In one final hurrah before turning his empire over to America Online, Time Warner CEO Gerald Levin couldn’t resist folding in EMI Group PLC.
No. 4 in the music business buys No. 3 to become No. 1. It will look good on the Billboard charts but will fail on Wall Street. Time Warner shares declined on the news.
The stock market has been paying up big for what might work profitably someday, giving huge multiples and enormous pots of capital to online and technology businesses like AOL, Juniper and Akamai. Wall Street isn’t paying for what the record business has to offer: cash flow. In fact, cash flow is for suckers. Cash flow is an addictive drug that, to borrow a Hollywood expression, suspends disbelief. No matter how good it looks in a Goldman Sachs acquisition spreadsheet, unless that cash flow is growing and can be protected, it will evaporate.
The dirty little secret of media companies like Time Warner is that their huge cash flow comes from their music divisions—enough to cover a lot of bad movie mistakes. It is no coincidence that every major company in the film business also owns record labels. The average movie loses money hand over fist. Without the support of Garth Brooks & Co., Hollywood would emit a giant sucking sound as it sank into the La Brea Tar Pits.
In contrast with $100 million film budgets, you can record Aerosmith’s next album for under $1 million (most of it for caviar and drinks for the boys), put it on a compact disk that costs 20 cents to make, ship five million copies at $13.99, pay the band $1 a copy and draw a steady stream of cash. By manipulating credit terms, return policy and sell-ins (as first-day orders are known), the big record companies—Sony, Bertlesmann, Seagram/Polygram and (pay attention, AOL) Time Warner-EMI—completely dominate the music distribution channel. They can force retailers to take large amounts of marginal CDs in order to be guaranteed access to the next Mariah Carey hit. New artists have been forced to sign with these guys to get their songs in stores.
But along comes MP3, a digital format for encoding and compressing music. Stick your Ricky Martin disk into your personal computer, and, in what the geeks call “ripping,” transfer the music to your hard drive with almost perfect quality. A four-minute song fits in four megabytes, about a four-second download with a cable modem. It’s just digital bits. You can use it as many times as you like, share it with friends (oops, piracy problem), make your own party CDs, and so forth. I’ve ripped my entire music collection, except for those old Engelbert Humperdinck eight-tracks.
But why rip at all? Eric Clapton could go directly online, from his music studio straight to me. All of a sudden, the record companies’ lock on the distribution channel disappears. Even better, some entrepreneur might store 10% of all the music ever recorded on a car stereo equipped with MP3 and a 20-gigabyte hard drive, and have us pay per listen.
It’s so easy. MP3.com CEO Michael Robertson admitted to not knowing what A&R stood for (“artist and repertoire,” which means attracting new talent) nine months before going public with a first-day value of $5 billion. He’s now got over 30,000 artists signed up on his Web site, and he pays them 50% of revenues. Most of them aren’t any good, and MP3.com’s model may be flawed. But it’s a start. Real Jukebox software from Real Networks digitizes 14 million users’ CDs onto their PCs.
The next step is direct from the recording studio to customers’ hard drives, wiping a few more middlemen off the charts. Then it’s like shooting fish in a barrel. Phish signs an online deal, then so does Mariah and then Whitney and Britney and then that guy who used to be known as Prince.
Music won’t be free. It’s just that a different set of grubby hands will control its distribution. New empires will be built as old ones are destroyed. This won’t happen overnight; give it a year. Perhaps Mr. Levin’s urge to merge arises because he knows full well what’s coming and he thinks the combined Warner-EMI music’s $1 billion cash flow will buy him some time.
Consolidation is inevitable, but successful consolidation is a matter of timing. For the music business to do it now is a bit like consolidating the brokerage business just before online trading took off. Morgan Stanley would happily give back Dean Witter.
AOL is an agent of this change, but why not kill off the music business first, and then swoop in and buy the spoils? AOL owns one of the more popular MP3 players, Winamp. It could easily set up online music delivery and handle transactions. But AOL-Time won’t do it in a big way. Instead the company is in the position of protecting recording industry cash flows, and there’s more to protect now that it’ll own EMI too. The likely outcome? AOL will be whacked at by Yahoo, Microsoft, AT&T and other modem toters.
Digitizing music and video is easy, and Wall Street is providing billions for broadband delivery to homes. First music, then TV, then film will shift to digital delivery. The question is no longer if, but when. The record companies’ stranglehold on distribution will slowly but surely be undone, and media turned upside-down by technology. And what’s AOL honcho Steve Case going to be doing while this is happening? Peddling CDs.
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