Peacock Nine Blog

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.