Music Lessons: How the music industry rediscovered its mojo

Introduction

The latest report in STL Partners’ Dealing with Disruption stream, this paper explores what telcos and their partners can learn from the music industry and its response to disruptive forces unleashed by the Internet.

Music was among the first industries to see its core product (compact discs) completely undermined by the Internet’s emergence as the primary distribution mechanism for content and software, throwing the record labels into a long standing struggle to maintain both relevance and revenues. After almost two decades of decline, sales of recorded music are growing again and, in developed markets, at least, the existential threat posed by piracy seems to have abated. Although the music industry still has problems aplenty, the success of streaming services has steadied the ship.

This report outlines how the music industry has regained its mojo, before considering the lessons for telcos and other digital service providers. The first section of the paper considers why music streaming has become so successful and whether the model will be sustainable. The second section of the paper explores the lessons companies from other sectors, notably telecoms, can draw from the ways in which the music industry responded to the Internet’s disruptive forces.

This paper builds on other entertainment-related reports published by STL Partners, including:

Apple’s pivot to services: What it means for telcos
Telco-Driven Disruption: Will AT&T, Axiata, Reliance Jio and Turkcell succeed?
Amazon: Telcos’ Chameleon-King Ally?
Can Telcos Entertain You? Vodafone and MTN’s Emerging Market Strategies (Part 2)
Can Telcos Entertain You? (Part 1)

Music bounces back

Over the past 20 years, the rise of the Internet has shaken the music industry to the core, obsolescing its distribution model, undermining its business model and enabling new forms of piracy. Yet, the major record labels have survived, albeit in a consolidated form, and the sector is now showing some tentative signs of recovery. In 2013, the global music industry began to grow again for the first time since the turn of the Millennium. It continues to recover and will grow at a compound annual growth rate of 3.5% between now and 2021, according to research by PwC, fuelled by growth in both the recorded music and the live music sectors (see Figure 1).

Figure 1: The global music industry has returned to growth

Source: PWC and Ovum

For most of the past two decades, revenues from recorded music have been shrinking, leaving the industry increasingly reliant on ticket sales for live performances. Widespread piracy, together with the growing obsolesce of CDs, appeared to be turning recorded music into a form of advertising for concerts and tours.

But in 2015, global recorded music revenues began to grow again. In 2016, they rose a relatively healthy 5.9% to US$15.7 billion (about one third of the industry’s total revenue), according to a report by the International Federation of the Phonographic Industry (IFPI). For music industry executives, that growth marks an important milestone. “We got here through years of hard work,” Michael Nash, executive vice president of digital strategy at Universal records, told the Guardian in April 2017, adding that the music industry was still going through a “historical transformation. The only reason we saw growth in the past two years, after some 15 years of substantial decline, is that music has been one of the fastest adapting sectors in the digital world.”

Contents:

Executive Summary
Introduction
Music bounces back
What has changed?
Is streaming the final word in music distribution
Lessons to learn from music’s recovery

Figures:

Figure 1: The global music industry has returned to growth
Figure 2: The way people buy recorded music is changing dramatically
Figure 3: YouTube pays particularly low rates per stream
Figure 4: YouTube is a major destination for music lover
Figure 5: Music is one of the slowest growing entertainment segments
Figure 6: Spotify’s losses continue to grow despite the growth in revenues
Figure 7: Spotify’s subscription service is growing rapidly
Figure 8: Concert ticket revenues are up sevenfold since 1996 in North America
Figure 9: Major concert tickets sell for an average of $77 apiece

Digital Entertainment: What Gets Measured Gets Money

Summary: For mobile entertainment services to generate revenues commensurate to the attention they receive, the industry needs to improve ‘discovery’ tools, create more effective creative inventory, and deliver proof of its effectiveness. A summary of the Digital Entertainment 2.0 session of the 2013 Silicon Valley Brainstorm. (April 2013)

Digital Entertainment 2.0: What Gets Measured Gets Money

Below are the high-level analysis and detailed contents from a 27 page Telco 2.0 Briefing Report that can be downloaded in full in PDF format by members of the Telco 2.0 Executive Briefing service here. The Digital Economy, Consumer Experience (including service ‘discovery’), Digital Commerce and the Internet of Things will also be explored in depth at the EMEA Executive Brainstorm in London, 5-6 June, 2013. Non-members can find out more about subscriptions here, or to find out more about this and other enquiries, please email contact@telco2.net or call +44 (0) 207 247 5003.

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Introduction

Part of the New Digital Economics Executive Brainstorm series, the Digital Entertainment 2.0 session took place at the Intercontinental Hotel, San Francisco, on the 20^th March, 2013. The title and objective of the session was ‘How to Make Mobile Work’.

Analysis: What Gets Measured Gets Money

The key steps for mobile entertainment services to generate revenues commensurate to the attention it receives in North America are: to improve measurement of the success of ‘discovery’ tools, create more effective creative advertising inventory, and deliver proof of its effectiveness, not just the attention.

Mobile is a ‘break out’ entertainment media

Mobile has for some time been an entertainment media in the eyes of consumers, and particularly younger ones who soak up ‘dead time’ by playing games, using apps and even just communicating for fun, although to date not all these forms of entertainment have been connected.

In the past 3 years there has been a significant increase in ‘on demand’ and mobile consumption in North American and European markets, particularly in these younger segments, although a key challenge has been that monetisation has not followed the use of time spent on mobile.

Mobile entertainment itself can be defined as related to a context (e.g. ‘out and about’, ‘dead time’, ‘second screen’), devices (featurephone, smartphone or tablet), or type of connection (e.g. none, 3G, 4G, Wi-Fi). In general though, there are two main scenarios: mobile as a medium in its own right; and mobile as a ‘second screen’ experience. So in either scenario, we think the clearest answer to ‘what is the role of mobile?’ is that it is a ‘break out’ media, either extending the context of a form of entertainment, or extending the nature of entertainment in the existing context.

For video in North America, TV is still the dominant form of consumption, but mobile is growing rapidly as the ‘second screen’ that controls or supplements the main screen, especially with the explosive growth of tablets since the introduction of the Apple iPad.

Segmentation – there’s no single dominant business model

There has been much debate about the viability of different business models, broadly: advertising funded; consumer ownership; and subscription. While most participants believed that the ownership model would be most successful in music, where there is a higher likelihood that a consumer will want to listen to a track or album numerous times, ‘collectors’ or owners will still exist for videos, books and games.

Digital Collector Segment Size April 2013

Equally, demand exists for single ‘on demand’ services (e.g. pay per view), subscription (e.g. Spotify, cable), and advertising funded (e.g. YouTube). The balance is likely to change in video in particular with a move to increasing ‘on demand’ services in line with the current trend in consumer behaviour.

‘Discovery’: finding a model that proves it works

As the previously dominant channel-based model of curation in broadcast media gradually dissolves, and as the screen size, context and characteristics of consumption change, consumers face an increasing challenge finding out what they want to see, play or listen to.

Curation still exists through channel guides, taste-makers and review sites, and indeed through many offline sources, but is increasingly less the property of the content producer or distributor that it once was.

Content Discovery, one of the great buzz phrases of the industry, is therefore an ongoing challenge, and the application of networked computing power provide some advantages to connected and interactive devices like smartphones and tablets. Approaches used include:

3^rd party classification (e.g. by genre, subject), enabling more structured self-selection through menu choices etc.;
Recommendation engines (the Amazon/Netflix model), that can be based on a ‘Big Data’ approach (‘other people who bought this also bought that’) and/or semantic association (‘here’s another sentimental family comedy you might like’);
Social approaches, based on what your friends like or are watching, either through generic social media like Facebook, and specialised social media such as Zeebox.com (for video) and Goodread.com (for books);
Search – although this is non-trivial due to the volume of material in existence, and the ever-changing art of Search Engine Optimisation (SEO) – getting the right items at the top of the list.
Hybrid approaches that combine ‘Big Data’ with ‘semantic association’ (e.g. see Jinni.com) and/or other forms e.g. Social (e.g. see this intriguing article on the $1m recommendations challenge from Netflix).

For all methods, the inconsistencies of the metadata recorded (e.g. is the media described accurately using your terms) is frequently a challenging limitation.

To a degree though, content discovery has always been a process of ‘trial and error’. Consumers read, hear or see a load of ideas, try a few out, stick to the ones they like, and grow to trust the means of discovery that is most successful for them.

To this end, an element that appears to be missing in many discovery processes today is the measurement of success rate for the user – “was this a good recommendation for you”? In our view, discovery applications that accurately track success well (easily, with a good UI, and with a tangibly good and improving success rate) will ultimately prove successful. All of the above techniques could and to a greater or lesser extent do adopt this approach, although it isn’t yet clear which will perform the best in the market.

Delivering the goods

The challenges of delivering content, particularly large volume (e.g. HD Video) and/or latency sensitive content (such as multi-player virtual gaming), were not addressed in the Digital Entertainment session, though Software Defined Networking (SDN), which offers the promise of more efficient routing through networks for certain traffic, was discussed in the Digital Economy session. Content Delivery Networks and other Broadband design techniques have also been addressed at length in other STL Partners research and brainstorms

However, ‘Bandwidth’ was one of the key determinants of success according to the ‘BBC’ heuristic offered from Mitch Berman’s experience as a guide to how mobile entertainment will operate in different markets: Bandwidth; Business Model; and Culture. (NB We think this can also be seen as a shorthand variant of our business model framework, with culture being a key driver of the content proposition, bandwidth of the technical capability, and business model as the value proposition.)

Getting money commensurate with the time spent on mobile

A major challenge for advertising funded mobile entertainment is that there is a significant gap between the ratio of the amount of time spent viewing mobile and the money spent on it, and other forms of media. This is illustrated by the stats that:

For The Weather Channel, mobile is 1.5 X the traffic but less than 50% of the revenue;
10% of media consumption occurs online Vs. 1% media spend (from the presentation by Cary Tild, CIO GroupM in subsequent Marketing and Advertising session).

While this imbalance is genuine, there are important advantages and limitations to mobile as a medium that haven’t yet been fully exploited or overcome, respectively.

One of the major limitations has been the need for more effective commercial inventory on mobile. At the Brainstorm there was, for example, much discussion on the limitations of banner type ads in a mobile environment. Many more innovative forms are now evolving, illustrated by:

The Weather Channel’s experimental creative commercial content within its app, in which instead of a rectangular banner at the top of the screen, appropriate commercial content is embedded on background of the weather screen (e.g. a cloud-wrapped image from a mystery film on a cloudy day’s forecast screen);
New trial applications that insert products virtually in existing content (e.g. a soft-drink on a table in an old TV show, as demonstrated in test form by ReinCloud);
And subsequently, the launch of Facebook Home, designed to increase the commercial inventory available to Facebook by taking over the screen of a user’s smartphone.

In the same way that advertising has always evolved (from print to radio, radio to TV, etc.), there is still much to be learned through innovation and experimentation – and of course the related measurements of success.

Charging differently for content rights by content owners, e.g. by the use of content rather than as an upfront fee, was also discussed, although many content owners are reluctant to move to or even test this model as they see it representing a significant risk to existing revenue streams.

The digital economy core themes of ‘big data’ and ‘localisation’ were also raised, and an example given by the Weather Company of a highly effective promotion of grass seeds based on locality and the detection of key seasonal weather changes.

Finally, a key theme in common with the subsequent advertising session was that proving the effectiveness of models to consumers, brands, and investors was the key step for most mobile entertainment concepts. We see thoughtful design, coupled with trial and experimentation, effective measurement and the ongoing application of learning processes to be central to achieving that proof.

Next Steps

Effectiveness in the ‘discovery’ phase of digital service is a key success criterion, particularly in Digital Entertainment. We will continue to research and explore this area in our Executive Brainstorms in Europe, the Middle East, and Asia-Pacific.

To read the note in full, including the following sections detailing additional analysis…

Brainstorm: Stimulus Presentations – summary and key points
Brainstorm: Table Discussions
Verbatim delegate questions & comments
Brainstorm: Panel Session in summary

…and the following figures…

Figure 1 – Traditional linear TV model is facing multiple disruptions
Figure 2 – Non-linear forms of TV becoming a massmarket requirement
Figure 3 – Tablets are changing the TV/video landscape
Figure 4 – The mobile problem
Figure 5 – Whither digital collectors?
Figure 6 – Shine on you crazy diamond?
Figure 7 – Sharing the locker?
Figure 8 – Do we all want libraries?

…Members of the Telco 2.0 Executive Briefing Subscription Service can download the full 27 page report in PDF format here. Non-Members, please subscribe here. The Digital Economy, Consumer Experience (including service ‘discovery’), Digital Commerce and the Internet of Things will also be explored in depth at the EMEA Executive Brainstorm in London, 5-6 June, 2013. For this or any other enquiries, please email contact@telco2.net / call +44 (0) 207 247 5003.

Background & Further Information

The 2013 Silicon Valley Brainstorm used STL’s unique ‘Mindshare’ interactive format, including cutting-edge new research, case studies, use cases and a showcase of innovators, structured small group discussion on round-tables, panel debates and instant voting using on-site collaborative technology. Around 30 executives from entertainment, media, telecoms and technology companies participated in this session in total.

The focus was on looking at “the true role for mobile” in the digital entertainment industry. Opening the session informally, various attendees were canvassed about their intentions & hopes for the day. This yielded a desire for information to assist in business modelling, to learn about the realities of the US entertainment market – or just to experience “inspiration and surprise” from a diverse set of speakers.

Objective: How to Make Mobile Work

The session covered three presentations and a demo, spanning the width of the entertainment business from TV to books, and from user behaviour to advertising. Its principle focus was around how content and telecom companies could generate sustainable businesses by leveraging the trend towards mobility – both devices and networks.

Designing compelling mobile entertainment experiences
4G: The impact on video distribution and consumption economics
Latest models for monetisation

The session included three Stimulus Speakers:

Andre James, Partner, Bain & Co
Alex Linde, Vice President, Mobile & Digital Apps,The Weather Channel
Keith McMahon, Senior Analyst, STL Partners/Telco 2.0

In addition, Dan Reitan, CEO, Reincloud gave an Innovation Showcase demo, after which these four were joined on the debate panel by two other industry luminaries:

David Gale, EVP New Media, MTV
Mitchell Berman, Principal, Blend Digital

We’d like to thank the sponsors of the Brainstorm:
Silicon Valley 2013 Sponsors

The Great Compression: surviving the ‘Digital Hunger Gap’

Introduction

The Silicon Valley Brainstorm took place on 19-20 March 2013, at the Intercontinental Hotel, San Francisco.

Part of the New Digital Economics Executive Brainstorm & Innovation Series, it built on output from previous events in Singapore, Dubai, London and New York, and new market research and analysis, and focused on new business models and growth opportunities in digital commerce, content and the Internet of Things.

Summary Analysis: ‘The Great Compression’

In the next 10 years, many industries face the ‘Great Compression’ in which, in addition to the pressures of ongoing global economic uncertainty, there is also a major digital transformation that is destroying traditional value and moving it ‘disruptively’ to new areas and geographies, albeit at diminished levels.

In previous analyses (e.g. Dealing with the ‘Disruptors’: Google, Apple, Facebook, Microsoft/Skype and Amazon) we have shown how key technology players in particular compete with different objectives in different parts of the digital value chain. Figure 1 below shows via crossed dollar signs (‘New Non-Profit’) the areas in which companies are competing without the primary intention of driving profits, which means that traditional competitors in those areas can expect ‘disruptive’ competition from new business models.

Figure 1 – Digital disruption

Source: STL Partners ‘Dealing with the ‘Disruptors’: Google, Apple, Facebook, Microsoft/Skype and Amazon’

The Digital Hunger Gap

For the incumbent industry players we call the near-term results of this disruption ‘The Digital Hunger Gap’ – the widening deficit between past and projected revenues. Chris Barraclough, Chief Strategist STL Partners presented the classic Music Industry case study of the ‘Hunger Gap’ effects of digital disruption.

Figure 2 – The Music Industry’s ‘Hunger Gap’

Source: STL Partners

In a vote, 95% of participants agreed that something similar would happen in other industries.

Chris then presented our initial analysis of the ‘Hunger Gap’ for telcos (to be published in full shortly), and asked the participants where they thought the telco industry would be relative to its 2012 position in 2020.

Figure 3 – Participants’ views on forecasts for the telecoms industry

Source: Silicon Valley 2013 Participants / STL Partners

As can be seen, participants’ views were widely spread, with a slight bias towards a more pessimistic outlook than that presented of a recovery to 2012 levels.

Chris argued that as the ‘hunger gap’ widens, and before new revenues are developed, there will be massive consolidation and cost-reduction among incumbent players, and opportunities for innovation in services, but the chances of success in the latter are very low and require a portfolio approach and either deep pockets, exceptional insight, or considerable good fortune.

Richard Kramer, Managing Partner of Arete Research, also presented a deflationary outlook for all but the leading consumer technology players in the handset and tablet arena.

Participants then voted on which areas needed the most significant changes in their business – and existing managements’ ‘mindset’ was voted as the top priority.

Figure 4 – ‘Mindset’ is the biggest barrier to transformation

Source: Silicon Valley 2013 Participants / STL Partners

It is also notable that all categories averaged 3.0 or over – or needing ‘Significant Change’. This points to a significant transformation across all industries.

Content:

Opportunities
Telco 2.0 Strategies
Big Data and Personal Data
Digital Commerce
Digital Entertainment
Mobile Advertising & Marketing
The Internet of Things
Outlook by Industry
Next Steps

Figure 1 – Digital disruption
Figure 2 – The Music Industry’s ‘Hunger Gap’
Figure 3 – Participants’ views on forecasts for the telecoms industry
Figure 4 – ‘Mindset’ is the biggest barrier to transformation
Figure 5 – The ‘Telco 2.0’ opportunities for CSPs
Figure 6 – The impact of ‘Software Defined Networks’ (SDN)
Figure 7 – Will ‘Personal Data’ be more useful than ‘Big Data’?
Figure 8 – STL Partners’ ‘Wheel of Digital Commerce’
Figure 9 – Who will in ‘SoMoLo’?
Figure 10 – Significant changes in viewing habits
Figure 11 – Transformation needed in the advertising industry
Figure 12 – Growth projections for M2M ‘mobile’ (e.g. 3G/4G) connected devices

Dealing with the ‘Disruptors’: Google, Apple, Facebook, Microsoft/Skype and Amazon (Updated Extract)

Executive Summary (Extract)

This report analyses the strategies behind the success of Amazon, Apple, Facebook, Google and Skype, before going on to consider the key risks they face and how telcos and their partners should deal with these highly-disruptive Internet giants.

As the global economy increasingly goes digital, these five companies are using the Internet to create global brands with much broader followings than those of the traditional telecoms elite, such as Vodafone, AT&T and Nokia. However, the five have markedly different business models that offer important insights into how to create world-beating companies in the digital economy:

Amazon: Amazon’s business-to-business Marketplace and Cloud offerings are text-book examples of how to repurpose assets and infrastructure developed to serve consumers to open up new upstream markets. As the digital economy goes mobile, Amazon’s highly-efficient two-sided commerce platform is enabling it to compete effectively with rivals that control the leading smartphone and tablet platforms – Apple and Google.
Apple: Apple has demonstrated that, with enough vision and staying power, an individual company can single-handedly build an entire ecosystem. By combining intuitive and very desirable products, with a highly-standardised platform for software developers, Apple has managed to create an overall customer experience that is significantly better than that offered by more open ecosystems. But Apple’s strategy depends heavily on it continuing to produce the very best devices on the market, which will be difficult to sustain over the long-term.
Facebook: A compelling example of how to build a business on network effects. It took Facebook four years of hard work to reach a tipping point of 100 million users, but the social networking service has been growing easily and rapidly ever since. Facebook has the potential to attract 1.4 billion users worldwide, but only if it continues to sidestep rising privacy concerns, consumer fatigue or a sudden shift to a more fashionable service.
Google: The search giant’s virtuous circle keeps on spinning to great effect – Google develops scores of free, and often-compelling, Internet services, software platforms and apps, which attract consumers and advertisers, enabling it to create yet more free services. But Google’s acquisition of Motorola Mobility risks destabilising the Android ecosystem on which a big chunk of its future growth depends.
Skype: Like Facebook and Google, Skype sought users first and revenues second. By creating a low-cost, yet feature-rich, product, Skype has attracted more than 660 million users and created sufficient strategic value to persuade Microsoft to hand over $8.5bn. Skype’s share of telephony traffic is rising inexorably, but Google and Apple may go to great lengths to prevent a Microsoft asset gaining a dominant position in peer-to-peer communications.

The strategic challenge

There is a clear and growing risk that consumers’ fixation on the products and services provided by the five leading disruptors could leave telcos providing commoditised connectivity and struggling to make a respectable return on their massive investment in network infrastructure and spectrum.

In developed countries, telcos’ longstanding cash-cows – mobile voice calls and SMS – are already being undermined by Internet-based alternatives offered by Skype, Google, Facebook and others. Competition from these services could see telcos lose as much as one third of their messaging and voice revenues within five years (see Figure 1) based on projections from our global survey, carried out in September 2011.

Figure 1 – The potential combined impact of the disruptors on telcos’ core services

Source: Telco 2.0 online survey, September 2011, 301 respondents

Moreover, most individual telcos lack the scale and the software savvy to compete effectively in other key emerging mobile Internet segments, such as local search, location-based services, digital content, apps distribution/retailing and social-networking.

The challenge for telecoms and media companies is to figure out how to deal with the Internet giants in a strategic manner that both protects their core revenues and enables them to expand into new markets. Realistically, that means a complex, and sometimes nuanced, co-opetition strategy, which we characterise as the “Great Game”.

In Figure 3 below, we’ve mapped the players’ roles and objectives against the markets they operate in, giving an indication of the potential market revenue at stake, and telcos’ generic strategies.

Figure 3- The Great Game – Positions, Roles and Strategies

Our in-depth analysis, presented in this report, describes the ‘Great Game’ and the strategies that we recommend telcos and others can adopt in summary and in detail. [END OF FIRST EXTRACT]

Report contents

Executive Summary [5 pages – including partial extract above]
Key Recommendations for telcos and others [20 pages]
Introduction [10 pages – including further extract below]

The report then contains c.50 page sections with detailed analysis of objectives, business model, strategy, and options for co-opetition for:

Google
Apple
Facebook
Microsoft/Skype
Amazon

Followed by:

Conclusions and recommendations [10 pages]
Index

The report includes 124 charts and tables.

The rest of this page comprises an extract from the report’s introduction, covering the ‘new world order’, investor views, the impact of disruptors on telcos, and how telcos are currently fighting back (including pricing, RCS and WAC), and further details of the report’s contents.

Introduction

The new world order

The onward march of the Internet into daily life, aided and abetted by the phenomenal demand for smartphones since the launch of the first iPhone in 2007, has created a new world order in the telecoms, media and technology (TMT) industry.

Apple, Google and Facebook are making their way to the top of that order, pushing aside some of the world’s biggest telcos, equipment makers and media companies. This trio, together with Amazon and Skype (soon to be a unit of Microsoft), are fundamentally changing consumers’ behaviour and dismantling longstanding TMT value chains, while opening up new markets and building new ecosystems.

Supported by hundreds of thousands of software developers, Apple, Google and Facebook’s platforms are fuelling innovation in consumer and, increasingly, business services on both the fixed and mobile Internet. Amazon has set the benchmark for online retailing and cloud computing services, while Skype is reinventing telephony, using IP technology to provide compelling new functionality and features, as well as low-cost calls.

On their current trajectory, these five companies are set to suck much of the value out of the telecoms services market, substituting relatively expensive and traditional voice and messaging services with low-cost, feature-rich alternatives and leaving telcos simply providing data connectivity. At the same time, Apple, Amazon, Google and Facebook have become major conduits for software applications, games, music and other digital content, rewriting the rules of engagement for the media industry.

In a Telco2.0 online survey of industry executives conducted in September 2011, respondents said they expect Apple, Google, Facebook and Skype together to have a major impact on telcos’ voice and messaging revenues in the next three to five years . Although these declines will be partially compensated for by rising revenues from mobile data services, the respondents in the survey anticipate that telcos will see a major rise in data carriage costs (see Figure 1 – The potential combined impact of the disruptors on telcos’ core services).

In essence, we consider Amazon, Apple, Facebook, Google and Skype-Microsoft to be the most disruptive players in the TMT ecosystem right now and, to keep this report manageable, we have focused on these five giants. Still, we acknowledge that other companies, such as RIM, Twitter and Baidu, are also shaping consumers’ online behaviour and we will cover these players in more depth in future research.

The Internet is, of course, evolving rapidly and we fully expect new disruptors to emerge, taking advantage of the so-called Social, Local, Mobile (SoLoMo) forces, sweeping through the TMT landscape. At the same time, the big five will surely disrupt each other. Google is increasingly in head-to-head competition with Facebook, as well as Microsoft, in the online advertising market, while squaring up to Apple and Microsoft in the smartphone platform segment. In the digital entertainment space, Amazon and Google are trying to challenge Apple’s supremacy, while also attacking the cloud services market.

Investor trust

Unlike telcos, the disruptors are generally growing quickly and are under little, or no, pressure from shareholders to pay dividends. That means they can accumulate large war chests and reinvest their profits in new staff, R&D, more data centres and acquisitions without any major constraints. Investors’ confidence and trust enables the disruptors to spend money freely, keep innovating and outflank dividend-paying telcos, media companies and telecoms equipment suppliers.

By contrast, investors generally don’t expect telcos to reinvest all their profits in their businesses, as they don’t believe telcos can earn a sufficiently high return on capital. Figure 16 shows the dividend yields of the leading telcos (marked in blue). Of the disruptors, only Microsoft (marked in green) pays a dividend to shareholders.

Figure 16: Investors expect dividends, not growth, from telcos

Source: Google Finance 2/9/2011

The top telcos’ turnover and net income is comparable, or superior, to that of the leading disruptors, but this isn’t reflected in their respective market capitalisations. AT&T’s turnover is approximately four times that of Google and its net income twice as great, yet their market cap is similar. Even accounting for their different capital structures, investors clearly expect Google to grow much faster than AT&T and syphon off more of the value in the TMT sector.

More broadly, the disparity in the market value between the leading disruptors and the leading telcos’ market capitalisations suggest that investors expect Apple, Microsoft and Google’s revenues and profits to keep rising, while they believe telcos’ will be stable or go into decline. Figure 17 shows how the market capitalisation of the disruptors (marked in green) compares with that of the most valuable telcos (marked in blue) at the beginning of September 2011.

Figure 17: Investors value the disruptors highly

Source: Google Finance 2/9/2011 (Facebook valued at Facebook $66bn based on IPG sale in August 2011)

Impact of disruptors on telcos

It has taken longer than many commentators expected, but Internet-based messaging and social networking services are finally eroding telcos’ SMS revenues in developed markets. KPN, for example, has admitted that smartphones, equipped with data communications apps (and Whatsapp in particular), are impacting its voice and SMS revenues in its consumer wireless business in its home market of The Netherlands (see Figure 18). Reporting its Q2 2011 results, KPN said that changing consumer behaviour cut its consumer wireless service revenues in Holland by 2% year-on-year.

Figure 18: KPN reveals falling SMS usage

Source: KPN Q2 results

In the second quarter, Vodafone also reported a fall in messaging revenue in Spain and southern Africa, while Orange saw its average revenue per user from data and SMS services fall in Poland.

How telcos are fighting back

Big bundles

Carefully-designed bundles are the most common tactic telcos are using to try and protect their voice and messaging business. Most postpaid monthly contracts now come with hundreds of SMS messages and voice minutes, along with a limited volume of data, bundled into the overall tariff package. This mix encourages consumers to keep using the telcos’ voice and SMS services, which they are paying for anyway, rather than having Skype or another VOIP service soak up their precious data allowance.

To further deter usage of VOIP services, KPN and some other telcos are also creating tiered data tariffs offering different throughput speeds. The lower-priced tariffs tend to have slow uplink speeds, making them unsuitable for VOIP (see Figure 19 below). If consumers want to use VOIP, they will need to purchase a higher-priced data tariff, earning the telco back the lost voice revenue.

Figure 19: How KPN is trying to defend its revenues

Source: KPN’s Q2 results presentation

Of course, such tactics can be undermined by competition – if one mobile operator in a market begins offering generous data-only tariffs, consumers may well gravitate towards that operator, forcing the others to adjust their tariff plans.

Moreover, bundling voice, SMS and data will generally only work for contract customers. Prepaid customers, who only want to pay for what they are use, are naturally charged for each minute of calls they make and each message they send. These customers, therefore, have a stronger financial incentive to find a free WiFi network and use that to send messages via Facebook or make calls via Skype.

The Rich Communications Suite (RCS)

To fend off the threat posed by Skype, Facebook, Google and Apple’s multimedia communications services, telcos are also trying to improve their own voice and messaging offerings. Overseen by mobile operator trade association the GSMA, the Rich Communications Suite is a set of standards and protocols designed to enable mobile phones to exchange presence information, instant messages, live video footage and files across any mobile network.

In an echo of social networks, the GSMA says RCS will enable consumers to create their own personal community and share content in real time using their mobile device.

From a technical perspective, RCS uses the Session Initiation Protocol (SIP) to manage presence information and relay real-time information to the consumer about which service features they can use with a specific contact. The actual RCS services are carried over an IP-Multimedia Subsystem (IMS), which telcos are using to support a shift to all-IP fixed and mobile networks.

Deutsche Telekom, Orange, Telecom Italia, Telefonica and Vodafone have publically committed to deploy RCS services, indicating that the concept has momentum in Europe, in particular. The GSMA says that interoperable RCS services will initially be launched by these operators in Spain, Germany, France and Italy in late 2011 and 2012. [NB We’ll be discussing RCSe with some of the operators at our EMEA event in London in November 2011.]

In theory, at least, RCS will have some advantages over many of the communications services offered by the disruptors. Firstly, it will be interoperable across networks, so you’ll be able to reach people using different service providers. Secondly, the GSMA says RCS service features will be automatically available on mobile devices from late 2011 without the need to download and install software or create an account (by contrast, Apple’s iMessage service, for example, will only be installed on Apple devices).

But questions remain over whether RCS devices will arrive in commercial quantities fast enough, whether RCS services will be priced in an attractive way and will be packaged and marketed effectively. Moreover, it isn’t yet clear whether IMS will be able to handle the huge signalling load that would arise from widespread usage of RCS.

Internet messaging protocols, such as XMPP, require the data channel to remain active continuously. Tearing down and reconnecting generates lots of signalling traffic, but the alternative – maintaining a packet data session – will quickly drain the device’s battery.
By 2012, Facebook and Skype may be even more entrenched than they are today and their fans may see no need to use telcos’ RCS services.

Competing head-on

Some of the largest mobile operators have tried, and mostly failed, to take on the disruptors at their own game. Vodafone 360, for example, was Vodafone’s much-promoted, but ultimately, unsuccessful €500 million attempt to insert itself between its customers and social networking and messaging services from the likes of Facebook, Windows Live, Google and Twitter.

As well as aggregating contacts and feeds from several social networks, Vodafone 360 also served as a gateway to the telco’s app and music store. But most Vodafone customers didn’t appear to see the need to have an aggregator sit between them and their Facebook feed. During 2011, the service was stripped back to be just the app and music store. In essence, Vodafone 360 didn’t add enough value to what the disruptors are already offering. We understand, from discussions with executives at Vodafone, that the service is now being mothballed.

A small number of large telcos, mostly in emerging markets where smartphones are not yet commonplace, have successfully built up a portfolio of value-added consumer services that go far beyond voice and messaging. One of the best examples is China Mobile, which claims more than 82 million users for its Fetion instant messaging service, for example (see Figure 20 – China Mobile’s Internet Services).

Figure 20 – China Mobile’s Internet Services

Source: China Mobile’s Q2 2011 results

However, it remains to be seen whether China Mobile will be able to continue to attract so many customers for its (mostly paid-for) Internet services once smartphones with full web access go mass-market in China, making it easier for consumers to access third-parties’ services, such as the popular QQ social network.

Some telcos have tried to compete with the disruptors by buying innovative start-ups. A good example is Telefonica’s acquisition of VOIP provider Jajah for US$207 million in January 2010. Telefonica has since used Jajah’s systems and expertise to launch low-cost international calling services in competition with Skype and companies offering calling cards. Telefonica expects Jajah’s products to generate $280 million of revenue in 2011, primarily from low-cost international calls offered by its German and UK mobile businesses, according to a report in the FT.

The Wholesale Applications Community (WAC)

Concerned about their growing dependence on the leading smartphone platforms, such as Android and Apple’s iOS, many of the world’s leading telcos have banded together to form the Wholesale Applications Community (WAC).

WAC’s goal is to create a platform developers can use to create apps that will run across different device operating systems, while tapping the capabilities of telcos’ networks and messaging and billing systems.

At the Mobile World Congress in February 2011, WAC said that China Mobile, MTS, Orange, Smart, Telefónica, Telenor, Verizon and Vodafone are “connected to the WAC platform”, while adding that Samsung and LG will ensure “that all devices produced by the two companies that are capable of supporting the WAC runtime will do so.”

It also announced the availability of the WAC 2.0 specification, which supports HTML5 web applications, while WAC 3.0, which is designed to enable developers to tap network assets, such as in-app billing and user authentication, is scheduled to be available in September 2011.

Ericsson, the leading supplier of mobile networks, is a particularly active supporter of WAC, which also counts leading Alcatel-Lucent, Huawei, LG Electronics, Qualcomm, Research in Motion, Samsung and ZTE, among its members.

In theory, at least, apps developers should also throw their weight behind WAC, which promises the so far unrealised dream of “write once, run anywhere.” But, in reality, games developers, in particular, will probably still want to build specific apps for specific platforms, to give their software a performance and functionality edge over rivals.

Still, the ultimate success or failure of WAC will likely depend on how enthusiastically Apple and Google, in particular, embrace HTML5 and actively support it in their respective smartphone platforms. We discuss this question further in the Apple and Google chapters of this report.

Summarising current telcos’ response to disruptors

Telcos, and their close allies in the equipment market, are clearly alert to the threat posed by the major disruptors, but they have yet to develop a comprehensive game plan that will enable them to protect their voice and messaging revenue, while expanding into new markets.

Collective activities, such as RCS and WAC, are certainly necessary and worthwhile, but are not enough. Telcos, and companies across the broader TMT ecosystem, need to also adapt their individual strategies to the rise of Amazon, Apple, Facebook, Google and Skype-Microsoft. This report is designed to help them do that.

[END OF EXTRACT]

Appstore 2.0: Amazon Vs Apple & Google

Summary: Amazon is probably the Internet’s best retailer. As it launches its own AppStore, we provide a detailed analysis of its digital media business and pick out the key opportunities it offers to content owners, network service providers and manufacturers.

Below is a major extract from this 18 page Telco 2.0 Analyst Note that can be downloaded in full in PDF format by members of the Telco 2.0 Executive Briefing service and the Telco 2.0 Dealing with Disruption Stream using the links below.

‘Growing the Mobile Internet’ and ‘Fostering Vibrant Ecosystems: Lessons from Apple’ are also key session themes at our upcoming ‘New Digital Economics’ Brainstorms (Palo Alto, 4-7 April and London, 11-13 May). Please use the links or email contact@telco2.net or call +44 (0) 207 247 5003 to find out more.

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Introduction

For Amazon, the world of downloading and streaming brings both threats and opportunities: threats in that a large proportion of its current business is at risk of being cannibalised; and opportunities in that a significant element of its cost base associated with the storing, shipping, picking and packing of physical goods could be automated and reduced further.

Amazon’s key strengths are the size of its customer base; its ongoing relationships with all the major content owners in all the key categories (Books, Music, Movies/TV and Games); and most importantly, Amazon is the most highly skilled retailer on the Internet. Amazon’s Achilles heel is that it has very little control over next generation devices, apart from the Kindle, whether Tablet or Mobile phone.

In this note, we examine:

Amazon’s current performance;
The rising costs of physical distribution;
The attraction of online distribution (streaming and downloading) to Amazon;
The success of the Kindle;
Why Amazon has failed to gain significant market share in music;
The rationale behind the move into movie streaming;
How Amazon will shake up the AppStore market;
Whether the success of the Kindle means a move into more own-brand devices;
Amazon’s potential impact on the digital value ecosystem and how content owners, networks and device manufacturers should interact with Amazon.

Amazon’s Current Performance

Amazon’s Operating Income in 2010 was $1.4bn with a typically low retail sector margin of 4.1%. This is a far lower margin than usually sought by the content industry, networks or the device industry and one of Amazon’s key strategic advantages – its investors do not expect huge margins. However, they do expect revenue growth and this it has delivered so far (see below) through the development of the most advanced retail platform on the Internet, fierce price competition, tight control over costs and increasing product diversification.

Figure 1: Amazon Operates with the Low Margins Typical of Retail

Source: Amazon, STL Partners

Amazon is now the world’s largest e-commerce site selling over US$34bn worth of goods and services in 2010. The Amazon main website attracts more unique visitors in a month than either eBay or Apple (see below).

Figure 2: Amazon is the busiest online store in the world

At the end of 2010, Amazon had over 130m ‘active’ customer accounts, a healthy increase of over 25 million in the year. In comparison Apple has over 200m accounts with credit cards stored – but does not break-out the percentage of these that are actually buying goods and services from it. It is therefore difficult to determine whether Amazon or Apple have the most paying customers passing through their stores. Whichever is the larger, Amazon’s retail prowess cannot be ignored, especially in entertainment media where its revenues continue to grow year-on-year.

Amazon’s Media Sales

Amazon’s roots are in selling books but over the years its portfolio has been extended successfully to other type of physical media so that its media category now comprises Books, Music, Movies, Video Games and Consoles, Software and Digital Downloads in most territories (USA, Canada, UK, Germany, France, Italy, Japan and China). The sales associated with its media business are still growing by over 10% per annum and, although declining as a percentage of total sales, still represented over 43% of total net sales in 2010. The reduction in percentage of total sales is therefore more a reflection of Amazon’s success in its diversified product range than any drop off in media.

Figure 3: Amazon’s media sales are still growing at over 10% per annum

Source: Amazon, STL Partners

It is noteworthy that Amazon doesn’t provide any further detail on the media category and therefore little is known outside of Amazon about how their customers’ habits are changing from physical media consumption to digital. However, Amazon has been very clear that it sees a future where media is consumed both physically and digitally. In short, it wants to grow the entire pie and Amazon is not abandoning the physical world in much the same way that Netflix is not abandoning the mailing of DVDs.

Amazon promotes itself to investors as growing the absolute level of Operating Income and therefore is less worried about margins than overall growth. This is important for content owners as it aligns with their priorities and means that Amazon is as concerned with cannibalisation of physical product revenues as they are. However, that does not mean Amazon is in anyway anti-online distribution.

Amazon is also highly focussed on growing Free Cash Flow per share which implies strict management of working capital and balance sheet expenditure and to understand the appeal of online business in this context, we first have to understand the costs and cost trends associated with physical products.

Counting the Cost of Physical Distribution

Amazon currently spends about US$1.4bn or 4% of revenues on the physical shipping of goods to its customers. Despite Amazon’s famed distribution efficiency, this percentage has increased over the last couple of years, eating ever further beyond the associated shipping revenues, as illustrated below.

Figure 4: Amazon’s Net Shipping Costs Continue to Rise Over and Above P&P Charges to Consumers

Source: Amazon, STL Partners

This is probably down to two factors:

Amazon offers an annual “Prime” shipping service where for a fixed annual shipping commitment, customers receive “free” shipping for each purchase. It is estimated that 15% of Amazon customers are “Prime” subscribers. It is assumed that “Prime” customers are more loyal to Amazon and are their heavier spenders; and
Amazon has moved into selling more bulky goods over the years, such as PCs, which are far more expensive to ship than books.

Furthermore, there are additional costs associated with physical distribution.

Figure 5: Physical fulfilment costs Remain Stable as a Percentage of Net Sales

Source: Amazon, STL Partners

Amazon spent around US$2.9bn or 8.5% of revenues in 2010 on fulfilment costs (or the picking and packing) of goods. Amazon doesn’t break-out how much it spends on payment processing (included within cost of goods sold) or maintaining the technology (elements include Technology and Content, Depreciation and Amortisation) for its various e-commerce sites.

The Attraction of Online Distribution

With Amazon’s ability to manage the combined physical costs of shipping and fulfilment to 12.5% of revenues in 2010, we believe that Amazon should be able to deliver online distribution for less than the 30% benchmark ‘agency fee’ revenue share typical in the online distribution model. And, that is before the additional efficiencies that Digital distribution offers over Physical. Therefore the margins offered up by the digital environment are highly attractive to Amazon.

Furthermore digital goods, in the main, fit perfectly into Amazon’s Operating Income growth model as the carrying cost of inventory is minimal and cash for goods is received immediately from customers, while the payment to content owners is typically dispersed 30-days after purchase. The major exception to this rule is when content owners demand large upfront fees for either access to content libraries or for exclusive deals. This is a major feature of both the Movies/TV and Music industry and may account at least in part for the differing levels of take up Amazon has experienced between these and e-books.

So, where does Amazon sit in online distribution – streaming and downloading? Is it a major player that needs to be actively worked with or against or can it be left out of the strategic thinking of the others in the digital online ecosystem – content owners, network service providers and device manufacturers? A closer examination of the position of Amazon in each of the major digital content categories – publishing, music, video and apps, provides valuable insight.

The success of the Kindle: more eBooks than Paperbacks

Amazon launched the Kindle in 2007 as an e-ink book reader for an introductory price of US$399, which in its first iteration had connectivity exclusively provided through the Sprint CDMA network. However, Amazon developed more than a hardware device with the Kindle, it built the whole surrounding ecosystem for sale, delivery and management of mainly electronic books but also other publishing media such as newspapers.

Figure 6: The Amazon Kindle

Today, the hardware price of the Kindle has come down to US$139 (WiFi only) to US$189 (WiFi+3G) and Amazon has launched Kindle readers across all the major platforms from Apple (Mac, iPhone and iPad), Google Android, RIM Blackberry and Microsoft (Windows and Windows Phone7). If a customer buys a book from the Kindle store, it can be read on most of the major platforms for a single fee.

Amazon doesn’t break out sales data for either Kindle or eBooks, but the following extract from Amazon’s 4Q 2010 earnings release provides just an indication of progress being made.

Amazon.com is now selling more Kindle books than paperback books. Since the beginning of the year, for every 100 paperback books Amazon has sold, the Company has sold 115 Kindle books. Additionally, during this same time period the Company has sold three times as many Kindle books as hardcover books. This is across Amazon.com’s entire U.S. book business and includes sales of books where there is no Kindle edition. Free Kindle books are excluded and if included would make the numbers even higher.

The Company sold millions of third-generation Kindle devices with the new advanced paper-like Pearl e-ink display in the fourth quarter and the third-generation Kindle eclipsed ―Harry Potter and the Deathly Hallows – as the best selling product in Amazon’s history.

The U.S. Kindle Store now has more than 810,000 books including New Releases and 107 of 112 New York Times Bestsellers. Over 670,000 of these books are $9.99 or less, including 74 New York Times Bestsellers. Millions of free, out-of-copyright, pre-1923 books are also available to read on Kindle.

January 2011’s sales figures from the American Association of Publishers also point to the growing success of eBooks – US$70m – a 116% increase year-on-year – despite a small, 1.8% (US$805m), fall in the overall market. eBook market share figures are hard to verify. Apple recently claimed 20% of the market, Barnes and Noble (US-only) also claimed 20% of the market and Amazon claims between 70% and 80% of the market – obviously not all can be true.

Wild market claims are to be expected in this high growth stage of the market development and there is uncertainty whether a 20% market share is by downloads or value and whether downloads include free, out of copyright eBooks which generate no revenue. All estimates that the STL team have seen indicate that Amazon is the market leader with a market share in the 50%-75% range. This CNET interview with Ian Freed, an Amazon vice president in charge of the Kindle, provides more detail on where Amazon sees itself in the market.

Although detailed data isn’t available about whether Amazon is yet making a contribution to operating profit from the Kindle and eBooks generally, all the indications are that Amazon is happy with the results and the continued investment speaks for itself.

The STL team believes Amazon’s success can be put down to five key factors:

Amazon probably has the highest concentration of book reader users as its customers;
Reading books on the Kindle is a very pleasurable experience and much better than some non-dedicated devices, especially the PC and the phone;
Amazon has developed a very easy-to-use platform which removes the friction of purchase and delivery of eBooks to a wide choice of platforms;
Amazon has tried to deliver great prices to its customers with new eBooks typically priced cheaper than their hardback alternatives. The Kindle Store has always included a wide selection of free out of copyright books; and
Amazon has built a store with access to material from the largest publishers to the smallest self-publishers. Self publishers are driving innovation with low-pricing for smaller episodic books.

The STL team believes that this last point is extremely important. Currently, Amazon has over two million sellers on its stores most of which are small businesses selling physical goods with the help of Amazon tools and services. This volume is far in excess of most developer schemes and almost certainly far larger than the combined total of content sellers across all developer platforms. Amazon will have little problem building and managing an even larger community as the developer community has largely adopted ‘Amazon Web Services’ as their cloud platform of choice, and sellers are already familiar and happy with Amazon tools and services.

Amazon and Music: Downloads not moving the needle

In the UK for example, Amazon share of the overall music retail market was a healthy 13.4% in 2009. Overall, the internet players have the largest share of the music market with 39%, compared to specialist retailers, such as HMV, with 33% and Supermarkets, such as Tesco and Sainsbury’s, with 23.6%. In a decade, the internet as an e-commerce channel has overtaken all of the UK’s high street. The download only Apple iTunes service with share of 10.6% clearly dominates the online distribution market.

Figure 7: Amazon’s Music Share is Healthy but not Dominant

Source: BPI Yearbook 2009

In the USA, Billboard estimated that in 2009 iTunes had 26.7% retail market share, which translated into 65.5% online market share. For a la carte download sales, the iTunes U.S. presence is overwhelming, with an estimated 93% market share.

In contrast, Amazon’s MP3 store had an overall 1.3% market share, which translates into about 5% share for a la carte downloads. Amazon commenced digital downloads in 2007 and has been a constant innovator.
The service launched with DRM-free tracks which were therefore portable between devices and with higher bitrate encoding, providing higher quality to the discerning ear. In the USA, the catalogue has continually grown and from an initial 2m tracks have grown to today having 1.4m albums and 15.2m tracks. But, as befits its corporate strategy of “everyday low pricing”, Amazon has put most effort into price innovation.

Figure 8: Amazon’s Smart Targeting & Competitive Pricing

Normally, Amazon has the lowest price for its chosen Album of the week. For instance, The Strokes new album is currently available for £4 compared to iTunes pricing of £8 in the UK. This is typical behaviour of a master retailer driving customers to their stores through headline offers and promotions to their customers. Apple has a very different approach relying on an agency model where the content owner has limited choice in setting retail prices.

In the USA, Amazon’s Daily Deal launched in June 2008 and it became the subject of a Department of Justice (DOJ) inquiry in May 2010 after iTunes began grumbling about Amazon promotions to the major labels. No comment has been released by the DOJ, but it seems clear that with Apple’s huge iTunes share that any attempt to discourage labels from participating in the Amazon promotions might be construed as price fixing. Amazon has continued to play its strongest card – differentiation though price competition.

Amazon has built an MP3 application for Android phones which allows the immediate purchase and playing of songs. It is noticeable that they haven’t built the same tools for Apple. In fact, the Amazon WindowShop application for the iPad actually displays download prices (and the playing of short clips), but doesn’t allow the direct purchase or download. Given, Apple’s domination of the music download market and the fact that Apple have allowed the Kindle store to operate on the iPad/iPhone, the STL team predict it will not be long before the DOJ launch another inquiry into Apple’s music practices.

In contrast to eBooks, Amazon does not seem to have built significant music share and the STL team puts this down to three main reasons:

The Amazon experience of buying music is not as good as Apple iTunes. This is made especially difficult to match as Apple control the device – the mass market seems to prefer convenience over price on low unit price items;
Amazon is not associated with the music market in the same way as Apple is; and
There are plenty of alternatives to paid music downloads. Spotify in Europe and Rhapsody in the USA, although of questionable profitability, have achieved success on other platforms with different business models, providing both paid-for and advertiser funded unlimited music streaming.

The move into Movie streaming

Amazon has taken a different approach to Movies than to either Books or Music.

In the UK and Germany, Amazon has recently acquired full ownership of a DVD and streaming service, called LoveFilm. This operates primarily under a subscription model providing access to a library of films. It is the UK and German equivalent of Netflix.

A subscription business operates under a vastly model than a retailer. It requires a much larger investment in both customer acquisition and retention and in content libraries. There is also reasonable investment required in gaining access and building clients for the plethora of devices coming onto the market to connect TVs to the internet. It also starts to compete with powerful payTV companies that have very deep pockets, large customer bases and similar ambitions.

In the USA, Netflix has managed to build a strong base of customers, a large market capitalization and is currently a darling of both the press and the investor community. The STL team has written extensively in the past about Netflix, its business model and prospects (see: The Impact of Netflix: Can Telcos Help Hollywood; Entertainment 2.0: New Sources of Revenu for Telcos?)

Amazon has decided to enter the fray in the USA with its Instant Video service. This service offers a limited selection of free streaming movies to subscribers of the Amazon Prime service. The Amazon Prime service is priced at US$79/per annum, compared to the Netflix streaming cost of US$8/month ($96/annum). Although, the annual fee may put some off, Amazon seems to have solved the problem of expensive customer acquisition. However, it is questionable whether Amazon under a licensing structure can afford similar levels of investment in content as Netflix.

A key factor in deciding this will be the support of studios for its model and their willingness to provide premium content and in this Amazon is gaining traction.

Figure 9: New Releases are Going to Amazon First

It is noticeable in the USA that Amazon are heavily promoting download-to-rent and download-to-own options which brings new releases to the library and are favoured by the Movie Industry.

Amazon is also an UltraViolet member which again we have written extensively about (see Telcos Risk Missing the UltraViolet Online Opportunity) and it is likely in the near future that Amazon will sell physical DVDs with the right to stream to multiple devices.

In Movies, STL Partners believes Amazon is uncertain which of the options will win in the future and is willing to invest in a wide range of options; effectively, it’s hedging its bets. But as in Music, Amazon has a long way to catch up with early platforms, whether that’s Apple, which leads the download-to-rent and own market, or Netflix which leads the subscription business. Again, this makes it an interesting target for partnerships, particularly for content owners looking to establish models that work better for them than Apple or Netflix.

Amazon shaking up the AppStore market

Amazon also has a significant business selling both physical electronic games and consoles. It was therefore hardly surprising that it launched Android AppStore heavily populated with games and featuring Angry Birds Rio as its launch game.

Figure 10: Amazon’s Appstore

The Amazon AppStore offers some very interesting features, including:

The ability to sample the game on a PC before committing to a purchase;
Amazon setting the retail price of the game with the developer only suggesting a retail price;
Free Daily Promotions of leading applications; and
Amazon performing a limited curation role, checking the applications are free of viruses

There are also teething problems with the service. For example, the Amazon AppStore is impossible to install on some “locked-down” Android handsets.

But Amazon has entered the market and the STL team believes it will be a serious player for years to come. It is also our belief that Amazon will want to develop AppStores for all major platforms, which will bring them into considerable conflict with certain platform owners, not just Apple.

To read the report in full, including the conclusions and recommendations…

Lessons for other players in the Digital Entertainment Value Chain
Content Owners
Network Services Providers
Device Manufacturers

…Members of the Telco 2.0^TM Executive Briefing Subscription Service and the Dealing with Disruption Stream can access and download a PDF of the full report here. Non-Members, please see here for how to subscribe. Alternatively, please email contact@telco2.net or call +44 (0) 207 247 5003 for further details. ‘Growing the Mobile Internet’ and ‘Lessons from Apple: Fostering vibrant content ecosystems’ are also featured at our AMERICAS and EMEA Executive Brainstorms and Best Practice Live! virtual events.

Full Report – Entertainment 2.0: New Sources of Revenue for Telcos?

Summary: Telco assets and capabilities could be used much more to help Film, TV and Gaming companies optimize their beleaguered business model. An extract from our new 38 page Executive Briefing report examining the opportunities for ‘Hollywood’ and telcos.

NB A PDF of this 38 page report can be downloaded here.

Executive Summary

Based on output from the Telco 2.0 Initiative’s 1st Hollywood-Telco International Executive Brainstorm held in Los Angeles in May 2010 and subsequent research and analysis, this Executive Briefing provides an introduction to new opportunities for strategic collaboration between content owners and telcos to address some of the fundamental challenges to their mutual business models caused by the growth of online and digital entertainment content.

To help frame our analysis, we have identified four new business approaches that are being adopted by media services providers. These both undermine traditional value chains and stimulate the creation of new business models. We characterise them as:

“Content anywhere” – extending DSAT/MSO subscription services onto multiple devices eg SkyPlayer, TV Anywhere, Netflix/LoveFilm
“Content storefront” – integrating shops onto specific devices and the web. eg Apple iTunes, Amazon, Tesco
“Recreating TV channels through online portals” – controlling consumption with new online portals eg BBC iPlayer, Hulu, YouTube
“Content storage” – providing digital lockers for storing & playback of personal content collections eg Tivo, UltraViolet (formerly DECE)/KeyChest

To thrive in this environment, and counter the continuing threat of piracy, content owners need to create new functionality, experiences and commercial models which are flexible and relevant to a fast moving market.

Our study shows that Telco assets are, theoretically at least, ideally suited to enable these requirements and that strategic collaboration between telcos and content owners could open up new markets for both parties:

New distribution channels for content: Telcos building online storefront propositions more easily, with reduced risk and lower costs, based on digital locker propositions like Keychest and UltraViolet;
Improved TV experiences: developing services for mobile screens that complement those on the primary viewing screen;
Direct-to-consumer engagement for content owners: studios taking advantage of unique telco enabling capabilities for payments, customer care, and customer data for marketing and CRM to engage with consumers in new ways;
Operational cost reduction for Studios and Broadcasters: Telco cloud-based services to optimise activities such as content storage, distribution and archive digitisation.

To realise these opportunities both parties – telcos and content owners – need to re-appraise their understanding of the value that each can offer the other.

For telcos, rather than just creating bespoke ‘enterprise ICT solutions’ for the media industry – which tends to be the current approach – long term, strategic value will come from creating interoperable platforms that provide content owners with ‘plug and play’ telco capabilities and enabling services.

For content owners, telcos should be seen as much more than just alternative sales channels to cable.

There is a finite window of opportunity for content owners and telcos to establish places in the new content ecosystems that are developing fast before major Internet players – Apple, Google – and new players use their skills and market positions to dominate online markets. Speedy collaborative action between telcos and studios is required.

In this Executive Briefing, we concentrate on the US market as it is both the largest in the world and the one that most influences the development of professional video content, and the UK, as the largest in Europe.

The developments in both are indicative of the types of changes that are facing all markets, although the exact opportunities and challenges are influenced by the existing make up of the video entertainment market in each country and the specific regulatory environment.

This report is part of an ongoing, integrated programme of research and events by the Telco 2.0 Initiative to foster productive collaboration on new business models in the global digital entertainment marketplace.

Sizing the opportunity

The online entertainment opportunity is often talked down by both telcos and media companies. It is, after all, just a small percentage of the current consumer and advertising spend. Examples are easily cited that diminish the value of the opportunity: global Mobile TV revenues (revenues not profits) don’t reach $1bn; on demand represents just 2% of total TV revenues; online film (rental and download) does slightly better but hasn’t yet reached 5% of filmed entertainment revenues.

Individually, these are not the sort of figures that are going to get telco execs bouncing with enthusiasm but collectively (as illustrated below) the annual digital entertainment market reached revenues of $55.4bn in 2009 and has a growth rate approaching 20%. And that figure is even better if you discount digital magazine and newspaper ad revenue. So, even today, digital entertainment is a market that equates to 83% of Vodafone Group’s 2009/10 revenue and it is experiencing the kind of growth that the mobile industry was once famed for. Realistically, the telco share will remain small for some time but as a growth market it cannot be ignored.

Table 1: Global Value of Digital Entertainment by Content Type 2009

Digital Content Type	Revenue (US$ bn)	% increase year-on-year
Video on Demand	4.09	11.6
Pay-per-view TV	4.56	-1.9
Mobile TV	0.99	7.2
Online and Mobile TV Ads	2.95	17.5
Digital Music Distribution	8.1	29.3
Online Film Rental	4.2	25.8
Digital Film Downloads	0.59	49.3
Online Games	11.63	21.3
Wireless Games	7.31	18.2
Online Game and in-game Ads	1.55	16.2
Consumer Magazine Digital Ads	1.31	-0.2
Newspaper Digital Ads	5.48	-5.6
Electronic Book Publishing	1.79	50.4
Total	54.55
Average		18.39

Source: Telco 2.0 Initiative and PricewaterhouseCoopers Global Entertainment and Media Outlook: 2010-2014

An important factor to note here is the continued growth of digital music distribution revenue. Music can easily be discounted as a medium that has already moved online but it still has a huge amount of growth space as a year-on-year revenue increase of approaching 30% indicates. This is the key point, digital entertainment is a growth opportunity for the next decade and when you look at the size of the physical products that currently serve the markets targeted by these digital alternatives, it is high growth potential for a market that is already of a considerable size, as illustrated in the table below:

Segment	Revenue 2009 ($bn)
Television subscriptions and licence fees	185.9
TV Advertising	148.56
Recorded Music	26.37
Filmed Entertainment	85.14
Newspapers	154.88
Trade publishing	148.11
Book publishing	108.2
Total	857.16

Source: Telco 2.0 Initiative and PricewaterhouseCoopers Global Entertainment and Media Outlook: 2010-2014

Once you take out the existing on line spend and those elements, such as movie theatre revenues that won’t move online, the current addressable market is in the region of $700bn a year.

Again, to put that in context at our recent Best Practice Live! online conference and exposition, Anthony Hill from Nokia Siemens Networks valued the web services 2.0 market at $1 trillion.

What is more, there is evidence to suggest that as well as the substitution of digital online for physical and broadcast formats, the virtual world is also bringing additional viewers and potentially additional revenue with it. An extract from Nielsen’s A2/M2 Three Screen Report presented at our 1st Hollywood-Telco Executive Brainstorming, suggests that while online video viewing in the US grew 12% year-on-year and mobile viewing grew 57%, this was not at the cost of TV viewing in the home which also grew, if only very marginally by 0.5%.

It is not surprising therefore that content owners are looking to take advantage of the shifts in the market and move up the value chain to take a greater share of the revenues, and that telcos also want to play a part in a significant growth market. Indeed, the motivations pushing both groups towards digital and online entertainment are truly compelling.

In the next two sections we examine these in more detail.

Telcos: Let us entertain you

Telcos are keen to build a bigger role in online entertainment for four reasons:

Entertainment provides the kind of eye catching and compelling content that broadband networks, both fixed and mobile, were built for
Broadband networks will carry the traffic irrespective of the role of the telco, so it’s strategically important to play in a part of the business that accounts for a majority of their total data traffic
(We estimate that online video makes up one-third of consumer internet traffic today and that this could grow more than ten times by 2013 to account for over 90% of consumer traffic overall. That makes it vitally important that telcos understand and maximise the opportunities associated with video and although not all video will be entertainment and not all entertainment is video, video entertainment is a major market driver. For more on broadband data trends, see our latest Broadband Strategy Report)
Entertainment is a growth market and the type of opportunity that can help build a Telco 2.0 business that, in conjunction with others, could re-ignite the interest of the financial markets in telecoms as a growth stock
It is a defensive play. Cable and DSAT providers are bundling communications services – broadband and telephony – into their service offering, eating into the customer bases of telcos. While telcos are still receiving revenue from these through wholesale, they are losing the direct link to customers and the associated customer information, both of which are integral to the ability of telcos to build effective two-sided business models

Downstream opportunity and challenges

Today, the vast majority of telcos are concentrating their activities in the entertainment arena in downstream activities – in IPTV and mobile TV, backed in some instances by a web TV offering as well. The primary success factors are, as might be expected, coverage/reach, quality of service and of course the appeal of the content. These are pre-requisites for success but there are no universally applicable targets by which we can judge success as so much depends on the competitive landscape within each market.

For example, mobile TV is bigger in China and India than in Western Europe and North America and this is despite the late entry of 3G systems in China and the very recent 3G spectrum auction in India which has kept connection speeds low. Furthermore, TV is far from ubiquitous, covering about 75% of the world’s population and Internet penetration sits around 25% and as low as 12% in developing markets, according to the ITU.

So why is mobile TV getting better take up on 2.5G in India than on 3G and 3.5G in mature markets? The simple answer can be found in the penetration levels of alternatives. Mobile simply has better reach than alternative transmission systems in emerging markets and the same factors influence mature markets with different results.
In developed markets, telcos are becoming part of the entertainment value chain as competitors to cable and DSAT but primarily with IPTV as opposed to mobile which, with a few exceptions, is coming more through content-specific apps than general services.

In the US, Comcast’s COO, Steve Burke recently cited telcos along with other cable providers and DSAT service providers as the company’s competition. Telcos have many options of how to enter the market but the default seems to be to think firstly, if not only, of full IPTV services or mobile TV, driven primarily by the desire to defend their communications markets.

Telcos are competing with TV cable and satellite companies for the home market on two fronts. Firstly to deliver high speed broadband connectivity and secondly to offer TV services. The problem for telcos is that IPTV, their TV service offering, has barely scratched the surface despite recent rapid growth.

According to the Broadband Forum, global IPTV subscribers grew 46% year on year for the first quarter of 2010. This equates to 11.4 million new IPTV subscribers, the most rapid growth in any 12 month period yet recorded and the global IPTV market totaled 36.3 million IPTV as at March 31st 2010. To put that number in some sort of context, according to Nielsen, there are 286 million TV viewers (not subscriptions) in the US alone.

The US IPTV broke the 6 million subscriber mark in the first quarter of 2010 and is growing fast but Europe is taking to the technology faster. France tops the IPTV charts, with just over 9 million users. This is perhaps no surprise given the weakness of its cable and satellite TV markets. Conversely, the UK which has decent broadband penetration, ranking 6th worldwide, doesn’t even register on the top ten for IPTV. Market entry is tough in the UK with BSkyB and Virgin Media dominating the pay TV market and in BSkyB’s case, tying up the premium content.

In many countries, telcos have also struggled to do the deals with studios and TV networks that will secure them the most compelling content and are therefore struggling to compete with cable and satellite services.

IPTV realities

In the US, AT&T’s U-verse and Verizon’s FiOS IPTV services have made some inroads. FiOS had 3 million subscribers at the end of Q1 2010, according to the company which also claims the service is available to 12.6 million premises or 28.8% of Verizon’s footprint. Its TV subscriber base had increased 46% to the end of 2009, while the major cable companies saw their shares drop by one or two percent but in absolute numbers cable remains dominant. Conversely, cable companies have seen their shares of broadband connectivity rise at the cost of the telcos.

Yet for telcos, the investments required for increasing speed and capacity through fibre is high. Fibre certainly represents the future for connectivity but its deployment is a long process and building complete end-2-end IPTV services will not make sense for every area in every country. Indeed, even within the US, Verizon is concentrating on core states and has sold its local wireline operations in 16 states to concentrate on building its fibre business where it is strongest. And fibre rollout is just the start.

Becoming a TV service provider is not straightforward and becoming a differentiated TV service provider is even more challenging. In addition to the technical connectivity, it requires deals to be made with networks to show their programming and, if real differentiation is to be made, deals also have to be brokered with studios, production companies and other owners of content, such as the governing bodies of sports, to secure broadcasting rights. Then it requires the development of an easy to use guide and the ability to at least keep up with the technical developments with which established TV providers are differentiating themselves – HD, 3D and integration with web features, such as social networking sites and delivery across multiple screens. This is a significant undertaking.

Many telcos are recognising that they cannot play every role in the video distribution value chain in every market. Indeed, even in France which we’ve established has receptive market conditions for IPTV, Orange has pulled out of competing in the sports and film genres that so often dictate the success of paid for TV services, and France is not alone.

At our 1st Hollywood-Telco Executive Brainstorm and at the 9th Telco 2.0 Executive Brainstorm, Telecom Italia’s representatives reiterated the company’s belief that IPTV was primarily a defensive play, designed to protect broadband revenues and that entertainment-related revenues would come instead from using telco assets and telco-powered capabilities to build new services around TV.

For Telecom Italia this is primarily about the upstream play based around QoE, CRM, billing and customer data and it also believes a business can be built around context and targeted advertising for free content on three screens. Building such functionality, linking consumer information and data about the environment to supplement TV services themselves and offer similar functionality to third parties is a core strategic decision being made by Telecom Italia, more about which can be seen on Antonio Pavolini’s presentation on our Best Practice Live! event site.

The upstream potential for telcos is something we shall return to later but we also believe that by working with, rather than in competition with studios and other content owners, telcos can become involved faster and more effectively in delivering entertainment services to their customers.

In addition, we believe an alternative and more accessible downstream opportunity exists based on digital rights lockers.

Digital Lockers: an alternative downstream option

Digital rights lockers are virtual content libraries hosted in the cloud that allow consumers to develop collections of content that are not tied to a physical format or device. There are a number of digital locker developments for online video, most notably Disney’s Keychest and UltraViolet, the new brand for the Digital Entertainment Content Ecosystem (DECE), a cross industry development.

These basically mean that a consumer can buy a piece of content once and then view it on any device at any time. For example, if a consumer buys Avatar on Blu-ray disc they would be able to register the disc into an UltraViolet-powered rights locker at the time of purchase or at a later date. Once registered, the digital proof of purchase is held in the cloud and then media service providers – cable companies, telcos etc., can access that information in my rights locker to know that they can deliver it to the consumer.

There are two important points here. The first is that from a consumer point of view it gives them what they want in the form of a one-time purchase for multiple formats; the second is that it breaks the tie between the device and the content. Content, in the form of rights, is held in the cloud, and is delivered in the appropriate form for any supported and registered device.

Ultraviolet works using a network-based authentication service and account management hub from Neustar that allows consumers log in and access digital entertainment they have rights to. The system authenticates rights to view content from multiple services, with multiple devices as well as manages the content and registration of devices in consumer accounts.

It means that content doesn’t keep a user locked with a particular device manufacturer as, for example, iTunes content does to the iPhone or iPad. Therefore if a consumer switches to a different device, assuming it is also supported, content will be viewable.

Furthermore, the fact that UltraViolet has multiple content owners committed, namely Fox Entertainment Group, NBC Universal, Paramount, Sony (which chairs UltraViolet) and Warner Brothers, makes it a strong proposition, as to try to compete with a proposition limited to one vendor, with one that was multi-device but limited to the content of a single owner is unlikely to succeed.

What this means for telcos is that an ecosystem is being built that they can simply tap into. A telco could use an UltraViolet-provided API to build access into its own customers offerings, whether that be IPTV, mobile TV or through a web-enabled storefront. They can access the rights locker in the cloud and see what a consumer is entitled to see and deliver it to them seamlessly. They make the enquiry, and deliver the video to the consumer which is in the right format for the device and complete with the necessary rights attached. An indication of how this flow works is illustrated in the diagram below.

Figure 1: Building the Digital Locker Proposition

Source: Telco 2.0 Initiative

The key point here for telcos is that such an approach overcomes the issues associated with scale and potentially with international distribution deals as well.

Both of these were uppermost in the minds of telco execs at the 1st Hollywood-Telco Executive Brainstorm, who constantly reiterated their frustrations at not being able to get the deals they need to give their customers the content they demand because of high ‘minimers’ and a mismatch between the internal operations and practices of telcos and studios. (See Telco 2.0 in Hollywood: There’s Gold in Them Thar Hills).

Collective activities such as UltraViolet are by definition more difficult to develop than those from an individual company as they require balancing of individual priorities and goals with those of the group. However, as we will discuss in more detail later, the desire of studios to compete with other groups to act as the retail and distribution point, makes working together more desirable.

It is also important to recognise that the strategic choices made by media companies have an impact on the options available to telcos. When media companies work together and create a new ecosystem, the value of upstream services from a single telco diminish, while their ability to enter as a downstream player increases as the open nature of an UltraViolet -like ecosystem allows them to grow incrementally. Should telcos want to play on the upstream side in such communities, then they too need to act collectively.

Telcos’ missed opportunity

Telcos have been notable by their absence in the development of UltraViolet which means many of the upstream capabilities they could have offered – authentication, billing, formatting for different devices – are being developed, at least in the first instance in different ways. However, there could be potential for these to develop over time based on building stronger relationships with the UltraViolet ecosystem, particularly around mobile device support. The formatting of data for specific devices is part of the basic operator function and this expertise could be highly valuable to the UltraViolet community but to be offered as an upstream service, rather than a downstream differentiator, it needs to be a collective proposition from the operator community, not piece meal.

However, if telcos are being challenged to develop new models to engage their customers, then content owners are even more so.

UltraViolet and other digital rights locker solutions open an alternative downstream opportunity for telcos and particularly for those that don’t have the market scale to compete with other Pay TV services. It is a middle ground that enables telcos to build an entertainment portfolio and overcome some of the challenges of building an entirely new business.

Content’s business model crunch

Once upon a time there were only two ways to get content to a large amount of people. Broadcast was one and the other was through a delivery chain made up of distributors, aggregators and retailers. The Internet changed that and high speed broadband access changes it again as even HD video can be accessed by individuals through the Internet, opening up new completion to those traditional channels.

All of these bring new challenges to the existing models of traditional media companies, which are both being challenged and pursuing new opportunities, as illustrated in the table below. The colour coding of the challengers reflects the severity of the challenge in the short to medium term (1-3 years).

Content Owner Category	Upstream Business Model	Downstream Business Model	Upstream Business Challengers	Downstream Business Challengers	New Business Opportunities
Film Studios	None	Revenue share from various sales windows – movie theatre, DVD sales, DVD rentals, Pay TV, Free-to-air TV – with the respective distributor/retailer	None	New online rental and sales channels eg Netflix, LoveFilm, iTunes, plus free and pirates	Downstream – sell direct to consumer getting all revenue and expand service offering with merchandising upsell etc Upstream – create upstream advertising business
Free to Air TV Broadcasters	Selling advertising inventory Public/government funding Syndication		Fragmentation of peak audiences; Google TV and online player services which undermine/destroy the value of advertising.		Upstream – greater distribution, lifespan delivering more ad value/opportunities; greater value to advertisers based on better measurement; greater targeting and personalisation; instant purchase opportunity.
Pay TV Broadcasters	Selling advertising inventory Syndication	Pay TV services to consumers	Google TV and online player services which undermine/destroy the value of advertising.	New sellers of TV content – Netflix, iTunes, New distributors of TV content – Hulu New Connected TV propositions – particularly Google TV	Downstream – Maximise value of content with pre-broadcast promotion, post-broadcast access Upstream – greater distribution, lifespan delivering more ad value/opportunities; greater value to advertisers based on better measurement; greater targeting and personalisation; instant purchase opportunity.
Games Publishers	Licensing of IP to third parties eg films, TV, books, comics etc Ad-funded apps	Largest share of product sales revenue. Total shared with distributor, retailer + licence fee payable to platforms In-play features	Piracy	Spiralling costs of production undermining profitability Online distribution potential to open the market and reduce the power and value of the publisher role; Piracy	On line potential to break links between the platform and the game and gain larger share of ‘hit’ game revenues; growth and monetisation of casual and mobile games
Independent Games Developers	Commissions from Publishers, platforms and studios Ad-funded apps	Revenue from product sales revenue shared with distributor, retailer + licence fee payable to platforms	Spiralling costs of production undermining profitability; Piracy	Spiralling costs of production undermining profitability	On line potential to break links between the platform and the game and gain larger share of ‘hit’ game revenues; growth and monetisation of casual and mobile games
Newspaper/Magazine Publishers	Sell advertising inventory	Revenue share with distributors and retailers	Proliferation of online publications hitting subs bases and diluting value to advertisers. Free is the dominant model	Online proliferation of publications; User-generated publications blogs etc;- readership dropping	Online provides opportunity for instant access to news, views – faster turn over and more inventory. Potential to leverage back catalogue and increase life/value of old articles
Book Publishers	None	Revenue share with distributors and retailers	None	Online cutting the price of the product and therefore revenue to be shared	Potential to go direct to consumers and dramatically lower production costs
Music Labels	Licensing model to third party	Revenue share with artists, distributors and retailers	None	Piracy; Free and low cost online models taking too much revenue out of the value chain to sustain it	Have to reinvent business model as opportunity already missed

Source: Telco 2.0 Initiative

For some entertainment sectors, especially the music labels, a major battle if not the entire war has been lost and the fear of following in their footsteps keeps the minds of TV and film studios, as well as publishers focused on the possible threats to their own revenue streams.

For other content owners, such as game developers, the opportunities look to outweigh the threats, as their position in the value chain is currently limited by the strength of the platforms and publishers. Indeed, by examining the games market we can see some of the opportunities that are developing for content owners to usurp failing business models and engage more directly with their customers in many more ways.

Games search for better business model

The online games market is currently the most valuable of online video content businesses but this is predominantly made up from mass online games, such as World of Warcraft, as well as casual games and not from the blockbuster platform games that permeate the market. There has long been a feeling amongst developers and even some of the smaller publishers that the business model is broken, stacking the odds against developers.

Developers, whether in-house with publishers or independent, face burgeoning costs caused by the fragmentation of platforms and the increasing reliance on mega hit games. These cost more and more due to competitive pressure driving the complexity and sophistication of the game itself plus licensing fees paid for IP and to console manufacturers, which bizarrely are paid according to the number of games produced not sold. Currently, average development costs range from $15m for two SKUs (the unit attached to each hardware version) to $30 million for all SKUs and the figures keep on rising. For example, according to Blitz games, it cost $40 million to develop Red Dead Redemption, the current number one best-selling game.

It is not surprising therefore that casual and social games which typically have six month development cycles and cost between $30,000 and $300,000 and mobile games which cost even less, generally in the range of $5000 to $20,000 per title, are attracting more of the time and energies of independent developers. What have been missing in the past are effective routes to market for these but in social networking sites for casual games and app stores for mobile games, these are now reaching mass audiences with ease and both bring new business models to the games industry.

The mobile model is a simple storefront revenue share one, which typically delivers 70% of revenue back to the developer. The causal gaming and social networking tie up is following a freemium model, whereby the basic game is played for free and higher levels, additional features and tools can be purchased. Both of these represent potential channels for ‘hardcore’ games to follow, if and it’s a big if, the experience of the console can be replicated online.
OnLive has become one of the first to examine this potential, launching the first version of its cloud-based games service on June 17, 2010 and we will follow up on the development of this and the business model alternatives and opportunities in an Analyst Note later in the year.

However, while the games market faces up to its own business model challenge, it, like many other content areas, should not be viewed in isolation. Games consoles are providing more functionality than just playing games. They also offer Internet access, apps, voice and are also capable of playing DVDs. Meanwhile, games also have the potential to be accessed via other entertainment channels and this is indicative of the blurring boundaries that have emerged across the entire entertainment arena.

Blurring boundaries

Today, we have global media companies, such as News Corp, that owns Film and TV studios, book and newspaper publishers, TV networks, DSAT and cable service providers.

This convergence is a long-standing trend which has also thrown up some very notable failures, such as AOL TimeWarner. However, the synergies across vertical entertainment sectors mean that companies continue to try for the ultimate media company. Indeed, the online environment only encourages this as the content type is no longer tied to the delivery medium. Furthermore, other companies are moving up and down the value chain. In fact the landscape is more complicated with three distinct but sometimes related trends emerging:

The value chain is breaking up with existing players given the opportunity to collapse it down to fewer elements and take a larger share for themselves
New players are disrupting the ecosystem with new business models that challenge the value of the existing chain just as it is being reconfigured
New functionality, such as integrated apps or extension to the mobile screen, is providing further ways to differentiate services

Each of these alone would be considered an industry challenge; combined they set up a bloody battlefield. What is more, the battle is not limited to a single content type. The distinctions between platforms are also blurring. You can get TV through your games console, films on TV from your pay TV service and TV through the internet and all together these forces are totally disrupting the value chain.

These forces have also prompted the emergence of four different business approaches as follows:

“Content anywhere” – extending DSAT/MSO subscription services onto multiple devices eg SkyPlayer, TV Anywhere, Netflix/LoveFilm
“Content storefront” – integrating shops onto specific devices and the web. eg Apple iTunes, Amazon, Tesco
“Recreating TV channels through online portals” – controlling consumption with new online portals eg BBC iPlayer, Hulu, YouTube
“Content storage” – providing digital lockers for storing & playback of personal content collections eg Tivo, UltraViolet /KeyChest

These are not mutually exclusive but are providing new approaches that media service providers are using alone or in combination to create new business models that are disrupting the traditional value chain and building new ones.

Disrupting and rebuilding the value chain

Using the example of video distribution, we can see more clearly how things are changing. The traditional value chain for video distribution (illustrated below) sees a consumer purchase the video content from a retailer, who in turn was supplied via a wholesale distributor who bought from the content creators, and watches it on a device bought specifically for the purpose – TV, video/DVD/Blu-Ray player, games console, hifi, etc.

Figure 2: Video Content Value Chain

Each role has a distinct group of companies that serve it and that are highly competitive amongst themselves but as distribution and delivery moves online, the two end points are moving towards the middle to gain greater control over the market and a larger slice of the pie.

The online digital value chain has the same functions to deliver but which companies should provide these are anything but clear as each player has a shot at cutting some of the others out of the chain completely. The obvious point of collapse is between the distribution and retail elements and this is where the likes of Amazon’s on-demand service come in. However, it is not the only convergence point and content owners should be defining the online value chain to position themselves at the centre of it, not taking what they are given.

In the physical world, selling content straight to the consumer had been a logistical impossibility for content owners other than TV broadcasters but with digital a direct channel to the consumer becomes a distinct possibility. What we now have is the possibility to combine distribution and content creation. For content creators this means direct serving through on-demand services of the Internet.

All the major film studios have their own service on-demand services and provide early access to on-demand content through these. For example, Universal launches films on its site the same day they are offered for release on DVD. This demonstrates that although the sale of DVDs is the most lucrative of the second rights windows, a direct online sales channel is even better value for the studios.

However, while a direct sales channel is good for studios, the highly lucrative DVD/Blu-ray retail market is being threatened from all sides – from subscription rental, from VoD download and streaming and from pirates – all of whom are targeting the online opportunities offered up by physical windows. Therefore studios are attempting to both maximise their opportunity for the new channel and protect their traditional revenue streams. It is a decidedly difficult path to tread and the winners and losers will be inevitably be defined by their ability to pull on the vital parts of the value chain.

Taking each link in the chain in turn, we can see how the four new business approaches are being created and how telcos could contribute to their development.

Content Creation

The major studios have the professional content ownership in the bag, at least for the time being. There is little doubt that while user generated content (UGC) creates an interesting new dynamic, especially for news services, and cheaper and more accessible production and online distribution theoretically opens up greater opportunities for independent productions, neither is close to making a serious challenge in reality.

There have been a few examples of this in music where independent artists have used the internet to distribute and social networks to market their work and thus cut out the need for a music label. Given that the experience that music companies have had with online distribution is the one cited as the one to avoid by all content owners, it is worth watching.

Perhaps a stronger play is to draw on new interactive capabilities to supplement the content creation process, helping to define plot lines and characters. This is an area that has already seen some collaboration between telcos and studios, for example when Sprint worked with WPP’s Mindshare and NBC to create a new character for Heroes. This was in fact seen as a development for advertising, rather than creative content but it establishes a precedent for engagement with a show’s audience.

These are both developments that demand tracking but they’re not the most pressing issue at the moment. That comes from the convergence of the online distribution and retail elements of the video value chain.

Distribution and Retail

The distinguishing line between retailers and distributors is a fading one in the digital world as getting the content from content owner to retailer is a simple electronic process. As a result no distributor is required and the content owner can go directly to the retailer, which, if independent of the studios can also act as an aggregator. So a more likely structure is that content owners will become their own retailers and they will compete with independent aggregator retailers that provide a one-stop shop for content for multiple media companies.

This might appear nothing but positive but without the distributor or a requirement for a physical outlet, retailers have the ability to completely reset the pricing model according to their vastly reduced cost base. Content owners have little or no influence over the prices retailers choose to set one the retailer, or indeed the renter has purchased the selling rights. That has already set a challenge to content owners, as we have seen with Apple iTunes and music and increasingly with TV and film content. The $0.99 film may appear a good deal to the consumer but is it enough to maintain the investment in new film development and once price expectations are set, can they be increased?
Studios are, not surprisingly, anxious to avoid having pricing dictated to them by a single dominant online retailer but to compete effectively they need to differentiate their online stores through content of course but also through the ease of use and relevance of its service.

Unlike telcos, or even cable cos and DSAT service providers, content owners have access to the content to differentiate their online service from competitors. They are of course limited to their own content but with a limited number of top studios or content creators, consumers would be able to find their way to the content they liked the most – just as they find their way to the content they want on different TV channels. But content alone does not a service make and this is the steep learning curve that content owners are embarking on.

A full service requires effective content delivery, quick, easy and secure payment/billing facilities, a slick search and recommendation engine, easy links and access to additional services or more video content and efficient customer care. None of these are core competencies for film and TV studios, or even games developers and publishers. However, they are core assets of telcos, the same telcos that are struggling to get the right level of premium content from the studios. There is a natural synergy here, even more so when you take into consideration the motivations for telcos to get into the entertainment arena.

To this end we have identified core telco assets that could aid that differentiation. These are:

Interactive Marketing and CRM, whereby telcos are capable and willing to share the information they hold on customers and their behaviours. These leverage both personal and contextual data to create valuable information services
Customer Care – a core telco competency that is completely lacking from the skill set of media companies
Three Screen Delivery – telcos have vast experience in identifying devices, the OS and software platforms, detecting software configurations and radio connectivity and transcoding to deliver content in the right format for the device
Direct Payments – through the telco bill, one click secure and easy payments are possible, overcoming one of the major obstacles identified to put off prospective customers. Includes the ability to detect account status, billing and payments capabilities
Identity-based Content Delivery – the telco ability to identify customers and deliver across platforms provides another way to build a content anywhere business

(For more, see How to Out-Apple Apple).

It will also be important for studios to act quickly as hardware vendors have watched the Apple phenomenon and are looking to get a slice of the pie, meaning there are many more than one new entrant.

New roles – device vendors sell content

Entertainment device manufacturers rely on new formats and technologies linked to content to sell new hardware – eg Hi-resolution and 3D films, TV and games. That is how their business model works but online also gives them potential to move up the value chain and get into the retail sector, grabbing a share of the revenue as Apple has done. It is a process that has been exemplified in the mobile industry. With apps and app stores, manufacturers of devices can build communities and develop the potential for three revenue streams: hardware sales, revenue share on app sales and even software licensing to app developers.

There are two converging trends involved here. On the one hand, entertainment and communications devices are becoming one and the same thing, while on the other, devices are moving up the value chain and vendors are looking to gain revenue from outside of the highly competitive consumer electronics markets.

For example, Sony has built up an Internet community around the PS3, using it as the backbone for its connected TV network. It is looking to gain a recurring revenue stream to go alongside the one-off hardware revenues of the TVs themselves. TV replacement cycles are around 7-8 years and while the speed of innovation is increasing – 3D is coming relatively quickly on the heels of HD when compared to the move from colour to remote control to digital for instance – it is still a more uncertain business and one more influence by macro economical trends than pay TV services.

Sony is particularly interesting because its previously separate divisions serving the consumer electronics and entertainment markets are combining their assets to provide a significant challenger to the value chain. For example, in 2008, the Sony Pictures film Hancock was offered to those in the US who had its Bravia TV sets just a few days after the cinema launch and before the DVD went on sale, completely usurping the window release process that sees films follow a well-defined path from cinema to DVD/Blu-Ray sale, then to rental, followed by pay TV and finally free-to-air TV.

The Hancock experiment has not been repeated and instead Sony has done deals other online distributors for film on its Bravia sets, such as with LoveFilm in the UK, but it does show the potential if, like Sony, a company can control both ends of the value chain. However, the new competition does not end there.

New players – TV changing times

Continuing with the TV example, we can see that traditional TV broadcasters look at web distribution as an opportunity to:

Extend their reach beyond the limitations of the time-specific schedule
Diversify their offering by creating additional services and interactivity around broadcast services

On the flip side of this though, the web is also a threat as it takes away the broadcaster’s iron control over the distribution channel. YouTube has proved to be a key battle ground as broadcast TV programmes that were one posted for free within minutes now have a fee attached and a raft of country-specific as well a general providers of managed solutions have emerged as quality becomes a greater differentiator.

Taking this a stage further are the internet players, such as Apple and Google, which have both released TV specific services that extend their Internet expertise and services to the TV screen. Most significantly though, these also extend their respective business models to the TV screen. How these fit into and challenge the overall connected TV market is illustrated in the table below, which features a number of players from the US, the biggest market for video entertainment and the UK, Europe’s largest market, that are trying out new business models in attempts to gain a greater share of the market.

Table 4: Who’s Doing What in Connected TV

Consumer Proposition

Company

Product

Business Model

Strengths/Weaknesses

Pay to view TV services

Amazon

Online retail community – streaming and download

Retail model for sale and rental

New Business Approach: Content Storefront

Strengths -strong online retail brand and community. Cloud based storage and access

Weaknesses – Complex rights management; weak mobile/portable service.

Apple

Apple TV box plugs into any HD TV to provide the Apple interface to content through AppStore and iTunes and Mac-like computer navigation. Available now

Rumours persist about a $30 per month subscription service but Apple has not yet been able to secure the content deals to make this happen.

Hardware sales and 30% revenue share of all film and TV downloads

New Business Approach: Content Storefront & Content Anywhere

Strengths: Apple Brand; Leverages existing content environment; iPhone, iPad for mobile reach and ads

Weaknesses: On-demand service only, now schedule broadcast; Depends on content it can get – has held up sub-based monthly TV service

Google TV

Box from Logitech or embedded in new Sony TV. Leverages Google search capabilities and Android developer community

To launch Autumn 2010

Revenue share from Android market and extension of AdWords from Internet to TV

New Business Approach: Content Channel & Content Anywhere

Strengths: Google brand; search engine; Android App Developer Community and mobile reach;

Weaknesses: Scale -hardware has to be bought; Access to content, currently blocked by 4 major broadcasters in US; Dependence on hardware vendors and content owners

IPTV Verizon FiOS

IPTV service with hundreds of channels, VoD and PVR

Triple play service – bundled with broadband and telephony. Defensive activity to protect comms revenues

New Business Approach: Content Anywhere

Strengths: triple play – have control of both Internet and TV channels into the home; control over the delivery pipe

Weaknesses: Scale; Lack of exclusive access to premium content and content differentiation

Sky Player (UK)

Web TV player behind pay wall giving same service to subscribers as they get through satellite TV service

Watch anywhere value-add. Defensive play against web TV players

New Business Approach: Content Anywhere

Strengths: Leverage existing premium content deals and original content – especially sports; Extensive back catalogue

Weaknesses: Ability to control the quality of the experience

NetFlix/LoveFilm

Postal and online rental service

Subscription model for rental that breaks pay-per-view rental model

New Business Approach: Content Anywhere & Content Channel

Strengths: Subscription model attractive to consumers wanting set cost; model naturally migrates to online and gets stronger with lower distribution costs

Weaknesses: At the mercy of content owners wanting to protect revenue from other windows; No control over the pipe.

Cable TV Everywhere

In Beta testing on Comcast’s Fancast

Led by Comcast and Time Warner, this provides online access to their cable content behind a pay wall

Watch anywhere value-add to prop up premium subscription packages. Defensive play against web TV players such as Hulu

New Business Approach: Content Anywhere

Strengths: Leverage existing premium content deals and original content; Extensive back catalogue; Ability to control the quality of the experience

Weaknesses: Late to the game. Limited to those who already have cable subscription – no online only business model

Hybrid Pay and Free

Hulu Plus

Launched June 29, 2010

$10 a month subscription premium service for near real-time access to TV content, on all screens with handover pick up and play across all of them

Freemium model building value add on top of the free Hulu service adding subscription revenue to advertising

New Business Approach: Content Channel

Strengths: access to premium new and catalogued content from its parent companies; two-sided business model; three screen delivery

Weaknesses: access to content outside of that from founders; no control of QoS of pipe – possible victim of throttling

YouTube

Free to view video upload for UGC, advertising supported professional content

Experimenting with paid for content

Ad-funded

New Business Approach: Content Anywhere

Strengths: Brand, scale and reach; Google technical and financial backing

Weaknesses: High costs of storage; lack of advertising placement

Free to view web TV services

Free to Air – Project Canvas (UK)

Extension of Freeview (all free to air digital channels) to the web with full player capabilities

Ad-funded

New Business Approach: Content Anywhere

Strengths: reach – accessible by anyone with web access.

Weaknesses: player functions, such as fast forward, undermine value of advertising ; late to the game; no control over QoS of delivery – possible victim of blocking/throttling

Hulu

Free access to a range of Flash-based streamed TV and Internet video. Scheduling based on

Ad-funded, although the intention has been announced to introduce some paid services

New Business Approach: Content Anywhere

Strengths: free access limited only by internet connections; access to premium new and catalogued content from its parent companies

Weaknesses: no control over the quality of the connection – possible victim of throttling; access to premium content from other media companies; non-sustainable business model for most valuable content

Source: Telco 2.0 Initiative

Apple goes it alone

Apple TV is predominantly a pay-as-you-go model based on iTunes; it is a virtual retailer and has pioneered the content storefront model. Interestingly, TV is the first Apple business not to be built around hardware, suggesting that the company believes its online store is strong enough to carry its own business. However, Steve Jobs has referred to Apple TV as a project that will remain a hobby for some time to come. Despite this, Apple still has a strong role influence over the online video market. Its pricing policies for video on iTunes reset pricing levels and its stand on not supporting Flash is not just a technology decision based on the ‘buggy’ nature of Flash as described by Jobs.

Flash fire

Certainly Flash is quite heavy and would slow the iPhone down, so Apple is protecting its user experience but it is also protecting both its up and downstream business models for professionally created video content.

The vast majority of online video services from Hulu to Netflix, LoveFilm and TV network players are Flash based. This means that they can be viewed via a browser by any device that supports Flash. By taking Flash out of the equation, video consumers on the iPhone are left with two choices: get a different device that supports Flash or purchase video content through iTunes and that means more revenue for Apple. Apple talks about HTML5 as the natural replacement for Flash but this is still new technology and Apple will look to maximise its position for as long as possible.

Video service providers or content owners also have two choices: to build a second site that works on HTML5, as the BBC has for the iPlayer; or create apps for the devices as Netflix, LoveFilm and Hulu have. This later again works well for Apple as the apps strengthen the consumers tie to Apple hardware as should the consumer want to move to say an Android device, they’d lose the app, so it reinforces the company’s hardware business model. Furthermore, where applicable, Apple also gets its 30% of the app revenue and of course, SDK revenue.

The decision not to support Flash may have something to do with technology and protecting the user experience but it clearly also has everything to do with reinforcing the strength of Apple’s existing business models.

As with all other services, Apple and Google are taking fundamentally different approaches with Apple expanding its closed iTunes environment, while Google is all open. Apple is betting on taking a share or distribution/retail revenue; Google on turning TV into another and potentially huge extension to its advertising platform.

The big question here therefore is what this means for the broadcaster’s advertising model, as if Google’s version, which is performance-based and uses real rather than predicted data, is available on a TV screen, won’t the value of TV advertising decrease?

In the Apple case, it establishes the direct relationship with the customer, while Google’s play is purely upstream, extending its reach and delivering a new audience to its advertisers.
Apple also has another and for them, more significant objective, and that’s selling new hardware. While its famous Appstore brought in $1 billion dollars in its first complete year of activity, 30% of which went to Apple, that is put into perspective by the company’s total revenues of $13.50 billion and net quarterly profit of $3.07 billion for the second quarter, 2010.

Connected TVs could represent another diversification for the company that has been so successful at moving into the mobile device market and, just as with the mobile industry, Apple is looking to leverage the tight integration of its content marketplace to differentiate its hardware. This has been the primary driver of Apple’s business model but the expectation is that the relatively low retail price of the box and the lack of any real design differentiation means that for TV, Apple will be looking to create value from the service on the big and combine this with tight integration on the portable ones – the iPod, iPhone, and iPad.

Google on the other hand, is working in conjunction with hardware companies, most notably Sony for the Internet-enabled TV end product and Intel to get the Google functionality embedded in the chipsets. And Google’s objectives are not small, as a spokesman for the company have been quoted saying that it aims to have as big an impact on the TV industry as smartphones have had on the mobile world.

Differentiation options

In essence all the forces converging on TV are competing for the eyeballs of the consumer and the way they are doing this is to offer the consumer more choice: more content on more devices to be watched at more times. The consumer utopia it seems is to be able to pick exactly what they want to watch, when they want to watch it and on what screen; or in other words, the complete antithesis of broadcast TV when you get what your given, when its broadcast and always on the same type of screen.

There are however, problems with the utopia and the companies that solve these most effectively will run out the long term winners. As we are starting to establish there are four key points of competition:

The range of premium content
Integration of Internet apps to enhance the viewing experience
The user interface/ guide for finding the content

Extension to the mobile screen for true anywhere anytime viewing and enhancement of the big screen viewing experience

This is not to say that they are the only ways to compete, merely that they are the primary ones at the moment. Of these, only the appeal of content is proven; consumer demand for and willingness to commit dollars to the other three are, as yet, not.

Companies are however beginning to place their bets and while some are predictable, such as Google looking to leverage its search expertise for content discovery and its Android app development community to bring Internet-style services to TV programming; a lot more remain unclear. In particular, the ability of content owners that don’t have an established distribution channel to draw upon, to go directly to consumers is in question.

Interaction with Internet applications

For Google, key is a Software Development Kit (SDK) that will help independent content providers develop widgets to access their platform, content and participate in Google’s advertising revenue sharing program, similar to AdSense on desktop apps.

The Google TV proposition is Android based to draw on the rapidly-growing global developer community to create new and innovative ways for TV viewers to interact with their TVs. Facebook and Twitter widgets would provide easy to use chat facilities around key programming, for example. They are already used and by linking them in real time with the programme screen itself adds a further level of social networking. Beyond that, the possibilities are almost limitless but platform owners must understand what they are doing and the possible impact on existing revenue streams, particularly advertising as they could find their business model undermined.

For example, at a recent conference in London, an ITV representative speaking about Project Canvas stated that widgets and other apps would be uploaded onto the platform for free. Now imagine if an existing advertiser, say BetFair, which advertisers alongside sports events, launched a widget that enabled live betting on the event being broadcast. Why would they pay for advertising in a prime spot when they can launch the widget for free?

So the big Internet companies are coming to the TV party. They bring with them their own business models and these will compete with and impact on those of established TV studios, networks and distributors.

Free to air broadcasting is a simple one-sided upstream business selling advertising timeslots, whereas pay TV has a two-sided business model which adds consumer subscriptions to the revenue pot. A third pay-per-view element also exists for some pay TV services but revenues from these have declined over recent years. Following these developments through, we can see some major changes on the horizon.

Impact on advertising

TV accounts for the largest single proportion of advertising spend. Globally, it secures 36.6% of total ad revenues, according to PWC, and although spending has fallen on TV advertising over the last two it remains a default choice for buyers. It’s the IBM decision – the no one gets fired for making the obvious decision but if the TV world is changing isn’t advertising following suit?

Initially at least, research suggests that the answer is no. The $56 billion US TV advertising segment is expected to recover, growing by 9.8% during 2010 and thus erasing last year’s losses and returning the sector back to 2006 -2008 levels, according to the Magna Global Advertising Forecast, April 13, 2010.

At the 1st Telco-Hollywood Executive Brainstorm, executives were at pains to point out how TV still dominated viewing consumption patterns, delivers a better reaction to advertisements and are therefore seen as more pervasive than radio, print or online. According to the TVB, Nielsen Media Research Custom Survey 2008, cited by one of the speakers, 70% of adults believe that TV adverts are more persuasive than adverts on other mediums. It would seem that the TV/advertising love affair is set fair. However, we believe that the building trend towards on-demand viewing is challenging this particularly for free-to-air broadcast services.

If we take online advertising, we can see that it currently accounts for 12% of marketing budgets versus 34% of time users spend online. However, tying strategy to a delivery medium rather than a business model is a fundamental mistake. It’s not about online or cable or broadcast but live or on-demand. This is the change that undermines the very foundation of TV, broadcast and scheduling.

Scheduling, search and discovery

Of all the new functions that are hitting the market, it is on-demand that is making the greatest impact at this stage. At the 9th Executive Brainstorm, we asked the audience whether discovery would become the new search. The results were negative but it was the wrong question for entertainment and particularly for TV. The bigger question is whether discovery can become the new scheduling?

Broadband connectivity means that there is the potential for anyone to watch what they want, when they want it and where they want to. In theory therefore the individual can do the job of the schedulers of TV networks and channels and personalize it for themselves. This is especially true for the mass of archived material that is the mainstay of a host of cable DSAT pay TV channels. And the usage figures seem to back up the fact that the desire for consumers to control their own viewing is an irreversible trend and not just a short term fad.

A clear trend has developed around time-shifting whether through VoD, on-demand, or delayed TV; watching when the viewer wants and not when the scheduler says, is proving ever more popular. According to ComScore research on US viewing behaviour, 55% of viewers now watch original programming at a time other than when it’s scheduled. Furthermore, although it is a more pronounced feature in the younger demographic groups, it is also permeating the viewing habits of the over 50s and even over 60s, with 43% of the over 65s watching programmes after they had been aired. In short: everyone is time shifting.

However, a completely unstructured service where consumers search for the content they want relies on them knowing what that is. TV is generally regarded as a ‘learn back’ experience. It doesn’t require a huge amount of concentration, unlike say, video games and as such consumers don’t want to and won’t spend protracted periods of time searching for something, especially if they don’t know what they are searching for. Therefore the default becomes to stick with what you know. Just as many of us do with music, our viewing tastes could get stuck in time and we will miss out on new and different content.

We therefore have two contradictory user behaviours driving service requirements for on-demand video. On the one hand, consumers want to choose their viewing not have it thrust upon them, on the other they don’t want to have to make a huge effort to find their viewing.

The viewing guide is one of the most criticised parts of cable, DSAT and IPTV services. Often slow and clunky the guides, which list the schedules for each channel, struggle to deliver the large amount of information they have in a meaningful and useful way. If we then take out the timings and searching becomes even more difficult.
More sophisticated ways of discovering content are needed that encompass search, recommendation and some form of default scheduling and models for this are appearing.

Recommendation engines such as that used by Amazon or Apple Genius, which use observed tastes to make suggestions for future purchases are now well-established practice for online retail. However, there is potential to take this a stage further.

For example, the online radio service Last.fm offers playlists based on popularity of tracks as a default, as well as search and recommendation. This is interesting primarily because it is having the effect of increasing the amount and variety of music listened to by consumers. This may seem to be a nice, fluffy feature, but it is important for the discovery and support of new music talent and therefore the continued life of the industry.

Last.fm has flaws. It runs two business models, a free, ad-funded one in the US and UK and a subscription model in all other territories. This, the company says, is because it doesn’t have the sales capabilities necessary to run an effective ad sales campaign outside of its core territories and which will dominate in the long term is still uncertain but the value of an effective recommendation engine that acts as a scheduler, is.

As one speaker said at the 9th Telco 2.0 Executive Brainstorm in London, the opinions that influence his viewing habits are those of British actor/comedian, Stephen Fry and his mate Dave. No scheduler can do that but an effective mash up of recommendations perhaps through Facebook, Twitter and a purpose built recommendation engine such as Amazon uses, could.

Pay TV services increased choice dramatically over free-to-air alone and split the ad revenue. That took the number or channels from single figures to hundreds. Now imagine what happens when everyone has an individual channel.
The impact is already being felt on advertising revenue as these predictions for the US market from Magna Global reflect.

Table 5: US Ad Revenue According to Platform

PLATFORM	2009 ($$$) Est.	2010 ($$$) Est.	2011 ($$) Est.	% Difference
Digital Online	$22,843.7	$24,611.7	$26,792.0	+ 8.9%
Cable TV	$20,148.8	$21,491.7	$22,477.3	+ 4.6%
Broadcast TV	$27,789.3	$29,047.9	$27,384.0	– 5.7%

Source: Magna Global data presented at 1st Hollywood-Telco Executive Brainstorm, May 2010

It does, however, mean that advertisers can target far more effectively and finally put to bed John Wanamaker’s infamous adage: “I know 50% of my advertising is wasted, I just don’t know which half.”
However, there are problems with this vision as well.

On the revenue side, it requires new ways to measure viewing of shows and ads, while in terms of the user experience, it is essential to find an effective way for users to find what they want and discover what they will like but don’t yet know about.

Basically this is a data crunching business. It requires personal data, usage information, content meta data, device preferences and more to be combined to create valuable information. Telcos with their knowledge of the customer, device and environment have high value. Even more valuable is the willingness of telcos to share this data with content owners, unlike many of the alternatives.

Extension to the mobile screen

Beyond time and place shifting, the other major area of competition and development is the ability to deliver content across multiple screens. In many ways it is a development of the same trend: consumers do not want to be restricted on where, when and how they view. The seamless shift from one screen to another would, for example, allow a consumer to move from TV to mobile and then to PC as the commute to work.

These pause and pick up services are of course already in existence. Netflix supports this and it is a central part of the cable industry’s TV Everywhere initiative. Meanwhile, the ability to buy once and view on any screen is the functionality at the heart of rights locker propositions such as Disney’s KeyChest or the UltraViolet initiative that we mentioned earlier.

However, we believe that this alone is only part of the story.

User behaviour suggests that consumers actually like to use more than one screen to interact with content. For example, it’s all very well getting detailed stats to accompany a baseball game through a multi-screen view on IPTV say, but this interferes with the primary viewing function. As ESPN has discovered, a more effective approach is to provide the stats to a mobile device through an app, giving the consumer the ability to choose when and how they look up the info. Add in a chat facility and watching the ball game at home becomes a social activity as it would be seeing it live.

Getting the right platform for the right content is not a trivial matter. It is often assumed that the more intense the experience, the more it consumes the viewer, the more valuable it is. Furthermore, the value is assumed to increase the faster the connection gets as this allows greater intensity. This is not necessarily the case.
Some ‘lean forward’ activities can benefit from greater speeds. For example, many online games will improve with faster response times and these are highly immersive activities. However, not all activities require and always benefit from greater immersion. 3D TV has provoked great debate along these lines as the most intense experience is seen to require greater engagement and brain activity, making it a more complete viewing experience but also a less social one.

Sociability is both a sought after and valuable feature and is not necessarily driven by high immersion, high speed experiences. It’s about getting the right device for the experience, related to the user’s activity. And that requires information about what screens the user has, how they use them, where and when. This is the kind of new user data that telcos can collect and use without drawing heavily on complicated legacy BSS and OSS systems.

So, in summary, we have a situation in which online video distribution is a reality and growing at a fearsome pace but the business models and value chain are far from clear. Indeed, the stress points in existing models for both studios and telcos are more obvious than revenue opportunities. Both of these are areas in which telcos are well placed to play an important part.

The next section therefore looks at how the assets and developments of the content and telco industries can be combined for the benefit of both.

Telco and Media Collaboration

The options for telcos are many and the approach taken is dependent on the structure of the entertainment industry in their country and their own set up. Amongst the considerations they must assess are their willingness to collaborate, the assets and skills available to them and the regulatory environment. As we’ve already established, for some IPTV is a viable option, for others mobile as a mainline channel is also worth pursuing as it is the most ubiquitous option.

In addition, a third downstream option is emerging for telcos to be an access provider to digital rights lockers.
On the upstream side, the opportunities are many but they are far less defined and their development seems to be stuck in an endless chicken and egg situation in which each side is waiting for the other to define the services required. To help move this discussion on and to define some near term opportunities we have honed down the list of possibilities by examining what media companies are looking for from telcos.

Where to Start

Surprisingly, combatting piracy which gains so many headlines is not uppermost in the list of priorities, according to our research.Instead the issues that dominate the thoughts of media executives are primarily those that we have outlined earlier, namely the ability to differentiate through delivering across any screen, enhancing the user experience and improving content discovery, as illustrated in the table below. Underlying that is the desire to re-define and build the value of the upstream side of the entertainment business ie advertising.

Table 6: Importance of addressing issues facing media companies rated 1-5*

*Where 1 is of no importance and 5 is critical Source: 1st Hollywood-Telco Executive Brainstorm, Santa Monica

However, along with piracy, the area in which telcos and entertainment distributors are most likely to interact is in conflict over the quality of the pipe they are receiving.

QoS, QoE and throttling back

Video is all about the viewing experience so anything that influences that experience is of vital importance to content owners and to the retailer/distributor if this is done by a third party such as Hulu, NetFlix or LoveFilm. As these media service providers have no ability to control pipe, they use adaptive rate video technology to sense the bandwidth available and deliver the quality of video the connection is capable of dealing with effectively.

Adaptive rate technology works to a point as it means that they can deliver the best possible video for the bandwidth at any given time. However, the underlying transmission speed and quality is still beyond the control of the media service provider, so though better connectivity may be possible it is not being delivered. Furthermore, within the confines of the thorny net neutrality debate, the throttling of service types and in some instances specific services is happening to the detriment of online video services. For example, in the UK, LoveFilm has examples of customers with 20MBit/s connections unable to get a satisfactory service even though other video streaming services including the BBC iPlayer work perfectly well.

Telcos want a share of the video revenue that is being generated over their networks, and in throttling, deliberately reducing the speed of connections, they have a stick to beat media service providers with, should they wish to and be allowed to use it. However, just like DRM, throttling is a negative activity and will serve no positive purpose as consumers are just as likely to move ISPs if their services don’t work as they are media service providers. If they want certain content, they will find a way to do and don’t be surprised if such throttling activities pushes more consumers to Pirate Bay and its like where an additional wait will be tolerated to download rather than stream and content comes free.

So is there a better relationship to be had?

Charging for QoS/QoE SLAs to media service providers would be the first choice of telcos and while our research suggests that telcos believe this to be more of a possibility now than a year ago, our view is that it is still a service that requires consistent failures in the market in order to prove its value before it could become a capability media service providers will pay for en masse. Therefore if telcos can’t charge upstream players for a guaranteed pipe, at least in the short term, they need to look at other what other telco assets can offer media companies.

In our analyst note, ‘How to Out-Apple Apple’, we identified a series of telco assets that could be valuable to media companies that are or are intending to sell their content directly to customers through online outlets. These and how they add up against competitors are summarised in the table below.

Table 7: Telcos Offer Unrivalled Asset Combination

	Payments	Content Delivery	User Experience – 3screen	Interactive Marketing/ CRM	Customer Care
Apple	Yes	Yes	No	No*	No
Amazon	Yes	Yes	No	No*	No
Netflix	Yes	Yes	No	No	No
Cable Cos/Satellite	Yes	Yes	Partially	Partially	Yes
Other enablers	Banks, Credit Cards, PayPal	Eg Akamai, L3, Limelight	–	Marketing Ad Agencies	Outsource
Telcos	Yes	Yes	Yes (Converged telcos)	Yes	Yes

*Apple and Amazon have interactive marketing and CRM functions but do not pass data on to content owners.
Source: Telco 2.0 Initiative

At our first Telco-Hollywood Executive brainstorm the value of these telco assets and other capabilities were discussed and rated. All were recognised as offering possible value to studios in the development of their own services. As the graph below shows, it was the functions nearest to the consumer that rated the highest.

Table 8: Telco Capabilities Rated (1-5*) According to Their Perceived Value to Content Owners

*Where 1 is not valuable at all and 5 the most valuable
Source: 1st Hollywood-Telco Executive Brainstorm, Santa Monica

Again, the value of owning the network infrastructure is recognised as hosting content locally and ensuring its effective delivery are natural roles for telcos to take on. Usage and access distribution is the next highest rated capability and the expectation from studios and media companies is that telcos should enter the market as media service providers in some form or another and the downstream market should not be ignored. That said, those assets that are a stage further removed from consumers were also rated as valuable.

Identification and authentication, payments, decision support and data mining (listed under the heading of Interactive Marketing /CRM in table 7) and content protection are all rated as useful. However, there is a caveat here in that what media companies want is complete solutions not raw data or APIs that they then have to build services around.

Over the next 12 months, telcos need to develop complete solutions that can meet the needs of media companies. Simply saying that they have the assets and capabilities is not enough. Also the speed with which the market is changing means that solutions need to be developed fast as the window of opportunity for media companies to gain a more powerful position in the ecosystem will be relatively short. New and powerful players are entering the market and putting pressure of established price paradigms. Once changed these are difficult if not impossible to change back until serious failures in the market appear. The next 1-2 years are therefore vital.

From a telco point of view, this makes playing upstream difficult if they have not already begun to develop solutions that could be packaged for media companies. Downstream opportunities are in some ways less time sensitive but the current market flux offers up opportunities to establish a position that will be harder to reach when it is more stable.

Strategic choices

Telcos therefore have a series of strategic decisions to make about how and where they play in the entertainment market. We have developed a structure of generic strategy choices based on the willingness and ability of telcos to move on and off their own network and whether they intend to offer and end-to-end solution to consumers or play a specific and limited role in the ecosystem. The overall strategies these choices create are illustrated in figure 3 below.

Figure 3: Generic Two-Sided Business Model Strategies

Source: Telco 2.0 Initiative

Taking this a stage further, we can map this general theory onto the specific choices facing telcos in the entertainment market to create a framework with four different approaches to telco involvement in the entertainment ecosystem. As the market is developing, on-net activities are providing the greatest opportunities, as illustrated in figure 4 below.

Figure 4: Entertainment-specific Business Model Strategy Choices

Source: Telco 2.0 Initiative

Entertainment is an increasingly complicated market with collapsing value chains, new entrants and new technologies that are allowing established players to compete in different ways. Having a clear idea of where telcos fit into this dynamic market structure is important and there are roles for telcos to both support media companies in their attempts to go directly to consumers and to go directly to consumers themselves. A second phase, supporting multiple third party platforms and media service providers may emerge but this is a stage further removed as these are currently competing with what telcos and media companies are trying to do themselves.

Taking a look at the bottom left quadrant – enabling media companies to develop a direct sales channel – in more detail, it is possible to identify a range of way in which to do this. There are firstly a range of activities and assets that can be undertaken, as we have already outlined above, and secondly there is a range of ways in which to utilise those assets.

Using Telco 2.0’s established gold analogy, we can see that telcos have the opportunity to be more or less involved; to offer what they have in raw data to media companies and let them do as they wish with it at one end of the scale, right through to offering a complete end-2-end service.
Examples of what type of entertainment-orientated services can be offered at each stage by telcos are illustrated below.

Figure 5: Possible Telco Roles in Entertainment Industry

Telco 2.0 research suggests media companies put greatest value on telco assets that are packaged to them as services. As illustrated above, this means a managed one click payment capability, not an API on top of which they have to build their own payment service. What is more, they want things that have been proven to work, either for other industries or for the telcos itself. Eating your own dog food is not just a sound bite to be trotted out at conferences, it’s an essential tactic if telcos are going to gain credibility as upstream suppliers to the entertainment industry.

Fortunately this is something the telecoms industry is recognising, as a vote at the recent Telco 2 Executive Brainstorm in London where delegates demonstrated that to take full advantage of the customer data they have, they must first find ways to use it effectively themselves. During the session focused on the use and monetisation of customer data, the 180-strong group of executives were asked to rank 1 to 4, the importance of different strategies for beginning to use the customer data they hold in the short terms (next 12 months), using it for their own purposes ranked the highest.

Telco’s two-sided business model for entertainment

There is little doubt that telcos have a strong strategic interest in the entertainment industry both for its opportunity to grow and its impact on their existing businesses. However, they are entering a market that is itself in flux and the opportunities are neither well defined nor static. The market is constantly changing and so are the possible roles and activities open to telcos. Under such circumstances a two-sided approach to the business makes even more sense, giving more choice and opportunity to build revenue as illustrated below.

Figure 6: Telco two-sided business model for entertainment

Source: Telco 2.0 Initiative

However, the extent to which a specific telco gets involved in the up and downstream opportunities will depend on the specific market conditions, together with the skills and assets of the telco. These must also be mapped onto the needs of media companies as telcos must be aware of what the market is looking for.

Over the coming months we will look at each of the downstream models in detail, examining the conditions that make each play viable, together with the tactics that make each downstream strategy effective.

In addition to these we will develop use cases and identify case studies that help define realistic opportunities for upstream services.

Conclusions

The transmission of entertainment online represents a significant growth market for at least the next decade. The addressable market is in the region of $700bn a year and growing, although it will take more than a decade if it ever happens to turn all entertainment into digital/online forms
Content owners are being challenged by the changing patterns of distribution, retail and viewing and are looking to secure their place in new value chains that at least protect, if not increase their existing revenue streams
Although the risks to content owners vary across genres, a major set of opportunities centre on the ability of content owners to go directly to consumers which requires a skill set outside of the core competencies of media companies. Telcos have many, if not all of these capabilities
A second set of opportunities exist for media companies to work together to build ecosystems with their content at its heart that compete favourably with the offerings of new internet players. UltraViolet is an example of this which could compete with Apple iTunes. These approaches create new and better downstream opportunities for telco as they lower the barriers to telcos to enter the entertainment delivery business and allow them to build the business incrementally
Complete end-2-end services in the form of IPTV require significant scale and huge investment. The success of these will be dependent on achieving these and they are heavily impacted by the maturity of competing solutions such as cable and DSAT. Therefore, while prospects look good in for telcos with large market shares that operate markets with weak pay TV markets, the majority of telcos will find differentiation through IPTV difficult and its deployment is therefore best seen as a defensive tactic against telephony and broadband service provision by TV service providers
Other downstream plays are possible for telcos including:
- Maximising the mobile opportunity by using it to enhance experiences on other screens and not just as another delivery channel. Telcos and content owners need to collaborate to develop value-added services that consumers will pay for
- Operating as effective storefronts for entertainment content. Telcos have the customer scale, billing, customer information and CRM capabilities that make them ideal retailers but to be effective, telcos must offer content owners more than existing online retailers, such as Apple and Amazon. Of particular importance here is a willingness and ability of telcos to pass back to content owners on data about customer activity
- The storefront proposition is strengthened further by developments such as UltraViolet which would enable telcos to build propositions while taking out the risk for both content owners and telcos
Telcos have a range of core assets that could enhance the ability of content owners to move up the value chain and go directly to consumers and therefore gain a greater share of the entertainment revenue pie
No other player has the range of enabling capabilities telcos have. However, the Telco USP is in combining these enablers and telcos must look at packaging them together as plug and play services for content owners. These need to apply across content categories (and possibly extend to other vertical markets) so that telcos can turn a niche vertical service into a broader and more valuable opportunity
There is a finite window of opportunity for content owners and telcos to establish places in the new content ecosystems that are developing before major Internet players – Apple, Google – and new players use their skills and market positions to dominate those ecosystems. Speedy collaborative action between telcos and studios is required

Introduction

Music bounces back

Figure 1: The global music industry has returned to growth

Analysis: What Gets Measured Gets Money

Mobile is a ‘break out’ entertainment media

Segmentation – there’s no single dominant business model

‘Discovery’: finding a model that proves it works

Delivering the goods

Getting money commensurate with the time spent on mobile

Next Steps

Background & Further Information

Introduction

Summary Analysis: ‘The Great Compression’

Figure 1 – Digital disruption

The Digital Hunger Gap

Figure 2 – The Music Industry’s ‘Hunger Gap’

Figure 3 – Participants’ views on forecasts for the telecoms industry

Figure 4 – ‘Mindset’ is the biggest barrier to transformation

Content:

Executive Summary (Extract)

The strategic challenge

Report contents

Introduction

The new world order

Investor trust

Impact of disruptors on telcos

How telcos are fighting back

Big bundles

The Rich Communications Suite (RCS)

Competing head-on

The Wholesale Applications Community (WAC)

Summarising current telcos’ response to disruptors

Introduction

Amazon’s Current Performance

Amazon’s Media Sales

Counting the Cost of Physical Distribution

The Attraction of Online Distribution

The success of the Kindle: more eBooks than Paperbacks

Amazon and Music: Downloads not moving the needle

The move into Movie streaming

Amazon shaking up the AppStore market

Executive Summary

Sizing the opportunity

Telcos: Let us entertain you

Downstream opportunity and challenges

IPTV realities

Digital Lockers: an alternative downstream option

Telcos’ missed opportunity

Content’s business model crunch

Games search for better business model

Blurring boundaries

Disrupting and rebuilding the value chain

Content Creation

Distribution and Retail

New roles – device vendors sell content

New players – TV changing times

Apple goes it alone

Flash fire

Differentiation options

Interaction with Internet applications

Impact on advertising

Scheduling, search and discovery

Extension to the mobile screen

Telco and Media Collaboration

Where to Start

QoS, QoE and throttling back

Strategic choices

Telco’s two-sided business model for entertainment

Conclusions

Sample Reports