TEACHING NOTE: SM-#112TN DATE: 06/20/05

TEACHING NOTE FOR UNIVERSAL MUSIC GROUP IN 2003

Introduction In 2003,Universal Music Group (UMG), the worlds largest recording company, was facing the third year of a severe industry downturn. UMG and its competitors had to contend with challenges presented by free online distribution services (such as the late Napster and popular KaZaa) and other technological shocks. This case examines the structure of the recording industry and uses the perspectives of UMG executives as well as a talent manager to explore the challenges and opportunities facing UMG and the recording industry. This case also gives instructors a good opportunity to explore several elements of the strategic dynamics framework including runaway changes that leads to industry transformation that the importance of making corporate change that recognizes the new environment. Themes 1. 2. 3. 4. Technology changes versus cultural change. Turning threats into opportunity. The role of collective strategy. The new digital entertainment industry.

Assignment Questions: 1. Until digital distribution, what has been the structure of the music industry? Who have been the key players in the value chain? What have been the rules of the game in this industry: the set of expectations, executive judgments, and behaviors that the different players have of each other and normally abide by? What has been the traditional business model of the music companies? How well was it working by the time Napster facilitated digital distribution? What has been the Napster effect on the traditional business model and how have the music companies attempted to protect it? By 2003, how effective have their attempts been?

2. 3.

This note was prepared by Professor Robert A. Burgelman, Philip E. Meza and Les Vadasz for the sole purpose of aiding classroom instructors in the use of Universal Music Group in 2003, GSB No.SM-112. It provides analysis and questions that are intended to present alternative approaches to deepening students comprehension of the business issues presented in the case and to energize classroom discussion.

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4. 5. 6.

What has been Universal Musics strategy to cope with digital distribution? How is it different from that of the other music companies? How effective? If they could play it over, what should the music companies do different? Why? Beyond 2003, what can the music companies still do to grow profitably in the next 5 years?

Class Plan Instructors can begin the class by establishing the structure of the music industry prior to the advent of Napster and the impact of illegal filesharing. Next, illustrate the impact that illegal digital distribution had on the recording industry, and discuss why it had such a powerful effect. It will be interesting to discuss how the music industry responded to the challenges they faced in 2003 and ask students what UMG can do in the future as they continue to face the challenges and opportunities represented by digitization and other forces. We have used variations of the class plans below to teach this case. I. Discussion of industry structure The way the industry works External and internal forces on the industry How it is adapting to changes How is UMG adapting How does the record industry make money? Studios: - revenue: CD sales - costs: manufacturing., marketing, distribution (Good margin, but high marketing etc costs.) Artists revenue sources: - CD sales, - Performance rights (radio, etc), - TV, film, commercials - Live performances (CD sales have direct impact. CD sales are declining) Problems with the business model Internal factors. High development cost High marketing/promotion cost Few albums per artist (average of 3) (A slowly eroding equilibrium. Below the line cost structure is not sustainable.) External factors PC with CD-W; other devices Internet (p2p, piracy) Broadband connectivity

II.

III.

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Counterfeits Alternate offerings video games, SMS, etc (Sudden, new forces make it easy to appropriate content) Consumer behavior Dissatisfied with price Studio not visible/artist is Dissatisfaction with content is widespread Artists using the net as an outlet. IV. Industrys response Defensive:

Trying to stop piracy Tighten up pre-release Legislation DRMs of various kind Spoofing, Interdiction Litigate services like Kazaa, Morpheus, etc Litigate investors (Hummer Winblad) Litigate users who use Kazaa, etc. Internal streamlining, cost reductions Adapt the technology On-line subscripts (MusicNet, Napster, etc) A la carte services (iTunes, BuyMusic, etc) (The studios made a poor start. They lacked an Internet instinct.)

Offensive:

V.

Universal Musics response e-Labs Adapts DVD-audio Participates in Pressplay Ask: How responsive is UMG to the new market environ. Aggressive why? Timid why?

I.

Before Napster, How Did the Music Industry Operate/Make Money?

Instructors can elicit the industry structure from the students. The music industry is an oligopoly, with 5 main players at the time of the case. (In 2004 Sony merged with BMG leaving 4 major record companies.) The main sources of revenue for a recording company come from selling recorded music and publishing.

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Since the industry enjoyed an oligopoly market structure, it had long been able to dictate terms to consumers. One of the biggest bones in the throats of consumers had been bundling. Prior to filesharing services, consumers had been forced to purchase the entire bundle (e.g., CD) of 10-12 tracks (i.e., songs) in order to obtain the perhaps 3-4 that they really wanted. In addition, by the late 1990s, the recording industry began experience declining sales. Much of this decline was attributed to the completion of the replacement cycle, as most consumers had replaced their vinyl albums and cassette tapes with CDs. Other observers pointed to additional factors contributing to the decline, including fewer popular acts and changes in the business practices of major labels with promoted more homogeneity among newly introduced (breaking) artists which contributed to fewer new hits emerging from the pool of less differentiated acts. While record sales were declining, the cost structure of the recording industry remained the same. Even thought the industry enjoyed high margins through the 1990s (see Exhibit 3), this would be harder to sustain since these costs were leading to fewer sales. In addition, like so much of the entertainment industry, the record business is a hit business in which most of the profits for the recording side of the business come from a few hit. In addition, most majority of sales come from a youthful demographic (12-24 year olds, a fact not explicitly in the case, but indicated by Exhibit 8). Despite this decline in sales, prices remained the same throughout the 1990s. Thus it was into the admixture of disgruntled consumers, increased processing power and memory on ubiquitous home PCs, which were increasingly networked to the Internet, especially among the most important demographic to the recording industry, that Napster was poured.

II.

Post-Napster, How Did the Music Industry Operate/Make Money?

In the advent of Napster, a byword for rampant illegal filesharing, the cost structure of the recording industry remained the same, but sales dramatically decreased. Concomitant with this, were changes in the dynamics of the business of the recording industry. For example, the number of albums produced per artist declined to around 3 albums per artist. Finding and developing talent was a very expensive activity for record companies, and it usually took more than three albums to recoup costs. Industry revenue decreased $6 billion in 4 years (see Exhibit 10). There is no single cause of this decline, but illegal filesharing within the recording industrys key demographic of consumers likely played a major role. Filesharing resulted from the confluence of forces such as digitization of content, ever less expensive PCs with powerful processors and copious memory and easy access to the Internet. Interestingly, digitization in the past led to a sustained boom for the recording industry as LP owners replaced their music collections with CDs.

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Is should be observed that consumers and technologies such as CD burners, PC memory and processing power) got ahead of the recording industrys ability to adapt their businesses accordingly. III. What Did the Recording Industry Do?

In evaluating the industry response to the challenges posed by illegal filesharing, it is important to draw a distinction between the industry-level response and the UMG company-level response. Industry Level The recording industry trade association, the Recording Industry Association of America (RIAA) became the public face of the industry. In addition to its traditional role as a Washington lobby group, the RIAA also took legal action on behalf of the labels. The labels used the RIAA as the vehicle for taking unpopular actions, such as suing Napster and individual uploaders. The latter actions earned the industry a tremendous amount of public scorn, as the lawsuits famously included a pre-teen honor student and a sixty-seven year old grandmother. In our class, we compare the actions of the RIAA to those of Microsoft, as it initially faced the threat from Open Source software, specifically Linux. The RIAA was quick to engage the courts to choke the treat from Napster. While not directly analogous, there are interesting parallels between the positions of the recording industry and Microsoft. The software giant waited until 2004 to start legal saber-rattling with the veiled and overt threats of legal action against Linux, and by supporting, by proxy, the legal battle of software company SCO in its claim that the Linux kernel contains code owned by the company. Company Level UMG waited until 2003 to take effective action at the company-level. UMG started eLabs to explore ways to exploit digital distribution of music. According to Amanda Marks, senior vice president of UMGs eLabs, speaking in late 2004, it took a few years for the industry to realize that the slowdown they first experienced in the mid 1990s was not just related to the trailing off of LP replacements. By 2001, UMG was slowly digitizing its vast catalog of music. This was a huge challenge to the structure of UMG and the effort needed a large capital investment in infrastructure. By the end of 2004, UMG had over 90 percent of active catalog available for digital distribution. UMG, along with Sony and others, also took part in founding a legal online music store called PressPlay. A competing company called MusicNet, was founded at about the same time by record companies BMG, Warner and Internet company Real Networks. Since neither service offered a very wide variety of music, and indeed offered only music that the participating companies controlled, neither service took off. Neither company represented much of a threat to Apples iTunes, which tookoff in 2003, offering a large selection of music from a wide variety of companies for 99 cents.

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By late 2004, UMG seemed to be ahead of its competitors in trying to cope with the challenges and opportunities represented by the combined forces of digitization and powerful PCs networked through the Internet. For example, UMG was the first major label to offer Internet-only releases, offering music online only. These releases were not supported by the expensive marketing campaigns associated with traditional releases.

UNIVERSAL MUSIC GROUP IN 2003 SUMMARY BY ROBERT A. BURGELMAN 1. Digital technologies divide industries and the products they produce and market into a new scheme of categories: atoms or bits or both. The emergence of digital distribution of content (e.g., music distributed as bits) is an example. 2. Technological change may engender and/or interact with cultural change. For instance, digital distribution of music has put into question norms established by the fair use doctrine (e.g., Internet is viewed as free; there is no legal framework for governing file sharing; digital sharing of music does not involve allocation of a scarce resource; and so on). 3. Digital disruptive technologies do not automatically lead to the creation of viable business models for their initiators because it is sometimes difficult to secure and protect property rights to the technology and capture potential rents. For instance, while digital file sharing technology has been disruptive for the music industry, the early movers (e.g., Napster) were not able to build a sustainable business despite having a very large, global user base. 4. Company visions are as important for what they prevent companies from doing as for what they enable companies to do. For instance, Napsters vision that music should be shared rather than sold, made it difficult to develop a subscriber model and/or to work with the media companies on protecting copyright. The very vision that made it a pervasive global force among tens of millions of users also restricted its ability to forge strategies for greater sustainability. 5. Initially, signals of change are usually weak (e.g., a slowdown can initially be explained in a number of ways), but the more entrenched an industry the stronger the denial of the disruptive change and the greater the resistance to adapt to it. This helps explain the music industrys early emphasis on defensive strategic action and its slow efforts to turn the threats posed by digital distribution into new opportunities for wider and faster profitable delivery of music. This has opened up opportunities for new entrants such as Apple Computer.

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6. Sometimes threatened industries will engage in collective action to try to counter the threat. Through litigation and lobbying activities, the Recording Industry Association of America (RIAA) has both reduced the amount of piracy and given impetus to the enactment of new legislation governing digital property rights. While this has drawn a lot of attention to the cause it also has made some customers angry, leading them to seek alternative providers. 7. Different incumbents, however, will eventually want to develop their own unique responses to digital distribution in order to strengthen their product-market position in the reconfigured industry. These responses are driven by market forces as well as by internal forces. This is manifest in the different actions of Universal Music, Sony Music, EMI, Warner Music, and BMG Entertainment. 8. Others?