Beware This Dinosaur Business Model

So a lot of stocks are on sale these days, right? Sure, but that doesn't mean any of us should go for dinosaur companies whose livelihoods rely on protecting old and broken business models. It is, however, a perfect time to seek the winning innovators that put those who are stuck looking backward out of business.

With that in mind, the recording industry strikes me as a perfect example of the type of non-innovative industry that long-term investors should avoid like the plague.

The bad old days of captive audiences
The recording industry's mind-set seems like the worst kind of nostalgia, wishing for the "good" old days when peddling records worked out a little better for the lumbering music giants.

Their Golden Age was decades ago, when vinyl record albums and cassette tapes were distributed through venues like Tower Records, Sam Goody, and a lot of small, independent record stores. However, it was a bleak time for audiophiles whose musical tastes diverged from mainstream. If you liked anything obscure, it was often close to impossible to find what you were looking for in mainstream retailers. But the recording industry didn't care. A cookie-cutter business model serving up only what appealed to the masses was easier and more lucrative than providing variety. 

Back in the day, this myopic attitude worked out fine. Finding middling, accessible, or outrageous talent and marketing the heck out of it was an easy and predictable way to make money. Recording companies could also look the other way on what was known back then as "dubbing" (copying), since the frequency and scope was fairly limited.

Digital disruption
The Internet changed the whole game. One of Amazon.com's (Nasdaq: AMZN  ) original strengths was that it could provide just about anything anybody could ever want, and ship it straight to their door. We may take the incredible variety available for granted now, but at the time it was absolutely mind-blowing.

Also, while Sirius XM (Nasdaq: SIRI  ) sadly has never been able to transform promise into profitability, it did illustrate that many consumers were ravenous for more listening choices than terrestrial radio had evolved to provide. Terrestrial radio, at times, went hand-in-hand with old-fashioned ways of doing things -- remember payola?

Of course, the most disruptive assault on the old-fashioned music business has been digital content, period. File-sharing sites, such as the infamous Napster (Nasdaq: NAPS  ) in its early days, allowed people to get music for free on the Internet.

Meanwhile, Apple (Nasdaq: AAPL  ) actually proved that people would pay to download music with iTunes, linked to its powerful iPod device.

Our customers, our enemies
The fact that the recording industry giants -- Warner Music Group, EMI, Universal, and Sony (NYSE: SNE  ) are the major players -- have been more than willing to sue their own customers says something powerful about the business model. They've gone so far as to sue grandmas, children, and even dead people.

Not only was their model broken, but the music industry liked it that way. Instead of choosing to innovate, they preferred the path of intimidating and infuriating consumers in order to collect small settlements.

Ironically, as much as the recording industry despises piracy, some degree of sharing for free is actually an effective way for people to discover new music and often eventually convert into paying customers and fans. Meanwhile, the traditional music industry has exhibited what looks like sour grapes about Apple's digital success -- which helped them, too, no less! -- wrangling with Apple over the flat fees it charges for downloads. At every step, the traditional music industry has seemed to want nothing more desperately than to just turn back the clock.

This is an industry that is under attack by innovation and will die one way or another. Some big-name musicians like Nine Inch Nails' Trent Reznor are going it alone, without a major label, and experimenting with different pay plans and content packages for consumers who can choose to buy direct or download for free. Meanwhile, many small bands are distributing their music on social networks like News Corp's MySpace instead of relying on the major labels' marketing machines. While MySpace's dive into digital music was a joint venture with the aforementioned recording giants, the New York Post suggests that Microsoft (Nasdaq: MSFT  ) -backed Facebook is exploring a move into music downloading that could be less accommodating to the recording industry than MySpace.

It may be a long and painful demise, but the traditional, old-fashioned recording industry is on its way out. I know I'll say good riddance, and I believe the future will be brighter, with more variety, without it.

Change is good for some, death for others
Investors should avoid industries that are reluctant to change -- it makes them loathsome sooner or later. If an industry is depending upon using lawsuits, lobbying, and cozying up to regulators to get its way, or worse, if it feels entitled to abuse its customers … well, my friends, you should bank on the fact that it will eventually be destroyed by smart and innovative disruptors, no matter how hard it swims against the tide of change.

When I contemplate stocks to invest in, I have no interest in companies that refuse to think about the future and instead cling to the past. And even in a recession, innovation happens and can even thrive as less forward-thinking competitors get weeded out. Google (Nasdaq: GOOG  ) really picked up steam and market share during the last recession: In 2001, its revenue jumped to $89 million from $19 million the prior year, and the company earned its first fiscal profit.

Google's non-fussy interface and highly relevant search results quickly drew fans and helped sound the death knell for old-school portals and search engines -- remember Excite@Home? And of course, Google's text-based targeted advertising, geared toward what users were actually interested in, was another blow to the old-school media company outdated model of inflicting content and advertising on captive audiences.

While Google is an extreme example, its 140% annualized revenue growth over the past eight years -- with a 150% share price gain in the past four since it went public -- shows that investors should be on the right side of disruptive innovation, and be wary of holding onto dinosaur companies forever.

As we all know, dinosaurs became extinct. Companies that are smart and willing to evolve likely won't share their fate, and hold much more promise for long-term investors than those that cling desperately to old, outdated, sometimes stupid ways of doing business.

Fool co-founder David Gardner and his Motley Fool Rule Breakers team of growth-oriented analysts specifically seek out disruptive companies and industries. They find companies like Google that are breaking the rules by improving on old and sometimes broken ways, and therefore have far greater promise for future growth and profits.

If you're interested in a free 30-day guest pass to the service, simply click here. There's no obligation to subscribe.

Alyce Lomax does not own shares of any of the companies mentioned. Apple and Amazon.com are Stock Advisor recommendations. Google is a Rule Breakers selection. Microsoft is an Inside Value pick. The Fool has a disclosure policy.


Read/Post Comments (5) | Recommend This Article (22)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 02, 2008, at 5:18 PM, ibEddy wrote:

    You missed the big picture; namely, that music itself is dead today. The music industry comes from a time when you would see 2 or 3 new worldwide hits every week. Each and every week you would hear something profoundly original. Music was powerful then, so powerful that it would change the direction of wars and politics. The Beatles alone save the entire British economy.

    Yes, the industry yearns for the Days of Yore, a river of power and money. And I think today’s honest musician does as well.

    Ed

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  • Report this Comment On December 02, 2008, at 8:06 PM, riz2121 wrote:

    My God these articles from this site are so boring and meaningless!

  • Report this Comment On December 02, 2008, at 8:50 PM, edfalc wrote:

    i thought this was a very good article...

  • Report this Comment On December 03, 2008, at 3:37 AM, waltervos wrote:

    I liked this article as well! Actually, Alyce, what other industries do you think will get into trouble because of the economic crisis and the digal economy?

    Kind regards,

    Walter Vos

  • Report this Comment On December 06, 2008, at 5:04 AM, Thamyris wrote:

    My God, some comments on this site are so boring and meaningless.

    I agree with all the other comments saying this article is interesting and thought provoking.

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