Friday, March 03, 2006

Audio Broadcast Flag legislation and Potential Price Fixing

After reading an Engadget post the proposed Audio Broadcast Flag, I considered the possible social and consumer implications.

Some in the music industry consider the necessity to control how listeners consume their content a central part of their business. The ability to control and restrict will allow the content publishers to resell the content and bundle it elsewhere, allowing them to increase top line revenue without taking a hit to margin. However treating the consumer with this much distrust can lead to a widening gap between the consumer's desires and that of the content owner's. Instead music and radio broadcasters should consider how to engage the customer in the way the customer wants to be engaged.

I do not think that more control is the answer. A certain amount of licensing control may be necessary but not at the cost of alienating customers. Since the introduction of cassettes, customers have been recording music. The real key is to increase the value add of non-music content (music videos), lower transaction costs of purchasing music (i.e. online sales), make a better product (high definition music DVDs) and such are much better forces to influence consumer behavior than restrictive behaviors.

A recent article on potential online price fixing by BusinessWeek brings to light some of the arguments that I brought up in my two part blog posts, "The Online Music Wars". The relative concentration of power of the major labels is much like an oligopoly. Many suppliers and vendors, other than major retailers like Walmart, have very little ability to influence the labels. However disruptive technololgies like Peer-to-peer and Apple's iTunes are shifting the power. In the face of dropping CD sales and an adjustment period to online sales, record labels are trying to preserve margins and profit by keeping prices high. These companies should instead focus on lowering its operating and supply-chain costs while lowering price (slightly) to increase adoption of online sales and weaning customers away from the more expensive CD sales. The labels should keep the customer in mind, and consider the customer's cost and reasons to purchase from the label. Though price is one factor, a successful brand will have customers focus on non-price characterstics, such as value-added, convenience, etc.

Netflix Throttling & Price Strategy Follow-up

If you have not read my post on Netflix's Business Paradox, I suggest reading it.

Recent articles about Netflix's "throttling" - that is where Netflix purposely slows down how many movies you receive based on your usage - strongly suggests that their pricing strategy is disconnected from their operational strategy, just as I discussed in my earlier blog post. Until Netflix considers changing its pricing or its operating practices, it is going to lose customers to dissatisfaction and competition.

Recently I had the opportunity to try out the Blockbuster service, and while Netflix's website and selection are still superior to Blockbuster's, it seems that Blockbuster's ability to leverage its retail outlets with its online rental business is a strong model. Blockbuster should continue to tie its online and offline to drive consumers into its retail stores (and vice versa). One way Blockbuster can do this is to place kiosks in their stores where users can access their queues and compare their queue to store inventory. This can also be used to print coupons for purchase of used movies based on the user's queue. There are many opportunities here for Blockbuster to use its multi-channel approach to drive sales in both retail and online venues.

Friday, February 24, 2006

The Necessary Reinventing of AOL

There was a time when AOL dominated the Internet portal and ISP markets. AOL was considered the gateway to the Internet by many. Today that legacy seems to be a distant memory replaced by the association of AOL with throw-away CD mailers. The merger between AOL and Time Warner was heralded as a sign of the dominance of the new economy. As time has shown and the reversion of the AOL-Time Warner name back to only Time Warner suggests, the merger and AOL has not lived up to the hype. To survive AOL needs to reinvent itself: 1) lose the big-company bureaucracies; 2) embrace change rather than be afraid of it; 3) use its size, customer base and knowledge of its customers to build a business based broadband content (paid and ad supported) tailored by its users; and 4) deliver regional, personalized content to users across the world.

To be fair to AOL, AOL was a major force in evangelizing the Internet to the mass market. AOL’s easy-to-use interfaces, community centric portal offerings made it possible for non-techies to use the Internet without their being an “IT pro.” AOL’s creative and persistent marketing tactics helped it build a large customer base. However as broadband emerged and began to replace dial-up and as Internet users themselves became more Internet savvy, AOL’s core business areas became vulnerable to competition.

As one of the world’s leading media Internet Service Providers (ISP) and online content providers, AOL faces significant challenges and opportunities associated with a sector shaped by a decade of fierce competition, rapidly evolving technologies and increasingly demanding customers. How a service provider responds to these challenges will largely determine its position in the market and whether it will ultimately thrive.
AOL continually needs to reinvent its business, competing with formidable rivals such as Yahoo!, Google and MSN and a growing number of specialty content providers. Furthermore, AOL also needs to compete against telecom and cable companies poised to assault its market share, by creating service bundles and undertaking marketing campaigns that continue increasing their user base and attracting advertisers.
There are several factors that affecting AOL’s ability to compete. To explore just a few on the many, let’s consider 1) online advertising industry; 2) content delivery; 3) consumer demographics; and 4) the media business model.
Online Advertising
• Double digit growth in online advertising, especially paid search
• Cost of online advertising rising for premium content, Cost-per-Click and Cost-per-Keyword
• Increased competition between AOL, Google, MSN, Yahoo! and an increasing number of specialty search engines and content portals
• Sophistication of Ad Agencies and Advertisers is increasing, demanding better ROI results on their advertising dollars

Content Delivery
• Growth of premium/paid content services through subscription and a-la carte models, especially for video, music, VOIP and other broadband services
• Growth of mobile and wireless as a content consumption device
• Increased piracy of copyrighted content
• Instant Messaging as a channel for content and service delivery continues to expand

Consumer Demographics
• Increased localization and personalization of content
• Emergence of online advertising markets outside of US and Europe
• Proliferation of broadband and a decline in dial-up Internet access
• New, sophisticated data mining techniques

The Media Business Model
• Continued convergence of telecom and media
• The link between the ISP as the content provider is weakening
• Maintaining high ad revenue margin as a competitive advantage is key
• Increased regulatory requirements
• Partnerships and industry consolidation increasing

To compete effectively, AOL recognizes the need for constant change and to protect its customer base, maintain a prominent position and continue enjoying strong growth in its advertising business. For example, the conversion of existing customers to broadband from dial-up has resulted in improved customer retention rates and page views, which are critical to increasing online advertising inventory. The introduction of broadband services like VOIP and content like video is helping AOL cater to changing user demographics and new competition from telecoms and cable operators. AOL has also moved to make its content available to all users regardless of AOL membership and has recently reached an important agreement with Google, whereby AOL’s search is now powered by Google. This makes complete sense as AOL’s core competencies are not in search (unlike Google), but rather in community development, user-friendly interfaces and content management.

AOL can be competitive. Already the growing advertising revenues suggest that its leaders understand the fundamental need for change. However stopping here is not enough. The launching of TV-over-the-Internet and other rich media channels require new underlying technologies, and AOL should continue to look at tactical and strategic acquisitions that could help it compete in these areas.

Other challenges require a focus on customer needs. It should leverage new broadband offerings (especially considering its tie with Time Warner) with its ability to develop top-notch user interfaces. This will help increase exposure of and revenues from higher margin broadband content to the masses just as it had introduced the Internet to so many people.

AOL should also consider totally dropping its dial-up business entirely. The dial-up business is highly competitive, primarily based on price wars, capital intensive and has low operating margins compared to its content based businesses.

The move by AOL to use Google to power its search engines was a smart choice. AOL should use its cash and assets to focus on its core strengths rather than trying to do everything. With the ad-based revenue growing and the need to not focus on developing search technologies itself, AOL can try to build its customer base in videos, music and other areas where (other than Apple) there is still no clear market leader. Here AOL’s smart marketing tactics and brand will help it build businesses that actually tie in to its Time Warner family.

Lastly and most importantly, AOL needs to develop a culture that is creative and entrepreneurial. Rewarding employees for taking smart risks and coming up with new ideas that help AOL move away from the status quo is fundamental. This should start from the top – AOL needs to have inspired leaders that are not afraid of change and taking risks. Reinventing itself from an ISP-centric company to a globally recognized content leader takes real culture change that has to be supported by the leaders. Then by tying employee compensation and non-compensation incentives (e.g. recognition awards) to its new goals, AOL can develop a culture that thrives on change and constant reinvention in order to stay competitive, deliver strong return to its shareholders and offer its customers something more than just a gateway to the Internet.

Thursday, December 15, 2005

The Commoditization of Media

Studios, networks, music labels and the like spend millions on particular movies, shows and bands to try to differentiate these "products" from other competiting ones (both direct and indirect). In most businesses, this type of marketing tries to build a brand that can desensitive the consumer from the underlying price of the product. For instance, you may buy a Coke and pay 33% more for the coke than for a similar Sam's Choice brand at Wal-mart. The marketing can also help drive sales and repeat business, but it is also a tool to drive pricing through a brand premium. Networks do this by being able to charge a higher price for ads when they attract more viewers. Now the video-on-demand, downloadable music and the Interent have come in full force and turned this practice upside down.

Consider that it used to be that unknown bands would sell their CDs for $6.99 while established bands would sell theirs for $13.99 - but now on iTunes, both sell songs for the same price $0.99. The effect is the commoditization of media. Unfortunately herein lies the problem, commoditization works for goods that a) all alike and the same and b) because they are the same (think salt, cotton, oil), price is the only factor that determines sales. However Madonna is not the same as the band in the garage next door. Producers of music and movies have had an enormous advantage of marketing stripped away from them!

Go to the store and buy a DVD -- chances are you will pay a higher price for a popular movie like Mr. and Mrs. Smith than you would for an unknown movie. However online, each is the same price to own! For those content owners and publishers that do not invest much in advertising, this commodity pricing can be an advantage for them as well as a disadvantage. It can be good, because the similar pricing can have the effect of rubbing off a strong brand on their own product. On the flipside, the companies lose control to lower price and spur sales that way. If both are the same price, consumers may tend toward the more well known brand.

Digital media publishers need to be conscious of the commoditization effect. To fight this, they need to be careful how they license their content to digital retailers. When negotiating, try to build in some ability to control the supply price which then would lead a retailer to raise their own prices. However when dealing with the major retailers, this may be quite difficult to do.

Another way to get around the commoditization problem is to practice product bundling, pre-sales, exclusive channel pricing, digital asset supply-chain management and more. Bundled products creates more skus, which leads to more price points. I suggest bundling products with concert tickets, DVDs and products than other digital downloads. Other digital downloads will carry the stigma of flat pricing. By bundling the product with something other than digital media blurs the line a little bit and gives the content provider more control over pricing.

Monday, November 07, 2005

Reminders from the Grokster ruling

After reading articles like the Financial Times article "Grokster closes illegal music download service" (, I wanted to share my own thoughts on this subject.

For several years, I fought resolutely against music piracy. At Trax In Space and Digital Rhythms, where I served of VP of Business Strategy, piracy took a toll on our artists. I worked directly with unsigned artists, many of whom had hoped to leave behind the corporate world and pursue a career based on music. For many of these artists, piracy would eat away at potential sales -- the compensation of getting their name out was not always enough. Many people would claim that those people that pirate would not have purchased anyway. I disagree with this notion (see my closing comments of this post).

I took an approach that goes counter to the one used by the big labels. My business, Trax In Space, was founded to help artists reach their fans in a market crowded by the big labels. In a legal way, I fought on behalf of independent artists. While the major labels choose the courtroom to stop piracy, I tried to educate people instead. I feel that most people do not pirate music to conduct a crime, but do so because they are ignorant as to what the implications of their act is. When a person steals of a new pair of shoes, it is easy to see who gets hurt. In the digital world, it is much harder for a person to identify those that are affected by their actions. The lure of "free" can be too strong for most people.

Although I could not stop everyone from pirating, I felt that my approach left a more long-term solutions. Those that finally understood the impact of their actions and weighed the pros and cons of pirating, were less likely to find a way to pirate in the future. With this in mind, labels and media content owners and publishers must continue to deliver media in ways (i.e. the Internet) that users want and at prices they can afford (in my opinion, $0.99 per song is still too high). Also it should be easy for users to do the right thing - do not complicate matters with hard-to-use custom media formats, ultra restrictive licensing (DRM), etc. The convenience factor and an affordable price will make it easy for people to do the right thing. By serving the customer in ways that the customer wants to be served, media publishers can avoid having to sue their own customers. They can, instead, reserve the legal route for their most serious offenders only.

Wednesday, November 02, 2005

The Online Music Wars, Part II

The Online Music Wars, Part II

Note: If you have not read Part I of this blog, I suggest you do so before reading this post. In this blog, I will cover distribution channels, standards, podcasting, and the future of online music.

Distribution Channels and Digital Rights:
The battle over delivery channels has just begun. While consumers have an increasing large variety of delivery mediums to choose from (Satellite radio, internet radio, CDs, DVDs, cable music channels, etc.), the content providers have the most to gain. Each of the channel owners, at some point, must purchase content from the content providers and creators. This one-sided delivery mechanism has made it possible for the content providers to demand that their delivery partners abide by very strict digital rights (DRM) schemes. For instance, if you buy music from Apple’s iTunes and you accidentally erase the song, you are out of luck. You have to buy the lost music again, even though Apple knows you bought the song. Consumer pressure and a worsening public image may force music content providers to be a bit more lenient and trusting of their consumers, but the music industry decision makers (unlike their film and TV counterparts) are slow to move when it comes to empowering their customers.

Video on Demand Emerges
Compared to the music industry, the film and TV industry are much more progressive when it comes to digital rights and licensing. With eroding box office sales, many studios have placed a renewed emphasis on DVD sales. Increasingly they are paying much more attention to the initial DVD release date, during which time a majority of sales of the DVD are made. Also the repackaging of existing content (i.e. classic TV shows) and TV shows has made a big impact in the overall DVD market. As this trend continues to grow, movie studios will have increased competition in this market.

While many studios came have as high as 80% margins on DVD sales, the emergence of media on demand will force rapid changes in the industry. Already Apple has ventured into this front by offering “day-after” video downloads of popular TV shows, such as Desperate Housewives and Lost. The $1.99 downloads come at the fraction of the cost of paying $40 for a season set of DVDs, for which a customer would have to wait as long as a year.

As pointed out earlier, Apple is leveraging its large customer base, economies of scale (in terms of new customer acquisition, leveraging existing technology platforms, cross-selling, etc.), and product tying practices to test the waters of the portable video. If successful (and all indicators suggest it will be), Apple will be able to migrate existing customers to higher-end, higher margin products where there is much less competition. The real competitor for Apple in this area is not Archos, which although was “first-to-market” does not command the same brand or media distribution channels as Apple does, but cell phones.

Delivery Channels as a Competitive Advantage
In the PC world, Dell and HP are two behemoths with two vastly different business models. Dell uses a direct-to-customer strategy while HP uses a more traditional retail model, which involves intermediaries and retailers. Dell’s exclusion of the distribution channel intermediaries gives them a significant pricing advantage. HP cannot match this model because it would destroy relationships with its partners and intermediaries, upon whom HP relies on for most of their sales. The cannibalization of their distribution channel is a big risk that may not pay dividends in the end. However the retail model does provide certain branding and marketing advantages to HP over Dell.

Similar to HP and Dell, the conflict between direct-to-customer vs. traditional, digital distribution channels is alive and well in the digital media space. Several of the major labels have expressed an interest to create their own digital music and video portals to sell their content. This direct-to-model approach carries with it pricing and customer relationship management advantages, but does not necessarily serve the end-customer well. Customers may not want to use several different sites to find their content as evidenced by the success of Apple and the struggles of Sony. The intermediary model in the digital media world diminishes some of the power that the major digital content providers have. Also as the customer base grows, intermediaries, such as Apple and Napster, create barriers-to-entry for the content providers and newcomers. The content providers become dependent on their intermediaries for sales and access to customers and newcomers must establish relationships with the same content-providers that their competitors use. In the end, those intermediaries with clear competitive advantages in operational efficiency (as exemplified by low prices, high volume and strong margins) or high value adds (e.g. user interface, additional content, premium services, etc.) will be the most successful.

Looking at Apple closer, Apple is a unique case. In many ways, iTunes serves as loss leader for Apple. iTunes customers tend to buy iPods, Shuffles and Nanos, incredibly high-margin consumer electronics that are the forte of Apple, a high tech discrete manufacturer. The addition of video will fuel growth of the video iPods and help QuickTime break into the PC market as the media standard. In many ways, iTunes is helping transform Apple from a niche player into a media consumer electronics and digital media leader.

Lastly the point-of-sale (POS) market for digital media will be interesting to watch. It has the potential to be a disruptive force in the digital media world by capturing impulse buyers in settings where price comparison is not as easy. Most notably, coffee retailer Starbucks has begun to test sales of digital music at its cafes. In the future, stores like Gap may follow suit. Right now the primary method to conduct sales of digital media at retailers is through kiosks. Because kiosks will probably prove prohibitively expensive for retailers, cell phones will serve as the ideal POS method for digital media sales. Customers could download or queue (for download to their home PC) songs and videos at the store. This will allow retailers like Best Buy to use their store foot traffic to capture customers that could be lost to purely online sellers.

Cell phones and Digital Media
As mentioned in the previous section, cell phones are poised as the ideal method for point-of-sale deliveries of digital music. The cell phone continues to emerge as the ideal multi-purpose platform for media. Already content companies are scrambling to deliver video clips and games to cell phones. With the cellular service providers (i.e. Verizon) handling the payments, smaller companies are freed up from cash collection and managing expensive, per-transaction micropayments. The larger, cellular service providers can spread out the costs of micropayments over a large customer base, high volume economies of scale to give them an operational efficiency advantage over the smaller content providers. This relationship benefits both the content providers and cellular service providers.

Considering music specifically, it all started with ring tones, the ring tones (the predictable unlikely billion dollar market). Little do most people know that in 1997, I approached Texas Instruments (in Houston, TX) with the idea of selling customizable and cover track tones for cell phones. Unfortunately my idea did not get much traction at the time and both Texas Instruments and I missed out on a golden opportunity. However fast forwarding to today, the ring tones business exemplifies the desire for people to personalize their cell phones. Ring tones allow a form of consumer-controlled mass-customization, a trend that is hitting almost all consumer industries.

Cell phones as a delivery device will give current music intermediaries like Apple problems, because the cellular service providers are intermediaries themselves. Content providers can access the cellular service providers directly without having to go through current retailers like Apple. The main advantage current intermediaries retain is their brand and existing customer base. Whether that advantage will continue to be a major competitive advantage in the future will depend on the strength of brands, new customer acquisition costs, offline extensibility (the ability to use purchased content on non-portable devices), and content supplier pricing differences. In this case, it may be in Apple’s advantage to be a first mover in the cellular music space (via Motorola’s ROKR phone) to strengthen their brand and use their existing customer base to crossover to the cellular model. The question for Apple remains though is that will customers who migrate to cell phones stop purchasing iPods and will margins for cellular sales be attractive to Apple. This space is still unfolding and the lowered cost provided by the cellular platform may give rise to several smaller content providers.

Standards and Licensing
Perhaps standards and licensing is the bloodiest and most sensitive war being fought in the digital media world. Many consumer groups are unhappy with restrictions placed by content providers on how end-customers can listen to and enjoy their purchased content. Licensing restrictions are not limited to digital music, but also show up in CDs. I recently bought a CD by the British band Elkland on the Sony label. When I tried to convert the music tracks to MP3 so that I could listen to them on my iPod, a message would appear that proclaiming that neither the Apple AAC nor MP3 formats were approved formats and that I should take my gripe up with Apple. Sony wanted me to use their proprietary format or at least those formats supported by players and companies friendly to Sony. I found Sony’s restrictions ridiculous. After all I bought the CD and if I want to listen to the music on an iPod rather than a Minidisk player, the choice is mine to make – not Sony’s to make. Sony’s practice of restricting music formats the songs can be converted to may be an illegal form of tying. Illegal tying occurs when two unrelated services or products are forced to be bought or consumed together. Sony forcing customers to choose their preferred formats (and essentially their preferred music devices, namely anything except an iPod) is not related to the intent of the original purchase – the personal use of the recorded music. How consumers listen to the music on the CD should not be dictated by Sony. After a lot of unnecessary work, I was able to find a way to convert the songs to MP3.

At Trax In Space, I promoted a much less restrictive licensing policy. Music was provided in MP3 format and the consumers who bought the music were allowed to listen to music as they pleased as long as it was for non-commercial uses. Although customers may have given the tracks to friends or made them available on P2P services like Grocksters, I trusted our Trax In Space customers. People who want to copy music will find a way anyway. We focused on building long-term relationships with music fans and musicians. This resulted in strong, growing sales; customers came back again and again to make additional purchases.

An interesting twist on licensing occurs in the net radio and podcasting space. Companies like Mercora, which allows users to stream their personal music collection over the Internet as a radio station, are pushing the boundaries of content licensing. The companies that allow net radios typically pay content providers based on percentage use of the music. Often the radio stations have a fixed licensing expense and content providers fight for a piece of that pool. This has the effect of turning the music into commodities, something that content providers do not want to happen. This model does not allow content providers to exercise pricing autonomy, being forced to reduce their prices to whatever the radio’s licensing pool will bear. Certain brands (e.g. Madonna, R. Kelly, etc.) may be able to command some pricing advantages for content providers, but the pricing control will diminish and content providers will focus more on volume.

Closing Thoughts
The digital media world is exciting. Perhaps no technology before has been as disruptive to the industry as the Internet has been and will continue to be. I know the power of digital media first hand – Trax In Space successfully allowed new, unknown musicians access to music fans all over the world as early as 1993. Although I was able to pioneer the early forms of digital music consumption, the industry has entered the early stages of high growth and high innovation. Although Apple has a great start and market share, it is unclear whether they will be able to keep their lead. The use of cell phones, growth of net radios and podcasting, and the emergence of new devices like automobiles will ensure that the digital media industry grows and adapts. While consumers will undoubtedly benefit from the impending changes in digital media consumption, many opportunities will arise for innovative people and companies to cash in on this change.

If you have thoughts, comments or would like to contact me about consulting, ventures or other opportunities, please do so by emailing me at saurin AT You can learn more about me at

Tuesday, September 13, 2005

The Online Music Wars, Part I

The Online Music Wars, Part I

If there is one area with which I am intimately familiar, it’s the digital delivery of music. Being one of the early pioneers of this business model, I started my business, Trax In Space, in 1993 and grew it to over a million customers by 2000. Often in business as in life, timing is everything, and my idea may have been a few years too early. Based on my expertise in digital rights and the digital media delivery, today’s major players today (e.g. Apple (via iTunes), Roxio (via Napster), (, Walmart, etc.) face an intense, competitive environment.

My hypothesis is that the near-zero incremental delivery cost of online music will turn music into a commodity and that two dominant business models will emerge: low-cost, volume retailers and premium, value-added retailers. This will happen because, as a product, each music site sells the exact same music provided mostly by the same suppliers (the major labels). Smaller, independent labels and artists (the group I targeted at Trax In Space), will grow in popularity, but for the foreseeable future make up only a small percentage of online music sales.

Even though millions of songs have been sold online, the online music industry is still in the early stages and relatively immature as a supply chain. Current competitive advantages arise from brand (Napster, iTunes), early mover advantage (iTunes), product tying (iPod) and cost/pricing strategies. I would like to examine a possible future state of the music industry as the online delivery model evolves.

Pricing and Piracy
Having dealt with music piracy at Trax In Space and seen its causes and effects, I consider piracy an issue rooted in culture and ignorance. Often those that pirate music do so because it’s easy and the effects of piracy are not clearly visible. Media companies should continue to educate people (especially teenagers and young adults) about the impact of piracy. However the real solution to this issue will be to deliver music and media cheaply and through the channels (digital) that customers want. At some price point, people susceptible to piracy will consider buying the song legally rather than deal with the time consuming and risky (from the stand point of hackers, viruses, spyware, etc.) method of downloading songs illegally. Personally I do not think that price point has been reached yet -- $0.99 per song is still too high.

Napster’s subscription model approach provides an interesting shift in consumer purchasing. As I have done for my clients over my career as a management and strategy consultant, the trend to turn customers from buying a-la carte software and services to purchasing subscriptions is a hot trend. In essence, Napster has turned their customers into annuities, taking out much variability in forecasting and cyclicality and simultaneously committing their customers to purchase more than they normally would have done. Some reports suggest that the consumers spend on average between $5 to $10 per year when purchasing music. At $10 per month, Napster has increased the average consumer’s spending up to 25x their regular spending! Simplifying the pricing considerations immensely, consumers often do this because of the 1) “bundling” effect – that is the large selection of music available makes the price seem like a great value (the customer disregards that the music s/he would actually listen to is much a smaller set) and 2) the subscription price allows the consumer to not have to make purchase decisions – instead the consumer can listen to music as s/he chooses without thinking about the impact to their pocketbook. Yes there are many other reasons why subscription pricing works for Napster, but I wanted to highlight two good reasons.

What about Apple and iTunes? Although many analysts consider iTunes to be a "loss leader" for Apple, I do not think that will be the case forever. iTunes does help sell iPods by tying the customer to Apple's proprietary format. Consider that Sony’s Memorystick helps to sell other Sony products. Once a customer has made an investment in Memorysticks, s/he is more likely to purchase other Sony products that use Memorysticks. Apple’s AAC mpeg audio format is just such a “tying” device – and it works exceptionally well. However from a pricing perspective, Apple’s first mover advantage has given it a brand premium. Apple can charge a dollar because people perceive Apple’s brand as 1) the only place to go to buy music and 2) legal and clean. However it is my theory that overtime as MP3 player competition intensifies and public awareness of competitive online channels increases, Apple may not be able to command the same brand premium – either price will have to drop or value-added services (i.e. video downloads, films, etc.) will increase.

Also I would like to point-out that while most people consider Apple the first-mover in the online music space, there were other companies doing this long before Apple. For instance, through my own company (Trax In Space and later Digital Rhythms), I was selling music (legally) online since 1993. By 2000, we had over a million customers worldwide (mostly Europe, USA and Japan). While I served mostly unsigned musicians and bands (and their fans), Apple’s entry into the market appealed to the consumers en-masse and hence they are considered the first-mover.

To be continued in part II: Distribution Channels, Standards, and more!

Tuesday, August 23, 2005

NetFlix and its Business Paradox

On July 25, 2005, NetFlix released its second quarter earnings, which were slightly higher than expected (view press release).

The home rental marketplace in the US now has several competitors in a few key verticals. From GameFly for video games, RentSexFlix for the adult market, BlockBuster, GreenCine and possibly Amazon in the future, NetFlix has competition from all corners. Then there are the substitute markets, such as Video On Demand (VoD) (e.g. ComCast, TimeWarner, CinemaNow,, etc.), vending machines at grocery stores and apartment complexes, retail rental stores (i.e. Blockbuster, Hollywood Video), and all other entertainment alternatives to DVD's (movies, sports, outdoor recreation, etc.).

With so much competition, NetFlix relies on its first-mover advantage, enormous customer base (which pales in comparison to Blockbuster's total customer base), well-known brand supported by strong Internet advertising, economies of scale through its many regional distribution centers, loyal customer base with low churn, and large library of hard to find movies. By leveraging its regional centers and large customer base, NetFlix can enjoy significant margin advantages over traditional competitors.

However for the purpose of this post, I would like to focus on the Netflix paradox -- its pricing and distribution strategy. On the surface, it would seem that building distribution centers in key geographic locations and large market cities would help it serve its customers better. While that is true, it is contrary its pricing strategy. Net estimates say that at its current pricing (around $17/month for 3 DVD's at a time), NetFlix is profitable as long as the customer rents less than 5 to 7 DVD's per month. Longer geographic distances, which increase the actual calendar time to send and receive DVD's, helps NetFlix lower the maximum number of DVD's a person could rent in a month. However with a local distribution center and one day shipping times, its theoretically possible for a person to rent up to 30 movies in a month. Most people will not rent that many movies, but a person may rent 10. At 10 DVD's per customer, NetFlix is losing money.

NetFlix considers some its more frequent users, "loss leaders" who are good for business. These users are often opinion leaders who spread the gospel of NetFlix and help bring in new customers. These customers offset their unprofitability by brining in new, more profitable customers. On the flipside, there are those customers who sign up and do not rent many movies at all -- perhaps the first few months they do, but then their activity trails off. These customers help NetFlix in many ways: 1) they are NetFlix's highest margin customers, 2) NetFlix does not have to invest in increasing capacity to meet additional demand, and 3) the longer they stay passive, the less likely they are to churn and leave NetFlix. How is the last point known? Health clubs, amongst others, have a similar strategy. Its well known that if all health club members actually used the health clubs, the health clubs would not have enough capacity to satisfy demand.

For NetFlix to improve its profitability while expanding distribution centers, it needs to do three things (primarily): 1) increase its customer base to spread the fix costs over a larger number of customers, thereby increasing its margin; 2) lower its operating margins by investing in better fixed cost processes and technologies; 3) increase price. A controversial fourth option may be to lower the usage habits by customers -- there may be ways to do this overtime, but it could be a dangerous road to take.

Increasing the price is perhaps the easiest option, but maybe not the most useful. Companies should focus on having customers value their brand for non-price purposes allowing them to have prices higher than competitors. Its not clear yet whether NetFlix has achieved this purpose. NetFlix does have strong consumer appeal with its no late fees, wide selection, convenience, etc., but by raising the price, its more profitable (low usage) consumers may drop out. And if the high usage, unprofitable customers still think the new price is a bargain, they will stick around, lowering NetFlix's profitability even further.

Investing in fixed costs processes is a must for NetFlix in all situations -- for a volume based business like Netflix, Netflix needs to lower its marginal cost by investing in overhead.

NetFlix is probably going to try to always increase its customer base by expanding into new areas such as video games and VoD, new markets like Europe, purchasing competitors (GameFly?), and partnering with channel participants (i.e. Wal-Mart). However this can be a long and expensive process, and does not solve the final problem that as customers increase usage due to geographically closer distribution centers, profitability per customer will drop.

One option for NetFlix is for NetFlix to reconsider its pricing strategy totally. The following scenario is a sample strategy that NetFlix could pursue -- it makes assumptions to NetFlix's actual operating numbers. NetFlix should employ a fix plus per use pricing strategy. NetFlix could have a $8 to $10 fixed monthly fee, almost like a club due. Then for each DVD rented by a customer, NetFlix would charge $2 flat. This should cover the shipping and return fees plus processing costs. Consider that if a customer rents 5 movies, the total fee would be between $18 to $20 -- the same as it is now for NetFlix's current break-even. However at increased usage, NetFlix does not bear the burden -- its profitability is still built into the $10 fixed cost. The $2 per use cost ensures that NetFlix does not lose money on more rentals. What about the higher usage users? Some of them may leave, but many may still find the conveniences, selection, etc. a bargain -- that is if NetFlix brands itself properly, then price will not be a central selling point. For lower usage customers, NetFlix is an even better deal, and therefore NetFlix may actually increases its new customer base without having to increase capacity much. Also customers who do not use NetFlix for a few months are less likely to leave and be content with paying the $8 to $10 monthly fee; whereas with NetFlix's current pricing structure, the customer may not want to pay a $17 monthly fee for no usage.

There are also other concerns to be considered with my pricing model -- namely cash flow and the effects on operational processes. From a cash flow point of view, potentially cash flow could become spread out more evenly over the month. I consider this a positive as it makes managing treasury much easier. However it is also possible, especially in the beginning, that revenue (and therefore cash flow) would drop as customers become accustomed to the new pricing model. Also I assume here that NetFlix charges clients as the movies are rented. This brings up a micropayment issue (which I will discuss as a broader topic in a later blog). Charging a client a $1.50 a time has a transactional cost which affects the bottom line immediately. So NetFlix may choose to charge the clients once or twice a month to pool their transaction costs, in which case there would be little affect on cash flow.

The idea with this blog is to consider that there are many ways for NetFlix to approach its future competitiveness. This is just option, but I would love to hear what you think!

Monday, August 22, 2005

An aside on the power of technology-based media as a social tool

I recently ran across a few articles (links to follow) on a documentary, "Born into Brothels," by Ross Kauffman and Zana Birski. Intrigued by the concept of following the lives of red-light district children who are given simple 35mm point-and-shoot cameras, I decided to rent this film. I wanted to point on an interesting facet of this film -- that is its illustration of media and technology as a social binder and empowering device.

I have always felt that art (be it film, music, paintings, poetry, photography, etc.) is an important keystone in any society. Through art, people have a connection to either the history of the culture or people, common threads and characteristics experienced by people, and a method to share information not easily said through everyday communication. This last point especially is why it takes a special "artist" to convey the messages with fidelity and emotion.

The film delves into how the lives of children of prostitutes are transformed with a simple camera. Consider the advent of the Internet and the ease of delivering media. Simply put the low cost delivery channel -- the Internet -- allows even the most detached and remote people accessible. Who knows where the next Picasso, J.K. Rowling or da Vinci is -- perhaps its one of these children shown in the film, such as Kochi or Avijit. In either case, I find that the power of technology based media will help these artists find their voices and audiences that care. Its true that with this ease will come lesser skilled artists, but that is a small price to pay as compared to gains of those invisible to or unwanted by society suddenly having voices and being heard.

At Trax In Space, the company I begin in 1993 to deliver music through the Internet directly from musicians to their fans, the effect of publishing MP3s online had a similar consequence. Many musicians like myself who did not have access to labels, promoters and products suddenly had an affordable method to push our message to those who would listen. Out of the tens of thousands of musicians, who used Trax In Space as their primary method to sell and distribute their music, several truly gifted artists were able to get their "big break." The normal distribution curve might suggest that with tens of thousands it would be expected for a few to outshine the others, but what is not suggested that if it were not for Trax In Space and the use of the Internet (and MP3) as a delivery mechanism, these artists would never even have had a chance. Hence from the remotest and direst of places like the red-light district in Calcutta to the drum and guitar filled garage of suburban youths, the technology driving media today is an incredibly powerful social tool.

A few articles on the film, the last link being the official film site:

Monday, August 15, 2005

An aside on US higher education and global competitiveness

Although I should be writing about digital media, I thought I would make a short aside -- an op/ed -- on a recent article I read in the Boston Globe about the state of US higher education. Many articles over the last few years (at least) have commented on this topic in some form or fashion. The underlying theme is that as manufacturing and now many professional services move out of the US, the US faces a competitive dilemma -- how to increase the number of math and science higher education graduates. Even Larry Ellison commented on this recently -- its a hot topic.

The US, for many years, enjoyed a brain drain advantage -- it pulled the brightest and smartest from all over the world. Typically the students came to the US and then stayed and worked in the US. But now, due to global geo-political situation and the rise of India and China as economic powers, many bright and prospective students are going to other countries, such as European nations and Australia. The international education marketplace is growing and competition is increasing. On a global scale, this should help increase the quality and price offerings of education everywhere. However on a local level, US students are not going into math and engineering. Instead the students focus on liberal arts -- the gap of science was made up by international students, but if the international students go elsewhere then the US will have a shortage of qualified graduates...

Globalization and economic sourcing is good for the world economy. If the US wants to compete in the future, it needs to take advantage of its financial, infrastructure, entrepreneurial culture and higher education strengths. Education is key to making a flexible labor market, which is adaptable to a changing world. The US should embrace the new competitive education market by pushing the domestic population toward higher education (especially math, science, engineering, finance, business, etc.) and drawing students from around the world. Lower the barriers for entry for foreign students and increase competitiveness and the US education system and its labor market will improve.