Digital Music Downloads - The Problems of a Next to Zero Margin Business

Loudeye released their 10Q yesterday along with their Q2 financials.  Let's look at their company as a relatively decent pure play proxy for the music download business since 72% of their Q2 revenue is from the music store business - this is a vast increase from 7% in Q2 2004 since they acquired European music download service OD2 in mid 2004, transforming the company along with other small acquisitions and divestments.  The reason I chose Loudeye is that Apple and RealNeworks have substantial other businesses besides downloads, and Napster has a growing subscription business, although there is some fun to be had with that 10Q as well.  Let's focus on what I think is the consistent key metric of a music download (or actually any) business - Gross Margin - this is the difference between the revenue of the service/good, and its direct cost of providing it, before other costs such as marketing and overhead.  It must be high enough and have enough volume to cover the operating costs of the business - seems basic, but often fades from view in bubble/frothy times.

So how does the music download business look?  It's pretty clear - Loudeye's overall Gross Margin for Q2 2005 was $170K, or 2% of revenue (when music store revenue was 72% of revenue), vs $1,900K or 39% of revenue in Q2 2004 (when music store revenue was 7% of revenue).  And amazingly enough, the 10Q projects that digital media margins may further decline in 2005 vs 2004 - one might ask how much lower can they go?  You could argue that the real problems are in the other 28% of the company's revenue since the 10Q makes it clear that the Content Protection/Overpeer business was a negative margin busines, but at less than 7% of overall revenue, it can't have been a huge factor unless it's a total disaster.  Plus it should have been offset by the remaining 21% of revenue, non-music store businesses such as encoding and hosting, which we can only assume are positive gross margin since they are for every other company.  If we assume the Loudeye is a proxy, then the basic conclusion is that the download business is actually close to a zero margin business for service providers, at least at volumes below Apple.

This post is not meant to focus specifically on Loudeye's issues since I believe the management team is trying to transform a company with a mixed bag of assets into a potentially valuable pure play in digital music, especially in mobile music through a significant Nokia relationship, and that takes time and effort.   But as we have discussed before,(and which is laid out in various Risks of the Loudeye 10Q), the digital music download business is, in particular, NOT a place for service providers, or in my opinion, for investors.  The margins are simply terrible, one has no leverage over your primary suppliers, there are legions of competitors, your business customers want to go directly to the labels, and there is a massive piracy issue.  If you want to masochistically be in the music provider business, there are potentially areas such as Internet radio, general subscription services,  ringtones, music  videos, independent  music  sites, etc. which MAY  provide a way to make a postive gross margin for a period of time - but if they exist, I haven't found it yet, at least not on a sustainable level.

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