(FORTUNE Magazine) – Steve Jobs loves music. But as with a lot of geeks in Silicon Valley, his musical tastes are a little retro. He worships Bob Dylan and is the kind of obsessive Beatles fan who can talk your ear off about why Ringo is an underappreciated drummer. So Dr. Dre, the rap-music Midas whose proteges include Snoop Dogg and Eminem, is the last person you'd expect to see huddled with Jobs, for hours on end, at Apple headquarters in Cupertino, Calif. No, they weren't discussing whether John or Paul was the more talented Beatle. Rather, Steve had invited Dr. Dre up from Los Angeles for a private demonstration of Apple's latest product. After checking it out, Dre had this to say: "Man, somebody finally got it right."

The product that wowed him was the iTunes Music Store, a new digital service for Mac users offering songs from all five major music companies--Universal, Warner, EMI, Sony, and BMG. Though Apple had yet to sell a single song by the time FORTUNE went to press, Jobs is already causing a stir in the record business. Forget about rumors that Apple is bidding for Vivendi's Universal Music Group, the world's largest record company. Jobs says he has absolutely no interest in buying a record company.

The real buzz in the music trade is that Steve has just created what is easily the most promising legal digital music service on the market. "I think it's going to be amazing," says Roger Ames, CEO of the Warner Music Group. Jobs, not surprisingly, is even more effusive. He claims his digital store will forever change not only how music is sold and distributed but also the way artists release and market songs and how they are bought and used by fans.

One thing's for sure: If ever there was an industry in need of transformation, it's the music business. U.S. music sales plunged 8.2% last year, largely because songs are being distributed free on the Internet through illicit file-sharing destinations like KaZaA. Unlike Napster, KaZaA and its brethren have no central servers, making them tougher for the industry to shut down. The majors have tried to come up with legal alternatives. But none of those ventures have taken off because they are too pricey and user-hostile.

The iTunes Music Store, by contrast, is as simple and straightforward as anything Jobs has ever produced. Apple users get to the store by clicking a button on the iTunes 4 jukebox, available for download when the service made its debut on April 28. You can listen to a 30-second preview of any song and then, with one click, buy a high-quality audio copy for 99 cents. There's no monthly subscription fee, and consumers have virtually unfettered ownership of the music they download. Jobs is rolling out the iTunes store with previously unreleased material by artists including Bob Dylan, U2, Missy Elliott, and Sheryl Crow. There will be music from bands like the Eagles, who have never before allowed their songs to be sold by a legal digital music service. And Jobs is personally lobbying other big-name holdouts, like the Rolling Stones and the Beatles, to come aboard.

The iTunes Music Store may be just the thing to get Apple rocking again too. As everyone knows, it's been a tough couple of years for the computer industry as well. Apple swung back into the black in the first quarter of 2003 after two quarterly losses, but its profits were only $14 million, compared with $40 million a year ago. And as popular as Apple's iPod portable MP3 player may be, it contributed less than $25 million of Apple's $1.48 billion in revenues last quarter. So Jobs is betting that by offering customers "Hotel California" for 99 cents, he can sell not just more iPods but more Macs too.

Apple's competitors dismiss the iTunes Music Store as a niche product. How, they ask, can Apple have any impact on the music industry when its share of the global computer market is a minuscule 3%? "It's a very positive thing for their community," says Kevin Brangan, a marketing director at SonicBlue, which makes Rio MP3 players. "But their community is a very small percentage of the overall market."

Jobs, however, isn't targeting just Mac users. He plans to roll out a Windows version of iTunes by the end of the year. (Apple already sells a Windows-compatible version of the iPod, which accounts for about half of all units sold.) It is a dramatic departure for Steve, who has deliberately kept the Mac's best features off the screens of the much larger Microsoft-dominated world.

Steve isn't suggesting that his new service will lift the computer industry out of its funk. But he is 100% convinced that the Music Store will rejuvenate the ailing music business. "This will go down in history as a turning point for the music industry," Jobs told FORTUNE. "This is landmark stuff. I can't overestimate it!"

The idea that anybody from Silicon Valley can swoop in and save the music industry seems laughable at first. But by nearly every account, this is not just some Steve Jobs sales job. In fact, the Music Store is being copied by rivals even before it hits the market. The reason, as Dr. Dre noted, is that nobody has come up with a better plan to sell music online. So iTunes or something like it had better work. Otherwise, the music industry as we know it could soon disappear.

It's a sunny afternoon in early April, and Jobs is rhapsodizing about his new music service at Apple headquarters. He is clad in the same outfit he dons nearly every morning so he doesn't have to waste time choosing clothes: a black mock-turtleneck shirt, jeans, and New Balance sneakers. There's been a slight change in his uniform, though. The 48-year-old Apple CEO now rolls up the cuffs of his jeans. (What would Dr. Dre think of that fashion statement?)

But Steve isn't interested in talking about his new look on this day. (He later allowed that he just bought pants that were the wrong size.) He's here to talk music. "It pained us to see the music companies and the technology companies basically threatening to take each other to court and all this other crazy stuff," he explains. "So we thought that rather than sit around and throw stones, we'd actually do something about this."

He was equally appalled by the music industry's reluctance to satisfy the demand for Internet downloading that Napster had unleashed. Who could blame him? After bludgeoning Napster to death in court, record companies promised to launch paid services with the same limitless selection and ease of use.

They did just the opposite. Universal and Sony rolled out a joint venture called Pressplay. AOL Time Warner (the parent of both Warner and FORTUNE's publisher), Bertelsmann (BMG's owner), EMI, and RealNetworks launched MusicNet. But instead of trying to cooperate to attract customers, the two ventures competed to dominate the digital market. Pressplay wouldn't license its songs to MusicNet, and MusicNet withheld its tunes from Pressplay.

The result: Neither service had enough songs to attract paying customers, who couldn't care less which record company a particular song comes from. "It was strictly the greed and arrogance of the majors that screwed things up," says Irving Azoff, who manages the Eagles and Christina Aguilera. "They wanted to control every step of the [Internet] distribution process."

The record companies were also fearful about doing anything that might cannibalize CD sales. So they decided to "rent" people music through the Internet. You paid a monthly subscription fee for songs from MusicNet and Pressplay. But you could download MusicNet tunes onto only one computer, and they disappeared if you didn't pay your bill. That may have protected the record companies from piracy, but it didn't do much for consumers. Why fork over $10 a month for a subscription when you can't do anything with your music but listen to it on your PC? Pressplay launched with CD burning but only for a limited number of songs.

At the end of last year, Pressplay and MusicNet licensed their catalogues to each other, ending their standoff. MusicNet also now permits subscribers to burn certain songs onto CDs. But MusicNet users still can't download songs onto portable players. "These devices haven't caught on yet," insists MusicNet CEO Alan McGlade. Never mind that U.S. sales of portable MP3 players soared from 724,000 in 2001 to 1.6 million last year. Pressplay, for its part, lets subscribers download some songs onto devices, but only those that use Microsoft's Windows Media software. That means no iPods.

Pressplay and MusicNet say it's too early for anybody to dismiss them as failures, but it's difficult to see them as anything else. The music industry has little to show for its investment--Sony and Universal are believed to have spent as much as $60 million so far on Pressplay. The two services don't release their subscriber numbers, but Phil Leigh, an analyst at Raymond James, believes that together they have signed up only about 225,000 customers. "It was clear to me in my first 30 days on the job that Pressplay was a first effort and a work-in-progress," says Andrew Lack, who took over as CEO of Sony Music Entertainment in February. "No one was saying, 'This is it. We can't sign up people fast enough.'"

Consequently, the five major record companies have had to slash costs in the face of declining sales. BMG laid off 1,400 people, EMI shed 1,800, and Sony Music recently announced it was reducing headcount by 1,000. Even with those cuts, average profit margins for the five majors have slipped to 5%, compared with 15% to 20% in the late 1980s when the CD came into vogue. "All the chickens are coming home to roost at the same time," says media analyst Claire Enders. "This industry has never been faced with such cataclysmic conditions before. It has no roadmap on how to cope with them."

The irony is that the music industry has always survived by introducing new formats--from the 78-rpm single to the 33-rpm vinyl LP album in the 1950s, to the cassette tape in the 1970s, to the compact disc, which sparked a rebirth of the industry in the 1980s. Now nearly everyone in the business admits that the only clear path to the future is to come up with a legal, online alternative to KaZaA and other illegal file-sharing services. This could be the mother of all format shifts, because it would largely eliminate manufacturing and distribution costs. But nobody in the music industry has been able to get there. "This new technology has swept by us," laments Doug Morris, chairman of the Universal Music Group.

As long as people can get free music online, the music industry's chances of recovery are dim. But stealing songs on the Internet isn't as much fun as it used to be. For one thing, file-sharing services are teeming with viruses. The Recording Industry Association of America has also upped the ante with a new suit accusing four college students of operating piracy networks. That's likely to put a damper on illicit computer activities in many dormitories. In addition, the record companies are planning to introduce new CDs with two sets of the same songs--one that can be played on your CD player and another that you can listen to on your computer but that can't be uploaded onto KaZaA.

In a world where CDs can't be shared on the Internet and music pirates are hauled into court, there may be huge demand for a legitimate digital music service. But it's going to have to be one that's a lot better than what the music industry has offered so far. Apple's timing, in other words, could hardly have been better.

Jobs didn't set out to be the music industry's savior. He was such a latecomer to the digital music world that some observers wondered if he'd lost his knack for spotting trends long before his competitors. Heck, Apple didn't even include CD burners as standard equipment on its computers until two years ago. But once Jobs focused on music, he was consumed by it. He saw people ripping CD tracks and loading them onto their hard drives. So in 2001 Apple introduced the iTunes jukebox software, which lets users make their own playlists or have the computer select songs randomly.

What else might Mac users wish to do with their MP3 files? Apple engineers were certain they'd want to load them into a pocket-sized portable player with a voluminous hard drive. So they created the iPod, a device that works seamlessly with iTunes. Apple has sold almost a million iPods, even though the least expensive one costs $300.

Then Steve had an epiphany: Wouldn't it be awesome if people could buy high-quality audio tracks via the Internet and load them directly into iTunes instead of going to the store to buy CDs to rip? It dawned on him that Apple had all the pieces in place to start such a business. For one thing, the company already had the Apple Store, an online operation selling more than $1 billion a year in computers and software, most of which can be purchased with a single mouse-click. It also runs the Internet's largest movie-trailer downloading site.

The only thing missing was music. Until recently it would have been impossible for a major tech company like Apple to license tunes from Warner, EMI, Universal, Sony, and BMG. Executives at those companies simply didn't trust their peers in the technology world. Many felt--not without some justification--that PC makers promoted piracy because it helped sell computers.

Apple, however, straddles the worlds of technology and entertainment like no other software or hardware maker. Along with running Apple, Jobs is CEO of Pixar, the digital-animation studio whose movies include Toy Story and Monsters, Inc. He also has plenty of admirers in the music world. Some of Apple's most zealous fans are rock stars who use Macs, both at home and in the recording studio. "Musicians have always adopted Macs," says Trent Reznor of Nine Inch Nails fame. Jobs is enough of a rock star himself--is anybody in the technology world as cool?--that he's been able to get U2's Bono on the phone to discuss the iTunes Music Store. He's personally demonstrated it to Mick Jagger.

The iPod, too, has become a fetish item among musicians and notoriously technophobic music company executives. "I'm addicted to mine," says Interscope Geffen A&M records chairman Jimmy Iovine. It made sense to Iovine and a lot of other record-company big shots that if Apple could transform a geeky device like the portable MP3 player into a sexy product with mass-market appeal, it might be able to work similar wonders with online digital music sales. It's probably no coincidence that the most vocal boosters of the Apple store are Universal and Warner, whose debt-ridden parents--Vivendi and AOL Time Warner, respectively--are under pressure from investors to get out of the music business entirely.

The record companies were still leery enough of Apple that they would agree only to one-year deals with Jobs. Nevertheless, he was able to persuade Universal, EMI, Sony, BMG, and Warner to stop fixating on their subscription models and take a radically different approach to selling digital music. People want to own music, not rent it, Jobs says. "Nobody ever went out and asked users, 'Would you like to keep paying us every month for music that you thought you already bought?'" he scoffs. "The record companies got this crazy idea from some finance person looking at AOL, and then rubbing his hands together and saying, 'I'd sure like to get some of that recurring subscription revenue.'" He adds: "Just watch. We'll have more people using the iTunes Music Store in the first day than Pressplay or MusicNet have even signed up as subscribers--probably in the first hour." We'll let you know in a future issue if that bold prediction proves accurate.

Record-company executives aren't ready to dump the subscription model--yet. "I'm not sure subscriptions are going to work," says David Munns, CEO of North American Recorded Music for EMI. "A mixed model where you can rent some music and download what you really like could work. Let's keep an open mind." But what really grabs music executives about iTunes is its sheer simplicity. "It's a lot easier to get people to migrate from physical CDs to buying individual songs online than it is to jump-start a subscription service," says Warner's Ames.

Apple is trying to make that transition as easy as possible. With the iTunes Music Store, you can browse titles by artist, song title, or genre. Songs will be encoded in a new format called AAC, which offers sound quality superior to MP3s--even those "ripped" at a very high data rate. That means each AAC file takes up a lot less disc space, so you'll be able to squeeze better-quality music, and more of it, onto your computer and iPod. Moreover, each song will have a digital image of the album artwork from the CD on which the track was originally sold. Says Sony's Lack: "I don't think it was more than a 15-second decision in my mind [to license music to Apple] once Steve started talking."

Apple has also come up with a copy-protection scheme that satisfies the music industry but won't alienate paying customers. You can burn individual songs onto an unlimited number of CDs. You can download them onto as many iPods as you might own. In other words, the music is pretty much yours to do with as you please. Casual music pirates, however, won't like it. The iTunes jukebox software will allow a specific playlist of songs or an album to be burned onto a CD ten times. You can burn more than that only if you manually change the order of the songs in the playlist.

And anybody who tries to upload iTunes Music Store songs onto KaZaA will be shocked. Each song is encrypted with a digital key so that it can be played only on three authorized computers, and that prevents songs from being transferred online. Even if you burn the AAC songs onto a CD that a conventional CD player can read and then re-rip them back into standard MP3 files, the sound quality is awful.

The iTunes Music Store will initially offer 200,000 tunes, paying the record companies an average of 65 cents for each track it sells. Ultimately Jobs hopes to offer millions of songs, including older music that hasn't yet made it to CD. "This industry has been in such a funk," sighs singer Sheryl Crow. "It really needs something like this to get it going again."

If the iTunes Music Store or something like it takes off, that could change how new music is released, marketed, and promoted. Until recently the chief fear in the music industry about letting people buy individual songs via the Internet was that it would kill the album by enabling consumers to cherry-pick their favorite tracks. Music company executives now bravely say that a singles-based business might actually revive sales.

Steve is doing everything he can to stoke their optimism. "Nobody thinks of albums anymore, anyway," he argues, perhaps a little too blithely. "People think of playlists and mixes. We'll still sell albums as artists put them out, but for most consumers of popular music, we think they'll more likely buy single tracks that they like. And then they'll organize them into customized playlists in their computers and on their iPods."

The reality is that initially, at least, the record companies will probably sell less music if they shift to an Internet-based singles business model. For years they have been able to get away with releasing albums with two or three potential hits bundled with ho-hum filler cuts. That has been wonderful for the industry, but it has made a generation of consumers who pay $18.99 for CDs very cynical. "People are sick and tired of that," says singer-songwriter Seal. "That's why people are stealing music."

For some artists, the idea of a singles-driven business is anathema. "There's a flow to a good album," says Nine Inch Nails' Reznor. "The songs support each other. That's the way I like to make music." But Crow says it would be a relief to put out singles instead of producing an entire album every time she wants to reach fans. "It would be nice to have a mechanism to release a song or two or three or four on their own," she says.

A renewed emphasis on individual songs could well improve the quality of music and lead to a reordering of the entire industry. It won't happen overnight, but the record companies had better get used to this new model. Now that Apple has gotten the music industry to support its pay-per-download store, nearly all of its Wintel PC-based rivals say they will augment their subscription businesses with similar offerings. "Steve's pushing the ball forward here," concedes Rob Glaser, CEO of RealNetworks, which owns nearly 40% of MusicNet and plans to purchase Listen.com's well-regarded Rhapsody subscription service.

But Glaser insists that Apple is ignoring a significant part of the digital music market by offering just downloading. He says Rhapsody users spend 72% of their time listening to streaming music. Only 13% pay $1 to burn cuts onto CDs. "If you make a really cool playlist of 200 songs on Rhapsody, you pay only $9.95 a month," he says. "If you use Apple, it's $200. Maybe guys like Steve and me can afford that, but I'm trying to run a service for everyone else too."

No matter what happens, Jobs will likely sell more Macs. But that's not all he's after with music. The Music Store is his latest effort to diversify Apple's sources of revenue beyond Macs. With Apple's share of the desktop computer market stuck at less than 5% in the U.S. and less than 3% worldwide for several years, the iPod is the most obvious new line of business, steering Apple onto the home turf of consumer-electronics giants like Sony and Matsushita. Now Apple makes almost as much operating profit on each iPod it sells as it does on each iMac, even though the iPod costs a fraction as much to manufacture. So it should come as no surprise that Jobs is releasing three new versions of the iPod in conjunction with the Music Store (for more on that, see Peter Lewis's column in Tech.)

Jobs has been very shrewd about the way he moved the iPod into the PC universe. Anyone who has tried the iPod with both systems will tell you it's a lot more fun to use if you plug it into a Mac running Apple's OS X than into a Dell with Windows XP. "The Windows iPod sucks" is Seal's appraisal. "But what they are really doing is trying to get people to wonder, 'Hmm, should I switch over?'" Jobs is betting that the iTunes Music Store, like the iPod, could be just such a Trojan horse.

It's not as easy as it sounds. How many Windows iPod owners know what they're missing by not using OS X? Do any of them really care? Perhaps that's why Jobs is rolling out iTunes for Windows too. In fact, Warner's Roger Ames is trying to broker a deal in which AOL would adopt iTunes as its music-management software. "Steve was resistant at first," Ames says. "But now I understand that he's decided to go that way." AOL has been trying to develop its own music store to go along with its subscription service but hasn't figured out a billing system for individual tracks as Apple has. A deal with AOL would land the iTunes Music Store on the desktops of AOL's 26 million subscribers. That could quickly make Apple the dominant seller of digital music on the Internet. AOL would neither confirm nor deny a possible deal.

A big play for Windows users would be a huge shift for a man who has largely created a product--the Mac--that exists in a walled garden cut off from the much vaster PC world. Clearly, Apple will benefit enormously if it boosts its share of the computer market by even 1%--such a gain would lift its revenues by nearly a third and increase profits even more. In the meantime, if the iTunes Music Store takes off--and computer users of all stripes start buying millions of songs online each month--that will translate into tens of millions of dollars in new revenues per month for Apple.

His adventures in the music business have led to other changes in Jobs' thinking. During the photo shoot with Sheryl Crow for this article, he acknowledged to the singer that he had never really understood what rap music was all about. But while playing with a prototype of the iTunes Music Store on his Mac at home in recent weeks, he had started downloading some of Eminem's tracks.

"You know, he really is a great poet," Crow said.

To which Steve replied, "Yeah, he's starting to kind of grow on me."

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