The Digital Music Revolution and

(by George Nichols; Jul 15 1999; Morningstar)

"The genie is out of the bottle. As MP3 demonstrates, when the industry doesn't come together and create a solution, things happen anyway."
- Rob Glaser, Real Networks CEO/Chairman, quoted by the New York Times

Why spend more than $15 for a piece of plastic that contains the hit song you want plus a lot of filler music you don't care about? Why not download digital music, customize your choices, and then pop them into a portable player that fits in your hand?

It's easy to see why music fans have gone wild about music they can download. The fever has spread to investors, who have bid up stocks like (HITS) and Liquid Audio (LQID) in explosive initial public offerings. Now, the buzz is currently building for the upcoming IPO, which is slated for next week under the symbol MPPP.

Retailers CDNow (CDNW) and (AMZN) are establishing themselves in this market by offering free downloads, with plans to sell downloads soon. The first portable music player, the Diamond Rio, has been a hot seller, and it's not hard to see why. It's tiny and doesn't skip because it has no moving parts. So you can drive your SUV up a rugged mountain path, go jogging, or be body-slammed by a professional wrestler, but your player will never skip. Several other such devices will be coming to market by Christmas.

"MP What??"

For the moment, digital music is practically synonymous with MP3, even though the terms aren't really equivalent. MP3 is a compression standard that shrinks music files by an 11:1 ratio while retaining near-CD sound quality. Thanks to MP3, you can download music faster, store more songs on your PC, and even put more than 100 songs on a CD (providing your PC has a CD recorder). MP3 has become the de facto compression standard and, according to at least one search engine, "MP3" has surpassed "sex" as the most common search term. After being pistol-whipped into the Information Age by MP3, the big music labels are fighting back with a new specification for secure music, called SDMI. News stories have already dubbed SDMI the "MP3 killer" and comparisons are being made to the Betamax vs. VHS war.

The music industry generates $38 billion in annual revenues worldwide, so the opportunity for digital music seems huge at first glance. In fact, Forrester Research, an Internet research group, estimates that the market for online music will reach $1.1 billion in 2003. Although this will only be a fraction of forecasted online CD sales ($7 billion) and just 7% of total industry revenues, it's enough to spark the current exuberance for Internet music stocks.

Unfortunately, mass-market delivery of digital music is still a long way off. A major obstacle is bandwidth. Digital delivery is glacially slow on a dial-up connections--it often takes more than two agonizing hours to download an album. Moreover, less than 3 million households will have broadband access by the year's end, although this number should increase to 27 million by 2003, according to Forrester.

The biggest obstacle of all, however, is the lack of legally available music from popular artists. Most of the MP3 music available on the Internet is of the more offbeat and obscure variety. The recording industry is trying to address this with SDMI, but in the meantime, you can find only pirated versions of most popular music online.

"Music for the Masses"

The soon-to-be-public is currently the most-popular Web site for obtaining MP3 downloads. The company, which had only $1.2 million in revenues last year, plans to raise about $200 million in its public offering next week. Sequoia Capital and Cox Interactive Media have given their ringing endorsements by investing a combined $55 million for large equity stakes. Yet in a recent New York Times article, Hilary Rosen, CEO of the Recording Industry Association of America, dismissed's business model as an "economic joke."

It is tough to get a handle on just what wants to be. Does the company intend to position itself as a record label, a music distributor, or a community site for musicians? Whatever its business plan, is truly looking out for the artists who allow their music to be downloaded from its site. gives artists 50% of profits, compared with the 7%-to-10% range big labels offer. is also reserving up to 1.8 million shares of its offering, some of which the company intends to distribute to its artists. It should come as no surprise that amateur musicians seeking a way to cheaply establish a marketing and distribution presence online see as a godsend.

But it is harder to determine what will offer the average music fan. Its content lacks recognizable performers, and it removes the intermediary role that labels traditionally provide, so it becomes the music fan's job to be the talent scout. This is a daunting task that probably won't be appealing to the average user gazing at an endless list of unknown artists. Downloading songs is a guessing game akin to Forrest Gump's box of chocolates: You never know what you're gonna get. A catchy tune, or noise sounding like an angry swarm of buzzing locusts? Although could shift toward being a traditional label by distributing the work of more well-known artists, it runs the risk of alienating its current artist base.

On the financial side, advertising accounted for 84% of's revenue last quarter, making the company look more like a portal than an e-commerce company. But still scores big with traffic--an important Internet metric. The site gets 250,000 visits per day, although it is unclear how plans to monetize these "eyeballs." "Ultimately, needs to go beyond advertising to sustain its growth," Forrester Research's Eric Schmitt says. will probably have a market cap of at least $1 billion after its debut, and it's tough to justify such a value for a company that does not make meeting the demands of the majority of music consumers its primary focus. The prospectus duly notes these concerns: "...we expect our music to continue to concentrate principally on lesser-known and local artists. If such an offering doesn't find a receptive audience, our business may not generate sufficient revenues to survive."'s ability to level the playing field for unrecognized musicians is certainly admirable, but the merits of the stock can't be valued on good feelings alone. Even though will almost certainly open at a tremendous premium to its offering price, investing in this amateur-artists hub entails unsuitably high risk for most long-term investors.