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

Rumors of NetFlix’s Pending Demise Are Greatly Exaggerated

One company we’ve always been impressed with is the DVD-rental-by-mail NetFlix. Various members of the BuzzSponge team have used NetFlix over the last few years, and each of them has raved about the convenience of the service. Consequently, whenever there’s an article in the business press about the company, we tend to take notice. You can imagine, then, that we read this morning’s Wall Street Journal article about NetFlix—portentously titled “DVD-Rental Firm May Be Victim Of Its Own Success”— with particular interest.

For those of you who aren’t familiar with the NetFlix business model, here’s a brief summary. NetFlix is a movie rental website that pioneered the concept of renting DVDs to customers for a flat monthly fee. Effectively, customers paid $19.95 a month to rent as many movies as they wanted, with the sole catch being that you could “check out” three movies at a time (if you paid a higher rate, you could rent more movies). You’d thus select a list of movies that you wanted to rent and place them in a “queue” of up to 10 movies, and NetFlix would subsequently mail the movies three at a time to you. When you were done with each movie, you’d simply mail it back to Netflix in a pre-paid envelope that came with the rental, and NetFlix would mail you the next movie from your queue. Customers flocked to this model, primarily because Netflix offered several things that brick-and-mortar video stores couldn’t: an astonishing selection of movies (since Netflix operates a few huge warehouses, rather than several dozen small video stores, they could stock a wider array of movies), an easy-to-use interface (searching for movies electronically beats walking through the local Blockbuster) and finally, personal recommendations a la Amazon.com (made possible by well-organized and executed customer data collection and “collaborative filtering”).

The upshot of all of this? NetFlix has been extremely successful, despite the wintry economic climate that we’ve suffered through the last few years, having managed to consistently turn a profit for over a year and a half. Perhaps more impressively, the company continues to steadily grow and gain market share, even in the face of new competition from firms like Wal-Mart and Blockbuster. As was noted in the WSJ, in its most recent 10-Q, Netflix managed to generate $72m of revenue, up to 25% from the prior quarter. Net profitability is still small—roughly $3-$5m a quarter—but steady.

The fact that Netflix is one of a small—but growing—handful of Internet businesses turning a profit has meant that its stock has skyrocketed this year (according to the WSJ, it’s up 322%; more than either Amazon [up 162.2%] or eBay [up 56.4%]), a fact that’s pushed it’s P/E ratio to stratospheric levels (95x’s this year’s estimated earnings). These facts have made Netflix a favorite target of business journalists when it’s time to write a story about the return of bubbalicious Internet stocks, and also a favorite for investment analysts eager for publicity. Today’s WSJ article was no exception to this trend, and proposed that a) Netflix is indeed proof of a bubble in Internet stocks and b) there’s no way that Netflix’s business will withstand competition from the likes of well-run businesses like Wall-Mart or badly-run businesses like Blockbuster and c) there’s no way that Netflix’s industry—DVD rental-by-mail will survive the coming consonance shock of video-on-demand. Nothing we haven’t read before.

We’ll leave the debate as to whether or not Netflix is over-valued for a later time—we’ll wait ‘til we have a few more finance classes under our belt for that baby—but we would like to take issue with the other two anti-NetFlix arguments on the table, namely those tired, old and square arguments that the firm will end at the hands of either new competition or video-on-demand.

Now that we’ve thrown down the gauntlet, let’s examine why new competitors—especially new competitors like Wal-Mart or Blockbuster— don’t pose much of a threat to Netflix. We’ve got three answers here. Most obviously, Netflix’s niche—film buffs who rent several movies a month—is vastly different than the more mainstream segment that either Wal-Mart or Blockbuster serves. Simply put, Netflix stocks a much larger array of the more obscure art house, foreign and critically-acclaimed films that its niche—film buffs—prefer than either Blockbuster or Wal-Mart, which carry more new releases and blockbusters than NetFlix does. This means that Netflix is shielded somewhat from price competition since its product isn’t really a close substitute to the product produced/rented out by a Wal-Mart. (Consequently, the fact that Wal-Mart’s decision to price its DVD rental service at a price $4.41 less than NetFlix’s probably hasn’t slowed NetFlix’s growth too much.) If Wal-Mart or Blockbuster were to try to go after the same film buff customer, they’d face the economic challenge of having a much smaller base of film buff customers to spread the cost of acquiring art house/foreign film over, since their own audience is pretty much middle American, with very few film buffs. Moreover, Wal-Mart and Blockbuster would face a huge credibility gap trying to win over the Netflix customer—after all, it’s not too likely that budding cineastes and film aesthetes would want to rent from a low-brow service like Wal-Mart, right?

Furthermore, it’s important to consider that the economics of the NetFlix model are vastly different than the Wal-Mart model. Since its customers rent several movies a month (meaning more postage costs, content, etc), NetFlix’s customers are lower-margin customers than the likely customers of Wal-Mart, who rent just a few movies a month. The fact that Netflix has figured out a way to serve these lower-margin, high-rental volume customers profitably—optimizing its service to its niche, and figuring out how to stock movies at its warehouses in a manner that enables it to meet demand most efficiently—gives it a huge competitive advantage over a Wal-Mart or a Blockbuster, who’d have to learn how to serve these customers from scratch. Finally, because the key drivers of Netflix’s costs-a national warehouse and distribution network—are already sunk, Netflix has a powerful weapon vs. Wal-Mart or Blockbuster to use should it be challenged directly in one market. Effectively, it can lower prices at a time when its total costs are low, while the challenger’s total costs are still fairly high, since the challenger is still building out and paying for its service. This means that Netflix can quickly turn Wal-Mart’s or Blockbuster’s challenge into an investment with negative returns.

We also believe that Netflix is fairly well protected against the challenge from video-on-demand. First, the content on video-on-demand—mainstream blockbusters—is probably less appealing to the Netflix customer than to the Blockbuster or Wal-Mart customer. Secondly, video-on-demand doesn’t offer quality and high-end features that the NetFlix DVD customer likely values—there are no anamorphic scan, no 6.1 channel sound, no “making of” featurettes or deleted scenes on a VOD product. Third, it’s also probable that the threat of VOD to Netflix is less imminent than the business press would like you to believe. Keep in mind that the supplier for both VOD and DVD content—film studios—has a vested interest in promoting DVD over VOD, since DVDs form the most profitable part of a studio’s revenues at present. As such, why would a studio rush to VOD when they still have the opportunity to harvest plenty of revenue from DVD?

Finally, even assuming that VOD ever matches the quality of DVD, and arrives in the market more quickly than we expect it does, there’s no reason to believe that this should be a threat to Netflix’s business model. Provided that Netflix’s management is adroit enough to anticipate when the change to VOD will occur, and assuming that they’re strong-willed enough to accept that the costs of their investment into DVD rental-by-mail at that time are sunk, and shouldn’t figure into their decisions, they’ll be well-positioned to take advantage of VOD. This is because of the fact that Netflix’s model gives it reams of data on customer preferences, tastes, and desires, and because of the fact that like Amazon, the company has done an exceptional job of mining and refining that data to understand who its customers are, and what they want. Accordingly, when VOD comes, Netflix will be in the enviable position of being able to cross-sell the VOD content its customer wants—high-end and more obscure films—far better than any of its current competitors, who are attuned to the needs of the straight-up, mainstream market (yo).

In summary, while it’s certainly true that Netflix might be overvalued at present, the arguments proposed by popular business press as to why Netflix’s success can’t continue are poor at best, and show very little grasp of either competitive strategy or economics. So don’t believe all the hype you read about Netflix. We think it owns a pretty tight little niche, and barring any stupid decisions on the part of its management, it should be able to maintain this position for quite some time to come.

Posted by Matt Percy | Permalink | Comments (5) | TrackBack

Marketing Via Rumor And Innuendo: A Thought Experiment

A few weeks ago, rumors started popping up on the Internet that Microsoft—a small company in Redmond, Washington—was poised to make “a significant announcement” regarding its video game console, the XBox, on Nov. 15, which just happens to be the two year two-year anniversary of the XBox’s launch, and the one-year anniversary of XBox Live, the online gaming service that complements the XBox. (We realize that some of our less savvy readers might have a hard time accepting that the Internet can play a significant role in fostering rumors, but a quick search reveals that this isn’t the first time that urban legends, rumor and innuendo have flown ‘round the Internet.)

A few days ago, rumors as to the precise nature of the content of this announcement began to circulate amongst several videogame-related websites. Specifically, it was claimed that Microsoft would be releasing Halo 2—the much anticipated sequel to its bestselling science-fiction military combat simulation, Halo, which has grossed upwards of $250m worldwide, and sold countless XBox consoles—roughly 8 months earlier than anticipated. Almost immediately, discussion boards, chat rooms and video-game related websites and blogs spun into overdrive, as XBox owners salivated at the prospect of playing what will arguably be the biggest console game of 2004 this year. However, as quickly as the rumor materialized, a member of Bungie—the Microsoft-owned software company that’s developing Halo—stepped up and quashed the rumor altogether:

Despite all the juicy rumors floating around the net lately, I can confirm with absolute certainty that Halo 2 is NOT coming out in 2003. As we have said for quite some time now, the game will be released when it is done and that will be in 2004. It is not coming out next week. It will not be on store shelves this holiday. Why would anyone want to do a "secret release" with a property as big as Halo 2 anyways? What possible benefit is there in sneaking it onto shelves without making the consumer aware? Please remember that unless you hear it direct from Bungie, you shouldn't pay attention to any release dates or speculation you see or hear. I'm sorry to crush hopes of playing the game early but it's better than getting your hopes up prematurely. I'm as eager as you are to get my hands on the finished game but we're not there yet. When the time is right, I imagine we will have more to say about a firm release date. For now, we stand by what we've always said - Halo 2 will be released when it's finished.

Rather than stopping the spread of November 15 rumor-mongering, though, Bungie’s announcement merely encouraged XBox owners and video game fanatics to revise the rumor, and argue that while Halo 2 wasn’t coming up, an “upgraded” version of the first Halo was. This re-release of Halo—called Halo Deluxe, or Halo 1.5—would be something like a director’s cut, featuring slightly upgraded graphics, possibly new levels, and online play over XBox Live, something that Halo fans have clamored for since the game’s release. This revision of the rumor made slightly more sense. As was noted on several video game sites and some respected industry publications, Microsoft could use this announcement to drive subscriptions to XBox Live, since many subscriptions would be up for renewal on Nov 15 (the one-year anniversary of the service), and moreover, the cost and technical complexity of re-releasing a slightly improved Halo would be SIGNIFICANTLY lower than rushing Halo 2 to market. Alas, for eager Halo geeks, this rumor was subsequently debunked by another Bungie employee this morning, in a slightly more terse fashion than the previous day’s statement.

So anyways, this whole videogame rumor-mongering thing got the marketing parts of our brains racing. (Cue image of hamsters running frantically on a wheel, lightbulbs turning on, smoke coming out of ears, etc.) Specifically, we began to think of the possibilities of utilizing the natural tendency of consumers—particularly hardcore, fanatical consumers of a certain product—to speculate and fantasize about the products they are most enthusiastic about. For example, let’s hypothetically speculate that Microsoft will indeed make a “major announcement” on November 15, the likes of which will send XBox owners and video game fanatics into paroxysms of delight. Let’s say, too, that Microsoft announces that it will make this statement to a few well-connected industry journalists, key influencers, and video game fanatics a few weeks prior to November 15, so as to seed anticipation. Furthermore, let’s also pretend that Microsoft makes a few cryptic references to “November 15” in its advertising copy (something which has supposedly already happened—Microsoft’s new ad campaign, featuring P. Diddy, supposedly features one ad where P. Diddy says “On November 15, you will believe.”—we haven’t found any hard evidence that this ad actually exists, but if anybody has actually seen it—and can verify it—let us know, and we’ll post a link) so as to encourage and foster speculation and rumor-mongering.

At this point of our hypothetical rumor-based buzz campaign, there would likely be plenty of user-driven gossip and excitement. In short, lots of great, free word-of-mouth. If Microsoft did follow through, and deliver a truly amazing product or service on Nov 15, the amount of customer gratitude, loyalty and support they’d have amongst their most die-hard customers would probably be phenomenal. Not only would they Microsoft have managed to market a product in a way that would truly differentiate it from the marketing clutter, sales of the product would probably be pretty phenomenal, too.

We’re speculating that the above scenario working well for media or entertainment products that have a strong legion of hardcore, devoted fans: Star Wars, the Matrix: Reloaded, Quentin Tarantino, books by Thomas Pynchon, J.D. Salinger, albums from certain bands, to name a few. Let’s go back in time to May of this year, and imagine that the Wachowski brothers announced at the beginning of a few weeks prior to the actual release of the Matrix that they were going to release their latest movie in a few weeks. Let’s also say that they’d also been able to keep the entire filming process of the Matrix 2: Electric Boogaloo totally and utterly secret. (This would have been harder to accomplish, but not necessarily impossible.) We’re confident that at this point, the hype machine would go into overdrive, and when the movie was released—assuming that it met the expectations of fans, which the Matrix movie didn’t—it would have had a pretty tremendous opening, one that would have been comparable to the numbers that it achieved with an expensive marketing campaign that was used to launch the movie.

We won’t beat the issue for much longer, but it is fun to conduct this thought experiment, and we’d love to see somebody actually attempt it in the real world, if only to see what happens. While we’re aware that this strategy sort of flies in the face of the traditional attitude that marketers should seed the market for an entertainment product with buzz or advertising months well in advance of a product launch—to get people salivating, and spreading the word!—it would be great to see marketers actually attempt to use the natural tendency of human beings to gossip and speculate in an interesting and entirely non-traditional fashion. So, uh, if there are any marketers of media or entertainment products with passionate and loyal fanbases (e.g. an army of geeks eager to do your bidding), we dare you to give this strategy a shot.

Posted by Matt Percy | Permalink | Comments (3) | TrackBack

The Young Elite Shun Chicago

One of the most fascinating products of the most recent census is the the special report published this month by US Census Bureau. In Migration Of The Young, Single & College Educated (pdf) we learn that Chicago is the eighth most popular major metro for young, well-educated singles to move to. The Bay Area, L.A. and Atanta are the top three metros, followed closely by D.C. and New York respectively. Although New Yorkers are up in arms about the fact that they are not the "first city" for the "hipster" set, they do have the dubious distinction of being the city with the greatest number of singles in the United States.
So what does all of this mean exactly? Why should we care? Well considering that the recent data not only is in sync with Richard Florida's perceptions of Chicago in The Rise Of The Creative Class but also tracks with the Forbes' Best Places List ranking of job growth in American cities, one has to wonder what the future holds for what is arguably the economic "jewel" of the midwest. Neither Silicon Prarie nor Boeing were the magic solution for Chicago. With the educated elite shunning Chicago for sunnier pastures, what is in store for the Second City's economy in the decades ahead?

Posted by Bradley Peacock | Permalink | Comments (0) | TrackBack

Traditional Market Research

We bill ourselves as a "non-traditional" team of market scientists. To understand "non-traditional" one must first understand the perceived value of "traditional market research". Many thanks to British designer Andy Foulds and Creativegeneralist.

Posted by Bradley Peacock | Permalink | Comments (0) | TrackBack

The Thirty Threshold

We are professional observers--part social scientists, part marketers, part pop-culture voyeurs (frankly, it depends who you ask). And at the moment, we are captivated by Book of Ages:30 and their accompanying blog site "blog of ages". We are captivated not only because the authors of the book have created a multi-platform, grassroots marketing effort that is a bellwether for successful trade publishing in the years to come but also because the authors of Book of Ages:30 have launched a product that is designed around a straightforward, powerful human truth--"the thirteith birthday is perceived to be a liminal point both in ones personal development and in his/her transformation into adulthood". This common perception is laden with emotions, both positive and negative---and therein lies the success of Book Of Ages:30. For often when one has a niche product/service that is fueled by both perception and powerful emotion the cornerstone of a profitable brand is laid. Playing upon the "threshold" theme, Josh applies his BOA:30 filter to the recent news that Google is formulating plans to go public in a blog titled Googillionaires. In the blog, Josh Albertson suggests that the potentially $15 billion windfall to befall Google founders Larry Page and Sergey Brin is akin to another tech maverick's thirtieth birthday bonanza (we will keep you in suspense, check out Josh's blog). The BOA:30 sheds light on other 30th accomplishments and such as Edvard Munch's The Scream as well as insights into 30th shortcomings:

At 30, Harrison Ford was working as a carpenter, and neither Oprah nor Jane Austen had found fame.
Book Of Ages:30 is a fascinating "measuring stick" for those in or approaching their third decade of life. It also is seemingly a fascinating case study for building a grass roots brand. Time will tell.

Posted by Bradley Peacock | Permalink | Comments (1) | TrackBack

Hell Freezes Over For Apple, Part the Second

Yesterday we talked about the challenges Apple’s iTunes faced—razor thin margins, likely price competition due to the raft of new competitors entering the market—and briefly assessed the wisdom of Apple’s desire to use iTunes as a “Trojan horse” with which to spur iPod sales. (See this article for to hear the official Apple position on this decision.) Today, we’re going to subject the iPod to the same rigorous scrutiny and analysis, in order to argue that while the iPod is indisputably a cool product, it’s highly unlikely that it will be able to retain its present levels of profitability. We’re confident in this assumption for two reasons. First, Apple’s success in the market for MP3 players has attracted a wide array of large and small manufacturers who are gearing up to compete on the basis of cost, which will likely trigger a price war in this industry. Secondly, Apple no longer has the exclusive rights for the key resource fuelling the iPod’s success—an ultra-small, 1.8 inch hard-drive for Toshiba—a fact which will enable a variety of competitors to easily knock-off the iPod’s innovative design.

There are three main types of MP3 players available on the market: flash-based MP3 players, CD-based MP3 players and hard-drive based players. Flash-based MP3 players—like Creative’s Nomad Muvo NX
tend to be extremely small in size (think slightly smaller than an cigarette lighter) and fairly durable, making them ideal for, say, jogging or working out at the gym. However, their small size and durability comes with the tradeoff: these players typically can’t hold too much music (roughly 2.5 hours on a 128 MB player) and moreover, if you’re a hardcore audiophile, the sound quality of these devices tends to be closer to tape than to CD. They tend to be priced in the $100-$200 range. Although these devices have a future, their relative lack of functionality, and easy-to-replicate technology (most of these devices now run off of USB drives) mean that these devices will probably fall substantially in cost over the next year or two with competition, making it very difficult to generate profits selling these items.

CD-based MP3 players—such as the Panasonic SL-CT800 —are essentially MP3 players that are capable of playing MP3s directly off of a CD. Where’s the fun in that, you ask? MP3 CDs are advantageous inasmuch as they can contain as much as 720 MB worth of music in MP3 form—e.g. about 15 hours of music per disc—as opposed to conventional CDs, which play about 74 minutes. Secondly, MP3-based CDs are customizable, enabling users to create 15 hour mix tapes for themselves and their friends! The downside is that these devices tend to be large and cumbersome, with plenty of moveable and breakable parts—just like real CD players! Additionally, while 15 hours of music sounds like plenty of music, it isn’t enough to accommodate most users CD collections. Consequently, CD-based MP3 players aren’t a particularly compelling long-term product to manufacture.

The most popular segment of the MP3 market—and the market that the iPod dominates, with 31% market share—are hard drive based MP3 players. Hard drive based players have been around for a few years—ever since Creative launched the 6 GB Nomad Jukebox in the summer of 2000—and were initially appealing to hardcore music fans who needed a way to lug a large music collection around the world with them. (Early hard-drive based MP3 players could hold as much as 120 hours of music—a pretty impressive amount.) However, these early players sounded much cooler than they actually were—they suffered from atrociously short battery life (about 2.5hrs to 4hrs), were very large and bulky (making them inconvenient for travel or use on the go) were fairly fragile (if dropping a CD player was bad, imagine dropping a hard-drive!), and suffered from overly slow and cumbersome interfaces. Even despite these limitations, there was a fairly receptive market for a hard-drive based MP3 player, and a fair number of users shelled out $300-$500 for the early versions of these devices, eager to fill them up with MP3s from their collections and other unnamed online sources.

Apple was one of the first significantly big and reputable firms to see the possibilities of hard drive-based MP3 players. Recognizing the fact that there was a market willing to part with a significant chunk of change for what were then relatively mediocre products from the likes of Archos, Creative and Rio, Apple decided that it could capture substantial market share by launching a similarly priced, but well-designed product. Rather than using the conventional hard-drives that its other manufacturers like Archos or Creative used in their devices, Apple used an exclusive Toshiba-made hard-drive that was inifintely smaller, lighter and more power-efficient than anything then available on the market. This drive enabled Apple to create the iPod, which was “smaller than a deck of cards,” (meaning that it was easy to move) housed in a stylish white casing (making it a fashion accessory, rather than geek chic), and offered vastly longer battery-life (thereby giving credence to the claim that hard-drive based MP3 players really could let you take your entire music collection on the go). (If you’re interested in learning the whole design history of the iPod, DesignChain.com has a great article on the subject here.)
At the same time as it was improving the hardware, Apple excelled on the software side, incorporating an extremely easy-to-use interface (interface design being one of Apple’s consistently strong points) for the iPod, and allowing the iPod to play Apple’s proprietary AAC music file format, which was far and away the best sounding digital music file-type available. All of these factors combined to ensure that the iPod was easily the best product to hit the market. And even better for Apple, it would be extremely difficult (at least initially) for competitors to copy, since Apple had managed to sign an exclusive deal with Toshiba to ensure it would be the only manufacturer to build MP3 players with the all important hard-drive which enabled the iPod to be another “insanely great” Apple product.

The rest, as they say, is history. The iPod was launched in the spring of 2001 (you can read a chronological history of the product here) and was an immediate hit. Since then, its importance to Apple has only increased: according to Apple’s most recent quarterly report (Oct 15 2003), the iPod contributed approximately $121m to Apple’s revenue in the 3rd quarter of 2003. Moreover, because Apple had exclusive rights to the Toshiba hard-drive that made the high-quality of the iPod possible, it could price the iPod at a premium far greater than competitors (a 20GB Creative Zen costs $242, compared to $388 for a 20GB iPod—you can compare them here– in other words, the iPod is about $150 more than an average MP3 player in the market), making it a disproportionately significant to Apple’s net income. (It’s estimated that the iPod contributed as much as 25% of Apple’s net income last quarter.)

While competitors couldn’t copy the style and features of the iPod at first, they eventually began to close the gap. Creative launched the aforementioned Zen a year or so ago, and has gradually been able to get it into an iPod-sized casing. Rio launched the ultra-light and small Nitrus, and although the device offered less storage than the iPod (1.5GB, or about 30 hours of music), it featured much longer battery life (up to about 10 hours). Meanwhile, high-end Japanese MP3 player and geek fetish object manufacturer iRiver recently launched a 15 GB player—the iHP-120—at the same price point as the 20GB iPod, but with one critical difference—its machine plays for a staggering 16 hours (as opposed to the iPod’s six), is more durable than the iPod, and simply looks damn cool. Thus, it looks increasingly likely that Apple may have created a market—generating awareness for the sophistication and usefulness of well-designed hard-drive based MP3 players—only to find itself competing in a price war with firms who’ve skillfully copied most of the benefits of the iPod. And a price war certainly seems to be what Apple’s competition desires: read this comment from Creative’s President, Craig McHugh: "We've been positioning our products to [cost] 30% less than a competitive iPod.”

Meanwhile, the device that facilitated the iPod’s creation—the Toshiba hard drive we mentioned earlier—is now off of its exclusivity deal. (Read this Business Week article for complete details.) meaning that the only uncopiable feature of the iPod is now publicly available to competitors. This fact appears to have motivated bigger players like Dell and Samsung to get in the marketplace—now that they can use Toshiba’s ultra-thin and small hard drive technology (Makes you wonder if Toshiba will capture all the value in this game, huh?) , they can create a machine to rival Apple’s and potentially dominate the competition given their—particularly so in Dell’s case—low-cost manufacturing capabilities.

Given the surge in competition and the loss of one of the key resource that’s driven the iPod’s profits for the last few years, Apple launched its online music store to help try and spur iPod sales. As we discussed yesterday, songs purchased via iTunes can only be played on iPods, and the goal of making iTunes iPod only primarily seems to be to provide the iPod with something that its competitors can’t copy. In short, what it seems Apple is trying to do is create barriers to entry—get so many people to buy iPods instead of competitors products, that those owners will be forced to go iTunes-only for their music fix online. Ideally, this will create a network effect, where each person buying a track on iTunes will be forced to purchase an iPod to play the song, and vice versa, to the point where Apple’s current market share in the MP3 market—31%—grows to the point where Apple has locked up the digital music market.

Accomplishing this goal—becoming the OS of digital music, in effect—requires two things: time and money. The problem for Apple is that it has an abundance of neither. Although Apple can pour a ton of money into a great advertising campaign in an attempt to build awareness, and hopefully send iPod sales into the stratosphere, in a few short weeks, Dell will be on the market with its iPod knockoff. Moreover, it’s unlikely that Microsoft will be willing to cede the opportunity to control digital file distribution—which would be the result of iPod winning the digital music game, thanks to the fact that iTunes sells downloads in Apple’s proprietary AAC format. While Apple has some cash on hand (about $3.4 billion in cash and cash equivalents, and another $2.6 billion in its remaining current assets), it has nowhere near the amount of cash Microsoft has ($42+ billion and counting), meaning that it would have a hard time spending its way to control of the market, something that Microsoft could easily do.

So what should Apple do? We’re not so certain if they can do anything, to be honest. While we’d love to see them win—we have to admit, that over the course of writing about Apple and the iPod for the last week or so, we’re really impressed with how cool the iPod is. (Does that mean we’d buy one right now? Probably not—we’re, uh, eagerly anticipating the price competition that will occur over the next few weeks to pick up an iPod at a more Apple-shareholder unfriendly price.) Some quick thoughts before we jet on out of here for the weekend: Apple could sell the manufacturing rights for the iPod to somebody who could make a go of it (e.g. Dell) in a price war, and try to sell as much as they possibly can at the lowest price as possible. While Apple would lose the short-term revenue from the iPod (which we’d guess is gone, anyways), they might get the long-term benefit of owning the digital standard for media files (which could be worth way more, anyways). However, this strategy of allowing a third-party to manufacture something was tried once before by Apple in the 90s with the Mac, and failed dismally—there’s probably some cultural resistance to doing this @ Apple. Secondly, Apple could sell the AAC format to Microsoft, and try and convince Microsoft to use the far-superior AAC format over WMA as the de facto file sharing device on the Windows OS. This would mean that Apple would forgo the long-term revenue from AAC, but could make its money as a manufacturer of superior, well-branded MP3 players. Although a deal with arch-enemy Microsoft seems unlikely, who knows? We kinda like the idea, and besides, hell’s already frozen over once.

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The N-Gage's Demise, As Predicted

As our erstwhile readers may recall, a scant two weeks ago we predicted the imminent failure of Nokia's new handheld video game device/PDA/cell phone, the N-Gage. We hate to say that we told you so (actually, we kind of enjoy gloating, but keep it under your hat), but it looks like our assessment was right on target: early sales figures reveal that the N-Gage sold less than 5000 units in its first week on the market. These low figures are especially stunning in light of the amount Nokia spent to hype the product in the US (an estimated $117m), and are hugely disappointing when you compare the N-Gage's sales figures at launch to similar technology products. For example, Microsoft's XBox managed to sell 1.5m units on the first day of its launch in the United States at an identical price point to the N-Gage ($299), while Nintendo's GameBoy Advance handheld--the N-Gage's closest competitor--sold 540,000 systems in its first week of launch. Ugh. We're sure that the N-Gage launch team is keeping a low profile @ Nokia HQ in Finland right now, particularly when you consider that just days ago, they were telling anyone who'd listen that the N-Gage would easily sell several million units through 2004. For the handful of analysts who continue to think that Nokia is a good bet, we'd suggest that they try to remember when the last time that they'd purchased a Nokia product that worked well (we've had problems with every Nokia phone our cell carrier has saddled us with), and adjust their ratings accordingly.

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Networking For Fun & Profit: Thoughts on Monster.com's Matchmaking Service

We saw in the Wall Street Journal today that the job board Monster.com is in the process of launching a subscription-based “Professional Networking Service.” Effectively, Monster.com plans on setting up a site that will enable people to “network” with one another, and exchange information about opportunities, jobs, careers and goals. Here’s the skinny according to the Wall Street Journal:


Here's how it works. Users set up profiles containing information including their first name, first initial of last name, skills, job, employment history, schools, interests and location. Users then can search among the network by those categories. To contact a person, however, users must pay membership fees. The fee structure hasn't been finalized, but Monster said it is likely to be on par with rates charged by online dating sites and similar services. Monster Networking is set to go live in the first quarter of next year.

On powerpoint, the idea of a fee-based networking service for job searchers sounds particularly compelling. As most of us who’ve looked for jobs at one point already know, most jobs are discovered via informational interviewing or networking, whereas very few job seekers actually land a position via responding to an ad. (One recent lecture about social capital in a Kellogg class we're currently enrolled in as part of our MBA--Leadership in Organizations-- highlighted the fact that 60% of job-seekers land positions via networking, while just 18% of job-seekers found jobs via an ad). Consequently, Monster.com’s foray into creating a networking board sounds pretty savvy: it’s creating more value for consumers (allowing them to network directly with one another) while allowing Monster.com to create an additional revenue stream in the process.

In practice, however, Monster.com’s networking service raises several interesting questions. First, as most of us who’ve networked in the past already know, it’s usually far more effective to be referred to a contact in a network via an individual—e.g. a friend, colleague or co-worker—or by virtue of the fact that each of you share a common background (e.g. a degree from the same institution, membership in a professional organization, etc). In short, having the right introduction makes a world of difference in determining not only whether or not somebody will speak with you, but also about the type of information you’ll receive.

It will thus be interesting to see how Monster.com’s networking service works. The According to the WSJ, the service will primarily work by allowing you to search for individuals based on criteria that you’re interested in (job, background, etc), and then force you to pay a fee in order to “network” with those individuals. Monster will also require you to use a standard Monster.com “icebreaker” note to contact the person you’d like to speak with. Here’s the dilemma as we see it: consider how willing you’d be to receive a ton of requests for “informational interviews” from strangers whose only shared interest/identification with you is the fact that each of you have utilized Monster.com at some point in your career. However, if the service does a good job of introducing/referring people with similar backgrounds, interests, and group memberships towards one another, it could be very useful to subscribers. Finally, the ultimate litmus test for Monster.com’s networking service is how good it as connecting you to high-quality members (and vice versa): if most of the people you meet on the service are relatively lackluster, how likely will you be to subscribe for it? Monster’s current approach calls for users to “rate” one another after a communication, a la eBay’s rating system for buyers/sellers. While such a rating service works for financial transactions where it’s easy to measure value (e.g. did the seller get me my product in time? Did the buyer pay me in a timely fashion), it’s very difficult to rate more complicated social transactions, since what’s relevant to one person may not be relevant to another. For example, an individual who's hugely interesting and compelling to me, might have little or no value to you, making it difficult to rate that person's overall quality.

In any event, we’re very curious to see how the Monster.com networking service plays out—while we’re not immediately convinced that the incorporation of a Friendster-like networking service into a job searching service will pay dividends for Monster.com over the long run, the idea is certainly intriguing.


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Dell Will Rule The Consumer Electronics World, And Look Ugly Doing It

Yesterday, Dell confirmed what many technology analysts had long suspected: it plans to follow the trend established by PC manufacturers like Apple and Gateway, and begin manufacturing consumer electronics. (You can read the official Dell press release here; alternatively, you can peruse the general media’s take on the subject at Google News.) In short, Dell believes that its direct sales model will enable it to dominate the consumer electronics business the same way it has been able to dominate the PC business, and plans to launch new handhelds, an iPod-esque JukeBox player, an iTunes-like digital music download center, and an LCD TV model to help it do so. Assuming that these products prove successful, Dell CEO Michael Dell hinted that more consumer electronics would be forthcoming from the company.

The big question today, is whether or not Dell will be successful in its foray into the consumer electronics world. Our opinions on the matter are mixed—examining things from a strictly economic perspective, we expect Dell to eventually dominate the competition. However, after looking at Dell’s, uh, somewhat less than stylish product line--in particular, what’s up with the design on the “digital jukebox,” anyways--we’re also fairly certain that Dell’s eventual success in this business isn’t going to come as easily as it did in the PC industry.

Let’s start with the economic reasons that will enable Dell to dominate consumer electronics manufacturing. By now, we all know that Dell’s direct-to-customer business model works by “eliminating the middleman,” and allowing Dell to produce machines much more cost-effectively than its rivals, while selling them at the market price. These lower costs ensures that Dell’s margins are much better than its competitors on the whole. Moreover, Dell’s model has proved to be insanely difficult for its competitors to copy—as Gateway, Compaq, and HP have all found out at various points in the last ten years. Not only is Dell just much further down the learning curve when it comes to knowing how to make electronic devices as quickly as possible (it currently holds about 2.3 days of inventory, as opposed to its nearest competitor, HP, which is at 11-12 days of inventory), its cost structure is exceptionally hard for an established rival or new entrant to copy. For example, its rivals are all saddled with the high costs of maintaining relationships with dealers, resellers, mainstream retail channels, and partnerships. This means that should rivals try to copy Dell and go direct, Dell simply has to lower its prices to a point where its rivals lose money, but Dell still makes money (thanks to its lower prices). Since lower prices tend to result in more sales, Dell’s volume increases while its competitor’s losses mount in a scenario that resembles death by a thousand cuts for Dell’s rival.

Although consumer electronics is a tough business to be in—
featuring razor-thin margins, short product cycles, and intense price competition across the board—the nature of competition is highly similar to that of the PC industry. In particular, other consumer electronics manufacturers sell through retailers and resellers, and have yet to go direct in a big way thanks to the problem of channel conflict. From the outset, this means that incumbents in the consumer electronics industry have higher costs than Dell, since Dell is direct-only. Moreover, the types of consumer electronics products that Dell is initially manufacturing aren’t too different from those that it already makes—the LCD TV it will sell, for example, is really little more than a variation on an LCD monitor it already produces, while the hideously ugly digital jukebox it will make is nothing but a hard-drive with headphones. By avoiding—for the time being, at least— more complicated CE devices, such as 50” plasma TVs, for example—Dell’s costs will remain far lower than established consumer electronics manufacturers for the foreseeable future. These lower costs should allow it to gain substantial share at the expense of others: not only can price its products slightly lower than competitors in order to gain volume, should a price war occur, Dell should still be able to turn a profit, while its rivals will destroy wealth.

The biggest threat to Dell is if the superior brands, and better looking products produced by MP manufacturers like Apple, compensate buyers for the lower prices Dell will be able to offer. Although we hate to admit it—we’re inclined to paraphrase Steve Jobs’ famous comment about Microsoft, and boldly state that Dell has no sense of style—we don’t think that the better-looking, but more expensive, iPod will win against the cheaper but uglier Dell Digital Jukebox. Dell will win because it produces machines that are the equivalent of a Honda Civic: they’re not the prettiest products, but they tend to be very reliable and have minimal problems to boot. We’d guess that unless the Digital Jukebox violates Dell’s long-standing track record of producing pretty durable, and easy-to-use machines it will probably more than satisfy the demands of mainstream consumers and dominate the majority of the market. There will probably be a market for iPod at the higher ends of the MP3 player market—much as there’s a market for Apple’s computers in the upper echelons of the PC market. We’re wondering, however, how quickly Dell quickly could have overrun the consumer electronics market if it knew the meaning of the word “aesthetic.” In closing, we like Dell, but if Dell was a person, they’d be an all-achiever desperately in need of a Queer Eye for the Straight Guy makeover.

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