Universal Music Group Readies DRM-Free Music, Sans iTunes

Universal Music Group, the music giant owned by Vivendi (VIVEF.PK), has announced a testing phase of an online music plan that will see the company sell digital tracks without Digital Rights Management [DRM].

The debate over DRM has raged since the inception of digital music and the growth of Apple (AAPL) and its iTunes Store. Even Apple's head Steve Jobs wrote a letter discussing DRM on Apple's website. Apple's first partner into the DRM-free world was EMI (EMIPY.PK) and together they launched iTunes Plus. An additional service for music that gave customers better quality tracks that were free of restrictions. These tracks could be played, burned or used anywhere, virtually on any device.

Universal has shunned the online music juggernaut that is iTunes and its 70+% market share. It has chosen to partner with Real Networks (RNWK), which has its well known Rhapsody service starting to gain some momentum in the space. The stock jumped off its 52-week low today finishing up 7% on the news. Before we jump on the Rhapsody bandwagon, investors need to consider that this 6-month Universal test is available also to online stores run by Best Buy (BBY), Wal-Mart (WMT), Amazon (AMZN) and Google (GOOG). While some of these big net names don't exactly offer complete online music services to consumers you can see that the biggest name is missing. Apple Inc.

Contract renewal negotiations fell apart between Universal and Apple some time ago and it was clear then that Apple's firm demands were not met with smiles. Reportedly during the talks, Universal wanted changes to pricing and Apple wanted to keep the same pricing simplicity and get rid of DRM completely. It seems Vivendi's Universal unit holds a big grudge. However, if DRM-free music is truly the wave of the future it wont be long before iTunes is back in Universal's good graces. With CD sales down sharply quarter after quarter and digital sales, although growing, failing to compensate, its only a matter of time before shareholders become unhappy with the fact that the biggest music distributer in the world excluded the most powerful online music store in the test.

The question investors have to ask now is whether the 6 month test period is enough for any competing service, such as Real's Rhapsody, to gain any traction against iTunes simply because of DRM-free music? The same songs will still be available through iTunes just packaged with digital rights management. Will this be enough to lure people away from the iTunes store and into competitor online music stores, where they can buy individual songs, put them back into the iTunes media management software and load them onto their iPods? Based on market trends it doesn't appear very likely.

iTunes music sales have always been a low margin business for Apple as its been said that of each $0.99 track almost $0.70 goes to the record label and the rest covers network and advertising costs. What Apple's profit machine feeds off of is sales of iPods and Mac Computers. So for Apple shareholders is this a big deal? Well, yes and no. It isn't a big deal being shut out of the DRM-free test by Universal, however if this strains the company relationships further and Universal decides to pull songs from iTunes that could provide a significant blow to Apple's music business. Universal does sell about 1/4th of the world's music.

Anything Apple loses in the online music business will most notably be picked up by Real's Rhapsody, which would have a positive effect on shares of Real Networks. However, the online music business is still very low margin and Real as a stock I would not recommend based on this DRM-free test alone.

The music trends are clearly forming to a purely digital age with freedom and sharing being at the forefront of consumer minds. With that will come more DRM-free offerings, which will spur further music player sales. The product everyone seems to still want is the iPod and the company making that particular gadget is none other than Apple. Those executives at Universal better start to mend fences soon because not working with Apple in online music is a severe mistake, with the iPod still on the consciousness of virtually every music consumer on the planet.

Disclosure: author is long AAPL.

Comments

[Tom B:]

These big labels should be informed that suicidal actions tend not to reward shareholders very well. Apple does not really need ANY of these labels to sell iPods; there is plenty of great free content on the web. The labels, on the other hand, need digital distribution, with CD sales slumping.

2007 Aug 13 09:08 AM

[brando:]

I have to take exeption with your contention the record labels need Apple more than Apple needs them. Apple has bullied the music industry by not licensing its DRM (called FairPlay) to other music retailers, and only FairPlay-encoded music will play on iPods. This is the main point of contention, in my opinion. If Apple would license its DRM to other music stores like Rhapsody, Napster, Yahoo Music, etc. UMG would be back at the bargaining table. Although DRM-free digital music is clearly more valuable to the consumer I believe consumers would consider interoperable DRM-agnostic music almost as valuable as totally DRM-free music. And why shouldn't Apple license its DRM anyway? It only stands to reason that more people would purchase iPods if iPods were capable of playing legal music purchased from sites other than just the iTunes music store. Under today's environment 80% of the music stored on all iPods is of the unprotected mp3 variety and I believe it is a fair guess that most of that is pirated. It will be an interesting test case, indeed, if we see that people continue to purchase UMG DRM-encoded music from the iTunes site rather than DRM-free UMG music from other sites. That would provide evidence consumers' issues are not so much with DRM in and of itself, but rather with the music's ability to operate with their chosen hardware. Such a result could enbolden the record labels to play even harder with Apple to license its DRM to other music stores. The record labels have been behind the curve since the digital music genie slipped out of the bottle, but I cannot have any sympathy for Apple either. Apple should open up the FairPlay license to all legitimate digital music stores. Alternatively, the record companies should band together and force a single interoperable DRM standard upon all retailers of their digital product. I think it is naive to expect a totally DRM-free world.

2007 Aug 13 08:37 PM

[Tom B:]

I think your argument is illogical: Universal is punishing Apple by not giving them DRM-free downloads for the crime of Apple not sharing their DRM system? Doesn't make sense to me. Maybe UMG just wants to test market their s**t in smaller markets before completing its negotiations with the Big Dog, Apple.


With regards to Fairplay: Jobs said opening it up could make it easier to hack. I don't know if that's true, or if that reflects his honest opinion, but I'll give him the benefit of the doubt.

"Under today's environment 80% of the music stored on all iPods is of the unprotected mp3 variety and I believe it is a fair guess that most of that is pirated."

Disagree. I have a mostly full 4 Gig Nano and there is nothing illegal on it, period. There's LOTS of free musical and spoken word content out there.

2007 Aug 15 05:00 PM

[brando:]

Dear Seeking Alpha,

Please put a spell checker in the comment boxes.

(Thanx)

2007 Aug 13 11:18 PM

[SA Editor J...:]

Thomas,

Web browser Firefox 2.0 or higher (Mozilla) gives you an across-the-board spell check feature.

Best,
Jonathan Liss
Seeking Alpha

2007 Aug 14 02:53 AM

[Chris Kraso...:]

While you have valid points about Apple licensing their DRM software, I don't think it'll ever happen. The simple solution of DRM free is best, so why would licensing DRM be better?
I don't think it's a fair guess that most of the music on iPods is pirated. First off, the biggest capacity iPods also store a lot of video for a lot of people and secondly, I think a majotiry of iPod users used iTunes to digitize their entire CD collections. Another point of contention in the entertainment business model is making consumers pay several times for the same entertainment. It happens in music, movies, tv, almost every form of entertainment. Vinyl, tapes, then cds, now mp3s. In films, theatres, pay per view, and you had VHS, then DVD and now blu-ray or HD-DVD.

When people throw around numbers like 100 million ipods sold and 3 billion songs so only about 30 songs per iPod so the rest of the space must be pirated, they always fail to mention how many people have vast CD libraries that they've burned to MP3 format to put on their iPods. So I feel like that point of piracy is not a strong one without and concrete study facts. Yes there is piracy in the digital world, you have to face that, but at the same time, making a consumer buy the same song or album from the same artists just cause its in a different format is an entirely different form of piracy.

I think this Universal DRM-free test will not fare well simply because those other stores do very little business, so to expect a massive uptick when most digital music consumers are already familiar with iTunes is very optimistic. I think if Universal were to embrace iTunes Plus they would see a much much higher increase in interest in their online music offerings.

Each side has had their faults in negotiations but it seems like Apple fights for the consumer (and of course their bottom line) and Universal fights simply for the bottom line. The way the music industry treats not only consumers but also artists I can't help but feel that them being well behind the curve in digital music is for the better in the long run. The trend of indie labels and bigger bands moving to indie labels has slowly started with this digital revolution and I think you'll see more of it as digital music becomes more and more of a social experience over the internet. Bands won't need massive major label marketing budgets, because word of mouth is your biggest selling point. Now if only the Payola would stop so some of these truly great musical acts can get their songs played on the radio once in a while we'd be living in a beautiful world, musically.

--
Chris Krasowski
wcpowertechfund.blogsp...

2007 Aug 14 12:22 AM

[Chris Kraso...:]

I had another quick point to add briefly but I didn't want to make the above comment too too long.
I don't think companies should be forced to license anything. You've made a great successful product, and consumers have embraced it. That's the end of that.
Would you also deman that Microsoft for example licensed the Halo games so they can play on PS2 or PS3. No! Because that would completely cannibalize sales of XBox so why would the company do that.

The simple fact of licensing is that it only makes sense to do it if it makes strategic sense for the company.
The way iTunes and iPod work so seemlessly together is one of the main selling points for a lot of consumers so why would Apple want to knock the fence down?

2007 Aug 14 12:26 AM

[brando:]

I hear your point about Apple's right to keep its license to itself. After all, I'm a free market libertarian. But it doesn't make long term business sense. More digital music stores capable of selling into the iPod ecosystem would mean more iPods sold. And after all, Apple makes money on the sale of hardware, not the iTunes store. What we have now is near total chaos, unless you are simply a cult-like lover of Apple who would never consider owning a device manufactured by anyone else. What if, in the 1970s, RCA 8-tracks would only play on RCA 8-track players and Motown 8-tracks only played on Motown players? There needs to be a content standard. We're not talking about games here, which are primarily played by a cult-like following of mostly adolescents, were talking about music that virtually everyone listens to. Even if the big labels go out of business the independent labels and/or the artists themselves are going to want to be paid for the IP and I suspect they are going to want a form of DRM. Again, IMO, it is simply wishful and naive thinking to believe DRM will totally go away. There should be a single interoperable hardware-agnostic DRM, and if Apple, who currently owns the "standard" by default, is not willing to license its DRM so it truly becomes the standard then the record labels should do what UMG appears to be doing and cut Apple out until it is forced to play ball. If Apple doesn't play then they should release their content on one DRM only and force Apple to license it. If that happens I suspect the DRM will be PlaysForSure of Microsoft's new DRM, PlayReady. I just don't think DRM is really going away. Lastly, even you admit you don't think this experiment is going to result in much. Well, if iPod owners continue to purchase UMG music via the iTunes store with DRM embedded rather than go to Rhapsody to purchase the same music without DRM I think that's a pretty good indication DRM is not as reviled as many suggest. And I think this is part of the experiment UMG is conducting. Of course, if UMG were to embrace iTunes Plus they would see a big uptick in digital music sales. UMG knows this. That's not the point of the "exercise." I must say that the way you wax so elequently about the seemles and flawless interopeation of the iTunes music store and the iPod one has to question your independence. Anyone who is truly consumer focused would want the most options possible for the consumer. So why not have a single standard for all content so all hardware manufacturers could compete head to head and give us the best product a competitive market is capable of delivering? Yeah, yeah, yeah DRM-free mp3 is single standard but it does not adequately protect the IP.

2007 Aug 14 09:23 AM