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Missing The Point In Online Music Sales

There’s a fact-heavy article in today’s NY Times about the increasingly crowded field in online music. In a nutshell, the article sees the forest, but misses the trees, wondering why businesses would get into online music at all. Not only are the costs of starting up a online music storefront steep fixed costs of technology + marginal costs of selling & marketing the service), competition that threatens to further erode everyone’s margins (Wal-Mart has priced tracks on its music store at $0.88 a track). The article cites Real Networks CEO Rob Glaser, and Steve Jobs’ opinions about the difficulties of making a buck in the online music business to underscore this point:

"The fixed costs of building this stuff out from scratch are high," Mr. Glaser said.
"It's not easy to do this well," Mr. Jobs said. "How," he asked, will other companies "justify investing R.& D. into something where there is no money to be made?"

Well, duh. However, where the article really gets the whole online music store model legitimately wrong is in its belief that without selling hardware to accompany it, selling music online is a foolish enterprise. Check this other comment:

Hardware manufacturers are trying to apply the lessons of Apple by combining the low-profit-margin business of selling songs with the higher profit margin business of selling the music players to go with them. That kind of thinking favors companies like Dell, which is selling its Digital Jukebox, and Sony, which once owned the portable music business with the Walkman, but stumbled as companies like Apple jumped into digital music. The company has said that it will create an online service this spring that will work seamlessly with its players. The new service, called Connect, will allow customers to pay for songs with frequent-flier miles from United Airlines.

While hardware sales might be able to cover for the economic losses of running an online music store in the short-term, they can’t do so for the long-run. (Note: I’m guessing that since the market leader—Apple—has already admitted on several occasions that it just breaks even on online music sales, it’s probably losing money on its investment from an NPV perspective. I’d also wager that if Apple is just breaking even, everyone else—with the possible exception of Real Networks, which operates a subscription model—is losing money.) The prices of all MP3 players—including iPod—will fall (as has already begun), or companies will start adding more features into their MP3 players (thereby raising costs, and diminishing margins) in an effort to compete. A far better model is to control the standards for digital music—DRM— and then hopefully parlay that standard into other media businesses, and create an annuity for yourself. (The Wall Street Journal grasped the essence of this logic in some ways on Monday, but didn’t get grasp all of the possibilities of DRM.)

So here’s the model as we see it: Apple sells as many tracks as possible on iTunes which enourages people to buy iPods, and subsequently more tracks on iTunes, while iTunes and iPod still have the cachet or higher perceived benefit to draw people away from lower-priced music services or competing products. If you’re investing in Apple, you want Apple to hit a scale where they control most of the market for online music, at which point the music companies and artists (content creators and copywrite owners) cease offering tracks to their competitors, and offer them solely to Apple, since Apple offers them access to the largest market possible, at the lowest cost possible. This is what’s called a virtuous circle, and is the essence of the network effect Apple’s trying to pull off.

One other random note to consider in light of network effects: Apple’s coming partnership with Pepsi (giving away 100m tracks on iTunes to Pepsi buyers, via codes distributed via bottle caps) is kind of a stroke of genius. Ideally, it gets more AAC formatted tracks on the market, and gets iTunes in the hands of people who have yet to use it, thereby increasing the potential market for AAC. Pretty slick stuff for Apple, and we’d also say that the partnership looks pretty good if you’re Pepsi, since you get to attach yourself to the ridiculous amount of cachet and credibility that Apple’s managed to create in the all important youth market.

Posted by Matt Percy | Permalink | Comments (4) | TrackBack

Vespa Heats Up The Heartland?

Conventional marketing wisdom suggests that trends start on either the West or East coast (it depends on who you are talking to... and whether they happen to live in LA or NYC) and move to the middle. Imagine how surprised we were to learn that the leading Vespa boutique (dealer) is located in Kansas City, MO! Does this mean that Vespa is losing its "hotness" and rapidly becoming ubiquitous (having already won over both coasts)? Or does it suggest that there is something happenning in the heartland of which marketers of "style" products should be aware?

Posted by Bradley Peacock | Permalink | Comments (2) | TrackBack

Employee Monitoring: Antithetical To Productivity

Just finished reading an article on today’s Globe and Mail website about how “big brother” technology—e.g. technology-based monitoring devices, in this case, biometric scanners—are winding there way into the workplace. In a nutshell, the article is largely about how a handful of employers—the article cites a McDonald’s on the Manitoba tundra, and a fish processing plant (an industry known for its cutting-edge labor practices) in British Columbia—are utilizing biometric scanners to determine a form of souped-up time clock. The rationale for utilizing such high-tech methods to ensure employees are checking in and out on time is succinctly explained by the owner of the fish-processing plant, Montgomery Burns…er, John Nordmann: “
“If you want to control a whole bunch of people, it's the only way to go," he says. His 50 employees would often "buddy-punch," meaning that they would punch the time clock for people who had not shown up. "They're typical workers," Mr. Nordmann said. "It's not nice work. You have a lot of turnover. You have them one week, and the next week they're gone. You can't tell the faces any more."
What we found interesting about the Globe and Mail article is how explicit it is on the reasons why firms adopt monitoring tools (profit maximization), in addition to inadvertently revealing the limitations of such strategies. In this case, the fish-processing firm is trying to ensure that their employees produce a full 8 hours worth of fish guts, and isn’t taking a longer lunch than necessary, a strategy that the firm believes will ultimately raise its profits by maximizing the amount of fish processed per employee. Although the fish processing co happens to be in a more lurid industry, its goals are no different than say, a larger Fortune 500 firm who installs, say, Internet or email monitoring software to ensure that employees aren’t browsing the web idly during down-time.

Here’s the catch, however: while we’d agree that some type of monitoring system is usually required in a large workplace (to clarify: we don’t have a problem with timesheets, but we think the idea of biometric scanners is pretty wack), ultimately, we’d argue that the results of the more big-brotherish monitoring will largely be counterproductive to the firm’s stated goals of increasing profits.

First, such intrusive devices will probably have the opposite effect of what the fish-processor, or the Fortune 500 company wants, and may actually lower productivity by fostering resentment among employees. (Who really wants to work for an employer that spies on you?) Secondly, and perhaps more importantly: such devices tend to address the symptoms of a problem--lower productivity and profits—rather than the root cause of that problem. Note that the fishmonger quoted above talks about the fact that the work in his plant isn’t nice, and has “lots of turnover.” Turnover, of course, has significant costs associated with it: hiring costs (want ads in the case of a fish plant, recruiting trips to top-tier schools in the case of a Fortune 500, etc), training costs, and in addition to the cost of losing an experienced employee (who we’d guess would be able to gut a fish more quickly than a newer employee). In other words, one possible strategy might be to improve the culture, training and processes at the fish plant to boost productivity and profits, rather than subjecting the workers to Orwellian scrutiny.

Of course, the obvious counter-argument to improving the culture or work environment and lowering turnover at, say a fish plant or a McDonald’s is that the work will always suck and you’ll always have a high turnover. There’s a degree of truth to this argument, but that doesn’t mean that at the very least, a fish plant or other firm can’t at least lower their turnover—and therefore, their costs—by thinking a little bit more creatively about the shape of their firm’s culture, motivational tools, and structure. To draw an analogy to another industry that features high-turnover, and is about as sexy as fish-processing—welding—a welding firm by the name of Lincoln Electric was able to boast tremendous profits (at the firm and the employee level) by designing a piece-labor based performance scheme, and deliver consistently high quality products. By recruiting the right type of people (e.g. people who were highly competitive, and would fit in with the culture at the firm), and maintaining a clear and transparent organization (management and workers had access to one another’s salaries, and the companies books, which ensured a level of fairness throughout the organization, and also functioned to motivate employees by showing them how much they could receive if they performed at the level of a highly-compensated employees), Lincoln Electric—and crucially, its employees—were able to thrive for a good thirty years. Until it embarked on a misguided acquisition strategy outside the US in the early 1990s, several Lincoln Electric welders were compensated almost as well as consultants and lawyers (upwards of $150K in 1980 dollars).

In conclusion, we’d have to say that far from ameliorating low productivity at a firm, such creepy surveillance tools like biometric scanners hinder it. In short, the problem at firms like the fish processor discussed above isn’t so much employees underworking—it’s human nature to slack off now and then. Rather, it’s a shortage of managers with creative approaches to motivating people, and designing the culture and processes that motivates people to over-perform, even in a decidedly unsexy industry.

P.S. Full disclosure about reading the Globe and Mail: it turns out I'm an expatriate Canadian, and despite the fact that I've managed to escape the barren socialist wastes of my homeland for the barren midwestern wastes of Chicago, I still harbor a secret affection for the Globe and Mail's earnest brand of journalism.

Posted by Matt Percy | Permalink | Comments (10) | TrackBack

McDonald's Bytes Off More Than It Can Chew With WiFi

McDonald’s is no longer attempting to pull American’s under those “golden arches” with Happy Meals and onsite playgrounds alone. Following in the steps of Starbucks, McDonald’s is “going WiFi”. Having launched the concept in UK this month, the American fast food chain has plans to roll out the idea across several major US cities in 2004-2005.

Although some members of our team have questioned the overall appeal of WiFi in a McDonald’s voicing concerns about sacrificing New Year’s resolutions for on-the-road internet access ("How can you concentrate with that entoxicating fries smell circling around you the whole time?"), there is a larger question to consider regarding this strategic move: “What was the strategic rationale behind McDonald’s recent WiFi decision?”

First, our research clearly shows that Starbucks is a direct competitor of McDonald’s. Does the WiFi decision suggest that McDonalds is trying to keep up with Starbucks, differentiate itself from traditional rivals like Burger King and Taco Bell, or both? Furthermore, if hotels and 2000 Starbucks have implemented WiFi in order to drive business traveler traffic, does this suggest that McDonald’s marketing target is changing from soccer-mom to the company-man/woman? One can only guess that professionals would rather their clothes smell of moca lattes than chichen mcnuggets. Counting the suits in our neighborhood McDonald’s, we were hardpressed to seriously believe that business travelers are a promising market segment for the fast-food chain.

In the end of the day, McDonald’s rationale for this decision can only be that its partnerships with wireless carriers are another means of generating revenue from its retail locations. The rollout of WiFi across McDonald’s restaurants is a straightforward real-estate play, no different from ATM alliances with Citi and other banks.
Unfortunately for industry experts, McDonald’s WiFi strategy suggests not that it is a innovator in the fast food category but that it is a company that has lost its focus and basic understanding of its core customers.

(Thanks Carolyn.)

Posted by Bradley Peacock | Permalink | Comments (2) | TrackBack

Of Changing Airline Business Models & Urban Economics

As the economy is finally emerging what looks to be a period of sustainable growth, it’s interesting to take stock of the last few years, and see how the recession and upheaval of the last few years has affected a variety of industries, and the consequences that these changes have for society as a whole. The airline industry is one that’s particularly fascinating to think about in this regard, since it seems to have been permanently changed in a way that other industries haven’t. We’re curious to think about how some of these changes will affect the economic growth in larger and smaller cities throughout North America.

Broadly speaking, there are two dominant business models within the airline industry: 1) the hub-and-spoke model, utilized by American Airlines, United, and most of the flagship carriers of foreign countries; and 2) the “low-cost-carrier” or point-to-point model, favored by Southwest, RyanAir and others. The hub-and-spoke model requires aggregating passengers from smaller second-tier “spoke” airpports (say, Philadelphia, St. Louis, etc) at a larger hub airport (e.g. Chicago’s O’Hare, Heathrow) and in order to fly passengers to a similarly large hub. In general, hub-and-spokes usually break-even or take a small loss on at least some of the spoke-to-hub flights in order to maximize the the profits they can create on the lucrative hub-to-hub flights. Airlines can charge a premium—especially on business class and above—on some hub-to-hub cross-continent routes, and especially on some transatlantic or transpacific routes: hence, these routes are disproportionately important to a hub-and-spoke. Furthermore, since the fixed costs associated with building a hub-and-spoke are so high—aircraft, gates, landing rights—they create a powerful barrier to entry for potential competitors, thereby limiting further limiting supply, and raising the premium an airline can charge on these routes. Contrastingly, point-to-point low cost carriers (LCCs) try to fly shorter distances between secondary airports (Chicago’s Midway, Love Field in Dallas) where landing rights are less expensive. Crucially, these airports are less congested, enabling LCCs to turnaround aircraft much more quickly than competitors, thereby allowing for more frequent flights, more efficient aircraft usage, and most importantly, increase the amount of revenue they can generate per each aircraft seat by getting x many more flights per year out of each plane. LCCs generate barriers to entry by locking up gate rights at the airports they operate in, thereby keeping particular carriers out. (We’d guess this is ultimately the challenge JetBlue will face vs. Southwest, since the latter has a dominant position at the lion’s share of good secondary airports in the US.)

The consequences of the recession within the airline industry has been to validate one type of business model in the airline industry—the point-to-point low-cost carrier business model—while largely invalidating the previously dominant hub-and-spoke model . While the hub-and-spoke model can create huge profits during boom years—and we agree that it eventually will, as soon as corporate travel spending picks up again—the aforementioned high fixed costs of the model mean that it racks up huge losses during a bust period. This means that the hub-and-spoke model bears greater risk for investors, and therefore has substantially higher capital costs than a well-run LCC, further cutting into profits. (Moreover, in a post 9/11 and post-SARS world, the international destinations served by a hub-and-spoke have a greater risk associated with them, translating into added security and insurance costs for hub-and-spoke carriers.) In contrast, while the LCC point-to-point model offers slightly lower margins (since these carriers offer lower prices than hub-and-spokes), the flexibility of this model, and the lower prices, mean that it thrives in boom years as well as bust years, making it a safer investment over the long-run.

As hub-and-spoke airlines climb out of recession, they’re trying to trim their high fixed costs by offering a “leaner” version of themselves. In a nutshell, what this generally means is that smaller regional cities—the feeders of the hub in the hub-and-spokes, e.g. places like Pittsburgh (Brad’s hometown), Edmonton (my hometown), or Clevelands of the world now have many less flights connecting them to hubs than they did previously. Since these hub airports tend to be located in larger cities, and offer gateways to other larger cities either domestically or abroad, one potential consequence of changes in the airline industry is to reduce the connectedness of smaller regional cities to major hubs in the overall world economy. In short, it makes them less cosmopolitan and less global.

Being less connected to the world and national economy, and being less cosmopolitan and less global has significant competitive ramifications for smaller cities. Economically, this means that cities have less access to capital , since most capital tends to be clustered in what University of Chicago sociologist and urban studies guru Saskia Sassen has termed the “global cities,” e.g. larger first or second tier cities—London, New York, Chicago, Tokyo, Hong Kong. Less capital means less fuel for growth, and a less dynamic economy overall.

There are also economic disadvantages stemming from the cultural consequences to being less cosmopolitan and “worldly.” One result of removing some of the connections between a city like, say, Cleveland to that of New York, London, Paris or Tokyo is that smaller regional cities offer slightly less variation than their big city counterparts, making them less interesting on the whole. This lowered access to culture is far from trivial, if you subscribe to the Creative Class argument (which we do) proposed by Carnegie-Mellon economist Robert Florida, there’s a strong desire on the part of “knowledge workers” to locate in cities that offer greater cultural amenities and a dynamic environment. Knowledge workers—the computer programmers, consultants, analysts, venture capitalists and so forth—create and attract disproportionate amounts of wealth and capital, and therefore growth, and are therefore of pivotal importance to any city’s long-term future. For a small regional city, having less access to these workers only dims growth prospects.

So given that shifts in the airline industry seem likely to result in a new set of challenges for the economies of smaller regional cities, what should they do? While this is definitely a topic for another blog, we do have some high-level thoughts on the subject. One potential option would be for smaller regional cities to make the world come to them, either by playing up their unique resources (be they economic or cultural resources), to ensure that the world comes to them. For example, smaller cities like Austin, Portland or Vancouver have ensured that they’ve remained connected to the larger world either through adopting policies to develop or stress their cultural amenities (physical beauty and a vibrant downtown core in the case of Vancouver and Portland). An even more effective strategy for these smaller cities is to use the cultural amenities as a platform from which to drive future economic growth—coupling cultural policy that attracts knowledge workers with economic policy that encourages firms and workers to locate in a particular region. Austin, Texas is a case study in this regard, since it combines an eclectic local culture (South by Southwest) with a dynamic technology industry (Dell et al). In short, despite the fact that smaller cities will probably face a growing array of economic challenges, smart strategic planning can provide some templates for sustainable future growth.

Posted by Matt Percy | Permalink | Comments (30) | TrackBack

Apple & HP's iPod Partnership: A Pivotal Moment in the DRM Race?

Yesterday, at this year’s CES--that’s Consumer Electronics Trade Show, for those of you not in the know—Hewlett-Packard announced that it would re-sell a variation of Apple’s iPod player, in addition to supporting Apple’s popular iTunes online music store. This partnership highlights a massive strategic shift for Apple, and is one that could potentially reap Apple huge dividends down the road.

In the past, Apple has tended to adopt a “go it alone” strategy, and has assiduously avoided making its software available for Windows machines, or manufactured devices that were compatible with Windows-based machines. Apple’s strategy for much of its 20+ year history has been to try and generate profits by releasing superior products or software than those based on the Microsoft/Intel standard, in an attempt to recapture the dominant position that it once held in the highly lucrative OS market in the early 1980s. The Windows-version of iPod, coupled with Windows iTunes store, marked the beginning of a shift, insofar as it was the first time that Apple had begun aggressively courting Windows-based users.

Apple ostensibly claimed that it was pursuing Windows-based users as a means to sell more of its highly profitable iPod. However, as readers of the BuzzSponge blog will note, it’s highly unlikely that the iPod will continue to be as profitable for Apple in the long run, especially now that much more cost-efficient manufacturers like Dell & Samsung have gotten in the game. These players will likely drive down Apple’s pricing ability over the long run, thereby cutting into profits.

Apple had a much better reason to pursue Windows-users than simply to sell more iPods, however. The war of digital music players is rapidly becoming a battle over who will control the software that will control media content—in short, it’s a battle for owning a digital rights management standard. In this match-up, Apple is pitting its proprietary AAC format for playing music against Microsoft’s WMA format, and Real Network’s RAM format. The rewards are large—theoretically, licensing fees from all content played over a particular software standard. Hence, the competition has been fierce—the last few months have seen a variety of MP3 players either being released or announced that will play an exclusive standard.

The phenomenal popularity of the iPod, the only player capable of playing iTunes, has enabled Apple to pull far ahead of Microsoft and Real Networks in the DRM race with its AAC format. HP joining forces with Apple marks a significant gain for Apple—and a potentially large loss for Microsoft—since it means that an additional number of Windows users will be pushed towards the AAC format. The importance of this cannot be understated, since it looks like the DRM race will be settled via “network effects”—e.g. the first player whose format reaches scale the fastest will likely be support by the majority of copywrite holders and intellectual property manufacturers. Once this happens, the DRM race will be over, and only one standard will prevail. By attaching itself to HP’s PCs and marketing clout, Apple has greatly increased the odds of its AAC format winning the battle.

Posted by Matt Percy | Permalink | Comments (56) | TrackBack