Quotes of the Day

When Seagram bought Polygram in 1998 for $10.6 billion, the French-born ceo Alain Levy found himself out of a job. Not for bad performance: Levy had turned PolyGram into the world's largest music company by a combination of organic growth and strategic acquisitions at a time when CD sales were booming. After the company was sold, Levy, then aged 51, spent several years consulting and pondering the state of a changing industry, and quickly concluded that old models for growth were gone. CD sales peaked in 2000, damaging companies bedeviled by piracy and the online trading of free music. Levy realized that the industry had to figure out how to make money from digital music. If he could run another company, he told colleagues, he'd do things differently.

That opportunity came in the autumn of 2001, when Eric Nicoli, chairman of EMI Group — the iconic British company whose superstars have ranged from the Beatles to Coldplay — offered him the top job at EMI Music. EMI was then a listing ship that had jettisoned more than 40% of its market value in one year, and had just issued an entirely unexpected warning, admitting that profits would slide 20%. One of Levy's first hires was a McKinsey & Co. consultant, John Rose, in January 2002, whose remit was to figure out how to make digital pay. "He knew digital wasn't going to go away," Rose recalls. "That was a large part of his hiring me." But Levy's decision to embrace digital bucked industry notions. "The prevailing feeling was, 'This isn't going to work because people are going to steal and not buy.'"

Four years on, people are still stealing music online. But they're also buying it — and at a fast-growing rate. The International Federation of the Phonographic Industry (ifpi) says that global sales of digital music zoomed to $1.1 billion last year, up from $380 million in 2004. Digital music now provides around 6% of most companies' revenues, up from almost nil two years ago, and that growth shows no signs of peaking.

And more than any other major label, EMI's comeback mirrors the changing fortunes of the music world. In its half-year results for the period ending Sept. 30, 2005, EMI's revenues returned to growth for the first time since 2000, rising 5.8% to $1.64 billion. Its global digital sales soared 142% to $79.3 million; that's 5% of total revenues, and growing fast. And EMI's global market share rose from 12.5% to 13.1%. "EMI is one of the leaders" of the digital era, says Mike McGuire, research director at Gartner. "They're innovative."

Yes, EMI benefited from big-selling albums by artists like the freestyle cartoon band Gorillaz and Coldplay (who nabbed the best album award for X&Y and best single for Speed of Sound at the Brit Awards in London last week). But the digital tide has hit — not only in the form of Apple Computer's iPod, but also through mobile-phone features, including ringtones, ringtunes (the actual songs) and ringbacks. Everyone from mobile-phone operators to supermarket chains like Tesco to coffee purveyors like Starbucks is offering online music services. In a recent report titled Digital Rocks!, Bryan, Garnier & Co. analyst Alexander Ivanovitch wrote: "We believe this amounts to a second digital revolution for the music industry, akin to the 1980s transition to CD."

Such optimism was unthinkable just a few gloomy years ago, when it seemed like the music industry had fallen off a cliff. "It was a frustrating time," says John Kennedy, head of ifpi. "We knew it wasn't going to be just a few bad years." Even Levy was shocked by what he found when he took over at EMI Music in October 2001. "The company was in much worse shape than any of us had realized," says Rose, now a director at Boston Consulting Group.

EMI had draft plans to sell digital music and combat piracy, but was forced to shelve them just to focus on its core operations. "The company was in such a bad spot in terms of both earnings and capital structure, frankly, we didn't have time to think of anything else," says Rose. Levy's team discovered that the Virgin label wasn't integrated into the business, so essentially two separate music companies were operating within EMI. Record sales were clearly not recovering, either. Indeed, after her Glitter album tanked, EMI had to pay Mariah Carey $28 million to extricate itself from the $80 million contract it had signed with her.

In February 2002, EMI issued another profit warning. Record sales were clearly not recovering. A month later, it announced a restructuring plan to trim $175 million in costs. That process included cutting 1,800 jobs and getting out of the business of manufacturing and distributing CDs. "It was a tough time," Rose says. And it left employee morale shaky.

EMI never flirted with bankruptcy, because its operating cash flow remained strong. Indeed, EMI's share price inched up to $5.30 around the time of the reorganization. But the financial community lost confidence in the music business, and a sell-off commenced. At one point, EMI's shares traded at around $1.30. At its nadir, the market valued the whole of EMI at less than the value of its publishing division alone. "The mood was tense and increasingly dark," says Rose. "We were fearful of losing control of the company. It could have been snapped up on the cheap." A 2000 merger attempt with Warner Music was rejected by the E.U. as anticompetitive. But twice during the later lean years, the companies discussed a tie-up. (And now that their balance sheets are improving, merger speculation is rife again, though Levy says the two companies aren't in talks.) Levy and Rose still believed that the ultimate solution had to come through a digital strategy. In-house consumer research indicated that most people didn't want to break the law, and that music fans would buy music online if the experience was better and easier than the illegal peer-to-peer (P2P) sites. So the company took a huge gamble in November 2002, announcing that EMI would license all of its legally-available music to anyone who would pay its set wholesale prices and meet its terms. And it began encouraging artists to make their music available online. Most have, though a few big names, including the Beatles and Radiohead, remain on the sidelines. By the company's own estimates, it made five times more tracks available in Europe than any other label.

The strategy had some external help. Legal action in 2001 shut down Napster, the P2P service that was the granddaddy of illegal filesharing. Last June, the U.S. Supreme Court unanimously ruled that companies whose software enables the trading of free music can be held liable for theft. Levy says the industry's legal crackdown is "paying off in raising awareness … that stealing music is as bad as any other form of stealing."

But the big breakthrough came from Apple, which finally convinced millions of consumers to pay for downloadable music. Apple's iTunes online music store — launched in 2003 — was easy to navigate and used a simple pricing structure: 99¢ per song; around $10 per album. ITunes downloads have now hit 850 million. "I will be eternally grateful for what Apple and the iPod have done," Kennedy admits. There are now 350 legal music sites online, up from 50 two years ago. Levy predicts that 25% of industry revenues will come from digital music by 2010, and many industry analysts and executives think he's right.

And then, EMI and the industry just got lucky. The unexpected cash cow of the digital era is the ringtone, and its wireless cousins: ringtunes, ringbacks and wallpaper. Last year mobile music sales were more than $400 million globally. EMI's publishing arm — with a catalogue of more than a million songs — is the world's largest, with a market share analysts estimate at around 20%. Last month, EMI Music reached a first-of-its-kind agreement with two royalties collection societies — Britain's mcps-prs Alliance and Germany's gema — to offer its Anglo-American songs under a single, one-stop license to European mobile and online services, rather than on a clunky territory-by-territory basis. And consumers — especially teens — are embracing the new technology with fervor. Ringtune sales of Atlanta rap group Dem Franchize Boyz's single, I Think They Like Me , soared to more than 850,000, when EMI made it available simultaneously with the radio release.

EMI's publishing business also reaps rewards from the growing use of music in other media: advertising, films and TV soundtracks, electronic games and toys. EMI even has a contract with a pottery company that prints song lyrics onto coffee mugs.

Nicoli is particularly keen on the future of wireless sales of digital music. Noting that MP3-player penetration is only around 15%, but "that nearly everyone has a mobile phone," he's excited by the prospect that half of all mobiles will be music-enabled within two years, and that the technology for wireless downloads of music is nearly at hand. "The combination of scale and convenience makes mobile a huge opportunity." EMI, for instance, recently struck a deal with wireless service T-Mobile to make more than 200,000 songs and music videos available to T-Mobile's 60 million customers across Europe.

Of course, no record label can afford to rest easy. Yes, selling digital music involves no manufacturing and distribution costs, which should boost margins. But there are other new costs, including credit-card fees and IT equipment. EMI, for example, has invested over $130 million in technology to manage digital sales. And CD sales continue to plummet. Globally, retail sales sank about 8% last year, to just below $31 billion. Illegal downloading has not disappeared. ifpi says 885 million music files are available online for illegal downloading. In Britain and Germany, Europe's two biggest markets, 6% of Internet users buy legal music online, while 5% engage in illegal file sharing. But illegal downloads are double the rate of legal ones in France, Sweden and Spain.

And any technology as disruptive as digital music is bound to create some friction. Several labels, including EMI, want more flexible pricing online — oldies and tracks by emerging artists might sell at a discount, while big hits by established acts might be premium-priced. Apple, however, is reluctant to mess with what it sees as a winning formula. But Levy tells Time: "I don't know of any product that has only one price, or that has only one perceived value to the consumer."

Currently, downloads of single songs outpace those of albums, theoretically spelling doom for one of the industry's most lucrative formats. EMI Music vice chairman David Munns says that's O.K., and likens the change to the situation in days of yore when 45 r.p.m. records and LPs thrived simultaneously. "People go in and buy the single and a couple of other tracks, then they come back and buy the whole album. We're not frightened of any of that. I don't believe that the album unit will just disappear. Our job is to make albums people want."

In the brave new digital world, one truth of the industry's economics remains unchanged. Typically only 5 to 15% of a label's artists — the megastars — bring in the cash to pay for the rest. That's why artist development — finding the next Radiohead or Kanye West — is critical. Grooming a new or niche act into superstardom in the digital era requires the same marketing effort it always did. "Just putting it out on the Internet without marketing is like shooting it out into space," Kennedy says. And only the labels pay those marketing costs. EMI has a reputation for investing heavily in artist development. It's got high hopes for several new acts, including New York City rockers Morningwood and Corinne Bailey Rae, a jazzy chanteuse from Leeds, England. Her case is a perfect illustration of marketing in the age of downloads. Rae's single, the soulful Put Your Records On, was released on the Net earlier this month, and is already a radio favorite. A few weeks later, it's now also available on that old-fashioned, once-profitable format known as the compact disc.

• THOMAS K. GROSE
• How EMI and the music industry learned to stop worrying and love the digital download