Saturday, July 30, 2011

Hollywood's inability to have its cake and eat it too

Now that it’s been successful (at least by Web 2.0 standards), the studio owners of Hulu have put it on the block. Various companies have expressed interest, led by Apple.

The problem is that after years of running an oligopoly in which they dictated terms, the Hollywood studios are hoping they will be able to have their cake and eat it too. As their record label siblings and cousins have already learned, it’s not possible in this brave new digital world.

As USA Today points out, the studios want to extract more onerous terms from Hulu to make more money off of online distribution. Examples include putting new TV episodes under a paywall, or delaying their free availability.

However, by doing so they may kill the market value for the Hulu joint venture they have been trying to spin off. Who wants to buy a distribution service whose business model only works because the studios have been pulling their punches — when they have made clear that they plan to start punching hard real soon now?

As the LA Times noted earlier this year, Hulu has been much more successful than anticipated — great for Hulu, but bad for the network parent:

In a short time, Hulu has exploded into one of the top Internet video destinations, defying skeptics who predicted that a service backed by such an unwieldy joint venture would never work. It now attracts some 27 million users every month, according to ComScore Video Metrix.

As a result, Hulu's media owners — the corporate parents of ABC, Fox and NBC — are tussling with the site's entrepreneurial managers over opposing visions for the venture. The companies originally crafted the service as a way to control online distribution of their content. But by offering popular shows such as "Glee" and "Modern Family" online at no charge, the media companies fear they may be encouraging consumers to drop cable and satellite TV services, one of their chief sources of revenue.
In other words, the network-studios created to Hulu to profit from the brave new world, but had no intention of speeding the transition.

The LAT points out (as others do occasionally) that the rapid growth of Hulu’s revenues is still a drop in the bucket compared to the revenues of the traditional TV network business model — more than 50:1. (The Hulu platform could equally be used for 2 hour movies rather than 22 minute TV shows, but that hasn’t been a priority of the network-owners.)

The problem with this thinking is that the original vision of Hulu was spot on: the new world is coming, whether the studios do anything or not. So if they don’t want to be a leader in the transition and proactively shape where it’s going, they can be a follower and be whipsawed as they react to the implosion of their long-cherished business models. (NB: Record labels in the 1990s).

Perhaps the behavior of the network executives is selfishly rational — like that of a Eastern European or third world despot. The dictators know they’re going to (at best) flee into exile or (at worst) join Cesusescu in hell — so the longer they hold onto the power, the longer they postpone the day of reckoning. Similarly, a TV exec in his 60s or even early 50s might hope to collect bonuses for a few more years while kicking the can far enough so it blows up on someone else’s watch.

Still, the slow-motion collapse of the broadcast-cable monopoly over pricing and distribution is utterly predictable and inevitable. So if the studios are rejecting a viable Hulu as their future distribution strategy, what’s Plan B (or Plan C or D)?

Friday, July 22, 2011

Fixing the economy: we need long-term solutions

Excerpt from a Business Week interview with Arminio Fraga, who helped turn around Brazil’s economy as president of the Central Bank from 1999-2002 [emphasis added]:

What do you think America needs?
The U.S. is clearly the most amazing economic machine ever put together. It’s an amazing model. And it may have, as a result, gotten complacent. The U.S. needs to blend the sort of firefighting that’s been taking place—you know, zero interest rates, very expansionary fiscal policy—with longer-term policies, longer-term reforms … including this budgetary situation that cannot go on like this forever. And then, more structural things: job creation, business confidence, education, infrastructure, all of that. So there’s a big agenda. I just feel, having spent my life looking at countries that went into a crisis situation and emerged in pretty good shape, in every single case there was this mix of short-term emergency measures and long-term building-the-future-type moves.

But politicians have always been reluctant to inflict pain.
[In the U.S.] It’s been a tough decade on the jobs front. There’s been very little growth if you exclude transfers from the government. There’s no way you can live without the business cycle. This notion that you only keep the upswing—you get rid of the downswing—is an illusion. And you end up paying a price.

Does it come down to regulation?
There is this excitement now because many people believe that markets were a complete failure. And they forget that markets operate in an environment where there is regulation. There are laws, there are rules. And one could argue in a pretty powerful fashion that sure, markets are far from perfect, but a lot of the regulatory aspects were pretty bad as well. Now I see the pendulum swinging, let’s call it to the left. If you have a system where the rules are such that the losers don’t pay, that’s a bad thing, and not just for economic reasons. I can argue all night long that that’s inefficient. I also think it’s terribly unfair. And I think society doesn’t put up with that for very long.

Friday, July 15, 2011

Netflix: a proven come-from-ahead strategy

Now that it seemingly has the DVD-by-mail and download markets locked up, Netflix has decided to gouge its customers for every penny that they’re worth. When the news hit, I tweeted

Joel West
Aren't monopolies grand? Netflix jacks up prices. Suggests they no longer worry about competitors.
12 Jul via Tweetie for Mac
A lot has been written about this decision. For example, the Merc wrote Thursday:
After the Los Gatos-based DVD and streaming video company announced Tuesday that it was raising rates as much as 60 percent, tens of thousands of disgruntled subscribers flooded social networking sites with complaints and threats.

"Sorry Netflix, but you're losing another customer of many years," read one of the more civil posts.

Because of a growing chorus of sentiments like that, the price hike is beginning to look like the company's first major misstep -- and one that could damage its business as consumers consider alternatives.
Indeed, the official Netflix blog entry announcing the decision attracted a flurry of comments — until the 5000 comment limit was reached.

While the AP speculated that the price increase was to get consumers to drop physical DVDs and go with streaming-only plans, this seems at best a contributing factor, for two reasons.

First — as the Netflix customers complained — everything is available on DVD but Netflix offers a much smaller range of content via streaming. Thus, a streaming-only account gets a much smaller library and the streaming — while convenient — is not yet a complete substitute.

Secondly, while Netflix has the DVD model wired, the streaming model has less barriers to entry and imitation. There are scale economies for digital download but not the network effects of physical DVDs. Netflix also has two established competitors — Amazon and Apple — who may not have the market share for movie downloads but certainly have the technology. By dropping a bundling discount for the combined DVD-download business, Netflix is shifting its download business into more direct (and less differentiated) competition with A&A.

Since Netflix has not backed down, I must conclude there’s something more than sheer greed at stake. One possibility is that Netflix is passing along a price increase from its main suppliers — Hollywood — who are facing declining DVD sales after relying on these for year to support the bottom line. Mike Masnick of Techdirt also wondered along these lines.

Still, it makes me glad I haven’t signed up with Netflix. With my relocation to a new city and a new job, I was about ready to sign up for a streaming-only service. Now I’m going to sit back and see what competitors emerge and how they try to exploit the opportunity that Netflix has handed them.

Thursday, July 14, 2011

How not to do strategy

In the recent McKinsey Quarterly, Prof. Dick Rumelt of UCLA writes about how often he finds companies who confuse bad strategy with effective strategy.

One type of bad strategy is a stretch goal that cannot be achieved — as with this vivid example:
The reference to “pushing until we get there” triggered in my mind an association with the great pushes of 1915–17 during World War I, which led to the deaths of a generation of European youths.
Over the years, Rumelt has identified four hallmarks of bad strategy:
  1. failing to face the problem
  2. mistaking goals for strategy: i.e. you have hopes (for change) but no plan that will get you there
  3. bad strategic objectives
  4. fluff, i.e. “A final hallmark of mediocrity and bad strategy is superficial abstraction—a flurry of fluff—designed to mask the absence of thought. Fluff is a restatement of the obvious, combined with a generous sprinkling of buzzwords that masquerade as expertise.”
(Looking at this list, this applies to any form of leadership — business, nonprofit, military and especially political.)

One source of such bad strategy is, in Rumelt’s words, the “template-style system of strategic planning”:
The template looks like this:

The Vision. Fill in your vision of what the school/business/nation will be like in the future. Currently popular visions are to be the best or the leading or the best known.

The Mission. Fill in a high-sounding, politically correct statement of the purpose of the school/business/nation. Innovation, human progress, and sustainable solutions are popular elements of a mission statement.

The Values. Fill in a statement that describes the company’s values. Make sure they are noncontroversial. Key words include “integrity,” “respect,” and “excellence.”

The Strategies. Fill in some aspirations/goals but call them strategies. For example, “to invest in a portfolio of performance businesses that create value for our shareholders and growth for our customers.”

This template-style planning has been enthusiastically adopted by corporations, school boards, university presidents, and government agencies. Scan through such documents and you will find pious statements of the obvious presented as if they were decisive insights. The enormous problem all this creates is that someone who actually wishes to conceive and implement an effective strategy is surrounded by empty rhetoric and bad examples.
For almost a decade, I’ve been trying to stamp out the template thinking in my students, because — like the companies they emulate — they regurgitate standard platitudes rather than think about what makes their company unique. I used to go to the Dilbert mission statement generator to make my point, but with it gone there are now several generators on the web that do the trick.

Another point I make with my students is that if the mission and values are to have meaning, then every employee (or at least every full-time employee) should be able to recite them from memory. A mission statement that covers everything means nothing.

Of course, this is easier said that done. At least twice I’ve been involved in exercises (with my own employer) that uses the template approach but have been unable to stop the drift — nay, stampede — toward platitudinous thinking. Perhaps with Dick Rumelt under my arm, next time I’ll have more luck.

Monday, July 11, 2011

When fiction becomes reality

From a column by Stephen Moore of the Wall Street Journal, Saturday July 9:

Many of us who know Rand's work have noticed that with each passing week, and with each successive bailout plan and economic-stimulus scheme out of Washington, our current politicians are committing the very acts of economic lunacy that Atlas Shrugged parodied in 1957, when this 1,000-page novel was first published and became an instant hit.

Rand, who had come to America from Soviet Russia with striking insights into totalitarianism and the destructiveness of socialism, was already a celebrity. …

For the uninitiated, the moral of the story is simply this: Politicians invariably respond to crises -- that in most cases they themselves created -- by spawning new government programs, laws and regulations. These, in turn, generate more havoc and poverty, which inspires the politicians to create more programs . . . and the downward spiral repeats itself until the productive sectors of the economy collapse under the collective weight of taxes and other burdens imposed in the name of fairness, equality and do-goodism.

In the book, these relentless wealth redistributionists and their programs are disparaged as "the looters and their laws." Every new act of government futility and stupidity carries with it a benevolent-sounding title. These include the "Anti-Greed Act" to redistribute income (sounds like Charlie Rangel's promises soak-the-rich tax bill) and the "Equalization of Opportunity Act" to prevent people from starting more than one business (to give other people a chance). …

These acts and edicts sound farcical, yes, but no more so than the actual events in Washington, circa 2008. …

The current economic strategy is right out of Atlas Shrugged: The more incompetent you are in business, the more handouts the politicians will bestow on you. That's the justification for the $2 trillion of subsidies doled out already to keep afloat distressed insurance companies, banks, Wall Street investment houses, and auto companies -- while standing next in line for their share of the booty are real-estate developers, the steel industry, chemical companies, airlines, ethanol producers, construction firms and even catfish farmers.
The take home message?
Ultimately, Atlas Shrugged is a celebration of the entrepreneur, the risk taker and the cultivator of wealth through human intellect. Critics dismissed the novel as simple-minded, and even some of Rand's political admirers complained that she lacked compassion. Yet one pertinent warning resounds throughout the book: When profits and wealth and creativity are denigrated in society, they start to disappear -- leaving everyone the poorer.

Friday, July 8, 2011

Integrity means don't hide behind your lawyers

The private equity investors who flipped Skype (from eBay to Microsoft) have decided to screw some of their employees out of their “vested” stock options.

The issue came up when one Skype employee, Yee Lee, found he forfeited his stock appreciation rights when he left Skype before the acquisition. He summarized his problem on a blog post last month.

Corporate lawyer-turned-law-school-professor (and New York Times pundit) Steven Davidoff summarized the controversy in two postings at NYT DealBook. (Not yet behind the paywall).

In the first article, he noted that PE firm (Silver Lake) could have settled the controversy for less than a million bucks. He attributed the decision to a culture clash between NY financiers and SV venture capitalists. The former is not about reputation or honor, but money.

But in Silicon Valley, the community is not only smaller, the people work together again and again, and so trust and reputation are valued more highly. On his LinkedIn page, Mr. Lee alone lists more than 10 companies where he has worked. When you are going to see and work with the same people repeatedly over many years, $1 million is small change to buy their needed loyalty.
Davidoff argues that while VC has a better reputation, both sides add value equally. Of course, he is a former NY lawyer who advised big companies on their acquisitions.

But the reality is that while VCs do is equally greedy and lucrative, what they do is more rare and economically valuable. Restructuring can be (and has been) done by PE firms, managers who lead a MBO, more traditional corporate acquirers, or even in-house executives with the proper incentives. Best practice in operational efficiency disseminates pretty quickly, so very little about the PE business model (or their value add) is protectable over time.

In a second article, Davidoff concludes that employees are just as likely to be screwed by carefully hidden legal mumbo-jumbo by Google or a raft of other recent startups. (What we don’t know is how each company verbally represented this clause — did they call attention to it or did they bury).

Davidoff’s solution to both cases is that the employee should see a lawyer. (In other words, his philosophy is to create a full employment act for his peers and his students).
In a narrow legalistic sense he's right — that is if Lee were lucky enough to find a lawyer with the right kind of experience. As an entrepreneur, I lost $50,000+ on a business deal that was vetted by my lawyer; my lawyer (of many years) didn’t understand my business well enough to anticipate the scenario that played out, I didn’t volunteer it and he didn’t ask.

However, more seriously, this sort of “ask a lawyer before doing anything” causes an unaffordable drag for startups and their employees. Yes,it might only be $500 for the one consultation that spotted the problem, but it’s also $500 for all those other times where it wasn’t necessary but you paid the lawyer just in case.

There is a non-lawyer solution: we acknowledge that there are fundamentally two types of options: those that actually vest, and those that are only exercisable by current employees.

If the ideas of the incentive stock option is to incentivize employee, then the terms and conditions should be clearly articulated in plain English. If necessary, the state or federal government should require employers to spell it out. (Banning misleading practices is the one place where I believe in aggressive government action.)

I once heard ethicist Michael Josephson say on his radio segment: "Integrity means doing the right thing when nobody’s looking.” (The original author is lost, but similar remarks have been made by quarterback-minister J.C. Watts).

In Davidoff’s world, employers and employees are adversaries using lawyers to duke it out even before conflict arises. In a company with integrity — the only sort I’d put my name to — the terms and restrictions for employee compensation are clearly explained in a way that every employee can understand. As an added benefit, doing the right thing makes sure that the employees and employer have their goals fully aligned (at least until after the end of the lockup period).

Wednesday, July 6, 2011

Network effects and self-perpetuating incumbents

As part of my travels to and from the latest user innovation conference, I’ve been traveling through a lot of airports.

Airport hubs are an example of both network effects and more general IO economics (i.e. Michael Porter) barriers to entry and supplier power. With enough market power — such as by reducing rivalry through mergers — large airlines can offer mediocre service at a high price and people will be stuck paying it. (Or, they won’t fly.)

This is particularly true since airlines have accepted commoditization of their service, with few offering differentiation. (Frequent flyer plans were once intended to offer differentiation, but once everyone copied them, all they do is create switching costs which discourage price shopping by business customers.)

Flying through European capitals this week, I realized how my view of airline competition was distorted by the US experience, where a few Midwest (or non-coastal) cities got nabbed by airlines to build fortress hubs: Chicago (United, American), Dallas (American, Delta), Houston (Continental), Atlanta (Delta), Pittsburgh (US Air), Minneapolis (Northwest), St. Louis (TWA), Salt Lake City (Western) — or secondary hubs like Denver (United), Kansas City (TWA), Cincinnati (Delta), Detroit (Northwest) and so on. A few international airlines had the bulk of their international departures from key “gateway” cities like New York, Miami, San Francisco and Los Angeles, but only later did these become international hubs.

In Europe, the pattern is very different. Most countries had one airline which offered non-stop flights from their capital (or largest city) to key international destinations. And of course for minor obscure languages, the national airline meant customer service in a language you understood.

Only later did they convert their capital to a through hub to attract through passengers. Judging from my efforts to book connecting tickets to small EU cities online, the most successful seem to be British AIrways (London), KLM (Amsterdam) and Lufthansa (Frankfurt).

Airline hub theory states that to make a hub work, you need both connecting passengers and terminating passengers (whether local residents or visitors). So big cities like NY, LA, London etc. have a lot of built-in demand to support the hub.

A few things surprised me about this airline competition during trip. One is the reminder that 40 years ago, every country (even Belgium) wanted its own airline no matter how sub-critical mass it was. Exhibit A: Sabena Airlines.

Meanwhile the Scandinavians (except Icelanders) swallowed national pride and combined the local demand of three countries. Even so, sitting in the SAS hub in Copenhagen today, it seems surprisingly weak compared to my first visit 15 years ago — in terms of size of planes and number of destinations.

I guess the problem is that Copenhagen is the connecting hub but Stockholm has twice the local traffic, so neither is particularly viable. Also, the rise of the Star Alliance and code-sharing means that it’s easier for SAS to code-share with longhaul partners than to offer its own tiny fleet of long-distance jets. (It was interesting to note that nonstop traffic between Japan and Germany is carried by both Lufthansa and Star Alliance partner ANA, with every flight by one code-shared on the other.)

The final observation is the reminder that the natural reaction to rent-seeking and extortionist monopolies (the aspirational goal of most airlines) is to encourage new entrants to do a better job. In the US, we hear about Ryanair (more penny-pinching than Southwest) and EasyJet but not the dozens of others that have sprouted up.

For this trip, to save $500 I bought a separate ticket from Copenhagen to the Vienna conference on AirBerlin. However, I ended up on Niki, the smaller Vienna-based Austrian discount airline that it acquired in 2010. Both seem to be German-speaking versions of Southwest, catering to German-speaking travelers, but (unlike Ryanair or EasyJet) offering slightly more amenities than Southwest (i.e. a free cold meal). I guess AirBerlin (which has longhaul flights to the US, the Caribbean, Africa and Southeast Asia) is a German version of Virgin Atlantic, but without Sir Richard and his out-of-this-world ego.

Niki is strictly a European short-haul carrier. Even though it is tiny (21 planes), it was clear at Vienna airport it was cutting into the business of Austrian Airlines (the former national carrier acquired in 2009 by Lufthansa). In Copenhagen we had Sterling and Norwegian, and of course European authorities showing (a limited) interest in competition has transformed the airline industry to make these carriers cheaper and quicker (if not quite as convenient) alternatives to the monopoly national train systems.

But then, that’s not that different than the US, either. American’s attempts to control Dallas passengers helped fuel the success of Southwest. Delta’s control of Atlanta begat ValuJet (rebranded to AirTran after that terrible crash) which is now a division of Southwest.

Interestingly, it seems that big destination cities are impossible to dominate. No single airline has dominated NYC or LA the way the middle-American hubs have been dominated. (Perhaps PanAm did so once upon a time, but that was well before my time). And if you look at London, while BA is by far the largest carrier, it has lots of competition.

In the end, it comes back to a first-year strategy principle: businesses hate competition and choice (except with suppliers) and customers love it. The entire field of IO economics is about how incumbent firms can develop monopoly (or oligopoly or monopsony) strategies and how new entrants and customers conspire to destroy them.

Saturday, July 2, 2011

The end of the Space Age?

Wandering through airports this last week, I keep being confronted by the cover of the July 2 Economist magazine, which proclaims “The end of the Space Age.”

Even for the iconoclastic editors of the Economist, that’s a pretty jarring statement. I was born after the first satellite was launched into space and grew up watching first unmanned missions to the moon, and then Apollo 11 and the other five manned missions to the moon. After the American West was conquered, space (as William Shatner proclaimed every week) was the final frontier.

Tied to the last Shuttle launch on July 8, the Economist cover story is pretty unequivocal, suggesting that at most geosynchronous orbit (22,000 miles up) is as far as man will go from now on:
It is quite conceivable that 36,000km will prove the limit of human ambition. It is equally conceivable that the fantasy-made-reality of human space flight will return to fantasy. It is likely that the Space Age is over.
The sidebar notes that in dollar terms, NASA’s budget has been flat for 20 years, but as a % of Federal spending, it’s fallen from 4.4% in 1965 to 0.5% today. (Update, Sunday 1pm: Gary Robbins of the San Diego Union has an excellent story on the false promises and design tradeoffs of the shuttle concept, based heavily on interviews with former astronauts.)

Privatization has been the hope of American space fans, but the unnamed authors point to the Achilles heel of these plans: dependence on government contracts to bootstrap their businesses. As the lead article continues:
Today’s space cadets will … point to the private ventures of people like Elon Musk in America and Sir Richard Branson in Britain, who hope to make human space flight commercially viable. Indeed, the enterprise of such people might do just that. But the market seems small and vulnerable. One part, space tourism, is a luxury service that is, in any case, unlikely to go beyond low-Earth orbit at best (the cost of getting even as far as the moon would reduce the number of potential clients to a handful). The other source of revenue is ferrying astronauts to the benighted International Space Station (ISS), surely the biggest waste of money, at $100 billion and counting, that has ever been built in the name of science.

The reason for that second objective is also the reason for thinking 2011 might, in the history books of the future, be seen as the year when the space cadets’ dream finally died. It marks the end of America’s space-shuttle programme, whose last mission is planned to launch on July 8th (see article). The shuttle was supposed to be a reusable truck that would make the business of putting people into orbit quotidian. Instead, it has been nothing but trouble. Twice, it has killed its crew. If it had been seen as the experimental vehicle it actually is, that would not have been a particular cause for concern; test pilots are killed all the time. But the pretence was maintained that the shuttle was a workaday craft. The technical term used by NASA, “Space Transportation System”, says it all.

But the shuttle is now over. The ISS is due to be de-orbited, in the inelegant jargon of the field, in 2020. Once that happens, the game will be up. There is no appetite to return to the moon, let alone push on to Mars, El Dorado of space exploration. The technology could be there, but the passion has gone—at least in the traditional spacefaring powers, America and Russia.
Poster for Vienna art exhibit
Photo by Joel West, 3 July 2011
As the other sidebar notes, military forces (now including China) are actively investing and monitoring developments, but again for communications and observation satellites (or destroying same) in earth orbit.

Given the broad shape of history and economic realities, I think the Economist is more likely to be right than wrong, at least in my lifetime. I doubt I’ll see human beings again leave earth orbit. And with the Shuttle, a certain boyhood hope will die: of understanding God’s universe beyond this little speck where 6.8 billion of us live today.

I guess there’s always retreating to the imaginary worlds of exotic space travel — of Clarke and Heinlein, or Roddenberry and Lucas. Ironically, the science fiction of the 1900s and 1950s seemed impossible — travel to the moon — but the technical problems could be solved. The science fiction of today has the same technical optimism, but hasn’t figured out how to solve the business model issues. (No, Total Recall doesn’t count).

One of my favorite childhood stories was Clarke’s classic, The City and the Stars. In that world, people no longer explored but just lived in their cities and visited imaginary worlds through interactive holo-dramas. The book was set in a world millions of years in the future, but that scenario could be less than a century off: Clarke was pessimistic about the technology, but (alas) optimistic about society’s willingness to maintain its frontier spirit.