Big Music Takes on Steve Jobs

The digital music revolution put Steve Jobs back on top. But nothing stands still. How record companies and telcos will try to steal the digital music business away from Apple.

Talk about inauspicious beginnings. Apple Computer’s iPod launch the month after 9/11 went largely unnoticed except by analysts who dismissed it as an expensive accessory for the Apple set. Technical problems, which caused some early units to quickly fail, couldn’t have helped. Apple’s stock price slipped $0.88 the day iPod was introduced.

But Steve Jobs, Apple’s chief executive, was just warming up. He soon cranked up the volume by convincing major record labels to distribute their tracks at his iTunes online music store.

iPod sales soared after he released iTunes for Windows, opening Apple’s digital music ecosystem to all computer owners. The iPod revolutionized the way people listen to music, challenging rival hardware and software makers and forcing the recording industry to follow his lead.

Call it Round 1 in the battle for dominance of the digital entertainment market and score it decisively in Apple’s favor. But now a growing ensemble of record labels, computer hardware and software makers, mobile carriers, and handset manufacturers are determined to take away its lead. “iPod is as ubiquitous as Crest toothpaste,” says Ted Cohen, a digital music consultant who used to set digital music strategy at EMI. “But we’re going into a new phase now.”

They won’t say so publicly, but record companies fear that Apple’s success has already given it too much clout in the burgeoning digital music sector.

The digital music market of tomorrow is full of promising new services and gee-whiz features. People who today download single tracks from Internet music stores will soon likely be music subscribers—downloading or streaming as much music as they want to their computers or phones for a fixed fee, and even sharing tracks with fellow subscribers. Those subscribers will also probably be able to program their “music valet” to scour the Internet for their kind of music and then make sure that it’s automatically downloaded upon release.

For a taste of the future, consider U.K. startup Shazam Entertainment, which has already developed recognition software for mobile subscribers who hear songs they don’t know: a subscriber just dials in a code and holds up the phone so Shazam’s “discovery engine” can solve the mystery.

“This market will be evolving,” says Gartner analyst Mike McGuire. But just how depends on which companies define the market. The stakes are undeniably high. Record companies racked up $1.1 billion in digital music sales in 2005, almost 6 percent of their overall music revenue. Digital sales are projected to account for 8 to 10 percent of record company revenues this year. On the hardware front, market leader Apple’s iPod sales topped $7.3 billion in the last 12 months.

Jockeying for Position

But that is just the tip of the iceberg. The very rivals jockeying over music right now are also laying the groundwork for products and services that will deliver music videos, games, television shows and movies, and user-generated content in the not too distant future.

“If you don’t make your mark in music now you’ve marginalized yourself as a digital entertainment provider for the future,” says Larry Moores, senior vice president for global marketing and business development at WiderThan, which builds platforms for mobile music services for customers like Verizon Wireless in the United States and South Korea’s SK Telecom.

Two business models are emerging. SK Telecom, for example, now accounts for half of South Korea’s entire music market after launching its MelOn service two years ago. About 600,000 of MelOn’s 4 million-plus users are $5-a-month subscribers getting unlimited music via PCs and phones—certain proof that the subscription-based mobile model works.

Fixed-priced single-track downloads via the Internet are all the rage in the U.S. and Europe thanks to Mr. Jobs. Apple’s approach has earned it more than 70 percent of the U.S. portable music player market and 85 percent of the U.S. digital music market. Apple faces strong local competition in Germany and France, but Mr. Jobs still leads the European market, too. “He’s in a position to invent the future,” says Phil Leigh, an analyst at Inside Digital Media.

Maybe, but not if the record companies have their way. They won’t say so publicly, but they fear that Apple’s success has already given it too much clout in the burgeoning digital music sector. Mr. Jobs is clearly more concerned with selling iPods than songs, so it was not surprising when he rejected the labels’ attempt to introduce variable pricing at his music store: he called them “greedy” for even asking.

One analyst says the record companies are angry that they have turned Apple into “a digital Wal-Mart.” And they’re mulling different business models to fight back. Universal Music Group has already announced that it will offer ad-supported digital music tracks for free through SpiralFrog, a digital media site set to launch in December. Other plans feature advertising-supported peer-to-peer services such as those soon to launch from startups Qtrax and Mashboxx.

But these services won’t likely make any headway if the industry doesn’t tackle the interoperability issue, one big lesson learned from Round 1.

Microsoft learned that the hard way. It teamed up with hardware partners like Creative and iRiver, as well as music stores like Napster and Yahoo Music, which built devices and services based on the software giant’s WMA file format. Microsoft promoted its devices and services with its “Plays for Sure” campaign, but they didn’t always live up to their billing and consumers stayed away in droves.

Sony also tried to get in on the act with its digital Walkman and music store, which used the company’s proprietary ATRAC file format. The result was a digital music market that was flooded with a bewildering array of devices, music stores, formats, business models, and prices.

iPod Mania

Apple, of course, was different. It was the only company that delivered a cool music player and a revolutionary music store that are seamlessly bound together with Apple’s proprietary software. Critics, of course, point to this closed music system and recall how Mr. Jobs squandered Apple’s early lead in the computer market because he refused to license his technology. PCs, on the other hand, thrived because scores of manufacturers built cheaper machines using industry-standard chips and software.

The difference this time, perhaps, is that consumers have snapped up more than 58 million iPods so far, raising concerns that the market has reached a tipping point at which Apple becomes the de facto standard. Worse yet, all those iPod owners are leading trends that should drive digital sales for years, so the challenge for record executives is to undercut Apple’s growing retail clout without alienating users.

“We want to make sure things are pretty seamless for people,” says a record company executive. “If you buy a piece of bread, you should be able to put it into any toaster you want.”

There is one solution that could work, one so radical that major labels considered it heresy only 12 months ago: sell music in MP3 format without the digital rights management (DRM) software they long argued was essential for preventing rampant piracy.

Unprotected MP3 tracks play on any portable music player, including the iPod. Music companies would have to swallow hard, though: unsheathed MP3s were exactly what allowed Napster to popularize illegal file-sharing, which hammered CD sales in the late 1990s.

Yahoo, which opposes DRM, broke a critical sound barrier in July when it began selling pop princess Jessica Simpson’s latest hit in unprotected MP3 format.

And some record executives now privately hint at releasing larger samples from their catalogues in MP3 format to test whether these tasters would ramp sales or boost piracy.

Many see DRM as confusing and annoying to consumers, an impediment to really developing the online market. Today’s standards war only discourages sales of players and tracks. Free music from closed standards, MP3 proponents say, and consumers would flock to any and all music stores in an orgy of digital downloading.

eMusic.com certainly makes a case for simplicity. It captured second place in the U.S. online music market by offering subscribers a set number of unprotected MP3 tracks every month. The major labels have stayed away, but practically all of the smaller independents are on board and they argue that selling music in MP3 format allows them to get out their music to as wide an audience as possible. “DRM stands between what people want and our ability to provide it,” says Jim Sturgeon, president at Naxos, one of the world’s largest classical music labels.

Seeking an Audience

Besides sorting out formats, the recording industry must also find alternatives to radio stations for turning songs into hits.

An obvious step would be for music retailers to tap into the social networking craze. Internet denizens can already list their favorite songs and bands and make recommendations on social networking sites like MySpace.com or MOG.com, which is dedicated to music. But users must then navigate to music stores to download tracks. It seems only a matter of time before major services combine the information and purchase functions.

“It’s not just about viral marketing, sharing, and recommendation,” says Gartner’s Mr. McGuire. “They need to link all that with transaction triggers.”

Microsoft is trying to do this with its Zune line of digital entertainment products expected to start shipping later this year. It includes an online service and a wireless music player and while details are scant, the company has repeatedly said its goal is to create a service that enables consumers to connect with others to discover new music and entertainment.

Can Microsoft catch up to Apple? The software giant will certainly try, for it can ill afford to leave Apple in control of the emerging digital entertainment market. Microsoft has demonstrated more than once that it can beat back competitors fielding better products, and it has the resources to do it again.

Encouraged by booming consumer demand for ring tones, the global mobile phone industry also hopes to cash in on digital music by shifting to full-track downloads. Carriers see music as a way to generate revenue from their massive third-generation investments, while handset makers see music as the next killer app to drive phone sales.

Leading the Digital Revolution

Japan has certainly demonstrated the potential of the wireless model. Mobile music applications account for at least 90 percent of the country’s digital music market. Chaku-uta Full has led the way since its launch in November 2004—it’s sold more than 50 million full-length songs via telecom KDDI. NTT DoCoMo, Japan’s largest mobile company, has also started to sell over-the-air full-song downloads.

SK Telecom followed up last year’s acquisition of YBM Seoul Records, South Korea’s biggest music company, by forging a joint venture with Warner Music Korea. The recently completed deal marked the first time a major music company fully merged its operations with those of a communications network to create a technology-content hybrid to make music available on cell phones and other digital platforms.

In the U.S. and Europe, less than 10 percent of digital music is downloaded over the air so it’s hardly surprising that iTunes dominates in the U.S., where mobile carriers have just begun to roll out full-track music services. But what makes Apple’s lead in the European music retail market so remarkable is that their mobile culture is so advanced compared with North America.

But there’s a caveat. While carriers like 3 in the U.K. and Telefónica in Spain aggressively promote mobile music services, Europeans still prefer to download music to their computers and then “sideload” tracks to their phones, according to Jaap Favier, vice president at Forrester Research in Amsterdam. “It’s very expensive and very cumbersome to find a track on a digital phone,” he says. Mobile downloads are expected to account for only about 20 percent of digital full-track music sales by 2011, he adds.

Industry analysts say, and some carriers privately acknowledge, that the biggest impediment to mobile music sales is pricing. Record labels, in a bid to carve out a bigger slice of the mobile music pie, are understood to have set wholesale prices for carriers of between $1 and $1.40 per track—significantly higher than the estimated $0.65 to $0.75 they are charging Internet music stores like iTunes. Also taking a cut are application service providers like WiderThan, Groove, and Melodeo, which provide the music downloading platforms that power carrier stores.

“Everybody wants 50 percent. The ASP wants 50 percent, the labels want 50 percent, and the carriers want 50 percent. It’s not going to work,” says Inside Digital’s Mr. Leigh.

Carriers also are grappling with the same interoperability issues that Internet music stores face—a big problem in the U.S. and Europe because most digital music consumers have consolidated their collection in a single jukebox on their computer, and that usually means Apple’s proprietary iTunes.

The Open Mobile Alliance, an international body of carriers, vendors, and content providers, is trying to work around this hurdle by developing interoperability standards, but those remain elusive. “The [carriers’] business models and agendas are really getting in the way of natural consumer behavior,” says Yankee Group wireless analyst John Jackson.

Phone Play

Yet, the trend appears inevitable: more mobile subscribers are gravitating to phones that can also store and play music, even if the majority of tracks are sideloaded. An estimated 27 percent of the mobile phones sold globally this year store and play music, according to market research firm Ovum. That will reach 69 percent by 2010.

Sony Ericsson is pinning its hopes on new Walkman phones, while Nokia, which predicts it will sell 80 million mobile phones with integrated music players this year, is shaping up to be one of Apple’s key rivals.

Apple is also widely believed to be eyeing the mobile music market. Apple won’t comment, of course, but some suggest it could launch a virtual mobile network, buying wholesale airtime from a carrier and contracting out billing and customer support so it could focus on marketing and content.

Others believe Apple will build an unlocked GSM phone that works with any GSM carrier in the world—a natural, you’d think, for any carrier wanting to provide over-the-air access to iTunes. Or customers could simply sideload tracks from their computers to their “iPhones,” regardless of the carrier they use.

Some critics, of course, argue that Apple has no experience in the mobile market and say Mr. Jobs doesn’t work well with partners.

Apple has managed to stay one step ahead of its music rivals for the past five years and now that the sector is gearing up for Round 2, pundits suggest that Mr. Jobs will once again raise the bar—this time incorporating wireless technologies, subscription services, and social networking into the company’s digital music portfolio.

Mr. Jobs has so far expressed little interest in making any such changes, but then again, he once argued that people would not want to watch video on a tiny screen—only to launch a video iPod shortly afterward.

(c) RED HERRING

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