Beating a dead horse - is there any future to the music industry? Part I

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The jeremiads are everywhere and have been for several years: the Internet will be the death of the music industry, at least as we know it. The reasons behind this death knell, and what they can do about it, are worth exploring.

First, a few facts. 

  1. This past week, Sony agreed to buy out Bertelsmann's stake in Sony BMG for $1.2BN, effectively valuing the entire business at $2.4BN. (In a small ironic note, Sony BMG was accused of software piracy by PointDev; those who live in glass houses...) Sony BMG has a reported $49MM loss in the last quarter, on sales of $820MM. Using some form of reasonable discounted cash flow analysis, a $49MM loss at 12% discount rate puts it worth negative $408MM. If you account for the fact that the $49MM loss is not constant, but a trend downwards from $21MM profit in the same quarter one year earlier, the valuation is much worse. Obviously, Sony CEO Howard Stringer sees some value there we do not. Either Sony can do things with it, they cannot do together with BMG - German companies, especially large ones, are notorious for rigidity and inflexibility - or there is a lot of hubris here.  
  2. The industry as a whole is shrinking fast. According to RIAA statistics, in the last two years alone, the value of sales was down 11.5% (2006) and 19.1% (2007). At this rate, they should be buying CDs from consumers by the end of next decade.
  3. The industry is shifting to online sales. From 2005-2007, online sales grew from 9.0% of total sales, to 16.1% to 23.0%. 

First, let's look at how 2008 is different from 1998, 1988, or any other year before. Largely, the major labels had access to several elements that were critical to music ownership and distribution, and allowed them to squeeze both ends of the chain - consumers and vendors (a.k.a. artists):

  1. Production: Copying music used to be a very expensive proposition. One needed to have good originals, and equipment that could reproduce, first to LPs, then 8-tracks (for those of us who remember them), then audio tapes, finally CDs. This, more than anything else, was the biggest barrier for most people.
  2. Distribution & Marketing: Getting music from a one or a few points (including a consumer's home) around the country or the world was very expensive. Even if someone wanted to ship pirate copies of Simon & Garfunkel in the 70s or Madonna in the 80s, assuming they got past hurdle #1, each shipped copy was expensive. Paying a few dollars to ship a tape to many people made it almost as expensive as buying it new. The major labels had enough volume to gain economies of scale in shipping, thus leaving plenty of room for other costs as well as a tidy profit and still selling at a price-point that allowed people to buy the product. The same holds true for marketing. Making Madonna a star takes a lot of effort and money.
  3. Legal: Copyright laws of various countries, and especially the United States, stood as a major barrier to re-distribution. Even if you could get past the first two hurdles, which meant a significant investment, you quickly ran afoul of copyright laws. Needless to say, if you got this far, you clearly had a lot of money, were doing a lot of damage to the labels, and they justifiably used the law to come after you, usually successfully.

What happened to these barriers?

  1. The advent of low-cost PCs with CD readers and even burners, eliminated barrier #1. Anyone could copy music to anywhere - your hard disk, another CD, take your pick. In 2000, your average CD burnder cost $150-200 USD, and even that is cheap for reproducing. In 2008, a 52X drive can cost under $40 and sometimes near-zero with rebates. A CD reader is basically free. 
  2. The Internet eliminated cost of distribution and marketing. Although there is some cost to distributing the bytes, they are minimal, and usually hidden within an ISPs "all-you-can-eat" plan. 
  3. Copyright laws were revamped with the 1998 DMCA, in many ways making anti-copying laws stronger, especially in the digital/Internet arena. 

With copyright laws the only avenue left to protect their existing business model, the major labels, mainly through their trade group RIAA, went on a campaign to sue anyone who copied and distributed music. In truth, this campaign is no different from what they have done for decades. The difference is that whereas in the 1970s, the target would be a business clearly investing significant sums and making a profit off of copying a label's work, in the 21st century, the target would be an 80-yr-old grandmother or 12-yr-old kid distributing a few copies to friends because they like the art product (i.e. the music). I do not believe that the RIAA decided to shift strategy entirely to go after millions of non-profit enjoyers; they simply extended the third prong of the strategy they had been using for years to go after anyone who had enough capital to get past the first two barriers and made money on it. This is an important point. Many paint the RIAA (and its brethren in the motion picture industry, the MPAA) as evil, shifting from "we want to sell you music you want" to "we want to bankrupt retired grandmothers." In truth, legal assault has always been an important and valid part to the industry, used with true for-profit violators. With the category of people copying shifting to fairly innocent individuals, the RIAA never realized how much had changed. They say generals always fight the last war...

Needless to say, it backfired. First, although a lion can defeat a gazelle who steals its grazing ground, a lion cannot defeat millions of small animals that come from every angle at once. Second, the public does not take kindly to suing grandmothers and children, especially coming from wealthy labels. Third, the labels are directly discouraging, even attacking, the people who are their customers and who they want to like the music from sharing that enjoyment. 

Summarizing the challenge: the labels profited for years by monopolizing production, distribution & marketing and legal rights. The elimination of the effective monopolies in production and distribution & marketing leaves the entire industry balancing on one very shaky leg, then hopping on that leg to try and kick (with the same leg) millions of people who are trying to enjoy exactly what they are selling. 

Unalterably, the market for the industry has changed, and its old model simply does not hold.

In Part II, we will explore what is getting in the way of the industry adopting a new mindset. In Part III, we will explore possible alternative models and where we see the industry heading.