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 saurin.net. You can learn more about me at http://www.saurin.net.