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Recording Industry in Denial

By Rob Landley

AUSTIN, TX (March 18, 1999) --

"Power corrupts. Absolute power is kind of neat."
-- unknown.

I'd like to put two seemingly unrelated thoughts together to explain why I'm glad we're not invested in record companies. The first is that "disintermediation" is a wonderfully long word. The second is that intellectual property is a funny thing. Let me explain.

This isn't the first time a Rule Maker column has talked about "disintermediation." But I for one didn't actually know a word for it until I read this column the other day. The word means cutting out the middleman -- something the Internet has proven remarkably successful at, as Amazon.com, Dell, and even The Motley Fool can attest.

Intellectual property is simultaneously worthless and almost infinitely valuable, depending on whether or not you can cash in on the spread of information. Especially on the Internet, information spreads instantly around the globe. Trying to control its flow is something that has frustrated government agencies for years. From U.S. encryption export restrictions to Chinese software piracy, any attempt to enforce restrictions on the spread of information without the consent of the enforcees has been resoundingly ignored by Netizens.

Together, disintermediation and intellectual property are the reason the music industry is rather unhappy at the moment. The Internet is threatening the industry's exclusive control over music distribution. So far, the music industry's reaction to the situation is a classic example of how NOT to deal with this problem.

The music industry's problem is the "MP3" audio file format, which is capable of storing CD-quality sound compressed into 1/10th the space, allowing a single CD to store over a hundred songs. While this seems like a fairly obvious technological advance, especially considering that the CD format is now 20 years old, it has the music industry up in arms.

The problem with the MP3 is that, like the CD, it contains simple digital data that any modern computer can copy and transmit an unlimited number of times without any loss of quality. Friends can share copies of the data that are identical to the originals, without any loss of quality after being copied a thousand times. People can and do download MP3 files off the Internet. While standard uncompressed CD audio has (until recently) been protected by its sheer size, the MP3 is eminently portable, and free software exists allowing anyone with a PC and a CD-ROM drive to create MP3 files from standard music CDs (a process called "ripping").

The obvious result is that not everyone listening to MP3 files bought them from the recording industry. This is why the Recording Industry Association of America (RIAA) has treated the MP3 format as an evil that must be stopped. "Piracy" is a direct threat to their revenues.

Unfortunately for the recording industry, they alone are harmed by this. They act as a middleman between music producers and music consumers, and both of those groups have expressed strong support for MP3 music.

The artists who record the music usually want their music to be heard to increase their fan base, so that they can rake in money from sold-out concerts, T-shirt sales, posters, and ultimately even sell more music than they give away. Fans who will buy a T-shirt will buy a CD. Heck, fans have been able to tape music off the radio for years anyway. One of the most popular bands in history, the Grateful Dead, even set aside special sections for audience members to tape their concerts for free. They didn't exactly suffer from cash flow problems as a result.

In fact, the Grateful Dead has put MP3 files on its website. Many other artists have done the same (although their record companies are often forcing them to remove the files). The list includes David Bowie, Tom Petty, and The Beastie Boys, just to name a few. Then again, disputes between artists and record labels are nothing new. For example, "The artist formerly known as Prince" changed his name to an unpronounceable glyph while trying to annoy his record company into letting him out of an unpleasant contract. His most recent CD is sold primarily through his website.

New bands love MP3 as a way to break into the industry. Put a demo tape on your Web page and maybe you can get a gig because of it, or wind up on the radio, without coming up with thousands of dollars to burn and distribute CDs. With the recent consolidation in the music industry, many established but mid-list musicians have had their contracts lapse, and have turned to web-distributed MP3 music as an alternative.

Fans love the convenience of downloadable music, the increased storage capacity of devices that play MP3 files, and the increased control allowing the listener to package together individual songs they like rather than buying an entire album to get a single song. The fact that a lot of the music is available free doesn't hurt, but it's not the entire reason for the format's popularity. A nominal cost of perhaps a dollar per song in exchange for access to a virtually unlimited library of downloadable music sounds like a viable business model to many people, especially if the quality of the recordings is assured and royalties are paid to the artists. MP3 distributors could take over the distribution, advertising, and quality assurance niche formerly held by record companies, only at a greatly reduced cost to consumers. Disintermediation at its best.

Traditionally, the recording companies provided a service to the artists and fans consisting of distribution and advertising services. In recent years, however, the record companies' attempts to increase profitability to please Wall Street investors have led them to reduce the variety of music they carry (concentrating on the top sellers) and to reduce the promotional services they provide (cutting expenses). These moves have reduced the recording companies' value to those for which they were acting as intermediaries. Meanwhile, artists and fans have accelerated the search for alternatives.

Rather than taking advantage of the new technology, the recording companies are fighting tooth and nail against the market forces dragging down their margins. Now that their comfortable, dominant position is under assault, the recording companies are fighting to maintain their niche in its old state instead of adapting to the new one that's more beneficial to the rest of their economic ecosystem. As a result, they've alienated their partners and been forced into a holding pattern they can't hope to win. If the current record companies don't fill the newly created niche of online music distribution, other companies will.

Miscellaneous links:

  • The recording industry shies away from MP3 even when it makes them money (click here).
  • RIAA sues to block first portable MP3 player (click here).
  • Two excellent articles on the subject from Time's February issue: article one, article two.
  • For more on MP3s, including a free player and downloadable music, click here.

- Oak

03/18/99 Close
Stock  Change    Bid
AXP   +6 11/16 127.63
CHV   +  7/8   86.50
CSCO  +  13/16 106.88
KO    +1 7/16  68.25
GPS   +  3/16  68.00
EK    -  3/8   67.75
XON   +  5/16  74.69
GM    +  9/16  89.50
INTC  +1 5/16  121.81
MSFT  +5 5/16  172.44
PFE   +2 3/4   143.00
SGP   +1 5/16  58.63
TROW  +1       38.38
YHOO  +3 3/16  175.31

                   Day   Month    Year  History
        R-MAKER  +1.75%   9.86%  14.52%  44.91%
        S&P:     +1.44%   6.32%   7.42%  32.90%
        NASDAQ:  +1.40%   7.65%  12.33%  49.01%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
    2/3/98   24 Microsoft     78.27    172.44   120.31%
    5/1/98   55 Gap Inc.      34.37     68.00    97.85%
   6/23/98   34 Cisco Syst    58.41    106.88    82.97%
    2/3/98   22 Pfizer        82.30    143.00    73.76%
   2/13/98   22 Intel         84.67    121.81    43.86%
   2/17/99   16 Yahoo Inc.   126.31    175.31    38.80%
   5/26/98   18 AmExpress    104.07    127.63    22.64%
   8/21/98   44 Schering-P    47.99     58.63    22.15%
    2/6/98   56 T. Rowe Pr    33.67     38.38    13.96%
   2/27/98   27 Coca-Cola     69.11     68.25    -1.24%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   17 General Mo    72.41     89.50    23.61%
   3/12/98   20 Exxon         64.34     74.69    16.09%
   3/12/98   20 Eastman Ko    63.15     67.75     7.29%
   3/12/98   15 Chevron       83.34     86.50     3.79%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
    2/3/98   24 Microsoft   1878.45   4138.50  $2260.05
    5/1/98   55 Gap Inc.    1890.33   3740.00  $1849.67
   6/23/98   34 Cisco Syst  1985.95   3633.75  $1647.80
    2/3/98   22 Pfizer      1810.58   3146.00  $1335.42
   2/13/98   22 Intel       1862.83   2679.88   $817.05
   2/17/99   16 Yahoo Inc.  2020.95   2805.00   $784.05
   8/21/98   44 Schering-P   2111.7   2579.50   $467.80
   5/26/98   18 AmExpress   1873.20   2297.25   $424.05
    2/6/98   56 T. Rowe Pr  1885.70   2149.00   $263.30
   2/27/98   27 Coca-Cola   1865.89   1842.75   -$23.14

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   17 General Mo  1230.89   1521.50   $290.61
   3/12/98   20 Exxon       1286.70   1493.75   $207.05
   3/12/98   20 Eastman Ko  1262.95   1355.00    $92.05
   3/12/98   15 Chevron     1250.14   1297.50    $47.36

                              CASH    $185.03
                             TOTAL  $34864.41

Note: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it adds $2,000 in cash (which is soon invested in stocks) every six months.

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