Disruption
David Pakman's Blog www.pakman.com

The Pressure on TV Networks, Ari Emmanuel and Cable Companies

Jun 06

Lots of recent discussion on TV and Hollywood. Ari Emmanuel accuses Google (again) of aiding and abetting pirates. Henry Blodget writes a nice piece on the changing TV viewing habits of consumers. Dan Frommer says those changing habits won’t really affect the MSOs and Networks anytime soon. And Jeremie Allaire seems to claim that Apple’s next move in TV will be to emulate TiVo’s (largely failed) box/cable-card strategy (but correctly points out the disruptive power of AirPlay). Oh, and Sean Parker launched version one of AirTime.

I wanted to add a few points to the discussion about the pressures on the TV industry. First, some basic observations:

TV programming is not homogenous

The uber-bright Hunter Walk provided me with a fascinating view into his opinion of the real tiers of TV programming. Out of the 4-5 hours of TV the average household watches each day, there are essentially three tiers:

  • Hour 1 (No Substitute) – This is the never-miss-an-episode, live-sports, must-see-TV that exists across many networks. The Sopranos, Mad Men, Yankees/Red Sox, French Open, Homeland, etc. When we watch TV, this is the first hour we watch. We watch this stuff live or DVR it and try never to miss it. We will pay for it any way we can and even endure roadblocks to watch it (like when networks won’t make it available on our preferred viewing device, or expire old episodes, etc.) While the networks believe 80% of their content fits this description, it is probably more like 20% of all shows currently on the air, at most.
  • Hours 2-3 (Nice to see) – This is stuff that we have an allegiance to, but are comfortable missing an episode and won’t really endure friction to see it. Many comedies fit this category, from 30 Rock to The Simpsons, as well as the countless procedural crime dramas like CSI, etc. The networks think all of this content is in the category above, but it really isn’t. And probably another 30% of all shows on the air fit this category.
  • Hours 4-5 (Filler) – This is the low-budget, mostly reality show programming that networks use to fill the time between their one or two hit shows. Think Kate Plus 8 or Let’s Make a Deal re-runs. The only time you watch this stuff is when you are couch-surfing. This is probably 50% of all programming on air.

When Ari insists that Facebook, Google, Twitter and everyone else in tech will have to “pay for Aaron Sorkin”, he is really talking about the “Hour 1″ category of programming. That stuff is really high-value and is not in a lot of danger of being disrupted any time soon (although the rising production costs and off-the-charts no-risk fees paid to talent are surely to be reconsidered in the future.) But as for the other two categories…

Our attention is shifting away from TV

All media operates in an attention economy. They compete for our attention against the backdrop of thousands of choices as to how we spend our time: email, video games, Facebook, Twitter, Flipboard, Instagram, etc. The latest numbers show those choices are finally catching up with TV; we are watching less of it, whether DVR’d or not. We aren’t watching less of that incredible No Substitute programming, but we are watching less of the 80% of the other stuff. And by the way, those big “hit” shows that Ari talks about have relatively small audiences. Only about 3 million people “tune in” for an episode of “Game of Thrones” and over the course of a week about 9 million people have seen it through various means. Same for Mad Men (3 million)Desperate Housewives (9 million) and The Good Wife (9 million). That’s a pretty small audience compared to, say, the 450 million on Facebook every day, the 800 million who watch YouTube videos every month, or the more than 100M people who watched the final episode of M*A*S*H. As TV and other entertainment choices proliferate, “hit” audience sizes have decreased. So, one of the immediate threats to network/cable television is that we are likely to watch less and less of the “Hours 2-5″ programming that fills so much of their programming grids. (The smart production companies know this and are already producing much lower-cost, quality programming for YouTube and other online-only outlets.) And where will that lead us?

The pressure will first come from the advertisers

If Nielsen didn’t lie and try to convince TV advertisers that the 50% of people with DVRs still watch commercials (hint: that is utterly ridiculous. We don’t watch any commercials anymore unless we watch a live sports event), I believe advertisers would appreciate that we aren’t seeing their commercials anymore. While the PC and mobile web still don’t offer nearly the great story-telling opportunities for advertisers as TV commercials do, it just doesn’t make sense to continue to buy very expensive TV media when no one sees your commercials. Certainly live sports TV CPMs will go up, but the rest has to fall as advertisers figure this out. And reports detailing that we are watching less TV has to start to sink in. Advertisers would love to try to buy only the hit stuff, but networks are good at bundling to force them to buy the filler programming too. But the whole bundle will start to feel more and more pressure.

The dual revenue stream model of the cable networks provides lots of air cover against decreased ad revenue. The affiliate fees they get for carriage will sustain them for a while. Brand advertisers are looking elsewhere to find places to tell their stories and to reach their audience. And online, we can target viewers and assemble audiences with drastically better efficiency (and reliability) than on TV. Online video is becoming so performance-based, that advertisers now can pay only when someone has actually watched the commercial and not pressed the “skip this ad” button. If you really care about making sure someone sees your commercial, online is the only place to show it. And more and more, we just aren’t seeing the ad on TV anymore.

What’s This Mean?

  • Advertisers will begin to spend less on TV and that will be the canary in the coal mine that big changes are afoot
  • We will continue our shift away from viewing traditional TV and towards IP-delivered unbundled shows, some which will have migrated from traditional TV, but many that will be organic and native to internet programming (the made for YouTube stuff is a prime example here.)
  • Ari will continue to demand high prices for the “Hour 1″ shows created by his elite clients, but the audiences for those shows will grow smaller and smaller.
  • As a result, networks will begin to feel the pinch of decreased advertiser spending, and they will try to raise carriage prices to the MSOs more aggressively
  • MSOs will keep trying to push our bundled TV prices up higher as a result of this, pushing more and more of us away and into other IP-delivered options
  • Finally, I believe the as more of us watch IP-delivered programming, the lure of certainty that the audience you really care about is seeing your ads will prove appealing to more and more advertisers, and online video ad revenues will continue a dramatic ascent
  • And so the cycle will go

(Update: this report from Pivotal Research refutes all of Henry’s points…but bases all of its observations on data provided from a single and biased vendor: Nielsen – a panel-based research method that looks at activities of only 25,000 households – and has concluded, for one, that those of us with DVRs still watch ads. Go figure. Oh, they make their money from the TV industry.)

 

 

Why Should eBooks Cost $15?

Apr 16

Last week’s announcement by the Justice Department that they are suing Apple and several of the world’s biggest book publishers for conspiring to keep eBook prices high generated plenty of media coverage. One challenge in wading through this coverage is that most of it tends to be written by…journalists. And some journalists are also authors. And authors seem to have a soft spot for publishers who fight for higher prices. So, we get lots of coverage sympathetic to the plight of the poor book publishers. Amazon is evil, you see.

Absent from most of this coverage are two main questions: a) what is the right price for eBooks and who gets to set it, and b) why are eBooks not interoperable on different devices? These questions, in my mind, are far more interesting than the ongoing struggle of publishers to adapt to Amazon’s dominance in book retailing. In fact, the answers can significantly help legacy publishers stay competitive for the future and avoid extinction.

eBook Pricing

First, a conversation about eBook pricing. Readers of this blog are familiar with my many discussions on digital good pricing and price elasticity. There’s “Weighing In On the Amazon/Macmillan Pricing Debate” where I detail that the market can tell you your optimal (i.e., highest profit producing) price for digital goods. Each incremental digital good has no additional cost. The marginal cost of distributing it is zero. So you really want to maximize total profit by finding the price that produces the most number of copies sold. In these markets, you make a mistake when you set your price by looking at your legacy costs (which were designed for a physical goods market in pre-digital times). Digital markets produce much lower profit per item, since digital markets tend to have lower prices for goods. (See “As Big Media Goes Digital, Markets Shrink“.) In all the discussions about why book publishers demand that eBooks should be $15 and not $10, they say it is because they cannot afford to sell books at $10. That is, they cannot cover their legacy cost models on that number. Right. Which is why you must rebuild your cost structure for a digital goods industry with far lower prices. You start by paying your top execs much less than millions of dollars a year. Then you move your offices out of fancy midtown office buildings. Why should eBooks cost $15? Amazon is far more of an expert on optimal book pricing. They have far more data than publishers, since they experiment with pricing hundreds of thousands of times a day across millions of titles. Amazon can tell you the exact price for a title that will produce the most number of copies sold. Amazon is pretty sure that number is closer to $10 than to $15. Yes, they want to sell more Kindles. And they believe that lower eBook prices mean more eBooks sold which means more demand for Kindle. The negative coverage of Amazon is centered on them selling eBooks below cost in order to reach the $10 price point. But that is a function of publishers setting the cost higher than $10. If the profit-maximizing price for an eBook is $10, then publishers must adapt to set a wholesale price lower than that, even if it means your legacy cost structure doesn’t allow it. And that’s the rub. [By the way, as publishers continue to resist this market force, new "publisher" models are appearing and will replace the traditional functions of publishers with more digital-friendly models.]

Openness and Interoperability

Now, how do legacy book publishers fight back? Well, to begin, their biggest mistake prior to over-reaching on pricing was to insist retailers DRM their eBook titles. Just like in online music, this insistence on anti-copying protection (albeit with limited usefulness) not only creates inconveniences for consumers, it allows for dominant proprietary ecosystems to form (like Apple did with iPod/iTunes, where tracks bought from iTunes only played on iPods, Kindle books can only be read on Kindles.) Instead, publishers should have demanded the opposite. All eBooks should be sold in open, interoperable formats, so an eBook sold at Amazon could be read on a Nook, etc. This would have separated the reader market from the retail market and lessened Amazon’s eBook dominance. It may be too late for this change to work, but it is worth exploring. Incidentally, I predicted this in 2009 with this piece, “The Book Industry Is In Trouble, But Piracy Is Just A Symptom.”

Here’s the essence of what I see — we have authors and publishers screaming that Amazon wants to sell their books at prices lower than the arbitrary costs the authors and publishers have set. But why must eBook prices be $15? What is so magical about that price? Will it maximize profit? I am skeptical that this price does optimize profit. I see how it attempts to protect a legacy cost structure that is out-of-whack with a digital goods market. Yes, Amazon is a relentless competitor. But they always seem to be on the side of lower prices. And as consumers, we love this about Amazon. But none of the articles I have read seem to mention that the winner in a lower-price eBook market is the person authors are all writing books for in the first place. The reader.

(Incidentally, I am completely unmoved by the argument that if Amazon forces traditional publishers to sell books at lower costs, then the publishers will go away and we won’t have books anymore. Hogwash. The publishers built for a printed books world may go away, but their digital native versions will replace them.)

Wither the Giants? The Arrogance of Aging Incumbents

Jan 25

My friend and former colleague Greg Scholl sent me an article this week and a provocative quote jumped out of it. Here is the view of Irwin Gotlieb, CEO of one the largest global advertising agencies on the planet, as he shared his view on this year’s CES. Given last week’s SOPA/PIPA debate, I thought Mr. Gotlieb’s observations were worth elevating, as they effectively capture a way of thinking that ultimately undermines incumbent media companies and the businesses that serve them:

 

Much of what we saw at CES relates to things we’ll be seeing 24 months out. In my mind, it’s all good: we’ll be able to target better, we’ll be able to segment better. The ads will be delivered on screens that are sharper, look better, larger, which ultimately provides more effective communication. There’s one last element: in the role that we [media buyers] play, we have a responsibility to ensure that technology develops in a manner that doesn’t shake up the supply-and-demand equation of our business, doesn’t destroy the content amortization business, isn’t disruptive simply for the sake of being disruptive.

If it does alter the supply-and-demand equation, it needs to do so positively, not negatively. When you have the share of the deal volume that we do, you can’t just be passive about it. You have to try and influence it. The technologies and devices that begin to get manifested at a trade show like this needs to be guided, so that it all works out in the best interests of our clients.

- Irwin Gotlieb, Global CEO, GroupM, originally appeared at TVExchanger.

We have a responsibility to ensure that technology develops in a manner that doesn’t shake up the supply-and-demand equation of our business.

A bold statement and, it seems, a common mindset for many incumbent business giants in their respective industries; a mistaken belief that they can somehow coax disrupting forces (be they new companies, or larger macro consumer trends) into conforming to their legacy business models and cost structures. As we have seen countless times, the actions of incumbents, when faced with technology disruption, often is to turn to litigation, legislation or other non-market strategies (i.e., anti-trust investigations, artificial price barriers) in an attempt to delay or block the challenging technology or companies. This perhaps work as a delaying tactic in the short term (Rio MP3 player case, Napster, book publishing agency pricing model with Amazon) but fails in the long term.

Mr. Gotlieb’s apparent belief that he and other advertising agency leaders can “ensure that technology develops in a manner that doesn’t shake up the supply-and-demand equation of our business” is futile in the long run but perhaps more pernicious is the implicit arrogance of thinking the market force of the web can be channeled into their bank accounts by sheer force of will. Of the many problems with this way of thinking, paramount is the ability to rationalize away making the hard choices and decisive actions to ensure the Group M’s of the world play a vital role in the new economy as they have done in the legacy one. (Cue Scotty from Star Trek…) “You cannot change the laws of physics.” For Group M and other incumbents, it’s almost difficult to fathom, given how entrenched and advantaged they are, that they could drop the ball. But, many will, as history has shown over and over again in times of market transformation.

Technology forces which bring greater efficiency and transparency to markets simply don’t care about privilege, access, and rolodexes. They disrupt predecessor markets because of structural problems like price opaqueness and false scarcity that no longer “work” in the new market. Look at Google: their entire approach to advertising is to ultimately remove the middle man just as increasingly, the media buying side of traditional agencies is the inefficient middle man, marketing up the cost of media to provide their services. Google is now selling $40B of media every year, the majority of it without a middle man (or at least with different sort of middle man … and in any case, getting far lower margins than traditional media bought by agencies.)

We watched as the music industry delayed their demise by suing Rio, Napster, and literally hundreds of others, delaying adoption of new business models not based on scarcity. We listen to Jeff Bewkes decry Netflix as the Albanian Army as he feverishly works to reduce their influence with his content. We observe the movie industry fight with everything they have to protect the windowing strategy and defend limited access to content instead of move towards open and immediate paid access to their movies. (Fantastic post on this from Rich Greenfield here, “Innovate Don’t Legislate”.)

And, as a microcosm of this larger conversation, we watched, over a very short period of time in the SOPA/PIPA debate, as the web demonstrated the disruptive advantages of network effects and scale, as over a period of weeks, legislation that appeared all but ratified was shuttered, up to and including an implied Presidential veto. Heady stuff. Granted, if we extend the metaphor and use SOPA/PIPA as a microscope, there are extremes on both sides, and it will be messy and require compromise if the big media incumbents and new technology disruptors are to learn how to co-exist. For big media companies and the service businesses that cater to them, this means recognizing the practical realities of changed business models – probably mostly that their cost of production needs to drop dramatically and they need fundamentally to re-think distribution and customer relationship management to remain profitable and relevant. On the tech side, it means recognizing that progress requires some level of institutional engagement and political compromise – because like it or not, this is the way our system of government works and how laws get written. This won’t be easy or natural, as it’s anathema to the culture of how new media tech and the startups that encompass it conceptualize and operate in our worlds. Facing reality and then demonstrating a bit more collaboration and compromise, however, would go a long way and be better for the customer, who, like our democracy, these industries ultimately serve. Because it’s the customer who is in the driver’s seat, and increasingly, they know it.

Perhaps it’s Pollyanna, but if so, my chips go on technology. Big media has the most to lose because after decades of the game being rigged in their favor, increasingly, it’s the opposite. Of course it is difficult and painful for media incumbents to embrace digital markets considering these markets ultimately are smaller and have less attractive economics. That’s presumably why big media executives are so well compensated – if it was easy, anyone could do it. The alternative, however, is to be disrupted by new entrants which don’t have any allegiance to aging business models and who could care less how out of whack someone else’s cost structure is. Coming back to Mr. Gotlieb’s view, I offer these thoughts. First, incumbents won’t be able to meaningfully guide the technology juggernaut of more efficient advertising mechanisms, so it’s perhaps better for them to focus their energies and advantages towards thoughtful reinvention. New technologies are bringing actual measurable performance and more efficient means of buying to a large share of advertisers. The challenge for incumbents is to adapt their enterprise to embrace this chaos and profit from it. The good news is, it’s doable. However, to think they can bluster their way out of this disruption is a fool’s errand.

This work is licensed under a Creative Commons Attribution 3.0 Unported License.

As Big Media Goes Digital, Markets Shrink

Jan 16

Lots of debate, lately, about Big Media and their bumpy transitions from analog incumbents to digital providers. Over the past few weeks we have had debates around the proposed PIPA and SOPA legislation, Rupert Murdoch (that bastion of new media savvy) railing against Google as a “pirate” and @fredwilson chiming in on the predictable monopoly actions of his cable company, Time Warner Cable in their dispute with MSG Networks. Yesterday Fred posted his views on the weaknesses of Big Media extending their scarcity business models to the internet.

My long-time opposition to scarcity models for digital media content online is well established on this blog and before that at Apple, N2K and eMusic. One thing Fred mentioned inspired me to revisit this subject, and that is market size. Fred says,

[quote]But the studios themselves are likely to do better in a direct distribution model where they reach a broader market at lower effective prices to the end customer. This is what happens in digital distribution. Prices come down, markets expand, customers see lower prices and broader availability. Producers do better. Everyone else does worse.[/quote]

A bunch of things happen when analog media markets go digital. First, prices come down. The cost of distributing digital content is far less than physical goods that used to carry that content (printed books, plastic CDs and DVDs, etc.). Consumers understand that and expect prices to fall. The music industry hated selling songs for $0.99 when CDs used to sell for $18. But almost no one bought tracks for $3.49 when digital music was first sold online. At $0.99, consumers bought a lot. Next, bundles break. Consumers expect to pay to hear or watch only the songs or episodes they want. TV shows sold as 22 episodes on a DVD for $49 will fail when you can watch any episode for $0.99. Consumers don’t like bundles when they have a cheaper alternative. And then competition increases. Because the old guard doesn’t have monopoly distribution anymore, lots of alternatives enter the market. Consumers get more choice. These are all good things.

But finally, and this is where my view diverges with Fred’s, markets shrink. I used to posit that when content is offered widely online with few restrictions, more of it will be sold. But because prices fall, bundles break, and competition increases, I think the legacy content owners end up with smaller markets. They may reach more people, but in many cases they will ultimately make less money per title.

This is not necessarily a bad thing. Since it costs almost nothing to distribute it digitally and the cost of online marketing is far less than on traditional media, content creators can still have great businesses and make lots of money. But the main reason, I think, so many legacy content companies resist the new digital markets and their new business models, is because their businesses will shrink. And that means significantly changing your cost structure. Fewer private jets and executive dining rooms with 4-star chefs (remind me to tell you about my lunch at News Corp a few months back…)

Because the new economics are scary, the incumbents resist it. But the startups embrace it. And this is why we do what we do. As digital media entrepreneurs, we are not working to preserve a legacy business model, we are hoping to create new ones.

Fighting Disruptive Business Models Through Legislation

Nov 16

While there are countless examples of emerging technologies disrupting incumbent industries, there are very few examples of new industries beating the old through legislation. Generally, Washington influence and power is amassed over many years as nascent companies and industries grow. Few industries have the power and influence of the copyright industry. Coincidentally, very few industries are under as much business pressure thanks to tech disruption than the content industry. The two are mixing in poisonous ways.

In 1996, I had a front row seat through my friend Nicholas Butterworth and his involvement with DiMA as the Copyright industry forcefully negotiated dramatic changes to copyright law for the digital era. Most importantly, the DMCA included a hard-fought safe harbor protection for online companies providing them protection from infringement claims if they dutifully followed certain procedures. This has served our online community well.

Despite this, the copyright industry, still not comfortable with navigating the transition from analog to digital, is agressively attempting to force new changes to copyright law that would unquestionably cause lots of collateral damage to the internet and to internet companies with digital native business models (which are, coincidentally, a threat to traditional media companies). The Stop Online Piracy Act (H.R. 3261), introduced in the House in late October (which includes the most controversial parts of the Senate’s PROTECT IP Act (S. 968)), would be bad for internet companies, for internet expression, and for the future of copyright law. Right now, the digital innovation community is the likely engine of economic growth. This is not the time to hand out business model protection to traditional media companies.

More information here and here.

Continued Disruption of Traditional Media Business Models

Jun 01

Coming out of the eG8 conference this week, there has been a bunch of discussion about copyright, piracy and the the continued erosion of traditional media business models. As readers of this blog know, I have discussed this in many posts over the years, like Jeff Bewkes’ Empty Netflix Threats, Why Netflix Won, A Few Things Paul McGuinness Forgot to Mention, and The Sad State of The Old Music Business.

One particular thread that caught my attention is here in TechDirt summarizing the thoughtful comments of John Perry Barlow. In response, Jim Gianopulos of 20th Century Fox responded:

Speech has to be free but movies cost money,” he said, adding that he hears plenty about the need for new business models but doesn’t see any actual alternative business models that generate the cash to fund big-budget films.

We hear this refrain from traditional media executives over and over again. They seem to believe that the laws of economics do not apply to them. As analog intellectual property markets transition from analog to digital, the production and distribution costs substantially melt away. When that happens, the resulting consumer expectations are that the products must be priced lower than their analog equivalents. The price of digital music singles is less than the analog ones. For the most part, eBooks cost less than paperback and hardcover. And now with movies, with Netflix’s $7.99/month all-you-can-eat streaming model emerging as the hands-down consumer favorite, the consumer will pay much less for movies than previously. This means the future total revenue market size for digital movies may actually be smaller than its current analog market. (One always hopes, as things go digital, that more people will have access to content and total volume of sales will increase to make up for the lower unit economics. That has not happened in music, however.)

It is not the responsibility of new digital distributors to protect the economics of the markets they disrupt. Music industry legacy executives have notoriously lagged in right-sizing the cost structures of their business (exorbitant salaries, fancy real-estate for corporate offices, too much staff, etc.) Recognizing this, Jonathan Shapiro noted astutely:

“There are three costs of interest in media: the cost of labor (including actors), the cost of production, and the cost of distribution. Gerry’s complaint disregards what has actually been happening to the cost of labor and production. Let’s compare what happened in audio recording (for which, in his view, there is an emerging business model) and what is happening in video recording.

“In 1990, recording studios could charge tens of thousands of dollars an hour for access to (then) advanced sound gear, and even more for access to expert recording engineers. By 2000, you could buy sound gear that was just as effective at commodity prices. By 2005, my home studio was technically competitive with almost any professional recording facility you might care to name for the type of music I do. Today, the wide-spread availability of cheap digital-audio workstation software, excellent and cheap sampled sound libraries, and people who know how to use them has compressed the value chain even further: many recording studios are closing their doors for lack of interest. iTunes and Amazon have now pretty well put the last nail in the legacy music distribution model, and most musicians see that as a God-send. The shift to concert-driven revenue isn’t new. It is merely a return to the pre-RIAA status quo.

“Over that same period of time, a similar exponential decline in video production costs has occurred as CGI methods have taken hold. Consider the level of realism coming out of Pixar, LucasFilm, and friends, and the slow but steady decline in the use of “name” actors for heavily CGI-based roles (e.g. in Avatar). Actors hired in 1940 were chosen for looks and had their careers destroyed when “talkies” arrived. Today, most people can’t tell you what Zoe Saldana (Avatar) or Andy Serkis (LOTR: Gollum) actually look like. The cost of actors is falling, and the use of extras will soon be a thing of the past. There remain several key pieces to be filled in before location shoots become obsolete, but fewer than you might think. Movies will be primarily built from sample libraries within my lifetime, and very likely before I exit middle age. A surprising number of advertisements are done this way already.

“I don’t see a business model that can sustain the current 20th Century Fox (et al.) production model, just as I didn’t see one in 1993 that could preserve the then-current production model of the recording industry. But the question isn’t how we preserve a legacy production model. The question is: why should want to?

“Audio today is lower cost and lower quality than it was 20 years ago, but not enough that most people would notice. The available variety is going up rapidly, and the ability of new innovators to get air-time has never been better. There is an enormous renaissance going on, and it’s happening largely because the oligarchies that have dominated that industry for the last 60 years are getting pushed aside. We should hope very strongly that the same will happen in video.

“As to 20th Century (and friends), the path to survival is to provide value to the content producers that they will continue to need: content and tools that manipulate it. Distribution and capital oligopolies aren’t sustainable over the long haul.”

I completely agree that the labor costs will continue to feel massive pressure in the movie industry over the coming years. And I would add “marketing” as an additional value add the studios presently provide but will need to substantively alter their skills to become more proficient in non-traditional media in order to remain relevant there. The economics of the future of the movie industry will look quite different than the current ones. And protectionist viewpoints from incumbents won’t stop that from happening.

Author David Pakman
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The Unbundling of Media

Apr 15

As a venture investor in internet companies, I look for technology-based innovation which causes major disruption among incumbents. Since advertising is the dominant business model for most of the web, I think a lot about these technologies and their impact on the future. Clearly the new devices we use to access information and entertainment are wreaking havoc on traditional business models based around ad sales. But I think the biggest change is the way new modes of consumption are forcing the unbundling of packaged media across a wide spectrum of industries.

In music, the carrier format shifted many times, from vinyl to cassette to 8-Track to CD to MP3. In all but the last shift, the content owners controlled the format changes. Along the way, largely driven by the allure of bundling economics, record labels started packaging songs together in albums rather than selling them individually as singles. This allowed the unit price to go up 3x – 6x. If singles cost $2 – $3, records cost $12 – $18. Consumer went along with it.

But as digital emerged, the labels were faced with a harsh reality: over the decades, consumers began to prefer singles. There was no economical way to get them, so we bought full albums to get the 1-2 songs we really wanted. We wanted the album unbundled, but we had no choice. With the emergence of alternative distribution (like Napster and then iTunes many years later), the latent demand for singles was unearthed and havoc ensued.

It was havoc because the labels had not prepared a business model or cost-structure for the unbundling of the record. They had grown accustomed to higher-margin and higher unit-priced albums. We started to witness the unbundling of media. And it took the record industry more than 5 years to offer digital singles for sale legally. Now, music industry total revenues are down more than 50% since their peak in 1999, and continue to fall every year. The biggest culprit is not piracy, it is the fact that consumers, when they buy music, are buying 10% of what they used to, because they only need to buy the single, not the album.

In print, newspapers and magazines have taken a bundled approach for decades. It is impractical to pay for editorial content by the article. Bundling articles into convenient formats like newspapers and magazines solved a distribution challenge and made the economics of selling editorial possible. Once editorial went digital and we could consume information by the article simply by following a link, the unbundling began. Today it is still impractical to charge consumers by the article, so newspapers are trying to convince us to subscribe to digital bundles.

But as it was with music, it is getting harder and harder to imagine this model holding for the vast majority of editorial we consume, since we are discovering more often what to read by following a link passed to us through social media. It might be from The New York Times, but it also might be from Reason Magazine or The Nation or Huffington Post. In looking back at the totality of the editorial media we consume online these days, I imagine it is from a far more diverse group of sources than in the past, making it harder and harder to justify these monthly subscriptions to bundled media, despite the model of metered access being touted the latest great hope for print pubs.

I believe the same unbundling is now happening to traditional and cable TV networks. For decades we watched networks. They made judgement calls about what shows we would like, and we had little choice, so we watched them. The economics of cable TV networks are fantastic (with their dual advertising and subscription revenue streams), so more and more of them popped up. But thanks to DVRs, and now internet video, we stopped watching networks and now only watch shows. We don’t even care on which networks they appear, nor do we tend to know. This is the unbundling of television. And if consumers could only pay for the shows they watch and not the 500 channels times 22 hours per day of other programming I pay for but never see, we’d spend a LOT less on TV than we do know, and the total subscription revenues of cable networks would crumble. Until we have real choice among digital distributors, this is not likely to happen. And the powerful forces of TV networks are working very hard to make sure we must be paying them even if we are watching shows online somewhere else (read more about TV Anywhere here.)

My observation is that unbundled media results in smaller markets than bundled media by artificially inflating total revenues. Some will say, “if you only bought (TV shows, newspaper articles) individually, you’d have to pay (10x, 100x) what you are paying now.” That is only true if you assume the cost structures must stay the same. And when media is unbundled, the cost structures do NOT stay the same. They are forced to radically alter themselves and become more in line with what the market is willing to pay to consume those atomized bits of content. We won’t pay $120 per TV episode. We’re willing to pay something closer to $2 per episode, and so production costs are going to have to fall dramatically. Mobile devices and the social web are accelerating the unbundling of media. This is the great disruptor.

Jeff Bewkes’ Empty Netflix Threats

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Dec 15
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Jeff Bewkes at Time Warner spouted some silly “threats” at Netflix this week, the latest sign that some content owners in the digital age forget who butters their bread. We saw this same thing happen in the music industry multiple times. Any time a distribution channel emerged that provided significant volume, the labels would start to sour on the power that channel exerted over them, largely on pricing, and try their best to cut their legs off. (Walmart, Amazon and Apple come to mind…) Now we are seeing it happen in the movie/TV industry. As I have discussed before, Netflix deftly navigated the treacherous pitfalls of digital video content licensing, building huge customer traction with their DVD business. This enabled them to be able to write big checks to studios to license their content. Now, it seems, as soon as the studios see Netflix’s consumers actually watching the shows, some are “threatening” to force Netflix to pay more for the content when the deals next come up for renegotiation.

These threats are likely pretty empty. Sure, Netflix expects to pay more for hit content over time. But they also expect to pay a lot less for non-hit content, and Netflix is great at surfacing the movies and TV shows we weren’t sure we wanted to see. In addition, Bewkes fails to anticipate that by the time his Netflix deals come up again for renewal, his core DVD business will be massively eroded and Netflix will be dominating on-demand viewing. This means that the cable companies who pay rates for on-demand viewing will offer less volume and economic potential than Netflix will. And who will need Netflix more than ever? Time Warner. I believe Netflix will hold the balance of power at the next negotiation, with more subscribers than the largest cable companies.

Let’s not forget that this animosity underserves Bewkes. Netflix represents the most customer-friendly way of watching movies today, period. Their 16M subs absolutely adore the service, and they aren’t going anywhere. Bewkes still views the world the old way, where studios could create movies and assume we’d watch them. We have more choice than ever and Bewkes needs customer-friendly distribution channels that keep sending money to him, even if the unit costs are lower.

Author David Pakman
Comments 13 Comments

Why Netflix Won

Oct 26

Very few digital media upstarts have been able to build scale businesses in online entertainment. No startup has succeeded at scale in digital music (with only Apple and, barely, Amazon registering any level of success — these are hardly startups). In online video, clearly YouTube reached scale (but had no meaningful business) when it was acquired by Google and now, with Google’s help, will clearly reach scale as a business. In online movies/TV, of the “Five Guys” who seem poised to be meaningful (Apple, Google, Microsoft, Amazon and Netflix), only one is a startup, and it sure is an outlier. And an amazing outlier they are.

In examining how Netflix successfully navigated the perils of licensed entertainment content businesses, important and familiar lessons emerge.

The movie studios wanted Netflix dead. They hated the model from the beginning. Only problem was, they couldn’t kill them. Thanks to the first sale doctrine, codified in copyright law, a lawfully purchased DVD could be rented. So, when many of the studios didn’t want to play ball with Netflix and offer them discounts (or even wholesale pricing) on DVDs, Netflix just went to the store to buy them at retail. This allowed Netflix to get off the ground and assess market demand for their DVD-by-mail rental business without any approval or licenses from rights holders. CEO Reed Hastings’ gut proved right — a more consumer-friendly model of no late fees and big selection overpowered the immediate convenience of going to a corner store to pick up a movie for a night. He offered a better service for consumers against the strong will of the rights holders. And by building a great product, he was rewarded with massive consumer adoption. There are more than 15MM subscribers today, and growing.

Many analysts predicted the death of Netflix as the world shifted from DVD viewing to on-demand streaming. It wasn’t that people believed Netflix couldn’t develop a compelling streaming service. Many of us thought Netflix would whither because the studios/networks would never license them content on reasonable terms. There is no first sale doctrine in digital goods, so Netflix could not get into the streaming business without negotiating painful voluntary licenses with each rights holder. The studios had begun licensing services like Amazon’s Unbox, Apple and Microsoft with limited titles loaded with consumer unfriendly restrictions and pricing (movies can be rented for $3.99 or $4.99, must be watched within 30 days, and once started, will expire and become unwatchable after 24 hours!) Reed Hastings, with 15MM subscribers and growing knew those terms were largely a non-starter with the mass market. He had built a huge business based on customer convenience — pay once a month, watch as many movies as you can, and NO restrictions! Keep a movie as long as you want!

So, it seems Netflix could either stay out of the streaming business or license limited content like everyone else with lots of restrictions. And this is where Netflix beat the odds. They knew the two main weaknesses of studios and networks: (1) big money talks — they are motivated by short-term profit and (2) the profit participants (directors, actors, writers, showrunners) will exert pressure when big offers are put in front of studios/networks.

As Netflix grew in size, an interesting thing happened — they were massive patrons of the postal service by spending a few billion dollars a year on postage. They reasoned they could simply shift that expense to content owners and have as good or better a business. When they waived a $1B check in front of the studios eyes, suddenly all those restrictions on pricing and limited viewing went away. Netflix used some great negotiating savvy to offer really big numbers to studios in total, but also big per-episode and per-movie-title guarantees. This allowed the profit participants to put pressure on the studios/networks to take the deal. Because Netflix can influence the shows we watch, they can afford to overpay on a per episode basis for hit shows to help with customer acquisition, but can steer us to lower-cost programming once we become members.

In short, Netflix developed great economic leverage with the rights owners — and that is the only way to force them to do deals that allow both customers to be delighted and also leave enough margin for startups to build a business. Without the first sale doctrine, however, Netflix never would have gotten there. And once they got leverage, they played their cards perfectly.

A Few Things Paul McGuinness Forgot To Mention…

Sep 02

Paul McGuinness, the esteemed business manager of U2, penned an essay (can we still say “penned”?) for GQ UK called “How To Save The Music Industry.” He says piracy killed the music business and he calls on tech entrepreneurs to help save it. Although it pains me to disagree with someone who helped build the career of musical icons, his argument ignores key facts important to remember about how the music industry arrived at this perilous point.

MIDEM, the largest global music industry conference held each year in Cannes, asked me to guest blog on their MidemNet site over the next year. So, my first posting over there is a response to Paul. You can read it here.

As always, I look forward to your comments.

(Here’s a link to my previous post on how the music industry could save itself, “The Sad State of The Old Music Business“.)

Author David Pakman
Comments 9 Comments