EMI Moves to non-DRM Music. What's Next?

The first big music label to change to freely transferable digital music may set a trend in marketing strategy—or set itself up for more piracy

by Michael Altberg and Patrice Cochelin From Standard & Poor's RatingsDirect

As the music industry's digital revenue has failed so far to offset declines in CD sales, it's only natural that labels are looking to expand the digital marketplace to help plug the leak. In an attempt to do just that, EMI Group (S&P credit rating, BB–) recently agreed to provide its online music offered through Apple's (AAPL) iTunes without the technology—digital rights management, or DRM—that effectively ties use of copyrighted music to payment. EMI's decision represents a landmark move that, if also undertaken by other major music labels, would represent a huge shift in strategy for the piracy-conscious music industry.

Major music labels have historically done everything in their power to combat piracy—the unauthorized copying and sharing of copyrighted material. What effect will removing DRM restrictions have on sales? Will providing greater interoperability to consumers among download services and devices stimulate customer demand, or will it further increase piracy?

On the positive side, Standard & Poor's Ratings Services believes that DRM-free music will certainly appeal to consumers because it will allow them to transfer music easily among hardware devices. Secondly, a two-tier pricing scheme could be a first step toward further pricing differentiation. Beginning in May, 2007, EMI will release its DRM-free music, encoded for a higher sound quality than current offerings, on iTunes for $1.29 per track in the U.S., €1.29 in Europe, and 99 pence in Britain, a premium of 25% over existing prices in Britain and 30% in the U.S. and euro zone.

Negative Short-Term Impact

How that premium breaks down among EMI, Apple, and artists is unclear, but it will provide higher margin digital revenue, and the conversion to a DRM-free format entails little additional cost to EMI. Even with these benefits, the most likely outcome is that DRM-free music will have little positive impact on sales over the short term and could even be detrimental.

Although total U.S. digital sales (albums and 10-track equivalents) have grown roughly 367% over 2004-2006, this growth came off a small base. The 16% decline in physical sales had a greater impact, causing total album unit sales to fall approximately 5% over the period. This decline has actually been more dramatic since 2000, with total album unit sales (excluding digital-track-equivalent albums with 10 tracks per download) declining nearly 25%.

Apple's iPod media player occupies an estimated 70% to 80% market share in the U.S., and slightly lower but equally impressive shares in Britain and Japan. Standard & Poor's expects the release of DRM-free music to offer Apple's competitors a better chance to compete in the portable-player market because other players besides iPod will now be compatible with DRM-free music sold on iTunes. This doesn't necessarily mean that the music industry will be selling more digital albums and single-track downloads. In the near term it will more likely mean that major music labels will be sharing their digital revenue with other players besides Apple, but that the overall pie will remain mostly unchanged.

No Subscription Service Model

Consumers might wait to purchase DRM-free music until they have the ability to replace their entire digital-audio libraries—both EMI and non-EMI music—with DRM-free selections. Other music majors haven't commented much on their intentions. Warner Music Group (WMG; BB–), however, has stated in the past that it is against DRM-free formats. Universal Music Group (UMG) has not commented on EMI's initiative but has conducted DRM-free music trials.

The second obstacle is that the major music labels have proposed no DRM-free model for the music they supply to subscription-based services. EMI's new strategy applies only to à la carte digital download stores.