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), Buy.com (BuyMusic.com), 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!