Warner’s Business Model Creates Losses, Digital Downloads Widen Them

November 13, 2007 by David Piccolo

Warner Music Group Corp. announced a larger than expected third-quarter
loss and attributed the larger loss to more consumers purchasing digital
music instead of CDs. While digital revenue increased seven percent from
the previous quarter, revenue from recorded music fell four percent. This
example provides an opportunity to examine the current business model
employed by recording companies in the near and long-term and whether they
would be better served with a different model.

The current business model for recording companies is to acquire copyright
from artists – generally the sole right to make any sound recording. As
the rights-holder, the recording company then releases a CD by the
artist(s). In theory, the CD would sell its greatest volume in the first
week and then a declining number in subsequent weeks. While this model
may have led to profits in the past, it may no longer be the case.
According to Warner Music’s management, sales for new release CDs are
declining. As well, the decline in sales in subsequent weeks is
expanding. Thus, the recording companies are seeing declines in sales on
both fronts. The increase in substitutes to purchasing a CD is the likely
cause for the current unprofitability of this business model.

Consumers today now have greater choice when deciding how to purchase
recorded music. Besides purchasing CDs, consumers can decide to purchase
individual songs or entire albums online or to illegally download the
music for free. With this increased choice, it appears that more and more
consumers are eschewing CDs for a digital option. The reasons for the
switch include cost, convenience and changes in technology.

It appears that Warner Music acknowledges the change in consumer habits
and the need to change. According to their CEO Edgar Bronfman Jr., “[t]he
industry needs to introduce a new platform that delivers higher quality
and more value to consumers than the compact disc.” Bronfman also stated
that “the company will accelerate and broaden efforts to strike deals with
artists and other industry players that will give Warner a piece of
revenue from other segments of the music industry, such as merchandising
and touring. Those segments are faring better than recorded music sales”.

Therefore, it appears that Warner Music has accepted that the current
business model cannot succeed in the near and long-term. Bronfman’s
comments on what the industry must do to be profitable signals a potential
shift in their business model. This shift would transform Warner Music
from a ‘recording company’ into an ‘integrated music company’. This would
be a welcome change that would benefit the recording companies
(rights-holders), artists (authors) and consumers (users).

It appears that current contracts between the recording companies and the
artists only assign the right to reproduce to the recording companies.
This means that the only way recording companies can earn revenue is
through the sale of recordings. This puts pressure on the recording
companies to exploit this area as much as possible. Also, it has forced
recording companies to protect this domain from illegal copying, which has
often pitted them against consumers. These actions have created animosity
between consumers and record companies. By becoming involved in other
areas of the music industry, recording companies will be less reliant on
revenue from the recording of music. By contracting for more rights from
artists, they could consider other business strategies. For example, an
integrated music company could sell their music for below cost and recoup
their costs in other more profitable areas. This would lessen the tension
between consumers and recording companies because recording companies will
be less inclined to take an adversarial stance with consumers while
broadening consumer access to recorded music.

This change would also impact the relationship between recording companies
and artists and the relationship between artists and consumers. The
former relationship will change for two reasons: first, there will be an
increased likelihood of conflict because there will be greater potential
for disagreement over money and creative control; second, it is unclear
whether the shift would cause more or less artists to be signed to
contracts (potentially affecting consumer access to music and artist
access to revenue). The latter relationship will be affected because the
integration could cause more or less consumer access to music. However,
any negatives consequences found here, I believe, are less than the
positive consequences stated above. Thus, if Warner Music wants to remain
profitable in the long-run, I suggest that they use their freedom of
contract to transform themselves from a ‘recording company’ into an
‘integrated music company’.