Why the online music industry is a mess

August 30, 2012, 2:44 PM UTC

FORTUNE — If disruption means losing money, then online music services know how to spend like rock stars.

Adoption and revenue growth rates at a few top players like Spotify and Pandora are real — Pandora (P) reported earnings yesterday, breaking even — but what are the costs to play? It’s still unclear in many cases if audience growth will translate to profit.

Every few years a new service rises up, captures audiences but then has the same cost-centric problems as every one that has come before: negotiating terms with rights holders. Music labels, music publishers, and in some cases, emerging artists who circumvent traditional music property conventions by going it alone — think self-managed Taylor Swift — all want or need a stake in streams or downloads, and that can make or break a deal.

“With most other businesses, if a supplier makes unreasonable demands, a retailer can turn to other providers,” wrote Michael Robertson, CEO and founder of MP3tunes.com, about the problems with the industry. “Since copyright law gives record labels and publishers a government-granted monopoly, no such option is possible with music. Digital vendors have only two options: Accept the terms or not include those songs in their offering.”

The profitability problem

From 2010 to 2011, Spotify grew revenues 140 percent to $236 million with a paid-subscription base of 4 million users and a total of 33 million registered users (most of whom use the free ad-supported version via Facebook), the Wall Street Journal reported.  Spotify revenue grew from $99 million in 2010. However, the number some analysts and industry watchers are looking at is the rate of loss. In 2010, Spotify lost $57 million, which was an increase from 2009’s $42 million in losses. Similarly, Pandora, paid $60.5 million in the second quarter this year for content acquisition –royalties to the music industry — a number up from $33.7 million in the same period last year.

“It’s still relatively early days,” said David Kusek of industry consultancy Digital Cowboys. “Online music is a still a small percentage of the overall market (CDs still being consumed). There really is no perfected business model yet. .. Remember, the largest online source for discovery of new music and sharing is still YouTube.”

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Listening and sharing music online couldn’t be more convenient or crowded. Options are easily found at the swipe of a finger or click of a mouse: the algorithm, radio-style option (Pandora); a social-sharing streaming strategy (Spotify); the download model to Apple-only devices (iTunes) and the download, keep in-the-cloud options from Amazon and Google on almost every other device.  Then there are the smaller streaming and subscription players: Rhapsody (who has missed the social boat so far), Slacker, Rdio, MOG and more. Or, there is straight-up piracy.

There are essentially two business models for online music right now: advertising–a losing model with scale, says Kusek, or subscription, which he thinks has more viability long term.

What complicates the issue further is unique to the music industry: Too many separate, competing interests fighting for a piece of the pie. Music labels, music publishers, and artists themselves (to a much lesser extent) all have certain terms in their favor including most favored nation, minimum payments, per-play costs, percent of total company revenue, and one of the most head-scratching, detailed reporting of the competition.

“Negotiating deals on a global scale is extremely hard,” said Kusek. “ What you used to have was revenue following format changes: From vinyl to 8 track to cassette to CD, the revenue always followed. That didn’t happen with MP3s exactly… ”

MORE: Spotify will never turn a profit? Not quite

What did happen was adoption of digital formats by listeners and home users, while the industry has been fighting and finger pointing, and looking to Washington for regulatory solutions. Yet, these now-name-brands are paying through the nose to have music content available, and consumers are never guaranteed to have every music artist they love on any one single entity. Spotify has to explain in its FAQ this delicate issue of not having the Beatles, Led Zeppelin, Metallica, Pink Floyd and releases by newer acts like the Black Keys in their library.

The solution?

It all starts with scale of influence. Right now, the music companies have the upper hand. But industry watchers believe between favorable government intervention — as in new laws adapting to more fairness in digital rights, continued year-over-year adoption rates and Facebook-sized user bases in the hundreds of millions of users — will tip the scale toward those music services.

“In the past, new formats brought new revenue. Vinyl became 8 track became cassette became CD. Yet that didn’t happen with MP3s,” said Kusek. “The adoption of the format did to some extent, but the revenues didn’t follow… The subscription players and new artists not playing by the industry rules will have more ability to influence global contracts and gain more favorable terms that will be good for everyone as users continue to scale.”

Another potential market for online music is as a bundled product. Kusek sees a future where Verizon or AT&T bundle a premium music service with mobile devices so it’s a simple add-on like texting or larger data package. This would allow the ISPs and phone service providers to get content on their networks. This is something Muve Music has embarked on with Cricket Wireless. Cricket is a lesser-known no contract carrier that offers Muve as a $10 add-on for unlimited music downloads, and it will be including the service at no extra cost with a few Android phones in the near future.

Will Pandora or Spotify head in this direction? If the Cricket Wireless bundling  example is any indication, more aggressive mobile device expansion may very well may be the next big move.