What Value Does Hss Create? to What Extent Does It Increase Expected Revenues and Profitability of Albums and Songs by New and Established Artists?

1. What value does HSS create? To what extent does it increase expected revenues and profitability of albums and songs by new and established artists?

Founded in 2002, Polyphonic HMI was established as a subsidiary of Grupo AIA to market the Company's expertise in the area of artificial-intelligence and the natural sciences (such as mathematics and physics) to the music industry via new technology referred to as Hit Song Science (HSS). The technology (HSS) analyzed the mathematical characteristics of music (by isolating aspects such as melody, tempo, pitch, rhythm and chord progression) and compared them with characteristics of past music hits making it possible to determine a song's hit potential. Recent analyses performed for music released in the U.S. suggest that Hit Song Science could achieve a success rate of 80% in predicting which songs will become hits, compared to the current industry success rate of 10% using traditional market testing techniques. Studies tend to support HSS's ability to improve record labels' ability to predict which songs will become hits, determine whether to market an album and choose which songs should be released first as singles. Additionally, HSS could help determine whether it would be worthwhile to make a record for new artists and offers the opportunity to test songs and albums during the production process. This would enable producers to make tweaks throughout the process, increasing the efficiency of testing and maximizing hit potential. Ultimately, HSS creates value by offering an alternative method to existing market testing methods with higher accuracy at a lower cost.

Table A gives the low, medium and high expected revenues for singles and albums with and without a Singles Top 40 hit. Taking a conservative approach, the estimated value of a single reaching the Singles Top 40 and the estimated value of a single not reaching the Singles Top 40 are $200,000 and $10,000 respectively. Given the success rate of a single becoming a hit without HSS is 10%, the expected value of a single without the use of HSS is $29,000. Given the success rate of a single becoming a hit with the use of HSS is 80%, the expected value of a single with the use of HSS is $162,000. This results in a total value-added of $133,000 per single. The conservative total value-added from the use of HSS in predicting the success of an album with and without a Top 40 Single is $1,337,000. (See Exhibit 1 for a Full Sensitivity Analysis)

In 2002, there were approximately 10,000 artists with a record contract in the U.S. and Europe, but only several hundred with some name recognition and commercial success. Tens of thousands--if not hundreds of thousands--of artists were hoping to secure such a contract. In an effort to land a record deal, unsigned artists often use "demo" recordings to attract music publishers' attention. Labels typically receive three to four hundred demos per week (or a maximum of 19,200 per year). Thus, competition for a "listening ear" is fierce. Additionally, the vast majority of record labels' revenues come from established artists. For example, Warner Music Group's established artists accounted for almost 90% of the $1.7 billion in revenues from newly released titles in 2003. Record labels are therefore highly incentivized to focus most of their time and energy promoting those artists who generate the majority of their revenues. This presents yet another challenge for unsigned artists as they must compete with established artists for the time and resources of record label executives. The use of HSS could, however, help unsigned artists create songs with predictive success by testing their songs' hit potential and thus allow them to evaluate whether or not they can be successful in the music industry.

For signed artists, the use of HSS could mean the difference between a successful career and no career at all. Often, if an artist's first single underperforms it can be the end of his or her career. Artists are generally given an up-front fee, or a "loan", to record their album which is to be paid back to the record label from the artists' income from album sales and other artist related revenues. Additionally, artists are given a sales-based payment, typically between 5% and 15% of the record's suggested retail price. In many cases, artists are given loans in the hundreds of thousands of dollars of which all must be repaid before the artist realizes any profit from his or her album or other sales. Given the enormous amount of money it takes to create and promote an album, the cost of a failed album is extremely high. Because of this cost and the danger of underperformance, it is critical that the artist release an album that will be highly successful. The use of HSS could provide the same benefits for established artists as it does for emerging, unsigned artists, primarily increasing their potential for success.

2. Who are Polyphonic's ideal customers; if you were the CEO of Polyphonic, which target market (unsigned artists, producers, record companies, others) would you pursue?

Polyphonic has identified three target markets: artists, producers and record labels. Polyphonic would benefit the most from record labels, specifically A&R executives. First, record labels have the buying power to take HSS to scale and integrate the technology into their company processes for creating and selecting hits. In this way, record labels are in the best position to reveal HSS's tremendous potential. HSS offers record labels cost-savings and revenue-maximizing opportunities. As industry performance declines, as demonstrated by several years of falling music sales and rising online and offline piracy, return on investment (i.e., artists) has grown increasingly important. For record labels, the traditional testing methods used in hit-song identification are very costly. Call-out studies cost between $5000-$7000 per song while Internet Polling and Focus Group research costs $3000 and $10,000 per song respectively. HSS technology, on the other hand, can analyze an album of 10 songs for only $300 (or $30 per song). This provides cost as well as time savings allowing record labels to release songs and generate revenues much earlier. Further, record companies have a strong desire to forecast sales levels for the titles in their portfolios enabling them to determine in which artists they should invest their resources. With a success rate of 80% in predicting which titles will become hits, HSS would clearly allow record companies to maximize their revenues by focusing primarily on those artists whose titles are predicted to be successful by HSS in the music market.

3. What are benefits and drawbacks of the Hit Song Science for each player in the music industry?