Record Labels Need a Digital Hit

S&P Ratings runs down the prospects for major players like Sony and Bertelsmann as they struggle to adapt to the MP3 era

From Standard & Poor's RatingsDirect

Entertainment companies are facing uncertain times as they redefine how they sell their goods. Determining the successful business model for Internet distribution is among the entertainment industry's highest priorities. In the first part of a two-part article, Standard & Poor's Ratings Services will look at the challenges facing music outfits. Part two will focus on filmed entertainment.

In contrast to the TV business, the recording industry has arrived at a consumer-friendly, commercial technology for online distribution that protects its copyrights. However, legal and illegal downloads continue to cannibalize CD sales. The movie business is at an earlier stage of development and must accommodate larger file sizes.

Digital music downloads of individual tracks have gone from zero only a few years ago to more than 525 million in 2006 (first 49 weeks), based on Nielsen Soundscan data. Growth of single tracks in this period amounted to 67%.

Growth has been aided by legal victories that have protected copyright holders and slowed piracy; the development of popular, inexpensive, and consumer-friendly digital music players; and the wide acceptance of the user-friendly iTunes Music Store, owned by Apple (AAPL).

Going the Way of the LP?

Internet research firm JupiterResearch has estimated that 62 million digital music players of various kinds are in use in the U.S., and that the number will jump to 196 million in 2011. Standard & Poor's believes that this may be a challenging projection. One major record company, EMI Group, says that digital music revenue will account for 25% of industry revenues by 2010—a projection that we view as reasonable.

Concurrent with the growth of digital revenue, sales of physical copies of music have dropped sharply. Worldwide, according to the Recording Industry Association of America, retailers sold only 750.4 million CDs in 2005 (the latest available full-year figure), down from 942.5 million in 2000.

The music industry sells digital music largely in single tracks, which are in general proportionately less profitable than album bundles. In the U.S. in 2005, consumers bought 353 million digital tracks but only 16 million digital albums, reflecting listeners' desires to fashion their own collections. Warner Music Group (WMG) has pursued the less-traveled road of selling digital albums at a premium to singles by bundling ancillary products such as song lyrics, music videos, and bonus tracks with its album offerings.

Consumer-Friendly Pricing

More than 70% of premium-priced album bundles sold on iTunes in the U.S. are from Warner Music Group. This has contributed to its relatively high proportion of digital sales, at roughly 10%, and its recent increases in EBITDA (earnings before interest, taxes, and depreciation and amortization) margins, because ancillary materials have little incremental cost.

The industry's pricing of digital music—already inexpensive at approximately $1 for a single downloaded song and $2 to $3 for a song downloaded to a mobile phone—could shift in the future. The dominant digital download service, iTunes Music Store, which accounts for about 70% of the paid digital-music download business, has resisted overtures by the major music labels to tier its download pricing based on various criteria such as top-selling vs. other artists and catalog vs. new releases. iTunes has steadfastly maintained that a consumer-friendly price will prove the best strategy for establishing a legal commercial-download model.

Mobile revenues, although still largely driven by purchases outside the U.S., continue to grow steadily and, for some labels, account for half of digital revenues. Consequently, major labels have rapidly entered into arrangements with mobile phone services, on both an á là carte and subscription basis.