Atomic Energy

In the first part of this post, we analyzed what the position of the dominant player (Google) is, where there are opportunities, and what they need to succeed. In this part, we will briefly review the one I interviewed recently, hakia. FYI, hakia is, indeed, spelled lower-case; this is not a typo. 

Given our list of criteria above for success, how well do hakia meet the requirements?

1. User Requirements. hakia seems to really get this space. They are investing some amount in making the results more user-friendly, not just fancier-looking – which users are not looking for – but enough content on the search results page itself to reduce the number of unnecessary click-throughs. More importantly, they understand that users want: (a) to ask questions in a normal human manner; (b) to receive highly relevant results. Additionally, hakia understands the concept of credibility. People want not just relevant results, but credible results. Your local massage parlour home page is great and credible for deep-tissue massage and back rubs (Google pun intended), but extremely low on the credibility scale for cancer treatments. This is an area that I have not heard clearly expressed by any provider outside of hakia.
2. Operations. This part concerns me. Even Google needs to struggle to index the exponentially growing Internet, and they have customized hardware, software, data centers and huge amounts of cash to invest in it. In FY2007, Google spent $630MM on R&D and $377MM on general and administrative. Although Google does not break down how much of that is directly related to crawling and indexing, $1BN on G&A and R&D, separate from sales costs, is a lot of money, and hard to play catch-up for anyone. hakia recognizes that they need to find a different model, one that is not as cost-intensive, but there is no avoiding the fact that the amount of Web content is enormous and keeps growing.
3. Customer acquisition. I have not seen indications one way or the other on this. However, I have rarely seen a consumer-focused Internet start-up that really calculates the customer acquisition cost. I saw one recently in the virtual world space and another in a related semantic advertising space that may or may not have properly calculated this, but do correctly recognize that individual/retail acquisition is incredibly expensive. In their cases, they took a saner route and are instead becoming infrastructure providers to those who already have millions or tens of millions of users acquired.
4. Business-model validity. hakia is building on direct advertising, unsurprisingly, yet is also diversifying into other areas where it can sell usage of the technology. They seem to have a good model but are hedging their bets, a good call, given the unpredictability of the cyberspace advertising market.
5. Investor patience. hakia gets a plus one on this one. They seem to have lined up investors who get the idea of long-term investment, and are even, in this day and age, focused on IPO, not on being bought out. They will need to get a lot bigger to deal with the registration requirements (=expenses), Sarbox nightmares, and securities class-action exposures (possibly fewer since Milberg Weiss has been cut down to size) that so plague any company attempting to go public, but they seem to be prepared for it.
6. Google response. Obviously, hakia has little control over this, although they seem somewhat dismissive of it. To their credit, they get that they need to focus on the first 5, get them right, and 6 becomes less of an issue.

Summary: good model, diversification, excellent customer grasp, investor management. Weakness or underplanning in operations and customer acquisition.

In the year 2008, there is one 80-pound-gorilla in the corner in the world of search, and its name is Google. FY2007 revenues were $16.6BN with net income of $4BN. In any industry, and especially one as R&D- (and hence expense-) intensive as technology and search, net margins of 24.1% is nothing to laugh it. Microsoft had slightly higher consolidated net margins (29%), while Cisco had only 21%, and both are much more mature businesses, having been around a lot longer than baby Google.

Several factors combine to create great opportunities in search:

1. Blinded by the size: It is hard to remember that Google didn’t really exist a decade ago, and most people searched, if at all, using Yahoo or similar. Given that history, Google’s invincibility should be taken carefully. No company is perfect or immune to a driven upstart, and larger companies tend to be more bureaucratic and slower-moving. More and more reports have been coming out of Silicon Valley disparaging some of Google’s internal issues, including poor hiring practices, bad politics and even internecine warfare. Personally, I take no pleasure in these – Google is a good company that did much good in and to the Internet, despite its warts – except insofar as it indicates that Google is going through some of the maturing growth that all companies go through. What it further indicates is that Google is becoming a company like any other – probably a lot of fun to work at, good perks, but quickly losing some of the hypercompetitive edge that and nimbleness that allows it to lead the pack.  Google is big, but there are serious chinks in the armour.
2. Speed of light: Technology evolves very rapidly, and what was great yesterday is basic expectation today. As a colleague I was working with today described, 5 years ago chat/messaging on a dating site was an extra; today no dating site can survive without it. It is simply the base level required. Put in other terms, the bar keeps getting higher. Google has done an excellent job on making its infrastructure faster, its index larger, its crawling better, and its PageRank algorithm truer. It has also been aggressive in adoption of new technologies or paradigms, especially some of the Ajax work, to make its interfaces better. Nonetheless, at its heart, Google relies on its index of keywords to pages. In 1995, when Sergey Brin and Larry Page were working on BackRub, this was the wave of the future, since the alternative was either no search, one driven by paid placing, manual search or manual placement. Clearly this system is much better. However, as users have gotten used to the abilities of index-based searching, they have come to demand more, that it more closely reflect human interaction. You do not ask your HR department, “2007 holiday schedule officer rank seattle.” Rather, you say, “what is the 2007 holiday schedule for officers who are based on seattle but rotate around the country supporting sales?” Anyone who grew up on Star Trek in the 1960s or 1970s cannot forget the crew talking to the female-sounding computer in normal, human language. Even back then, they got it.
3.  The Content Monster: The amount of content on the Internet, let alone corporate Intranets or the so-called “Deep Web,” has grown exponentially, or probably more. What provides reasonable answers for 1MM pages of fairly narrow reliability does not necessarily do so for 1BN or 1TN. This is completely separate of the operational question of having a good enough engine to both index these pages and provide responses to queries in user-acceptable time. Even given those (which are not insignificant challenges), the results can become poor as too much irrelevant or unreliable content overwhelms the desired results. In engineering terms, this is known as having a low and dropping signal-to-noise ratio.

Given the above – inherent weakness of the dominant player, rising expectations, improved technology and overloaded content – there is plenty of room for several small, nimble competitors today to enter the search space and make meaningful advances. Their success will largely depend upon:

1. How well they really understand user requirements. They must meet and exceed user expectations, but not to a point that users cannot appreciate it. This is the classical engineer’s problem: engineering a solution too far ahead of what people want.
2. How well they manage their operations. Too many companies, especially small start-ups, underestimate what it takes to grow, especially in the technology space, where operations costs can be huge, and the cost of failure of either results or availability on the long-term can be extraordinarily painful, sometimes fatal.  
3. How well they market. Anyone in marketing (including the author) will tell you that acquiring consumers is a very expensive proposition. Most wireless carriers measure the cost of acquiring a customer and the cost of losing one to the penny. The “churn rate”, akin to employee turnover rate but as applied to wireless customers, is measured and followed rigidly (at least the better run ones, if such a thing exists in the United States). The newer players must account for customer acquisition costs. 
4. Business-model validity. Google built itself up on advertising. The advertising market is shrinking due to the current perceived economy and diffusing across the proliferation of publishers, making building a large business on advertising harder.
5. Investor patience. It takes a long time to build up a solid profitable consumer-oriented search business. Most investors, especially in Silicon Valley and the tech sector in general, lack the patience to wait for these models to play out.
6. How well Google responds. Notice this is last. Google will likely be around for a long time. Whether or not they can be nimble enough to respond to this depends on the company, its culture, its structure, and its ability to step outside itself. This is akin to the music labels in Part II of my analysis of the music industry.

Most new search entrants are focused on the semantic search space. Semantic search depends not on keywords, at least not directly, but on really understanding what a query means. I recently interviewed the founder & CEO of one of the leading firms in this space, hakia. The interview was on behalf of ArnoldIT, one of the top experts in search. The owner’s blog is listed in the blogroll, at right, and the interview itself is here. I will review hakia and its interview in a follow-up article.

Some time in the near future we will be publishing an article analyzing the search industry. Although it appears to everyone that there is just one big company in this business (hint: $16.6BN in revenue and $4.2BN in net income FY2007), this is an incredibly fast-moving industry. Microsoft recently attempted and failed to spend around $40BN for Yahoo, and Google itself was a nobody a decade ago. 

As an advance, I recently interviewed Dr. Riza Ahmed, founder & CEO of hakia, based in New York, on behalf of ArnoldIT, which itself is one of the expert firms on search. The interview is available here, with a short summary here.

In Part I of this series, we explored why the music industry is suffering, and what the market, technology and legal forces are that brought it to this point. In Part II, we discussed what the barriers to change are within the music industry, and what might be done to plan for the future. In this final Part III, we will look at some possible models.

We begin with a caveat. “The future is unknowable.” The entire rationale behind free-market economics is that the millions or billions of people making individual decisions will do so far better than a select few or one. The corollary to this insight is that whatever one person predicts, it is unlikely to match the future precisely, since it is only one person, not the market as a whole. For a more interesting look at why some people do seem to predict the future fairly well, have a look at Nassim Taleb’s books in the “Recommended Reading” list (on the right).

We are making several assumptions as to the behaviours of consumers in the music industry.

1. People want music and are willing to pay reasonable prices for it. In a year when pirated music is easy to come by, and you can even buy DRM-free music on Amazon and iTunes and redistribute it, the fact that the industry sold $10.4BN of music in 2007 indicates that people will pay for music they like.
2. People will pay what they believe is reasonable, while either not paying or pirating what they believe is unreasonable. This is the “carrot and stick” method. It is not enough to say, “we will sue you if you pirate,” or to use ads comparing casual copiers to Blackbeard the Pirate or the Enron perpetrators (let alone Fannie Mae); you need to make it as easy and cost-effective for them (or reasonably close) to do something legally as illegally.
3. Most people do not view casual copying as piracy, and never will. Their perspective is that they enjoy the music, they want to share it with a few friends, or perhaps use a small clip of it on their Website / MySpace / Facebook page (which relates to the Fair Use Doctrine, out of scope here).
4. People have gotten used to social networking, as well as mobile media. They expect it to be reasonable to take pictures at a concert with their mobile phone, or even stream it live to their Website. “Look at the great concert I am attending, listen to it!” 
5. The people who do the most casual “piracy,” e.g. the streamer and sharer above, are likely the most passionate about the artist, and most willing to expend energy to spread the word. 

The industry can either fight these trends – they have been attempting to do so for years, with little success – or embrace it. As Jeff Pulver pointed out at his recent Web 2.0 NY keynote, several artists and/or labels have actually encouraged live attendee Webcasting of concerts. The question becomes, if they embrace it, and thus remove the last barriers to people doing casual copying, how do they make money off of it?

The labels need to recognize that without the old barriers to reproduction (see Part I), music content is largely commoditized. The source is still special – very few have the talent of Billy Joel – but once it is recorded and distributed just once, it is reproduced infinite times. Thus, the music itself must be sold at prices that are almost as cheap as piracy, in other words, near-zero or actual zero. $0.99 per track on iTunes or Amazon will have to be replaced by a fraction of that price. Of course, music industry revenues then apparently evaporate. Where do they make it up? Here are just a few of the possibilities.

• Concerts: Someone who owns an MP3 of Natasha Bedingfield can reproduce it and redistribute it infinitely, but they cannot reproduce the concert experience. The music itself – the MP3 file – becomes advertising, an investment, in getting individuals to buy non-reproducible services, like the concert. Concert ticket prices, however, have gone through the roof as well. In order to make up the revenue losses, ticket prices would need to come down, while the number of concerts would need to go up (revenue = number of tickets x price per ticket). I am currently working with a software start-up that is dealing with an identical issue: can we avoid fighting piracy entirely by essentially giving away the software, but only selling the ancillary online services?
• Memberships: Most music fans – certainly those who currently or until recently paid for music – tend to be fanatical about their fan-hood (pun intended). Very few who were around or have seen videos of teenagers flocking by the many thousands or more to see the Beatles in the 60s can doubt that, and the trend is only stronger since then. Labels can essentially give away the music as advertising, but sell club memberships, or sell the music with membership and special benefits embedded. For a long time, media celebrities have viewed fan clubs as a loss-leader, advertising to drive music/movie sales. In an era when music/movie sales are low and getting lower, they need to explore the other way around.
• Frequent Flyer: Although this has rarely, if ever, been applied in the entertainment industry, it has worked quite well in many others. The story of American Express haughtily turning down American Airlines’ AAdvantage for their members is legendary and taught in just about every business school. Someone can download 100 MP3s of Kate Perry from EMI or Alicia Keys from Sony Music (the label formerly known as Sony BMG), but actually buying 10 or 20 can get a free concert discount, signed copy, special release, etc. 
• Volume: It turned out, much to the music industry’s surprise, that the entertainment business is very price-elastic: when they raise prices on CDs, concerts and movies, fewer people attend. But there is another side to this price-elasticity: if prices are lowered, more music will be sold. Can it sell 10 times the amount to make up for it? I doubt the industry produces enough music per year to get to that volume. However, people were very skeptical that, following telecom deregulation, people would make enough long-distance calls to make up in volume what was lost in per-minute profit, and we were all quite wrong. Volume will definitely make up for a lot of the reduced price, although unlikely to do so entirely. Total direct sales of music will likely come down, but overall profit margins can actually go up. Where will the volume come from?
  • Increased sales of existing artists. Plenty of people who love Madonna will not buy Coldplay or vice-versa at $0.99 per track. On the other hand, plenty will be willing to pay a dime or a quarter to try a few and see if they can expand their tastes.
  • Increased artists. The industry will need to expand its pool of artists to go beyond superstars into those who can “only” sell a few tens of thousands or hundreds of thousands of tracks (not albums). The Indies are already doing that, and will continue to eat into the major labels unless they restructure for it. The restructuring will need to include lower-cost methods of finding talent, producing it and promoting it.

There are many other possibilities…

Note that all of the above require not only serious and fundamental strategic rethinking, but also a hard look at the operations side, likely leading to major changes to support new business models. 

What impact will all of this have on the industry in general and artists in particular?

1. Likely greater competition for moderately talented artists, leading to greater revenue for those who do not hit superstar status.
2. Reduced gross profits (but possibly higher profit margins) for the industry, or at least those who adapt.
3. Reduced compensation and harder work for superstars, who will no longer be able to get wealthy on percentages of sales, but rather on ongoing labor, such as working with fan clubs, signings, concerts, etc., and greater competition from the next tier.
4. A more mobile growth and ranking system. A good but not superstar artist will be able to make a living, or at least supplement one, through labels, while possibly moving up the ladder as they get better. Conversely, it will also be easier for superstars to fall down the rankings as their star wanes.
5. Greater availability of varied music.
6. Possibly a dilution of culture. I am unsure if this will happen, or if it matters, but fewer superstars and more music means fewer shared elements among everyone in society. I am not worried about this, but a recent piece by Elizabeth Wurtzel, author of Prozac Nation, did worry about this. Personally, I cannot believe that greater consumer choice or competition is ever damaging.

Short form: lots of challenges to the industry. I see a number of failing players, consolidation, and rising Indies. Whether or not even one of the major labels can rise to the challenge is a question time will tell.

In Part I, we explored how the market and world within with the music industry operates has changed, especially in the last decade. Clearly a new business model is necessary, as any turnaround or strategy expert could have predicted as far back as the late 1990s, while one well-attuned to the technology sector could have predicted even earlier. In this section, we will explore what are the barriers preventing the major labels from abandoning its current model and thinking creatively enough to come up with a new model.

• Psychology: Undoubtedly, a major barrier is psychological, also called inertia. Quite frankly, the industry has been making money more or less the same way for a very long time. They will undoubtedly argue that they brought talent (the ability to identify, groom and promote music ability) to the mix, but in the end, they paid for that with capital. Leopards do not easily change their spots. The ancestors of the Big Four labels go back to the 1930s and 1920s, nearly a century. People who have grown up in this industry, have learned that this is the way to make a lot of money, have it in their DNA. They are highly unlikely, with a few rare exceptions, to find new ways to do so. In the famous words of Bill Gates, “Success is a lousy teacher. It seduces smart people into thinking they can’t lose.” Most of the very smart people running the music industry are desperately looking for a way to go back in time. 
• Organization: In theory, every business organizes around the primary products and services (divisional) or functions (functional) it provides. In actuality, every business is some mix of the two. The classical music industry model (ignoring standard administrative overhead common to every business like financial management, information systems, etc.) involves the major functions of talent discovery, recording, distribution, and promotion. Any new model will, by definition, change the functioning of all of these. Some will shrink, some will grow, others will disappear entirely, while new ones will arise. The incentives in each of these silos works against new ideas coming to fore. Until the businesses involved in the industry are willing to step outside the organizational model in place, innovative thinking will be confined to either (a) those outside the silos, who are normally too far removed from the day-to-day market and customer to really get a feel of what will work or (b) mavericks who almost always suffer for their innovative thought, since it benefits the organization as a whole, but to the detriment of the particular division or silo.
• Systems: Having done business largely the same way for decades, many systems, especially financial and information systems, have been built around the current model. Although one should view these as sunk costs, executives are loathe (psychology again), to write the investments off. Further, these investments are normally capitalized, thus requiring an actual financial write-off if these are made obsolete ahead of schedule. As one example, purchasing music online as singles, as distinct from albums, has been available for upwards of five years. The iTunes Music Store has been in operation since April 2003. Nonetheless, almost every music label still pays royalties and compensates artists by album sold, and their systems know of no other way to do so. Recent estimates as to the cost of conversion run past $50MM per label. Per-track as opposed to per-album is not a very new model, and is far less radical than any major strategic change, yet the cost of conversion is enormous and daunting to the labels. One can only imagine what the costs of converting the existing model to a new model would be.

Given the above major hurdles – psychology/inertia, organization, systems – how can the CEO or board of any major label create an environment that will allow them to thrive in the years ahead? It is important to remember that thrive does not mean, “we make as much money as we make money, or as we did on our heyday.” Thrive does mean, “we might make as much money, or possibly even more, but we survive as an important, profitable entity, not driven to the ground by forces that we fought against.” There is the old paradox, “what happens when an irresistible force meets an immovable object?” The market forces here are, despite the industry’s best efforts, an irresistible force (or, more correctly, many millions of small forces that are jointly irresistible). The industry, its trade group, and the businesses themselves need to remember that they are not an immovable object.

How can a player create the innovation to thrive? These are broad brush-stroke recommendations; the details are unique to each company and situation.

1. Step outside the organization. The CEO and Board of any label needs to create a separate team, preferably a separate subsidiary. Here are some key features it must have:

•  
  • It must operate totally and permanently outside the normal organization, with its own Board, reporting directly to the CEO and Board of the parent as they are investors. As long as any individual in the group has to worry about going back to the normal organization at some point, these will bias his/her thoughts, however subconsciously. 
  • Populate it with a mix of insiders and outsiders. Outsiders doesn’t mean someone from Universal, if the company is EMI. It means someone who knows just enough about the music industry to be dangerous, but not enough to have become assimilated, i.e. “drunk the kool-aid.” 
  • Populate it with a mix of ranks. If it is all senior executives, you miss a lot of “ears-to-the-ground” input that is invaluable.
  • Give it a clear mandate: “Build a music business that will be profitable in ten years.” 
  • Free it from shackles: it must be completely free from the normal administrative and financial processes of the parent. Very few start-ups succeed when they must buy equipment from some slow-moving corporate parent.
  • Give it access: It must have complete access to the parent, but any value it gets, it must pay for.
  • Give it funding: agree on a strategic plan to get to the new model, and fund it like a VC.
  • Get out of its way.

How many companies have really successfully done this, built a subsidiary whose job it is to compete with the parent, and possibly put it out off business? The list is painfully short. On the other hand, the list of companies that have failed because they could not bear to cannibalize their own business, and thus left it for other upstarts to do, is very very long.

In Part III, we will explore some perceived directions of the industry, and possible models.

The jeremiads are everywhere and have been for several years: the Internet will be the death of the music industry, at least as we know it. The reasons behind this death knell, and what they can do about it, are worth exploring.

First, a few facts. 

1. This past week, Sony agreed to buy out Bertelsmann’s stake in Sony BMG for $1.2BN, effectively valuing the entire business at $2.4BN. (In a small ironic note, Sony BMG was accused of software piracy by PointDev; those who live in glass houses…) Sony BMG has a reported $49MM loss in the last quarter, on sales of $820MM. Using some form of reasonable discounted cash flow analysis, a $49MM loss at 12% discount rate puts it worth negative $408MM. If you account for the fact that the $49MM loss is not constant, but a trend downwards from $21MM profit in the same quarter one year earlier, the valuation is much worse. Obviously, Sony CEO Howard Stringer sees some value there we do not. Either Sony can do things with it, they cannot do together with BMG – German companies, especially large ones, are notorious for rigidity and inflexibility – or there is a lot of hubris here.  
2. The industry as a whole is shrinking fast. According to RIAA statistics, in the last two years alone, the value of sales was down 11.5% (2006) and 19.1% (2007). At this rate, they should be buying CDs from consumers by the end of next decade.
3. The industry is shifting to online sales. From 2005-2007, online sales grew from 9.0% of total sales, to 16.1% to 23.0%. 

First, let’s look at how 2008 is different from 1998, 1988, or any other year before. Largely, the major labels had access to several elements that were critical to music ownership and distribution, and allowed them to squeeze both ends of the chain – consumers and vendors (a.k.a. artists):

1. Production: Copying music used to be a very expensive proposition. One needed to have good originals, and equipment that could reproduce, first to LPs, then 8-tracks (for those of us who remember them), then audio tapes, finally CDs. This, more than anything else, was the biggest barrier for most people.
2. Distribution & Marketing: Getting music from a one or a few points (including a consumer’s home) around the country or the world was very expensive. Even if someone wanted to ship pirate copies of Simon & Garfunkel in the 70s or Madonna in the 80s, assuming they got past hurdle #1, each shipped copy was expensive. Paying a few dollars to ship a tape to many people made it almost as expensive as buying it new. The major labels had enough volume to gain economies of scale in shipping, thus leaving plenty of room for other costs as well as a tidy profit and still selling at a price-point that allowed people to buy the product. The same holds true for marketing. Making Madonna a star takes a lot of effort and money.
3. Legal: Copyright laws of various countries, and especially the United States, stood as a major barrier to re-distribution. Even if you could get past the first two hurdles, which meant a significant investment, you quickly ran afoul of copyright laws. Needless to say, if you got this far, you clearly had a lot of money, were doing a lot of damage to the labels, and they justifiably used the law to come after you, usually successfully.

What happened to these barriers?

1. The advent of low-cost PCs with CD readers and even burners, eliminated barrier #1. Anyone could copy music to anywhere – your hard disk, another CD, take your pick. In 2000, your average CD burnder cost $150-200 USD, and even that is cheap for reproducing. In 2008, a 52X drive can cost under $40 and sometimes near-zero with rebates. A CD reader is basically free. 
2. The Internet eliminated cost of distribution and marketing. Although there is some cost to distributing the bytes, they are minimal, and usually hidden within an ISPs “all-you-can-eat” plan. 
3. Copyright laws were revamped with the 1998 DMCA, in many ways making anti-copying laws stronger, especially in the digital/Internet arena. 

With copyright laws the only avenue left to protect their existing business model, the major labels, mainly through their trade group RIAA, went on a campaign to sue anyone who copied and distributed music. In truth, this campaign is no different from what they have done for decades. The difference is that whereas in the 1970s, the target would be a business clearly investing significant sums and making a profit off of copying a label’s work, in the 21st century, the target would be an 80-yr-old grandmother or 12-yr-old kid distributing a few copies to friends because they like the art product (i.e. the music). I do not believe that the RIAA decided to shift strategy entirely to go after millions of non-profit enjoyers; they simply extended the third prong of the strategy they had been using for years to go after anyone who had enough capital to get past the first two barriers and made money on it. This is an important point. Many paint the RIAA (and its brethren in the motion picture industry, the MPAA) as evil, shifting from “we want to sell you music you want” to “we want to bankrupt retired grandmothers.” In truth, legal assault has always been an important and valid part to the industry, used with true for-profit violators. With the category of people copying shifting to fairly innocent individuals, the RIAA never realized how much had changed. They say generals always fight the last war…

Needless to say, it backfired. First, although a lion can defeat a gazelle who steals its grazing ground, a lion cannot defeat millions of small animals that come from every angle at once. Second, the public does not take kindly to suing grandmothers and children, especially coming from wealthy labels. Third, the labels are directly discouraging, even attacking, the people who are their customers and who they want to like the music from sharing that enjoyment. 

Summarizing the challenge: the labels profited for years by monopolizing production, distribution & marketing and legal rights. The elimination of the effective monopolies in production and distribution & marketing leaves the entire industry balancing on one very shaky leg, then hopping on that leg to try and kick (with the same leg) millions of people who are trying to enjoy exactly what they are selling. 

Unalterably, the market for the industry has changed, and its old model simply does not hold.

In Part II, we will explore what is getting in the way of the industry adopting a new mindset. In Part III, we will explore possible alternative models and where we see the industry heading.

Recently, I had the experience of seeing two related events in the business of amusement parks.

First, The Wall Street Journal, one the front page of its Tuesday, August 5, 2008, edition, had an interesting article on the financial troubles of Six Flags and the turnaround plan of its CEO and CFO. The short form is as follows:

1. Six Flags is in trouble. Without going into too much depth, over the last three years, it lost $105MM, $203MM and $234MM, in 2005, 2006 and 2007, respectively. Although a large chunk of that loss is due to losses from some of its minority interest in other investments (approximately $40MM) and its huge debt load (payments of about $200MM per year), its revenues have hovered between $945MM and $973MM, i.e. not growing significantly, while its operating income has shrunk from $148MM (15%) to $33MM (3.4%). SixFlags has way too much debt, growing expenses and stagnant revenues.  
2. In order to fix this, the management team is shifting away from its classical customer – the high-octane teenager who wants ever greater thrills – and towards families – smaller rides, lots of kiddie rides, tighter dress codes, etc. The theory is that families will spend more, and more in one shot, than a single teenager. Additionally, the big rides teenagers want cost about $20MM to build (and much more to operate); family-friendly rides are significantly cheaper, and lower-end roller coasters average about $7.5MM. 
3. Six Flags tried raising prices about $5-10 per person and saw a drop in attendance. The management team was quite surprised to find that attendees are price-sensitive, or that there really is significant price elasticity. 

Second, last week, I was one of those families going to amusement parks, taking my family to HersheyPark, owned and operated by the privately held Hershey Entertainment and Resorts (which, of course, does not provide financial statements to the public). Interestingly, I spoke with several local season pass holders (those who spend $1,000 or more per year to bring the family as often as they like). Apparently, Hershey has been attempting to reduce expenses by cutting back on service where it can, as well as using less-experienced (and hence lower-paid) employees. The season pass holders – who are the bread and butter of the business as they are local and provide reliable cash flow – immediately noticed the differences, and several are considering cancelling their season passes. It is likely they will still come, but if you pay for each visit, you come a lot less frequently and spend less. Interestingly, Hershey is already on the family-friendly model that Six Flags is striving towards: bathing suits are banned outside of the “Boardwalk” water area; there is a huge number of children’s rides; etc. 

The key question is, will the Six Flags management plan, such as it appears to be, work? Only the future will tell for sure, but here are some predictions:

1. Keeping the costs of constructing rides down is the right way to go. Roller-coasters have some element of keeping up with the Joneses (“my ride is bigger than yours”), but unless there is intense competition nearby, there is less of a need. Maintain what you have, build new as necessary, but a new $20MM ride is not going to bring in the masses. No one will pay $40 to go ride the new Space Coaster or Fahrenheit once or twice. 
2. Family-friendly is theoretically a great idea… but families are far less likely to spend $200 on a day at an amusement park than a single teenager spend $30-40. If they do, it is a once per summer, perhaps twice per summer, event.
3. Make the parks more appealing to families not just by environment, but by economics. Most families are strained – gas is around $4/gallon (much more in high-tax states like New York, California and Illinois), food prices are multiples of just a few years ago, clothing is more expensive and families have kids to clothe – while $200 for a day at an amusement park is discretionary. Provide ways to make it economically sound for families by tying into their needs, not just their wants, and make their wants better fulfilled. These provide additional revenue and cash-flow management opportunities.

What sort of opportunities arise? Any family with children has constraints on them in terms of food, child-care, rides, etc.

• Make better line-management (Disney is an excellent example of this); nothing turns a family away more than half an hour on line in the hot sun with a cranky, impatient child. 
• Provide limited at-ride child-care. Yes, child-care. Parents with two little kids actually want to ride the coaster or the flume, but someone has to stay with the kids. Parents will pay a premium for this, because they get a family day *and* time alone, even if only for 15 minutes. 
• Provide stroller and bag parking at rides. Parents with kids might want to go, but someone has to watch the bag. Adults online or teenagers don’t carry the same massive baggage.
• Allow food into the park. Yes, it will cut into some of the food sales and the high margins those provide. But families with kids are non-stop hungry, and if the cost is $100 in food on top of $200 in admissions, they are not coming. On the other hand, every family wants to buy some food in the park and will probably spend all day. Let them bring food in, and they will bring one meal and some snacks while buying another.
• Many many more ideas… 

And last, but not least, retire the debt. This is a crushing debt burden, with monthly payments equal to greater than 20% of revenues. If Six Flags cannot find a way, then Chapter 7 may be the only way to go.

Good luck to them.

I recently received a call from a potential client who is considering a sale of their business. The sale had not been initiated by the owner, but rather by several competitors who had approached the owner to purchase their business. In other words, it was a horizontal merger situation. The owner wanted to know when to use an investment banker as opposed to a business/management consultant (i.e. someone like me). Apparently, this question comes up often, and deserves its own entry. Investment bankers (as well as their counterpart, business brokers) and consultants have distinctly different goals and purposes, as well as different compensation plans, and each should be used appropriately.

• Investment Banker: Investment bankers work the deal. Quite simply, they are there to represent the buyer or seller through the actual acquisition (or merger), and are compensated based on the deal. Normally, large investment bankers will received about 7% of the purchase price, while smaller ones who specialize in small transactions will receive some amount upfront and a somewhat higher amount, normally up to 10% of the purchase price. I-Bankers are expert at finding the seller the best acquirer and negotiating the highest price possible.
• Business Consultant: Business consultants are interested in maximizing the value of the business. Quite simply, they want to find whatever is in the best interest of the client, normally the owner. If that means growing the business, they will do it; selling the business, they will maximize the appropriate metrics (EBITDA, cash flow, whatever) to maximize the purchase price; liquidating, they will do that. The business consultant will delve into the owners’ emotional needs as much as their financial needs, and look at all aspects of the business’s operations. Consultants are paid a time and materials fee, whether a flat monthly rate or an hourly rate, and thus do not care if the most expensive deal gets done, or none at all, as long as it is in the client’s true best interests.

So which one to use? The answer is pretty straightforward.

• If you are intent on selling the business, and need just someone to structure the deal and find the appropriate acquirer, get an investment banker. This is what they do, and their percentage fee structure, while expensive, will align their incentives with yours.
• If you are unsure of what you want to do, if you want to find ways to increase the business value prior to a sale, if there are hidden assets you want to leverage to raise the business to a higher plane, then you need a business consultant. 

An investment banker works best if, and only if, you are there to do the deal and have already maximized the internal value of the business. The moment even one element of this is incomplete, invest in a good business consultant.