launched a web version of it and it's a really nice effort, allowing users to access most of the Rhapsody feature set with just a 500K plug-in component.  Combined with the Rhapsody 25 free sampling service, this is a very easy way to try out the service, and it follows the general Web 2.0 trend of making services easily linkable and shareable across the Internet.   

Some of the advantages of this approach are that it exposes the differentiated Rhapsody editorial features to a wider audience, Real can now attract Mac and Linux users, and that it should open up additional advertising opportunities due to the removal of the required client download.  As one would expect, there are limits to the service to encourage heavy users to upgrade to the full subscription service, such as no skipping in the radio stations, and no ability to move tracks to portable players, but it's otherwise a rich web music experience.  The only issues I'm running into right now are intermittent skipping, but that could be a beta issue since there is no real reason for that to occur.

Given the Apple iTunes juggernaut, "Websody" is a much smarter way to approach the digital music market rather than just pounding away on client software and on downloads.  I'd say that RealNetworks just raised the bar for competitors Napster, Yahoo Music, Pandora, etc  with this innovative approach.

Who Really Sets Digital Download Prices?

Record label EMI turned in a good yesterday and as part of the presentation, CEO Alain Levy indicated that he believed Apple would go to a multi-tier pricing scheme next year for its iTunes store, presumably with higher prices for well known artists and hopefully with lower prices for lesser known artists.  He also had the following quote  "We do not set the price, Apple sets the price".  Although technically and legally accurate, it's a misleading statement in the real world since it implies that Apple has looked at its business and has decided that it's better for iTunes to increase prices for better known artists - the question is Who Really Sets Digital Download Prices?

The fact remains is that music labels effectively set retail pricing by setting wholesale prices, with an eye toward expected retail price for rational distributors who wish to make some sort of profit.  Therefore, if a label wants to see a $.99 retail price point, they charge a $.75 wholesale price, giving the distributor a 20-25% margin, similar to what is seen at retail.  If they want to see a $1.49 retail price point for part of their catalog, they will charge a $1.10-$1.15 wholesale price for those tracks.  Now there is no question that iTunes or other distributors can continue to charge $.99 per track (or whatever price they want), but it begins to drive an already low margin business into negative margin territory, which makes it hard for distributors to survive, although you see this occur sometimes with loss leaders on new album releases in retail stores. 

What's interesting is that Apple is in the best position of any digital distributor to absorb potential losses on each music download due to its massive iPod business - therefore, one could map out a scenario where Apple refuses to change retail prices, which then forces all of its competitors (Napster, Real, Yahoo) to remain at $.99, but they can't absorb the losses through other profit centers, and eventually exit the business, which is exactly what the labels do NOT want, since they would prefer to see a lot of players in the market.  This would be more likely if Apple could significantly grow its video download sector, which is an area where it has relatively little competition, and that would offset the possible losses in the music unit due to increased wholesale pricing.

It certainly appears with all of the label signaling (since they theoretically can't conspire - see ) that we'll see different wholesale prices for digital downloads in 2006, with the probable resulting changes in retail prices by rational distributors like iTunes.  With the threat of piracy receding a bit in label executive minds due to a series of legal wins, they now appear focused on:

  • Cranking up the focus on DRM - see continuing SonyBMG rootkit fiasco and EMI/Macrovision
  • Expanding the legal fight to other sectors - e.g. satellite radio rates and time shifting may be the next big battle
  • Nudging download prices towards the higher mobile rates - e.g. see NYT review of Sprint Mobile Store at $2.50/track, even though I believe that the price elasticity of this market would dictate another path.

The good news is that the digital market is starting to deliver rewards for music labels, with it now representing 5-6% of revenue, much of that at very high margins, but they still have a much larger declining CD market, so the scramble will continue to increase revenue from other sources.  I've always said, and will repeat, that the labels will end up making more money from digital than they ever made from physical, but it's going to be a rough transition in the next few years due to the different market sector sizes.

 

Loudeye Q3 Report: Downward Spiral Continues

I've posted about the margin difficulties in the digital download business before, by using Loudeye (LOUD) as a public proxy.  Unfortunately, what can you really say about Loudeye's Q3 report that isn't covered in the 10Q?  To summarize it:

  • Negative gross margin - yes it's actually negative
  • Increasing loss from previous quarter
  • Decreasing revenue from previous quarter
  • 6 months of cash in the bank and a "going concern" doubt
  • Market delisting battle continues
  • Overpeer unit accelerating downward
  • Resignation of Chairman
  • Retention of Allen & Co to explore strategic options

The stock dropped 38% today, but still sports a $50M+ market cap.  Given that MusicNow was just sold last month to AOL by Circuit City for a rumored $15-20M, I assume a company will buy Loudeye for some amount between the MusicNow deal and the current market cap due to its European presence (OD2 acquisition) and its mobile deal with Nokia.

Pandora Goes to Free

Pandora, the new pesonalized subscription radio music service I previously discussed, announced this week that they are now offering a free version that has the identical feature set, but which will eventually be ad supported.  I say eventually, since it doesn't seem to currently have ads in it.  If it were me, I would decrease the feature set a bit in the free version, usually by offering a lower bit rate or limiting some of the features, and then add house ads to the equation right now to make clear the differences between the paid and free options, but I can understand this move in a competitive market. 

Given that it now was free, I went back to try the service again.  It's clear that Pandora is one of the best radio services in the marketplace, but I still struggle with the web page radio concept (vs a client) since my Amos Lee station was abruptly ended today when I clicked on an unlrelated AIM link from a colleague which took me away from the Pandora page, thus killing the stream.  In general, I'm still not entirely sure that Pandora is better than the "good enough" of free competitors such as AOL Radio, Yahoo Radio and MSN Radio, but they're making a great run at proving me wrong.

Napster Q3 Results: Napster Preparing a Music Portal

Napster announced their calendar Q3 results today, which was basically a quarter of zero growth once you take out the $2M in one-time hardware sales for the Bell South promotion.  Subscribers were flat at 450K or so and revenue came in at roughly $21.4M, excluding the negative margin hardware sales.   Margins dipped down to 21.4% from last quarter's 31.4%, again due to the hardware sales.  Marketing spend dropped almost 40% due to the need to conserve cash, and gross new subscriber ads apparently dropped a commensurate amount, plus they had a large churn bubble hit due to people coming off their preliminary sign ups from previous quarters.   Loss was $13.6M, an improvement from last quarter's $20M loss, but given the lack of growth, nothing to crow about.  So the company has stopped growing, is still losing money, and faces increased competition due to the Real/Microsoft deal, although Yahoo has at least backed off a bit.

What was the good news?  Well if you do the revenue per paying customer math, Napster is generating an impressive roughly 2.5x the revenue per subscriber that RealNetworks is, given that Napster had 448K subs who generated $21.4M in non-hardware revenue ($48/sub) while Real is claiming 1.3M paying subscribers generating $25M in revenue ($19/customer).  But it's hard to compare the numbers since Real includes the lower revenue but very profitable Radio subscribers in that number, as well as the Comcast ones, which are of unknown revenue and profitability.  In addition, Napster's revenue number is now in striking distance of Real's, which is an accomplishment, at least for this quarter until the Microsoft marketing deal kicks in for Real - they are, of course, all single-low double digit revenue market share compared to Apple.  Other potentially good news was the impending launch of Napster Germany and then of Napster Japan the following quarter since they don't have any subscription competitors there, but it's too early to tell how those deals will do and non-US services can be really tough to profitably scale.  Finally, the initial XM/Napster-compatible devices will ship this Christmas, but the cooler ones which integrate Napster to Go will come later in 2006 - they could really be big wins if the XM audience converts to Napster users given the traction that XM is getting (BTW:  that functionality is going to be dragged into the brewing epic battle between the labels and the satellite radio services over these types of advanced music capabilities)  And the company still has $100M+ cash, which is enough for the next 2 years, according to them.  As a sidenote, it was a little surprising to see a relative lack of focus on mobile and an almost total lack of comment on Best Buy, given how crucial those categories were in the last 12 months, but the market continues to morph and you have to give Napster some credit for morphing with it.

However, the key part of the call (and the new investment thesis for Napster) was that, as predicted in an earlier post, Napster announced that they will be launching a free, ad-supported destination site at Napster.com sometime soon in 2006.  Given that it's been 6 months since the last change in focus (first it was downloads, then subscription, then mobile), this is not a huge surprise, given the favorable advertising trends on the Web.  The often repeated investment thesis is that deploying this unique destination site will take advantage of the large traffic Napster receives at its site to generate high margin advertising revenue, decrease customer acquisition costs and reduce churn since the site will be so compelling. 

This is not impossible, but is certainly a tall order.  The first data point you have to believe is that Napster can deploy a site substantially better or more compelling than MTV, Launch, MySpace, AOL Music, RollingStone,  etc., which are sites which have been delivering strong music services for years at this point.  You must then believe that Napster.com gets a very large amount of traffic due to its brand - unfortunately, most data points I can find show that Napster is a moderately popular site not listed in the 10 Internet music destinations, and if you use the poor man's data source, Alexa, it has only 10% more reach than a moderately popular site like RollingStone.com, let alone the big ones like MTV, and that Napster's traffic has actually declined 50% in the last 6 months.  And finally you have to believe that the conversion to Napster subscription services will be incredibly high due to the great editorial placement of it within the new site - having run RollingStone.com, which is probably roughly comparable to what Napster will deploy, I wouldn't expect the conversion rates to be off the charts and they might be lower than the ones on Napster's current site since users will be going to the new editorial site for reasons other than signing up for a subscription music service.  Those 3 data points don't lead to the obvious new investment thesis that ad revenue will be large, marketing costs will massively decrease, and churn will be lower - it's possible, but unlikely. 

So we're left with a company attempting to do a large pivot to a new business model while still maintaining its irons in the other fires, none of which are large margin businesses due to supplier leverage, and all of which have intense competition.  I always credit CEO Chris Gorog for making a large and incredibly passionate bet on digital music, but I'd say the odds of a winning hand for Napster shareholders are getting increasingly difficult.

Digital Music Group S-1: Weekend Humor

I can't decide if this is Halloween scary or April Fools funny, but a company known as Digital Music Group (I have linked it, but there is no active web site - presumably they will fix this before they go public, at least if they plan on communicating with shareholders) filed an S-1 this month in order to take advantage of the hype surrounding digital music and the "long tail".  DMG is the name of the shell company which acquired a small 20 month-old digital music aggregator called Digital Musicworks International, and then acquired the digital rights to a set of music recordings from another entity called Rio Bravo Entertainment LLC (www.psychobaby.com)

Digital music aggregators act almost like record distributors in the physical world.  Since there are thousands of independent music labels which want to offer their content through the digital (e.g. iTunes and Rhapsody) and mobile (e.g. Moderati and Infospace Mobile) services, aggregators fill in the gap, becoming the single point of contact representing tens or hundreds of smaller labels to the larger music services.  The "long tail" theory of it is that the unlimited shelf space of digital services will allow all of these small content owners to monetize their recordings, and any company which can facilitate that process is bound to do well.

However, it's a slice of a slice business, as many distribution businesses are, and they tend to need massive scale to overcome the very small margins.  My best guess is that DMG is probably 5th in size in this sector - the other bigger ones are The Orchard, IODA, Digital Rights Agency and Iris, and there are no signs that any of them are going public any time soon since the entire group probably does $20M in annual revenue.

So we're left with a 7 month old company with 10 employees (reduced from 15 three months ago), $224K in revenue for the 1st 6 months of 2005, a 9% gross margin (sounds like Loudeye as we discussed in an earlier post), and a brutally competitive sector with multiple larger players where all of the leverage is held by the music services such as iTunes, which currently accounts for 80% of DMG's revenue.  The idea that this company is going to go public is clearly ridiculous and dredges up bad memories of MusicMaker from the last bubble.

RealNetworks Microsoft Settlement - Rob Glaser Deserves the Credit

So RealNetworks and Microsoft finally announced today their long awaited settlement of Real's anti-trust litigation, with Real receiving $461M in cash, and $300M of promotional credits, as well as pretty broad integration of Rhapsody and RealArcade into MS properties such as Messenger, Music and Search - the RNWK stock promptly shot up 35%. 

I have to give Real's CEO, Rob Glaser, full credit for this deal.  We may not always have agreed on operating or management philosophies, but he almost single handedly drove this litigation against a lot of naysayers, and it turned out be a huge win for Real's shareholders, including myself :)  He could have settled just for cash, but hung in there to negotiate as broad a business relationship as possible.  The integration of Rhapsody into MSN's properties will certainly drive overall usage, and the web-Rhapsody version they showed looked pretty cool, although we'll have to see it in full release before passing judgment.

What this means for MSN Music is unclear, but can't be good for that unit since they have a negligible impact on the music market so far.  And Napster?  I assume we'll see some type of announcement around their earnings call which repositions them as a music destination site since it's time for their semi-annual business plan revamp.  And Apple?  My guess is they ship a subscription service in the Spring, but it's too early to tell.

Erik Flannigan's New Post at AOL - Great Move

AOL announced today that they had hired Erik Flannigan to run Programming, managing AOL Music, AOL Radio, AOL TV and Moviefone, continuing to be based out of the LA office.  Erik was briefly a colleague at RealNetworks as we were acquired, but we previously knew each other from the Mr Showbiz days and he soon moved on to run programming at Disney's ultimately cancelled MovieBeam movie service.  He's a talented executive with true creative credentials and a skill for effectively motivating his teams - it's a great move for AOL, especially as Yahoo and MTV beef up their teams in those areas.  It's another example of Real's large and often successful alumni group.

IPod Nano - Size Matters

Having now played with a new for the past few days, I am simply amazed at how Apple has continued its winning streak with this new player - it's quickly become an object of Techno Lust among friends and employees, even those with functionally-comparable iPod Minis whose value must be plunging on eBay this week.  And no, I don't own stock in Apple, and in fact, competed fiercely with them for years, so I have no great love for the overall company, but the product simply rocks.

There are numerous positive reviews of the product, including one by Walt Mossberg in the WSJ this week, but it's hard to explain how attractive this package is until you actually hold it in your hand.  The combination of the tiny size/weight (between Mini and Shuffle), simply great screen for pictures & album art, and the usual brilliant overall design blows away any other MP3 player I have used.  Since a recent study by Solutions Research Group has shown that the average iPod user has 504 songs on it, the 2-4G size is just perfect for the sweet spot of the market.  And since it continues to use many of the same accessories as the previous players, there is a huge ecosystem around the new player, in addition to the new accessories created specifically for the new player.  Apple deserves huge rewards for taking the chance of replacing their leading SKU (the Mini), instead of just continuing to add feature bloat such as just increasing storage for the new generation, as others would have done.

So what's most interesting about the Nano from a business perspective?  It's the fact that my entirely and admittedly back-of-the-envelope calculation of Flash costs would lead me to believe that not only is Apple now the largest consumer of Flash RAM in the world, but that its cost of 4G of Flash is probably almost as low as the equivalent 4G of hard drive costs, meaning that the immense scale of Apple is now making it almost impossible for competitors to match it on a cost basis, which is an astonishing shift from Apple's 3% market share in PC systems. 

If the production and sales rumors are true that Apple will sell an astonishing 30M iPods in 2006, then we can reasonably guess that 75% of them will be Flash-based, with probably 50% of the total being Shuffles due to lower price points.  If we guess that the average Shuffle is 750K of Flash (50/50 split between 500K and 1G) and that the average Nano is 3G of Flash (50/50 split between 2G and 4G), then Apple will consume 34 Million Gigs of Flash in 2006.  There are other large scale flash consumers, but the most often quoted large one is from mobile phones (although digital cameras and basic Flash memory sticks are presumbly also large).   800M mobile phones will be probably be sold in 2006 and the average Flash memory, including all the lower end ones in developing countries, is around 32MB according to recent storie, at least in Western phones.  If that large assumption is true, then the entire mobile phone consumption of Flash is around 26M Gigs, which is significantly less than Apple's solo consumption.  Another way to look at it is that Apple has contracted for 50% of Samsung's entire Flash production, which was 1/3 of the entire market in Q2 2005 - that would put apple at 17.5% of the worlds Flash market, clearly larger than other players in a very fragmented market.

This is not to simply say that size matters, whether it's Nano form factor, or the size of the global Flash market.  What's key here is that Apple has not only out-designed every other firm on earth for the 3rd year in a row, but that it has taken the ROI competition to a new level, where only their purchasing scale can allow them to offer 4G-based MP3 players at costs similar to what others will sell 4G hard drive players for - it's time for competitors to go back to the drawing boards yet again.

Yes, I'm ignoring the ROKR iTunes phone - I've had a Treo with 1G of music on it for almost 6 months ago and have used it once - the form factor, software and battery life simply don't compare to what I can do with a true MP3 player, so I don't yet think we're going to be tossing our iPods for MP3 phones.

Tivo's Tom Rogers Loves Digital Media

I think it's great that Tivo's new CEO, Tom Rogers loves digital media.  In fact, he loves it so much that his digital media requirements are built into his new employment contract, as is detailed Apparently a $750K annual salary, $500K annual bonus. and 2.3M+ stock options, stock appreciation rights, stock grants, etc. are not enough to cover Tom's personal digital media needs.  Therefore, his new deal entitles him to be reimbursed for up to $15K in media equipment for his home office and up to $6K in annual home media services (that's a lot of Rhapsody, Movielink and iTunes purchases).  I suppose it's better than the usual golf membership reimbursements...

Pandora Review

The veteran digital music company formerly known as Savage Beast recently launched a new online radio service called Pandora.  (Note: I have known company founder Tim Westergren for a few years now and spent a little bit of time with the Pandora team during the beta period).  This may seem like an obvious statement, but a radio service differs from an on demand service (e.g. Napster) in that it offers music streams which adhere to a certain algorithm that limits the number of consecutive tracks by an artist or from a certain album within a period of time, but which often still offers a degree of customization and the ability to skip songs.  Unlike an on demand service, a radio service receives an automatic statutory royalty rate rather than having to negotiate deals for every single song, so the rates are lower and you can offer all songs, not just certain ones.

My thoughts on the service are generally positive from a product angle, but mixed from a business perspective.  I admire the fact that they are taking the great core editorial assets they created in Savage Beast and are rolling them into a high quality radio product, similar to what we did at Listen when we moved from an editorial directory model to the Rhapsody music service.  I think the Pandora service is easy to use since it's all Flash based, it offers a high quality MP3 stream, and that it offers a greater degree of customization down to the song level than almost any radio service I know.  The service is free for 10 hours and then requires a $36 annual fee, but it has no commercials.

However, from a business angle, I'm not sure that it addresses the primary issue, which is "Is it Better than Good Enough?".  This means that most enthusiast music consumers have adopted a client-based music service such as Rhapsody, Yahoo Music, Napster or iTunes, which offers them a wide range of features, as well as editorial and radio.  Novice or less experienced music consumers are probably pretty happy with free options from AOL Radio, Launch or MSN Radio, as well as bundled ones such as Comcast Rhapsody Radio.  The strong recommendation features of Pandora and its subscription price tend to aim it at enthusiasts, while the flash-based, low feature nature of the service would seem to aim it at novices, so I think it's stuck between 2 masters. 

However, from my point of view, the most interesting part of the approach is that that Pandora should be a great partner for syndication partners or advertisers who are interested in embedding an easy to use, high quality, radio service into their web pages - e.g. Ford F-150 Country Radio - there are no longer any viable players in this sector, and I'd focus Pandora in that direction since I believe it will be a lucrative one. 

In any case, strong congrats should go to the Pandora team for delivering a high quality music service and for continuing to build on the great work done by the Savage Beast team over the past few years.  Other Pandora overviews are here - http://www.ventureblog.com and http://www.techcrunch.com/?p=167.

Music Label Unhappiness with ITunes - a Price Elasticity Debate

In what has become somewhat of an annual ritual in the digital music business, the music labels are again complaining about the $.99 price point for tracks on Apple's iTunes digital music service (the other download services aren't big enough to matter and would have to follow whatever Apple does)- good NYT article about it here.  Having lived through this discussion more times than I would like to remember, my first thought was that I was glad not to have to go through it again, but let's look at the primary issue.

The core disagreement is that labels feel that flat rate pricing doesn't capture enough margin for those hot tracks where users would pay more.   Numerous studies will be trotted out, showing that consumers will pay up to $2-3 for hot singles, so the labels are giving up substantial margin by wholesaling all tracks at $.70-75.   Then they will point to ring tones where pricing is 2-3x higher, and that's not even for the whole track or even the song itself in case of polyphonic ringtones.  Finally they will offer up a lower price point which will be added to the equation so that it doesn't look just like a price increase - the goal is probably a $.50-$.75 price point for deep catalog/less desirable tracks, $.99 for the majority of music, and $1.49-$1.99 for more popular tracks, the overall algorithm to be determined in some TBD way.

It's an interesting point - in most markets you see differential pricing along the life cycle of the product - e.g.  a movie starts at $9 in a theater and then goes down the price curve (VOD, DVD, Pay Cable, etc.) until it reaches free in the broadcast market.  Video game consoles are introduced at $300+ price points, and gradually move down to a $99 price point towards the end of the 7 year cycle.  And everyone should be incented to generate additional margin, so why shouldn't the service providers go right along with this theory?

The reason is that most service providers I know (including Listen.com before our purchase by Real) have done their own price elasticity studies which show that digital download purchases are utterly price elastic when measured over a period of time across a large group of consumers - that means that demand for the product is closely related to the price - increasing the price will actually drive down revenue since fewer people purchase the product, while decreasing the price actually increases the overall revenue since many more people purchase the product, more than making up for the lower price per unit. 

I have no doubt that if you picked one hot track, and polled users in isolation to ask them if they would pay more than $.99 for that track, many would tell you yes.  But the studies show that when you measure behavior across a longer period of time, everyone is better off with lower prices for music downloads, with $.50 being actually the magic number, especially for a business which has NO hard cost of goods outside of artist royalties, which are almost never on a fixed basis so they will decrease with the price.  The explosive growth of DVD sales are a classic example of this - DVDs used to cost $90+ and very few were sold outside of rental stores.   Once the price dropped to the $20 range, the number of retail outlets exploded, consumer demand sky rocketed, and DVD sales became the most profitable part of movie studios.

Admittedly, there are other parts to this discussion, such as the operational difficulty of frequently changing prices (one label actually once proposed changing it on a weekly basis according to how many radio spins the track had recorded the previous week - no joke), the confusion in the market place with multiple price points, the seeming amnesia about the continuing massive piracy issue, the bitterness the labels feel about Apple's iPod profits and growing digital market power, channel conflict pricing issues with physical retail,  label concern about "lowering the value of music", label unhappiness that the publishers statutory rate would not go down with the price decrease, etc - but it really comes down to one point - is digital music price elastic and if so, by how much

Digital Music Downloads - The Problems of a Next to Zero Margin Business

Loudeye released their 10Q yesterday along with their Q2 financials.  Let's look at their company as a relatively decent pure play proxy for the music download business since 72% of their Q2 revenue is from the music store business - this is a vast increase from 7% in Q2 2004 since they acquired European music download service OD2 in mid 2004, transforming the company along with other small acquisitions and divestments.  The reason I chose Loudeye is that Apple and RealNeworks have substantial other businesses besides downloads, and Napster has a growing subscription business, although there is some fun to be had with that 10Q as well.  Let's focus on what I think is the consistent key metric of a music download (or actually any) business - Gross Margin - this is the difference between the revenue of the service/good, and its direct cost of providing it, before other costs such as marketing and overhead.  It must be high enough and have enough volume to cover the operating costs of the business - seems basic, but often fades from view in bubble/frothy times.

So how does the music download business look?  It's pretty clear - Loudeye's overall Gross Margin for Q2 2005 was $170K, or 2% of revenue (when music store revenue was 72% of revenue), vs $1,900K or 39% of revenue in Q2 2004 (when music store revenue was 7% of revenue).  And amazingly enough, the 10Q projects that digital media margins may further decline in 2005 vs 2004 - one might ask how much lower can they go?  You could argue that the real problems are in the other 28% of the company's revenue since the 10Q makes it clear that the Content Protection/Overpeer business was a negative margin busines, but at less than 7% of overall revenue, it can't have been a huge factor unless it's a total disaster.  Plus it should have been offset by the remaining 21% of revenue, non-music store businesses such as encoding and hosting, which we can only assume are positive gross margin since they are for every other company.  If we assume the Loudeye is a proxy, then the basic conclusion is that the download business is actually close to a zero margin business for service providers, at least at volumes below Apple.

This post is not meant to focus specifically on Loudeye's issues since I believe the management team is trying to transform a company with a mixed bag of assets into a potentially valuable pure play in digital music, especially in mobile music through a significant Nokia relationship, and that takes time and effort.   But as we have discussed before,(and which is laid out in various Risks of the Loudeye 10Q), the digital music download business is, in particular, NOT a place for service providers, or in my opinion, for investors.  The margins are simply terrible, one has no leverage over your primary suppliers, there are legions of competitors, your business customers want to go directly to the labels, and there is a massive piracy issue.  If you want to masochistically be in the music provider business, there are potentially areas such as Internet radio, general subscription services,  ringtones, music  videos, independent  music  sites, etc. which MAY  provide a way to make a postive gross margin for a period of time - but if they exist, I haven't found it yet, at least not on a sustainable level.

Amazon and Digital Music - Is this a Story?

Starting from an employment posting on last week, the word quickly spread that Amazon was entering the digital music business, with 120+ articles about it now listed in Google News. My initial comment is that is must have been a slow news week, competing solely with yet another Russian sub disaster.  My general view is that, although I have a huge amount of respect for Amazon's online prowess, this is akin to Sneezy joining his fellow dwarves in the digital music forest Why do I think this "news" is not news-worthy?

  1. Amazon is about the only signficant retailer without an online music play, so this is not exactly groundbreaking news if they enter the category unless one assumes that this category has now "made it" if they enter.    and Target both have their own services, while Best Buy and Dell have partnered with Napster or Music Match for integrated packages.
  2. Outside of a large customer base and a well honed marketing edge, how does anyone think that Amazon is going to differentiate itself when the label licenses are essentially identical, Amazon doesn't directly make music hardware, and when Amazon is starting from scratch in the category?  Neither Walmarts $.88 pricing plan nor the $.49 Top 10 that Real runs appears to be making a difference, and there is no way to provide free shipping...
  3. Looking at EMI's and Warner Music's earnings announcements, it looks like overall digital music is probably around 5-6% of their revenue, split between mobile and PC.  Adding Amazon to the PC download and subscription list is certainly not going to matter to those numbers, especially when their primary focus appears to be shifting to mobile music and music videos vs PC downloads - see Universal Music's announced into Amp'd Mobile as an example.

I think Amazon will grow the overall music business with its entry, but not dramatically enough to be worth 120+ articles, just as MTV's long awaited entry will also not be worth the noise it will generate.  It will take a signficant shift in the business, such as a move to mobile phones, to dislodge Apple from its leadership position in any reasonable time frame.  Until that happens, Snow White will be ruling the forest with an iron hand.

Digital Music - A Really Tough Business

Due to my previous experience at Listen.com/RealNetworks, I seem to get a lot of business plans and questions about digital music.   When starting Donnerwood, we spent a lot of time looking at the music business, and we were simply not smart enough to discover a sustainable way to drive value in that sector.   

Why is that?  At the end of the day, you have what I call a "serial monopoly" of 4 suppliers (labels), meaning that it's more difficult to get reasonable music rights than it is negotiating with an oligopoly like OPEC since Eminem and Norah Jones are not substitutable, while crude oil from Mexico and Saudi Arabia is relatively substitutable.   This is not a knock on the labels - in fact I spend a lot of time defending labels who generally act according to what they believe their best interests are - it's simply a matter of leverage - a start up needs to have rights from all of the major labels (EMI, Sony/BMG, Universal, Warner) and most of the smaller ones in order to compete in the sector, and the lack of those rights generally cripples the business - therefore, there is essentially no negotiating leverage, which makes for very low margins.

To top it off, you need to pair those low margins/lack of leverage with an intensely competitive marketplace, with RealNetworks, Napster, Apple, Sony, Yahoo, Wal-Mart, MSN, and a host of others all marketing like wild, discounting the product (MSN's buy 1, get 5 free), and trying to cut exclusive content deals.  Only Apple has truly managed to show profits in the business, primarily through sales of related hardware, and finally, through an 80% market share of the download market, but it's must just be brutal for the others.

I think digital music will eventually be extremely profitable for the content providers, including publishers, but I struggle to find a business model for the middle man in this business, at least for any model which requires broad label rights.  And when you consider the joys of the mobile music sector, where you have both a concentrated supply chain AND a concentrated customer base (4 -6 carriers), you begin to see why I find that sector to just be a disaster in spite of the hype.

So we will most certainly not be in the digital music business here at Donnerwood, primarily due to our collective experience in it over the last 5-10 years, but I have no doubts that companies will continue to pour resources into it.

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Sean's Favorite Sites

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