Amazon in the Internet Music Business

Technology Strategy Final Assignment: Amazon in the Internet Music Business 1 Executive Summary ....................................................................................................... 2 2 Abstract .......................................................................................................................... 3 3 Analysis.......................................................................................................................... 3 3.1 3.1.1 Introduction of internet music – S curve and industry life cycle................... 3 3.1.2 Overall Industry Evolution – Effects of disruption........................................ 3 3.1.3 Outlook of the industry .................................................................................. 6 3.1.4 Internet music industry – an E-retailer perspective ....................................... 7 3.2 4 External Analysis ................................................................................................... 3 Internal Analysis .................................................................................................... 8 3.2.1 Background .................................................................................................... 8 3.2.2 Business Model and Key Competitive Advantages....................................... 8 3.2.3 Strategy .......................................................................................................... 9 3.2.4 Competition.................................................................................................. 10 Potential Strategic Options .......................................................................................... 12 1 of 20 1 Executive Summary • In the beginning of the new millennium, the Traditional Music Industry began to observe a new technology that could tremendously disrupt the industry, changing the relative value of complementary assets and rebalancing the power in the value chain - internet music (IM) • When compared to the traditional music, internet music still lacks quality but its convenience, easiness and flexibility to acquire and manipulate, coupled with the presence of strong complementors such as portable and trendy player devices or cellular phones with increasing storage capacity, make it a very compelling and potentially disruptive technology • The disruption of the internet music promises to change not only the rules of the game, empowering retailers and artists and significantly reducing the value historically captured by record labels, but also the way the game is played • The Internet Music industry is still in its ferment stage, with no Dominant Design, and is very consolidated (C5 – 5 players with more than 90% of MS) • Given the nature of the externalities (threshold), limited lock-in, slow pace of change (IM is expected to represent less than 20% of industry sales by 2009) and serious conflict of channels and interests for a forward integration of major labels there will not be a single winner standard in this industry, but rather: two WMA (Microsoft) and AAC (Apple) • Amazon plans to enter the IM market, however entering this market will be quite challenging for Amazon because, although it owns tightly held complementary assets such as: strongest brand in e-commerce, powerful customer base, great expertise in recommendation software, and opportunities to market through cross-selling, it will have to overcome serious limitations due to the externalities driven nature of market, such as being a laggard / late entrant in a market in which competitors are already riding their externalities loop; not having a patent nor standards, nor complementary goods to fight the standard war • Amazon should partner with Microsoft to entry the e-music retailing, that would softer rivalry, provide Microsoft with complementary assets which it does not have in the retail business, prevent Apple to take the whole market and open the “door” to Amazon’s entry in the electronic music retailing with and edge to the competition 2 of 20 2 Abstract The objective of this paper is to recommend what Amazon should do to succeed in the internet music business. To reach such conclusion, we will conduct a four step methodology, where we will a) understand current market and assess its evolution, b) analyze Amazon and its main competitors’ capabilities, c) identify potential strategic options and d) provide recommendations. 3 Analysis 3.1 3.1.1 External Analysis Introduction of internet music – S curve and industry background The music industry has been through many innovations since its inception; however its structural characteristics and value chain remained relatively unchanged, with record labels capturing most of the rents. In the beginning of the new millennium, though, the Industry begun to observe a new technology that could tremendously disrupt the industry, changing the relative value of complementary assets and rebalancing the power in the value chain. Powered by the universal access to the Internet, the excessive and cheap availability of bandwidth, and the evolution of compression technology, a new form of music was born, the internet music. When compared to the traditional music, internet music still lacks quality but its convenience, easiness and flexibility to acquire and manipulate, coupled with the presence of strong complementors such as portable and trendy player devices or cellular phones make it a very compelling technology. (See S curves in exhibit 1) 3.1.2 Overall Industry Evolution – Effects of disruption 3.1.2.1 Industry Structure Historically, the music industry has been characterized by its attractiveness for the average record labels, which used to capture most of the value, owning the uniqueness of the artist’s songs, protected by intellectual property laws, and holding tightly complementary assets such as brand, distribution network and key relationships in the “show business”. 3 of 20 In a classical industry analysis framework we conclude that this industry was indeed very attractive for an average record label, because it had a) relatively high entry barriers: although this industry does not benefit from learning effects or significant minimum efficient scale, brand and relationships are a fundamental positional competitive advantage which 1) creates an endogenous entry barrier and 2) creates a reinforcing loop for major record labels, in which the most talented artists are attracted by the firms relationships and brand and which, in turn, contributes to enhance even more the brand and relationship attracting more talented artists; b) weak substitutes; c) moderate supplier power, renowned artists have high bargaining power but new talents do not retain much rent; d) low buyer power (fragmented buyer base) and e) rivalry based on marketing and talent recruiting, in addition traditionally this industry has a very heterogeneous demand allowing niche players co-exist with industry majors and discouraging price wars. However the disruption of the internet music promises to change the rules of the game, empowering retailers and artists and significantly reducing the value historically captured by record labels, namely: • Uniqueness is worth less given the difficulty of enforcing IP laws over the internet • Previous tightly held complementary assets are loosing importance (e.g. distribution – record labels; geographic presence / brand – traditional retailers) • Lower entry barriers: decrease relative importance of brand / distribution and existent relationship with traditional retailers • Empowerment of internet retailers: own AACess to customer; threat of backward integration (may compete with record labels – promoting new talents); increase concentration as mix of sales goes over the internet • Empowerment of artists: new talents may choose to go “directly to the consumer” (forward integration) Nevertheless it is always worth to mention that without an efficient method of enforcing IP there is a risk that the majority of the value be captured by the consumers, potentially threatening the existence and sustainability of key players in the industry. 4 of 20 3.1.2.2 Value Chain The Industry Value Chain may be greatly affected as well by the increasing importance of internet music, presenting threats and opportunities for labels, e-retailers and artists. The threat for E-retailers (iTunes, Wal-Mart, Microsoft, Real, Amazon etc…) is that Record Labels might try to forward integrate, whereas the threat to the Record Labels is the “double” integration play, where E-retailers would integrate backwards and Artists (mainly the biggest) forward. Addressing the first point, the reasons major labels might forward integrate are: • Avoid Double-marginalization and/or hold up: It is possible that some E-retailers will have market and bargaining power. This can and will happen if there is a standard winner in the “standard wars”. If the market continues to develop as it is now, Apple’s iTunes, with more than 70% of market share, can become the leader and standard setter in the industry. If this happens there will be a tension in pricing between the Record Labels and the E-retailers (mostly iTunes), resulting in potential Doublemarginalization and /or hold up. However, there are some major drawbacks that have to be taken into the equation before integrating forward: • Conflict of interest: labels would not want to sell through their competitor’s channel • Conflict of channels: the slow pacing transition from CD to internet music sales will magnify conflict with key clients (i.e. Wal-Mart, Amazon), which markets both products: CDs and Internet Music • Tight complementary assets: hard and costly to construct share of mind and trusts of internet customers • Lack of complementary goods (e.g. MP3 Players and Music Mgt. SW): hard to compete in the environment in which externalities play an important role Addressing the second point, a double play of forward integration by the Artists and backward integration by the E-retailers might occur because: 5 of 20 • Commoditization of role of labels: While in the past and somewhat in the present the Labels have played a major role in promoting, managing the distribution and the launching of albums, much of these roles can be played even better either by the Artist themselves or by the E-retailers. (Although this division would probably work for the biggest and most famous artists, this would be much harder for smaller and not so famous artists). To sum up, although we believe that there potential integration in the value chain are possible, we don’t believe they will happen in the short-term and possibly neither in the long-term. First, the forward integration of the labels will most likely not take place, because of the pressure of key clients (Wal Mart, Amazon), and lack of key complementary assets. And finally the double play is much more attractive and compelling if used as a negotiation tool to value capture (there are no clear synergies or evidence that such integration would create value) 3.1.3 Outlook of the industry Looking forward, it is interesting to notice that the threat of disruption will change not only the rules of the game but also the one being played. Below you will find the potential change of strategy that each player is pursuing or may have to pursue to maximize each share of value capture: - Record labels: most affected – lost not only uniqueness (lack of enforcement of IP), but experienced devaluation of key complementary assets. Current strategy is focused on 1) sponsoring methods to enforce more IP over the internet, 2) forward integration to access the customer 3) fight to create open standard for internet music - Retailers: a) Traditional: probable victims of disruption. Some are trying to transport model to internet, most will milk and disappear 6 of 20 b) Internet: try to capture most of the value deploying 1) proprietary standards, 2) alliances with format owners record labels and 3) network effects (indirect – through complementors) - Artists: renowned artists will face a decrease in value capture over music sales and may have to increase to mix of live presentations to recover some of the value lost. New talents may want to integrate forward, or create alliances with known internet retailers to mitigate the power of record labels. - Customers: will try to maximize value capture (e.g. downloading free music as long as it is feasible and low enforcement risk) and will bet / adopt on the standard with the largest network effect 3.1.4 Internet music industry – an E-retailer perspective The internet music industry, although currently representing a very small part of total music sales approx. $ 500 million out of 11 billion (5%) is growing extremely fast (173%) and is expected to continue to grow fast next five years (83%). It is worth to mention, that if we consider that the major share of downloads is done through illegal or non-commercial peer-to-peer websites (90% in 2002, decreasing to 50% in 2007 and beyond), the trend would look much stronger (Exhibit 2). However, even considering the stronger trend, the pace of change is not that fast, once internet music sales are not expected to surpass those of CD in the next five years, and, thus total disruption, if it occurs, shall happen only in the long-term. In terms of industry life cycle, the Internet Music Business is in its Ferment stage, where there is no clear format, price, or complementary products; in other words, there is no Dominant Design. The biggest players in the Industry are still fighting to determine the winner standard and it is not clear if there will be one (Exhibit 3), actually it is our belief that this market will not have only one standard, but rather two. Our opinion is based mainly on two issues a) it is a threshold rather than extensive network effect, as you have to purchase your own music, the value for an incremental increase in the install base is not that significant, users will only want to be sure that there will be music available and complementary good available under the format chosen and b) it is and will be increasingly 7 of 20 easier to swap between formats (e.g. today there is already software available that convert from one standard from the other). Despite the early stage of the industry, and numerous standards / formats the market is quite consolidated, with top 5 players representing more than 95% of industry total sales, with I-tunes being the clear market leader with 70% of market share (Exhibit 4). 3.2 3.2.1 Internal Analysis Background Founded as Cadabra.com by Jeff Bezos in 1994, the early days of the mainstream Internet, Amazon is today one of the biggest e-commerce companies in the world. It begun as an online bookstore but has grown into many areas, such as DVDs, music CDs, electronics, jewelry, apparel, furniture, and more. At the same time that Amazon grew its offerings it increased the number of countries it operates in. Starting only with the U.S. store it has grown to other 8 countries: Canada, the United Kingdom, the Netherlands, Germany, Austria, France, Japan, and China. Amazon’s overall revenues have totaled 7 billion dollars in 2004 with net income of 600 million. 3.2.2 Business Model and Key Competitive Advantages Amazon’s business model is to sell goods over the internet at low prices, leveraging on operational excellence (through centralized distribution centers and low inventories), unique recommendation software and large customer base. These main competitive advantages are reinforced by two theoretical concepts best applied in e-commerce: Long Tail1 and Collaborative Filtering2. The Long Tail theory shows a known phenomenon, that demand of most kinds of products (e.g. DVDs, CDs, books) are highly concentrated on few items and then there is a small demand for a large number of items; whereas, collaborative filtering is a very effective way of recommending products to an individual user mostly based on either past behavior or similar buying pattern. In order to fully capture the benefits of Long Tail and collaborative filtering two things are needed for an e-commerce player a) effective software and b) scale – large user base. Thus, 8 of 20 in Amazon’s case, it enacts a reinforcing loop of its leadership (more customers -> more effective use of long tail and collaborative filtering -> more sales -> bigger gap from 2nd place -> more awareness -> more customers) and strengthens its complementary assets. In order to take advantage of these competitive advantages in higher margins businesses Amazon also allows third parties such as individuals and businesses to retail their products on the site through its auctions, zShop, Amazon Marketplace (small businesses) and Merchants@ (larger businesses) programs. The revenues come in form of fees and commissions for new and used products. Amazon also operates a Syndicated Stores program where it sells its products through other businesses’ websites. Under this arrangement, Amazon is responsible for the inventory, set prices, fulfillment, and customer service, while the businesses hosting the links to Amazon products receive a sales commission. The company’s other services include merchant.com, where Amazon uses its eCommerce services, features, and technologies to operate another business’ website, sell its products under its brand name and URL, and occasionally offer fulfillment services. Amazon also offers technology services including search, browse and personalization, and other marketing and promotional services, such as its co branded credit card. 3.2.3 Strategy Amazon’s overall strategy is to be the main destination to shopping online, in other words, sell anything to anybody online. This means that customers might use Amazon to buy something from the company itself, other stores, or even just search and find the best product and buy it anywhere (hopefully Amazon or one of its associates will offer the best price). Following this strategy Amazon did some acquisitions that would seem weird otherwise, such as Alexa Internet (an online research company), IMDb (Internet Movie Database), PlanetAll, etc. Recently the company has engaged in many initiatives related to digital content, such as launching a9.com (a search company), Search Inside the Book and selling of book downloads. These initiatives can be understood from two different perspectives. On the one hand there is a pressure from investors (Wall Street) for Amazon to increase its margins 9 of 20 and increase its revenue from high margin business, as does Google, eBay and Yahoo. On the other hand it is in-line with the corporate strategy to sell anything to anybody online, so these services can lead to better informed customers who hopefully will buy more from Amazon. Amazon in the Internet Music Business As surprising as it can sound, Amazon has not entered the Internet Music Business yet. It would be expected that as the leading online retailer it would be one of the enthusiasts of this new industry, but this has not been the case. In the meanwhile, new companies (Napster), companies that have no tradition in retail (Apple, Real Networks), the Internet (Wal-Mart) or in the combination of both (Microsoft) have dominated this small but fast growing business (Exhibit 4). Entering this market will be quite challenging for Amazon because, although it owns tightly held complementary assets such as: strongest brand in e-commerce, powerful customer base, great expertise in recommendation software, and opportunities to market through cross-selling, it will have to overcome serious limitations due to the strong externalities driven nature of market, such as being a laggard / late entrant in a market in which competitors are already riding their externalities loop; not having a patent nor standards, nor a complementary good to fight the standard war and try to tip the market in its favor. 3.2.4 Competition As stated above, there are already various players in the market that Amazon will have to overcome in order to exercise a leadership in this industry. They differ in many ways, from function in the value chain to adoption of standards and production of complementary goods. Therefore it is important to understand who they are and what are their key strengths and weaknesses in order to analyze Amazon’s chance against them (see Exhibit 5 for a summary and exhibit 6 for relative positioning). 10 of 20 Apple Apple, with its iTunes, was the first company to legally sell music downloads in big scale. The main reason for its success was its launch of the most successful digital music player to date, the Apple iPod. Apple has sold already 10 million iPods and more than 300 million songs through iTunes, making it the leader by a big margin in this industry. iTunes offers in its website more than 1 million different songs in the AAC proprietary format that only play in the iPod. Pros: undisputable leader, large array of complementary goods. Cons: competition from Microsoft in the software standard (WMA), and from the cell phone manufacturers in the hardware (iPod) (Exhibit 7). Real Networks Real is one of the first online music services provider. Its Real Player is widespread all over the world. It offers over 1 million songs for download and subscription through its Rhapsody and Music Store products. Pros: large base of players, experience in the industry. Cons: Lack of complementary goods, lack of financial resources, strong competition from Microsoft and Apple. (Exhibit 6) Yahoo! The biggest internet portal is expected to launch its own online music store today (5/11/05). It will, for the first time, slash subscription prices by almost 50% (it will charge US$6.99 per month). Yahoo! will offer more than 1 million songs and it will also sell songs for the same price most services do (US$0.99). Pros: huge portal and instant messenger installed base, expertise in internet properties. Cons: Lack of complementary goods, lack of control over technology (it uses MS’s WMA) strong competition from Microsoft and Apple. (Exhibit 6) Napster Born as an illegal file sharing company, Napster was the creator of the Internet Music Industry. After many legal battles its brand and assets were acquired by Roxio Inc. from chapter 11. It offers more than 1 million tracks as a subscription services, and it uses Microsoft’s WMA format. Pros: Known brand and some complementary goods. Cons: Lack of financial resources, strong competition and lack of proprietary technology. (Exhibit 6) 11 of 20 Wal-Mart The largest retailer of the world has had a successful trajectory in its Internet venture. Its website is a destination of many customers from all social classes and it sells mostly anything. It offers 500,000 songs using Microsoft’s WMA technology. Pros: Financial strength, lower prices, and opportunities to cross-sell. Cons: It is not a technology player, and has no patents or technology standards. (Exhibit 6) Microsoft Microsoft also entered late in this market, launching its online music store in 2004. It currently offers more than 1 million songs and uses its proprietary standard, WMA. Pros: Financial strength, huge Windows installed base, opportunities to leverage other user bases’ like MSN and Messenger. Cons: Questionable brand, lack of experience in e-commerce. (Exhibit 6) 4 Potential Strategic Options As we already mentioned, the current market penetration for digital music is still very low, but with a huge growth potential. From the analyses above, we can see that Amazon will have very strong competition, especially from Wal-Mart, Apple and Microsoft – the current strongest players. However Amazon can count on some strong competitive advantages to lever its success in retailing electronic music: strong client base, recognized retail brand, trustfulness in online sales and cross-selling opportunities. Before understanding Amazon’s alternatives, it is important to understand the possible scenarios for industry evolution. There are two major hypotheses to describe the future: 1) There will be no disruption at this time and the market will stay concentrated in the CD’s until new technologies emerge or 2) The electronic music will grow sustainable and creates an industry disruption. As we mentioned before, we believe that that the latter point will prevail (exhibit 8), and if such it would put Amazon in a very good position in two cases: a) The market accommodate two or more standards and all standard owners make them available for sales in the e-retail; or 12 of 20 b) Amazon establish a partnership with the winner standard However, there are some questions whose answers can determine many different outcomes for the industry evolution. Some important questions are related to number of standards in market, i.e.: - How many standards will exist in the future, one, two or many? - If only one will survive, who is most likely to be the one? Regarding the enforcement of standards: - How enforced will the “incompatibility” among standards be? Will the complementors have the capability to play any standard? Will softwares to convert music from one standard to another be widely available? The answers for these questions will determine which layer will capture more value in the future value chain – label companies, retail, hardware manufactures, or standards owners. In one extreme scenario; only one player dominates the market and holds the standard (uniqueness) therefore Amazon will have very limited upside to negotiate and sell the winner’s format and can capture a very small portion of the total profits– for example: Apple wins and keep selling the songs thru the iTunes, maintaining tide Uniqueness over the AAC standard. Because of the market size and power of players, this is a very unlikely scenario, although not impossible. On the other extreme, two of more standards split the market with loose control over the standard and customers have wide access to music in different formats throughout many different channels. In this case Amazon will sell music in whatever format, have the access to the whole market and can strongly rely only on its competitive advantages to compete and win, Our best guess for the future is an intermediate scenario (see exhibit 9), in which only two standards will survive after the long battle for the standard dominance among Microsoft, Apple and Real. The finalists will certainly be: Microsoft – because of its massive installed base of Windows media player; and Apple – because of its current 70% market share in electronic music sales and strong reinforcing loop with iPod. Our recommendations to Amazon are based on the current market structure and our most likely scenario for future. Considering that Amazon is entering “late” to this market, it will face a major competition, (as we already analyzed in the preceding section of this paper). Thus our recommendation 13 of 20 to Amazon is to enter in the market in partnership with one of the two major players (either Microsoft or iTunes). The base for this recommendation is: 1) Competing against the two players is much harder, and 2) Microsoft and Apple need to build allies to win the war Amazon can profit from the war of attrition and its complementary assets, highly valuable for both sides. The pros and cons from each the companies and Amazon in maintaining a partnership are summarized below Partnering with Apple Although it might seams awkward in the first view, both sides have potential benefits. To Apple, it benefit from: 1) getting Amazon’s exclusivity and close a valuable “door” to Microsoft; 2) increasing sales of music and devices, levered by Amazon’s opportunity to cross-selling/channel distribution and 3) access to Amazon’s capability to e-retailing. All these benefits would reinforce the iPods’ positive loop, helping to consolidate AAC victory. The downslide for Apple would be losing its monopoly, cannibalizing iTunes music sales. In the shoes of Amazon, the advantages to have a partnership with Apple would be: 1) access to the current e-music market leader and 2) softer competition with the market leader. The negative side is would be: 1) get locked-in with only one side instead of profiting from both and 2) the risk of selecting the wrong standard. Partnering with Microsoft From our analysis, at this point in time, Amazon would certainly create more value to Microsoft than to Apple. But in this case, since Microsoft has less to offer, the deal should give Amazon the outsourcing of Microsoft e-music sales. In this case, any request to buy a given music on the MSN domain, the customer should be directed to Amazon to choose and close the deal. A good question for all that would be; why would Microsoft ever consider this hypothesis? Because Microsoft could use Amazon’s Complementary Assets to guarantee that it’s standard will sell enough units to either tip the market or guarantee a 14 of 20 market position. Furthermore, Microsoft can focus on software development which is the company core business. The negative aspect for this partnership in Microsoft’s prospective would be: 1) lose the direct access to the customers, 2) risk of conflict with the other channels (such as WalMart, Music Match …) and 3) giving up part of the profits. Moreover, why would Microsoft choose Amazon for its partnership? Considering that Microsoft needs a experienced retail partner, the main candidates would be Amazon and Wal-Mart. But Wal-Mart has lower e-retailing recognition and a much higher potential bargain power that will certainly be used in the future. Therefore Amazon is the better of the two options. Finally, for Amazon the main positive points are: 1) soften rivalry, have MS as an ally instead of an enemy, 2) leverage on the MSN and messenger huge market penetration, (more that 100 million users), 3) ability to capitalize on MS investments to reinforce externality loop, needed to catch up Apple in the standard wars. On the other hand, the negative side for Amazon would be: 1) risk of selecting the wrong partner, 2) risk of potential retaliation from Apple and 3) locked-in with only one side instead of profiting from both. 15 of 20 Exhibit 1- Potential S Curves Performance: Availability of titles Performance: Storage media Players (e.g. Ipod) Internet Music CD (MP3) CD LP Internet Music CD LP Time Time ? Internet Music Performance: Quality ? CD LP Time Exhibits 2 – Comparison between CD and Internet Music Sales Music Sales Evolution - CD X Internet Music (US$ Million) 14000 12000 10000 8000 Student's assumptions 6000 4000 2000 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004* 2005* 2006* 2007* 2008* 2009* Download/Subscriptions CD Sales Digital distribution value (including illegal file sharing) 16 of 20 Exhibit 5: Characteristics of Internet Music Services Name Apple Itunes Market Share 70% # Songs 1,000,000 Price 0.99 Format AAC Napster (NP) 11% 1,000,000 0.99 wma Microsoft N/A 1,000,000 RealNetworks (RN) WalMart (WM) 6% 6% 0.99 0,49 to 1,000,000 0,99 500,000 0.88 wma wma wma Business Model Hardware Compatibility Support Software Sell MP3 players? Reviews, Playlist, Top Charts, etc per song monthly fee / per song monthly fee / per song monthly fee / per song per song ipod Yes Just Ipod Yes several Yes Yes, several Yes several Yes No Some several several Yes No No Yes, several Some No Exhibit 6: Uniqueness and Complementary Assets in the Internet music 18 of 20 Exhibit 7: Internet Music Devices – Forecast (Jupiter Research) Exhibit 8 – Scenarios of Industry Evolution (A) Total Disruption Heaven or Hell1 One winner Takes the market Expected future Two stand. coexist Amazon is ok with CDs Amazon plays in both worlds Small Niche market 1 will depend on Amazon’s strategic positioning, i.e. “picking” the winning horse 19 of 20 Exhibit 9 –Scenarios of Industry Evolution (B) Total Disruption Amazon Leads Expected future Amazon Follows Windows Std. wins Apple std. wins Label’s Utopia Amazon is also ok selling CD’s Total Fad 20 of 20