Wharton Tech Blog

Recently I stumbled on a rant by a self proclaimed digital enthusiast and real-life investment professional that goes by web alias Thomas Hawk.  Mr. Hawk was particularly taken by the announcement that the iTunes Music Store (ITMS) sold over one billion legal downloads, and proclaims that everybody that buys music from the ITMS is a sucker (his words not mine) because they are locking themselves in to the Apple’s proprietary DRM format.

Brushing aside Mr. Hawk’s misconceptions such as:

• Crystal clear MP3 (dude have you heard of lossless encoding?)
• Legality of buy a CD, rip-it, return it scheme he proposes
• Apple’s DRM is awful (again, his words not mine - obviously Mr. Hawk is not aware that Apple licenses DRM in use on ITMS, thus it’s not Apple’s strictly speaking.  Also, awful is an interesting way to describe a relatively seamless technology without any other relevant benchmark)

This piece prompted me to think about one real question: What is the price I am actually willing to pay for a song?  To make things simple I consider only two variants: buying a song through ITMS or by going to a physical store, buying a CD, and then ripping it to a digital file or doing whatever else I want.  I have covered some music subscription service issues in this blog about one year ago.

We know what the first alternative gives us: You pay $0.99 for a song, it’s in 128kbps AAC (aka advanced audio coding - a part of mpeg4 format with quality roughly equivalent of 160kbps mp3). You can burn it as many times as you want, you can transfer it to up to 5 computers, listen it on as many iPods as you want. Sorry other players are not supported, but really - who cares?

On the other hand if I go to a store to buy a CD, in addition to the price of the CD I actually have to pay cost of my time, because I really can’t use it to do something else (like spend an afternoon in the park with my son). So what’s the time commitment:

• 55 minutes to go to the store, find/select a CD, check out, come home
• 5 minutes to rip the CD

OK, so if I am an average American and I make about $39K (2002 census data adjusted by 1.5% average annual real wage growth in last 4 years), which means that one hour I spent purchasing a CD just cost me about $19.5 in lost wages. (And I am not even going to go into how much I value my free time but it’s definitely more than $19.5).  Those of you with higher wages, go ahead, make the adjustment: the end numbers are actually going to be really funny.

In addition to the cost of my time, let’s say that I am an average American living about 10 miles from the mall driving an average efficient car that gives me 20mpg.  Thus, I’ll consume about 1 gallon of gas during this trip costing me about $3. (I don’t have an exact statistics on this, but if you are going to beat up $3 number, remember that you are paying for a car usage, insurance, etc, and that your alternative is to take a bus or a train - if there are any - in which case you will be paying about the same).

So for an average American total looks like $22.5 plus the cost of the CD. 

BUT!, you say,  I am not going to the store to do only this, I am running a bunch of errands. OK, fine. Average mall store purchase is about $90 according to ICSC research, so if an average retail cost of a CD is $12 (don’t have a precise statistics for this, but I seem to remember RIAA claimed some such number recently), then my percentage of total spending allocated overhead to purchase this CD is $3 ($12/$90 x $22.5 = $3), on top of which I need to carry the cost of the CD

Masterpieces excluded, there’s only between 1 and 3 good songs on an album, so (optimistically) I am paying a dollar to purchase the CD in the store, plus 1/3 of the sales price.  If we use the average CD price (my CDs somehow always end up being much more expensive than average, but hey, at least I am not average in something), the total per song is $5.

Is paying $4 differential for being locked into the Apples "awful" DRM a lot?  I guess it depends. This back-of-the-envelope analysis suggests that the likely outcomes for DRMd music industry behavior are:

• Random hit songs, and experimental music (where longevity and flexibility is not an issue) will be purchased via ITMS (or alike)
• Masterpieces that have a long-term value will be purchased in a more durable format which is flexible and allows higher fidelity and portability.

And what if a brand new format comes along in 3-10 years?  Well, heck, I just might spend that $1 to purchase the song again. At least I am not investing $4 in an non-interest bearing account at RIAA bank!

Unless you lived under a rock and have not been exposed to media (not likely since, after all, you are reading this post), you probably have noticed that manufacturers of venerable iPod made change to the other white product line.  Yes, Apple still makes computers, and good ones at that, and no, they do not run Windows.  However, they are a step closer: now two of four Apple’s computing lines feature processors made by Intel, same as those commonly found in new Windows computers.  Now that architecture differentiator has been removed, what lies ahead for the consumer and the industry?

There are two key issues underlying this change: speed and heat.  The latter one is also referred to as power, since higher power chips consume, more heat they usually dissipate.

During the annual Macworld keynote, Apple CEO, Steve Jobs showed some benchmarks that pitted G5 (processors based on PowerPC architecture and made by IBM) against new Intel, and claimed that new Intels are 2-5 times faster. There’s been a lot of head scratching about this in user and tech communities since nobody can really believe such a quantum leap. IBM guys are no duds, they know performance computing, and sans specialized architecture optimized code (aka AltiVEC for those of you initiated in PowerPC ways) applications should run comparably, if not faster on PPC solutions featuring similar clock speed.  Some benchmarks have been run by 3rd parties to see what’s up.  A good comparison is done by Ars guys here, and benchmark results are here.  Also, Walter Mossberg in his WSJ column compared usability aspects before and after.

Here are some bottom line(s):
1. Dual core Intel processor = higher performance on multi threaded applications v. single core G5. In real terms that means that stuff that has been developed with multi processor architectures in mind (e.g. ripping a CD or exporting a movie in quicktime) will run faster on dual core intel than on single core G5. DUH!
This, however, is the crux of Intel advantage: ability to provide a solution with 2 cores consuming same power as IBM’s one.  Marketingly (is this a word?), Jobs used SPEC benchmarks that favor mutithreaded apps over those that test peak performance to show off new computers.  And voila!  Performance in real-life apps, however, does not appear nearly that much better: 40% faster on CD ripping, 15% faster on movie recoding, and no advantage in many other apps.

2. Some software is not native and has to run through a PPC-to-X86 translation engine (a.k.a. Rosetta). But, things are not all that bad.  Again it’s a 2 core thing: one core translates code and cashes it for later use, while second core executes.  On "simple" applications such as MS Office - lag is apparently imperceptible.  Photoshop and other heavy duty workhorse programs have issues - obviously.

3. Core graphics performance.  This is where G5-based architecture has an edge (as much as 15-20%), which comes as no surprise because Quartz has been tuned for years to run on PPC optimized architecture.  Given Intel’s interest in taking on graphics processor manufacturers, I believe it’s a matter of time before they lick this issue.

4. Intel-based system seems to have higher disk performance. This is a bit of a puzzle to me right now, but it’s a welcome development in a long run due to rapid proliferation of files and their size - mostly driven by media content commonly found on our computers.

So, if you are a consumer with regular needs (documents, pictures, home movies, music, and occasional games) this transition is as lateral and as seemless as it probably could be.  In a good old Apple way, things just work, and do so out of the box. Wisely, Apple changed one thing and one thing alone, and made sure this change is as imperceptible as possible.

In terms of industry and future developments, Intel and Apple have aligned incentives: low power, high performance consumer devices.  Laptops and small-format machines are becoming prevalent and substituting common workhorse desk stations. While it remains to be seen how fast will true benefits of this alliance be realized, exponential growth in performance will certainly be significant as cumulative effects of optimized code and architecture kick in.

What happens next?  Well, it’s no news that OS X (Mac operating system) works on already available Thinkpads, Dell’s etc. While compatibility is not perfect (incomplete graphics support and some networking issues), it’s more than 90% there. This opens up a logical question: Will Apple return to clone war days of John Scully and thus launch a frontal assault on MS by licensing OS X for OEM distribution?
While PC industry has been becoming boring for years now - with competitors edging each other out on shipping costs, and although such lateral assault would provide something for journalists to write about, I personally doubt this initiative will give quick results. MS is built its ecosystem very carefully with OS at its base and communication and data productivity applications around it.  In addition IT staff (which makes purchase decisions) is more likely than not educated (indoctrinated?) by MS and will go the route they know better - not necessarily one that is better, even if products do offer some advantages.

But is this where the beef is?  PC manufacturers are emphasizing laptops more and more as portability becomes crucial and technology allows desktop replacement workstations to be packaged into mobile formats. Apple has been there about four years ago, with Jobs declaring the year of the laptop when Apple launched the new generation of Powerbooks. Now, Apple it’s mostly about consumer electronics and associated devices.  All along the industry, in fact, consumer segment is what has been driving growth and novel applications for a while now.  Gateway got out of trouble with TVs, Dell followed into PDAs, TVs, projectors, and HP went in with Media PCs. What all PC manufacturers are finding though is that CE space is fundamentally different from PC one.  Consumer demands simplicity and performance combined, as opposed to extensive set of features. Just think of VCRs flashing 12 because nobody in the household knows how to program them.  Such demands are contradictory with requirements traditional, enterprise-oriented manufacturers are used to, and hence they tend to get products wrong.  They attempt too much and achieve too little. Apple’s core, however, is the widget that works out of the box: fully integrated, everything plays together, and thus is positioned to succeed in CE market.
Thus, I don’t think opening OS to OEMs is on top of Apple’s list - no matter how funny it would be to see Dell ship OS X powered computers few short years after Michael himself said that if he were Jobs, he’d shut the company down and return money to shareholders. What I do expect to see, is further strengthening of home-base and building a network of externalities akin to that of MS in enterprise market, and keeping OS wars on a low heat.  One way of doing so, perhaps, would be opening some aspects to the open source and letting pent up demand take care of compatibility issues.

Microsoft faced huge challenges with the launch of the Xbox 360. John Porcaro, Group Manager of PR Communications for Microsoft’s Home & Entertainment Division, responds to customer frustration surrounding the launch of Microsoft’s big bet in consumer electronics and gaming.

"Here’s the challenge," he writes, "Design a Go-To-Market campaign" given a list of 16 issues, including:

• "The product has a multi-year sales cycle with forecasts into the tens (hopefully hundreds) of millions of units"
• "The product doesn’t hold market majority, and competes against a product with significant market share advantage"
• "The product relies on follow-on sales (games) and licensing fees to be profitable
• "Coming out too early allows competitors to build their plans/product reacting to ours"
• "Coming out too late means our competitors have first-mover advantage, and can build games portfolio and customer base"
• "The customer you need to reach in the future has almost no awareness of your brand"

The central dilemma here is that the "hardcore gamer" demographic is pretty much in the bag. In order to grow marketshare, however, Microsoft must build awareness in the broader population, but to do so requires marketing that exacerbates short-term product shortages that enrage the early adopters. Tough job.

Lest few weeks were rather fertile when it comes to announcements of portable video players and related services.  Apple announced video-capable iPod with capability to download TV shows (only ABC for now) 24 hours after they air.  Dish Network announced PocketDish player series which allows Dish Network (DN) customers to download and view any TV programming stored on their DN DVRs. 

At first glance DN presents a first formidable attack to iPod fortress.  DN owns programming relationship, and apparently they
have achieved the holy grail of mobile content by ironing agreements with content originators to distribute
programming, and at much wider scale and lower marginal cost than ITMS can. Sure, you have to pay for DN subscription, but hey you are doing that anyway if you are considering this device. Which brings me to the second advantage Dish Network has.  They own the customer. If you’ve got the dish, they’ve got your address, and they can easily target their marketing to you thus getting higher marketing ROI. In addition, if you are in the market for this type of device,
and already DN customer then you are more likely to stay w/ Dish, and they can reduce their
overall costs from customer churn.  Finally, if you are interested in this particular device, then you might be interested in signing up with DN, thus their customer acquisition costs may go down somewhat.

However, DN still has a fairly small install base (compared to iPod user base) which in turn means that devices penetration and thus economies of scale will be limited, and therefore device price will likely remain high. In this I assume that device as is will not be interesting to non-users of DN services.  This is consistent with adoption of other mobile media players so far. Thus, adoption will likely be both slower and limited to a subset of DN’s install base and will not likely represent a significant competitive threat to Apple’s offering.  Moreover, popularity of iPod stems from superb integration with computer and service,
streamlined UI and multitude of price points - some being more accessible than
the others, but offering more or less everybody a taste of technology leadership. Given features, I don’t see PocketDish being anywhere close to iPod prices, and it certainly does not look easy to use.

Be it as it may, this development offers some possible insight into what’s to come from Apple side.  Should an universally DVR reusable device emerge, i.e. one that would work with TiVos, Dish Network’s DVRs, Time Warner’s DVRs, etc. we’d have a real competitor.  Or perhaps Apple’s on the way there.  Wide speculation is that MacMini is actually a DVR in disguise, and it even may offer iPod docking capabilities in one of next revs. Also, we’ve seen some of DVR-ish features coming along with new Front Row application.

One thing is certain: Apple, even in current state of iPod world domination can afford to stand still. Digital revolution is only starting.

After all the talk, and there has been much of it lately, I really don’t get the music subscription store economics. Arguably subscription model better fulfills demand of music listeners. Hey, who would not like to have every tune ever recorded at his or her fingertips? However, to make a model sustainable you have to think about more than just demand requirements.

My understanding is that subscription stores incur some variable cost, which can be made up of one or more of the following:
1. Per-user license fees
2. Broadband cost
3. Misc (referrals, customer database tracking, CPU costs, etc)

Whatever these costs are, and whatever they are made up of, it seems that they have to be non zero.

From there, subscription model leads to following dynamics:
1. Initial curse of the commons:
Whenever there is a resource that is free to use it gets overused, i.e. listeners download huge amounts of songs by which causing resource provider to incur costs beyond recuperation. This fits with the idea that this store “better” satisfies needs of users which would all like infinite access to music
2. Steady state:
Once users download all music, store collects the fees and incurs only costs of new downloads. But, user does not get incremental satisfaction of getting access to huge amounts of music as s/he did before, and has to be satisfied with new music only. That means that they would be willing to pay to continue using service only the amount that they would ordinarily spend on music per month. Willingness to pay and price vary per user dramatically (just think of pop-crazy teenager and mid-age user that knows he likes Rolling Stones). So, per-month pricing has to be set so that it reflects an average per-song willingness to pay which may be very hard for a very diverse user group. Moreover, there is only limited ability to price-differentiate between offerings, so user is either able to access music (videos, collections, etc) or s/he is not.
3. Piracy risk:
Once DRM for a subscription service is cracked all available content can be pirated and distributed around. So, pricing has to include a risk premium that would take into account probability of such thing happening. Given that it is not question whether, but when will the DRM be broken, I am not sure how or even if such risk premium can be assessed.
4. Consumer churn:
Every time a subscription service looses a customer (and why wouldn’t it since their customers can transition to a better service w/out incurring music repurchase cost), they loose a revenue stream. Whenever they acquire a customer they incur startup costs (customer acquisition + initial downloads from part 1). This is reminiscent of cable-DSL wars in which consumers win, but it takes 10 years for broadband to be adopted in the most prosperous country in the world.

On the other hand, per-song store economics allows user to pay only for songs they use. In Apple model this is very close to the 2-part tariff, which is an optimal pricing model (remember MGEC?):
- ITMS charges users marginal cost of song distribution (license fee + distribution costs + transaction costs)
- Apple captures consumer surplus (entry or membership fee) through iPod margins
Kind of reminds you of Costco, doesn’t it?

In this model there is no initial curse of the commons, since marginal costs of music distribution are covered, there is no steady state problem since it allows flexibility to exactly satisfy variable demand of users (pop-crazy teenager and mid-age user). There is only a limited piracy risk since users don’t have access to the whole library of music. Finally they don’t care if customer leaves, since profit was made when customer entered (bought an iPod), so if they want to leave - so be it.

It seems to me that the only way Yahoo and alike stores can survive is to extract extra revenue per download through other channels (such as advertisements). But, actions like these further reduce customers’ willingness to pay and thus reduce resulting revenues. And the vicious cycle continues.

Right now, my money is on ITMS.

One Wednesday October 27^th, the Media and Entertainment club hosted a panel entitled “The Digital Revolution: Are We There Yet” featuring Marcel Garaud, VP of Technology Sony/BMG and John Penney, VP of Business Development, HBO.  The discussion was moderated by Randy Lake from Booz Allen.

So much attention has been paid recently to the digital distribution of entertainment, whether it is the success of Apple’s iTunes store or the recent Microsoft announcements regarding the home entertainment media center.  Yet even in the music industry, digital distribution represents such a small percentage of the revenue currently being generated (roughly 3%). 

The panelists shared much insight into the struggle that entertainment, technology and consumer device companies have endured in trying to grow the digital market.  In discussing what has gotten the industry to this point, it was clear that the growth in P2P usage played a huge role.  Marcel spoke about how record labels were faced with their own demise and had to react.  It was Apple that came up with a novel solution that provided record labels with the security they were looking for and the consumer with the ease of use and freedom that they wanted. 

On the flip side, John indicated that the fact that the movie and television industry hasn’t gone through this same crisis has been a major factor in its reluctance to fully embrace the digital channel.  Revenue from the sale of DVDs continues to be a huge boom for studios and they don’t have the same fear that the record labels had (and still do) that drove the need to find ways to move towards digital distribution. 

In spite of the recent developments, there remain several challenges ahead for digital entertainment industry.  The legal aspects of the entertainment industry still lag way behind the technology.  John spoke of complicated agreements with the various talent agencies and their restraint on a studio’s ability to explore new distribution strategies.  Marcel spoke of the continued problem with trying to limit P2P usage and indicated that as long as consumers can get music for free, legal services will never thrive regardless of the consumer offer. 

Both John and Marcel seemed dubious of the industry’s attempts to add one more physical format before the transition to digital.  While the dual disc (CD on one side, DVD on the other) might offer an exciting opportunity, Marcel felt it would not revolutionize the industry in the way that the CD did.  Marcel said that the days of consumers re-buying their library in another new format are over.  However, he did express that moving to more secure formats such as DVD Audio and encrypted CDs would help reduce the amount of files traded on P2P networks. 

John was much more skeptical of the growing debate over the Blu-Ray vs. HD-DVD formats.  He felt that neither format was a big leap over the capabilities of the current DVD standard and that this new development was also being driven forward by the studios’ desire to move to a more secure format in terms of consumers’ ability to make unauthorized copies of DVDs. 

When asked about the concept of the fully comprehensive digital entertainment experience, both panelists seemed very enthusiastic about the possibilities.  They both discussed how this business would eventually move away from the concept of entertainment tethered to a device to entertainment tethered to a person.  Your library of music and videos would follow you whether you were in the house, office, car, plane or a hotel in a different country.  However, both panelists were also wary of what needed to happen for these possibilities to become a reality.  Consumers’ are not as accepting of technical problems once you move off of the desktop.   In addition, the standards war that is taking place between companies such as Apple, MS, Sony and RealNetworks would have to end in order for consumers to experience a seamless entertainment experience in moving from one environment to the other. 

In terms of which company would dominate this new environment, neither panelist felt that there was an obvious winner but believed that the battle between Sony and Microsoft would be the main event.  Both indicated that Microsoft was an obvious choice, both because of its huge cash horde and its desire to touch the consumer at so many different points.  Marcel seemed to indicate that the company that could find a way to make this system as seamless and easy to use as possible would be the winner.  John on the other hand felt that there was a huge opportunity for those companies willing to provide customer service throughout the entire system.  As he indicated, many of the companies in the space (especially consumer hardware companies) have such thin margins that providing such a high level of consumer support might not be feasibly possible.  Because of this, he indicated that software companies with their high margins represented by the best opportunity.   

When asked about the structure of entertainment companies going forward, Marcel and John seemed to indicate that there was no right choice.  The marriage of hardware and content has not always served Sony well while Time Warner (parent company of HBO) has certainly struggled in combining content and distribution assets.  Marcel made an interesting point in that in spite of the all of the online music activity, radio and MTV would still determine the success of an album.

John indicated that studios would shift from being organized into silos centered around the different products (theatrical, home video, syndication, etc) into silos differentiated by function such that all the creative people would be under one roof, all the people focusing on distribution (regardless of format) would be under a separate roof.  He indicated that there needs to be a separation between the creative process and the process in adapting the finished product to the various platforms and distribution systems. 

The Register reports that 3G phone standards organization has adopted HE-AAC format for streaming audio to mobile phones. After the DVD Forum adopted this format for audio in the new HD DVD media, this brings a loss for Microsoft in the platform adoption battle for the future digital media. The HE-AAC is a slight modification of the AAC format used in Apple’s iTunes songs that has increased efficiency. This means we have a 2-jockey horse when it comes to HD DVDs with Microsoft ruling the video stream with the WMV 9 format and Dolby rulling the audio stream. This poses interesting challenges for the makers of HD DVDs. Given how retardedly difficult it is to assemble DVDs today (it’s actually easy with today’s software, but the format and files are unnecessarily convoluted), it beats me why these minor decisions are made. This could be intentional by the DVD Forum to prevent a single vendor (ie Microsoft or Apple) from rulling the HD DVD format stream and collecting exhorbitant fees later on. I have my own doubts as to the viability of the HD DVDs when they start coming out but I’d be interested in comments.

The decision by the 3G companies to adopt the HE AAC format in mobile phone puts Apple’s iTunes store in the driver seat for the future of digital audio. If you can imagine that the future generation iPod will be a wireless device, one can but instantly songs from iTunes and have them streamed to their iPods. You need a high speed wireless connection granted, but this isn’t far off in some countries. Maybe we’ll get rid of multiple audio devices finally and have high quality audio collection of our own available everywhere. This scenario may work only if the current DRM schemes survive a technology upgrade cycle, hi speed wireless is readily available, and the record companies continue to support more artists through digital distribution. Any comments on this?

In a timely follow-up to my previous post, a UK magazine Revolution reports from a survey that a vast majority of people prefer CDs to online music as a lasting music purchase. The survey reports that most people view online music sales as impulse purchase or to sample new albums before buying the actual CD. In fact, most people indicate that they will buy same number or more CDs in the future.

This survey is based on 1400 respondents and could be biased toward

The Wall Street Journal reports today that Yahoo agreed to buy MusicMatch for $160MM in cash. This purchase, to be completed in the next quarter, effectively puts Yahoo in the downloadable music business. Let’s take a quick look at this rapidly growing market:

iTunes — 1 million songs, AAC format, 100MM downloads, 70% share of market, iPod
MSN Music — over 1 million songs, in beta now, WMA, brand new service, over 70 devices
MusicMatch — over 700,000 songs, WMA
Napster – over 700,000 songs, WMA
RealPlayer Music Store — over 600,000 songs, AAC format
WalMart — over 400,000 songs, WMA
BuyMusic — over 500,000 songs, WMA

This puts the legal online music selection to anywhere between 1MM songs and 5MM songs.

Prices per song start at $.49 and go up to $.99.