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

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

Ipod & The Dirty Secret Of Grassroots Marketing

No company understands the power of grassroots marketing better than Apple. In fact, the movement that was to become "Apple" was even foreshadowed in Apple's own, famous 1984 advertising campaign. While Apple has been quick to reap the rewards of an almost unparalleled ability to leverage the power of the grassroots marketing over the last two decades, the dirty secret of grassroots marketing "movements" is that they can just as easily be turned against you, as work for you. This is especially true when your "brand believers" are creatively minded folks with an idealistic world-view, an ability to design websites/edit video and a deep skepticism of everything that smacks of "The Man".
One frustrated Apple believer recently learned that Apple wanted to charge him $255 to replace the dead battery in his 18-month old iPod. What would any self-respecting grassroots believer do? Why launch a guerrilla marketing campaign of his own, of course. The disgruntled Apple-kid has been stencilling the words "iPods Unreplaceable Battery Lasts Only 18 Months" all over Ipod ads throughout New York City. In fact, he has even gone global and created an downloadable movie chronicling his efforts via Gizmodo]
It is critical that Apple remains true to its believers---for the believers brought Apple to the party in the first place and have helped Apple remain competitive in the cutthroat world of the pc manufacturers. Apple's believers are the bagdge-bearers who, like the Harley-owner who puts up with the potato decibels, gladly rebuilds his/her desktop every six months and evangelizes the supremacy of Apple 24/7 to anyone who will listen.
In grassroots marketing--once your believers turn against you, the endgame has begun.

Posted by Bradley Peacock | Permalink | Comments (8) | 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 Manifold Failures Of The N-Gage, Part the Third

As every avid BuzzSponge reader knows, we're no stranger to taking pot-shots at the strategic and design shortcomings of Nokia's hapless GameBoy/cell phone, the N-Gage. This will probably are last N-Gage-related potshot. Not only is making fun of the N-Gage's shortcomings like shooting fish in a barrel, we're sure after failing to understand its target market (see our article on the subject here), launching the N-Gage to, uh, less than impressive sales (selling 5000 units worldwide, despite Nokia's insistent claims that it would sell in the "millions and millions"), and then having their N-Gage hacked (yesterday, hackers devised a way to not only copy the N-Gage's games, but to play them on other--much cheaper, and better--phones), the team behind the N-Gage is well-aware at this point that they're probably about to become a case study in how not to launch a product. But before we invoke the mercy rule, we couldn't resist but post a link to the following site devoted to making fun of the N-Gage's ridiculously stupid (and not stoopid fresh) design, SideTalkin. (With only 5000 users worldwide, most people won't have seen an N-Gage in use, so we'll take a second to explain the joke behind the site: in order to make the N-Gage more cool, avant-garde, or possibly just more obtuse, Nokia's product designers decided to make users hold the phone like a pizza slice to their head in order to make calls. To explain this, take your cell phone, and hold it sideways to your head, rather than simply so that the speaker/mike face in front or behind you. Looks cool, doesn't it? The N-Gage's designers also thought so!). Anyways, you know you've got a problem when hundreds of people in your target demographic start up a website devoted to making fun of your product's ridiculous design, as is the case here. Enjoy.

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

Online Gaming For Fun And For Profit

There’s a thought-provoking article in this week’s Economist about the spectacular growth of online video games. The highlights:

[In 2002], Americans spent over $6.9 billion on games for a personal computer (PC) or a console (ie, a television-based unit such as Microsoft’s Xbox, Sony’s Playstation, or Nintendo’s Gamecube). Polls show that more than half of all Americans above the age of six play video games. Nor are the players all spotty teenagers: in 2002, 42% of console-game buyers and nearly two-thirds of PC-game buyers were over 36. A poll for the Entertainment Software Association said that 26% of all gamers are women: video gaming, it seems, is a more heavily female pastime than subscribing to The Economist print edition (just 8% of its subscribers are women). Young men dominate professional gaming, but that is bound to change, just as women broke into the previously male world of professional poker as the game became more popular and respectable.

We’re thrilled that the Economist is effectively validating a guilty pleasure of ours—we defy any of our readers to match our mad Halo skillz on a PC/mouse set-up, and we’ll gladly challenge some of you to some Rainbow Six action as soon as we pick up our copy—but (wearing our business hats for a moment), we were more intrigued by the Economist’s description of gaming for fun and for profit. Specifically, the Economist described something called “the World Cyber Games” that was held in Seoul, South Korea this summer, where video gamers competed for cash prizes and rewards:

On October 18th the fourth annual World Cyber Games (WCG) in Seoul ended with Germany victorious over 600 competitors from 55 countries. The German team will split a $350,000 purse stumped up by the South Korean government and by several corporations; Samsung alone spent $12m to back the tournament. The team had to beat a field of about 300,000 to qualify; Britain’s qualifying tournament saw about 10,000 people vying for 15 spots on the national team.

Reading about the popularity—and the size of the purse—of online gaming got us to thinking: how long will it be before Microsoft, Sony or Electronic Arts start holding online tournaments with significant prize money as a way to generate interest in their games? Imagine playing in a Madden online where the winner could garner cash (or other) prizes. Similarly, what about a basketball game that culminates every spring in an online tournament that parallels the NCAA’s march madness. Not only would such events further accelerate the growth of online gaming, they might provide marketers with another way to reach customers: e.g. Anheuser-Busch or Miller could sponsor the NCAA tourney as a way of reaching ever-so-hard to contact 21-34 year-old males. There’s already a huge number of individuals who attend LAN parties (events where sometimes as many as 128 users lug their computer gear to a rented space to play games in close proximity with one another over a lag-free LAN) where cash prizes—usually in the range of $500-$1500 are awarded, and it would seem to make sense for corporations to start sponsoring such activities. At the very least, it would certainly generate some buzz, if only because it would be so unusual (at first).

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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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Hell Freezes Over For Apple, Part I

Last week (October 16, 2003, to be precise) Apple launched the long-awaited PC version of its much lauded, and so far, very successful iTunes subscription-based music download service. The launch was accompanied with plenty of fanfare in the mainstream press for a variety of reasons, not the least of which is that iTunes is something of a revelation for the music industry in the sense that it actually gives music fans what they want: legal downloadable music with limited restrictions in an easy-to-use and understand package. Moreover, the fact that Apple released an iTunes for the windows-based world was seen as a shift of strategy on the part of Microsoft-hata Steve Jobs, a fact that Apple’s marketers cleverly manipulated to their own advantage, advertising iTunes for the PC with the great tagline, “Hell Freezes Over.” Financial and industry analysts also praised Apple for this move, because although iTunes has been a success thus far—selling roughly 13m tracks at $0.99 a pop since its launch—its “Apple-Only” distribution strategy meant that the market for it was rather limited. (Apple’s machines comprise roughly 3% of the PC market, according to this article, whereas Windows PCs are a vastly larger market, meaning much more potential iTunes subscribers.) Even musicians had eagerly chimed in on the perceived greatness of Apple’s move, with Bono—of U2 fame, no less—stating that Apple’s move to PCs was an occasion for him to “kiss corporate ass”, which is something that he doesn’t “do for everyone.” (Excepting the producers of the Tomb Raider soundtrack, that is.)

However, despite the fact that iTunes is clearly a solid service—we just downloaded it, and it looks like a typically well-designed Apple product—it’s less clear whether or not it will be a boon for Apple over the long-run. The logic behind iTunes appears to be an attempt to be twofold: one) create a relatively profitable new sales channel (online music) and two) sell more iPods. However, after carefully considering the situation, we’re not so convinced that Apple’s foray into the wild world of digital music is a great bet for its shareholders. Not only is Apple’s position as a leader in the arena of digital music downloads looking less tenable as new competitors enter the market, both the markets for online music distribution and MP3 players looking like their headed toward destructive price-based competition that will only hurt Apple’s bottom line.

Let’s start by examining the market for digital music, and Apple’s position within it. Up until now, there has been very little competition for iTunes. In fact, when Apple launched the service in April, its competitors included such lackluster services as Rhapsody (an overly complicated, poorly-executed Real Networks/major label service that had failed to catch on), and popular peer-to-peer services like KaZaa or Grokster, where users could download music for free, but only at the risk of incurring the RIAA’s wrath and possible lawsuits. Little wonder, then, that when Apple launched an easy-to-use service, with an extensive catalog (200K plus songs at launch, approximately 400K songs to date) that it was able to capture the lion’s share of the market for fee-based downloadable music.

However, as has happened time and time again—consider as it did with GUIs, user interface, and hey, even MP3 players—iTunes revealed Apple’s skill in being to get a product and service just right, only to have its design choices quickly copied by competitors. Admittedly, the first service to copy Apple—BuyMusic.com htt kinda sucked—but newer services, particularly MusicMatch.com make downloading music on a PC just as easy—if not better—than iTunes. For example, not only does MusicMatch feature the same pricing scheme as Apple ($0.99 a track/$9.99 an album), it features a highly similar, very intuitive interface, and vastly superior editorial content (piping in album information and using collaborations from the All Music Guide, which is easily the most comprehensive source of music info on the web). Moreover, MusicMatch currently features the same number of songs as Apple’s iTunes service, and offers more esoteric or obscure content, which is a boon for music consumers like ourselves, who tend to avoid most of the mass market stuff sold on iTunes. All of these factors make MusicMatch a potentially better option than iTunes for music fans.

Although MusicMatch might not be able to best iTunes’—despite having what we think is a better product, the company is much smaller than Apple—it is merely the tip of the iceberg of in terms of the competition that Apple is about to face. Consider this: in the next few months, the following competitors will be entering the market for digital music: Microsoft, whose bottomless pockets give it the ability to fight a protracted price war, Dell, which plans on launching a service to support a line of MP3 players it announced mid-September, Amazon.com, whose extensive customer data and large amounts of site traffic make it easy to recommend and cross-sell music direct to users, and a revitalized, subscription-based Napster service, which has the advantage of a recognizable brand-name, with plans to have twice as many songs available for download at launch. Clearly, while Apple may have had a captive market to sell to in the Mac world: mac users had virtually no choice when it came to downloadable music—the PC world is shaping up to be a much different battleground. As a plethora of new entrants—each with a roughly identical product (music downloads from the same array of artists) enters the music download marketplace—competition on price will likely occur as each download service tries to gain market share at the expense of their peers.

The likelihood of price competition is compounded by the fact that any would-be players in the music download arena—iTunes included—faces razor-thin profit margins. Due to the fact that there’s effectively one source for content in this industry, artists and recording labels, with many potential buyers (each new download music service) gives content suppliers—labels and artists who control the rights to their music—substantial power over download services (it’s estimated that record companies collect as much as $0.35 per song downloaded). Meanwhile, marketing, administration and technology costs for each service are relatively high (and will likely remain so, as long as competition in the music download market continues to increase). Consequently, of the $0.99 you’re paying for each music track you download, ultimately less than $0.10 ends up as profit for a music download service, according to industry analyst Charles Wolf of Needham & Co.

Given the competitive forces of the online music download world, the key to long-term profitability seems, put simply, get big, fast and become the dominant player in the category. By achieving a pre-eminent position in the music download position, a firm like iTunes could theoretically demand better terms from content providers in exchange for providing them access to their audience, giving them a lower cost structure than competitors. Additionally, a leading position could also create a virtuous cycle for a player that would be very difficult for competitors to match—a leading player could demand exclusive rights from specific artists or labels who wanted to sell digital versions of their songs, which in turn would increase the customer base of a service, which would thereby give a download service greater clout to demand exclusivity from their artists, and so on.

In order to achieve this scale, and hopefully insulate themselves from competition, online music firms are using a combination of several different tactics. Some of these tactics include extensive marketing and advertising to build awareness, trying to secure as larger library of music than that of competitors or paying content producers to provide content exclusively to a specific service in order to encourage fans to use that service rather than competitors. Additionally, firms are also trying to compete by offering fans different levels of access or permission with respect to the songs they purchase or download: some firms offer generous rules on the number of times a specific track can burned to a CD, or alternatively, offer more liberal rules on the types of devices—computers, MP3 players, CDs—that the song can be played upon. (These “rules” are all enforced by technology-based copy protection.)

Apple’s strategy for iTunes appears to be twofold: aggressively outspending its smaller competitors—MusicMatch and Roxio’s Napster— in terms of advertising and marketing, while trying to sign artists to iTunes-exclusive digital distribution deals, either by luring them with Apple’s brand (the Rolling Stones) or by simply paying them for this exclusivity (Dr.Dre, the Eagles). These tactics are relatively smart for Apple right now—as it has significantly more cash and current assets than these competitors—it can easily outspend them or force them to spend more to gain traction. Furthermore, since it has a much larger market share than either of these rivals, it can spread these costs in a way that its smaller competitors can’t. Apple’s aggressive moves in these areas clearly highlight its desire to quickly build up an unassailable lead in the online music domain, and hopefully shield it from larger entrants—e.g. Microsoft or Dell—who could easily afford to outspend Apple in terms of advertising and marketing.

However, while Apple is doing well with utilizing marketing and signing artistis to exclusivity deals to support iTunes, the biggest flaw in Apple’s iTunes strategy is this: whereas other services like MusicMatch allow users to download music they’ve purchased to whatever device they’d like, no matter who it’s manufactured by, Apple is currently only allowing music from the iTunes store to be downloaded to iPods. This seems to put iTunes at a considerable disadvantage relative to its competitors—although it’s true that the iPod is the most popular MP3 player on the market, it should be noted that the iPod only has 31% of the MP3 player market. (And when you factor in the fact that the majority of iPod owners are also Mac owners, iTunes share of the market for Windows users with MP3 players is probably significantly smaller.) In other words, competitors like MusicMatch or forthcoming services from Microsoft and Dell have a huge potential leg up on iTunes when it comes to trying to gain share in the digital music market. The market for online digital music is still up for grabs meaning that Apple’s iTunes has yet to gain the market share that would enable it to sign up most artists or label to exclusive contracts, which is the one area that Apple could truly differentiate itself from its competitors in. Moreover, since iTunes’ competitors are roughly equivalent in terms of the service and features they offer users, the much greater flexibility that they offer users should help them steal share from Apple.

So what’s behind with Apple’s decision not to go the whole hog when it comes to providing iTunes users the same flexibility as competing services? We suspect that a large part of it comes from Apple’s desire to hedge its bets, given the current uncertainty of who will emerge as a leader in the online market world (or who will enter it), the tight margins associated with digital music download, and the she and the tight margins of the online music world and the profitability of its iPods. Apple likely recognized that it would be extremely to generate significant profits in the digital music market without maintaining a near-monopoly position in the marketplace. Consequently, one way to compensate for the riskiness of entering the digital music marketplace was to use the iTunes service as a means of hopefully selling more iPods, which have played a pivotal role in Apple’s success over the last two years. (It was recently revealed in a press conference that iPod sales were responsible for $12.1m of Apple’s net income last quarter [roughly 25% of its profits].)

We’re surprised that so many analysts see Apple’s use of iTunes as a “Trojan Horse” with which to increase iPod sales as a “good thing” or a “win-win” for each product. While there’s no disputing that the iPod is a great product, given its small market share (31% of MP3 players) we still can’t see how it allowing users to download from iTunes to iPod will enhance iTunes position in the marketplace. Furthermore, although the iPod is currently the leader in the world of MP3 players, it’s also relevant to ask whether or not it will be able to maintain this position in the face of much improved, and significantly cheaper products from competitors like Creative and IRiver, which threaten to erode the iPod’s profitability to consumer electronics product levels. (As we’ll discuss tomorrow in more detail, the iPod’s continued success is by no means a certainty.) Our best guess right now is that Apple hopes to somehow use iTunes as a means of insulating the iPod from price competition and vice-versa. While such a strategy sounds great in theory, it will be very hard to pull off successfully in a competitive marketplace. We’ll have more on this tomorrow.

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