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Digital music's path to profitability
No one appears to be making money right now, but investors jump in unfazed. Are they crazy?
November 25, 2003: 2:16 PM EST
By Eric Hellweg, CNN/Money contributing columnist

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SAN FRANCISCO (CNN/Money) - In the world of digital-music downloads, the hits keep on coming. Consider the following news from the last couple of weeks:

  • For the first time ever, the No. 1 song on Billboard's Hot Digital Tracks chart ("Hey Ya," by Outkast) outsold the No. 1 song on the Hot 100 Singles Sales chart ("I Can Only Imagine," by MercyMe). Outkast sold 8,000 copies, and MercyMe sold 7,000.
  • CNET (CNET: Research, Estimates) bought online-music pioneer The terms of the deal were not disclosed, but you can bet the site fetched a lot less than the $400 million that Vivendi Universal paid for it a few years back.
  • Wal-Mart (WMT: Research, Estimates) announced that it is getting into the digital-downloads business, and many observers forecast that it will follow its offline model and undercut the current price point of 99 cents per track.
  • Microsoft (MSFT: Research, Estimates) announced that, starting next year, it will offer digital downloads on its MSN service.

Phew! That's a lot of activity, but all the announcements about companies throwing their hats into the digital-music ring raises one question: Is anyone making a profit on these downloads right now?

None of the companies currently selling music online would comment on profitability for this column, and none of the industry observers I spoke with would even hazard a guess. Investors have reacted favorably thus far, however, to the various digital-music moves.

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When 1 million songs were downloaded from the iTunes Music Store in the first week of operations, shares of Apple (AAPL: Research, Estimates) saw a nice bump. And when RealNetworks (RNWK: Research, Estimates) announced that Comcast (CMCSK: Research, Estimates) would be offering the company's Rhapsody music service, trading levels in the stock tripled.

Are investors' reactions misguided? Not necessarily, although seeing the logic in the investment requires a dash of late-'90s faith. "Online music is a gold rush," says Phil Leigh of "It's obvious the gold is in the hills, and everyone's going to rush in to stake their claim."

Right now, we're witnessing the no-holds-barred scramble for market share in a nascent market, and it harkens back to Amazon's late 1990s market-share-at-all-costs strategy, a maneuver that now appears vindicated.

Like Leigh, I'm bullish on the long-term prospects for paid digital music. Napster proved in the late 1990s that consumer demand for it exists, and the music industry is finally loosening the reins enough that its licensing terms are no longer a slap in the face of consumers.

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The terms under which companies can distribute digital music, however, are costly enough to prevent profits in the short term. Analysts, based on discussions with people at digital-music distributors, estimate that 60 to 65 cents of every 99-cent single goes to the record label. An additional 3 to 8 cents is forwarded to the song's publisher. Add to those payouts the not-insignificant technology costs associated with delivering the songs, plus marketing expenses, and you're most likely looking at losses for downloads.

The companies best-positioned for the digital-music world in the short term, then, are those that can use the downloads as loss leaders. Obvious candidates here are, again, Apple and Real, which can use the singles to juice sales in iPods and in premium radio subscriptions, respectively.

"It's our strategy to use the iTunes Music Store to sell iPods," confirms an Apple spokesperson. Wal-Mart sells CDs in its offline stores as loss leaders for other items, according to Leigh, but the ability to cross-sell unrelated merchandise isn't as easy online. One also must wonder what cross-sell opportunities MSN will present to its users.

In the long term, digital downloads will become profitable, and their need to serve as loss leaders will diminish. Two events will mark this stage of the category's evolution. First, consumer awareness of the sector will reach a point that the marketing and advertising blitzes can subside, reducing some of the overhead cost for distributors.

"The more attention the market gets, the better," says Dan Sheeran, a senior vice president at RealNetworks. "It's free advertising for the category."

Second, investors will start to hear of online-music companies renegotiating their contracts with the record labels. Right now, the labels hold all the power, but "the balance will move from labels to distributors," Leigh says. "It won't be so lopsided five years from now."

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