How to be a Player - Making Money as a Portable Music Device

How to be a Player Making Money as a Portable Music Device Manufacturer Introduction For millennia, music has provided a powerful accompaniment to the events in our lives, such as weddings, funerals, and myriad celebrations. Historically, this music only took place in a relatively fixed location (e.g. where the band was standing). While there were some early advances such as the semi-portable record player, starting in the 1950s, the handheld transistor radio truly gave us the ability to add music to almost any aspect of life. Suddenly such mundane activities as riding the bus, washing the dishes, and walking down the street could be set to our own personalized soundtrack. The idea of portable music is no longer new, but the enabling technologies and the accompanying industry dynamics are still in rapid flux today. For the companies involved in this industry there are several challenges to both creating and capturing value. We explore some of these challenges and provide our assessments of the best approaches to competition. Portable Music Player Industry Market Definition Many kinds of businesses relate to the music industry, and depend on its health for their success. Portable Music Value Chain From this point of view, the music industry is the of which portable music device manufacturing is a much richer ecosystem. This ecosystem encompasses a variety of critical players from music artists to retailers as show in the value chain El ectronic Suppli ers Recordi ng & Dupli cation one. It is therefore important to note that the focus of our study, the device manufacturer, is a subset of Technology IP Owners Arti sts center of a confluence of several niche-industries, Record Labels Device Manufacturers Content Aggregators (Radi o, Tower, i Tunes) Consumer Electronic Retailers (BestBuy, Amazon) Internet Servi ce Providers Portable Musi c Consumers chart. Companies we are calling “Device Manufacturers” have two separate functions – manufacturing/assembly (often outsourced) and design /marketing/ distribution (the core functions of this level). We are further limiting our analysis to MP3 type device manufacturers. The other important distinction in the portable music industry is between enabling technologies and music publishing (the two relatively separate value chains above). Although our analysis will focus primarily on the enabling technology of portable devices, we will see that strategic ties to the music industry can be employed to varying effect. Market Evolution How and why have MP3 players come to be the dominant format in portable music? Let us examine the history of portable music’s evolution. Portable music encompasses three main categories: broadcast radio, pre-recorded media, and digital media. Broadcast radio refers to the industry where federally-regulated channels of content are transmitted into the air; this also includes modern advances such as digital radio, and premium satellite radio. Pre-recorded media refers to tapes, CDs, mini-disks, etc. where content is bought and sold in physical packages. Digital media refers to the recent development in which content is encoded in a purely digital (non-physical) form that can be stored and copied using a computer and the internet. To understand how this industry evolved to its current state its important to look at performance along what we believe are the three most relevant dimensions: music fidelity, selection, and robustness. Fidelity The portable radio listening experience began tinny, and gradually improved, due to improvements in broadcast technology and in the radio handset itself. Recently, radio has enjoyed a bump in clarity from the incremental advent of Digital Radio and Satellite Radio. In Pre-recorded Media, tape began almost as good sounding as radio, but quickly improved. CDs, however, were a huge incremental leap in clarity, thus the common descriptor, “CD-quality sound.” When MP3s were first introduced they were streamed through a modem and sounded inferior, but fidelity quickly exceeded anything in broadcast and now approaches CD quality. As evidenced by the growing dominance of MP3 players, the fidelity of MP3 is now “good enough” for most users who now look to other performance dimensions in their purchase decision. Selection Anywhere, anytime, custom selection may be the new driving force behind device purchase. On this dimension MP3 is clearly superior. Radio listeners can access any of a handful of available stations. Much as cable increased the menu for TV viewers, Satellite Radio expanded the set of available channels for radio listeners but the broadcaster still picks the specific content. The selection of Pre-recorded Media is within a person’s own collection. No matter whether a tape or CD user, a person’s collection grows over time, creating an ever-expanding selection. However, the “collection,” at any given point in time, is limited to only those CDs a person has with them. The MP3s encompass people’s entire collection, and more. Because the MP3 user culture co-evolved with a pattern file-sharing, personal collections of MP3s often dwarf their pre-recorded media collections, thus creating the ultimate music menu. With large capacity MP3 players, this music is with you at all times (like a large collections of CDs) and easily accessible through innovative interfaces. Robustness The transistor radio was a solid state marvel. Not long after its introduction, the handheld radio was light, rugged, and had decent battery life. But even today, radio cannot be received underground or in a thunderstorm. The portable tape player (Walkman) was a hit for its style and control, but all those moving parts made for a fragile device. Just about the time the walkman had matured, portable CD players came onto the scene. However, the Discman was a step backward in terms of reliable music at your fingertips. Most notably, they skipped rather easily. The portable CD player got more robust, but the design could never escape the necessity of precision moving parts. In this dimension, the portable MP3 player was immediately superior and decisively so. With no moving parts to wear out (at least in flash based versions), and no risk of skipping, it was clearly superior to the previous technologies. Market Size The portable digital music player market is large and growing rapidly, both domestically and abroad. The U.S. market in 2004 was 12.5M units shipped growing at a CAGR of 20%. Using the projections for units shipped and assuming an average price point of $175, and 3% inflation, the US will be home to a $5 billion market in 2005. $10,000 $8,000 $6,000 $4,000 $2,000 10 09 20 08 20 07 20 06 20 05 20 04 20 20 20 20 03 $- 02 S ale s ( $ m illio n s) MP3 Player Market Size U.S. 1 As shown in the next projection, the installed base is expected to plateau around 70 million. However, sales could potentially remain strong, as with televisions, because of a frequent replacement rate. None the less, since this product is at least semi-durable there is a chance for a period of overshoot and collapse. This is not reflected in the Jupiter research shown here. Market share statistics for portable music device makers are difficult to pinpoint. Apple appears to have between 58 and 65% market share, with no other player greater than 10%. It is also reasonable to assume that C5 (concentration of the top 5 players) is around 85%, as suggested by the chart above. One reason for the difficulty in obtaining accurate share information is that it changes rapidly. For example, SanDisk clocked in at 6.7% share of February US sales3, second only to Apple, while they were not even in the top 10 five months earlier. Profitability Current Industry Profitability The makers of portable music players do not sit in a highly attractive industry. The retailers of their products wield significant power. The suppliers (who sell them crucial inputs) capture substantial portions of the value pie. New players (like SanDisk) faced few barriers to entry. There are also several competing mobile entertainment substitutes. Finally, rivalry in the industry is high, albeit not always in terms of prices. Buyer Power Medium Lots of big retailers to deal with but some direct/web sales Supplier Medium The value from hard drives, processors and other key technologies Power Entry Barriers pass largely to suppliers Low Substitutes Brand to some degree; Access to distribution channel barriers are limited (especially given the rise of the Internet) although more difficult within the “big box” retail outlets Medium FM Radio, CD players, cell phone games, books, portable TV Rivalry High Not all price based but heavy feature-based competition Underlying Industry Dynamics What are the underlying realities that lead to the creation of this relatively unattractive industry? The table below lists the key dynamics underlying the industry’s structure. While the heterogeneity of demand (which on the one hand allows for more competition via differentiation while on the other lowers the barriers to entry) and the high touch nature of the product create some levers for profit generation, on the whole things are grim. Heterogeneity of Demand High Consumers have very different uses from sports to commuting to fashion all of which can potentially be best served by purpose built devices. Consumer Emotional Involvement High Consumer wears the device on their body Product Spillovers High Easy to reverse engineer. Economies of Scale Medium Advertising and manufacturing. Economies of Scope Low Nothing specific to this industry. IP Lock-up Low Typically not that important due to spillover. Companies like Apple currently have some interface IP and a hard drive lock­ up, but competitors are quickly working around this Manufacturing Learning Curve Low Since much production is outsourced and since we believe there to be very high spillover (i.e. you do not need to actually make the product to take advantage of learning because it is shared amongst the players) the learning curve has low impact on the formation of this industry. Switching Costs Low In general consumers face low switching costs. However, firms do try to create them, such as Apple, with proprietary music formats, or Sony with the mini-disk. Network Externalities Low Neither direct (if more people have iPods it doesn’t matter much to me) nor indirect (you can still get Pink Floyd in all competing music formats and don’t need to rely on proprietary “developers” such as in the case of a computer operating system). General firm profitability drivers There are two generic techniques that firms in all industries employ to capture value: uniqueness and complementary assets. Uniqueness As a rule, uniqueness in this industry is short lived; however, it can be the basis for value capture while it lasts. One form of uniqueness comes from creation or adoption of an emerging new music format. Naturally, new formats cause consumers to purchase new consumer electronic devices (often the device and the format co-evolve). The first device manufacturer to successfully address a new format wields uniqueness in the consumer’s mind. For example, recall the Walkman and now the iPod. When a breakthrough device is successful, it quickly becomes the dominant design. But, other entrants soon erode the technical uniqueness by mimicking the functions of the blockbuster device, perhaps even making improvements in price and features. Other sources of uniqueness include device design and potentially device components. The iPod is again a good case example. The iPod employs a patented touch wheel and interface that has proved popular with consumers. However, other manufacturers are already experimenting with similar and potentially better new designs, eroding the uniqueness. As for components, the Apple, when it was first released the iPod, secured an exclusive relationship with its supplier of micro-hard drives which helped it maintain a unique physical format. However, it is likely that this supplier is capturing the surplus from this uniqueness and not Apple. Complementary Assets Competitors in this industry seem best served by attempting to create complementary assets, such as brand. Apple, for example, is trying to leverage its temporary uniqueness into a brand image of leadership and quality. This image will help it win customers even when devices from competitors are roughly equivalent. Distribution is another potential complementary asset. Companies that can create exclusive relationships with retailers and/or create their own retail channel may benefit as uniqueness erodes. Finally, and perhaps most visibly, companies are trying to gain assets in content distribution, with iTunes being the most prominent example. Potential Strategies In a fast-growing industry with limited long-term profit prospects, how will firms make money? We divide the strategies being pursued by firms into three categories – winning, aspiring, and unsuccessful. “Winning” Strategy - Complementary Assets in Adjacent Sub-industries The only clear “winning” strategy at this point is Apple’s use of complementary assets in brand, content delivery and product design to drive sales of devices. Apple is the dominant MP3 device manufacturer (hard drive or flash memory) and is making record profits owning this market. Apple, in addition to being a hardware manufacturer and marketer, also runs the most popular website for downloading digital music (iTunes). Early on iTunes was a huge advantage for Apple as it was the only place to download digital music legally and iTunes only worked with iPods. In fact, it is arguable that Apple was the first to address the digital rights management problem in an acceptable (to the music industry) and profitable fashion. This created the first “whole product” for most consumers – music and player. The advantage has eroded as there are now multiple legal music download sites that work with multiple players, however, Apple greatly benefited by having this advantage at a critical time in the market. By being the only “whole product” for early adopters, Apple took an early lead in market share and market perception. This lead fed into positive reinforcing loops as Apple was able to use it’s early success to invest in R&D (leading to better products and thereby more reason to buy iPods) and marketing investment (leading to more awareness thereby greater sales). It also allowed Apple to create a web of key relationships with music companies and distribution. In this way, the temporary advantage that the complementary asset of music distribution gave to Apple, while eroded, gave them a huge lead for the long run that will be difficult for other competitors to overcome. These advantages combined with existing assets Apple brought to the market: brand, design expertise and distribution channels. Apple’s brand is one of the best known and best respected brands in the world. They have spent hundreds of millions of dollars and many years building this brand (Apple already had a great brand name prior to its entry into the portable music marketplace). Apple has been know for great design skills for many years across multiple products. Finally, Apple has an established distribution network – website, Apple stores, other retailer relationships, HP partnership, etc. (more of a point of parity than a point of competitive differentiation). “Aspiring” Strategies There are a number of firms that, while not achieving Apple’s level of dominance, have had a modest amount of success in this market. They are pursuing two primary strategies: pure play and forward integration. Pure Play / Feature Differentiation Rio represents a die-hard pure play firm. Rio competes only at the device level of the portable music value chain. Rio is the 2nd leading provider for MP3 players, both hard-disk and flash-based. Rio’s strategy is to be the best of breed in this rapidly growing sub-industry of the portable music space. The company single-mindedly drives toward creating a unique product. Even though the digital music player lineage is still in late ferment stage, most of the features users need can be supplied by many devices on the market. In other words, it is difficult to create a differentiated position based on exceptional features. Rio has exceptional features, but their primary focus seems to be style. Every Rio players has an unusual shape and color, unlike anything else on the market. They are probably the best-known alternative to iPod. Rio has approached the business of MP3 players with the philosophy that “If we build the coolest product that does exactly what the customer wants, we will succeed”. While that is a compelling story in the abstract, it ignores the reinforcing loops necessary to win in the long run (loops that Apple is attending to). Furthermore, if customer demands prove to be as heterogeneous as in, say, cell phone handsets, a firm with small market share (<10%) may have trouble achieving the necessary scale to persist. Finally, as the performance of portable MP3 players becomes easy to replicate and production cost becomes the chief axis of competition, a niche strategy that relies on contract manufacturing will struggle against the large scale manufacturers like Sony and Apple. Vertical Integration SanDisk is a prime example of forward integration. Prior to entering the MP3 player market, SanDisk was the leading provider of flash memory cards used in digital cameras, flash MP3 players and other consumer electronic devices in need of cheap storage (e.g. cell phones, PDA’s etc.). However, as this market commoditized, Sandisk began to see its profits margins shrinking. It has reacted by differentiating its storage products – the addition of security or higher speed data access are examples of this (this strategy continues today) and forward integrating into MP3 players. Consumers appear to choose portable music devices on an array of factors, most importantly the dimensions discussed in our S-curve analysis but also including cost, battery life, form factor, and ease of transferring music4. What advantages will a component manufacturer have compared to a pure device manufacturer on these competitive dimensions? Product Feature Advantage Reason Cost Component Mnfrs Economies of scale and other drivers of lower manufacturing cost Battery life Parity All manufacturers will have access to the same battery technology Form factor Device Mnfrs Device manufacturers have more experience and credibility in consumer design, but the gap will likely decline over time. Ease of transfer Parity Increasing reliance on industry standards Brand Device Mnfrs Device firms depend on consumer awareness, and have sunk much cost building brand. In addition to these product dimensions, the manufacturers will also require access to distribution channels, an area where SanDisk likely has parity with it’s memory offerings. It seems unlikely that cost advantage alone would allow component manufacturers to overtake pure-play device manufacturers. While they may make some significant inroads, there will be substantial segments of the market where component manufacturers’ cost advantage will not overcome their relative weakness in interface design and style. For example, brandconscious consumers will look to more established brand such as Apple or Sony. The component manufacturers will likely be unable to stretch their more techie brands into the specific demands of this market. As a result, we would predict that component manufacturers will use their cost advantage to take substantial share in the “low end’ of the device market but device manufacturers will be able to rely on brand and design to survive in the upper end of the market. This prediction is borne out by SanDisk’s performance with their flash-based MP3 player. From a technical point of view, the product does the job. However, the SanDisk name means fast and reliable ram-based storage. It evokes an image of memory cards, which are the modern equivalent of the floppy disk. The brand image doesn’t inspire consumers to check out their exciting new consumer electronics the same way Sony or Philips does. Therefore while SanDisk has made respectable inroads in the portable player market, the cultural gap between embedded memory card design and glamorous consumer electronics design could be a prohibitive barrier for SanDisk in the long run. Unsuccessful Strategies Complementary Assets in Content Creation Sony, like Apple, has complementary assets in other related industries. With a great brand name and design skills, why has Sony not played a larger role in the portable digital player market? Ironically, part of the reason has been its “complementary assets”. Sony owns several music labels (Columbia, Epic and others) and thus has a major stake in the control of digital content. Digital music, which looked like an opportunity to Apple, looked like a threat to Sony, since in the early days of the industry the most common way to acquire digital music was to get it for free. Sony was more concerned about protecting it’s assets in content than in selling players. Even their more recent moves to embrace digital music have fallen flat. Their internal prejudices have interfered with proper execution of their own online music store. One review of Connect, Sony’s online music store, uses the phrase “control-freak behavior” to describe the interface5. Proprietary Standards A company called iRiver sells one of the rare devices that requires that a user to use their proprietary software to manage the songs on the device. Most other devices appear as a standard hard drive to your computer and you can copy songs back and forth like any other kind of file. It seems clear from user reviews that consumers really don’t like this approach but some put up with it begrudgingly because the iRiver reputation is so strong among portable audiophiles. This represents a huge vulnerability because the brand can be eroded and the market share can be claimed by other ambitious players who have engineered equally good sound quality. “Soft” Standards With the iPod, Apple has attempted to build “soft standards” in music format through their use of the AAC format. The iPod plays MP3s and other formats, but many features of the iTunes/iPod experience work better with the AAC format, which is technically an open standard but is conspicuously supported only by Apple. In this space, value-added extensions to an open standard do not proffer the benefits that they might in other areas such as telecommunications hardware. The performance improvements from these extensions do not appear to offset the “hassle” for consumers of managing the additional complexity or the restriction to a single source of content. Future Developments As mentioned, the portable digital music device market is still undergoing rapid change. There are number of developments on the horizon that could impact Apple and other current device manufacturers, including changes in communication technology and device technology. We will examine four possible scenarios and describe potential firm strategies for each. The dimensions we use for our scenario analysis are product maturity and convergence: • Will the portable digital music player become “good enough” across all relevant performance metrics (i.e. s-curve flattens)? • Will music replay become a feature of other devices such as cell phones or PDAs (i.e. convergence) to the extent that most users no longer desire to own/carry a separate purpose built device for music? By plotting future developments on these two dimensions, we can examine four potential outcomes. Business as usual Wild West ? Price wars Nokia/Palm win Devices converge Stand-alone dominates S-curve continues S-curve flattens Business as Usual If portable digital music devices continue to improve and do not “converge” with another device, then Apple is well positioned to dominate the market. They will be able to ride the reinforcing loops of brand and R&D to demand premium prices, which they can re-invest in brand and R&D – the cycle continues. To prepare for this scenario, a company like Apple should “keep on keeping on” – invest in R&D and marketing to stay on top of evolving customer demands. Low-cost players will seek lower feature and less brand-sensitive segments and fight for crumbs from the high-end table. Price Wars Almost every component of an MP3 player is or is becoming a commodity. It’s quite possible that the player itself will follow. As we noted earlier, any form of uniqueness will be very hard for Apple (or any other player) to maintain. If the performance of the device reaches “good enough” across all relevant metrics, there is a risk that price will become the dominant consumer choice factor. In this scenario, companies with high costs will be unable to compete with low-cost producers (potentially including component manufacturers). A company like Apple would be forced to license technology to low-cost players who could design and assemble a device at competitive prices. Lower-cost players would seek to build scale and rationalize supply chains to drive cost down as low as possible while investing very little in non-process based R&D. Nokia/Palm Win If the portable digital music player reaches “good enough” and consumers prefer to carry only one digital device, that device is likely to be a cell phone (or PDA for some). In this scenario, phone makers will embed the necessary software and hardware into their products, relegating MP3 device makers to a small niche. In this scenario, companies may still be able to capture value from delivery digital content. Apple, Sony and others who have established online digital music stores are wellpositioned to transform themselves from hardware players to software players. In addition to their direct link to consumers, they may also be able to license software to phone manufacturers as those companies attempt to differentiate their products. Companies such as Rio or iRiver will be forced to fight for customers in the small music-only devices space. Wild West If portable music players continue to improve in performance while customers begin to demand one digital device, it is hard to predict who will succeed. MP3 player manufacturers will offer the latest and greatest players with new and improved features, but phone or PDA manufacturers will offer non-cutting edge features bundled conveniently into their products. To prepare for this scenario, a company like Apple would need to advance on two fronts – continue to push the envelope on new device features, but build relationships with phone and PDA manufacturers to license one-generation-behind technology. The goal would be to extend their existing complementary assets (R&D, brand, distribution) into these new applications wherever possible. Low-cost MP3 producers would likely find themselves commoditized as high-end consumers split between “nice” MP3 players and converged devices, leaving relatively few consumers for the lower end of the MP3-only market. Conclusion The portable digital music player is an exciting new market, but one that resembles in many respects traditional consumer electronics. We have seen that Apple was able to use one key complementary asset in the form of content distribution to take an early lead, which is significant in a market where there are meaningful reinforcing loops that make it difficult to overtake the leader. Other players without this key asset have attempted to use low cost or standards to build share, but with less success. The reinforcing loops do not appear to be overwhelming, however - like manufacturers in similar fields, early leaders in MP3 players will likely see their initial margins eroded as costs drop and the devices become “good enough” for most consumers. The elements of success will be different for the market leader and for everyone else. Secondary players will need to identify niches where they can carve out an advantage either on feature or cost and hope for the best. More interestingly, the key to success for the market leader (Apple) will lie in two skills: extending the “s-curve” of devices for as long as possible (and dominating that s-curve), and correctly predicting (or hedging against) the evolution of digital devices. Only by avoiding these two traps – commoditization and disruption – will a device manufacturer be able to claim to “be a player”.