Michael Munves

May 10, 2002

It was a typical Tuesday morning for me June 27, 2000. I was not quite up yet and on the phone with one of the most powerful executives in the music industry. " We are dead. Fucking dead. This Napster shit has to end. How are we going to compete? We can’t even agree whether this net thing is good or bad internally. This Napster guy is fucking us. He has to be stopped." As the conversation progressed, I realized how threatened he felt. I thought this ironic -a man who manages a billion dollar multi-media conglomerate feeling so threatened by a kid who started his company in his dorm room.

There is little debate that one of the most important technological innovations of the late 1900’s is the Internet. It has made vast amounts of information easily accessible to billions of people by annihilating patriarchal physical boundaries. The Net has had a dramatic impact on our culture in a relatively short period of time. For comparison purpose the Net has reached a critical mass in lightning speed: ten years. Other major technological innovations of the last century such as television, radio and the telephone took a quarter century or more to reach a critical mass. One of the most promising future business models regarding the Internet is the digital distribution of music. In fact’ from a consumer standpoint digital distribution of music or the downloading of music is the number three reason people use their computers, right behind e-mail and word processing. (Drummond 156-157).

One might point to Napster to gauge the demand for digitally distributed music. Napster was able to amass a customer base of 63 million in under two years with no advertising budget. A study by Ipsos-Reid found, almost one-quarter (23 percent) of the U.S. population over the age of 12 has downloaded a music or mp3 file off the Internet. That's more than 50 million down loaders within the current U.S. population. The digital distribution of music offers the record labels two major production efficiencies: the abolishment of the production of a physical product and its distribution. These two efficiencies could save the major record labels hundreds of millions of dollars per year. Such transformation within an industry is called an Inflection Point. An Inflection Point can be defined mathematically as the point where the rate of change of the slope of the curve (referred to as its "second derivative") changes sign, for instance, going from negative to positive. In business or life an Inflection Point occurs where the old strategic picture or way of thinking dissolves and gives way to the new, allowing a business or individual to ascend to new heights. (Grove) With such great consumer demand, a high conversion ratio, and great efficiencies one might ask why haven’t the major record labels dived head first into this new paradigm in order to take advantage of this Inflection Point? The majors’ response thus far can be defined as ambivalent. The majors are lumbering their way into the digital age. In all fairness to the major labels one might say they are experiencing a common dilemma, which is the ratio of inertia to size, but this is no excuse for their ambivalence. Like many american corporations the major record labels have a myopic vision of their business model, which causes them to react as if they were under attack by some alien force. They have spent hundreds of millions of dollars trying to stop the digital distribution of music, with no real effect. Below I will analyze their claims for the status quo, the cost of the major labels ambivalence, and postulate how the major labels could be gaining if they defined their business model correctly and formulated a proactive response to this paradigm shift.

The major labels’ first response to the success of Napster, or the great consumer demand for digitally distributed music, was to control it and shut it down. Through a lengthy legal proceeding the RIAA’ in conjunction with the major labels, filed suit against Napster and took them off line. This legal battle cost them in the neighborhood of $20,000,000 dollars and has resulted in a rise of downloads over the Internet. Shutting down Napster did little to address the consumer demand for music, which is the central point concept the majors need to accept in order to correctly define their business model. According to Jupiter Media Matrix, after Napster was shut down the number of users of file-swapping applications other than Napster grew almost 500 percent from March to August of 2001. Audio Galaxy, a music file-sharing network almost identical to Napster that was launched after Napster’s demise, amassed a customer base or over 71 million users in just ten months.

To illustrate why consumer demand is the core issue (and protecting intellectual property isn’t) we can look at an example from the Nobel Prize winning economist W. Edwards Deming. In Deming’s book The New Economics he suggests that the key to responding to innovations is to know the essential nature of the business in which you are involved. He provides the following example to easily illustrate his point. Deming uses a manufacturer of carburetors as an example and states, " The makers of carburetors made good carburetors, better and better. They were in the business of making carburetors. It would have been better had they been in business to put a stoichiometric mixture of fuel and air into the combustion chamber, and to invent something that would do it better than a carburetor. Innovation on the part of somebody else led to the fuel injector and hard times for the makers of carburetors." (Deming 10) Deming’s example is a simplistic explanation of creative destruction, which is an inevitable factor of the business cycle, and is precisely what is currently taking place in the music industry.

Further support for the concept of misidentification of a corporation’s business model, and the damage which this misidentification causes can be found in Theodore Levitt’s article " Marketing Myopia" first printed in the Harvard Business Review September 1975. In this article Professor Levitt states, " Every major industry was once a growth industry. But some that are now riding a wave of growth enthusiasm are very much in the shadow of decline. Others which are thought of as seasoned growth industries have actually stopped growing. In every case the reason growth is threatened, slowed, or stopped is not because the market is saturated. It is because there has been a failure of management." Professor Levitt’s statement clearly identifies the problems which the music industry is undergoing. The major record labels’ ambivalent response is causing the erosion of pre-recorded music sales. Professor Levitt provides the following example to crystallize his concept. " The railroads did not stop growing because the need for passenger and freight transportation declined. That grew. The railroads are in trouble today because the need was filled by others (cars, trucks, airplanes, even telephones) because it was not filled by the railroads themselves. They let others take customers away from them because they assumed themselves to be in the railroad business. The reason they defined their industry incorrectly was that they were railroad-oriented instead of transportation-oriented; they were product-oriented instead of customer-oriented.

" Hollywood barely escaped being totally ravished by television. Actually, all the established film companies went through drastic reorganizations. Some simply disappeared. All of them got into trouble not because of TV’s inroads but because of their own myopia. As with the railroads, Hollywood defined its business incorrectly. It thought it was in the movie business when it was actually in the entertainment business. ‘Movies’implied a specific, limited product. This produced a fatuous contentment which from the beginning led producers to view TV as a threat. Hollywood scorned and rejected TV when it should have welcomed it as an opportunity — an opportunity to expand the entertainment business." (Levitt 19)

If we apply both Professors Levitt's, and Dr. Deming’s examples to the music industry major labels must ask themselves what business are they in? Are they in the intellectual property acquisition business? Are they in the entertainment business? Are they in the lifestyle enhancement business? The major labels’ second response has been to launch digital distribution hubs. Sony and Universal as MusicNet, and BMG, WEA, and EMI as Pressplay. Both MusicNet and PressPlay are intentionally clumsy and non-consumer friendly. RealNetworks recorded a $3.946 million loss on there investment in MusicNet. RealNetworks loss is industry wide. According to a late January study by media analysts at investment bank ABN-AMRO in London, the five major-label —backed services spent a collective $1.976 billion on developing digital music services. That includes investments in such major —label-backed services as MusicNet and Pressplay and acquisitions of such existing companies as Myplay and MP3.com. All are poor replacements for Napster. The major labels’ online services were recently reviewed in an article entitled "Off Key: The Music Industry Is Finally Online, But Few Listen" which appeared on the cover of the May 7^th 2002 edition of the Wall Street Journal. In this article MusicNet’s chief executive Alan McGlade is quoted speaking to MusicNet’s board " The current version of the service is not viable." ( Mathews, Press, and Wingfield A1 )This is a very powerful statement coming from the chief executive of the world’s largest legal online digital distribution network. Mr. McGlade’s acknowledgement of MusicNet’s poor business model supports the notion that the majors know that the only way they can compete with the free services is offer better service than the free sites. AOL, which was supposed to be Musicnet’s biggest distributor, says it wants something better before they will support it. MusicNet plan’s to offer over 100,000 titles, but even in offering this number of titles Musicnet’s service will still have a vast gap most notably the titles from the other two majors Sony and Universal. Since its launch, MusicNet has attracted only about 40,000 subscribers. Napster was able to grow rapidly because they correctly identified their business model early in the game. For starters, a consumer cannot find all of the music he or she might want in one location. Both services offer a limited amount of product (not their entire catalog) and the customer cannot burn a CD for their enjoyment.

On the other hand, Napster was one of the most consumer friendly web sites and had none of the aforementioned restrictions. An anonymous source who holds a key position at one of the majors Internet sites told me, " the consumer awkwardness is intentional. It was a tradeoff for security’s sake." Will Pole, VP of digital media for Microsoft , supports this concept in the following statement, " The problem is, it is becoming ever more apparent that stopping file sharing may be technologically impossible. Legal challenges effectively shut down Napster last year, so it’s demonstrably possible to stop centrally controlled legal means. However, stopping peer-to-peer distribution is probably not possible via technical or legal means. All intellectual property holders-studios, labels, software companies, and publishers-must face this reality." (qtd. in Marlowe 23.) This understood, another course of legal action be considered by the majors’ is going after the end user. Peter Jaszi (a professor of copyright law at American University) states, "No matter how the pending legal cases turn out, the only truly effective litigation strategy may be to go after the end users themselves." Are the RIAA and the majors willing to carry out this strategy? My guess is no. This practical legal strategy might be effective because most people are litigation- adverse, however it would be highly costly and serve to alienate the majors’ customers. All of these legal solutions are single-looped in their logic, and reactive at best. It addresses one of the major labels’ major concerns: security of their intellectual property in a half-baked manner while simultaneously degrading the consumers’ experience. There is no evidence that supports the notion that not allowing the burning of CDs or prosecuting consumers will aid in the security of their intellectual property.

A nine year old with a computer can record a stream of music in the analog mode (which the majors’ services will let you do) and then copy it back to the hard drive and than burn a copy all in under six minutes. This idiotic security technique cost the majors millions to develop and has had no effect on the amount of music being downloaded from the Net. In an additional attempt to protect their intellectual property the majors developed a copy protected CD. Their thought process in this endeavor was equally single looped, and flawed. It was based on the notion that if you cannot rip a CD then you cannot post it on the Net, making their intellectual property secure. This data protection method also fails the nine-year-old test. If the major labels probed deeply enough they would find out they are in a customer service based business, not the intellectual acquisition business. Proper acknowledgement of this could have aided them in a proactive response. The following statement by IFPI Chief Executive Jay Berman best illustrates the real dilemma the majors face," The industry's problems reflect no fall in the popularity of recorded music: rather, they reflect the fact that the commercial value of music is being widely devalued by mass copying and piracy," (qtd in Pastore).

The majors’ first and second responses to the paradigm shift which occurred in the late 1990’s were reactive not proactive. They responded as if they were under attack, which might have been true on the surface or if they where indeed in the business of intellectual property acquisitions, but this is not the case and is not the core issue. In other words the downloading of music for free is a result of demand and should have been addressed as such. Succinctly, any money spent on protecting their intellectual property (when there is no current or future technology that can protect data 100 %) is a great waste of their resources.

In order to understand the major record labels’ reasons for their ambivalent and awkward responses to this new paradigm shift or to the digital distribution of music we must first understand their current business model. Simply put, the major labels’ business model is contingent on the ownership of intellectual property in perpetuity. Even more specific, the valuations or the ABVs’ (Adjusted Book Value) of the major record labels are contingent on the amount, quality and the exploitation of their intellectual property. (Cornell) With this understanding the protecting of their intellectual property is tantamount to protecting their companies. There is no known technology that can protect digital data, or in the record labels case, digitally encoded music with 100 % accuracy. Security of their intellectual property is the number one reason for the major labels’ ambivalence regarding moving into the new paradigm. As far as the major record labels are concerned they are in the business of intellectual property acquisition and exploitation.

The major labels’ second largest issue, which is also related to protection of their intellectual property, is the validity of their legacy artist contracts. The aggregate of any of the major labels’ value is derived from their rich back catalogs of master recordings. In the past when technological shifts have occurred such as the shift from LP to CD the major record labels have profited handsomely. This technological shift allowed the major labels to resell their catalogs to the same consumers. This is not the case with the Internet. Language in the older recording contracts, regarding the major labels’ rights to new technologies in perpetuity is vague at best. There is a standard paragraph in older recording contracts that date back 20 years or more which reads something to the effect that it covers all future technologies. The problem with this clause is that the older artists and the estates, which represent the deceased artists, are contesting the fairness of this term " all future technologies". The crux of legacy artists’ argument is based on the following premise: how can I sign my rights away for undefined technologies in perpetuity. Recently, new artist lobbyist groups have formed such as ARC (Artists Rights Coalition). ARC is primarily made up of legacy artists and their estates. Their primary mission is to question the unfairness of these old artist agreements. The thought of a class action suit by these legacy artists (and the estates of these artists) is equally threatening to the major labels and serves as a secondary catalyst for their ambivalent response.

Data form The RIAA’s website states that (Recording Industry Association of America) the dollar value of all music product shipments has decreased from $6.2 billion at mid-year 2000 to $5.9 billion at mid-year 2001 — a 4.4. percent decrease. Unit shipments have dropped form 488.7 million at mid —year 2000 to 442.7 million at mid-year 2001- a 9.4 percent decrease. First glance of the RIAA’s data might suggest relevance to the record labels reactive response, whose main goal is control of an outmoded business model. Analyzed in greater detail the RIAA’s data suggests one thing very clearly, a change in consumer demand. Large corporations, ineptness in their ability to change or move ahead or even keep pace of current market demand is nothing new.

The Internet has ushered in the Age of Discontinuity on a global economic scale not only in the music industry, and it did not arrive by happenstance. It arose from fundamental economic forces: increasing efficiency of business due to dramatic decline in capital costs, the rise of national liquidity due to the improved profitability of US corporations, and strengthened fiscal management by the federal government. (Foster, Kaplan 65). The major labels’ current response to the paradigm can be viewed as a sector of industry suffering from "Cultural Lock —In". Cultural Lock-In — is the inability to change the corporate culture even in the face of a clear market threat. Cultural Lock —In can result from the exponential stiffening of the invisible architecture of the major record labels and the ossification of its decision making process abilities, control systems, and mental models. To better understand the costs of Cultural Lock-In let us look at the Sterling Drug case. For a half century, Bayer aspirin drove the growth of Sterling Drug until Johnson & Johnson introduced Tylenol. Out of fear of cannibalizing its Bayer aspirin leadership, Sterling Drug refused to introduce its leading European non-aspirin reliever (Panadol) to the US. Instead, it tried to expand its Bayer line overseas. Misidentification of Sterling’s business model caused by fear or "Cultural Lock- In" ultimately led to Bayer being acquired by Kodak. (Foster, Kaplan 19-20 ).

The major record labels’ ambivalent response to the digital distribution of music has created a black-market environment for digitally distributed music. Kaza, Morpheus, Audio Galaxy, WinMx, etc… all offer the customer free music that they can download and burn to a CD, but all of these services operate in a mediocre manner at best. These file-sharing services provide a poor level of costumer service. They all operate intermediately, and awkwardly at best. For example, when looking for a particular song there is no clear efficient way to search for it .On these illegal sites titles have been altered, misspelled performance data is posted haphazardly, thus making a search more time consuming than it should be. Once you have found your song there is on guarantee of the quality of the file. A consumer is offered whatever type of file is available. When downloading a file, it is also very common to be cut off. Which occurs when a user on the file- sharing network logs off while you are downloading your file. If this happens you are out of luck and must to repeat your search.

What would happen if the major record labels acted proactively? It is important for the majors to recognize that consumers are entitled to make copies of downloads. Reliability and ease of use are other areas where the majors can offer far superior service to black-market sites. To better illustrate my point let us look at the current market data, and use some basic assumptions in order to project the majors’ potential future profits. Firstly, there is a vast exponentially growing demand for the digital distribution of music.

Secondly almost all Internet business are customer service related, and lastly there is no-none method of copyright protection that is 100% infallible. The above points are important because the majors’ current response, which is based on the strategy of locking down the net before taking action, is costing them hundreds and millions of dollars, and therefore must be calculated into future projections. According to Market Watch (a chart compiled from a national sample of retail store and rack sales reports collected, compiled, and provided by SoundScan) single sales are down 59.3 percent from 2001 to 2002, and CD sales are down 12.1 precent during the same time period. That is a loss of <$122,664,000.00> for CD’s and <$13,337,400.00> for singles that is a total loss of <$135,981,000.00>. (This data is less aggressive than the RIAA’s but agrees with a dramatic loss) As we make our assumption let us allow a 20 percent deduction for factors outside the Internet. e.g. a slowing economy, and competing media for a total projected loss due to downloading of <$108,785,000.00>. For our second factor in our assumption let us estimate the cost of both losing customers and acquiring new customers. To better understand this operational cost let us take a look at AOL. AOL has acquired a vast costumer base of 32 Million users, (the largest ISP in the World) by distributing their software for free. AOL also deeply discounts the first couple of months o it’s " free trial period." AOL’s customer acquisition cost is about $15 dollars. AOL’s cost of the loss of a customer is about <$239.40>. As you can see form this example the cost of costumer loss is much greater than the cost of customer acquisition. AOL is a good case to study in regards to the cost of customer acquisition. Major record labels are losing customers at an alarming rate. New customers (ages 9-14) are downloading music for free because there are no for payee legal alternatives that are better than free sites. The loss of new costumers is the majors’ highest cost of ambivalence, and as you can see from the AOL example will cost them greatly to reacquire these customers.

T.S. Eliot in his 1934 poem "The Rock" states, "Where is the wisdom we have lost in knowledge? Where is the knowledge we have lost in information? (Eliot) From my research I conclude that the best way to respond to this paradigm shift is to offer legitimate commercial alternatives to the black-market sites. The executives at the majors need to realize that in the future music will be consumed in many different ways. All of the digital media executives whom I interviewed in the course of my research agreed that the major labels thus far have sabotaged their own piracy alternatives by weighing them down with restrictive security schemes and unattractive business models.

The dilemma over this new paradigm is omnipresent. It is the number one issue within the music industry. At the 2002 43^rd annual Grammy awards Michael Green, the president of NARAS (National Academy of Recorded Arts and Sound) gave a 20-minute speech regarding the costs of no action. He reiterated the major labels’ fears regarding piracy and protection of intellectual property. These sentiments are a good gauge for the aggregate feelings of the music industry, and just how lost they are. If the major labels do not want to be left behind they have to recognize the paradigm shift, accept that they are a part of the age of discontinuity, correctly analyze the market data, and act proactively. Simply put, they need to respond to the vast consumer demand by launching pay sites that are focused on the consumer experience. This type of reaction would greatly reduce piracy. They need to out Napster Napster. Napster (who identified their business model correctly as customer service, not the distribution of digital music) grew rapidly with very little or next to no advertising and marketing budget. Since its artificial death the amount of music being downloaded has increased exponentially, eroding the major record labels’ current business model. Holding on to the old business model has already cost the major record labels hundreds of millions and at the current rate of growth will cost them billions. By not offering the consumer an enhanced service experience the major labels may have missed the boat on one the greatest technological advancements of the last century. Simultaneously their reactionary measures have created a black market where no one profits, and also is creating a generation of music fans who are becoming accustomed to getting music free.

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