November 1, 2011, 12:00 AM

A crescendo of competition

Internet giants battle over digital music, in a broader war for consumer loyalty.

Lead Photo

Three Internet powerhouses are competing toe to toe to become consumers' favorite source for digital music. And that raises the question: Why are Apple Inc., Google Inc. and Inc. so focused on a relatively small business that's not particularly profitable?

The answer is that they are following a similar strategy as the razor blade manufacturers that give away razors to hook consumers into buying their blades, over and over. A consumer hooked into a company's online music service is going to be more likely to buy that company's hardware and other services for years to come.

"Music is a carrot to lure people in," says James McQuivey, a vice president and principal analyst at Forrester Research Inc. Companies use music to forge deep, long-lasting and profitable relationships with consumers, he says. "They want you to be so tied in with them that at some point they'll make money from you."

Some innovative newcomers are also entering this arena, which could spur a race by all players to offer appealing music services. But the financial strength of these three highly profitable companies—Amazon's market value is nearly $90 billion, Google's twice that and Apple's nearly $340 billion—means they can compete aggressively on price and service, even if they're not making money on music.

"They don't need music to survive," says Paul Verna, a senior analyst at research firm eMarketer Inc. who focuses on the music industry. "That means they can afford to experiment with what works and wait it out. It's obviously important to them, but it's not important in a bottom line sense."

Apple and Amazon have already demonstrated how online services can promote other profitable products.

Apple uses iTunes as a gateway to the iPod, iPad and iPhone, Verna says. Getting consumers accustomed to the Apple aesthetic via iTunes has spurred sales of its devices, the company's primary business. "The word about iTunes is it's never been a profit center," he says. "But that doesn't matter as long as it serves its purpose—to draw people in."

Amazon replicated that model with e-books and its Kindle e-book reader. From its launch until last year the world's largest online retailer sold most e-books for $9.99, making the digital books a loss leader. In fact, the American Booksellers Association in a 2009 letter to the antitrust division at the U.S. Department of Justice complained that Amazon was engaged in illegal predatory pricing designed to spur sales of other merchandise, including Amazon's Kindle e-book reader. The book retailers noted that because Kindle e-books do not use the most common ePub e-book format, consumers who buy Kindles must then buy their e-books from Amazon.

Low notes

The argument that Amazon, Apple and Google have other things in mind in aggressively promoting their online music services gains credence from the decline in music sales over the past decade.

Save the first half of this year when Nielsen Soundscan's sales report found both digital and physical album sales produced a slight 1% uptick from the year-earlier period, album sales have been on a downward slide since 2004. When sales are measured by so-called "track equivalents," which uses the rule of thumb that 10 downloaded single tracks equal an album, sales were slightly better in the first half of the year—up 3.6% year over year, also the first increase since 2004.

But even that smidgen of good news didn't alter many experts' bleak outlook for the music business, as digital sales steadily supplant more lucrative physical album sales. "Music is a relatively small business that is getting smaller," Verna says.

U.S. retailers sold $3.2 billion worth of digital music in 2010, up 3.0% from 2009, but that is still only 1.9% of total U.S. e-commerce sales last year of $165.4 billion, according to the U.S. Commerce Department. Sales of music CDs, meanwhile, fell 20%, according to the Recording Industry Association of America. That caused the overall retail music market's sales to fall 10.9% to nearly $6.9 billion.

But the gloomy state of music retailing hasn't stopped Apple, Google and Amazon from diving headfirst into the next frontier of music delivery. Each has launched products this year—iCloud, Music and Amazon Cloud Drive, respectively—aimed at establishing themselves as the primary music source for millions of consumers (or, in the case of Apple, maintaining its dominance) by rolling out offerings that store consumers' music on the web and stream it back to them for their listening pleasure.

Loss leader

None of the three seems consumed with profiting directly from these services. The cost of Apple's server farm that houses iCloud reportedly stretched north of $1 billion. And the cost to consumers using the service? Nothing for five gigabytes of data, enough for more than 80 hours of music. Apple's iCloud is free as long as consumers use Apple's iOS 5 mobile operating system, which is loaded on the iPad, iPhone and iPod Touch. Apple doesn't count music, apps, books and TV shows purchased through iTunes or its App Store against that five gigabyte limit. Consumers needing more storage can add 10 to 50 gigabytes of storage for $20 to $100 a year.

Google's Music offering, which is in an invitation-only beta testing period, is also free. Meanwhile, like Apple, Amazon Cloud Drive service offers free storage of five gigabytes of data, and free space for any content purchased from Beyond that limit anyone can pay to upgrade their storage, and shoppers will be upgraded for no extra charge to the 20-gigabyte level if they purchase a digital album from Amazon.

The differences

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