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What's the real cost of free music?

Do services like Pandora and YouTube cut into music sales, or are the music industry's expectations unrealistic?

SpiralFrog met its end just days ago, and already, operators of other ad-supported music services are rushing to put distance between their business models and that of the doomed site.

"The concept was good, but the management, board (not all), and execution were poor," wrote Robin Kent, the former CEO of SpiralFrog who went to work as an adviser to Qtrax, one of SpiralFrog's competitors. "It was obvious to anyone...it wouldn't survive."

"I think there is a hope in the music industry to turn back the clock. This is not 1999 anymore. There just isn't as much money as there once was in music."
-- Matt Graves, Imeem spokesman

What might encourage supporters to jump to the defense of ad-supported music services, which don't charge users to listen to music but support themselves through ad sales, is the undeniable whiff of failure floating around the sector. In the first three months of the year, SpiralFrog has followed Ruckus, the music service that catered to college students, onto the scrapheap.

Ad-supported music sites have been around for two years, and some have burned through lots of cash, but none has reported a profit. According to a letter sent to investors by SpiralFrog's attorneys last week, the company owed $34 million when it ceased operations on March 13.

Then there's the crumbling ad market. Even before ad money began drying up, questions lingered about whether ad-supported sites could generate high-enough ad rates to pay their costs, which include the hefty fees they pay to license music. Now, against this bleak landscape, comes a new threat.

Some label executives are questioning the value of offering the public music free of charge. For decades, a large number of people have believed that giving away music, such as playing songs on broadcast radio or handing out CDs at concerts, promoted music and helped boost sales. But now some in the music industry suspect that instead of promoting sales, ad-supported services are replacing them.

The problem appears to come down to a question of control. Broadcast radio for years served to introduce the public to new music. Radio was and still is a powerful music discovery tool, says Mike McGuire, a digital-music analyst for research firm Gartner. Only word-of-mouth recommendations drive more music sales, says McGuire, who is working on a forthcoming report on the topic.

But many ad-supported music sites are very different than broadcast radio. Traditional over-the-air radio enabled listeners to hear songs for free but gave them no control over when, or how many times, the song played. At Imeem, a social network that focuses on video and music, and YouTube, the Web's top video site, visitors can listen to songs in their entirety as many times as they want.

"There's nothing left to promote...this way," said a high-level music industry executive who wished to remain anonymous. "At what point do they stop promoting and start competing?"

Greg Sandoval/CNET

According to information supplied to CNET News by the music executive, who requested anonymity, a recent study showed that music purchases made by people who listen to three free-music sources fell 44 percent from the first quarter of 2005 to the third quarter of 2008. Over the same period, the purchases made by people who listened to four sources declined 49 percent.

The sources of free music included both traditional and new-media sources, such as broadcast and online radio, cable and satellite music channels, as well as TV and Web music video outlets.

There are plenty of questions that the data doesn't answer. For example, what were the buying habits for people that listened to two sources or one? Did they boost sales? That information wasn't provided. But what's important to music executives is that the data indicated that the more free music sources a person had, the fewer the number of purchases he or she made. That's not what the record companies want to see.

The source also said the labels are not giving up on sites like Imeem, Pandora, or YouTube. Nonetheless, this is likely one of the reasons why some recording companies are asking for higher fees in negotiations with digital services.

The thinking among some of the labels is that if ad-supported services are cannibalizing music sales, the record companies want licensing fees to cover the losses, the source said. The music services say they can't pay any more.

Matt Graves, an Imeem spokesman, acknowledged that his company's executives asked for and received a break on their licensing terms from some of the labels. That was before the economic meltdown. The labels are less willing now to cut similar deals, the music industry insider said.

Graves said this kind of thinking is short-sighted. He said ad-supported music has been the best defense against piracy. He said the labels should remember that Imeem and the other sites pay licensing fees and often share ad revenue with the labels. Peer-to-peer sites, he says, don't pay or share a cent.

"There's nothing left to promote...this way. At what point do they stop promoting and start competing?"
-- Music industry executive

"I think there is a hope in the music industry to turn back the clock," Graves said. "This is not 1999 anymore. There just isn't as much money as there once was in music. Imeem is not only sharing ad revenue but generating significant download sales. I understand their hopes. If my income dropped by 50 percent in four years, I'd probably be feeling the same way, but we're trying to help them understand the new reality."

McGuire from Gartner argues that a big part of the problem is that ad-supported services haven't figured out how to make money. He says they have struggled to charge advertisers an effective CPM, which, in Web advertising, stands for cost per thousand (page) impressions.

Michael Robertson, a well-known Silicon Valley entrepreneur, founder of MP3tunes.com, and record industry adversary, has long been critical of ad-supported plays. He says the economics just don't work because the sites must pay penny-per-play royalty rates to the major labels, and they just can't deliver enough ads at a high-enough CPM to cover the royalty fees, much less than the other costs of running a business.

He says the sites can't generate a high CPM because advertisers know that people often listen to the free music that YouTube, Imeem, and Pandora offer without paying attention to the ads. "People's ears may be engaged, but it doesn't mean their eyes are."

"What's stunning to me is that anyone is surprised about SpiralFrog," Robertson wrote to CNET. "The economics are very obvious to all in the know, but people keep pretending that the charade of ad-supported music works. It does not."

McGuire agrees that ad-supported sites must adjust their models but disagrees that they are without hope. He says that if word of mouth is still the best music-discovery tool, then social networks are places that "amplify word of mouth." He says his research shows that awareness that social networks offer music is still very low.

This means, said McGuire, that "there's a lot of room to make these things vibrant and relevant."