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Of the Zune, DRM, and Universal Music

Microsoft’s Zune portable media player goes on sale in the United States tomorrow, marking the company’s first entry in a market dominated for five years (and counting) by Apple’s now-iconic iPods. Although the Zune is a non-starter for Macintosh users – it doesn’t work with a Mac – the Zune’s introduction is notable on three levels. First and most obvious: Microsoft’s vast resources and long-term tenacity may make the Zune the first credible challenger to the iPod. Second, the Zune represents an about-face for Microsoft in affirming the closed-garden, proprietary digital media business Apple first introduced with the iTunes Store. Third, the Zune introduces a new financial model to the digital
industry, whereby music publisher Universal – and probably other labels, as well – will receive royalty payments for every Zune player sold.

I’ll leave punditry and prognostication about the success or failure of Microsoft’s first Zune device to others; for a look at early reaction to the Zune, see Glenn Fleishman’s article, “Zune Doom,” elsewhere in this issue. I’m mostly concerned with the latter two points: the Zune’s online music and video store (and its digital rights management), and the revenue-sharing arrangement Microsoft has crafted with Universal Music Group.

Of Gloom and DRM — For years, Microsoft and its partners have been arguing that Apple’s iPod/iTunes model is flawed because it’s a closed system. Apple protects tracks purchased via the iTunes Store from piracy with its FairPlay digital rights management technology; as a result, material purchased via iTunes can only be used with iTunes software or on an iPod, and cannot be transferred to non-Apple software or devices. (If you’re willing to spare the platters, you can burn the music to disc and then re-rip them into iTunes as MP3 files; it’s sufficiently annoying to discourage casual piracy.) So far, Apple has declined to license FairPlay to others, so if you buy a song from iTunes and want to play it on
one of those cute little iRiver Clix players… well, you can’t, even though you “own” the track.

Since 2004, a good portion of the non-iPod camp has been toeing the line represented by Microsoft’s PlaysForSure initiative, which guarantees PlaysForSure-branded music and devices are all compatible. If you buy protected songs from, say, Yahoo Music, they can be played alongside protected songs purchased from any other PlaysForSure-savvy seller. If you wanted to switch from a Creative Zen music player to a SanDisk Sansa, PlaysForSure would make sure your music would transfer neatly. Consumers wouldn’t be tied to a single vendor for either their music players or their music purchases.

PlaysForSure is built upon the Windows Media platform – essentially Microsoft’s equivalent to Apple’s QuickTime. Windows Media includes its own digital rights management technology, which Microsoft happily licenses to others. As a result, hundreds of companies employ Windows Media DRM, while only one uses FairPlay: Apple.

For all its touted benefits, however, the PlaysForSure platform hasn’t lived up to its promise. Some users – particularly users of music subscription services who move music to portable devices – have found their DRM licenses unexpectedly expiring, while others experience problems transferring music or synchronizing playlists. The variety of services and gizmos trying to use the PlaysForSure platform – and all their quirks and differences – creates havoc for developers trying to build simple and reliable PlaysForSure devices and software.

Implementation issues aside, there is one other glaring fact: all the PlaysForSure services and devices combined have failed to hinder Apple’s iPod/iTunes juggernaut. Heck, the industry generally concedes that the second most-popular music service after iTunes – albeit a distant second – is eMusic, which offers music in unprotected MP3 format. Purchases from eMusic play fine on iPods and essentially any other digital music player, but, since MP3 offers no copy protection, the major music labels want nothing to do with eMusic.

The Zune Marketplace — As Microsoft pondered developing its own digital media players, it took a hard look at PlaysForSure and did something exceedingly rare: it threw in the towel. Microsoft’s Zune is not a PlaysForSure-compatible device; in fact, the Zune doesn’t even support Microsoft’s Windows Media digital rights management. Customers who purchased music through PlaysForSure-branded services – like Napster, Yahoo Music, AOL Music Now, MusicMatch, or even Microsoft’s MSN Music or MTV-partnered Urge – cannot play that music on a Zune player. And, it should go without saying, the Zune doesn’t support music or video purchased from iTunes.

So how will Zune buyers get media onto their new device? They can rip music from their standard audio CDs and import unprotected music and video using the Zune software. However, Microsoft certainly wants Zune owners to get media from their new online Zune Marketplace.

The Zune Marketplace will operate much like other online music stores, offering millions of tracks from major and independent music labels on an a la carte basis, along with album info and artist news. Microsoft will also offer a Zune Pass, which is an all-you-can-eat music subscription for $15 a month. Using a Zune Pass, users can download as much music as they like from the Zune Marketplace – and listen as often as they want – so long as their subscription remains current.

The initial price for music tracks on the Zune Marketplace will be 79 Microsoft Points. You may have heard of Microsoft Points if you have Microsoft’s Xbox 360 video game console. In short, the system works like a pre-paid telephone calling card: Microsoft Points enable Microsoft to support online micro-transactions too small to be practical for credit cards, as well as avoid setting prices in individual currencies. Points are also redeemable for games, demos, and features at Microsoft’s Xbox Live Marketplace, and Microsoft recently announced it will start offering selected movies and television shows to Xbox 360 owners via Xbox Live – some in high definition – beginning 22-Nov-06. Microsoft Points are non-refundable and currently non-transferable, but don’t be surprised when Microsoft expands Microsoft Points into other areas of its online businesses, including user-to-user transactions.

Taken together, the Zune player and the Zune Marketplace will operate as a closed system astonishingly like Apple’s iPod/iTunes combination. Microsoft’s Zune platform can be seen as a validation of Apple’s closed-garden approach to marketing digital media: clearly, even Microsoft believes that the only way to offer a seamless, feature-rich experience that can compete with Apple is to control both the hardware and the service, just like Apple. The decision can’t sit very well with Microsoft’s PlaysForSure platform partners: after all, they’ve been trying to compete with the iPod/iTunes double-whammy for years, using tools even Microsoft feels are inadequate.

An open question is why Microsoft couldn’t implement the Zune as a PlaysForSure device and service. Although there have been no official confirmations, the answer seems to be that Windows Media DRM wouldn’t let the company implement Microsoft’s vision of a future filled with Zune and Xbox devices, enabling at least these capabilities:

  • Online sales and rentals of protected mainstream music, games, and video
  • Time- and usage-limited user-to-user sharing of protected content
  • Distribution and sales of protected user-generated content

Windows Media DRM can (and does) handle the first point, but falls down on the second and third. For example, the Zune enables users to wirelessly share music they’ve purchased from the Zune Marketplace with other Zune users: recipients don’t get just a 30-second preview clip, but the entire track at full audio quality, with the ability to play it three times over three days.

(There’s an interesting tangent to the Zune’s wireless media sharing. The activity it encourages could be seen as within the realm of “fair use” permitted under U.S. copyright law; however, it’s not something Windows Media DRM supports for protected media. So, an argument could be made that the Zune’s DRM may infringe less on lawful uses of content than Windows Media DRM; see Adam’s article “Why DRM Offends the Sensibilities,” 2005-07-05, for more background.)

Microsoft believes this sort of media sharing will be key to establishing a vibrant Zune user community. For commercial music, the Zune enables users to flag shared tracks they’ve received for later purchase via the Zune Marketplace. But that’s just part of the user-community strategy: Microsoft eventually wants to create a milieu wherein owning a Zune device provides anywhere-you-go access to anything Zune users want to share – including commercial music, podcasts, pictures, garage-band demos, video, and games. If there are enough Zunes around (say, in a coffee shop or a school campus), just being a Zune owner may enable users to tap into – and socially connect over – a wealth of content favored and/or produced by local users.

With its new digital rights management technology, media sharing capabilities, and existing micropayment-capable transaction system, Microsoft is looking beyond now-standard monolithic commercial digital media outlets like the iTunes Store. The company hopes to create a system where users can purchase or subscribe to content from major publishers and share both commercial and user-generated content amongst themselves. Furthermore, Microsoft wants to enable users to engage in peer-to-peer transactions independent of its own marketplaces, selling their own content or third party content through affiliates, incentive programs, and viral marketing initiatives.

Universal Sufferage — Given the scope of Microsoft’s Zune project, last week’s announcement from Universal Music Group that Microsoft would be paying it a royalty on every Zune unit sold came as a surprise. The royalty is in addition to standard payments Microsoft will make to Universal for selling its music in the Zune Marketplace, and Universal is not granting Microsoft any special content or consideration as part of the deal. Universal is the largest of the “Big Four” music labels, commanding about one quarter of the world’s music sales.

According to Jeff Leeds in the New York Times, Universal will receive more than $1 of every Zune’s $250 purchase price in exchange for licensing its music for sale through the Zune Marketplace. Microsoft plans to offer similar royalty arrangements to other participating music labels. As more music publishers nose up to the trough, it wouldn’t be shocking to see $3 to $6 of each Zune’s purchase price go directly into the pockets of music distributors.

Universal says half the money it collects via the Zune royalty will go to its artists, presumably in proportion to the volume their music is distributed. (This means the lion’s share of these funds will be allocated to top-selling acts; the leftovers might amount to fractions of pennies against artists’ contractual debts and, therefore, never leave Universal’s coffers. The other half will presumably flow directly to Universal without even a passing glance at artists.) Microsoft is positioning the deal as a win for music creators. Microsoft’s VP of Entertainment and Devices Bryan Lee said in a statement, “We believe that the music consumer will appreciate knowing that when they buy a Zune device, they are helping to support their
favorite artists.”

Don’t be fooled: the deal is about money. Simply put, Universal put the screws to Microsoft and made the Redmond giant smile the whole time.

There is precedent for hardware manufacturers paying music publishers royalties on the sale of systems. At the urging of the RIAA, the Audio Home Recording Act of 1992 amended U.S. copyright law to, among other things, impose royalties on “digital audio recording devices.” In practice, the royalty applied to digital audio tape (DAT) recorders and blank digital media. The theory was that the capability to make perfect digital copies of music would reduce demand for commercial recordings, and artists and publishers deserved to be compensated for revenue lost to digital technology. DAT recorders never took off in the consumer marketplace (although they were embraced by audio
professionals), but anyone who buys blank music CDs in the United States pays a portion of the sales price into a fund distributed to publishers, “interested parties,” and artists’ organizations according to a rather lugubrious formula. In a rare defeat for the RIAA, a 1999 court ruling made iPods and other digital media players exempt from this royalty system; thank Diamond Multimedia for that one.

Of course, Microsoft’s payments to Universal aren’t being mandated by law: they’re part of a business contract. Here’s how that happened:

For several years the music industry has watched its sales decline as the digital music revolution has taken off. Sales from music download services like the iTunes Store offer a new source of revenue, but as of 2005 they were just barely making up the difference. (The RIAA called 2005 a decline; the numbers read as a wash.) The music industry doesn’t believe people are listening to less music – in fact, they’re probably listening to more music – and came to a conclusion: we’re losing money to digital music piracy. So, the industry launched a campaign to shut down the original Napster, initiated legal action against other peer-to-peer file sharing
services, filed thousands of lawsuits against individuals, and developed a frantic zeal for digital rights management technology.

In early 2003, when Apple lobbied the major music publishers to sell music in the iTunes Store, it promoted the store partly as an experiment and partly as a way for the music industry to offer a legitimate digital alternative to music piracy. To their credit, the industry took a chance on the iTunes Store, but in some ways they haven’t been thrilled with the results. After all, when these deals were made iPod sales weren’t even worth breaking out on Apple’s financial statements. In contrast, during its 2006 fiscal year Apple sold more than 39 million iPods for almost $7.7 billion in revenue.

The music industry looks at those numbers and believes their content has been instrumental in creating a $7 billion a year business for Apple. Moreover, the industry reads research reports that say fewer than one in five iPod owners buy digital music regularly and that the average iPod contains a scant 20 songs purchased through iTunes. They conclude Apple’s legitimate alternative to piracy isn’t as effective as everyone had hoped.

Since all the major music labels are public companies, the primary mission of their leadership is to maximize value to their shareholders. It’s hard to convince investors and board members how that goal is met when presented with declining sales and the fact that they helped create a multi-billion-dollar industry for a charismatic California computer maker. Music labels began churning for business strategies which would bring more of that shiny digital music player money their way. Last year, they tried to force Apple to give up its $0.99-per-song model in favor of differential pricing, whereby hot new songs would carry higher prices and catalog music could be discounted. Since iTunes currently represents the vast majority of digital
music sales, Apple was able to hold the labels to uniform pricing. Embittered, the labels put their noses back to their grindstones and watched Apple’s iPod business continue to grow, waiting for their moment.

And into this grist mill walks Microsoft with plans to launch Zune, a brand new vertically integrated music player and digital music store.

It’s easy to imagine music executives wringing their hands with undisguised glee. See, Microsoft doesn’t control the market-leading digital music service – to date, its MSN Music and Urge offerings have barely been blips on the digital music radar – so the company can’t realistically threaten the labels with dropping them from its online music offerings. There’s also some bad blood between the four major labels and Microsoft: a year ago, Microsoft was reportedly planning a music subscription service but broke off negotiations, claiming labels’ royalty demands were too high. And with Zune, Microsoft also wants to launch hardware devices: Apple has proven that the real money in an integrated digital music service is in the hardware sales,
not the music sales.

So Universal informed Microsoft it wanted a piece of the hardware action.

Microsoft didn’t cave immediately: both companies played down to the wire, weathering three months of negotiations only to reach an agreement a few days before Zune was due to hit the market. But the simple fact is that Microsoft could not afford to launch Zune without the world’s largest music publisher, so negotiations likely centered on the nature of Universal’s hardware royalty, not on whether Universal would get one.

We’ll Know Zune Enough — The implications of Universal’s Zune royalty for Apple’s music business are unclear, but will hinge on the Zune’s success in the music marketplace.

If the Zune proves to be yet another footnote to Apple’s dominance of the digital music industry, Universal’s hard-nosed negotiations with Microsoft will likely have no impact on Apple’s business. If the Zune proves to be a legitimate competitor to Apple’s iPod/iTunes combination, the music labels may be able to leverage the Zune’s success to wring concessions out of Apple. These might come in the form of differential pricing in the iTunes Store, special promotions or marketing deals, or – if the Zune is a tremendous success – even a cut of the iPod’s sales.

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