Thursday, July 31, 2008

Cannibalization is hard

Cannibalization is hard. Really, really hard. But it’s often the only way to survive.

When a new technology comes along, the biggest problem for incumbents is being willing to cannibalize their existing businesses. We’ve known this for decades, and it was reinforced as a major theme of Clay Christensen’s 1997 bestseller. This unwillingness to cannibalize seems to account for the paralysis and the CFIT for a wide range of information goods.

In particular, I’ve been watching it happen in three industries within the US media sector. One that I recently blogged about is the newspaper industry, my former employer. The second I wrote a teaching case for my MBA tech strategy class back in 2001 — about how the record industry botched the MP3 challenge. The movie industry faces the exact same problems as records, but their files are bigger so pirating content has been less technically feasible (so far).

This dilemma was the topic of the first session today at a workshop I’m attending at USC’s Institute for Communication Technology Management. It was a killer media panel, of the sort you could only find in LA (or maybe NYC).

Leading off the panel was USC vice provost Adam Clayton Powell III (son of the famous Powell) who like me is interested in the newspaper industry. Also on the panel was Chris Gwiazda, CFO of Generate and Gerry Tellis, a USC marketing professor who’s studied disruptive innovation for more than a decade.

But the issue of why Hollywood (the movie industry) seems in denial about the digital world was the central focus of the final speaker of the panel: Steve Weinstein, founding CEO of Motion Picture Laboratories, Inc. (“MovieLabs”). MovieLabs is a 501(c)(6) cooperative R&D arm of the big six studios — Disney, Fox, Paramount, Sony, Universal, Warner Brothers — set up to come up with a quick tech fix to deal with piracy.

Weinstein made it clear: Hollywood has done such a good job of optimizing their revenue model that that it makes change nearly impossible. It uses a standard time schedule for release (versioning in the Hal Varian sense):

  • In first 3 months, theatrical release earns 25% of total revenues but almost no contribution margin
  • Hospitality (e.g. airlines), negligible revenues
  • DVD, 6 months after initial release with 50% of the revenue and 60% of the contribution margin
  • Pay TV such as HBO and Showtime a year after initial release, with 10% of revenue
  • Commercial TV with 10% of the revenue, but two years after HBO.
(Don’t quote me on the numbers, I was typing very fast).

Weinstein identified three generic problems that the industry faces. To avoid putting words in his mouth, I’ll mark my own comments in italics.

First, although they have the highest growth potential, the new revenue sources are small — perhaps hundreds of millions of dollars a year. DVD sales, while declining, are $16 billion/year and provide the bulk of the profits and thus the bulk of the clout within a studio. With this relative share of short-term revenues and profits, “another year of selling 2 billion DVDs would not be so bad. Maybe it will be 1.9 billion,” as they watch this largest revenue source gradually decline.

Of course, this is straight out of Christensen’s Innovator’s Dilemma — sales execs and CEOs banking their commission checks up until the plane hits the side of the mountain.

The second issue is that all the contractual commitments restrict what movie moguls can do. If HBO has been promised no ad-supported distribution for two years, then you can’t give the movie to YouTube at any price during that period. Similarly, the union contracts — which include revenue sharing agreements — are extremely difficult to change (as the last few years of negotiations have demonstrated).

Finally, the uncertainty about the digital future — particularly with the unions and other conflicting stakeholders — has produced an institutional paralysis. To use Weinstein’s example: “How much are the rights to a theme song on YouTube going to worth? No one knows.” Without a precedent — or a fair way to price one — no one is going to be reasonable in trying to negotiate a deal or pricing.

As Prof. Tellis noted in the talk (for his earlier research), not only is cannibalization hard, but it’s necessary: cannibalization determines which firms will be able to survive a radical shift into the new era.

If any of the big six will survive, I’d have to put money on either Disney or Fox (NewsCorp.). Their respective CEOs — Bob Iger and Rupert Murdoch — were both mentioned today as understanding this brave new world better than the rest of the industry. I think Disney has more of a margin of error (i.e. time to fix things) than the other studios, given their unique positioning (particularly now with Pixar). Fox seems to be the most aggressive in moving into new media (NB: MySpace). So watch for one of these two to come up with a better revenue model for online media.

Nothing I heard today made me think that anything significant will change in the next two or three years. But if nothing changes in the next 10 years, they’ll all be sold off for a fraction of their current value to new owners who will find a better way to realize value from these assets.

1 comment:

Anonymous said...

Dr. West:

Just wanted to let you know that I loved your article "Cannibalization is Hard." You nailed everything vis a vis this issue. In particular, you brought up something that I've been arguing about for years: Talent controls way too much of the cash-flow and distribution decisions via restrictive contracts. If so-called "sweetheart deals" are inhibited, then true synergy cannot fluorish, thus limiting the maximization of shareholder value for media concerns.

Considering that there are a plethora of statistical studies indicating that a celebrity's star quotient is not necessarily proportional to the return-on-capital generated by a celluloid asset, and that developing a hit piece of content is merely a random walk, it behooves media conglomerates to end profilgate deals with talent and seek out lesser-known names who have an equal chance at coming up with the next "Blair Witch Project."