Music Confidential — Revisiting Rhapsody

MUSIC CONFIDENTIAL
The Weekly International News & Analysis Report
STRAIGHT FROM THE SOURCE
July 9, 2009, Issue 27
www.MusicConfidential.biz

Executive Editor Susan Butler
Delivered Weekly via Email

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REVISITING RHAPSODY

By Susan Butler

Despite the media frenzy and industry accolades for Spotify, the free-to-consumer, ad-supported service that hopes to turn people who want free music into paying subscribers, Music Confidential is not buying into the model at this point. While every licensed service will hopefully be profitable, there are serious doubts at this time about the fledgling Spotify. Instead, those services that are still surviving in the digital market, like RealNetworks' Rhapsody, deserve a closer look.

The reasons are simple.

The year was 1999. We stood on a sidewalk in San Francisco before the now infamous dot-com bubble burst. My legal client pointed to a taxi with a billboard on the top which advertised the Web site of the company he just sold to a publicly-traded educational software corporation for millions of dollars in equity interest. As part of the deal, he landed a seat on the board of directors. He was now struggling with the old guard of the traditional corporation to enlighten them on the economics of Internet businesses.

"They don't get it," he said. The CEO was focusing too much on the fluctuations of the share price rather than understanding the long-term strategy of dot-coms, he believed.

My client had built the top learning Web site that was attracting hundreds of thousands of visitors. These consumers could find answers to questions like how to carve a turkey, what a best man for a wedding is expected to do and thousands of other niceties about life. This free site attracted the Web traffic to promote my client's revenue-generating business, which was developing and designing high-end Web sites.

In this new Web-based economy, he said, it was all about getting the people to your site. You first had to spend lots of money to build the brand, like taxi billboards and media coverage, to get people to your site. Then you could figure out a way to monetize them.

You really had to be living in the San Francisco Bay area during the last half of the 1990s to appreciate the full impact of the dot-com frenzy. For nearly five solid years, every media report was filled with news on dot-coms and tech companies. As a contributing columnist to the most visited tech news site, ZDNet (which later became CNET), a contributing feature writer to the top tech magazines and an attorney for some start-ups, I made it to business parties launching new dot-coms practically every night and attended monthly "salons" where new millionaires mingled with journalists and tech developers to discuss business strategies. The mantra was the same.

Most of the companies that believed "free" could become "revenue-generating" have since crashed and burned, leaving investors and executives empty handed.

Yet some companies survived. Among them are AOL, then considered the Internet service provider (ISP) for "newbies," and EarthLink, the ISP of choice for "techies."

Former EarthLink executive Mike Lunsford last month celebrated his one-year anniversary as the head of music services for RealNetworks. Even though most companies will see fluctuating results during the current economic climate, this executive VP for strategic investments saw first quarter 2009 music revenues increase 16% over the prior year quarter.

Rhapsody is not a free, ad-supported model. It is a subscription-based model.

FREE, AD-SUPPORTED MODEL
"People have historically set up the free, ad-supported model as loss leaders to feed into some other side of the business, which is the second digital business model of subscriptions, MP3 [downloads], etcetera," says Lunsford. "That has been the folly to date. I think you have to set the ad-supported business up to itself be standalone profitable. It doesn't have to be hugely profitable, but that part has to break even before you can pair it with a subscription or an up-sell service."

As an example, Lunsford points to the relationship between broadcast radio and the music industry.

Radio has been very heavily ad-supported, which generates revenues for the music industry. Record distribution separately creates revenues for the industry.

"The two models are so different, and the service you get out of each is so different," he notes. "To date, the issue with digital ad-supported sites is that you have to make it such a rich service on the free side that it's not compelling to upgrade to the paid side. Until we get to a model in the digital world that looks like the [radio and] physical models did 30 years ago—with both profitable—I think the digital space will continue to be confused."

With increased Web traffic, ad-supported services can, of course, increase advertising prices. Adding click-through ad opportunities and attracting video ads also help generate revenue.

"But most of those guys should be—and most of them are—focused on how many [ad] impressions they can get per song played. If you can drive 10 page views before a user actually plays the first song, then you're much better off than if you can only get one page view for one or three plays," says Lunsford.

As Web site operators learned a decade ago, this leads to intrusion. Spotify has been adding new advertisements on its site, and some U.K. music executives say the ads are already becoming more intrusive. Users might elect to upgrade to pay for the music to avoid the ads, but they could easily find another service that doesn't first lure them with ‘free' and then interfere with that free use.

THE RHAPSODY MODEL
The Rhapsody site include some free components, like 25 free streams, but the company's focus is to offer a music service without interruptions or distractions.

"Rhapsody is primarily a direct-to-consumer subscription service," says Lunsford. "Everything else we do is set up to either feed that or monetize that."

The service currently has about 800,000 subscribers. This figure is expected to be updated in RealNetwork's next earnings announcement the end of this month.

Integration: Integration is key, and the service is moving toward more integration with devices and mobile. This benefits Rhapsody in a couple ways, says Lunsford.

First, it means that Rhapsody is distributing "on someone else's dollar," he says. The distribution network is built with the money of device and handset manufacturers and mobile operators rather than the digital music service.

Second, it makes the ‘service' an easier sell.

"One truism I learned from my EarthLink experience is that people have trouble conceptualizing a service," he says. "When we launched broadband, we had a very difficult time convincing anyone to buy the product until we started giving away the modem for free. People felt like they were actually renting the modem, not [paying] for the dial-tone service. It was a really goofy thing, but that was the switchover when we started getting huge adoption [of broadband]."

In other words, it is the flip side of free music to play on a not-for-free iPod or mobile phone handset. It is a free device to use for a paid, subscription-based service.

When digital music services become more integrated with devices, and companies can advertise and promote the device with the service, there will be more rapid adoption of digital music by the consuming public, predicts Lunsford.

Since the fall of 2006, Rhapsody's strategic partnerships with device manufacturers have grown to include Pioneer, Vizio, Philips, SanDisk, Haier, Denon, Logitech, Moxi, Sony, Escient, Yamaha, Control4, Sonos, Cisco and TiVo.

Rhapsody measures its success with these partnerships in two ways.

"One is how many customers come in through the channel," he says. "Today, that is still the MP3 players. Some of our oldest, longest relationships are there. Samsung comes to mind, for example."

The other measure is ‘churn,' a word used often by ISPs, cable operators and mobile service providers and a word that promises to soon be commonly used in the digital music industry. A churn rate in this context is a measure of how many subscribers leave a service or company during a period of time. A high churn rate means a company is losing a lot of subscribers.

"Our churn, or, a more positive way of saying it, our customer lifetime, is twice as long on the Sonos customers as it is on our average customer," he says. "The customers who use [Rhapsody] the most and stay the longest are our Sonos customers and what I call our living room device customers. A streaming service without a PC is just by far the best service. When you pair that with the great interface that the Sonos guys have, it really makes the service sing."

Mobile: On the mobile front, industry relationships between digital music providers and mobile carriers have changed in the last year. The success of the iPhone has driven mobile carriers in the U.S. to think differently about the products they bring to market, says Lunsford.

In the past, "carriers tried to have a cohesive, consistent set of services across products with the same look and feel," he says. While carriers still do this with ‘feature' phones, they are moving away from this effort on ‘smartphones.'

"The iPhone taught them that you can have, on the high end, some smartphones that feel different, look different and have different services on them because people are buying the phone not your video or music service," he says. "The fact you have a music service kind of checks the box for them."

This "shift in paradigm," he predicts, will lead to "more handsets that are completely vertically integrated before the carriers get their paws on them."

So the race to integrate digital services with handsets is on.

In the past, Rhapsody hasn't pursued direct relationships with handset manufacturers, he says.

One reason is that Rhapsody is a service of Rhapsody America, a joint venture between RealNetworks and MTV Networks. Verizon Wireless is Rhapsody America's mobile partner.

Rhapsody and Verizon have a "semi-exclusive relationship," says Lunsford. "When they control the deck on the phone, we are the [exclusive] music service provider. Anywhere the deck is unlocked—like an Apple iPhone if Verizon could get that phone—Verizon can have other music providers."

For example, Verizon's VCAST Music with Rhapsody is on handsets manufactured by RIM, LG, Motorola, Samsung and Nokia. But Rhapsody would not be a service on carriers like Sprint, T-Mobile or AT&T.

Just as Verizon could offer different makers' handsets with unlocked decks and, for example, offer iTunes as the default music service on an iPhone, Rhapsody could reach out to handset manufacturers, like RIM, and become its default music service on the RIM platform offered by any carrier, he says.

Whether Rhapsody and other digital music services will be able to land deals with handset manufacturers may depend on whether the manufacturers are operating their own in-house music services, like Nokia, or whether they partner with others, like Sony Ericsson's deal with Omnifone.

"It's unclear if the world is moving more toward in-house or will revert back to partnerships," says Lunsford.

Powered by Rhapsody: Separate from RealNetworks' Rhapsody music division is the company's business-to-business Technology Products & Services (TPS) group.

TPS provides businesses with software and services to deliver digital solutions, including music, to their customers.

"We're providing the infrastructure, the back-end, for someone else to provide music," says Lunsford. "We're extremely good at that because we take the time to do things right. We add royalty reporting, we have the billing systems, we track everything we do. We're very clean, and I don't think that everyone [i.e., other services] can say that."

Rhapsody also has one of the best databases of information pertaining to current publishing rights in commercial music in the U.S., sources have said.

Through deals with TPS, Rhapsody powers Yahoo! Music, Vodafone Spain's unlimited streaming service and others.

The company also offers Helix Media Delivery Platform, a mobile infrastructure used to deliver mobile music and video. More than 100 mobile carriers worldwide have used Helix products, including AT&T, Bell Canada, Sprint, T-Mobile and Verizon.

With this and other types of software solutions, Rhapsody can bring more to the table when negotiating with potential device and mobile partners than just a subscription music service.

BUILDING ON THE CORE
Although there is much more to Rhapsody than the number of its subscribers, the service still needs to attract subscribers.

In addition to marketing the service through device and mobile integration, Lunsford believes that bundling products and expanding strategic relationships offer promising opportunities.

Bundling with network service providers (NSPs), i.e., companies that provide backbone services to Internet service providers, "will be slower to evolve, particularly in U.S., but I think the service provider market will eventually embrace music as a piece of the service," says Lunsford.

Rhapsody is also looking to expand "with partners that have a broader footprint—more eyeballs—who need to do a better job of monetizing those eyeballs and getting them to a paid up-sell," he says. "I keep reading about [executives] from companies like Imeem or MySpace saying they have to find a way to move customers to paying. I have the exact opposite. I need more customers in the funnel. Once I get them, I can make money off of an individual customer. So we're all natural partners at this point."

Having MTV as a joint venture partner has built up Rhapsody's brand awareness, but hasn't built subscribership substantially.

"The marketing we do on MTV and related networks has done a fabulous job of raising our brand awareness," says Lunsford. "It's doubled in the lifetime of the venture. What hasn't come out of it is the advertising leading to a significant surge in signups. I can tell you from 10 years at EarthLink, it's very hard to turn television into signups. We might still be able to find a way to do that, but my experience has been if you use the marketing for brand awareness, you'll be very happy. If you're trying to just drive subscribers, it's not going to get you there."

Meanwhile, RealNetworks continues to pursue the vision of "your media—music, games, video, etcetera—where you want it, when you want it, any place, any time, all that good stuff," he says.

The only aspect that is not yet fully integrated across RealNetworks is video.

"In games and music, we provide content, software and services," he says. "In video, we don't provide the content piece. We're not an aggregator, and we don't create our own content, as we do with games. We can create the desktop—the RealPlayer—where you can play anything you want, but we don't provide the video services. What you saw with RealDVD [player] in its brief life on the shelf, and now under a long-time restraining order, is an attempt to get into the video play as well."

Motion picture studios sued RealNetworks, claiming that the RealDVD player is software that unlawfully circumvents copy protection technology on DVDs. The action is still pending.

THE FUTURE BIZ
Like many others in the music industry, Lunsford sees a future where consumers move more toward streaming and renting music—using it—rather than owning it.

"I knew that broadband would be ubiquitous at some point—it just took five years longer than I thought—and that we would be getting email on wireless devices," he says. "Some of these things are just obvious. When the unholy trio of networks, devices and applications line up, the rental model will be more compelling than the buy model."

The networks are "very close" to being where they need to be, he says, with 4G networks coming. Devices are aligned.

As for software applications, they are "largely there." But applications are not yet optimized for handling multiple tasks at the same time.

We're going to have to get better at power management and other sorts of multi-threading, those kinds of things that allow you to use your device for two things at once," he says. "That's going to have to happen."