Consumer electronics and the culture of fear

More than 140,000 people attended the annual Consumer Electronics Show in Las Vegas in January, and contrary to the belief they were drawn by the latest gadgets and the glittery setting, the overwhelming lure was fear.

If you visited CES 20 years ago, the most interesting innovations were some of the first camcorders and CD players, the Sony Walkman (the iPod of the 1980s), the Commodore 64 home computer and video games from Atari. The biggest debate in the fledgling pre-recorded video industry was whether VHS or Beta would win.

The show in those days involved three primary value-chain participants: component suppliers, device manufacturers and retailers. Negotiations were about “how many” for “how much.” Participants also deliberated technology standards to ensure the industry could continue to improve on size, quality or cost that while stimulating consumer spending on new generations of TVs, radios, stereo systems and car stereos. Nearly all innovation took the form of new devices rather than new business models. The video game industry, where the sale of a console could result in ongoing proprietary software revenue, was the rare exception. Other than that, the industry built boxes and sold them to retailers, which marked them up and sold them to consumers, year after year.

The consumer electronics industry has undergone considerable change since then. Music has become nearly completely digital. Pre-recorded video media has become a $26 billion industry. Consumer photography has become predominantly digital, with digital cameras in 60% of homes. PCs, owned by 78% of U.S. households, have become audio/video playback and creation devices. The broadband Internet, in 50% of homes, has become a major distribution channel for purchase of devices and digital media. As a result of broadband and the rich content available on the Web, online advertising has become a $15 billion industry, and consumers generate and upload millions of hours of new content daily. Affordable big-screen HDTVs are stimulating purchase of new sets and consumption of high-definition programming. Wireless phones, now used by about three-fourths of the U.S. population, are rapidly becoming mainstream media playback devices. Digital video recorders (DVRs) and devices like Slingbox are transforming the video-viewing experience.

As a result of these trends, several completely new consumer electronics product categories have emerged (Figure 1). These trends also have obliterated a number of categories and many companies that have lost significant revenue opportunities by being slow to act on market trends. In many cases, the leaders prevailed because of business model innovation rather than product innovation.

For example, game consoles from Microsoft, Nintendo and Sony are software-subsidized devices, sold at low margins to increase take rate and share, then earning higher margins on the proprietary game software. Mobile carriers for years have offered service-subsidized devices. Google and others use advertising subsidies to support giving away services to attract users.

Vertical integration is among the other business model innovations. With the iPod and iTunes, Apple has created an integrated customer music experience spanning content selection, content purchase and device in which all pieces feature equal ease of use.

Another innovation is exclusivity. Service providers can use attractive content or devices to generate customer preference for their ongoing service revenues. For example, wireless providers seek exclusive rights to sell popular devices (like the iPhone or Motorola Razr) for a defined period of time in order to stimulate customer take rate.

Then there's user interface appropriation. Some devices like Logitech's Harmony Remote, Slingbox and TiVo create a virtual customer experience by inserting themselves as a replacement user interface for others' devices and services. These devices enhance usability and create new revenue opportunities (for instance, advertising) for the innovator.

These business model innovations show both the opportunity and threat for competitors to use content and services to gain competitive advantage in devices, or vice versa. The most obvious example at this year's CES was the explosion of broadband-delivered video services. Microsoft demonstrated movie downloads, both through its Vista operating system (OS) and through an Internet-connected Xbox 360. CBS Chairman Leslie Moonves showed how CBS was working with YouTube to distribute its content. Concurrent with CES, at the Macworld Expo in San Francisco, Apple demonstrated Apple TV, its new set-top box that connects broadband to the TV, allowing users to buy videos using iTunes and watch them on TV. Within days after CES, the founders of Skype announced a new video service called Joost, and Netflix announced a 1000-title instant viewing download library. These services allow content owners to bypass traditional distribution channels.

All of these industry trends — especially content digitization, broadband penetration and business model innovation — have expanded the boundaries of consumer electronics. This has led to a broader variety of CES attendees-but again, why do so many people go? The simple answer is they fear being relegated to an irrelevant portion of the value chain.

Consumer electronics has become a “subsidize or be subsidized, marginalize or be marginalized” environment. Traditional device-makers historically saw profitability decline in years when devices were too similar to previous years' models to stimulate demand. For example, manufacturers suffered through years when color TVs remained relatively unchanged. The current buying surge in HDTVs has energized the category.

But as the HDTV replacement market saturates in the years ahead, consumer electronics manufacturers fear that consumer spending and industry profits will migrate to the content and enabling devices that supply those TV sets. Consumer electronics manufacturers lost the digital music player market to Apple, which integrated the iPod with an easy-to-use content delivery service. Over time, the iPod's and iPhone's increasing screen size will shift an ever-larger portion of viewing time to those and similar devices. With its Apple TV device, integrated with iTunes, Apple is poised to own a new device category: the broadband-connected set-top box.

Among other groups, brick-and-mortar retailers lack the recurring relationship with customers that online retailers enjoy. They fear losing customers to online stores with a broader selection of content and to other players in the value chain — service providers, content owners and manufacturers — which could sell more products directly if they chose. They also risk losing negotiating power with suppliers that have a larger selection of distribution alternatives. Retailers also fear the impending loss of physical music and video sales. They must find a way to compete with online distribution channels, using modern merchandising techniques such as recommendation engines and user profiles, etc.

Next, there's software developers. Microsoft has earned the lion's share of profits in the PC industry for years, but it is less relevant in other device categories. It fears the rise in importance of these other categories to consumers and a loss of ability to serve as merchandising platforms for content, relative to PCs. Microsoft also fears that a player like Google will use advertising to subsidize the OS and applications on whose profits Google relies. Meanwhile, other software developers continue to fear they will become irrelevant when Microsoft incorporates similar features into the latest version of the Windows OS.

Service providers have fears, too. Telcos are in the midst of a catastrophic decline in voice revenues and are seeking to replace those with video services. However, they fear being unable to match the innovations and variety of broadband-delivered content. U.S. cable operators have a lot of wireline and wireless telephony growth ahead of them, but their fear is the erosion of their core business, which grows about 6% per year. Broadband content from non-traditional sources threatens to limit consumer spending on service providers' video-on-demand service, while consumers increasingly choose alternative sources to multichannel video.

But content firms such as movie and TV producers and networks also fear they will suffer a similar fate to the music industry, which reacted slowly to Napster and is suffering what appears to be a permanent slide. To avoid such a fate, they are attempting to transition their content distribution and advertising businesses online, but don't know yet if this will help.

AOL, Google, MSN and Yahoo! control a large online audience by offering access to compelling content and communications services. They fear the overnight emergence of online advertising competitors, such as MySpace and YouTube, potentially making their services and brands irrelevant or requiring acquisitions. Portals also rely on open access to the Internet and fear a new large, proprietary online service such as mobile. Although portals have found ways to create relatively high switching costs for their users, they lack the strategic control a mobile device could provide. If Apple's iPhone becomes as popular as its iPod, its direct connection to the Internet could make Apple the Google of the future. Google and Yahoo! may be forced to take control of consumer electronics devices to compete effectively with Apple, Microsoft and others.

It's not certain all these fears will prove valid. Given the uncertainty across the consumer electronics value chain, there is still time to choose and execute winning strategies. A decade or more in the future, we will watch news stories about of the winners on TV-perhaps, if we are fortunate enough-on a 100-inch screen.

CONSUMER ELECTRONICS EVOLUTION

Category	Currently leading	Missed their chance
MP3 players	Apple	Sony
Digital cameras	HP	Polaroid
Multimedia PCs	Dell	Panasonic
PC software	Microsoft	Lotus
Digital music service	Apple	Warner Music Group
Web advertising	Google	CBS
Video game systems	Nintendo	Atari
Source: Altman Vilandrie & Co.

---

Jonathan Hurd is a Director at Altman Vilandrie & Company