Microsoft's Zune deal with Universal Music Group to benefit artists?

This morning, Microsoft and Universal Music Group jointly announced that the two would be making songs from UMG's artists that are specially formatted to work with Microsoft's forthcoming Zune portable audio player available for online purchase (presumably through Microsoft's online Zune music store). But what makes this announcement different from many other such deals is that some portion of the proceeds from sales of Zune hardware would flow back to UMG and eventually onto the artists themselves. The language in the press release instantly raised several questions in my mind and I contacted UMG's press relations department to see if they had some answers. According to the release:

Microsoft Corporation (Nasdaq: MSFT) and Universal Music Group, the world's leading music company, announced today an agreement which creates a groundbreaking, new revenue stream for UMG and its artists: in addition to the standard payments it will make to UMG for the sale of its music, Microsoft will also pay UMG a portion of Zune device sales. Microsoft plans to offer a similar arrangement to other music labels and their artists.

"This agreement with Microsoft around Zune is a significant milestone for our company and our artists," stated Doug Morris, Chairman and CEO, Universal Music Group. "This move demonstrates there can be a win-win situation where consumers have a great experience while labels and artists are also fairly compensated. We applaud Microsoft for its innovative and consumer-friendly Zune store and device."

"At a time of transition for the music industry, Zune aims to be a leader in supporting artists and enabling the creative possibilities associated with connected entertainment. We look forward to working with the industry to make sure labels and the artists have a very bright future," said Bryan Lee, Corporate VP Microsoft Entertainment & Devices. "We believe that the music consumer will appreciate knowing that when they buy a Zune device, they are helping to support their favorite artists."

Reading between the lines, it appears as though the goal is to tap a vein of altruism amongst music buyers by telling them that if they purchase a Zune instead of an iPod, that they'll be providing additional financial support to artists that those artists wouldn't otherwise receive.

For starters, of the music buyers out there that concern themselves with the legal acquistion of music (as opposed to those who will hunt to the end of the earth for free but illegal downloads), most of the ones I know stop concerning themselves with the welfare of the musicians as long as their song acquisitions are legal. Put another way, they don't view Apple as robbing musicians. Even if music buyers were that concerned about how much money artists were getting for their work, in order to tap that vein of altruism, the marketing dollars that would have to go into educating the market would be so extraordinary and even then, there's no telling how effective it might be (bearing in mind that iPod is the drug -- a very powerful one at that -- that must be overcome).

But, in addition to the market's willingness to pick up and process the signal (and then act on it), the deal raises all sort of questions on the execution side. For example, like many other segments in the consumer electronics space, the portable audio player market is extremely competitive and thusly, the margins are low. Throw in the fact that Zune must hit a price point that will distract buyers from the iPod, and there'll be even less money to go around.

Then, who must that money be shared with? Microsoft just said in the press release that it plans to enter into similar agreements with other record labels. So, when Robin Hood makes his first round, he'll be divvying up the money between Microsoft and all of the record labels that are in on device profit sharing. Then, after that, each of the record labels -- if I read the press release correctly -- will be passing some amount of those proceeds onto their artists. To find out how much, I contacted UMG spokesperson Peter Lofrumento. According to Lofrumento:

[The proceeds] will flow through the normal royalty channels.  In addition to the normal royalties [artists] get from the sales of their music, they will get an additional payment for each Zune that is being sold. 

But then I asked Lofrumento how many artists UMG has and what the formula might be for dividing the proceeds up amongst them. Said he:

I couldn't say how many artists we have exactly. But it's in the thousands. I can't go into those details [regarding the formula] -- I actually don't even know them -- but we have a way of doing it.

I asked some more questions, but first, I thought I'd do a little financial modeling. Forgetting for a minute how every penny that exchanges hands in the music industry is connected with a dot over an i or a cross through a t in some archive of contracts (contracts that would probably need to  be renegotiated before any money started flowing), let's say Universal Music Group has 3,000 artists. On average, what amount of total money (as a result of Zune sales) could make a material difference to each artist, assuming that the fans of those artists would be inclined to buy a Zune knowing that it ultimately helps the artist out. In other words, place a dollar value on that help. Let's say it's a measley $25,000 per year (that's actually pocket change for many of UMG's artists... but let's stick with it). Just assuming UMG takes nothing out of the proceeds for itself and passes Microsofts payment all the way through to its artists, Microsoft would have to pass $75,000,000 per year to UMG.

Now let's say that Microsoft and the retail channel was so incredibly generous that it decided to pass all of each Zune's $250 anticipated retail price to UMG. In order to make sure that each of UMG's 3,000 artists got their $25,000, 300,000 Zunes would have to be sold. OK, so it's pretty much impossible that the entire retail price will flow to UMG. Looking at some approximations however, Apple sells iPods at around a 45 percent profit margin before marketing and distribution costs. It's unlikely that Microsoft can beat that by much but let's say that after marketing and distribution and Microsoft's cut of the sale, it passes 30 percent of the retail price to UMG. Now the number of units that needs to be sold is 1,000,000.

But wait a minute, let's say Microsoft cuts the same deal with each of the remaining four major record labels (Sony, EMI, Warner Brothers, and BMG). I don't know how many artists they have but let's say the total number of artists goes up to 10,000 (a conservative estimate). Now, the total amount that must be passed through to the record labels goes up to $250,000,000 and the total units sold must be 3.33 million units per year. Possible? Perhaps.

<Update> TechCrunch is reporting, based on coverage in the NY Times, that $1 will go to UMG for every Zune sold, of which half will go to the artists. No news on the criteria for which artists get paid, but the math becomes very different at this point. If only one artist were to get $5,000 per year, 10,000 Zune's would need to be sold. For UMG's 3,000 artists alone, that would be 30,000,000 Zunes that would have to get sold per year. For 10,000 artists across all the record labels (a guess), that number goes up to 100,000,000 Zunes per year that would have be sold -- significantly more than all iPods ever sold in Apple's history.</Update>

But, assuming Microsoft and the record labels are successful at educating the market about this interesting form of altruism, my personal feeling is that they should be more transparent about the whole process. Give us some idea of how much money each of the record labels' artists can realistically expect to see after everyone gets their cut. And, if the money isn't divided evenly amongst all artists, then give us some idea of the formula. For example, will there be some sort of pro-rated formula that's connected with an artist's revenue production? If so, that changes things too. If you're a big fan of oldies like I am, but you buy a Zune, the proceeds may end up going to artists you don't care about. I'm not saying this is the case. But if Microsoft and the record labels are saying "you should buy Zune because it will ultimately help artists," then show us how.

Finally, in the bigger picture, based on what we know about how Apple forced the major record labels to knuckle under, this certainly comes across as being a more cooperative arrangement than what's happening between the record labels and Apple. To the extent that Zune is Microsoft's answer to the iPod, one can't help but wonder if UMG would back out of its arrangement with Apple given how much better of a partner Microsoft appears to be being. I asked Lofrumento about that at which point he reminded me that UMG was actually Apple's launch partner when it opened the iTunes Music Store. Said Lofrumento:

Our current deal with Apple is in place until sometime next year. [Whether that needs to be renegotiated] is something that will be discussed when the deal comes up. In terms of the possibility of Universal pulling out with Apple? It's hard to answer that. We were the first music company to do a deal with iTunes. We helped them launch with several of our top artists and we have a very close relationshihp with them.

Not to mention how Apple's iTunes Music Store commands 88 percent of online music sales (downloads) and how the iPod represents a 70 percent share of portable digital audio players. Unless Microsoft pulls a rabbit out of the hat and usurps Apple in the digital audio market, the record labels will have very little leverage against Apple's massive and growing market share.