The Digital Music Supply Chain: How Streaming is Catalyzing a Transformation

Kathleen McReynolds

MBA 5220 Spring 2012

Appalachian State University

Table of Contents Title Page1 Table of Contents 2 Executive Summary3 Introduction.5 The Traditional Music Supply Chain and Music Royalties..6 Emergence of New Media: Music Streaming.8 How Does Streaming Change the Traditional Supply Chain?.........................................................9 The Flow of Goods...9 The Flow of Information.11 The Flow of Funds..12 Industry Reactions to the Changing Landscape..14 Technological Solutions..15 Future Opportunities and Obstacles16 References.19 Appendix 1: Summary of Grahams (2004) The Transformation of the Music Industry Supply Chain: A Major Label Perspective..21 Appendix 2: Spotify Features22 Appendix 3: Percentage of Minutes for Audio Sources by Location from Center for Research Excellence.23

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Executive Summary
Media and entertainment firms have been some of the businesses most drastically affected by the rise of digital technology. The music industry in particular has struggled to reorganize itself to capitalize on digital channels of distribution like song downloads and music streaming. While digital downloads may be more relevant in terms of revenue value, the scope of this paper will lie in investigating music streaming technologies and their impact on the digital supply chain. The rapid growth of streaming within the last three years has made it a more interesting topic for scrutiny, as many hail it to be the future of the music industry. This investigation will not seek to support or refute this possibility. Rather, it will investigate the impact that streaming technologies have already had on the traditional supply chain, as well as some issues we can expect to face in the future.

This research on music streaming is written through the lens of supply chain management analysis in particular using Crandalls (2010) framework of supply chains as including a flow of goods, information, and funds. The evolution of music consumption channels has drastically affected each of these system flows in several ways. The flow of goods has changed because music files are decreasingly permanent products and consumers are currently demanding different value propositions (i.e. accessibility and APPS). Consumers have also found ways to steal or record these digital files, making product leakage (piracy) a huge issue. The flow of information is becoming more voluminous as hundreds of streams replace several downloads. The applications of massive stores of data are becoming available (targeted digital marketing) yet more burdensome (computing tiny royalty payments on millions of
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streams by thousands of artists). Finally, the flow of funds has become something of a hot topic in the industry because artists and record companies are not confident that the tiny royalty payments (regardless of quantity of payments) will add up to a feasible business model. In all, the confusion and complexity surrounding this new form of music consumption make it a very intriguing topic for further reflection.

In general, the music industry has been somewhat slow to embrace this new form of distribution, possibly because it has not yet proven itself a feasible replacement for other forms of consumption. However, several technological solutions like Accenture and Oracles Incentive Compensation have been designed to aid the supply chain members in organizing and communicating transparent information.

In assessing the feasibility of streamings future, I believe that one of the largest hurdles will be overcoming the impatience of rights holders. In order for streaming to generate massive revenues, companies like Spotify need time to generate massive user bases. This requires a legal and technological infrastructure that simply has not materialized yet. The potential for music streaming lies in scalability, but if major industry participants are not willing to build that foundation or wait until it unfolds naturally, we as consumers may truly lose out on what could have been a great system of legally receiving and enjoying music from around the globe.

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INTRODUCTION

Following the tumultuous 2000s, the global music industry seems to have finally regained some foothold in the market, particularly in the digital music arena. According to IFPIs Digital Music Report 2012, global digital music revenues have been on the rise for several years, reaching $5.2 billion in 2011 (IFPI, 2012). See Figure 1 Below for digital revenue growth figures since 2009.

Figure 1: Digital Music Trade Revenues (Global)

2009 Trade Revenues (US$) Growth 4.6 Billion 10%

2010 4.8 Billion 5%

2011 5.2 Billion 8%

Other figures also indicate positive growth for the digital music market on a global scale. 2011 brought an unprecedented number of digital downloads (singles and albums combined), with global purchases reaching 3.6 billion in 2011a 17% increase over equivalent downloads in 2010. The number of paid subscriptions to music services grew by a stifling 65%, rising from 8.2 million in 2010 to nearly 13.5 million in 2011. In terms of revenue generation for record companies, digital music consumption has actually surpassed physical channels in several countries (IFPI, 2012). See figure 2 below for a list of countries that obtain over half of their record company revenues by digital transmission.

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Figure 2: Record Company Revenues from Digital Sources

Country China South Korea USA

% of Record Company Revenues from Digital Sources 71 53 52

According to Nielson SoundScan, US digital music sales are growing even more quickly than worldwide digital sales. Digital album sales and digital single sales rose 19.5% and 8.5% respectively from 2010 to 2011. Sales figures for January 2012 show even more promising growth, as the same figures rose another 17.4% and 6.3% respectively compared to January 2011 sales (Glenn, 2012).

With the worldwide proportion of digital music sales to total music sales averaging 32%, it is clear that digital consumption has become more significant than ever (IFPI, 2012). Consequently, those who have a vested interest in music industry value chains must understand and anticipate this evolution of music distribution in order to remain competitive.

The Traditional Music Supply Chain and Music Royalties

In the past, the big five record labels (now the big four) dominated the music industry, capturing about 80% of the global market. Activities were performed in a structured sequence and artists generally used a record company, distributor, and retailer as intermediaries to reach final consumers. See figures 3 and 4 for Grahams Traditional and Industry Models in terms of value activities and the actors involved.

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Figure 3: Grahams Traditional Music Supply Chain (Activities)

Composition

A&R

Recording

Reproduction & Packaging

Marketing

Distribution

Retailing

Consumer

Figure 4: Grahams Traditional Music Supply Chain (Actors)

Artist

Record Company

Distributor

Retailer

Consumer

However, the digital era is changing the dynamics of music supply chains. According to Graham (2004), the upstream supply chain is least effected, progressing from (1) music composition to (2) A&R, and (3) recording. However, the later activities (reproduction & packaging, marketing, distribution, and retailing) are now divided between the online model and the offline model, with trends favoring online prominence. Traditional vertical integration has now been replaced by a complex constellation of participants who engage in simultaneous, parallel activities of value creation. Resources, capabilities, and information are shared more readily among transient, virtual partners who interact as a network rather than a sequential assembly line. Artists and record companies can now reach customers more directly, making intermediaries (physical distributors, retailers) less necessary (Graham, 2004). See Appendix 1 for more detailed information on several supply chain changes implied by Graham.

One of the supply chain issues not covered thoroughly in Grahams model is the payment of royalties to rights holders in the digital era. Performers, songwriters, publishers and record companies receive income through a complex system of royalties, which are essentially
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rates of compensation that are due to an individual or group when their copyrighted material is used. These rates vary widely depending on the nature of the use and the contractual terms that the rights holders operate under. Each royalty transaction differs in the amount paid and the split between recipient parties, but it is important to understand that copyright owners royalty income depends on the contractual terms and also the quantity of uses of the copyrighted material and these parties receive royalties for every music download or stream (Krasilovsky, 2007).

Emergence of New Media: Music Streaming

Although global digital downloads are on the rise, they have not yet managed to match the level of revenues that firms enjoyed in the days of physical product. Consequently, the digital delivery age of music is still in a state of unrest as companies attempt to configure the optimal system for exploiting recorded music.

One of the most quickly growing types of digital music in the U.S. is streamed music, with Sweden-based Spotify leading the way (Knopper, 2012). Spotify, which entered the U.S. market in July 2011, boasted 2.5 million premium (paying) customers by November of that year, and gained another half of a million by the following January (Peoples, 2012). The company aims to have 50 million total U.S. users (at least 7.5 million paying) by the end of 2012. Several other streaming services exist in the market (Pandora, Rdio, Rhapsody), but none have purely on-demand content, which is what truly differentiates Spotify. In fact the technology is so new that the U.S. Copyright Office has not even written legislation to govern on-demand streaming and charge providers a statutory rate for the use of protected material
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(Krasilovsky, 2007). As such, music streaming is a very tumultuous and current phenomenon that is interesting to examine through the lens of supply chain management. This state of disharmony as well as its effect on supply chain flows will be discussed in detail below.

How Does Streaming Change the Traditional Supply Chain?

Crandall, Crandall, and Chen (2010) describe supply chains as involving various participants who perform a sequence of activities in moving physical goods or services from a point of origin to a point of consumption. The authors further posit that supply chain transactions exist in the context of physical flow (flow of goods), information flow, and funds flow. This descriptive framework will be used to analyze the ways in which music streaming has already begun to alter the industrys traditional supply chain.

The Flow of Goods

Digital distribution methods and ever increasing bandwidth have made the transfer of digital files all but effortless.Furthermore, Spotify and other providers add value that exceeds that of the music tracks in isolation. Sharable playlists, countless music Apps (See Appendix 2 for a list of Spotify features), and seamless integration with other social websites have made the music streaming experience much more than just accessing a series of tracks. Users derive value from these features and are able to create even more value for themselves by investing time and effort into amassing playlists and becoming members of the many interactive web spaces related to music streaming. In this respect, the stream of a music track has become just one pixel in the larger picture that is online leisure.
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The flow of goods is certainly a critical aspect of any supply chain. However, music streaming is changing more than just how goods flow downstream its affecting the composition of the goods themselves. One could argue that the good in question is still the recorded music that is being transferred (however ephemerally). However, a Spotify user would certainly be perturbed if he logged on to the system only to find that his newly-designed, 30song playlist were missing. He may be equally upset if his inbox of music suggestions was empty. The point is that consumers are not solely consuming the sound recordings. They have come to value the infrastructure that allows easy sharing of playlists, recommendations, and customized stations. In that respect, the good that is being purchased is accessibility to a network of media that is easily customizable to ones own taste.

One could argue that providers of music streams have avoided nearly all of the risks associated with supplying physical music products like CDs, cassettes, and vinyl records. Providers face no breakage, inventory costs, or demand forecast issuesfactors that were once dominated the distribution managers time. Today, however, distributors of digital music streams face a whole new batch of woes.

Since ownership of a sound recording copy is not transferred to the user during music streaming, consumers must return to the provider every time they wish to access specific content. Instead of delivering the product to a user once (i.e. the user downloads a track), streaming services are expected to deliver this content seamlessly to a user possibly hundreds of times over the span of the customers relationship with the company. Even with the abundance of internet technology, this is a major challenge for any firm. Any hiccup in the

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delivery system could leave users angry and annoyed, particularly if they are paying for premium services.

Product leakage is another issue. Since music streaming subscriptions are often free to begin with, it would be fair to assume that users of such services would have little incentive to take part in music piracy. However, Anderson (2011) points out in his article, Stream Capture: Returning Control of Digital Music to the Users, that users of online streaming services are easily able to record streamed content and save the resulting MP3 files locally. Technologies already exist to capture streamed music in this format with little or no loss of sound quality, making this additional consumption method attractive to many users. This leakage of product presents a major problem for everyone but consumers, who are easily able to obtain music goods at no charge.

The Flow of Information

The migration away from physical or even digital ownership has important implications on the flow of information. One benefit is that the lack of ownership reduces the need for suppliers to collect demand information, with the exception of extreme conditions (i.e. extra bandwidth needed for a highly anticipated streamed event). The bullwhip effect is of little concern to members of the supply chain due to the absence of physical inventory, making demand forecasts less critical in terms of logistics.

Also advantageous to streaming servers is the wealth of consumer information that is readily available from users. Data is often willingly provided to streaming servers as users

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update their profiles and become more entrenched in the systems features. Artists are also given intricate reports of their listenership on streaming services, which can be a very powerful marketing tool. Unfortunately, this massive base of information can become overwhelming when needed for purposes outside the scope of internal market research. For instance, royalty payments for a users every stream depend on other company information like user membership status and ad revenue for the period. This integration of user data, ad sales data, and contractual data is endlessly convoluted.

The Flow of Funds

Under the Digital Millennium Copyright Act of 1998, SoundExchange became the sole collector of digital transmissions of sound recordings over non-interactive streaming sites. However, no such organization was ever set up for interactive streaming sites (services in which the user controls the upcoming music). Furthermore, no statutory rates were set by the government for these on-demand streams (Krasilovsky, 2007). Out of necessity, artist aggregators began to negotiate contracts with the interactive streaming sites to collect royalties on behalf of their artists (who would then pay a fee for the collection service). According to their website, Spotify currently contracts with thirteen artist aggregators (including CDBaby, TuneCore, and AWAL) who upload independent artists content and then distribute royalties earned from streams and other e-stores. In some ways, the artist aggregators seem to be a replacement of previous intermediaries like the record company and distributors. However, this process is more streamlined (the aggregators contract with nearly all

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major outlets) and independent artists are able to exercise more control over their copyrighted works.

Even after the four largest record companies decided to cooperate with Spotify, some of the artists on those labels bluntly refused to do so. Commercial successes like Adele, Coldplay, and The Black Keys have all prohibited their new albums from being released on streaming services. Instead, these individuals and many similar artists will only offer their latest albums for purchase for some window of time. Eventually (presumably once demand for the album has leveled) these artists may offer their back catalogue as well as new albums on streaming services. This practice mirrors the strategy of Hollywood movie companies that wait to offer DVDs until long after movies have left theaters (Fixmer, 2012).

Artists like the aforementioned feel that revenue from streaming is not fair compensation for their musical goods. Spotify and other streaming services do not disclose their exact contractual terms with copyright owners; however, several journalists have attempted to estimate the royalty rates that are used to pay for music streams. Glenn Peoples (2012) of Billboard Magazine states that at 0.3 cents per stream, a four-minute song would need to be played for 22 hours to equal the revenue from a single $1.29 track purchase, which is particularly troublesome for album-centric bands who cannot expect a hit to be played on repeat. Peoples (2012) also calculated that it takes about 275 stream royalties to equal one download and 1,845 stream royalties to equal one digital album. These comparisons are sobering indeed, but they are derived under the assumption that streaming and purchasing are mutually exclusive activities. This either-or mentality has not yet been grounded in research.

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The threat of piracy (via illegal downloading or recording of streams) also had obvious implications on the flow of funds. Since royalty calculations are based on the number of streams from the providers system, consumption of music off the system (legally or illegally) accrues no income for writers, publishers, or record companies. Furthermore, off-site consumption precludes the generation of ad revenue, throwing the whole value chain off balance. Although this issue could become a serious threat to the industry, its prevalence could be mitigated by increasing portability of streaming services. In principal, the threat of recording streams differs little from traditional music piracy in that both depend on the extent to which consumers insist on owning their music library, rather than gaining access to a music library.

In a quest for additional revenue streams, product developers are expanding streamings compatibility with other mediums for delivery, like smart phones and tablets. Alex Farber (2009) of the magazine New Media Age suggests that mobile applications may be a better source of income than many think because culturally, people are more used to paying for things on their mobile and having things available for free online. If this is true, the increasing population of individuals owning a smart phone or similar electronic device may provide the needed boost in streaming revenue in the near future.

Industry Reactions to the Changing Landscape

In general, the reaction of the major US record labels to streaming services has been somewhat slow and stubborn. Music Week author Robert Ashton (2014) uncovered evidence that major labels were actually trying to re-design Spotify for their own benefit before signing any licensing deals. One insider commented, The majors have been trying to shape how the
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service should look in the US, but Spotify has been successful in rebuffing them. The majors also took large advance payments from Spotify before its US launch, once the company won them over (Fixmer, 2012). However, many indie record companies like Merlin, Sub Pop, and Nexos were eager to contribute to Spotifys catalogue of music (Ashton, 2011).

Sellers of recorded music must embrace changes in consumer preference and move away from the traditional notion that one track is worth a fixed $0.99. Suppliers and rights owners should be more concerned with adding more value to this infrastructure of virtual media access. Monetization of this system will flow to the extent that upstream supply chain members make the consumption experience indispensable to users. Major players need to be more future-oriented instead of taking a myopic view of the market and trying to maximize profits by stubbornly enforcing outdated contract terms. The Copyright Office must also get involved in laying the legal groundwork that is needed for this system to flourish.

Technological Solutions

In terms of fully integrated supply chains, music streaming services are nowhere near perfect. In fact, the emergence of this new business model has almost put these streaming companies right back at square onedetermining which entities to include in the supply chain, negotiating the compensation system, etc. However, several companies have designed software programs to ease the transition into the digital music world.

Accenture, a product based on Microsoft Dynamics AX, includes a Rights & Royalties Service Center (RRSC), which manages all facets of rights management from end-to-end. The

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software follows transactions from acquiring the rights and selling the licenses to collect fees all the way to paying the original rights holders. One of the key advantages of this is that it truly facilitates information transparency among all parties to the transactions. Clients like music publishers and songwriters can actually access real-time data about usage of their copyrighted material. This is a definite step toward integration.

HCL Technologies has also developed a system that manages artists royalties as a derivative of their sales commission payment software. The program, Oracles Incentive Compensation (OIC) module inputs artists as salespeople and then calculates payment on a peruse basis. Record companies and artists can then view online statements, pay online fees, and request reports at will (HCL Technologies, 2012). While this system may be useful for a start-up company in the entertainment business, it does not seem feasible on a global scale because it is not integrated with the rest of the supply chain. There is definitely an urgent need for innovative supply chain management software in this complex and rapidly evolving market.

Future Opportunities and Obstacles

In terms of market potential, I think music streaming is extremely promising, but the infrastructure needed for it to flourish is not yet available. In order for streaming to be profitable for all members of the supply chain, streaming services need to be the providers of a large percentage of all music consumption, meaning they need to minimize the amount of time that users spend listening to music off of the streaming system. In a 2009 report entitled How U.S. Adults Use Radio and Other Forms of Audio, the Council for Research Excellence found that U.S. consumers source 12.6% and 6.7% of audio using a digital streaming service while at
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work or at home respectively. However, while these consumers are in the car or in other locations (restaurants, stores, etc.), less than 1% of their audio consumption is sourced from digital streams (Council for Research Excellence, 2009). This indicates that users are not yet comfortable or able to stream to their cars and other locations. Spotify and other streaming services may need to become involved in development of products that easily allow customers to stream directly to the cars speakers without loss of audio quality (much like HDMI cords or the Roku allow users to stream Netflix and other media providers directly to a TV). Car manufacturers could even build this type of feature into the cars stereo system in the future if consumer demand for streaming were high enough. This notion is supported by the fact that US consumers listen to far more broadcast radio while in the car (74.2% of minutes) than they do while at work, home or in other locations (53.8%, 46.4%, and 23.3% respectively) (Council for Research Excellence, 2009). It stands to reason that broadcast radio dominates consumers time in a car more markedly than in other locations because digital audio is largely unavailable in that venue. See Appendix 3 for more detailed results from this study.

On a similar note, users would probably be more likely to stream directly from their phone if it were equipped with higher quality speakers that did not significantly contribute to bulkiness. Essentially, in order to increase the quantity of streams, technological and infrastructural advances must eventually make streaming to all locations as seamless and easy as streaming to a computer.

In the short-term, artists and rights holders should put more effort in to ancillary sources of revenue. A recent study conducted on over 2,000 French participants suggests that

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music streaming has no effect on offline music purchases, but it actually has a positive effect on online music purchases. Streaming music also correlates positively with attending concerts of national or international stars (Dang, 2012). Yet many label executives fear music streaming is strangling the industry. Clearly more research is needed on how streaming affects users other music consumption habits, like attending concerts and purchasing merchandise. But early studies like the one mentioned above indicate that music fans are still willing to spend money on music products. Thus executives may need to shift their efforts to other areas like touring and merchandising. Some labels have already starting doing this by contracting new artists under 360-deals, in which the label involves itself in all aspects of the artists career development, rather than simply the exploitation of recorded music.

In general, the potential for market penetration is high. Technological advances are contributing to the widespread adoption of computers, smartphones, and cars around the globe. I believe that interactive streaming sites have a place in the future, but leaders need to build the phenomenon from the ground up starting with a legal and technological infrastructure and ending with market domination.

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REFERENCES
Anderson, J. (2011). Stream Capture: Returning Control of Digital Music to the Users. Harvard Journal of Law, 25(1), 160-176. Ashton, Robert. "Indie Gold Rush for Comprehensive Service." Music Week, 23 July 2011. Web. Council for Research Excellence. "How U.S. Adults Use Radio and Other Forms of Audio." The Nielson Company, 29 Oct. 2009. Web. 22 Apr. 2012. Crandall, R. E., Crandall, W., & Chen, C. C. (2010). Principles of Supply Chain Management. Boca Raton: CRC Press/Taylor & Francis Group. Dang Nguyen, Godefroy, Dejean, Sylvain and Moreau, Franois (2012), Are Streaming and Other Music Consumption Modes Substitutes or Complements? Farber, Alex. "Double Dipping." New Media Age 9 July 2009: 22. Web. 23 Mar. 2012. Fixmer, Andy. "Spotify Doesn't Sound So Great to Some Artists." Bloomberg Business Week. Bloomberg, 05 Jan. 2012. Web. 3 Apr. 2012. Graham, G., Burnes, B., Lewis, G. J., & Langer, J. (2004). The Transformation of the Music Industry Supply Chain: A Major Label Perspective. International Journal of Operations & Production Management, 24(11), 1087-1103. IFPI Digital Music Report 2012: Key Statistics. IFPI.org. Ed. IFPI. Institute for Policy Innovation, 23 Jan. 2012. Web. 14 Apr. 2012.
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Knopper, Steve (2011). Digital Musics Cloud Revolution. Rolling Stone, 1146, 16. Krasilovsky, M. W., Shemel, S., Gross, J. M., & Feinstein, J. (2007). This Business of Music: The Definitive Guide to the Music Industry (10th ed.). New York: Billboard Books. Peoples, Glenn (2012). Turn On The Jets. Billboard, 124(5), 5. "Royalty Management." HCL Technologies: Transformational Global Services for IT and Engineering. Web. 24 Apr. 2012. <http://www.hcltech.com/enterprise-applicationservices/oracle/royalty-management>.

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Appendix 1: Summary of Grahams (2004) The Transformation of the Music Industry Supply Chain: A Major Label Perspective.

(1) The structure of activities Traditionally Physical product Sequential Supply Chain (A&R, recording, production, packaging, promoting, distributing) (2) The Choice of Actors Traditionally High vertical integration with limited choice of participants (static).

After Internet Digital product and communication Supply chain is more of a network and less sequentially structured.

Three intermediaries between the music and consumer: Record company, distributor, and retailer. (3) The Governing Mechanism Traditionally Vertical integration (growth through acquisition) gave some record companies power because they didnt need to negotiate contracts with the other links that they owned.

After Internet Flexible relationships of varying length; high choice of members (dynamic), Outsourcing is prevalent for companies who do not specialize in a task. Direct contact possible between music and consumer, and among all chain members.

After Internet Even artists with the majors can be more self-sufficient, so the record companies have less power. Artists can also omit the record company altogether. Consumers are getting more power because they have options to contract with any number of providers of the service they need.

(4) The Coordination Structure Traditionally Dyadic coordination between links, but they did use some systems like point-ofsale scanning. Sequential communication

After Internet Real-time constellations of open information, reduces bullwhip effect. Direct communication with all partners AND consumers.

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Appendix 2: Spotify Features

Free Accounts: *Seamless creation of playlists (click-and-drag) *Inbox for sharing playlists, bands, songs with other users *Integration with Facebook and other social and music-related sites *Personalized recommendations of music *Sound Drop: Genre-specific, user-managed music rooms (users vote songs to be played next) *Moodagent: Creates playlist based on the tempo and mood of a song you like *Personalized concerts calendar based on your playlists *Charts and playlists from Billboard and other media companies *Tunewiki: provides lyrics synched to the songs you play, so you can sing along *Easy import of your iTunes library or other music files saved locally *Home page that advertises new additions to the music catalogue

Paid Accounts *Storage of songs offline *No commercials *Mobile Service (Premium)

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APPENDIX 3: Percentage of Minutes for Audio Sources by Location

Own Home
Digital Audio (Streamed) 7% Digital Audio (Stored) 9% CDs & Tapes 21% Portable Audio 8%

Other Audio 2%

Broadcast Radio 46%

Satellite Radio 7%

Work
Portable Audio 1%
Digital Audio (Streamed) 13% Digital Audio (Stored) 5% CDs & Tapes 4% Satellite Radio 12% Other Audio 11%

Broadcast Radio 54%

Reproduced from: How U.S. Adults Use Radio and Other Forms of Audio by the Council for Research Excellence
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Portable Audio 4% Digital Audio (Streamed) 0% Digital Audio (Stored) 1% CDs & Tapes 16% Satellite Radio 5%

Car

Other Audio 1%

Broadcast Radio 73%

Other Location

Other Audio 43%

Broadcast Radio 23% Satellite Radio 8% CDs & Tapes 18% Digital Audio (Stored) 3%

Portable Audio 4% Digital Audio

(Streamed) 1%

**Note the sharp decline in use of streamed audio from Own Home and Work to Car and Other Location. Use is comparatively very low in the latter two, almost at zero.

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