Frank Hecker on Challenges to Apple's Digital Music Business (AAPL, AMZN)

The Mozilla Foundation's Executive Director Frank Hecker left an insightful comment on Carl Howe's article on Amazon's challenge to Apple's iPod/iTunes businesses. Here's Mr. Hecker's comment reprinted in its entirety:

I agree with the view the Amazon service, like those of Napster, AOL, Yahoo!, etc. etc... is probably doomed before it starts. The basic problem is that those services don't support the iPod, and of course the Amazon service won't either. It's hard to compete when you're forced to limit yourself to 20% of the potential market, unless you think you can radically expand the market.

What I find telling in articles like this is that there's a lot about how Amazon might serve the major labels' desire to "claw back" pricing power from Apple, and very little about how this actually serves music listeners. In my opinion in their quixotic quest for control over their customers the major labels have basically handed control of their own digital music business over to Apple, and are not likely to get it back as long as they persist in their obsession with DRM.

In my opinion the only way for the labels to break Apple's control would be to move to a model where they sell non-restricted MP3s playable on all devices, including iPods, and can then undercut the iTunes Music Store on older releases and album filler while charging more than iTMS for recent releases and hot singles. For example, on a 10-song album they could price the two singles at, say, $1.50 per track, and the other eight tracks at $0.50 per track. They could then undercut iTMS on the whole album, at $7 as opposed to $9.99, and stimulate demand for whole-album downloads while likely getting more money from the people who simply like to get the singles. But this would only work if they and/or their partners can offer a digital music service that's equivalent to or better than iTMS, which means being iPod-compatible using the one digital music format that Apple doesn't control but can't afford not to support, namely MP3.

Note that some people in the digital music business are beginning to figure this out. See for example recent comments by Dave Goldberg of Yahoo! urging major labels to consider selling digital music without DRM. Goldberg presumably believes that Yahoo!'s digital music business is dead in the water until/unless something changes, and he appears to be trying to put a dent in the mainstream music business consensus that there is no viable digital music business in the absence of DRM.

However the place that is really worth watching is eMusic, which already has a thriving digital music business that by their own account is second only to Apple's, built on low prices (as low as 20 cents a track), the absence of DRM, and music from independent labels not locked into the RIAA/major label conventional wisdom. For an insight into eMusic's strategy and what makes it successful, check out this interview with David Pakman, CEO of eMusic. Key quote: "[T]here are really only two companies in the world who can market music to iPod customers, and that's Apple and us."

If I were an investor in the digital music industry (which I'm not), I would look for the following signals:

1) More data on the growth of eMusic, especially relative to the growth in iPod sales (since every iPod user is a potential eMusic customer). This might be more trackable now that eMusic is reporting sales data to SoundScan. (incidentally, that press release also claims that eMusic sells more digital music than all other non-Apple services combined.)

2) Rumors about eMusic being acquired by a major label or (more likely) by a company like Yahoo! (Based on Dave Goldberg's comments, he certainly knows about eMusic and likes their model.) eMusic is owned by a private equity firm, so I'm sure it's for sale at the right price.

3) Rumors about a major label starting an eMusic-like service (subscription-based, 20-50 cents per track, using the MP3 format) either by themselves or with partners, to sell back catalog material and "major label indie" music (i.e., similar to what eMusic offers from true independent labels).

If eMusic sales grow faster than the growth in iPod sales, and especially if the eMusic model spreads to more mainstream companies (either through acquisition or emulation), in my opinion this would be the herald of a possible major shift in the digital music business, with possible long-term consequences for Apple's current market dominance (and hence for Apple's stock price).

Comments

[SeekingAlpha Editors:]

In response to Mark: You make good points, especially regarding anti-trust concerns (an issue I hadn't taken into account); my responses are as follows:

1. Regarding your point that lowering prices "seems totally anti everything the labels’ executives have ever uttered": certainly the concept of variable pricing to the major labels sometimes seems to mean only the ability to raise prices beyond $1/track, not the ability to lower them beow that price point, and I don't dispute that going to an eMusic-like model of lower prices and no DRM would be a 180-degree shift from the conventional major label/RIAA wisdom. That's why I don't propose that any label make such a shift immediately and totally. It would make far more sense for a major label to follow Clayton Christensen's advice (in "The Innovator's Solution") and spin off a separate unit to experiment with more radical pricing schemes and business models, in a part of the market distinct from that currently being addressed by the iTunes Music Store and its various competitors.

The most obvious opportunity to me is in "bargain bin" back catalog material (including material currently out of print), followed by major label "indie" material and possibly also "world music" not widely popular in the US and the rest of the developed world (e.g., Bollywood soundtracks). (Not so coincidentally, all three of these areas are well-represented on eMusic.) Selling "top 40" material (or what passes for top 40 these days) can come later.

The key is rather for the major labels to experiment with new pricing schemes and business models in areas that are not perceived as threatening to their core franchise, and to do so in an organizational framework that gives the people running these new businesses the freedom to succeed and fail on their own without being beholden to the parent organization's pricing structure and business priorities.

Interestingly, eMusic was potentially exactly this sort of experimental major label spinoff back when it was owned by Vivendi Universal. However apparently Vivendi didn't know what to do with it, and saddled eMusic with an unprofitable business model, namely selling "unlimited" MP3 downloads per month for a fixed subscription fee, vs. the current eMusic model of $9.99 per month for 40 tracks. It was left to JDS Capital Management/Dimensional Associates to correct this, in large part by implementing a key Christensen maxim: "be patient for growth, impatient for profits". Their first very move (back in 2003) was to ditch the unlimited download scheme; they then slowly built up the business and only now are spending major dollars on marketing (including TV advertising) to grow their customer base.

2. Regarding the anti-trust issue: I'm no anti-trust lawyer, but perhaps the key here is that DRM-protected music and DRM-free music are actually two different products, so that the major labels might be able to set different pricing schemes for each without running afoul of anti-trust concerns. In particular, why not continue to offer DRM-protected music under the current iTMS flat-pricing model, but then also offer everyone (including Apple) DRM-free music under a variable pricing model, with price points from well under $1 to well over $1? Such a scheme would leave Apple free to lower iTMS prices, but only at the expense of giving up DRM lock-in based on Apple's FairPlay scheme.

I'm not so sure that this is an option Apple would want to take advantage of. Apple's control of the digital music market rests on its control of three key "choke points": the hardware device (iPod), media player software (iTunes), and online store (iTMS). To the extent that iTMS moves to selling tracks in MP3 format, it opens up the possibility of users making more use of non-iTunes media player software, for example new offerings like Songbird designed to work with MP3 tracks and potentially with non-Apple MP3-capable devices and MP3-based online stores like eMusic. (It's surely no coincidence that David Pakman of eMusic has expressed support for Songbird.) I therefore think that offering lower-priced music at the expense of supporting MP3 is an option that may be strategically unattractive to Apple, and it's quite possible that Apple wouldn't try to enter a price war with non-Apple services based on selling low-priced MP3 tracks.

3. In my opinion you are absolutely right that "the labels need to become more pro-consumer than Apple has been. Lower prices and DRM-free." However I think that that while the "rent your music" subscription model is problematic, other subscription models are not. In particular, I think eMusic's subscription model (commit to buy a certain number of tracks per month) is attractive to consumers and also to eMusic itself: For consumers like me it offers a way to budget for music purchases in a predictable way, while for eMusic it offers an ongoing relatively-predictable revenue stream combined with the ability to price lower than they might otherwise be able to otherwise. (In the eMusic subscription model there's no carryover of unused tracks to the next month, so people who don't download their entire quota of tracks are in effect subsidizing people like me who do.)

I realize I'm running the risk of sounding like a shill for eMusic, but I really do like the service. I also think that eMusic's current managers have "cracked the code" on how to run a successful digital music business in competition to Apple, and I'm surprised that more people haven't taken a closer look at how eMusic is innovating in this space.

(A final disclaimer: Again, the above comments are my personal opinions only, and do not necessarily represent the position of the Mozilla Foundation. The Mozilla Foundation has no relationship with eMusic, and I personally have no relationship with eMusic other than as a satisfied customer of the service. Also, although Songbird is based on Mozilla/Firefox code and I've had dealings with some of the folks creating it as part of my Mozilla Foundation position, neither the product nor the company are affiliated in any way with the Mozilla Foundation. Again, as with eMusic I just like the concept of Songbird and hope it's successful.)

2006 Feb 27 10:07 AM