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Napster May Hurt Music-Firm Stocks


By Hal Plotkin
Silicon Valley Correspondent
May 1, 2000

Although financial analysts haven’t factored it into their earnings projections yet, music-industry observers say the popularity of Napster’s song-sharing software is contributing to a decline in music sales to young consumers that could damage entertainment and perhaps even digital-rights management stocks down the line.

San Mateo, Calif.-based Napster Inc. provides free software that lets users share music files over the Internet.

“It’s a little too early to know for sure how all this is going to play out,” says Katherine Styponias, an entertainment-stocks analyst at Prudential Securities in New York. “We haven’t measured it yet; I’m not sure anyone has. But it’s clear Napster is already taking money out of [entertainment companies’] pockets.”

The stocks that could be hurt down the line should Napster continue to gain momentum include virtually any firm that sells recorded music, such as Japan’s Sony Corp. {SNE} Time Warner Inc. {TWX} and The Walt Disney Company {DIS}. The rise of Napster also poses a threat to digital-rights management stocks such as Liquid Audio Inc. {LQID} and Sonic Foundry Inc. {SOFO}. Over time, the underlying technology behind Napster could also be extended to other products sold by large entertainment conglomerates, such as books, videos and even movies.

“The implications of Napster are very significant,” says Edmund Ha, an analyst at the Giga Information Group, based in Cambridge, Mass. “And there really doesn’t seem to be a whole lot the industry can do about it. They’re going to have to adapt, and they’re clearly not moving fast enough.”

Napster, on the other hand, is moving very, very fast. The software has attracted hundreds of thousands, perhaps millions, of users in the few short months since 19-year-old college student Shawn Fanning created it, initially for use within his own small circle of friends. It has also helped spawn a similar though not-yet-as-popular file-swapping software program called Gnutella that analysts say is even harder for the recording industry to combat, because records of its use aren’t maintained at any one single location.

Like Gnutella, Napster’s free software makes it easy for users to anonymously trade music files over the Internet after the files have been converted into the high-quality MP3 format. Napster’s software also generates a dynamic index of all the MP3 files available on the hard drives of other users simultaneously logged on to the service. Napster’s distributed archive can be searched and the individual songs downloaded free of charge. Once a user downloads a song, it is theirs for the keeping. MP3 songs can be played on a growing number of devices, including computers and portable MP3 players.

“Napster is very important in the threat it represents,” says Van Baker, vice president at Dataquest, based in San Jose, Calif. “It’s changing the economics of the music-distribution model.”

There are some well-known bands, such as the Grateful Dead, that have authorized non-commercial copying and trading of their songs over the Internet in the MP3 format. The easy-to-copy MP3 music file format has also been embraced by thousands of lesser-known acts hoping to attract a following. But the vast majority of the more than 500,000 songs available at any one time within the Napster community are pirated copies of copyrighted commercial material, everything from the Beatles to Luciano Pavarotti.

“It’s astonishing how quickly this thing has caught on,” Ha says. “Entire college computer networks are being brought down because too many students are using Napster at the same time to trade songs.”

All that song-trading threatens to exacerbate an already apparent downward trend in sales of recorded music to young people.

Although overall music sales were up in 1998, the last year for which figures are available, sales to consumers between the ages of 15 to 24 fell sharply, declining to 28 percent of overall sales, down from 32.2 percent two years earlier, according to the Recording Industry Association of America, which has filed a lawsuit against Napster.

Analysts say Napster’s success is sure to accelerate the downward trend in sales of recorded music to young people.

“I’ve seen students quoted saying they never visit a record store anymore,” Baker says. “They’re too busy downloading free songs.”

Although lawsuits are flying fast and furious, several technology analysts say the recording industry may have slim chances of permanently shutting down Napster and similar online file-swapping services.

That is because there are many legitimate, perfectly legal uses of Napster’s software, including the trading of MP3 files that have been authorized for distribution by their creators. Banning Napster because it is being used inappropriately would be similar, some say, to banning guns or knives because they can be used to commit crimes.

“That’s the problem,” Ha says. “There’s no way to tell which MP3 files are authorized and which ones are not. And even if there was a way to tell, that might not be enough to stop it.”

That, Ha says, casts a shadow over the business plans of companies in the online digital-rights licensing market, such as Liquid Audio and Sonic Foundry, among others. A key component of the strategies of such firms involves assuring the secure distribution of online music and other forms of digital entertainment. The entire premise on which these businesses are based could be undermined if MP3 file-swapping can’t be stopped.

“I don’t know what’s going to happen for certain,” says Greg Blatnik, vice president at Zona Research, based in Redwood City, Calif. “But the Internet will collapse if some element tries to force everything to be freely distributed content. Over time, that could include everything, not just music, but also software, books, documents — you name it.”

Other analysts, while also alarmed, paint a somewhat less-apocalyptic future.

“I think ultimately what we’ll see happen is that new business models are going to evolve,” Styponias says. “The industry really doesn’t have a choice.”

Those new business models might, for example, involve recording artists selling personalized CDs that contain only the songs an individual buyer wants, offering subscriptions and preferred seating for live concerts, or selling ancillary products similar to the way movies are often used to market a variety of complimentary items.

“Over time, it’s my sense we’ll be looking at lower prices for music and more volume sales,” Styponias says. “It could be a good thing for the industry.”

Others, such as Blatnik, are still holding out hope the industry will arrive at some kind of technical fix that will protect copyrights online, despite their already widespread violation.

“At some point all this stuff is going to be protected, and if you want to listen to it you’ll have to pay a meter,” Blatnik says. “I’m surprised it has taken this long.”

Others, however, say the cat is already out of the bag and won’t ever be pushed back in.

“MP3 is not going to go away, and you’re never going to be able to squelch MP3 pirating,” Baker says. “The only way you could do that would be to recall every CD player now in circulation. That’s not going to happen. There’s not going to be a technical fix or a legal fix that totally eliminates the problem.”

Nonetheless, Baker, like Blatnik, says he does expect to see Napster “reined in” in some way over the coming months, perhaps by making voluntary agreements with record companies that might help the company crawl out from under the avalanche of lawsuits it has attracted. “There’s no argument that Napster isn’t facilitating piracy and profiting from it,” he says. “I think it’s a given the recording industry will prevail in some way at some point in time.”

But even if the recording industry does prevail in court, Baker says the music-file swapping phenomena might only be driven underground or to a harder to detect version of the software, such as Gnutella.

In the meantime, Styponias says that investors holding entertainment or digital rights management stocks have little choice but to watch future quarterly earnings reports to determine, after the fact, how big a hit Napster is taking on the bottom line.

Ha adds that most traditional financial analysts are underestimating the impact of Napster on the stocks they follow. He says the analysts would already be revising their earnings estimates if they were dealing with an issue with which they were more familiar, such as rising interest rates or reports of excess inventory.

“Wall Street isn’t watching this because it’s not something that affects them; it’s not something [downloading music] they do,” Ha says. “But the kids are doing it, and they are the most-important market, the future really, for these companies.”

Ha says he thinks it will be at least several years, if ever, before the music industry works out a new set of technical arrangements or new marketing approaches that insulate it from unauthorized MP3 music file copying.

“This is not going to play out anytime soon,” Ha says. “The music industry is extremely reluctant to change their existing business model. Once they realize that’s really what they have to do, it might be too late for many of them.”

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