Steve Jobs Didn’t Get It Right; The Future of the Music Industry
Will record companies look the same in ten years as they do today? Almost assuredly not, but a bright spot may be emerging for the record company veterans. Music streaming is thriving.
“The three major labels — Universal Music, Sony Music and Warner Music — saw their collective recorded-music revenue from streaming grow to just under $1.3bn in the second quarter of 2017. That represents 38.5% growth year-on-year, with the three label groups now collectively making $14.2m a day from streaming.” — music.ally
“Recorded Music sales increased due to an increase in digital streaming revenues.” — Sony, SEC filling 2017
Does this represent a shift for a struggling sector? Or have these companies already lost?
Regardless of the industry, companies create value. While heiresses and debutantes disagree, ordinary people don’t thoughtlessly jettison capital. Companies exist to provide legitimate service to customers. When that value exceeds their cost structure, companies make a profit. As consumers and economic landscapes change, businesses must adapt their value network. Adapting a value network is not easy. Very few companies survive the necessary depreciation of an antiquated value network. In fact, this is by design. Large companies design processes to remain competitive in their current value network. This works when a market is stagnant, but is detrimental when it changes.
It was the late 1980’s. Bon Jovi had just released the smash hit, Living on a Prayer. Little did the music industry know, a new technology was about to disrupt the music nation. The CD was unique. Compared to the record, it was cheaper to manufacture, yet record companies could sell the product at a higher price point. The CD was a sustaining, yet substantial innovation. This was a unique and extremely advantageous circumstance for record companies. Even though CDs were a significant innovation, they were NOT a disruptive one. The CD technology maintained record companies’ same value network and business model. But since a CD was cheaper to manufacture than a record, record labels were more profitable than ever.
Before the internet, customer distribution channels were record stores. These were necessarily modularized, because location prevented the entire population from a single record store’s patronage. The internet changed that. Every music fan is now able to go to a single location to get music.
For the music industry, record stores were only a small part of music and artist discoverability. They mainly existed for physical good sales. Discoverability was mostly a product of the radio and other advertising channels. This was the golden age of record labels. Back then, Record companies integrated the most complex parts of the value chain. Because the record companies dictated supply, they also dictated demand. The distribution channels (record stores) were the commoditized portion of the value chain. The music was the differentiated product. Lack of centralization made it so artists, or suppliers, couldn’t access customers directly. The Record companies’ product is as much for an artist as the end customer. Record companies were the curators, but more importantly, they contained the relationships and operational excellence that differentiated their services.
Since the advent of the internet, the music industry has been thrown for a cosmic roller coaster. The first notable player was Apple. No pun intended. In 2001, the company commercialized a lovable MP3 player, the iPod. The iTunes store functioned the same as a physical record store. It was another channel to sell music.
Apple integrated up the value chain, but from the very beginning incentives were aligned. Apple wasn’t incentivized to integrate backwards, because iPod users owned the music. Apple didn’t need to pay mechanical royalties. Apple would make attractive profits in hardware sales, their core competency. Record Companies would make attractive profits in music, their core competency. This, in hindsight, was a mistake for record companies. It eroded the record companies ability to “go to where the money would be”. Core competency is a fallacy debunked in Clayton Christensen’s Innovators Solution.
“Core competence… is a dangerously inward-looking notion. Competitiveness is far more about doing what customers value than doing what you think you’re good at… Staying competitive as the basis for competition shifts necessarily requires a willingness and ability to learn new things rather than clinging hopefully to the sources of past glory”. — Clayton Christensen, Innovators Solution
Music clearly wanted a way that made consumption of music a lovable experience. As we iterated on that experience, the market converged to a platform that record companies never learned to provide, the experience of consuming music.
Steve Jobs was famously a critic of music streaming, but it didn’t matter. The market ran towards the idea of an infinite music library for a fixed cost. After the height of iTunes, people stole music. Despite conventional wisdom, stealing music isn’t free. It is the time, risk, and guilt of the thief. This caused the music industry to face the “true market price” of music. The price a user is willing to pay to avoid the headache of consuming stolen music. Users are willing to pay for experiences. A premium experience is no longer a luxury, but a necessity for companies.
Ben Thompson’s Aggregation Theory states that in an interconnected world, where marginal transaction costs are zero, firms can integrate at the level of the consumer. In this scenario, the supplier, which was previously integrated, becomes modularized. This commoditizes their product, which in turn converges profit to zero. Because of this large firms enjoy scale benefits in experience and price, these benefits not only protect them from new entrants, but also benefit society as a whole. Simply said, the internet encourages that markets converge to an oligopoly.
Direct to consumer integration shifts bargaining power from record companies to streaming services. Now modularized suppliers, or independent artists, can conduct business directly with the integrated distributor. Because modularized businesses, in this case independent artists, require less operational overhead, they have a competitive advantage in supplying content. Artists interact directly with their customer using tools built by the integrated distributor, which allows for them to scale reach, without bloating operational costs. It scales infinitely. The feature that prevents integrated distributors from commoditization is the experience. Not only the consumer experience, but also the artist experience.
Why Record Companies Can’t Coexist
Music streaming services are a special type of aggregator. They rent inventory paying per use, but customers have unlimited access at a fixed cost. There is no marginal transaction costs for the customer, but there are for the supplier. Before Netflix started developing content, they were in a similar situation. In this scenario, suppliers must be modularized. If a supplier has bargaining power, attractive profits cannot flow up stream to the aggregator, which creates an unsustainable equilibrium. But as a reactive molecule will seek stability, so will the market. The profits slowly begin to tip to aggregator and away from the supplier, because the aggregator controls the consumer.
“When an industry gets too consolidated, any company who tries to compete with them or survive in their supply chain will get crushed” — John Oliver, Last Week Tonight
The record companies are trying to survive in a streaming services supply chain. But artistically driven industries have protections, which cause markets to stay “reactive” longer than expected.
This all traces back to Mickey Mouse, the Disney corporation, and copyright laws. The company has spent 87.6 million in lobbying dollars over the past 20 years to extend the maximum copyright protection period to protect the billions brought in by the cute little rodent. see here. As excessive lobbying dollars often do, this has unintended consequences. Copyright law protects previously integrated incumbents. Incumbent suppliers hold copyrights for the content the current market demands. These incumbent suppliers would otherwise have no bargaining power.
“Success in the music industry … is subject to the vagaries of public taste. The Music segment’s future competitive position depends on its continuing ability to attract and develop artists and products that can achieve a high degree of public acceptance.” — Sony, SEC filling 2017
High quality entertainment is not only expensive to produce, but brand loyalty gives established artists a competitive advantage. Imagine if a patent extended could be held for 100 years longer than the normal 20 years. This is what copyright does for the music industry. Record companies haven’t survived because of their cunning ability to evolve and navigate the ever changing market place. They have survived, in large part, because they have been protected. This protection is temporary. It lasts until the companies that have learned to provide “direct to consumer relationships” discover the importance of the “direct to supplier relationship”. If this strategy sounds familiar, it should, it’s Netflix’s strategy. Streaming services will need to own the content.
The Incentive shift
Streaming services are structured to make profits off music distribution, which causes them to directly compete with the record companies. This was a fundamental shift from when Apple was selling the iPod. As Sony outlines in their SEC filing, “If streaming services cannot attract sufficient subscribers to offset this decline [in music sales], the operating results of Sony’s Music segment could be negatively impacted”. Translation: if streaming services aren’t able to get enough customers listening to OUR (the record companies) music, our unit economics don’t work. As noted earlier in the article, record companies previously had owned demand by dictating supply. So I pose the question… What happens when streaming services dictate demand?
For perspective, look at the Netflix, it is pretty clear what type of content is promoted. The Netflix originals panel is twice the size of licensed content.
As Clayton Christensen outlines in his books, incumbents swim upmarket to invest where profits are most attractive. More and more musicians are fighting for the coveted spots on the most prestigious playlists. The record companies and artists are flocking towards playlists because that is where the coveted customer is, but this plays right into Spotify’s hand. The record companies have resigned ability to dictate supply. Users are becoming accustomed to curated playlists as their vehicle of music consumption and discovery.
Streaming services’ goal is to make the best product possible, as quickly as possible, and ignore how much it costs. Once these services own demand, they raise the average sales price (ASP) and focus on generating investor value. Don’t believe me? Let the CFO of Netflix tell you himself…
“There is no timing correlation between our intent to grow content and content spending, and the price increases. I mean this has been planned for a long time” — David Wells, CFO Netflix, Netflix Earnings call Q3 2017
Despite his clear misunderstanding of the word correlation, the context implies there is no accidental correlation between the timing of these two initiatives.
Record companies will never again be able to distribute music directly to the consumer. They never developed the skills. They are too far behind to catch up. We all know how much of a smashing success Tidal is…
The Record companies must be dependent on a “reactive” marketplace in which they have little bargaining power. This puts Record companies in a precarious position. The companies’ business model or cost structure are not built to deal with the inherently lower margin market. While the companies see this phenomenon in their bottom line, they probably don’t understand how it will change the business.
“Revenue from digital distribution, such as subscription streaming services and digital downloads, may not be sufficient to offset the decline in physical media sales that has affected and may continue to affect the operating results of Sony’s Music … business.” — Sony, SEC filling 2017
There is still hope. No company is currently more qualified to build artists’ brands than record companies. Record Companies should find the Instagram to their Facebook. They have the relationships and experience to build brands more effectively than incumbents. The companies should acquire as many small management companies as possible. Small modular teams that are incentivized by small wins add up. The record companies should acquire companies that innovate around artist and directly interface with the consumer. Think merchandising companies, event / festival companies, signing 360 deals, etc.
In short they have found themselves needing to move from an Apple strategy, one where they integrate and optimize the entire supply chain, to a Johnson & Johnson strategy, an umbrella company that let’s their portfolio companies make their own mistakes… Because if they don’t, in their old age, the overbearing parent will find themselves cut out of their thriving children’s life.
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