The day recorded music dies is not far away, say labels

Illegal downloads are costing the world's record companies millions a year. Richard Northedge reports on how they plan to fight back

'Put your hands up," sang Kylie Minogue to some 5,000 fans in Cardiff last night. They did, and they had already put their hands in their pockets to buy tickets selling officially for £85 but changing hands outside the Motorpoint Arena for much more. However, when it comes to downloading songs from the star's Aphrodite album, those same fans are reluctant to pay even a few pennies and many download the music illegally.

This reluctance to pay for recorded music is causing problems for the world's record companies. Kylie's label, part of EMI, has, like the rest of the industry, seen its sales of physical discs fall but not offset by an increase in revenues from digital music.

EMI was acquired last month by Citigroup and recapitalised but that is only a temporary home while a new long-term owner is sought. Its rival Warner Music is also seeking a buyer but with the companies missing out on the millions that fans are prepared to pay for music, what future is there for these former giants?

EMI was bought four years ago by Guy Hands's Terra Firma private-equity group for £4.2bn, but exploiting its assets proved as hard as repaying the £3.4bn borrowed to buy it. The outcome of an acrimonious legal battle was Citigroup taking possession of the music company, but despite operating costs being cut from £445m to £392m over three years, the underlying problems persist.

Sales last year, at £1.65bn, have steadied, but are below the £1.81bn turnover of 2007, despite six million Katy Perry albums being sold and the remastered Beatles albums selling twice as many. EMI's losses over the past four years total £2.82bn.

Warner, America's only quoted music company, whose artists include James Blunt and Michael Bublé, has suffered even more. Its fourth-quarter revenues in 2010 was down 14 per cent at $789m and its digital turnover fell 5 per cent, leaving it with a loss for the three months. Its chairman, Edgar Bronfman, blames "rogue websites" that allow theft of its products.

In Britain, 1.2 million tracks were downloaded illegally last year – the equivalent of the content of a 74-mile high pile of CDs, says the BPI, the trade body for British recorded music. A survey of computer use found 7.7 million people regularly making illegal peer-to-peer downloads – a greater share of the market than official digital providers such as Spotify.

BPI's chief executive, Geoff Taylor says file-sharers who believe music should be free but who expect companies to keep supplying it are living in a digital utopia. "We must decide whether we can afford as a society to abandon values we stand by elsewhere – that stealing is wrong and creativity must be rewarded," he says.

The record companies were slow to recognise how digitalised music would replace discs, relying on a revival of CD sales in the 1990s. Paul Bedford, an investment director at Ingenious Media, a fund manager and

adviser, says: "They saw it as a threat rather than an opportunity".

Companies such as EMI and Warner make money from selling discs, performance royalties, synchronised royalties for music used in advertising or computer games, and also from uses such as mobile ringtones. They initially resisted digital outlets but now license recordings to companies such as Napster, eMusic and We7. Spotify now has 10 million tracks to download and is adding 10,000 a day.

Black Eyed Peas had the first million download with Gotta Feeling last year and 19 albums had 100,000 UK downloads – equivalent to a "golden disc" sale – with Lady Gaga's The Fame and the Kings of Leon's Only By The Night racking up 250,000.

A fifth of all British album sales were digital last year, and 99 per cent of singles. That meant 160m singles – only 10m more than in 2009 – and 21m albums compared with 16m a year earlier. However, Mr Taylor at BPI complains: "This growth is a fraction of what it ought to be. Illegal downloading continues to rise. It is a parasite that threatens to deprive a generation of talented young people of their chance to make a career in music."

Yet the stars are reluctant to criticise fans. Although they suffer financially, the big money is in live music – as Kylie's Cardiff ticket sales showed. "The consumption of music has changed massively," says Mr Bedford. "It's the live scene where people are prepared to pay. Artists make 90 per cent of their money from live music."

Last night's concert followed a similarly packed gig on Friday evening and Kylie has another dozen UK dates as part of a world tour that started in Denmark last month and ends in Australia in June. Following her round the British circuit are acts such as Take That, Katy Perry and Westlife. And besides tours, fans willingly fork out for festivals.

Falling disc sales may have contributed to the collapse of major retailers such as Zavvi and Woolworth but their disappearance may also have hit sales. The Chancellor, George Osborne, announced Budget measures last week to curb internet sales of cheap discs through subsidiaries in low-tax offshore centres.

Governments are belatedly considering other ways to protect the music companies. The European Parliament has backed the Gallo report, which recommends legislation to limit copyright infringements while a Combating Online Infringement & Counterfeits Act is planned by the US. Mr Bronfman says: "This bill is a welcome step in severing the financial lifeline that sustains rogue websites" but he wants the internet service providers to back the music world.

Warner was a sister company to AOL until its 2005 flotation but he says: "The momentum to implement programmes in which ISPs notify and eventually institute sanctions on copyright-infringing customers continues to build. We are heartened to see this recognition of the enormous responsibility that ISPs play in protecting content from theft."

But Warner has now asked investment bank Goldman Sachs to seek buyers for the company, just as Citigroup considers EMI's future. One possibility for each company is to split off their music publishing divisions. The Warner Chappell publishing company saw sales fall 15 per cent to $120m in the last quarter but it broke-even. EMI Publishing saw revenue rise 2.5 per cent to £478m and earnings increase 13 per cent to £150m in the year to last March.

Paul Bedford says: "The jewel in the crown for EMI is EMI Publishing and for Warner it is Warner Chappell. The publishing divisions will spin off but what do you do with the recording side?"

David Lancefield, a media partner at consultants PricewaterhouseCoopers, says: "The growth in digital has not offset the decline of physical, but publishing has done well. We're seeing a big increase in digitalisation and lots of new services coming but we're still in a period of experimentation over where you can make money and the battle for market share. The music companies need to have fingers in lots of pies."

That means considering new partners and ways to add value by recapturing the spending on live acts, says Mr Bedford. He suggests access to tickets for fans who download and adds: "I could imagine music being part of your mobile phone bill. Through their marketing, the music groups are creating an artist's brand – so why not capitalise on it?"

The big companies think they have learned lessons. Citigroup cut EMI's debt from £3.4bn to £1.2bn when it took control last month and the bank's vice-chairman, Stephen Volk, says: "Our objective is to have EMI perform its absolute best for our shareholders over time. It is business as usual for everyone at EMI."

Mr Bronfman has a similar message at Warner. "We are positioning the company for long-term growth," he insists. "We've got plenty of work to do but we are on the right path." Half a dozen bidders have expressed interest in Warner, but the most serious, the German rival Bertelsmann, would face severe competition issues. The EMI auctionhas not yet started.

Yet Warner and EMI have spent the last decade courting each other. A 1998 merger attempt was followed by Warner trying to buy EMI two years later. In 2006, the British company bid for Warner and the US group then bid for EMI. All without success. But now that EMI has escaped from Terra Firma's control and Warner is no longer part of a conglomerate, perhaps it is time to try again so that they can confront the digital age together.