Peacock Nine Blog

Rumors of NetFlix’s Pending Demise Are Greatly Exaggerated

One company we’ve always been impressed with is the DVD-rental-by-mail NetFlix. Various members of the BuzzSponge team have used NetFlix over the last few years, and each of them has raved about the convenience of the service. Consequently, whenever there’s an article in the business press about the company, we tend to take notice. You can imagine, then, that we read this morning’s Wall Street Journal article about NetFlix—portentously titled “DVD-Rental Firm May Be Victim Of Its Own Success”— with particular interest.

For those of you who aren’t familiar with the NetFlix business model, here’s a brief summary. NetFlix is a movie rental website that pioneered the concept of renting DVDs to customers for a flat monthly fee. Effectively, customers paid $19.95 a month to rent as many movies as they wanted, with the sole catch being that you could “check out” three movies at a time (if you paid a higher rate, you could rent more movies). You’d thus select a list of movies that you wanted to rent and place them in a “queue” of up to 10 movies, and NetFlix would subsequently mail the movies three at a time to you. When you were done with each movie, you’d simply mail it back to Netflix in a pre-paid envelope that came with the rental, and NetFlix would mail you the next movie from your queue. Customers flocked to this model, primarily because Netflix offered several things that brick-and-mortar video stores couldn’t: an astonishing selection of movies (since Netflix operates a few huge warehouses, rather than several dozen small video stores, they could stock a wider array of movies), an easy-to-use interface (searching for movies electronically beats walking through the local Blockbuster) and finally, personal recommendations a la Amazon.com (made possible by well-organized and executed customer data collection and “collaborative filtering”).

The upshot of all of this? NetFlix has been extremely successful, despite the wintry economic climate that we’ve suffered through the last few years, having managed to consistently turn a profit for over a year and a half. Perhaps more impressively, the company continues to steadily grow and gain market share, even in the face of new competition from firms like Wal-Mart and Blockbuster. As was noted in the WSJ, in its most recent 10-Q, Netflix managed to generate $72m of revenue, up to 25% from the prior quarter. Net profitability is still small—roughly $3-$5m a quarter—but steady.

The fact that Netflix is one of a small—but growing—handful of Internet businesses turning a profit has meant that its stock has skyrocketed this year (according to the WSJ, it’s up 322%; more than either Amazon [up 162.2%] or eBay [up 56.4%]), a fact that’s pushed it’s P/E ratio to stratospheric levels (95x’s this year’s estimated earnings). These facts have made Netflix a favorite target of business journalists when it’s time to write a story about the return of bubbalicious Internet stocks, and also a favorite for investment analysts eager for publicity. Today’s WSJ article was no exception to this trend, and proposed that a) Netflix is indeed proof of a bubble in Internet stocks and b) there’s no way that Netflix’s business will withstand competition from the likes of well-run businesses like Wall-Mart or badly-run businesses like Blockbuster and c) there’s no way that Netflix’s industry—DVD rental-by-mail will survive the coming consonance shock of video-on-demand. Nothing we haven’t read before.

We’ll leave the debate as to whether or not Netflix is over-valued for a later time—we’ll wait ‘til we have a few more finance classes under our belt for that baby—but we would like to take issue with the other two anti-NetFlix arguments on the table, namely those tired, old and square arguments that the firm will end at the hands of either new competition or video-on-demand.

Now that we’ve thrown down the gauntlet, let’s examine why new competitors—especially new competitors like Wal-Mart or Blockbuster— don’t pose much of a threat to Netflix. We’ve got three answers here. Most obviously, Netflix’s niche—film buffs who rent several movies a month—is vastly different than the more mainstream segment that either Wal-Mart or Blockbuster serves. Simply put, Netflix stocks a much larger array of the more obscure art house, foreign and critically-acclaimed films that its niche—film buffs—prefer than either Blockbuster or Wal-Mart, which carry more new releases and blockbusters than NetFlix does. This means that Netflix is shielded somewhat from price competition since its product isn’t really a close substitute to the product produced/rented out by a Wal-Mart. (Consequently, the fact that Wal-Mart’s decision to price its DVD rental service at a price $4.41 less than NetFlix’s probably hasn’t slowed NetFlix’s growth too much.) If Wal-Mart or Blockbuster were to try to go after the same film buff customer, they’d face the economic challenge of having a much smaller base of film buff customers to spread the cost of acquiring art house/foreign film over, since their own audience is pretty much middle American, with very few film buffs. Moreover, Wal-Mart and Blockbuster would face a huge credibility gap trying to win over the Netflix customer—after all, it’s not too likely that budding cineastes and film aesthetes would want to rent from a low-brow service like Wal-Mart, right?

Furthermore, it’s important to consider that the economics of the NetFlix model are vastly different than the Wal-Mart model. Since its customers rent several movies a month (meaning more postage costs, content, etc), NetFlix’s customers are lower-margin customers than the likely customers of Wal-Mart, who rent just a few movies a month. The fact that Netflix has figured out a way to serve these lower-margin, high-rental volume customers profitably—optimizing its service to its niche, and figuring out how to stock movies at its warehouses in a manner that enables it to meet demand most efficiently—gives it a huge competitive advantage over a Wal-Mart or a Blockbuster, who’d have to learn how to serve these customers from scratch. Finally, because the key drivers of Netflix’s costs-a national warehouse and distribution network—are already sunk, Netflix has a powerful weapon vs. Wal-Mart or Blockbuster to use should it be challenged directly in one market. Effectively, it can lower prices at a time when its total costs are low, while the challenger’s total costs are still fairly high, since the challenger is still building out and paying for its service. This means that Netflix can quickly turn Wal-Mart’s or Blockbuster’s challenge into an investment with negative returns.

We also believe that Netflix is fairly well protected against the challenge from video-on-demand. First, the content on video-on-demand—mainstream blockbusters—is probably less appealing to the Netflix customer than to the Blockbuster or Wal-Mart customer. Secondly, video-on-demand doesn’t offer quality and high-end features that the NetFlix DVD customer likely values—there are no anamorphic scan, no 6.1 channel sound, no “making of” featurettes or deleted scenes on a VOD product. Third, it’s also probable that the threat of VOD to Netflix is less imminent than the business press would like you to believe. Keep in mind that the supplier for both VOD and DVD content—film studios—has a vested interest in promoting DVD over VOD, since DVDs form the most profitable part of a studio’s revenues at present. As such, why would a studio rush to VOD when they still have the opportunity to harvest plenty of revenue from DVD?

Finally, even assuming that VOD ever matches the quality of DVD, and arrives in the market more quickly than we expect it does, there’s no reason to believe that this should be a threat to Netflix’s business model. Provided that Netflix’s management is adroit enough to anticipate when the change to VOD will occur, and assuming that they’re strong-willed enough to accept that the costs of their investment into DVD rental-by-mail at that time are sunk, and shouldn’t figure into their decisions, they’ll be well-positioned to take advantage of VOD. This is because of the fact that Netflix’s model gives it reams of data on customer preferences, tastes, and desires, and because of the fact that like Amazon, the company has done an exceptional job of mining and refining that data to understand who its customers are, and what they want. Accordingly, when VOD comes, Netflix will be in the enviable position of being able to cross-sell the VOD content its customer wants—high-end and more obscure films—far better than any of its current competitors, who are attuned to the needs of the straight-up, mainstream market (yo).

In summary, while it’s certainly true that Netflix might be overvalued at present, the arguments proposed by popular business press as to why Netflix’s success can’t continue are poor at best, and show very little grasp of either competitive strategy or economics. So don’t believe all the hype you read about Netflix. We think it owns a pretty tight little niche, and barring any stupid decisions on the part of its management, it should be able to maintain this position for quite some time to come.

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.

Disney’s Moviebeam: A New Media Distribution Channel With Revolutionary Potential

This morning, Disney announced the launch of a particularly interesting new technology entitled Moviebeam. (Incidentally, when was the last time you heard the words “Disney” and “cool new technology” used in the same sentence? It's certainly been a long time since we have.) On one hand, Moviebeam represents a very interesting and inexpensive means for media firms to develop a direct content distribution channel without having to spend billions to acquire a cable network, a la Time Warner. Secondly, assuming that Moviebeam is able to find subscribers, it has the potential to revolutionize the way we think about the distribution of film and TV entertainment, and render video rental stores like Blockbuster, video on demand (VOD) services from cable companies like Comcast and subscription rental services like Netflix obsolete.

For the last few years, there’s been a growing belief in the media industry that the future of media depends on the ability to control the distribution channel to customers. For example, part of the rationale behind AOL’s merger with TimeWarner was that AOL would be able to use the web to pump Time Warner’s music, movies and TV programming direct to consumers. Similarly, News Corporation's (e.g. Fox) forays into satellite broadcasting, and Vivendi-Universal’s ownership of Canal+ (a French cable network) largely represent the desire of media firms to control a distribution network that they can use to resell content to consumers. Not only would such a distribution network potentially increase a media firm’s ability to create value (by eliminating the middlemen of theater distribution, video rentals, or simply by creating an additional distribution channel), it would also provide media firms with a more effective means of generating revenue from their older content, by inventing a means to sell this content direct to consumers. (Generally speaking, sales of older content—e.g. backlist, catalog, syndication—offer media firms the highest margins, since the marginal costs on such sales are extremely low.) Finally, being able to own a distribution channel that permitted sales of video-on-demand might also provide a means of getting around the challenge TiVo poses to advertising revenues in the TV industry: viewers who don’t want advertising can simply purchase a subscription to their favorite shows over a VOD network, giving the revenue directly to the media firm behind the content.

However, as attractive as developing a direct content pipeline to the customer has been for media firms, it’s been insanely hard to accomplish for a number of reasons. Thanks to the limited number of Americans with broadband connections (although, in fairness, it should be noted that this number is actually starting to increase fairly rapidly), and a lack of desire to watch films and TV programming on computer screens, the Internet hasn’t lived up to its potential as a distribution mechanism. Moreover, because of regulatory rules and costs driven by scarcity and competition, acquiring a cable or satellite network for distribution has been prohibitively expensive for most media firms. Building a satellite network of one’s own to act as a distribution content—which was Fox’s solution—has proven to be exceptionally expensive. And media firms have been less than eager to partner with existing cable firms to deliver content digitally (via VOD services), in part because cable firms can use the inability of media firms to forward integrate into distribution as a position of power in negotiations, and capture most of the revenues from VOD sales for themselves.

Moviebeam is a particularly elegant solution to the challenge media firms face with developing a VOD network. It’s essentially a set-top box with a 160GB hard drive inside that receives digital content the old-fashioned way—over the airwaves. This avoids the high costs of having to build out or buy a cable or satellite network to distribute content, while creating a direct pipe to the customer. Subscribers to the service—rather than selling the box outright, Disney plans to charge consumers a monthly fee of $6.99 for the box, plus a per movie charge—can select content from all the major Hollywood studios (with the current exception of Paramount) over the Moviebeam service. The starting menu of films offers a range of recent blockbusters like Lord of the Rings: The Towers, Bringing Down the House, Die Another Day, and some older movies--about 100 movies in total, each of which are priced at $3-$4, or roughly the same price as a rental. The Moviebeam hard-drive offers interesting revenue possibilities, too, as viewers can theoretically pay slightly more to buy movies outright from and store them digitally. It’s also hypothetically possible that over time, Disney—or Moviebeam—can use the data it collects on viewing habits to determine your interests, and recommend films to you accordingly, thereby increasing sales (and selling from its backlist of titles). Finally, because the costs of adding a market to the Moviebeam service are so low—Moviebeam uses local TV stations to broadcast a signal, at a cost of approximately $250K a market—it’s conceivable that Disney could use the Moviebeam network to sell additional content like TV programming, music, or events, and effectively become a cable distribution outlet on its own.

The two biggest challenges Disney faces with Moviebeam is marketing yet another set-top box/consumer peripheral to consumers. Although the fact that Moviebeam is a set-top box that is plug-and-play is a great thing from an ease-of-use perspective, the fact that it’s a set-top box still poses a problem. For example, do you really want another box connected to the TV, after having already wired the cable box, the DVD player, the VCR, the videogame console, and the TiVo, to it? We think that Moviebeam’s pricing will go along way to ensure its popularity with consumers—a $6.99 rental is a small price to pay for the convenience of not having to worry about rental fees, and being able to order up top-caliber content from your living rooms—but Disney needs to develop creative ways to increase the attach rate of Moviebeam to TV sets. (Thinking aloud, perhaps bundling the technology inside new TVs via a revenue-sharing deal with existing consumer electronics manufacturers might be a good idea…) Secondly, continuing to ensure that viewers have access to top-quality content is absolutely critical to Moviebeam’s success. While it’s encouraging that Disney’s been able to line-up the participation of virtually every other major studio (except Paramount), they’ll need to ensure that each is properly compensated for distributing their films and not try to charge exorbitant fees to their partners, lest other studios develop Moviebeams of their own. (We think that Paramount will quickly fall into place and participate, especially if the launch of the service goes well.)

In closing, we’ll be watching Disney’s launch of Moviebeam closely: after all, it’s not every day that a firm shakes up the media business, and creates compelling new business models for media conglomerates in the process…

Some additional notes: if you’d like a detailed visual explanation of how Moviebeam actually works, there are several flash demos detailing the intricacies of the product at the Moviebeam website.

File this under tangentially related, but this is the third favorable article we’ve written about Disney in less than a month (see our take on the Disney Channel’s strategy here; or read about how impressed we are with the passion of Disney’s employees here. This sudden interest in Disney is particularly surprising (to us, at least), since we’d hardly thought about the company at all for the last few years. Is Disney suddenly becoming a hotbed of innovation and a model for media companies around the world, or what?

Is There Something More To Yahoo Shopping's New Price Comparison Tool?

This morning’s Wall Street Journal has a brief but thought-provoking article about Yahoo’s plans to incorporate a shopping comparison service into its online mall, Yahoo! Shopping. This tool will allow shoppers to compare products on the basis of brand, price, merchant rating and so forth, and closely resembles comparison services like MySimon in terms of functionality. However, whereas the information on other comparison sites tends to be somewhat out-of-date—sites like MySimon or BizRate crawl the web at regular intervals to pull down price information, meaning that they don’t necessarily capture up-to-the-minute price information—Yahoo! promises to provide up to the minute comparison information. By paying a small fee, Yahoo! Shopping’s merchants can use the comparison tool to list their wares in real-time. Ideally, this new feature will help boost site traffic and increase sales at Yahoo! Shopping, and play an important component of Yahoo’s growth.

Although Yahoo! Shopping is currently the third-most visited online shopping site, boasting 15.1 m unique users, it trails the market leaders—Amazon and eBay by fairly significant amounts. (According to a handy Nielsen/NetRatings chart kindly provided in the Wall Street Journal, Amazon.com has 26.1m unique visitors and eBay has a hugely impressive 42.4m unique visitors.) Although the number of Yahoo shoppers is large, it’s imperative that Yahoo find a way to grow this figure for two reasons.

The first danger to Yahoo is that the success of online malls such as Yahoo! Shopping, Amazon.com’s Marketplace, and eBay to date has largely been dictated by what economists call network effects. Effectively, what this means is that the sites with the largest number of unique visitors (and even more importantly, the sites that have the proven ability to convert those visitors into actual buyers), attract the most merchants, which in turn attract more shoppers (since they offer more shopping choice) in what’s called a “virtuous cycle.” In Yahoo’s case, this means that for many smaller merchants, eBay offers a potentially more effective location for an online storefront, given the fact that eBay has nearly three times as many visitors as Yahoo! Shopping. Yahoo clearly hopes that providing shoppers with a useful comparison tool will help merchants increase sales, and thereby hopefully give it a way of catching up to eBay in the numbers game.

The second major threat to online malls is that improvements in search engine technology render the concept of an online mall that funnels traffic to virtual storefronts all but irrelevant. Effectively, as search engines like Google continue to refine their ability to find things online, it’s possible that they could theoretically own the online shopping experience. Google has already been heading this direction: last year, it launched Froogle, a souped-up search engine devoted to shopping that allows users to type in, say, “widgets” and receive a list of sites selling widgets and their pricing. In the future, Froogle will likely provide information regarding brand, quality, reviews, shipping and perhaps a merchant rating. Yahoo’s new online shopping comparison feature is designed to head this challenge off at the pass by offering merchants enhanced functionality—real-time pricing data, and an opportunity to provide greater information about brand and merchant reputation to customers—before an upstart like Google can offer similar functionality.

On the surface, Yahoo’s comparison tool seems like an example of what we call “so what?” functionality. The only truly unique feature that Yahoo’s tool offers shoppers and merchants is the ability to access real-time pricing data—everything else (merchant ratings, brand information, shipping data, etc) is already available at other comparison tools like MySimon. What’s even worse is that the only way Yahoo can provide the benefit of real-time price comparisons to customers is by convincing merchants to participate in the program. And this begs the question: what type of merchant would want to opt-in to—yet alone, pay for—a service that promotes destructive price competition by pushing consumers to the least expensive version of an item they’re shopping for?

However, what makes Yahoo’s online comparison tool worthy of analysis and discussion is this: one of the first merchants to opt-in to the service happens to be a biggy, the aforementioned Amazon.com. We suspect that Amazon is interested in this service for two reasons. First, Amazon’s cost structure is already significantly lower than the competition—thanks to the fact that it’s the largest online retailer, it’s able to spread the high fixed costs of online commerce (e.g. fulfillment centers and slick technology) much more than its smaller competitors can. This means that Amazon has little to lose from a service that promotes lowest prices—since it can still turn a profit at reduced prices, thanks to its lower costs—and much to gain in the form of increased traffic. Secondly, like Yahoo, Amazon also needs to find a way to reach the deal with the network effects that eBay is able to continue to accrue due to the size of eBay’s audience, if Amazon is to hope to lure in retailers to participate in its Marketplace program. From Yahoo’s perspective, landing a huge partner like Amazon is valuable (if not vital), since Amazon’s participation more or less provides merchants with a strong incentive to opt-in to the comparison shopping program—and pay Yahoo! money—or be undercut on price by Amazon.

Ultimately, the Amazon connection to Yahoo Shopping’s new comparison tool is particularly interesting because it potentially highlights future partnerships that could benefit both companies. We could possibly be witnessing the birth of a joint-venture between the two firms, in which Amazon provides its ability to generate sales and revenue to Yahoo in exchange for Yahoo’s ability to refer its audience and traffic to Amazon in exchange for transaction fees. If this is indeed the case, and such a hypothetical strategy works, Yahoo and Amazon’s position in the world of ecommerce will grow significantly.