From: Max More (max@maxmore.com)
Date: Tue Aug 15 2000 - 17:22:28 MDT
From: "Mainspring.com" <customer-support2@MAINSPRING.COM>
Subject: Mainspring Executive Briefing: The Endgame for Old Media? (Augu
st 15, 2000)
Executive Briefings illustrate Mainspring's perspective on important industry events so you are informed and prepared to respond strategically.
5:30 pm, August 15, 2000
Author: Charles Gerlach, Karolina Minda
August 15, 2000Issue
- Claiming that Napster is "operating as a haven for music piracy," the recording industry sued in federal court to shut down the hugely popular Internet-based music-sharing service. The Napster phenomenon is only the most acute symptom of a technology-enabled revolution that is undermining the foundations of traditional media. What does the Napster saga tell us about the threat of the Internet to media incumbents? How will creators and distributors of content get paid in the Internet Economy??
Only the Beginning
In December 1999, having grown increasingly concerned about the viral growth of the Napster music-sharing system, the Recording Industry Association of America (RIAA) filed a multimillion-dollar lawsuit against the San Mateo, California-based start-up, claiming that it is engaged in "wholesale piracy." On July 26, 2000, Federal District Court Judge Marilyn Hall Patel granted a preliminary injunction requiring Napster to block all songs owned by RIAA members from its service, but two days later the 9th Circuit Court of Appeals granted a last-minute stay of the injunction. Barring settlement, the case will go to trial in September. At least until the end of that trial and the inevitable appeals, millions of Internet users around the world will enjoy free access to an extraordinary library of digital music. Millions of music consumers will have experienced the power of the Internet to transform the experience of music consumption.
The Napster phenomenon is the tip of an iceberg that will ultimately sink many incumbent media firms. Napster is only the most visible example of how the Internet and the digitization of content are transforming media. At the most basic level, the digitization of content transforms it into a commodity. Untethered from familiar physical forms like CDs and cassette tapes, it is difficult for content creators and distributors to directly capture revenue from content. The source of the value associated with the digital file must become the experiences, the activities, and the relationships wrapped around it.
Established legal principles and business models are under attack. The ability of content creators and packagers to extract value for their work using traditional business models will continue to erode. The old media companies who successfully make the transition to the digital world will likely be those who wisely use the time bought by lawsuits and other rearguard actions to ally with and reinvent themselves in the images of upstarts like Napster whom they so aggressively resist today.
Analysis
The Napster Conundrum
In a 1992 essay entitled "Selling Wine Without Bottles," Electronic Frontier Foundation co-founder and Grateful Dead lyricist John Perry Barlow described the conundrum of digitized property. To Barlow, this conundrum "seems to be at the root of nearly every legal, ethical, governmental, and social vexation to be found in the Virtual World." Specifically, he wrote, "the riddle is this: if our property can be infinitely reproduced and instantaneously distributed all over the planet without cost, without our knowledge, without its even leaving our possession, how can we protect it? How are we going to get paid for the work we do with our minds? And, if we can't get paid, what will assure the continued creation and distribution of such work?"
The digital property conundrum is now playing out with multi-billion-dollar consequences for the recording industry. In fact, the issue of digital property rights has repeatedly reared its head in the years since Barlow wrote his essay, with each successive wave of growth in Internet users and processing power raising the level of concern among content companies. Napster with 20 million users and more than 850,000 music files consisting of some 3,500 gigabytes of data has now made the issue of digital property rights and business models the overriding concern of nearly everyone associated with the music industry. As technologies mature, other forms of media (e.g., video, print publishing) will face this conundrum as starkly as the music industry faces it today.
Napster and Its Cousins
Napster acts as an MP3 (Motion Picture Experts Group 1, Audio Layer 3) search engine and distributed file management platform. Napster does not store any MP3 files on its servers but enables users to make MP3 files on their computers available to the Napster community as well as to perform fast, simple searches to see which music files are available on the computers of other Napster users. With a click of the mouse button, users can then download music files from fellow Napster users' computers.
MP3 is an open digital music format that compresses large audio files into small, CD-quality files (although the person encoding the MP3 file can choose the quality level depending on desired file size). The relatively small file size makes this format attractive for uploading, downloading and otherwise sharing over the Internet. In addition, millions of free and shareware MP3 player and encoder applications are sitting on PCs around the world, creating a huge installed base of users for the format and allowing users to easily create high-quality MP3 files from their audio CDs. Because MP3 does not incorporate rights management or encryption capabilities to control copying of files, the music industry has sought to develop or back alternatives that do incorporate such features.
Even if the RIAA is successful in shutting down Napster, several harder-to-control alternatives are waiting in the wings. The second most popular music-sharing platform, Gnutella, provides similar capabilities to those of Napster but without the "weak link" of a centralized server. Freenet goes even further than Gnutella, providing a PC-to-PC solution that passes requests through a number of computers, providing complete anonymity to its users.
Music Sharing Platforms
Source: Company information, The Industry Standard, May 8, 2000.WAP Forum
Perhaps even more importantly, Napster and its file-sharing cousins are precursors of a new form of distributed computing that will become increasingly common as more and more computers are connected to the Internet by always-on broadband connections. A number of firms are developing technologies that enable general purpose file sharing across the Internet supporting extremely reliable shared, distributed storage of all types of content and applications. In time, most of the computing devices on the planet will be knitted into an integrated fabric of processing and storage resources that will create even greater challenges for those seeking to maintain control over digital property.
Grassroots Innovation
Like so many Internet phenomena, Napster is a grassroots innovation sprung from the mind of a young consumer cobbling together an elegant solution to a problem. Shawn Fanning was an 18-year-old freshman at Boston's Northeastern University when he wrote the first version of the program.
The other current high-profile media industry lawsuit seeking to protect digital property rights involves public distribution of the source code for the CSS system created by a coalition of movie and technology interests to prevent copying of DVD videos. This system was cracked by 15-year-old Norwegian Jon Johansen as part of his effort to create a DVD video player application for the open source Linux operating system. Johansen embarked on this effort because the creators of CSS had not provided drivers enabling users of the increasingly popular operating system to play DVD videos.
The Napster phenomenon yet again demonstrates the extraordinary power of the Internet to foster innovation. It is unlikely that any coalition of music industry players or technology vendors would ever have created a platform like Napster, yet Napster elegantly addresses a number of key consumer needs. Fanning and Johansen provide dramatic examples of the power that technology has placed in the hands of consumers. Because of this power, consumers are increasingly unwilling to wait for or accept inadequate solutions from the traditional producers of content and technology. The Internet, the processing power, and the communities of interest available to individuals seeking to create solutions have enabled them to rapidly create and disseminate significant innovations. This environment makes it difficult for established firms to successfully lead innovation in the marketplace and calls for new approaches to understanding and meeting customer needs.
"A Match Made in Heaven"
Edgar Bronfman Jr., who controls the world's biggest music company, Universal Music Group, told an audience in March 2000 that "Music and the Internet are truly a match made in heaven." Bronfman is right, but unfortunately for UMG many of the characteristics that make the match so perfect tend to undermine its current business model.
Listening to music is an emotional and a social experience. Musical tastes are created and evolve based on a wide range of influences. The great advantage of the major recording labels in the pre-Internet world was their ability to leverage mass media to shape demand for their content. They are masters of this marketing-driven or "push" model of demand creation. They have effectively leveraged mass media to create the motivations that lead consumers to buy particular types of music and associate themselves with particular genres and artists. As masters of this marketing engine, record labels have been in a position to be the key gatekeepers for artists and entire genres of music.
The marketing-driven business model of the current music industry is necessary in a world where physical distribution channels are required to deliver music into the hands of consumers. Everything from CD-manufacturing capacity to shelf space in retail outlets is a limited, capital-intensive resource for which demand must be effectively managed in order to create acceptable returns on invested capital. Freed from these limitations by digital files and the Internet, a very different music industry will inevitably evolve. As Napster demonstrates, the mass marketing approach to creating experiences around and demand for music will increasingly be supplanted by a much more consumer-driven model.
As a direct result of Moore's Law, increasingly powerful tools for creating highly professional digital content (audio, video, digital photos, text, multimedia) are now in the hands of the masses. With the Internet as an extremely inexpensive means of distribution, vast quantities of this digital content are reaching the public. While the artistic and entertainment value of this content is uneven, the necessary gatekeeper role played by old media in a world of capital-intensive production and distribution resources is eroding. Consumers of content will increasingly coalesce into more fragmented communities with closer relationships to the creators of content. The roles of intermediaries between the creators and consumers of content will change dramatically.
Napster teaches us several important lessons about this new media marketplace. Because musical tastes are personal, consumers require access to a vast universe of choices. Because music is social, it must be easy for consumers to share music with their friends. Because people like to listen to music in a number of different contexts and on multiple devices, it must be easy to move files between devices and locations. Consumers also need to be able to listen to individual songs without feeling that the meter is running.
Benefits of Digitally Downloaded Music
Consumers" Allows greater control of the content
Artists
Music Industry
" Able to choose only the songs they want, arrange them in play lists and digitally remix the music
" Play lists can be accessed from many places
" Ability to easily share music with friends
" Fledgling musicians, who often are ignored by record labels, can upload their music to web sites for easy distribution to anyone
" Ability to have direct contact with consumers ·
" Cost of distributing music is drastically lowered because no physical good needs to be transported
" Direct marketing and delivery conduit to individual music fans
" Ability to learn about consumers' tastes and habits
Source: Mainspring.
The Internet has changed the dynamics of diffusion of new technologies into the marketplace. Even technologies that succeed require time and expensive marketing to change consumer behavior. Exploiting Metcalfe's Law, Napster has led to an extremely rapid diffusion of the MP3 format into the marketplace. Other media technologies such as audio CDs took many more years to reach the same levels of adoption in the marketpalce. Yet, relying only on Internet-driven viral marketing, the number of Napster users has grown from 1 million a year ago to more than 20 million today, with over 1 million joining each month. According to CyberDialogue, the number of adults going online to get music content increased 48 percent between December 1999 and March 2000.
Consumer Adoption of New Technologies
Source: McKinsey Quarterly, Number 2, 2000, "Unscrambling Digital TV".
The greatest limitation of the MP3 format from a consumer standpoint is the dependence of most users on their computers either to play the files directly or to load them on to dedicated players. Dedicated MP3 players like the Diamond Rio are increasingly popular while several new Microsoft PocketPC devices like the Compaq iPaq incorporate MP3 players. MP3 players are now available for automobiles and Ericsson has even demonstrated a prototype mobile telephone handset that can play MP3s using a wireless link to an add-on device. The desire of consumers to copy and synchronize music files across multiple personal devices will be another important factor limiting consumer acceptance of digital rights management systems that limit copying of music files.
Recording Industry Blues
Although the recording industry understands the power of the Internet and the power of the consumer hunger for digital music, they are hesitant to make any significant moves towards digital delivery. Everyone seems to understand that digital music will mean the end of the old era. As Val Azzoli, the co-chairman and co-CEO of the Atlantic Group put it in 1999: "I can't avoid [the Internet]. I wish it would go away, because it's a pain in the ass. I don't want to retool my operation, but it's not going to go away."
Both global and the US music markets are dominated by 5 biggest players: Universal, Sony, Warner, EMI and BMG, representing a collective $250 billion in market value. Although independent recording companies not owned by a major label are slowly beginning to gain market share, at less than 20 percent in 1999, they are yet to become a major threat to the Big Five.
Like any industry, the recording industry is the sum of its history. That history has led to a complex, multi-layered structure in which many incumbent players are struggling to protect significant established economic interests.
Traditional Music Value Chain
Source: IDC, Mainspring.
This complex industry structure can be mapped back to the cost of the typical CD that a consumer buys in a music retailer.
CD Economics
Source: RCA, via "RCA Records: The Digital Revolution", HBS Case Study 9-800-014, rev. Oct.1999.
Estimates by Billboard suggest that for a typical $17 CD, distribution, shipping, and store markup account for more than $9.50 of the retail price. All of this analysis shows how much of the cost of a CD is consumed by the processes and bottlenecks created by today's physical distribution infrastructure. If you remove these processes, the costs are dramatically reduced. For example, Yankee Group estimates that the cost to send a song directly over the Internet is $1 and rapidly dropping.
In addition to these obvious costs, almost all of today's mass market consumer media are classic hit-driven businesses where huge sums of money are spent to create hits. For every hit though, there are a lot of money losers. To mitigate some of this risk, content distributors increasingly rely on focus groups and other tools to create content and even artists with a greater likelihood of creating hits. This model manifests itself in artists like the Backstreet Boys who are carefully crafted by marketers to generate instant hits among target demographic groups.
Legal Codes and Moral Rights
"Intellectual property law cannot be patched, retrofitted, or expanded to contain the gasses of digitized expression any more than real estate law might be revised to cover the allocation of broadcasting spectrum. (Which, in fact, rather resembles what is being attempted here.) We will need to develop an entirely new set of methods as befits this entirely new set of circumstances." - John Perry Barlow
The most visible action taken by the recording industry in response to the rapid spread of digital music has been to turn to the courts. In recent months, the RIAA has filed a number of suits against firms facilitating the sharing of MP3s. These suits follow an earlier, failed attempt by the RIAA to prohibit the sale of the Diamond Rio MP3 player in the U.S.
Recent RIAA Lawsuits
Source: RIAA, via The Industry Standard, August 7, 2000.
The RIAA's case against Napster is not a slam dunk because while Napster facilitates the distribution of music files in violation of the rights of many copyright holders, the actual digital songs that are being downloaded are located on servers that have no connection to Napster. Napster argues that it is just providing a software application that end users are using to share music files non-commercially. The RIAA has to prove Napster is inducing illegal activity. What's more, the RIAA will have to prove that Napster is used almost exclusively for illegal activity, and Napster clearly provides access to content whose copyright holders wish to be distributed on the platform. Some observers don't buy the Napster argument, though. Music agent Ron Stone says that "It's like they [Napster] are selling crack pipes to crack heads and making believe they aren't contributing to the problem."
In the U.S., the 1909 Copyright Act laid the foundation of our current system of awarding composers a royalty each time a song is carried on a record or other format that can be replayed mechanically. As content is increasingly taking a digital form, laws designed to preserve rights in the physical expression of ideas are becoming increasingly difficult to apply. The Napster conflict is a perfect example of the challenges of trying to force a new technology into old law.
In addition to the legal issues is the moral issue of the rights of artists to control the fruits of their creativity and get paid for them. Napster's success does not necessarily mean that consumers wish to willfully infringe the rights of artists. Consumer anger over the price of CDs seems more to be generated by disgust at subsidizing the expensive stream of middlemen, promoters and lawyers driving up the cost of final products. Artists' opinions about Napster vary. Many, often more established musicians, contend that such programs are robbing them of their royalties. Sean "Puffy" Combs says the program is a form of "abuse," while Scott Stapp, lead singer for Creed, says that Napster is "robbing me blind." Meanwhile, many others see it as a way around the corporate gatekeepers who have prohibited them from reaching a broader audience.
Finally, the RIAA claims that Napster poses a threat to sales of recorded music but so far the evidence is mixed. Although a May study by SoundScan reported that sales of CDs were down in stores near colleges, blaming Napster for the dip, the RIAA's own statistics for 1999 demonstrate clear growth in both overall music industry sales and revenues. Moreover, a July study by Jupiter Communications reported that Napster users are 45 percent more likely to purchase music because digital music swapping is a catalyst to buying music that they would not otherwise have discovered.
Implications
Milk Your Cash Cows While You Can
If Napster heralds the eventual end of old media, what is the endgame for the incumbent firms in the old media value chain? Is it possible to make money in the age of digital content?
The good news is that old media is not going away any time soon. A vast installed base of consumers for old media in all of its forms exists and will continue to generate revenues for years to come. In fact, in the near term, digital media may (as suggested by the Jupiter study of Napster users) actually drive an uptake in sales through traditional media channels. The challenge for old media players is not to allow stable or even growing revenues from traditional media to lull them into inaction. To remain viable on the other side of this disruptive set of market developments, old media players will have to dramatically rethink and recast their roles. While technology investments, experimentation, and partnerships will be important, the biggest steps that many incumbent media players will have to take involve systematically rethinking their value propositions and how they will communicate those value propositions to their customers.
This means, too, that incumbent media firms need to focus on improving operational efficiencies within their existing businesses. There is no room for waste in this evolving economy. The pressures are greater than ever to build flat, efficient organizations where every costs are aggressively controlled.
Get to Know Your Customers
The balance of power has shifted dramatically in favor of consumers. More than ever before, media creators and distributors need to develop strong relationships with their customers and work relentlessly to meet their expectations. The world in which the push, marketing-driven model gave content creators significant power to influence consumer demand are over.
Establish a Meaningful Brand
Old media players need to start creating brands that have meaning for their consumers. Traditionally, most media brand building has focused on branding artists and individual pieces of content. If the recording labels want to have any relevance, they are going to have to educate consumers about who they are and the value they do provide.
Unfortunately, the Napster battle has raised the profiles of the recording labels in a largely negative manner. Scott Rosenberg of Salon.com strikes a note typical of the wide-spread public attitude towards the record companies when he writes that through the legal battle "the brain-dead, colossally wasteful, artistically homogenizing old order of the recording industry is committing collective, time-delayed suicide in court."
It is not that the record labels do not perform services or value to consumers, but most consumers don't have a clue what they really do or what value they add. A lot of consumers are getting to know the recording industry players right now for the first time and they are forming some negative impressions.
Explore New Revenue Models
As one poster wrote in an Internet news group, "Music companies will find new financial sources; there is no other way. The faster they change, the easier they will cope with the new reality." The models of how to get paid in this new world are out there. In the long run, it will be easier for the artists to get paid than the middlemen, because most of what the middlemen do will be cut out by digital distribution. Looking to other industries, like the IT channel, for example, we can see how new models remove huge chunks of revenue from channel players while delivering even greater value to consumers. A subscription model, for example, might mean that tens of billions of dollars of revenues evaporate, while artists actually receive greater compensation, although artists' revenue will be shared among a greater number of artists.
Perhaps the most intriguing set of models for getting paid in this environment comes from the Open Source software movement, where firms like Red Hat software have figured out how to get paid for selling software that anyone can get for free from multiple alternative sources. Many of these players have consciously copied the models created by firms that have built successful businesses selling commodity products like soap, tomato paste, and gasoline. Creating a meaningful brand and wrapping a set of services around the product are key in this type of environment. With digital content, a player that can enable consumers to find the precise content that they want when they need it and ensure that it is delivered in the appropriate format and that desired quality standards are met, has the opportunity to still make money from the sale of the content.
About Mainspring
Mainspring is a leading strategy consulting firm that focuses exclusively on developing actionable Internet strategies primarily for Fortune 1000 companies. Mainspring works with clients to develop eStrategies that are designed to enable them to protect, evolve and transform their businesses in the new Internet economy. The Company provides three integrated service offerings: eStrategy Consulting, eStrategy Direct and the eStrategy Executive Council. Mainspring is organized into four vertical market practice areas: financial services; retail and consumer goods; technology, communications and media; and manufacturing. Mainspring is currently working with 38 Fortune 1000 companies. For more information, visit www.mainspring.com
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