Wednesday, September 17, 2008

Superconvergence: thoughts on the digital music and phone businesses

Sometimes it seems like deja vu it's so common, but every business school class has a case on digital music and iTunes these day. Since I've written a lot on it recently, I thought I would try to compile my thoughts into a somewhat coherent post on my view of where the industry is going. These are just jotted down thoughts over the past week, but they may stimulate something thinking.

What's the future look like?

As a futurist, I imagine a converged device where through a phone or Wi-Fi connection (quite likely it’s looking, an iPhone) on a 4G network where any piece of digital content can be streamed to a phone. This is the subscription service that many would pay for and it could in the future be offered by a combination of a cellular network provider and an iTunes subscription service. Until then, I don’t really foresee a subscription service coming from Apple. If it happens, it will be because someone with the power to make it happen is able to offer such a compelling subscription service that users are willing to pay.

Content ownership shouldn't be an isue - DRM will die, and people will own their content and have plenty of storage. With storage increasing the existing rates, we'll have 500 GB mobile devices in 8 year or 10 years. That's no problem for music where songs are 4 MB files. Video might end up being a little bit more of an issue.

The more interesting question is whether Apple will get to control this market as well. There will be more heated competition in this space. However, handsets are more complex devices with many fierce and innovative competitors. In terms of a platform, they are much more like PCs with many different needs and demand for software. Apple’s closed platform strategy may face resistance as Google Android emerges, and other manufacturers develop innovative converged phone devices that meet customer needs.

What about existing subscription services?

David Pakman came in and spoke the other day at MIT about his company eMusic. eMusic is one of the smartest models for selling music out there, and I think they think about it the right way. Their customers spend on average $170 a year, and the amazing thing is that they don't have any of the big 4 record labels. This is quite amazing. What eMusic does have is record labels 5 through 50,000, a reasonable model to pay them, while retaining a reasonable share of the profits. They also have good technology to help adult users find music. It's great if you're a fan of jazz, blues, classical or any other Top 40 type music.

I'm not sure that in its present form this can be a dominant market player, but it's a smart way to build a business. Pricing wise eMusic has a subscription service with different tiers that give you a certain number of download. Pakman says these were figured out through research and optimization models. It's positive for the music industry because unlike what Apple does, it's a genuine effort to maximize revenue. That helps long-tail artists and record labels, which means more good music.

I still don't think subscription services will become wildly popular until they sit on a platform like the one described earlier in this blog post. That is, the integration with the platform (software and hardware) has to provide a compelling customer experience.

Will digital music cost a song for ever $.99 forever?

The cost of digital songs have been at $.99 for some time now. Given inflation, that means the real cost of music has been falling since this model has fallen into place, and indicator of the ferocity of competition and indicative of how no one has really answered the question of how to make money selling digital music (as opposed to selling music players).

The reality is that people are incredibly price sensitive in digital music market (hence all the people willing to brave the terrors of the Internet to download free music). Professor Richard Schmalensee, the former dean of MIT Sloan who is teaching Industrial Economics this semester mentioned -3 as the elasticity of price. For marketing and economics reasons, the price of a song has been set at $.99. If Apple even raised prices 1 cent, a large drop in demand or groundswell of disillusionment could be envisioned. The worst thing that Apple could do is hurt highly profitable iPod sales by making people who are locked into their platform unhappy. Apple should seek to keep market conditions as they are in the digital music and player business as long as possible.

But how about someone else? With the value of the dollar constantly deflating and expenses rising, how can the music industry not afford to raise their prices? The Big 4 record labels will eventually want to increase their share.

On the other hand, it's possible that the price of some music could go down. Some songs just aren't worth a buck (one could argue that people's WTP for many songs they pirate is zero). Some songs would be best priced at $.50. More bundling, either in the form of subscription services or selling additional incremental units of music make sense. Eventually, firms should be more innovative about increasing the amount of revenue (and hence profitability, since the marginal cost of selling additional music is virtually nothing except paying the record label, a little bandwidth and payment processing).

Apple hasn't been very proactive about this, but I think it's their best interest to do so. If Apple could figure out different ways to bundle songs to increase sales and albums, that ought to benefit everyone. Some ideas include dynamic bundle pricing or selling a higher number of downloads at a higher price. Part of the problem is that albums tend to have pretty bad reputations, a grave that the record industry helped dig themselves in their heyday. Myself and many other music fans felt that an album where there were more than two or three tracks worth buying was rare. When a CD was $15 and singles were $5, it was still worth it to buy the album just to be able to play it continuously without changing the CD. It’s different with the way digital music is played. You only buy the album if you believe that 9 out of 12 songs are worth buying individually, which rarely feels like the case. It might be better to accept the reality and get people to buy the 3rd and 4th songs off those albums (e.g. 99 cents for the first two songs, 50 cents for the 3rd, etc.)

What's going on in the existing market?

The state of the existing market is an interesting one. Apple’s dominant position as the platform provider means they own approximately 70% of the digital songs and music player market. While normally, these would be considered separate markets, Apple’s integration means that they are a platform with a significant advantage against competitors who generally only make hardware or sell songs. Even though some of these firms have tried to partner up to form platforms, they have been able to wrest much market share from Apple. This allows Apple to sell music at a small gain and increase lock-in to their platform, since Apple’s DRM means users would have to go through a major hassle to convert their music into other playable formats. Meanwhile, Apple’s control and popularity gives them tremendous market power in selling their innovative hardware.

What are paths to success in digital music?

Economies of Scale: The music game has historically been a game of giants due to the economies of scale required in distribution. In order to justify paying an artist and producer big money, a massive reach is necessary to maximize profits. Digital content allows for many of those intermediaries to be cut out.

Loyalty/Switching Costs: Apple’s strategy of creating a locked-in platform on both the hardware and software fronts didn’t work that well in the fight against Windows. This type of strategy makes it more difficult for open and outside innovation to meet a diverse set of needs (in the case of PCs, the software the drives businesses globally). However, for most people, music is a simpler proposition. An intuitive, elegant, integrated solution that is easy to use right of the box is ideal. It’s interesting that Apple continued to follow this integrated approach to win the music business. For RealNetworks, this means partnerships with hardware makers and operating systems will be important. This ended up being a major barrier for RealNetworks. They ended up in a messy anti-trust suit with Microsoft that was settled in their favor in 2005, and of course Apple has its own product.

Differentiation: Rhapsody had the right idea in terms of creating an attractive platform with high quality editorial information, interactive tools and quality content. Acquiring exclusive content is important, as is providing a superior customer experience through user interface and the available of additional content like reviews.

Business Model/Pricing: Driving adoption of your particular business model(s) is essential. For subscription based services, it seems that a sensible strategy would be to give low-cost subscriptions (but not necessarily free, since that tends to make people feel as though it is an inferior product). Getting people to commence a subscription and leave their credit card information helps lock-in the customer as well.

Barriers to Entry: While it is a digital good, a piece of content that would be desirable to users must be produced by an artist, corporation, professional sports league, etc., go through post-product and be marketed. The value chain is not simple and entering the online content market is complex business. It is not easy to set up all the relationships, satisfy all the players and do so on a scale that would be worthwhile

Suggestions for Digital Music Companies

Obviously, this seems a lot easier in retrospect. Some strategic ideas would be:
1) Partner up with hardware makers and other distribution partners to lock-in new users. Do this quickly and beware of being locked out of platforms. Partners like OEMs (Dell, HP), Microsoft, AOL, web portals, etc. would be incredibly important towards acquiring the scale necessary to be a winner.

2) Continue to differentiate by producing quality goods and services around content delivery, and offering higher level packages at a premium. Consider facilitating open innovation and user contributed content to drive with establish base of music enthusiasts to drive differentiation at a low cost. This also helps to amplify the advantages of existing network externalities that RealNetworks has.

3) Get users to try the subscription service at a discount knowing that they can be profitable long term customers with at some switching costs. Meanwhile, make it very easy for users to switch to Rhapsody through ease of use and integration with software and hardware that users are already using.

2 comments:

Nokia Nick said...

Nice post. Thanks, Ted.

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