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David Pakman's Blog
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Taking the Other Side in the Amazon/Hachette Debate

This post is likely to be unpopular.

In April of 2012, I wrote “Why Should eBooks Cost $15” in response to the news that the Justice Department was suing Apple over price collusion with the book publishers. In it, I discussed 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.

Now, more than two years later, we find ourselves having the same discussion. The Amazon/Hachette dispute (most of the journalists covering it have been sympathetic with Hachette) is largely over the retail price Amazon believes it should charge for eBooks. Hachette wants this price higher, Amazon wants it lower. Hachette seems to want to try to keep eBooks priced about the same as physical books. But why should it? eBooks have no marginal costs, and consumers therefore expect the pricing to be lower. Amazon agrees.

While the hardball tactics Amazon has used to force Hachette to lower prices have, somewhat uncharacteristically, inconvenienced Amazon’s customers, I believe their larger point is the right one. Many legacy industries who’s models were built in the analog world have trouble adapting to the lower prices of digital markets. (See the music industry.) Amazon’s pricing data likely shows they will sell more eBooks at lower prices. They want Hachette to price eBooks lower. In this new world, more copies can be sold, for lower retail prices, but with no physical costs. The profit might well be close to the same amount, or it may even be less per unit. But adapting to the increased competition for consumers’ attention/spend and the inevitable price erosion of digital goods compared to their physical peers requires prices to fall. Amazon is attempting to force the publishers’ hands.

Most of the emotion around this debate has centered on the effects of Amazon’s tactics on authors. I understand how a dominant retailer can hurt sales by temporarily refusing to stock titles or make them hard to buy. But the long term effects of Amazon fighting for lower eBook prices is likely to make the eBook industry healthier in the long-term. For that, authors should be supportive.

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The FCC Decides to Eviscerate the Neutral Internet

Like many in the tech community, I was both shocked and dismayed at the FCC’s sudden about face on the basic principles of net neutrality.

“The principle that all Internet content should be treated equally as it flows through cables and pipes to consumers looks all but dead.” – The New York Times

FCC, in a Shift, Backs Fast Lanes for Web Traffic

If the FCC’s proposed rule-making goes forward, this will be the beginning of the end of the open and non-discriminated internet. This proposal so obviously favors large companies with deep pockets at the expense of new entrants and startups. An internet where all content is treated equally and routed without preference has served to create a culture of massive innovation and has witnessed trillions of dollars of wealth creation and millions of new jobs. Allowing giants to buy preferred access to end users will automatically diminish the quality of service of non-payers. On the internet, we know speed and responsiveness are necessary to deliver high-quality user experiences and to delight customers. This proposal would make it far more difficult for non-payers to deliver those types of experiences so essential for success. The FCC should immediately re-write their proposed rule-making and eliminate any notion of favorable treatment to any content or payer.

The Piano Man

The Price of Music

Will the recorded music industry ever grow again? Since 1999, the industry has been in rapid decline as CDs became unbundled into downloaded singles. The digital download market never came close to the size of the physical music market. Now we are in the midst of another format transition, this time from downloaded singles to streaming. The question many people ask, like the thoughtful Marc Geiger, is how big will the streaming market be? I think the answer lies not in consumers’ appetite for streaming songs but in the price services charge consumers for streaming.

Recorded Music Industry Sales

At the 1999 peak of the recorded music market about $40 billion of recorded music was sold. How much did the average consumer spend per year on recorded music? Hundreds of dollars? Nope. According to IFPI at the time, across the total 18-and-over population (both across many countries or individually within one), the average amount spent came to $28 per consumer. But that includes people who did not buy any music that year. If we look at just the consumers who bought music, they spent $64 on average that year. And that was at a time when one had to buy a bundle of 12 songs in the form of a CD in order to get access to just one or two. What has happened since?

Once the bundle broke, the average spending per consumer decreased. This is predictable, since bundles artificially raise the amount of total dollars a consumer spends. The chart below shows the average spending per capita in various countries according to IFPI (note UK Pounds):

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Another study by NPD Group in 2011 found similar spending, about $55 per music buyer per year on all forms of recorded music (they note that this spending is slightly higher among P2P music service users.)

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But the one retailer on the planet who would really know what consumer are willing to spend on recorded digital music today is Apple. They are the largest music retailer in the world. Their data is very consistent, about $12 per iTunes account per quarter is spent on music, or about $48 per year. Note that this figure declines year by year as iTunes users are confronted with many more choices on which to spend their disposable income like apps and videos. Also note that total disposable spending, on average, is decreasing per account as iTunes gets bigger and bigger. As a service becomes truly mass market, it reaches fewer and fewer consumers willing to spend as much as previous consumers.

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So, the data tells us that consumers are willing to spend somewhere around $45 – $65 per year on music and that the larger a service gets, the lower in that range the number becomes. And these numbers have remained consistent regardless of music format, from CD to download.

Curiously, the on-demand subscription music services like Spotify, Deezer, Rdio and Beats Music are all priced the same at more than twice consumer spending on music. They largely land at $120 per year (although Beats has a family member option for AT&T users at $15 per month.) This is because the three major record labels, as part of their music licenses, have mandated a minimum price these services must charge. While it may seem strange that suppliers can dictate to retailers the price they must charge end users for their service, this is common practice in digital music. The services are not able to charge a price they believe will result in maximum adoption by consumers. The data shows that $120 per year is far beyond what the overwhelming majority of consumers will pay for music and instead shows that a price closer to $48 per year is likely much closer to a sweet spot to attract a large number of subscribers.

For this reason, I believe the market size for these services is limited to a subset of music buyers, which in turn is a subset of the population. This means that there will be fewer subscribers to these services than there are purchasers of digital downloads unless one of two things happen:

(a) consumers decide to spend more than two times their historical spend on recorded music or

(b) major record labels allow the price of subscription music services to fall to $3 – $4 per month

I think the former is highly unlikely given the overwhelming number of choices competing for consumers’ disposable income combined with the amount of free music available from YouTube, VEVO, Pandora and many others. The data shows consumer spending per category decreases in the face of many disparate entertainment choices. The latter is the big question. My experience with the major labels when I was CEO of eMusic was that they largely did not believe that music was an elastic good. They were unwilling to lower unit economics, especially for hit music, to see if more people would buy. Our experience at eMusic taught us that music *is* in fact elastic and that lower prices lead to increased sales. If the major labels want to see the recorded music business grow again, I believe the price of music must fall.

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An Emerging New Model for TV? Crunchyroll.

As the viewer trend data make clear, legacy TV is undergoing a dramatic transformation, led by the many alternative ways of watching video. Cable subs are in decline, network TV viewership has tanked, and now even cable TV viewership is eroding. We frequently discuss the new streaming providers (YouTube, Netflix, Amazon, Hulu) and the on-demand show/movie retailers (iTunes, Amazon, Vudu), but a new model is emerging and worth discussing — the over-the-top (OTT) TV network. Our recently-exited investment in Crunchyroll provides a prime example.

Crunchyroll is the largest provider of Japanese anime online. They license scores of hit and long tail anime shows from Japanese media companies for streaming throughout the world ex-Japan. They offer a free ad-supported viewing option and attract millions of unique monthly viewers. They also offer a paid commercial-free offering at seven dollars per month which makes available a deeper selection of shows. They are available on the web for PC streaming, and have an app available on every mobile and connected TV platform available (iOS, Android, Roku, AppleTV, PS3, Xbox, etc.).

Crunchyroll has amassed hundreds of thousands of paying subscribers and is profitable with net margins many internet and legacy media companies would envy.

While they don’t benefit from the incredibly rich we-will-pay-you-a-fee-even-if-no-one-watches-your-network affiliate fee model of legacy cable TV, they enjoy a more accountable dual advertising/consumer subscription model. While most of us would consider this content niche, their total active actual viewers are considerably larger than most cable networks on your cable grid. Perhaps most impressively, like most technology companies, they are highly efficient, employing fewer than fifty employees.

This model benefits from many of the advantages of the web. An embedding/link-sharing culture helps Crunchy, as everything viewable can be shared and discussed throughout the web. The product is highly mobile and feeds our preference for snackable media consumption on phones and tablets. Non-subscribers get easy access and a thorough chance to experience the content without paying. And the team is staffed by fantastic technologists who rapidly adopt and optimize the service for every new platform that emerges. The team has already started expanding their successful model to new content verticals.

Their success, I think, points the way for niche programmers to deliver great video services directly accountable to their viewers and advertisers alike, and not polluted by the MVPD indirect affiliate fee model nor the antiquated Nielsen people viewer/sweeps model.

For these reasons, Peter Chernin’s The Chernin Group is the new owner of this impressive company and team. I look forward to watching the continued success of Kun, Brandon, James, Brady and the whole team. Without much fanfare, they have pioneered a way forward for much of the video programming world. We are honored to have been investors since 2007 and to have watched you succeed.

Will the Internet Unbundle Higher Education Too?

I was fortunate enough to be asked to deliver the keynote address at this year’s Sustainable Scholarship Conference, put on by ITHAKA. Here, I attempt to review how the internet has disrupted bundled industries and consider the question of whether it will unbundle higher education too.

ITHAKA is a not-for-profit  that helps the academic community use digital technologies to preserve the scholarly record and to advance research and teaching in sustainable ways. They run the popular JSTOR service, a growing digital library of more than 2,000 academic journals, nearly 20,000 books, and two million primary source objects provided to colleges, universities and scholarly communities. I serve as a trustee of ITHAKA.

My slides from the presentation are here:


Thank you to Kevin Guthrie, ITHAKA’s CEO, for the invitation to speak and for the overly-generous introduction!

advertising

Why AdTech is Back (It Never Left)

One of the most valuable characteristics of venture investing is that sectors go in and out of favor. Certain sectors, no matter the investment climate, have perennial long-term value. At least, that is my view. And I hold that view strongly about the AdTech sector.

More than 60% of the enterprise value created by internet companies comes from companies whose business model is primarily the selling of ads. Since the internet is both a communications medium and a transactions platform, I believe it will always create massive value through advertising. The internet, unlike most traditional media, is inherently a performance-oriented medium and it delivers on the promise to make advertising and marketing more accountable and more efficient. Underlying the delivery of better ad performance, in a world filled with big, quantifiable data, is an ever-increasing slate of sophisticated technology operating on massive datasets in real time. If you advertise on the internet, and eventually, every brand and service in the world will, you need exposure to these technologies or you will underperform your competitors. The AdTech sector, fundamentally, is the delivery of these advanced advertising technologies to all advertisers.

In my previous posts on the evolution of online advertising, I painted a picture, like so many observers of the space, of a world where all impressions are traded on exchanges. That inevitable transition is happening at light speed now. More than 17% of display impressions on the web are traded on exchanges and the forecasts are bullish on this trend. In that world, online advertising looks much more like trading stocks than the buying of ads over lunch meetings. In 2008, we believed that significant value would be built in this exchange layer. It was this thesis that supported our Series B investment in AppNexus. That company continues its incredible run and is one of the largest global ad exchanges in the universe. We believe AppNexus will remain one of the most important companies on the internet.

While a huge amount of buying has moved to the exchanges, the level of sophistication of many advertisers taking advantage of these RTB platforms is still rudimentary. It turns out, just like outperforming the stock market year in and year out, it’s hard to do it well. The amount of data available to buyers is enormous. The number of parameters available in tuning and targeting your audience is almost limitless. And, most importantly, there are always better data scientists down the road doing a better job than you can at building proprietary targeting models. For all of these reasons, in our opinion, the second-most valuable layer in AdTech is the data-driven ad network layer. (Not to be confused with the inventory driven ad networks.) Data-driven ad networks employ either large proprietary data sets or proprietary targeting models on top of very large data sets. The sophistication of the data scientists within these companies delivers a sustainable performance advantage over their less well-equipped peers. Two examples of these companies in our portfolio are Dstillery (formerly Media6Degrees) and Bizo. Both Rocket Fuel and Criteo are two additional companies in the space. Rocket Fuel’s recent IPO fetched it a market cap of more than $1.7B and Criteo is now over $2B. Many are asking themselves, “Why?”

[As an aside, Zach Coelius, the CEO of Triggit, points out that these companies should no longer be called ad networks because they no longer amass large amounts of inventory. They are instead more accurately “algorithmic media buying” companies or “data-driven targeting” companies…not really sure, but they aren’t traditional ad networks.] 

The reason these companies are so valuable is that buyers on the exchanges are dominated by performance-oriented marketers today. Their dollars seek the best performance. The data-driven ad network layer is increasingly a case of the haves and have-nots. The better you perform relative to your peers, the more ad dollars you receive. These four companies significantly out-perform their peers, and their incredible revenue growth (and enviable media margins) indicate this.

The reason these companies have bright long-term futures is that this layer is increasingly necessary, hard to replicate, and experiences tremendous network effects. In the early days of AdTech, some believed the traditional media buyers would be able to build their own technology stacks and deliver better performance and value than independent companies in the market. This has not turned out to be true. The best performance can be found elsewhere, largely within technology companies, and so that is where the dollars are flowing. This presents enormous long-term challenges for the incumbent media buyers and will continue to pressure them to flow more and more of their client’s dollars to the better performing AdTech companies.

I believe this layer will eventually see tens of billions of dollars of media buying flowing through it. Of course, the exchange layer benefits from all of this too. For these reasons, there will be additional public AdTech companies which will fetch multi-billion dollar valuations coming to market. AdTech is back. Except it never left.

 

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Venturescape: This Year’s NVCA Annual Meeting

I’m going to Venturescape, the NVCA Annual Meeting May 14 and 15 in San Francisco and you should too. I haven’t been to one in many years, but this year is different.

The NVCA is the National Venture Capital Association. It’s much more than just a trade organization, and this year’s annual meeting demonstrates that.

My friend Jason Mendelson from Foundry Group is on the NVCA Board of Directors and he is running Venturescape. That being said, if the meeting was going to suck I wouldn’t go. But it looks quite good.

I’m excited about the agenda, as this is the best lineup I’ve seen at one of these events. Included in the mix are:

  • Dick Costolo, Twitter CEO
  • General Colin Powell
  • Ginni Rometty, IBM CEO
  • Anne Wojcicki, 23andMe CEO

There is also the world’s largest VC Office Hours. And for the first time, “fun” is part of the meeting in the form of NVCA Live! — a great concert featuring Pat Monahan from Train and Legitimate Front, a band in which I’m staring as the drummer and main groove man.

If you are a VC, I hope to see you there. If you are an entrepreneur, ask your VC funders for tickets to NVCA Live!, as that is open to everyone, although tickets are only purchasable by NVCA members.

If you are coming, especially to NVCA Live!, let me know. See you there.

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Facebook is No Longer Real-Time

It’s a good thing Facebook is thinking of redesigning the News Feed. Because I think a funny thing is happening to Facebook. For me, the news feed no longer surfaces anything of interest. The opaque algorithm behind it is just not able to produce anything relevant and, more important, timely, at least to me. Facebook appears to be turning back into what it once was: a way to research people in non-real time. A look back into the past. A people-stalking product. It’s back to being a personal LinkedIn.

People publish stuff on the (increasingly mobile) web that is timely and relevant. Sharing baby pictures isn’t really one of those. Sharing pics of how you are experiencing life, which is the Instagram use case, is a great example of this. But my News Feed does not have anything like that in it. My Instagram feed does.

People share highly informative and timely links to news articles and blog posts on Twitter all day long. But my News Feed does not contain any of those. And when I share these types of posts on Facebook, I get no engagement. When I share pics of my kids, I get a lot.

People share bookmarks of products and apparel they want to buy on Pinterest all day long. People don’t do that on Facebook.

Facebook started as a non-real-time service. It was a way to check people out. In the face of the rise of Twitter, they responded aggressively with a News Feed product that showed promise. But now I feel they really screwed the filters up that govern that feed, which creates feedback to those of us who post into it and it feels like a vast river of noise and irrelevant posts from people and events who aren’t really relevant to me. Perhaps most importantly, I can’t tune it. The tuning mechanisms are either too subtle (“hide”) or too crude (“report as spam”). I feel powerless.

The irony is that LinkedIn is moving to increase daily engagement by syndicating highly informative posts from influencers. They are trying to become more real-time just as Facebook seems less so.

It’s still amazing for stalking people, though.

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TV Is Changing Before Our Eyes

It’s finally happening. The Internet is taking over TV. It’s just happening differently than many of us imagined. There are two major transformations underway.

  1. The Rise of The Internet Distributors. Led by Netflix, the group of new distributors includes Amazon and Microsoft now, but maybe Apple and Google later. They are largely distributing traditional TV shows in a non-traditional way. All the content is delivered over IP and usually as part of a paid subscription or per-episode EST (electronic sell-through). Important to note that all of this content contains no advertising and is available entirely on-demand. This content falls into the “non-substitutional” cotent bucket. To watch it, you don’t need to be a cable TV subscriber.
  2. The Rise of Alternative Content Producers. Thanks to YouTube’s Channel strategy and investment in hundreds of content providers, new producers of content are emerging and offering non-traditional programming, usually in shorter form. This content is marked by dramatically different production economics than traditional TV content, taking advantage of an expanded labor pool and low-cost cameras and computer editing. This alternative content is chipping away at long- and mid-tail viewership on traditional networks (the “filler” and “nice-to-see” buckets.)

Both of these transformations are successful to date and will only become more-so. Rich Greenfield has a nice summary of why the TV industry suddenly loves Netflix. (Disclosure: I am long NFLX and have been a stockholder for some time.) The first transformation takes advantage of the massive pressure MVPDs place on traditional cable nets to not offer their programming direct-to-consumer. In this case, the HBO’s and AMC’s requirement that you authenticate your existing cable subscription in order to watch their programming over IP successfully persuades the cord-nevers to just avoid the programming on those networks until the hit shows are offered through Netflix or EST. Netflix, once again, looks like the hero. Those empty threats by Jeff Bewkes that he will never work with Netflix turned out to be, well, empty. The second transformation will take longer to fully prove out, but I believe it will happen. As more of our viewership takes place over IP, we lose our allegiance to networks as the point of distribution and allow new distributors to guide us towards content choice.

There is a third budding area of transformation, but I don’t yet see evidence that a business exists: trying to re-package cable TV bundles and sell them over IP. Companies like Aereo and Nimble.TV offer versions of this. I believe we live in a show-based world. Consumers aren’t looking for networks (with the exception of ESPN and regional sports nets) so much as they are looking for shows. Shows delivered over IP allow for the slow unbundling of television. One of the many challenges about this model for traditional broadcasters is that there is no advertising in this world. The traditional cable net business model enjoys two great revenue streams: affiliate fees and ad dollars. In IP-delivered shows, there are no ads.

Who are the winners and losers in this model? Well, show creators continue to flourish. The new distributors enjoy great success. Of course, ISPs, who are often the same companies as the MVPDs, do fine in the ISP business, but I believe the decline in total cable subs will continue. In a world where shows do not contain advertising, why do we need Nielsen? They have been a measurement standard for decades largely because advertisers needed a third-party validator of viewership. You can see why they have a vested interest in insisting TV ad viewership is not on the decline (despite everyone’s experience to the contrary.) I don’t think cable nets are in immediate trouble. They enjoy a great business model now, and also get to reap EST or licensing benefits after the shows air. But the Netflix House of Cards effort shows that consumers will now expect to be able to watch shows whenever they want and not be bothered by inconvenient broadcast schedules. The day is coming when the cable nets will have to respond.

For startups, one of the wide open spaces seems to be in cross-provider discovery. Now that my shows are spread among Netflix, Amazon, YouTube and on my DVR, I would prefer one interface to reach them all. Companies like Dijit’s NextGuide, Peel, Squrl, and Telly are taking cracks at this important space.

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