Net Loss

Despite recent courtroom victories against free-music sites Napster and MP3.Com, a little-known report obtained by the Voice says the major labels’ worries are far from over—and the woes of record shops are just beginning.

“We estimate that a worst-case scenario would be 16 percent of all U.S. music sales in 2002 being lost to Web piracy, representing a $985 million loss in U.S. music profitability,” reads the analysis, issued last month by the Sanford C. Bernstein & Co. Investment Research Group. Add this to a May settlement over federal allegations of price fixing—which may lead to a decline in prices of up to $5 per CD—and the overall picture for the music industry looks bleak.

Even if MP3.com and Napster get canned, the report notes, more efficient file-sharing apps like Gnutella will take their place. “While Napster and MP3 are frightening enough to the music industry, Gnutella may be even scarier,” the report continues. “As best we can tell, the only way to stop Gnutella, aside from physically removing the software from every user’s machine, is encrypted digital music.”

Which would be fine, if the future of guarding tunes by encryption didn’t look even bleaker than the fate of the recording industry. According to the report, protected CDs will not become prevalent until 2003, because the 18-month-old Secure Digital Music Initiative has so far failed to create and institute an encryption system everyone can agree on. “The problem is that it’s such a consensus-driven process,” says the report’s lead writer, Bernstein analyst Michael Nathanson. “They need to get the software authors, the builders of networks like LiquidAudio and RealAudio, the consumer electronics companies like Sony and DiamondRio, and then finally the labels to get on board.”

And in the meantime, every CD sold in the stores is a CD that someone will post for free online. Any successful encryption system would have to block that kind of pirating without infringing on a listener’s “home use” rights to make copies for personal playing. “How is that program going to know whose hard drive is playing the music, or if it’s a Rio player, or a Sony Memory Stick?” says Jupiter Communications music analyst Stacey Herron. “And you’d still be able to pass these files along via e-mail anyway.”

Yet Nathanson says the music labels will eventually use online distribution to increase profits. How? By undertaking a “migration strategy,” he says. “They’re going to have to undercut the brick-and-mortar retailers by moving their products online.”

That way, Nathanson argues, the labels will not only save on distribution, but acquire reams of valuable marketing information and establish one-to-one relationships with consumers. “They need to own their customers. Right now when you buy an album, Warner doesn’t know who you are. How can they market you?”

But the migration will not be easy. Brick-and-mortar chain stores and mass-merchan- disers currently drive the vast majority of sales—as much as 80 percent, according to a recent Sound Scan report—and they’re scrapping for a place in the new business model. This month RedDotNet, a digital music distribution company, began setting up CD kiosks in Sam Goody, Wherehouse, and Target stores. In theory, a consumer walks in, chooses individual singles, and receives a custom CD burnt on the spot. In practice, the retailers face the logistical challenges of burn time (four minutes for 32 minutes of music) and consumer fear of change.

According to one source inside a major-label marketing department, the labels are so dependent on brick-and-mortars that they pick up the tabs for advertising, and even pay fees on top of the ads’ cost. “They can’t leave the Towers and the Musiclands out of the loop,” the source says, “because right now, the retailers drive most of the sales.”

The source says the music industry is struggling to have its cake and eat it, too. “They want to embrace the medium but maintain their relationships with the retailers,” says the insider. “And eventually, it’s just not going to work. They can’t have it both ways.”

Nathanson agrees. “Simply put, if the labels don’t move to the Web, they’re going to lose their profits. The brick-and-mortars will retaliate, and [the labels will] take a hit for two or three years, but in the end they have no choice. By 2003, the brick-and-mortars will be on the ropes.”