Sunday, January 29, 2006

Synergy: Good, Bad and Ugly

We’re witnessing the rise and fall of two strategies that have been around for years: Convergence and synergy. Convergence is rising and synergy is falling. The problem is that synergy doesn’t know it’s dead yet.

The textbook definition of synergy is the combination of two or more items that result in more than the sum of the items: The whole is greater than the sum of the parts. A hydrogen atom plus a hydrogen atom is ready for an oxygen atom to form water, but smash two hydrogen atoms together and you get both helium and an enormous release of energy. The same is supposed to be true for business: Put the right two or more businesses together, and you get a combination that’s more valuable than the sum of the individual, separate businesses. Put the wrong ones together, and you have a black hole.

Media and consumer electronics companies have a particular affinity for synergy. For example, Viacom started as the former television syndication division of CBS. Then, under Sumner Redstone, it acquired Paramount Pictures, Simon & Schuster, MTV Networks, CBS, Blockbuster Video, TDI outdoor advertising, Infinity Broadcasting and King World television syndication. They were all acquired in order to increase the parent company’s synergy.

Unfortunately, along the way, Viacom found out that synergy isn’t all that it’s cracked up to be. Blockbuster hit the wall when DVD sales gutted the video rental business, so Viacom spun it off. Infinity’s revenues tanked as advertisers shifted a portion of their expenditures to non-broadcast outlets such as the Internet. There really wasn’t much synergy between MTV and CBS because their audiences were quite different.

So, as of January 1st, Viacom split into two companies: Viacom and CBS. Viacom got Paramount and MTV, and CBS got the rest. (Sumner Redstone is the largest investor and still effectively runs both.) Viacom and CBS still have to wrestle with their own synergy problems, but at least the divisions of each of the two parent companies make more sense.

So, we come to the Good, the Bad and the Ugly. Let’s start with the Ugly: The AOL-Time Warner merger. The less said about that the better, except to note that it was probably the worst merger in U.S. history.

The Good and the Bad are more interesting. My examples are two companies that both sought to bring together content and consumer electronics: Sony (Bad) and Apple (Good.) In 1988, Sony acquired CBS Records, and the following year, it purchased Columbia Pictures from Coca-Cola. The reason for both acquisitions was synergy: Sony was, and still is, one of the world’s largest suppliers of audio and video consumer electronics. The company was still smarting from the years that the movie studios spent trying to get Betamax outlawed. By controlling its own supply of content, Sony could both give itself enormous influence in the media industry and provide itself with a secure supply of material for current and future generations of consumer electronics.

Instead of building synergies, however, Sony’s media acquisitions caused schisms. The consumer electronics divisions wanted to build products that would sell to the greatest possible number of customers. The media side of the company wanted the electronics divisions to put strong limitations on how consumers could copy and distribute their content, in order to battle piracy.

The results can best be seen in Sony’s portable digital audio players. In 2000, virtually all the players on the market supported MP3, which was shunned by the major recording companies because it could be freely copied. Sony’s players addressed the problem by implementing a proprietary compression and security system called ATRAC. The only audio format that Sony’s players supported was ATRAC, so all of a consumer’s MP3 audio files and CDs had to be converted to ATRAC before they could be played on Sony’s players. The conversion software that Sony provided was very hard to use.

In addition, three different divisions of Sony shipped three different lines of digital players. Each line’s features and user interfaces differed from those of the other two. Products changed dramatically from generation to generation, but they all kept the same dependence on the ATRAC format. The result was that Sony, whose Walkman trademark was once synonymous with portable audio, found itself an also-ran to Apple with a miniscule market share. It’s been only a year since Sony started shipping players with MP3 support, and even today they still don’t support Windows Media, Apple FairPlay or any copy-protected audio format other than ATRAC.

Now, Apple. In October 2001, Apple introduced the first iPod. It was considerably more expensive than other portable digital players, but it was much better designed. Apple completely skipped the flash memory generation of audio players and launched the iPod with 5GB of hard disk space for $399. The first model supported MP3, WAV and AIFF formats and had no digital rights management system. Consumers could purchase an iPod and start using it immediately without having to convert anything to a proprietary format.

Through subsequent generations of the iPod, Apple added bigger hard drives, smaller players, color displays and a wide range of prices, but it kept the user interfaces of all the players consistent. Once you know how to use one iPod (the Shuffle excepted,) you know how to use them all.

With the launch of the iTunes store, Apple implemented its own digital rights management system called FairPlay, which uses the AAC audio format. Like ATRAC, FairPlay was proprietary, but FairPlay’s licensing terms were by far the most liberal of any commercial DRM: The same track could be copied to any number of iPods and up to five personal computers simultaneously, and could be recorded to standard audio CDs any number of times.

There were two additional advantages that Apple had over Sony: First, Apple’s iTunes software was dramatically easier to use than Sony’s software, and second, Apple’s Steve Jobs convinced all of the major record companies to sell their songs through iTunes for 99 cents each. For the first time, consumers could legally acquire digital music from all the major labels in high quality at a very reasonable price. The combination of iTunes and iPods was explosive. As of November 2005, iTunes was the seventh largest music retailer in the U.S., ahead of Tower Records but behind Circuit City. And, in the fourth quarter of 2005 alone, Apple sold over 14 million iPods.

Like Sony, Apple adopted its own proprietary DRM format and launched its own music store that only supports that format. So what makes Apple’s synergy good and Sony’s bad? Here are some reasons:

  • In designing the iPod, Apple focused on the needs and wants of consumers, while Sony focused on placating its record labels.

  • Apple didn’t own a record company, so it had no record company’s profits to protect, while Sony’s goal became maximizing record division revenues at the expense of player sales.

  • Apple’s players had a consistent look, feel and user interface, while often the only way to tell that a player had been made by Sony was to look at the label.

  • In launching the iTunes store, Apple was able to convince all the major labels to let it sell their recordings, while Sony’s competitors were always suspicious that Connect was somehow giving Sony Music an unfair advantage.

The lessons of success and failure at achieving positive synergies will continue to be learned. In the latest round of convergence, everyone (wireline and mobile phone companies, cable operators, satellite operators, content providers, consumer electronics companies, infrastructure suppliers, etc.) will be looking for synergies with everyone else. If history is any guide, they won’t find them.
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