Sunday, December 14, 2008

Thoughts on the Supply Chain for Recorded Music

I have extensively edited this entry in an effort to make it more clear. I hope that helps. I have also updated the Music sales graph to include all years through 2008 - wrs

“A business (also called a firm or an enterprise) is a legally recognized organization designed to provide goods and/or services to consumers, governments or other businesses. A business needs a market. A consumer is an essential part of a business. Businesses are predominant in capitalist economies, most being privately owned and formed to earn profit to increase the wealth of owners. The owners and operators of a business have as one of their main objectives the receipt or generation of a financial return in exchange for work and acceptance of risk.” – Wikipedia

The music recording industry involves a number of discrete businesses. These businesses link together in a sophisticated way to create a “supply chain”. Historically, the collaborative effort of these businesses created a viable economic ecosystem and an acceptable financial return for all participants.

The recording industry supply chain starts with the composers and performers. They create and perform the music.

Next step in the supply chain is the labels. They finance, record, manufacture, promote and market the music.

The next step is the distributors. They take CDs in bulk from the labels, warehouse them and ship them, on demand, to retailers or directly to the consumers.

The last step is the retailers. They put the CD on the (physical or virtual) shelf and sell it directly to the consumer. They collect the money.

Each player in the supply chain brings unique capabilities that combine to make the supply chain work. The money paid by the consumer flows back through the supply chain (in a pretty convoluted manner) to provide the financial return needed by each member of the supply chain to make the system economically viable. (There is another “supply chain” through the broadcast industry to the consumer but I will ignore that for now as it represents a pretty small percentage of the total revenue generated.)

Technology and the Internet have spawned three separate phenomena which have undermined the financial viability of the traditional supply chain. These are:

· Internet retailers
· Direct digital distribution, and
· Theft

What impact have these phenomena had on the supply chain?

Retailers

The first casualties of this disruption were the physical retailers. All three of these developments have had the effect of reducing the number of CDs purchased at physical retail and undermining their financial viability. Thousands of CD stores are gone and the few that remain are under tremendous financial pressure. It is estimated that there are fewer than 200 physical retail outlets left in the US with a significant classical music inventory. With Borders on the brink of bankruptcy, this trend will only continue to its logical conclusion.

The on-line retailers had an initial boom based on their much lower cost structure and the breadth of virtual inventory that they can provide (they don’t have to invest in this inventory or the space to house it). The death of the physical retail channel drove many consumers to on-line sources. This was particularly true in the classical domain where ArkivMusic.com focused exclusively. Arkiv managed to grow for several years in a market where the primary demand was shrinking because their share of market was growing faster than the market was shrinking. However you can’t grow forever in a shrinking market. The latest year with complete statistics is 2007. According to the New York Times:

“A total of 500.5 million albums in the form of CDs, cassettes, LPs and other formats were purchased last year, down 15 percent from the unit total for 2006, said Nielsen SoundScan, which tracks point-of-purchase sales.”

This marks the 7th straight year of double digit declines from the peak year of 2000. See the graph below:


Vinyl peaked in the 1980s, cassettes around 1990 and CDs in 2000. You can project the CD curve yourself past 2005.

Distributors

There are three distributors in the US who account for over 80% of the CD volume. These are Alliance, Baker and Taylor and Ingram. All three are struggling. Their customers are the retailers. The physical retailers are all but gone. The on-line retailers rely on the distributors to warehouse the CDs and to pick, pack and ship them to the consumers. This keeps the cost down to the retailer but passes that cost on to the distributor. As the business shrinks the cost of maintaining a huge inventory becomes unsustainable. Distributors are eliminating the low runners – the CDs will small or negligible volume. As you can imagine, the classical CD inventory is shrinking rapidly. This industry will continue to shrink and consolidate. It is likely that a niche player like Naxos will emerge and do for the distribution link in the chain what Arkiv did for the retail link. This will extend the life of the chain for a while.

Labels

In the classical recording industry the major labels are Sony, Universal and EMI. Warner was a 4th major but they exited the classical business 2 years ago. No one has to further describe the plight of the labels. Their troubles are regular news items for those of us in the industry. EMI Classics has 2 employees left in the US and they will be the next to go. Classical CDs account for about 3% of the CD sales and it is only a matter of time before Universal and Sony downsize again and eliminate the classical business. Naxos has a business model which is much lower cost and therefore they are better adapted to a lower volume market. As mentioned above they are well positioned to be the consolidator of the classical recording business and benefit from the demise of the higher cost competition. Their business model is controversial among the performers however because, in general, Naxos does not pay for the recording and they never pay residuals. This is a major factor in keeping their costs down but it does not pass the financial return benefit back to the performers.

There are a large number of boutique labels which do a very small business. They will continue on with business models similar to Naxos. Artists will be able to make CDs if they can find sponsors or some other way to finance the recording and production of the CDs. The major outlet for these CDs will be signing events at concerts. This will continue to be an important promotional activity but with the decline of the rest of the supply chain it is unlikely that these CDs will end up providing meaningful income to the artists.

No industry can exist without a healthy supply chain. The CD recording industry supply chain is VERY unhealthy and getting worse by the day. No one in the supply chain can make an adequate financial return. Without a supply chain – or at least without the current supply chain - what happens to the recording industry?

Digital downloads save the industry?

Some people put their faith in legal, purchased, digital downloads. Apple totally dominates the legal download business. From an article in the New York Times, November 9, 2006:

“A recent study estimated that Apple has sold an average of 20 songs per iPod — a fraction of its capacity. The rest of consumers’ music files — 95 percent or more — come from ripped CDs, possibly including discs from their own collections, and illegal file-trading networks, the study said.”

Theft is the major source of music on the IPod. Check this URL for another data point for your consideration - “Average teen stores 842 stolen tracks on their IPod.”

http://www.gizmodo.com.au/2008/06/_average_teen_stores_842_stolen_tracks_on_their_ipod_-2.html

If you think Apple is in the business of selling music you are seriously deluded. Apple is in the business of selling IPods. Selling music is a necessary sideshow for Apple and, with 75% + of the market they barely break even. I personally spent 2 years as an investor in and manager of a major legal download business. I can tell you from painful personal experience that there is no long term opportunity in competing with Apple and selling digital downloads. The margins are razor thin and the market is shrinking. It is true that classical buyers are less likely to steal than teenagers but, unfortunately they are also older, less technology savvy and much less likely to be active users of the Internet and Internet commerce. According to the Soundscan data presented at 2008 NARM, classical CDs accounted for 3% of CD sales in 2007 but classical downloads accounted for only 2% of downloads. The supply chain for digital downloads is no healthier that the supply chain for CD sales.

The definition of “business” observed that the ultimate objective of a business is to earn a financial return. A supply chain is only as strong as its weakest link. For a supply chain to operate successfully all participants must make an adequate financial return. We define the recorded music supply chain as a system where recorded music is created by performers and composers, paid for by consumers and there is adequate financial return to create and maintain a healthy supply chain. There is no prospect of this supply chain enduring through the next decade.

There is a lesson to be learned from Apple however. They are using the ITunes store as a promotional tool to sell IPods. The power of music as a promotional tool is enormous. The best way for artists, performers and composers to leverage the recording of music in the internet age is to use it to promote their performance-based income opportunities. In this application recorded music has enormous potential if it can be created and distributed at low enough costs to justify its promotional value. Recorded music has a great future but the business model will be radically different. Future postings will explore this further and, with luck, the discussion generated will be useful to the community.

2 comments:

George Flanagin said...

Note: I am more literate than typing in a tiny window would suggest.

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I don't really follow your argument. You quote the NYTimes article as evidence of a crippling level of piracy (I guess) when you mention the statement:

"A recent study estimated that Apple has sold an average of 20 songs per iPod — a fraction of its capacity. The rest of consumers’ music files — 95 percent or more — come from ripped CDs, possibly including discs from their own collections, and illegal file-trading networks, the study said."

I checked my iPod as far as ratios of music that came from iTunes versus other sources, and 5% from iTunes is about right. Ripping my own CDs is not illegal, and the mere existence of the iPod has encouraged me to buy more music now that I can listen to it more easily and portably.

The next point reminds me of universities who tout the quality of their educational product based on the SAT scores of incoming freshmen who have yet to take a class:

"Check this URL for another data point for your consideration - 'Average teen stores 842 stolen tracks on their IPod.'"

Based on my own teenage years, I don't think teenagers are big threat to legit music.

You go on to argue, "If you think Apple is in the business of selling music you are seriously deluded. Apple is in the business of selling IPods."

Well, yes, in marketing we call that the razor and blades argument. Very often your product is one thing, and you use another as a vehicle to sell it.

Finally, this post and your one from 9 December ignore the consumer behaviour factor. People like to shop, and the shopping itself is entertainment. I think that finding a track or a disc of music that a friend can offer you for free is a different experience from browsing the "store" at iTunes, or ordering CDs from Amazon.

I agree with your conclusions that the road ahead is difficult, but the history of media would lead us to believe that new marketing channels reshape the marketplace without eliminating the pre-existing channels. Think of TV and Radio; TV did not dispel radio. Internet and radio; successful radio stations have begun to offer podcasts and streaming.

Kind Regards,

robb said...

Bill,

I agree that the current model is crumbling, but I think that there are options. I think that it is possible that significant revenue streams are possible at lower price points. A performer gets something on the order of a dollar from the sale of a CD with the rest going to the supply chain.

With non-physical distribution, lower sales prices are practical. For example, if you got $.05 but had 20x sales, you would be equally well off.

I think that so far, this kind of economics is operating in the Iphone app store. instead of apps that cost $40 and sell in the hundreds or thousands we have apps in the $1 or $2 range selling millions.

No one is going to bother to steal or share if the song cost is a few cents and you make it easy to access. Now of course, the infrastructure for this doesn't exist. Perhaps Apple prevented it from coming into being.