Peacock Nine Blog

Microsoft Merger or Google Gamesmanship?

This morning, reports from the New York Times as well as other sources suggest that Microsoft initiated merger/acquisition talks with Google over two months ago. The pairing of the two companies would marry the world's largest software company with the world leader in search. Is the recent annoucement of a pending IPO by Google a certainty or merely gamesmanship to better their bargaining position with arguably one of the twentieth century's greatest m&a gamesmen? Regardless of the outcome, it has been an exciting week, what with pre-IPO Google-mania on the rise, the very public launch Amazon's creative solution for outflanking Google's squishy ball entrepreneurs, and tody's announcement that Bill Gates has released the hounds on Google.
And we thought that what looks to be the greatest economic rebound in two decades was going to be the most exhilarating sign of things to come. Silly us.

J&J's Three Mile Moment

Now is a Three Mile moment for Johnson & Johnson. Sixty people have died. The FDA is on its case. Its greatest success story of 2003 is on the ropes. And shares in J&J have rebounded slightly from their lowest point in over a year. Sure it may be the "world's largest and most diversified health care company" consisting of pseudo-latinate corporations such as Ethicon, Centocor and Cordis among others, but in the end of the day Johnson & Johnson most powerful perceptual position is less about biotech and more about its role as protector of the "mother-baby" bond. General Robert Wood Johnson intuitively understood this and drafted J&J's famous Credo to insulate J&J's unique focus from the fuzzying effects of multinational delusions of grandeur. The credo has been revised over the years, but the principals remain intact. The credo provided a gameplan to then Chairman Charles E. Burke during the Tylenol Scare nearly twenty years ago. Today's Chairman & CEO of J&J, William C. Weldon is the newest keeper of the credo and he is faced with an issue that may be even more dangerous to the long-term viability of the company than that faced by Burke. Arguably his most valuable constitency (physicians) has been given reason to doubt J&J. We believe that Weldon missed an opportunity live the credo and pre-empt the FDA report by taking the bad news public himself. What could have been framed as the responsible actions of a confident company, has been characterized in the press as just another example of the careless profiteering so common among "big companies". Weldon's next move will be just as critical. Will he make a public mea culpa and take the defective stents from the market (as any responsble mother would do and his credo demands) or will he be influenced by his financial stakeholders (Wall Street) and follow in the footsteps of Coke and another great brand killing moment of late? Only time will tell. We hope that he lets the credo be his guide.

TiVo, Part the Second: TiVo Shakes Up The Advertising Industry (But More Importantly, How?)

****NOTE: THIS ARTICLE WAS ORIGINALLY PUBLISHED ON AUG 23, 2003 ON OUR OLD WEBLOG, HTTP://P9THINK.BLOGSPOT.COM.*****

Here’s how in love we are with Tivo: not only is it impossible for me to stop telling (boring) my friends with tales of its coolness, but we feel compelled to write a second blog about it, a scant two days after our first TiVo-related story!

After finishing our last blog regarding how TiVo will do in the face of new competition, we started wondering what effect TiVo would really have on advertising. Does TiVo spell the end of television advertising as we know it? Will TiVo and PVRs be subjected to a dozens of legal challenges from advertising agencies and television networks, eager to protect their advertising revenue streams, in a situation which resembles the Recording Industry Association of America’s current war on file-sharing? Or is the issue more complicated—and potentially more interesting or lucrative—for advertising agencies? After thinking the issue through, we’re convinced that TiVo may ultimately prove to be a financial boon for advertising agencies, particularly great ones. (We’ll get to exactly what constitutes a great advertising agency in a few paragraphs.)

The conventional wisdom suggests that advertising agencies are in pretty tough against a machine that enables the viewer to skip the product (tv advertising) they sell to their clients (marketers). Usually, when TiVo’s effects are discussed in the annals of business, it’s positioned as a doomsday device that will (almost certainly) pose the end of the advertising agency as we know it. This perspective is best-summed up by a recent article in BusinessWeek, which declared in the overly-dramatic and over-hyped fashion that’s a hallmark of that magazine: “Coming Soon: A Horror Show For TV Ads.” . The article goes on to describe that thanks to TiVo’s ability to collect highly precise information on the television watching habits of its viewers, it’s becoming apparent that (surprise!) most viewers skip through ads, particularly on the most popular shows:

TiVo's initial data reveal some trends that ad agencies and networks might prefer to bury…On April 11, 2002, ABC's popular TV drama The Practice drew a TiVo rating of 8.9, meaning 8.9% of TiVo owners watched the show live or recorded it and watched it later. But those viewers watched just 30% of the ads shown.

In other words, the early data from TiVo suggests that advertisers face a big dilemma: it’s exceptionally hard to get large amounts of viewers to turn into an ad, as viewers of popular shows (like the Practice) will tend to skip ads altogether.

An additional finding of note from TiVo’s data is that “event” programming (e.g. sports, reality TV, awards ceremonies) has a much higher percentage of viewers who watch ads than “episodic” television content (e.g. narrative tv shows like Friends, The O.C., or our personal favorite, Diff’rent Strokes.) Here’s BusinessWeek on the subject:

Certain genres are "stickier" than others, TiVo's research shows. Big-budget situation comedies and dramas tend to have the lowest retention and commercial-viewing rate because couch potatoes tend to record them and skip through the commercials rather than watch them live. Reality TV, news, and "event" programming such as the Oscars do significantly better at getting viewers to see the commercials. Just 39% of viewers watched ads during the highest-rated network TV show, Friends, vs. 75% for the 45th Annual Grammy Awards and 58% for Fox reality show Fear Factor.

This finding suggests that its much better to spend advertising dollars on “event” programming than it is on Friends, as marketers can be more assured that the eyeballs they’re paying for are more likely to actually watch the ads. Of course, this discovery—assuming its corroborated over time with more data—will also significantly increase the price that networks charge for advertising slots on these programs, making them inherently riskier (due to the need to justify the larger initial investment) for marketers buying spots on these channels. In turn, this places a greater burden on the advertising agency to show that the expensive spot delivered at this time actually delivered what it was supposed to (awareness, recall, and ultimately, sales and loyalty). The bad news here is that as of yet, nobody’s been able to develop an industry standard of actually measuring what constitutes ROI for an advertising campaign.

So are advertising agencies up the creek without a paddle? A particularly ominous prediction from the usually-reliable Wall Street Journal about a PVR study from Forrester Research says that they are. (Unfortunately, the complete Wall Street Journal article is only available in the WSJ archive, for the princely sum of $2.95. The complete citation of the article is at the end of this blog.) Last year, Forrester polled 112 marketing execs (including the heads of marketing at P&G, General Motors, and Coca-Cola), and learned that 76% of them planned on reducing TV outlays “significantly” when PVRs reached 30 million US homes. Although there are only about 3m PVRs currently in US homes, that number is increasing quickly, thanks to cable companies eager to bundle them into set-top boxes, and Forrester projects that we will reach the 30 million number before 2007. We’d also be willing to bet that as more data about how the relatively scant attention viewers pay to (most) TV advertising begins to filter out from the good folks at TiVo, the more likely it is that marketers start paying much closer attention to their TV advertising budgets.

It’s our perspective that although TiVo poses a significant challenge to the advertising industry, the increased prevalence of TiVo and PVR’s will likely result in a culling of the herd of advertising agencies, rather than resulting in the extinction of all television advertising as we know it. Moreover, we strongly believe that for some advertising agencies—even some agencies that concentrate exclusively on producing tv advertising—will actually see their profitability increase over the long run because of TiVo.

Why do we feel so strongly that the threat of TiVo is a little bit overstated? First, let’s examine the facts: although many TiVo users (ourselves included) utilize TiVo to fast-forward through ads, it’s important to note that we don’t fast-forward through all ads. The data BusinessWeek cites bears this out, too: even if only 39% of viewers watching Friends on their TiVo aren’t skipping through ads, that’s 39% of viewers who are actually choosing to watch ads (or choosing to watch the ads that they like). Secondly, people were skipping through ads long before TiVo, either by channel surfing through commercial breaks or by simply leaving the room to pursue alternative activities (making a snack, using the phone, going to the bathroom, etc). The difference was that in the pre-TiVo days, the existing ratings systems (Nielsen) had no way of capturing or measuring this viewer behavior. Consequently, when marketers purchased television advertising, they were essentially making a leap of faith and hoping that television audiences stayed tuned in during the advertising slots that they had bought. The only difference in TV advertising in a pre-TiVo and a post-TiVo world is that now marketers can better determine whether or not the ads that they’re buying are being tuned out, or listened to.

TiVo’s ability to measure and report (with a greater degree of accuracy) whether or not audiences actually watch commercials is what makes it as much of an opportunity for ad agencies as it is a threat to them. With TiVo, it suddenly becomes possible to accurately measure how good an agency really is: can an agency or specific creative team consistently deliver advertising that viewers want to watch, or does an agency consistently create advertising that viewers choose to ignore (fast-forwarding through it, skipping it, etc)? In such a world, advertising agencies will be priced by the marketplace in a different fashion: good agencies will receive top dollar, and average ones will receive less, and bad ones…well, bad agencies probably won’t be long for the world. It should also be noted that since TiVo and PVRs makes it harder to create audiences for commercials (by allowing people to opt-out of advertising more effectively than ever before), the price of good advertising that can deliver an audience should also increase (as a function of scarcity and the law of supply/demand). In other words, agencies that excel at create advertising that “works” (e.g. advertising that people tune in to) will not only be able to charge more than their competitors, they should see their ability to generate revenues soar. Much as television stars that could “guarantee” a big national audience saw their value skyrocket through the 1990s as it became harder to assemble such an audience due to the proliferation of cable channels and other media—consider the ever-increasing salaries of the cast of Friends, top-flight agencies will be able to extract significantly greater value from their buyers than in previous eras.

There are two catches with the scenario outlined above. First, there will be a lot of bloodshed in the advertising industry over the next five to ten years, particularly for agencies that specialize in television advertising. This is largely because of the fact that the market for quality in the advertising world is uneven—while all agencies are created equally, not all agencies are equal in terms of their ability to create advertising viewers want to watch. At a certain level, the buyers of television advertising services seem to have realized this, and the rumblings of a shakeout can already be heard. Consider Coca-Cola’s decision to shift its TV advertising from McCann-Erickson to the reputedly more creative, and much smaller, boutique agency Berlin Cameron/Red Cell agency last November. Obviously, we’re hypothesizing that a “more creative” agency might be better at creating “more interesting” ads that are consequently less likely to be fast-forwarded through by viewers. Regardless, however, Coca-Cola’s decision to go with a smaller, “edgier” agency has recently been mirrored by several large firms—such as Sun and Coca-Cola’s own Sprite division—who’ve sought to relocate their creative work to other such stylish boutiques. At the very least, the growing trend to go with shops that look more “creative” signifies growing client dissatisfaction with the current status quo of agencies and a desire for more effective television advertising.

The second catch is that while advertising that can deliver an audience to marketers will dramatically grow in value, it is less clear as to who will ultimately capture that increased wealth within an agency. Although agencies would ideally like it ensure that they increased ad spending, the real question at hand is, who is ultimately responsible for creating consistently great advertising: the entire agency, a creative team, an individual within the creative team (a great copywriter like Bill Bernbach, for example), a savvy account planner, or another party altogether? If great advertising is the product of an entire agency, than the agency will get to receive the spoils of client spending. If, however, it becomes apparent that such advertising is more the result of one part of an agency than another—a great copywriter, or a planner who can consistently intuit what a customer segment needs, and how to best reach that segment—than the pay scales of advertising agencies will change significantly. In this scenario, since such talented individuals will be able to move quickly between agencies, or simply sell their services directly to clients, they will capture virtually all of the value of increased client spending on advertising.

In closing, TiVo doesn’t portend the end of advertising as we know it. What it does portend, however, is a fascinating shift in the economics of advertising itself. Most importantly, TiVo will ensure a Darwinian shake-out amongst advertising firms that choose to specialize in selling television advertising itself, with the best firms surviving, and the worst dying out. In short, it’s clear that the advertising world is going to get much more competitive in coming years.

(The citation for the Wall Street Journal article mentioned in this article is as follows:
Vranica, Suzanne. “Technology Confronts TV Marketers—Economics May Change As Consumers Use Devices To Shift Time and Skip Ads,” The Wall Street Journal, November 26, 2002. You can find the archives for the Wall Street Journal here.

Overpowered by Tivo

****NOTE: THIS ARTICLE WAS ORIGINALLY PUBLISHED ON AUG 21, 2003 ON OUR OLD WEBLOG, HTTP://P9THINK.BLOGSPOT.COM.*****

Over the weekend, we (finally) hooked up our brand-new TiVo. Ordinarily, the installation of consumer electronics products is a pretty mundane activity, and not a very blog-worthy activity at that. However, in case you hadn’t heard from the growing course of TiVo fanatics (a roster that includes publications like the Wall Street Journal, cult leaders like Oprah Winfrey, and fictional characters like Miranda from HBO’s Sex in the City, TiVo is a revelatory, life-changing, and even epiphanic experience.

Although most American consumers currently consider TiVo’s and personal video recorder (PVR) technology to be little more than a souped-up VCR that uses a hard-drive rather than tapes, there’s actually much more to it than that. (You can find a reasonably decent demo of what a TiVo actually does by clicking here, if you prefer visual descriptions to written ones.)

First, TiVo has a variety of interesting bells-and-whistles—the ability to “pause,” (to answer a call, go to the bathroom, or gorge yourself on food), “fast-forward,” through commercials and “rewind” through live TV, a feature that works via a buffer in the TiVo hard-drive that records the channel you’re watching as you watch it. Secondly, TiVo has an interesting feature that recommends shows and TV events to viewers based on their viewing habits—imagine Amazon’s “Users Who Purchased this Item” feature applied to TV programming—enabling non-Entertainment Weekly reading viewers to quickly get up to speed on pop-culture.

However, the most compelling feature TiVo offers is that it not only records TV, but it does so via a remarkably easy-to-use interface that allows you to easily record what you want to watch, and then access that content at a time that’s convenient for you. In short, the TiVo achieves what VCRs were supposed to accomplish way back in the day: the simple recording of television programming. For most Americans, VCRs have been “recorders,” in name only: although it’s theoretically possible to record tons of TV programs with a VCR, most people don’t do so due to the complexity of programming the VCR, and the cumbersome nature of videocassettes themselves. And when people do record TV, they usually record the channels that they’re watching at that time. Consequently, for most people, VCRs have existed primarily as VCPs—video cassette players, used mainly to play movie rentals, or home movies created on a different device altogether.

The recording feature of TiVo is great simply because it’s so liberating. We stopped watching large bursts of TV about a decade ago, not because we hated the quality of programming, or because Iwe're anti-pop culture Luddites, but simply because we're almost always been preoccupied or busy with work, school, or a social life during the prime-time hours during which the lion’s share of worthwhile TV happens to be aired. Since that time—e.g. prior to TiVo—most of the episodic TV (the Sopranos, Six Feet Under, etc) we watched has been on DVD. In any event, it’s hard to describe how amazing it is to finally be able to watch television programming that was previously unavailable due to a hectic schedule—after just four days of having convenient access to Sponge Bob Square Pants, The O.C., The Office, Queer Eye for the Straight Guy, etc, it’s simply thrilling to be plugged back into the mainline of pop culture. Not too mention the fact that it’s a pleasure to finally be able to watch the cream of the television show crop, and not have to settle for the chaff that’s regularly on.

Obviously, PVRs is vastly superior to any substitute product used to currently record television programming, such as a VCR. Furthermore, from the perspective of consumers, it’s pretty clear that TiVo is, to use Dave Eggers-style random capitalization, A Truly Great Thing! Whether it’s a great thing for investors, however, and moreover, whether it’s TiVo that ultimately wins the coming battle for dominance in the PVR marketplace between cable and satellite companies and giant consumer electronics firms, remains to be seen.

Recent analyst reports—not too mention the current consumer buzz in the marketplace—suggest that PVR’s like TiVo are on the cusp of mass acceptance. The technology consultancy Forrester Research projects that 14m PVRs will be in use by the end of 2004; TiVo’s own projections, according to its SEC filings, call for its subscriber base to rise to more than a million (from 703,000 users today) by January 2004. Meanwhile, the prevailing conventional wisdom in the consumer electronics world suggests that PVRs look like they will be the DVD player of this Christmas season. The growing size of the marketplace, coupled with the fact that technological barriers to entry are especially low—a PVR is effectively just a combination of a hard-drive and software of average complexity—has ensured that TiVo is facing increased competition from a collection of electronics firms and cable companies eager to capture TiVo’s revenues for themselves.

With increased competition, the threat to TiVo will increase substantially, especially since its most recent quarterly report (released in April) reveals still mounting losses at the firm--$7.8m on $26.5m in revenue. (TiVo’s latest financial reports should be coming out later this week.) It’s hard to see how these losses can’t do anything but grow given TiVo’s current model, which sees revenue being generated by sales of hardware (which the firm is considered by analysts to break-even on) and “subscription” revenues (users pay a monthly fee of $12.95 or lifetime fee of $300 to receive TV listings that allow the easy recording of TV programming.) Increased competition will almost certainly lower prices of PVRs, perhaps pushing TiVo’s hardware sales from a break-even revenue stream into a loss-generating one. Competition will also likely cut the fat out of the hefty subscription fee (the one element of TiVo that we found hard to swallow, incidentally), which should also pose a challenge to TiVo's efforts to turn a profit.

Moreover, the new competitors TiVo is starting to face have advantages that TiVo will have a difficult time matching. Large consumer electronics firms have more complete distribution systems, and greater clout with retailers like Best Buy and Circuit City. Cable companies have the advantage of being able to bundle PVR functionality into their set-top boxes, which thereby reduces the complexity of installing the system, and ensures that it will work seamlessly. (This is happening much more quickly than anticipated—AOL Time Warner is currently rolling out PVR cable boxes to subscribers in areas that it covers. And given the positive feedback it’s receiving from users—check out this review from the popular blog-site Atmaspheric –things look good for such offerings.) Due to the fact that TiVo isn’t particularly asset rich—it has just $57 million in total assets, of which just $39 million is cash, according to its April filing—things look pretty challenging for the company.

The good news for TiVo is that its business model and strategy has anticipated the commoditization of the PVR marketplace for some time. The company has always stated its desire to outsource the manufacturing of TiVo’s to consumer electronics partners such as Sony and Toshiba. In its reports and presentations, TiVo reveals its primary focus to be the “service” side of the business. The service side of the business is composed of two elements. The first of these is providing TiVo software to manufacturers, software that allows the easy recording of TV programs, enables users to record entire seasons of TV shows, and (most importantly, as we’ll discuss in a moment), TiVo’s semi-famous “recommendations” system, which allows viewers to easily find content based on their viewing habits. The second component of TiVo’s business model calls for providing information about viewers to advertisers, enabling advertisers to better understand who they’re reaching, and how their advertising is being consumed (if at all).

Can TiVo’s changing business model withstand what’s sure to be intense competition? The first component of TiVo’s business model—emphasizing the software component—will shield it somewhat if it turns out that creating the TV guide software, and the content programming, is much harder and more expensive than consumer electronics firms and cable companies seem to think it is. In our perspective, although TiVo’s software and interface is very easy-to-use, it doesn’t look like it will be too difficult for any new entrant to copy. Its recommendation system might be harder for any potential competitor to mimic, since the system relies on understanding viewing habits of existing customers, and then applying slightly more sophisticated data mining or cross-filtering software to that data, and finally making recommendations to users. However, anecdotal evidence and our experience suggests that TiVo’s recommendations—while fun—aren’t really as useful as you’d expect. Most viewers are already aware of what they’re missing, thanks to the cornucopia of media programming about television programs (e.g. Entertainment Weekly, Entertainment Tonight, and various online websites), and can easily find this content without a recommendation service. It is therefore unlikely that TiVo’s recommendation system will protect it from competitors.

The second component of TiVo’s model—selling data to advertising agencies and firms that want to reach their customers—is potentially much more powerful, and possibly much more lucrative. As TiVo already has the largest database of subscribers in the PVR marketplace—about 40% of what is still a fragmented marketplace—and because it has emphasized data-mining from day one, it has a much richer database and understanding of its viewers than any other one of its competitors. Building up such a detailed database, being able to use it effectively, is very hard to do, as most retailers who tried to compete with Amazon (Target, Toys R’Us, CD Now, Virgin, etc) have found out. (We’ve talked about this issue before, here.) It’s also clear that TiVo’s data is potentially much more valuable to advertisers than its competitor in this area—Nielsen—since unlike Nielsen, TiVo has a much deeper sample size, a better way of recording viewing habits (electronically versus forcing viewers to complete notoriously inaccurate viewing diaries) and moreover, an exact understanding of what advertisements viewers actually watch. (Nielsen doesn’t account for channel surfing during commercials, whereas TiVo can provide precise detail about such activities.)

However, the big hurdle TiVo faces selling its customer data is migrating the advertising industry to what’s clearly a better product, but one that will likely face ongoing advertiser reluctance. If, for example, TiVo’s data reveals that television advertising is largely ineffective, how likely is it that advertising agencies will want to use it, given that the current industry practice calls for agencies to receive approximately 15% of client billings, and TV advertising happens to be the most expensive form--and therefore most profitable, from an agency's perspective--of advertising around? Secondly, despite the fact that TiVo counts virtually all the major TV networks amongst its investors, how thrilled would those networks be when forced to tell the advertisers buying ad-time that most viewers simply fast-forward through or skip ads altogether when using TiVo? Perhaps TiVo will succeed in developing new subscription models to overcome these potential pitfalls—viewers who don’t want to pay a subscription fee will be unable to fast-forward through commercials, for example, or perhaps TiVo will be able to utilize broadband technology and its data to push relevant ads to users who’d actually want to watch them—but in each case, it’s likely to take time. And for a company that doesn’t have much cash on hand, and isn’t currently profitable, this poses an ongoing and growing challenge.

The one thing that TiVo has going for it right now is phenomenal awareness and buzz. TiVo, like Kleenex and facial tissues, or Xerox and copiers in the 70s, is in the eyes of many consumers, is inseparable from the category it currently dominates, PVRs. Yet history is also littered with companies that initially had great awareness, but ultimately lost out (the just-cited example of Xerox!). The biggest obstacle TiVo faces right now is its ability to complement its brand with a viable business strategy. As TiVo lovers, we hope they accomplish this goal.

Hell Freezes Over For Apple, Part the Second

Yesterday we talked about the challenges Apple’s iTunes faced—razor thin margins, likely price competition due to the raft of new competitors entering the market—and briefly assessed the wisdom of Apple’s desire to use iTunes as a “Trojan horse” with which to spur iPod sales. (See this article for to hear the official Apple position on this decision.) Today, we’re going to subject the iPod to the same rigorous scrutiny and analysis, in order to argue that while the iPod is indisputably a cool product, it’s highly unlikely that it will be able to retain its present levels of profitability. We’re confident in this assumption for two reasons. First, Apple’s success in the market for MP3 players has attracted a wide array of large and small manufacturers who are gearing up to compete on the basis of cost, which will likely trigger a price war in this industry. Secondly, Apple no longer has the exclusive rights for the key resource fuelling the iPod’s success—an ultra-small, 1.8 inch hard-drive for Toshiba—a fact which will enable a variety of competitors to easily knock-off the iPod’s innovative design.

There are three main types of MP3 players available on the market: flash-based MP3 players, CD-based MP3 players and hard-drive based players. Flash-based MP3 players—like Creative’s Nomad Muvo NX—
tend to be extremely small in size (think slightly smaller than an cigarette lighter) and fairly durable, making them ideal for, say, jogging or working out at the gym. However, their small size and durability comes with the tradeoff: these players typically can’t hold too much music (roughly 2.5 hours on a 128 MB player) and moreover, if you’re a hardcore audiophile, the sound quality of these devices tends to be closer to tape than to CD. They tend to be priced in the $100-$200 range. Although these devices have a future, their relative lack of functionality, and easy-to-replicate technology (most of these devices now run off of USB drives) mean that these devices will probably fall substantially in cost over the next year or two with competition, making it very difficult to generate profits selling these items.

CD-based MP3 players—such as the Panasonic SL-CT800 —are essentially MP3 players that are capable of playing MP3s directly off of a CD. Where’s the fun in that, you ask? MP3 CDs are advantageous inasmuch as they can contain as much as 720 MB worth of music in MP3 form—e.g. about 15 hours of music per disc—as opposed to conventional CDs, which play about 74 minutes. Secondly, MP3-based CDs are customizable, enabling users to create 15 hour mix tapes for themselves and their friends! The downside is that these devices tend to be large and cumbersome, with plenty of moveable and breakable parts—just like real CD players! Additionally, while 15 hours of music sounds like plenty of music, it isn’t enough to accommodate most users CD collections. Consequently, CD-based MP3 players aren’t a particularly compelling long-term product to manufacture.

The most popular segment of the MP3 market—and the market that the iPod dominates, with 31% market share—are hard drive based MP3 players. Hard drive based players have been around for a few years—ever since Creative launched the 6 GB Nomad Jukebox in the summer of 2000—and were initially appealing to hardcore music fans who needed a way to lug a large music collection around the world with them. (Early hard-drive based MP3 players could hold as much as 120 hours of music—a pretty impressive amount.) However, these early players sounded much cooler than they actually were—they suffered from atrociously short battery life (about 2.5hrs to 4hrs), were very large and bulky (making them inconvenient for travel or use on the go) were fairly fragile (if dropping a CD player was bad, imagine dropping a hard-drive!), and suffered from overly slow and cumbersome interfaces. Even despite these limitations, there was a fairly receptive market for a hard-drive based MP3 player, and a fair number of users shelled out $300-$500 for the early versions of these devices, eager to fill them up with MP3s from their collections and other unnamed online sources.

Apple was one of the first significantly big and reputable firms to see the possibilities of hard drive-based MP3 players. Recognizing the fact that there was a market willing to part with a significant chunk of change for what were then relatively mediocre products from the likes of Archos, Creative and Rio, Apple decided that it could capture substantial market share by launching a similarly priced, but well-designed product. Rather than using the conventional hard-drives that its other manufacturers like Archos or Creative used in their devices, Apple used an exclusive Toshiba-made hard-drive that was inifintely smaller, lighter and more power-efficient than anything then available on the market. This drive enabled Apple to create the iPod, which was “smaller than a deck of cards,” (meaning that it was easy to move) housed in a stylish white casing (making it a fashion accessory, rather than geek chic), and offered vastly longer battery-life (thereby giving credence to the claim that hard-drive based MP3 players really could let you take your entire music collection on the go). (If you’re interested in learning the whole design history of the iPod, DesignChain.com has a great article on the subject here.)
At the same time as it was improving the hardware, Apple excelled on the software side, incorporating an extremely easy-to-use interface (interface design being one of Apple’s consistently strong points) for the iPod, and allowing the iPod to play Apple’s proprietary AAC music file format, which was far and away the best sounding digital music file-type available. All of these factors combined to ensure that the iPod was easily the best product to hit the market. And even better for Apple, it would be extremely difficult (at least initially) for competitors to copy, since Apple had managed to sign an exclusive deal with Toshiba to ensure it would be the only manufacturer to build MP3 players with the all important hard-drive which enabled the iPod to be another “insanely great” Apple product.

The rest, as they say, is history. The iPod was launched in the spring of 2001 (you can read a chronological history of the product here) and was an immediate hit. Since then, its importance to Apple has only increased: according to Apple’s most recent quarterly report (Oct 15 2003), the iPod contributed approximately $121m to Apple’s revenue in the 3rd quarter of 2003. Moreover, because Apple had exclusive rights to the Toshiba hard-drive that made the high-quality of the iPod possible, it could price the iPod at a premium far greater than competitors (a 20GB Creative Zen costs $242, compared to $388 for a 20GB iPod—you can compare them here– in other words, the iPod is about $150 more than an average MP3 player in the market), making it a disproportionately significant to Apple’s net income. (It’s estimated that the iPod contributed as much as 25% of Apple’s net income last quarter.)

While competitors couldn’t copy the style and features of the iPod at first, they eventually began to close the gap. Creative launched the aforementioned Zen a year or so ago, and has gradually been able to get it into an iPod-sized casing. Rio launched the ultra-light and small Nitrus, and although the device offered less storage than the iPod (1.5GB, or about 30 hours of music), it featured much longer battery life (up to about 10 hours). Meanwhile, high-end Japanese MP3 player and geek fetish object manufacturer iRiver recently launched a 15 GB player—the iHP-120—at the same price point as the 20GB iPod, but with one critical difference—its machine plays for a staggering 16 hours (as opposed to the iPod’s six), is more durable than the iPod, and simply looks damn cool. Thus, it looks increasingly likely that Apple may have created a market—generating awareness for the sophistication and usefulness of well-designed hard-drive based MP3 players—only to find itself competing in a price war with firms who’ve skillfully copied most of the benefits of the iPod. And a price war certainly seems to be what Apple’s competition desires: read this comment from Creative’s President, Craig McHugh: "We've been positioning our products to [cost] 30% less than a competitive iPod.”

Meanwhile, the device that facilitated the iPod’s creation—the Toshiba hard drive we mentioned earlier—is now off of its exclusivity deal. (Read this Business Week article for complete details.) meaning that the only uncopiable feature of the iPod is now publicly available to competitors. This fact appears to have motivated bigger players like Dell and Samsung to get in the marketplace—now that they can use Toshiba’s ultra-thin and small hard drive technology (Makes you wonder if Toshiba will capture all the value in this game, huh?) , they can create a machine to rival Apple’s and potentially dominate the competition given their—particularly so in Dell’s case—low-cost manufacturing capabilities.

Given the surge in competition and the loss of one of the key resource that’s driven the iPod’s profits for the last few years, Apple launched its online music store to help try and spur iPod sales. As we discussed yesterday, songs purchased via iTunes can only be played on iPods, and the goal of making iTunes iPod only primarily seems to be to provide the iPod with something that its competitors can’t copy. In short, what it seems Apple is trying to do is create barriers to entry—get so many people to buy iPods instead of competitors products, that those owners will be forced to go iTunes-only for their music fix online. Ideally, this will create a network effect, where each person buying a track on iTunes will be forced to purchase an iPod to play the song, and vice versa, to the point where Apple’s current market share in the MP3 market—31%—grows to the point where Apple has locked up the digital music market.

Accomplishing this goal—becoming the OS of digital music, in effect—requires two things: time and money. The problem for Apple is that it has an abundance of neither. Although Apple can pour a ton of money into a great advertising campaign in an attempt to build awareness, and hopefully send iPod sales into the stratosphere, in a few short weeks, Dell will be on the market with its iPod knockoff. Moreover, it’s unlikely that Microsoft will be willing to cede the opportunity to control digital file distribution—which would be the result of iPod winning the digital music game, thanks to the fact that iTunes sells downloads in Apple’s proprietary AAC format. While Apple has some cash on hand (about $3.4 billion in cash and cash equivalents, and another $2.6 billion in its remaining current assets), it has nowhere near the amount of cash Microsoft has ($42+ billion and counting), meaning that it would have a hard time spending its way to control of the market, something that Microsoft could easily do.

So what should Apple do? We’re not so certain if they can do anything, to be honest. While we’d love to see them win—we have to admit, that over the course of writing about Apple and the iPod for the last week or so, we’re really impressed with how cool the iPod is. (Does that mean we’d buy one right now? Probably not—we’re, uh, eagerly anticipating the price competition that will occur over the next few weeks to pick up an iPod at a more Apple-shareholder unfriendly price.) Some quick thoughts before we jet on out of here for the weekend: Apple could sell the manufacturing rights for the iPod to somebody who could make a go of it (e.g. Dell) in a price war, and try to sell as much as they possibly can at the lowest price as possible. While Apple would lose the short-term revenue from the iPod (which we’d guess is gone, anyways), they might get the long-term benefit of owning the digital standard for media files (which could be worth way more, anyways). However, this strategy of allowing a third-party to manufacture something was tried once before by Apple in the 90s with the Mac, and failed dismally—there’s probably some cultural resistance to doing this @ Apple. Secondly, Apple could sell the AAC format to Microsoft, and try and convince Microsoft to use the far-superior AAC format over WMA as the de facto file sharing device on the Windows OS. This would mean that Apple would forgo the long-term revenue from AAC, but could make its money as a manufacturer of superior, well-branded MP3 players. Although a deal with arch-enemy Microsoft seems unlikely, who knows? We kinda like the idea, and besides, hell’s already frozen over once.

Hell Freezes Over for Apple, Part One

Last week (October 16, 2003, to be precise) Apple launched the long-awaited PC version of its much lauded, and so far, very successful iTunes subscription-based music download service. The launch was accompanied with plenty of fanfare in the mainstream press for a variety of reasons, not the least of which is that iTunes is something of a revelation for the music industry in the sense that it actually gives music fans what they want: legal downloadable music with limited restrictions in an easy-to-use and understand package. Moreover, the fact that Apple released an iTunes for the windows-based world was seen as a shift of strategy on the part of Microsoft-hata Steve Jobs, a fact that Apple’s marketers cleverly manipulated to their own advantage, advertising iTunes for the PC with the great tagline, “Hell Freezes Over.” Financial and industry analysts also praised Apple for this move, because although iTunes has been a success thus far—selling roughly 13m tracks at $0.99 a pop since its launch—its “Apple-Only” distribution strategy meant that the market for it was rather limited. (Apple’s machines comprise roughly 3% of the PC market, according to this article, whereas Windows PCs are a vastly larger market, meaning much more potential iTunes subscribers.) Even musicians had eagerly chimed in on the perceived greatness of Apple’s move, with Bono—of U2 fame, no less—stating that Apple’s move to PCs was an occasion for him to “kiss corporate ass”, which is something that he doesn’t “do for everyone.” (Excepting the producers of the Tomb Raider soundtrack, that is.)

However, despite the fact that iTunes is clearly a solid service—we just downloaded it, and it looks like a typically well-designed Apple product—it’s less clear whether or not it will be a boon for Apple over the long-run. The logic behind iTunes appears to be an attempt to be twofold: one) create a relatively profitable new sales channel (online music) and two) sell more iPods. However, after carefully considering the situation, we’re not so convinced that Apple’s foray into the wild world of digital music is a great bet for its shareholders. Not only is Apple’s position as a leader in the arena of digital music downloads looking less tenable as new competitors enter the market, both the markets for online music distribution and MP3 players looking like their headed toward destructive price-based competition that will only hurt Apple’s bottom line.

Let’s start by examining the market for digital music, and Apple’s position within it. Up until now, there has been very little competition for iTunes. In fact, when Apple launched the service in April, its competitors included such lackluster services as Rhapsody (an overly complicated, poorly-executed Real Networks/major label service that had failed to catch on), and popular peer-to-peer services like KaZaa or Grokster, where users could download music for free, but only at the risk of incurring the RIAA’s wrath and possible lawsuits. Little wonder, then, that when Apple launched an easy-to-use service, with an extensive catalog (200K plus songs at launch, approximately 400K songs to date) that it was able to capture the lion’s share of the market for fee-based downloadable music.

However, as has happened time and time again—consider as it did with GUIs, user interface, and hey, even MP3 players—iTunes revealed Apple’s skill in being to get a product and service just right, only to have its design choices quickly copied by competitors. Admittedly, the first service to copy Apple—BuyMusic.com htt kinda sucked—but newer services, particularly MusicMatch.com make downloading music on a PC just as easy—if not better—than iTunes. For example, not only does MusicMatch feature the same pricing scheme as Apple ($0.99 a track/$9.99 an album), it features a highly similar, very intuitive interface, and vastly superior editorial content (piping in album information and using collaborations from the All Music Guide, which is easily the most comprehensive source of music info on the web). Moreover, MusicMatch currently features the same number of songs as Apple’s iTunes service, and offers more esoteric or obscure content, which is a boon for music consumers like ourselves, who tend to avoid most of the mass market stuff sold on iTunes. All of these factors make MusicMatch a potentially better option than iTunes for music fans.

Although MusicMatch might not be able to best iTunes’—despite having what we think is a better product, the company is much smaller than Apple—it is merely the tip of the iceberg of in terms of the competition that Apple is about to face. Consider this: in the next few months, the following competitors will be entering the market for digital music: Microsoft, whose bottomless pockets give it the ability to fight a protracted price war, Dell, which plans on launching a service to support a line of MP3 players it announced mid-September, Amazon.com, whose extensive customer data and large amounts of site traffic make it easy to recommend and cross-sell music direct to users, and a revitalized, subscription-based Napster service, which has the advantage of a recognizable brand-name, with plans to have twice as many songs available for download at launch. Clearly, while Apple may have had a captive market to sell to in the Mac world: mac users had virtually no choice when it came to downloadable music—the PC world is shaping up to be a much different battleground. As a plethora of new entrants—each with a roughly identical product (music downloads from the same array of artists) enters the music download marketplace—competition on price will likely occur as each download service tries to gain market share at the expense of their peers.

The likelihood of price competition is compounded by the fact that any would-be players in the music download arena—iTunes included—faces razor-thin profit margins. Due to the fact that there’s effectively one source for content in this industry, artists and recording labels, with many potential buyers (each new download music service) gives content suppliers—labels and artists who control the rights to their music—substantial power over download services (it’s estimated that record companies collect as much as $0.35 per song downloaded). Meanwhile, marketing, administration and technology costs for each service are relatively high (and will likely remain so, as long as competition in the music download market continues to increase). Consequently, of the $0.99 you’re paying for each music track you download, ultimately less than $0.10 ends up as profit for a music download service, according to industry analyst Charles Wolf of Needham & Co.

Given the competitive forces of the online music download world, the key to long-term profitability seems, put simply, get big, fast and become the dominant player in the category. By achieving a pre-eminent position in the music download position, a firm like iTunes could theoretically demand better terms from content providers in exchange for providing them access to their audience, giving them a lower cost structure than competitors. Additionally, a leading position could also create a virtuous cycle for a player that would be very difficult for competitors to match—a leading player could demand exclusive rights from specific artists or labels who wanted to sell digital versions of their songs, which in turn would increase the customer base of a service, which would thereby give a download service greater clout to demand exclusivity from their artists, and so on.

In order to achieve this scale, and hopefully insulate themselves from competition, online music firms are using a combination of several different tactics. Some of these tactics include extensive marketing and advertising to build awareness, trying to secure as larger library of music than that of competitors or paying content producers to provide content exclusively to a specific service in order to encourage fans to use that service rather than competitors. Additionally, firms are also trying to compete by offering fans different levels of access or permission with respect to the songs they purchase or download: some firms offer generous rules on the number of times a specific track can burned to a CD, or alternatively, offer more liberal rules on the types of devices—computers, MP3 players, CDs—that the song can be played upon. (These “rules” are all enforced by technology-based copy protection.)

Apple’s strategy for iTunes appears to be twofold: aggressively outspending its smaller competitors—MusicMatch and Roxio’s Napster— in terms of advertising and marketing, while trying to sign artists to iTunes-exclusive digital distribution deals, either by luring them with Apple’s brand (the Rolling Stones) or by simply paying them for this exclusivity (Dr.Dre, the Eagles). These tactics are relatively smart for Apple right now—as it has significantly more cash and current assets than these competitors—it can easily outspend them or force them to spend more to gain traction. Furthermore, since it has a much larger market share than either of these rivals, it can spread these costs in a way that its smaller competitors can’t. Apple’s aggressive moves in these areas clearly highlight its desire to quickly build up an unassailable lead in the online music domain, and hopefully shield it from larger entrants—e.g. Microsoft or Dell—who could easily afford to outspend Apple in terms of advertising and marketing.

However, while Apple is doing well with utilizing marketing and signing artistis to exclusivity deals to support iTunes, the biggest flaw in Apple’s iTunes strategy is this: whereas other services like MusicMatch allow users to download music they’ve purchased to whatever device they’d like, no matter who it’s manufactured by, Apple is currently only allowing music from the iTunes store to be downloaded to iPods. This seems to put iTunes at a considerable disadvantage relative to its competitors—although it’s true that the iPod is the most popular MP3 player on the market, it should be noted that the iPod only has 31% of the MP3 player market. (And when you factor in the fact that the majority of iPod owners are also Mac owners, iTunes share of the market for Windows users with MP3 players is probably significantly smaller.) In other words, competitors like MusicMatch or forthcoming services from Microsoft and Dell have a huge potential leg up on iTunes when it comes to trying to gain share in the digital music market. The market for online digital music is still up for grabs meaning that Apple’s iTunes has yet to gain the market share that would enable it to sign up most artists or label to exclusive contracts, which is the one area that Apple could truly differentiate itself from its competitors in. Moreover, since iTunes’ competitors are roughly equivalent in terms of the service and features they offer users, the much greater flexibility that they offer users should help them steal share from Apple.

So what’s behind with Apple’s decision not to go the whole hog when it comes to providing iTunes users the same flexibility as competing services? We suspect that a large part of it comes from Apple’s desire to hedge its bets, given the current uncertainty of who will emerge as a leader in the online market world (or who will enter it), the tight margins associated with digital music download, and the she and the tight margins of the online music world and the profitability of its iPods. Apple likely recognized that it would be extremely to generate significant profits in the digital music market without maintaining a near-monopoly position in the marketplace. Consequently, one way to compensate for the riskiness of entering the digital music marketplace was to use the iTunes service as a means of hopefully selling more iPods, which have played a pivotal role in Apple’s success over the last two years. (It was recently revealed in a press conference that iPod sales were responsible for $12.1m of Apple’s net income last quarter [roughly 25% of its profits].)

We’re surprised that so many analysts see Apple’s use of iTunes as a “Trojan Horse” with which to increase iPod sales as a “good thing” or a “win-win” for each product. While there’s no disputing that the iPod is a great product, given its small market share (31% of MP3 players) we still can’t see how it allowing users to download from iTunes to iPod will enhance iTunes position in the marketplace. Furthermore, although the iPod is currently the leader in the world of MP3 players, it’s also relevant to ask whether or not it will be able to maintain this position in the face of much improved, and significantly cheaper products from competitors like Creative and IRiver, which threaten to erode the iPod’s profitability to consumer electronics product levels. (As we’ll discuss tomorrow in more detail, the iPod’s continued success is by no means a certainty.) Our best guess right now is that Apple hopes to somehow use iTunes as a means of insulating the iPod from price competition and vice-versa. While such a strategy sounds great in theory, it will be very hard to pull off successfully in a competitive marketplace. We’ll have more on this tomorrow.

Getting "Real" & Marketing In Publishing

"Authenticity" and "Marketing", not two words that most Americans are likely to pair with one-another. (Gallup suggests that advertisers/marketers are as trusted as HMO's and car salesmen) However, they are two words that we are increasingly fascinated by thanks to some powerful hypotheses posed by our own MJP. The key question? If the primary driver of brand strength is TRUST, then does marketing/advertising to an increasingly skeptical American population necessarily help forge stronger brands?
While we wrestle with this question, it is interesting to note that there is a movement afoot in advertising and marketing circles to embrace "guerilla/viral" tactics not simply because they are seemingly more cost-effective than traditional tv spots and magazine spreads, but because they are more effective from a targeted reach point of view...and arguably more authentic than mass. It isn't exactly rocket science. What is a more effective means of getting you to try a new product, a billboard or a recommendation from a friend? Whereas "guerilla/viral" marketing a la Malcolm Gladwell doesn't necessarily fill the coffers of traditional advertising agencies as efficiently as a solid, corporate image television campaign does, it has worked well for some of the most powerful brands on the marketing radar screen these days (Altoids, Mini). In fact, it is a lesson that NBC learned just last month. In fact, one could argue that as "guerilla" becomes mainstream in advertising and marketing circles, the way that clients measure successful advertising agencies is changing. Today, it is the small, "big idea" shop like a LBWorks and a Crispin Porter + Bogusky that has the "leg up" on the mega-agency.
Recent signs suggest that even the staid marketers in the publishing industry are jumping on the "authenticity marketing" bandwagon. No longer is trade marketing all about relationship building with the Barnes & Noble buyer or soliciting a good review from the "mass influencers" like Publishers Weekly and the Sunday Book Review. By leveraging the likes of viral movements like Bookcrossing, author-centered blogsites and even trade-book blogs a handful of maverick marketers for the publishing industry are starting to dip their toes in the "guerilla" pond of internet-based viral marketing. In fact, the UK's Guardian stated as much in Click Lit, earlier this month about Douglas Copeland's Hey Nostradamus! promo. Net/Net a select few in the publishing industry have finally realized that books sales have historically been driven by two factors, trust and word of mouth. It is nice to see that they are getting back to their knitting on the marketing front. Who would have thought that a few maverick marketers in the publishing industry would eventually be in a position to teach the P&Gers a thing or two about cutting edge marketing. In terms of marketing, the good old "one-to-one" referral is the "new" solution, "small" is shaping up to be more powerful than "big" and it is an exciting time to reinvent the rules of the games of advertising, marketing, sales and relationship building.

The N-Gage's Demise, As We Predicted

As our erstwhile readers may recall, a scant two weeks ago we predicted the imminent failure of Nokia's new handheld video game device/PDA/cell phone, the N-Gage. We hate to say that we told you so (actually, we kind of enjoy gloating, but keep it under your hat), but it looks like our assessment was right on target: early sales figures reveal that the N-Gage sold less than 5000 units in its first week on the market. These low figures are especially stunning in light of the amount Nokia spent to hype the product in the US (an estimated $117m), and are hugely disappointing when you compare the N-Gage's sales figures at launch to similar technology products. For example, Microsoft's XBox managed to sell 1.5m units on the first day of its launch in the United States at an identical price point to the N-Gage ($299), while Nintendo's GameBoy Advance handheld--the N-Gage's closest competitor--sold 540,000 systems in its first week of launch. Ugh. We're sure that the N-Gage launch team is keeping a low profile @ Nokia HQ in Finland right now, particularly when you consider that just days ago, they were telling anyone who'd listen that the N-Gage would easily sell several million units through 2004. For the handful of analysts who continue to think that Nokia is a good bet, we'd suggest that they try to remember when the last time that they'd purchased a Nokia product that worked well (we've had problems with every Nokia phone our cell carrier has saddled us with), and adjust their ratings accordingly.

Changing The Game: Puma & Mini

A close friend a Leo Burnett sent us two fascinating links today that have us buzzing around the office this morning. In today's business climate the timeline between innovation and commoditization is shorter everyday. The fruit of reverse engineering, globalization and the democratization of information, this trend has forced many a company/product to fail.

The name of the game is no longer purely "differentiation" within the category. To succeed today, companies must be flexible and willing to adapt BEYOND its category. Good companies may originate within an established category, but truly GREAT companies look for opportunities to CREATE THEIR OWN CATEGORY.

One company doing just that is PUMA. An established player in the athletic shoe market, PUMA has leveraged the 1970's nostalgia of its brand and morphed into the new hip hybrid in fashion apparrel. PUMA has moved from the number four player in a highly competitive category to the leader in a new category much of its own making, "athletic chic". No longer is Puma exclusively forced to compete head-to-head with the likes of Nike, Reebok and New Balance for the callused feet of sports fanatics. Puma has taken the time to understand its "meaning" (via customer segmentation) and has leveraged this knowledge into the dominant position in an equally lucrative (if not more lucrative) market populated by the likes of smaller, less well-financed players such as Vans and, most recently, Adidas.

And for a residual benefit to the dawning of the "athletic chic" trend/market, it will be increasingly difficult to pick out Americans on the Champs Elyses with their jeans and "white trainers".

Another company that has done a phenomenal job at crafting a niche category for itself is Mini Cooper. At the $16,000 to $20,000 price point, Mini could have found itself vying in the brutally competitive American automobile market witht the likes of the Ford Escort. However, Mini has zigged while everyone else zagged with "out-of -the-box" innovations like zero percent financing. Again, due to a bit of customer segmentation and an intuitive understanding of the various reasons that people "drive", Mini has laid claim to a niche previously owned by the likes of Mini's parent, BMW. The niche? The "ultimate drivers". Whereas, it was once believed only that "real" driving enthusiasts could appreciate the corinthian leather and fine craftmanship of the elite vehicles from Mercedes and BMW, Mini understands that there is huge opportunity with the under 20K "ultimate wanna-bes". The result has been that Mini no longer competes for customers who need to get from A-to-B for under twenty-thousand dollars. Mini competes alone for the subset of those individuals who drive not because they have to get somewhere, but because they want to enjoy the thrill of the road. Individuals who want to "motor". The residue of Mini's dogged pursuit of this previously untapped market, is that it has created a movement that has garnered micro-categories for "motoring gear".

One could argue that the recent success of PUMA and Mini are due to their obvious commonalities such as design innovation and co-branding. However, the true secret to their success is that both of these companies took the time to understand their market, their potential customer base and their respective places on these two planes. By understanding their unique "tapastries of meaning" relative to the competition, both Mini and PUMA were able to create wholly new categories that they alone could dominate.