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

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¨C) recently agreed to provide its online music offered through Apple¡¯s (AAPL) iTunes without the technology¡ªdigital rights management, or DRM¡ªthat 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¡ªthe 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¡ªboth EMI and non-EMI music¡ªwith DRM-free selections. Other music majors haven¡¯t commented much on their intentions. Warner Music Group (WMG; BB¨C), 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 ¨¤ la carte digital download stores.
Lack of interoperability¡ªwhich has created an inability to play music encoded in different formats on all portable devices¡ªhas been one of the main obstacles to the subscription model so far. Consequently, it seems illogical to address the interoperability problem with DRM-free ¨¤ la carte sales, but not for subscription services.
The obvious reason for this is that a DRM-free subscription model simply doesn¡¯t work. Subscription services¡¯ only deterrent to cancellation is that customers who cancel automatically lose all of their downloads. Imagine the repercussions for subscription services of a consumers downloading all the music they want for an average monthly fee of $19.95, copying the DRM-free music to another device, and then simply canceling the service.
Some companies, such as eMusic.com, which offer MP3-encoded, DRM-free subscriptions to music from independent labels, have attempted to address the problem by setting a fixed number of downloads per 30-day period based on the monthly fee elected.
Better Format Requires Patch
The most user-friendly and universal format is MP3. But Apple will be offering DRM-free music from EMI in 256-Kbp AAC encoding, which has higher sound quality than current iTunes downloads (in 128-Kbp AAC encoding with DRM), somewhat justifying the higher price per download. File sizes, though, will be twice as large as the current 128-Kbp AAC files with DRM, using up storage capacity faster for iPod users. Since iTunes accounts for roughly 70% of the paid digital music download business, it¡¯s safe to assume that AAC will also become the future standard for DRM-free music.
But according to digital music retailer estimates, only 10% of digital-audio players on the market currently support AAC. Those that don¡¯t would require firmware patches to achieve AAC compatibility. Firmware patches should start to become readily available as free downloads to consumers, making AAC compatibility only an immediate-term obstacle.
The most significant risk to a DRM-free strategy is the potential for increased unauthorized copying and sharing of copyrighted material. Although it¡¯s impossible to accurately measure, we believe that a pandemic of illegal file-sharing networks most likely contributed heavily to the 20% drop in CD sales between 2000 and 2003. But we don¡¯t expect that releasing DRM-free music will cause a reversion to the rampant piracy of that period. The upward trend in legal downloading sales over the past few years suggests a greater public acceptance of paid digital downloading since then.
Uncharted Waters
It¡¯s hard to imagine that DRM-free music won¡¯t increase illegal file sharing among a certain customer demographic, especially in the college environments where the original Napster file-sharing service first gained prominence. For this reason, although removing DRM protection shouldn¡¯t undermine music labels¡¯ ability to track through watermarking and to prosecute offenders, it could contribute to the volume and cost of legal battles.
It¡¯s too early to predict all of the effects this dramatic turn of events will have on industry credit quality. If EMI is the only major label to adopt a DRM-free approach, the effect will be minimal and limited to EMI, which alone would be vulnerable to a jump in piracy. If other labels also shift strategies, then the industry as a whole will enter uncharted waters.
The envisioned benefits of the strategy¡ªa jump in download sales and more advantageous pricing¡ªmust more than offset the potential increase in piracy. If this doesn¡¯t happen, not only will losses flow through to music majors¡¯ bottom lines, but lower royalties to artists would mean less economic incentive to write and record music, which could further affect labels¡¯ revenues.
So far, Apple seems the most likely near-term beneficiary of the trends in digital music because it will probably reap a portion of the pricing premium associated with new, DRM-free downloads and sell more memory to accommodate the larger DRM-free file sizes. Like the music majors, we¡¯ll have to wait and see the actual effects on industry credit quality.

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