Options for music companies

My colleague Gina Faridniya today picks up on a recent New York Times interview with Bill Gates, when reporter Jeff Leeds caught up with the multi-billionaire. Gates had some interesting things to say about technology and the music industry, which Faridniya duly picked up on.

Since Faridniya at least deals with some of the topics Gates was addressing - as opposed to The Times' Leeds, who really didn't get it at all, I'll use hers as the basis of the quote section and commentary:

People are going to listen to a lot more music because it’s going to be easy to find neat new exciting music, it’s going to be easy to have your music with you, in the car, when you’re running,” he told the New York Times last week.

Didn’t iPod do that six years ago? I suppose we can cut the Microsoft chairman some slack. After all, he doesn’t own one.

“It seems like there ought to be a way to translate that into an opportunity,” he continued.

... The Zune strategy is reminiscent of an unlimited download offer from eMusic foiled by the music industry. The subscription-based online music store abandoned its unlimited service in exchange for limited subscriptions in 2003. The company cited legal pressures from the music industry as reason for the change.

... In short, Gates’ plan sounds remarkable in theory, but improbable in practice.

It's not Faridniya's fault that Leeds' reporting is so unremarkable that all he could come up with from an interview with Gates was a tabloid-style article detailing just why the founder of MSFT didn't quite get it, but it's still not an entirely accurate picture.

In fact, it's a common mistake. What Gates was talking about was the "optionable" element to the music industry. As much as the music industry resembles a conventional business model, it is in fact a giant call option on itself, with that option exercisable on the advent of new "disruptive" technologies.

Disruptive technologies have several traits in common: they are low-tech, cheap and incredibly convenient. And usually, they are a good thing for an industry like music or film, because an organization which owns the rights to a library gets to exercise the call option on its back catalog. For example, when the CD, a lower-quality version of the cassette was released, music co.'s basically had a license to print money as users all gravitated towards the new tech product category. And that's pretty much the way a medium-term P&L of a music company looks: like a call options curve, vacillating up and down in an overwhelmingly upward direction. The equation can be represented simply: p = >t, where p is profit and t is time.

But something different happened with the release of the MP3 Player. Suddenly the music companies were unable to cash in on their back catalogs, which is the process Gates is referring to. This is because every options curve depends on a steady supply-demand ratio, which keeps the call option from expiring, or even mutating. When the MP3 player came out, because of it's nature as a radical - as well as disruptive - technology, the former equation reversed itself (t = >p), since the supply of the product went from finite (the most you can buy in any store on any given day) to infinite. As any business owner will tell you, an infinite supply of your product on the market is bad news for margin.

In other words, the options curve inverted due to supply-demand inversion. Instead of being a traditional call option, it became a put - the option to sell outright, rather than call up, future profits.

While Apple execs have been keen to promote iTunes as the revolutionary online marketplace, in reality it's little more than a record store with infinite supply and 24 hour access. What Gates is saying is that in order for the music industry to use this particular (radical &) disruptive technology to effectively call up its options again, the best chance is to fight infinite supply - and by implication decreasing margins - with infinite product choice. And he's right, too: it's a much more appealing choice for a music company to get back in the business of throwing off excess cash by generating multiple hits in different geographies than it is to see its call option rapidly look like a giant put which it can't buy back into.