Rule Breaker Portfolio

<THE RULE BREAKER PORTFOLIO>

MP3: Music of the Future?
Or will it fall flat?

By Charity Taylor

Introduction by Jeff Fischer:
This summer, David Gardner and I had the privilege of working with Charity Taylor. Charity is a junior this year at the University of North Carolina, Chapel Hill, where she is a Morehead Scholar. Charity was the official Rule Breaker Motley Fool intern this summer, working closely with David and me on everything "Rule Breaker." Her work didn't stop there, however. Charity also worked on a Fool University marketing project, the Drip Portfolio, business history and research reports, and company studies including MP3.com
(Nasdaq: MPPP) and Red Hat (Nasdaq: RHAT). Being a musician, Charity's thoughts on MP3 were especially relevant.

Before Charity returned to the autumn-tipped days that harken the opening of a new school year, we asked her to write a Rule Breaker column. Her column today concerns MP3, the technology. It was written before MP3.com, the company, went public, fetching more than $6 billion in market value. MP3.com is now valued at $1.8 billion. The company had $1.2 million in sales in 1998, and its business plan -- how it will make money that scales -- is still, by any practical measure, up in the air.

With that backdrop... Charity's column.

Alexandria, VA (August 11, 1999) -- I was introduced to the technology of ISO-MPEG Audio Layer-3 last year as a sophomore in college. My friend was working on my computer when he discovered that I was unequipped with a new type of music program he called MP3. He proceeded to download an MP3 player and several individual song files so that I could test the new technology.

A small picture of a stereo face appeared on my screen with a list of the song titles. We played the music and he told me how he spent much of his free time wandering the Internet looking for his favorite music. It was an entertaining way to avoid studying for one afternoon, but one year later, the player remains on my computer with those same files of The Wonder Years theme song and something from Pearl Jam virtually untouched. I have listened to them once or twice and displayed my little wonder to a couple of unknowing friends, but on the whole I have not been persuaded to spend much time with MP3.

As both a musician and an avid music listener, I remain a bit skeptical of MP3's business potential. To begin with, any song that I want to download is free and anything free gives me reason to think twice. Next, the technology that was used to create the standard MP3 is continually exploring other formats that will likely attract greater interest. Others, like myself, view MP3 and its distributor companies, such as MP3.com, as a new hassle (they offer too much noise) for those who do not have time to explore the grassroots world of digital music to finally find something worthwhile. MP3 does offer some advantages, but I'm going to hold on to my CD collection a little while longer.

As a musician, I definitely play music mainly for my own enjoyment. Yet, when I consider taking my abilities to the next level, my first concern is certainly money. Who will be willing to support me financially as I create music? In turn, I am willing to assume that most other musicians have at least pondered the money issue. Therefore, when I find that I can now go on the Internet and download the product of a musician's work and talent for free using MP3, I have several questions. How are artists being rewarded for this work? Essentially, they are not -- other than the good feeling they must receive from people enjoying their music.

Artists must be compelled and supported to create quality music, and having their music widely distributed to anyone through a new technology for free will certainly not provide the needed financial support. Many artists are not willing to become involved in the standard, and the number of popular artists that can be found through a MP3.com search is evidence of this. The result of searching for the artist "Jewel" on MP3.com produced one result -- "Jewel Thieves," a Los Angeles based modern rock band that I (and everyone else I asked) have never heard of. This result is then followed by a list of 64 grassroots artists/bands who produce music that sounds similar to Jewel. I don't think the average music fan looking for a particular song by Jewel will have the time or interest to test out 64 people that MP3.com has said will sound like Jewel.

If someone does have time to listen to band after band, great. But can free music like this last? I don't think so.

Currently, only a small number of popular artists have supported the MP3 standard on its currently free terms, including Chuck D and Billy Idol, and most recently Alanis Morissette and Tori Amos. I don't believe that many others will follow until they see that something substantial is in it for them -- something substantial (revenue and promotion) that at the same time won't harm their existing sales.

Revenue is precisely how MP3 may be brought to the next level. The MP3 standard does allow for a different type of market for artists and labels to sell their music, and I have no doubt that digital music will bring the industry to a new level. For example, artists and labels will be able to sell individual songs rather than a collection of titles, while at the same time advocating their complete latest releases. Many companies will build new businesses around the industry providing software and related products and support. What does that mean for the consumer? Another means of buying music -- perhaps an easier means. Precisely how revenue will be doled out, however, is a large question mark. If artists can go directly to consumers online, why not cut out the record company? Then, if the artist is selling directly, who shares in the revenue? The MP3 distributor? What percentage do they get?

Then there is the legal issue. The problem remains that many individuals and websites have the ability to easily download free music files illegally. The music industry remains concerned about the piracy involved with digital music. In the fall of 1998, the Recording Industry Association of America charged Diamond Multimedia with violating copyright laws governing digital recording devices through the distribution of their Rio portable MP3 player.

The Association has also sued various websites that offer music without copyright permission. The International Federation of the Phonographic Industry reports that the Internet is a growing part of the piracy problem that cost about $10 billion in lost sales worldwide during 1998. Neither the record industry nor the digital distributors will succeed in promoting the MP3 standard until an agreement is reached regarding the copyright protection of legitimate online music. The major MP3 players are adding security features into their compression systems to eliminate the illegal downloading, but the tight security may ultimately discourage some MP3 users looking for a wide variety of formerly free music.

Finally, MP3 is the leading new wave in music technology now, but many do not believe that it will remain the most used standard. With the continuing advancements online, MP3 has a good chance of being replaced by a simpler, higher quality standard. Steve Grady, vice president of marketing at MP3 distributor GoodNoise recently stated, "Something better than MP3 will come along. The ability to move music around is key, and if you try to force something that has attributes they [the consumers] don't want, it won't be successful." It is certain that the consumer will continue to seek the latest in the advancing technology of digital music, and MP3 may not remain at the top for long.

I do believe that the MP3 standard represents the general turn of business from product development into providing services for the consumer. The open standard will allow a greater realm of involvement for both artists and audience. Artists will be able to take control of the distribution of their music (assuming workable copyright protection and proper pay falls into place), while their audience is able to choose the music they prefer in a format befitting their technological interests. The viability and interest in digital music will continue to grow, and the true potential of the standard has not yet been reached.

This is only the beginning. The standard that will be most accepted by the public is yet to be determined. Meanwhile, artists and the music industry will eventually use the technology to produce the greatest profit for their businesses. So, while great opportunity exists, even more uncertainty remains. Which technology will lead? How will enough profit be made (and trickle down) to finally reward investors who own shares in digital music companies? Which companies will lead and win? MP3.com may have the leading name, but this race has only just begun.

--Charity Taylor (cltaylor@email.unc.edu)

08/11/99 Close
Stock  Change    Bid 
------------------ 
AMGN  +2 1/4     77.25
AMZN  -  1/16    90.94
AOL   +7 1/8     91.38
ATHM  +  13/16   35.44
CAT   +  3/8     59.25
CHV   -  3/4     96.06
DD    +2 3/8     72.69
DJT   +  1/4      4.44
EBAY  -1 9/16    87.69
GT    -  13/16   56.06
IOM   -  1/16     3.69
SBUX  +1 1/2     21.56
TDFX  +  1/8     14.00


                  Day     Month   Year   History   Annualized 
      R-BREAKER  +3.54%  -5.67%   4.08%  944.67%   59.65%
        S&P:     +1.60%  -2.02%   6.49%  198.27%   24.34%
        NASDAQ:  +3.01%  -2.79%  16.98%  256.16%   28.82%

    Rec'd    #  Security     In At       Now      Change
   8/5/94  2200 AmOnline       0.91     91.38    9953.91%
   9/9/97  1320 Amazon.com     6.58     90.94    1282.19%
  5/17/95  1960 Iomega Cor     1.28      3.69     187.99%
 12/16/98   580 Amgen         42.88     77.25      80.17%
  4/30/97 -1170*Trump*         8.47      4.44      47.60%
  12/4/98   900 Excite@Hom    28.04     35.44      26.38%
  2/23/99   300 Caterpilla    46.96     59.25      26.16%
  2/20/98   260 DuPont        58.84     72.69      23.53%
  2/23/99   180 Chevron       79.17     96.06      21.34%
  2/23/99   290 Goodyear T    48.72     56.06      15.08%
  2/26/99   300 eBay         100.53     87.69     -12.77%
   7/2/98   470 Starbucks     27.95     21.56     -22.87%
   1/8/98   425 3Dfx          25.67     14.00     -45.46%

    Rec'd    #  Security     In At     Value      Change
   8/5/94  2200 AmOnline    1999.47 201025.00  $199025.53
   9/9/97  1320 Amazon.com  8684.60 120037.50  $111352.90
 12/16/98   580 Amgen      24867.50  44805.00   $19937.50
  12/4/98   900 Excite@Hom 25236.13  31893.75    $6657.62
  5/17/95  1960 Iomega Cor  2509.60   7227.50    $4717.90
  4/30/97 -1170*Trump*     -9908.50  -5191.88    $4716.63
  2/23/99   300 Caterpilla 14089.25  17775.00    $3685.75
  2/20/98   260 DuPont     15299.43  18898.75    $3599.32
  2/23/99   180 Chevron    14250.50  17291.25    $3040.75
  2/23/99   290 Goodyear T 14127.38  16258.13    $2130.75
   7/2/98   470 Starbucks  13138.63  10134.38   -$3004.25
  2/26/99   300 eBay       30158.00  26306.25   -$3851.75
   1/8/98   425 3Dfx       10908.63   5950.00   -$4958.63

                              CASH   $9924.87
                             TOTAL $522335.50
Note: The Rule Breaker Portfolio was launched on August 5, 1994, with $50,000. Additional cash is never added, all transactions are shared and explained publicly before being made, and returns are compared daily to the S&P 500 (including dividends in the yearly, historic and annualized returns). For a history of all transactions, please click here.

</THE RULE BREAKER PORTFOLIO>

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