What effects will this major announcement (pun intended) have on the digital music industry?  We believe the best way to analyze this deal is to focus on the more comprehensible short-term effects and identify the factors that are not predictable -- of which there are several. 

Short-Term Effects

As far as EMI is concerned, the deal was shortsighted, risky, and possibly irresponsible to the company's shareholders.  EMI is the smallest of the four majors, enjoys no synergies with corporate siblings, and is undergoing financial hard times.  This move with Apple was a lunge for near-term revenue, at the quite possible expense of longer term revenue for EMI and the rest of the industry.  EMI gets a cash advance of US $5 Million from Apple.  It should enjoy a short-term revenue spurt as some consumers respond to the hype and purchase DRM-free tracks for $1.29 (in the US market). 

Our back-of-the-envelope calculation suggests that this ought to amount to less than $10 Million (email us if you really want to know).  This type of short-term revenue gain is insignificant: it amounts to only 3% of EMI's current annual run rate of $290 Million from digital revenue, and a tiny fraction of the company's overall revenue of about $3.4 Billion.  Any longer-term revenue effects from the deal are unpredictable.  The financial markets concur with this assessment: EMI's stock has edged down slightly in the days since the Apple announcement. 

Yet the deal could help EMI's position with respect to Warner Music Group's attempt to acquire the company -- another short-term effect.  Not only could it raise the price tag, but then WMG would be put in a position of deciding whether to continue with DRM-free music or face negative publicity by reinstituting an all-DRM policy, as it did quietly when it acquired the Ryko catalog (which features remastered reissues of artists like Big Star and Frank Zappa) a year ago.

The short-term effects of this announcement on Apple, as with EMI, are predictable; but unlike EMI, they look positive (Apple's stock was up about 1% on the news).  Apple is now well and truly in control of music download economics for Internet distribution.  This deal should also be a huge help to Apple in defusing consumer advocacy actions in many European countries.  Certainly it is far cheaper and easier for Apple to satisfy DRM interoperability concerns by doing away with DRM than by opening up FairPlay to other vendors, which would likely require massive re-engineering and introduce various other complications. 

Apple has determined that it no longer needs DRM to sell iPods.  It stands to benefit most from any additional unauthorized copying resulting from the lack of DRM.  And any additional movement towards DRM-free music will hurt its would-be competitors among device and platform makers, notably Microsoft.  In other words, give credit where it is due: Apple has indeed played this scenario smartly. 

Missed Opportunities

As for the longer-term future, both Apple and Microsoft have pointed out that the lack of DRM will lead to more innovation from device makers and service providers, thus benefiting consumers -- but the outcome of that is not predictable.

What does EMI get in the longer term?  No one really knows.  The effect that the lack of DRM will have on content misuse or on revenue is unpredictable.  What we do know is that this deal flies in the face of the music industry's view that Apple has too much control over it.  That's where the irresponsibility part comes in.  If EMI wanted to go DRM-free, it would have been better off in the long run if it did so with an iTunes competitor. 

The simplest short-term deal could have been with the likes of RealNetworks (Rhapsody) or Napster for permanent downloads, indie download sites like eMusic, or even Yahoo.  A more effective arrangement would have been with a major multinational retailer, like Amazon or Target, that has no current digital music strategy, but such a deal would have probably required the cooperation of the other three majors.  (MySpace would have been another good choice, but SonyBMG would be unlikely to agree to anything that lines News Corp's pockets.)

Any such deal would have been just as valuable as the iTunes deal in gauging the true economic value of DRM -- something that desperately needs to be done in any case.  Instead, this deal strengthens Apple's control of Internet music distribution, at least for downloads.  It's a missed opportunity for the majors, most likely gone forever.  EMI has launched an experiment from which there is no turning back. 

The other feature of the deal that is hard to understand is the 30 percent price differential.  According to 2005 European market research from Berlecon Research and INDICARE, people claim to be willing to pay more than double the price for DRM-free music. EMI even cited this INDICARE study in its presentation on Monday.  (We'll get to the validity of such market research later.)  The enhanced sound quality may make for nice marketing, but we don't believe that many users will care about the difference.  In any case, it will be hard for other service providers to go much higher than 30 percent for DRM-free in the future.

Silver Linings

Yet this development does accomplish two things for the music industry.  First, it helps fend off charges of anticompetitive behavior among the majors: it is firm evidence that they do not move in lock-step.  Secondly, it should help record labels get variable pricing on iTunes, which they have wanted for a long time.  Apple's long-held position against variable pricing is now undermined and looks hypocritical.

Of course, the move is good news for consumers -- if only because it does exactly what DRM is supposed to do: enable more choice of offers in the digital marketplace.  Somewhat lost in the news over the DRM-free offerings is the fact that EMI and iTunes will continue to offer the same tracks with DRM at the lower prices.  That's choice, which makes for efficient markets.  Consumer choice has been good for ISPs, wireless carriers, and many other digital players.   

Unpredictable Future

The market will decide whether music tracks without DRM (and with less audio compression) are worth the extra money.  We do not believe that the existing market research really predicts how consumers value DRM versus DRM interoperability versus no DRM. 

First of all, we believe that the number of consumers who would truly benefit from "interoperability" is small.  Furthermore, market research that asks consumers if they would pay more for "interoperability" is strictly hypothetical -- of course people prefer interoperability; it's like asking if you prefer "pure" or "chemically treated" water -- and fails to isolate DRM as a factor in interoperability. 

That same INDICARE study also established that most consumers don't understand what DRM is.  There are factors in "interoperability" besides DRM that are at least as important.  For example, we know tech-savvy people who have both iPods and Palm Treos.  The Treo has a music player application.  They can presumably transfer MP3s from the iPod or iTunes to the Treo. Yet they don't even try, because it just seems too complicated to bother. This has nothing to do with DRM.

Effects on revenue and piracy are unknowable at this point, as are the next steps of the other three majors.  (When Steve Jobs said on Monday that he expects half of the tracks on iTunes to be available in DRM-free format by summer, no doubt he's really referring to music from independent labels, which already sell DRM-free on eMusic, MySpace, and other sites.)  We won't have any valid results until at least a year from now: that's after the honeymoon period for DRM-free downloads -- and, most likely, better-quality tracks from iTunes posted on websites and P2P networks by temporarily emboldened users -- is over.

Beyond Encryption

Is DRM dead?  We don't think so.  Rights management should continue to play a role in helping content owners define different economic offers.  Subscription on-demand services like Rhapsody and Napster are unworkable without DRM, and certain types of users prefer them.  Furthermore, we don't see film and television content owners changing their stances on DRM anytime soon; this deal will most likely fall under the heading of "music industry mistakes we don't want to repeat."

More importantly, our definition of rights management encompasses more than encryption-based technologies like FairPlay and Windows Media DRM.  If the role of content encryption is diminished, then alternative technologies like fingerprinting and watermarking become even more valuable to content owners and other players in the content value chain.

Mobile Next

The next frontier will be mobile, where DRM interoperability is in more of a mess than for Internet/PC/Mac distribution.  The music industry needs to get behind mobile DRM interoperability fast, or it will lose control over that channel to whichever device maker comes out on top there, Apple or otherwise.  We can imagine a DRM strategy that focuses on low-end music-playing handsets (i.e., not iPhones) that enables side-loading from PCs, which consumers will demand, but controls redistribution and enables over-the-air streaming and subscription models.  Device interoperability for consumers has to be part of that picture, though both device makers and carriers will naturally resist.  

Although we don't believe DRM is going to die, it will surely go through some gyrations over the next year thanks to this announcement.  We'll see developments in technology, standards, and economics.  One thing about the future is predictable: it won't be boring.

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