Fear is Never a Substitute for Strategy

Despite what you may have heard, Napster - the Internet service that lets users illegally copy and download tunes - could well prove to be the warm-up band for the major music labels' best gig in the past 100 years. It just depends on how clearly the big five understand the nature of their core business.

Unfortunately, they may not. Sony, Universal, EMI Group, AOL Time Warner and Bertelsman have all announced some kind of Napster-like subscription service, now that lawsuits against the upstart will force Napster to license tunes and charge fees. But the major labels are still focused more on defense - protecting copyright than using the Internet and digitization to profitably expand their core business: finding talent and engaging fans. And missing the beat is costing them. A recent study by Bain & Company shows that major labels could acquire $5bn to $15bn in new revenue that currently goes to radio, TV and concert ticket intermediaries if they took the real page from Napster and helped artists reach their audience one-on-one.

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Ironically, other Internet companies may have the clearest notion of this opportunity. Microsoft announced this spring, that it would launch a radio-like service, MSN Music, which will offer CD-quality music that can not be picked, packed or copied. Meanwhile, MTVi, the Internet arm of MTV, announced it would broaden its offerings in music distribution. It plans to become the first one-stop-web-hop for all five major labels where customers can download for a price.

Trust Microsoft to target the most lucrative part of an industry. Today, record labels rely on radio and music television to promote their artists, and on retailers to distribute CDs. Because the radio stations and music television channels get their content virtually free from the labels, they enjoy huge margins. Our analysis shows that programmers of radio and television take home a whopping 71% of total music industry profits, distributors and advertisers another 15%. Record labels take home only 14% of industry profit, and artists a CD-thin slice within.

The Internet could turn this entire system on its head. The labels' move to online subscriptions anticipates at least some of the change. But a Napster-style service is only a good first step toward greater profitability for the majors. Subsequent steps should move major labels from a world where each tries to grab the largest chunk of a small slice of profits, to one where they claim profits from other parts of the broader music industry by relating directly to listeners. To see what the future might hold for music makers, flashback on an un-jazzy industry: financial services. By putting customer relationships at the core, single-product companies like American Express, founded on express payments in 1850, have grown revenue around a variety of related services and claimed profits from banks, travel agencies and credit consortia.

So, too, can content makers use the Internet to scoop profit from radio and music TV, by becoming audience-centric. They can aggregate talent and reach fans via the landline Internet, wireless Web and other platforms. And, while they are at it, they can cost-effectively re-activate a unique, core asset - their vast back-catalogues of content. They can grab profits from retailers by offering subscriptions and from concert promoters and ticket agents by bringing recording studio talent live online. They can even branch into adjacent businesses-artist-linked accessories, clothing or scores - that bring artists closer to their audience. And they can use the technology to develop entirely new, richer products.

What's holding labels back? For one, fear of cannibalization. The industry wants to prevent a new Internet product from cutting sales distributed through other channels. But our analysis shows that the introduction of new formats (such as compact disks for cassettes) has spurred not hindered overall industry growth.

Second labels fear piracy, which is, indeed, estimated to grow to about $4.5 bn of revenue by 2005. But if history is any guide, piracy, though costly, will not, ultimately, debilitate content providers. According to a report by Lehman Brothers, music piracy rates in developed countries have historically hovered around a tolerable 10%, despite the ease of taping a cassette or burning a compact disk.

Labels should spend more energy wrestling with how to create new, value-added services and content that would encourage users to pay a premium for a "store-bought" file. Certainly the medium presents unprecedented intellectual property challenges, but as we have seen, direct sales represent a relatively modest slice of overall industry profits, even now.

The digital transformation of content is happening already: the consumer appeal and the economics are simply too compelling. And although dramatic changes underway may scare incumbents, fear is never a good substitute for strategy. It will not be easy, but it is up to the labels, studios, and publishers to decide whether they want to control the industry's evolution - and its profits - or simply react.