Post of the Day
July 18, 2000

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Rule Breaker - Strategies

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Subject:  Portrait of a Rule Breaker Scorned
Author:  Ubermensch1

The Internet is fast becoming the next mass-medium. No, really, it's true. Kidding aside, this observation should be old hat by now. It is a medium whose phenomenal growth to date is made more phenomenal by the fact that its nascence is barely in the wake and its pre-adolescence has barely begun. The Internet is expected to eventually reach an audience even larger than that which exists for television now. However, this maturation will not occur without an infusion of crucial nutrients; the most important being those technologies that enable the Internet to become the ultimate media delivery device. Chief among these is streaming media. A few reasons why streaming media is so groundbreaking when compared to television are:
(1) It's global - it inexpensively eliminates geographic boundaries;
(2) Anyone can do it; you don't need FCC permission or expensive equipment;
(3) Thousands upon thousands of highly specialized channels will be on at any one time;
(4) There exists the ability to personalize broadcasts; and
(5) Broadcast on demand changes the rules. For example you will no longer have to watch your favorite programs at a particular fixed time, you will be able to watch them whenever you want, and watch past episodes on demand as well.
With these things in mind, a lot of people already see the proverbial writing on the wall. Long-term market estimates for media delivery over the Internet are in the hundred billions of dollars. And yet, astonishingly, the company that is driving this bold new paradigm shift has been largely overlooked, misunderstood, and all but dismissed by the powers that be. It doesn't seem possible, but it is, and as usual confusion and misinformation are to blame. That company is RealNetworks, and it is a Rule Breaker scorned.

Most anyone sufficiently familiar with RealNetworks (RNWK) and their operations would have to conclude that there have been precious few companies more deserved of the Fool's "Rule Breaker" anointment. RNWK more than satisfies the criteria enumerated by TMF David Gardner for Rule Breaker status. Nevertheless, David Gardner and others have been reluctant to include RNWK under the RB umbrella because they believe RNWK is destined to be "Netscaped" by Microsoft (MSFT). It is a flawed conclusion but apparently still a widespread one, for it seems RNWK is seldom mentioned these days without this perceived possibility either insinuated or sewn onto its coattails outright. What I find of particular irony here is the fact that, despite MSFT's considerable efforts over the course of several years, RNWK still commands over 85% market share, and has at least doubled their revenues every year since their inception in 1995, proving themselves as capable of breaking the latest addition to the financial media's canon - the "Netscape Rule" (invoked now with reckless abandon whenever ol' Softie happens to amble onto the playing field) - as they are of breaking all the others. And yet, the strategy is cast aside. The hand-wringing continues. Every day the same concerns are aired�

"Isn't MSFT catching up?"
"How can RNWK possibly avoid getting steamrolled by the big behemoth?"
"Hay, dis is MICROSOFT we're tawkin' about hehh!" (pause for laughter, providing New Yawk accent up to snuff).

�and so on. One can point to examples where MSFT is getting its round hiney kicked like a shiny new Spalding at an Arsenal match - Adobe has been doing it with photo and imaging software, and AOL with ISP and subscription-based services. Still, the MSFT legend somehow looms bigger than any of that and is capable of dazzling pundits even when all evidence points to a sore posterior and a couple of Tylenol come the morning after.

So what's a conscientious Fool to do, but pound the table? And that's what I'm going to do in the paragraphs that follow. I'm going to pound it with both fists in hope that the world wakes up and David Gardner sees the light before RNWK becomes a Rule Maker and his brother gets bragging rights around the holiday dinner table.

Before I get into the MSFT threat (such as it is), and supposed parallels to Netscape, I'm going to offer a fresh Rule Breaker analysis of RNWK for the record. Here we go:

1. The company should be a top dog and a first mover in an important, emerging field.

RNWK is the pioneer of streaming media over the Internet, and continues to be the undisputed top dog. One might even liken them to "Clifford", the giant pooch in the children's book of the same name - only with claws and teeth. RNWK dominates media delivery over the Internet and is entrenched in every facet of that enterprise. Even their top competitor MSFT has admitted as much in their response, dated 4/10/2000, to the U.S. Government's proposed final judgment in the antitrust case: "RealNetworks' strong leadership in the Internet media delivery market is based on a rock-solid foundation -- the world's best and most extensible technology, the industry's deepest ecosystem of partners, and over 120 million unique registered RealPlayer users, by far the most in the industry."

I've already touched on how important the emerging field of Internet media delivery is in the introduction. For anyone who is not yet convinced of the enormity of this market, I invite you to consider the numbers with me in this post: http://boards.fool.com/Message.asp?id=1230279002601003

2. The company needs to demonstrate sustainable advantage gained through business momentum, patent protection, visionary leadership, or inept competitors.

Business momentum never looked so good. RNWK is growing their revenues at a rate of over 100% per year, and this number shows no sign of declining...rather, just the opposite. Their customer base is expanding at a pretty good clip too. The number of unique registered users of RNWK software is currently in the neighborhood of 120 million, and they are recording an average of 200,000 software downloads a day from Real.com.

They have proprietary streaming formats (codecs) the latest of which is vastly superior in quality to all others in the field, delivering VHS quality video at 200-500 Kbps, and DVD quality at 1 Mbps. As broadband proliferates, RNWK will be there waiting with a compelling quality of product.

CEO Rob Glaser is a visionary if ever one existed. He walked away from a well-paid top executive position at MSFT when his multimedia overtures were rebuffed, and struck out on his own. He is a high-energy leader - brilliant and passionate about his business and the new frontiers they are opening up. Anyone who has ever heard him speak in person will testify to that. He knows the value of the products and services his company provides and has gone on record more than once dismissing any possibility of RWNK being acquired by another. He has his own vision for the future of the industry, a clear understanding of his company's potential and the way in which to reach it. He has successfully positioned RNWK in all three facets of the media delivery business - content, delivery, and consumption. His is the only company to have a presence in all three tiers, and the result has been a well-diversified set of revenue streams.

The competition, while not what I would characterize as inept, is nevertheless doomed to failure as a result of their own cross-purposeful agendas. More on this important issue to follow the RB analysis.

3. The market should have recognized a Rule Breaker's promise by rewarding it with strong price appreciation. A good indication of this is a relative strength rating of 90 or above.

RNWK had a relative strength rating over 90 before the broad market crash in March this year. It plunged along with the rest of the Nasdaq and has been slow to recover. It's now starting to climb back up again and has a RS of 30 at the moment.

4. Look for good management and strong backing.

Rob Glaser and his team provide excellent management. Let's consider the financial data:
Revenues for the last quarter were $53.5 million. Trailing 12 month revenues were $159.9 million. Last quarter's earnings were $8.8 million, and the total annual earnings for this past year were $19 million. As the estimable RobDeFool has noted, a good indication of how well the business is being run is the net margin, which for the trailing 12 months is 19/159.9 = 12%. The net margin for Q1 2000 is 8.8/53.5 = 16%. This is quite significant. I think RobDeFool said it best: "The company has almost reached the 20% net margins typical of a software company, and they have only been profitable for 3 quarters! This is stunning, and may be a sign that net margins in the future will be significantly higher than 20%."

The company enjoys strong support from a number of important partners and allies. AOL/Time Warner has embraced RNWK, as has Intel, Nokia, Seagram's Universal, Sony, IBM, Sun Microsystems, AT&T, The Associated Press, CBS, and many others. In fact, it can be (and has been) argued that RNWK sits at the center of its own distinct media-keiretsu.

5. Also important is having a strong consumer brand.

Like Kleenex and Xerox, RNWK is virtually synonymous with its respective industry. I have heard consumers use their name even when referring to another company's product or service. Co-branding has helped reinforce this too, as in the example of music property Spinner for instance, where the Real logo is prominently displayed. Also, the Real.com media portal ranks consistently in the top 10 most trafficked sites in the world, according to Media Metrix.

Consumers may also be familiar with Windows Media Player, but principally because it is integrated into Windows and thus unavoidably visible. WiMP still has far less market penetration than RNWK, only being used by about 3 percent of all active Internet users as of November 1999, according to Nielsen/NetRatings. This represents roughly a quarter of RNWK usage.

6. We also consider it a good sign when the financial media, not seeing the big picture, calls a company overvalued.

Does The Motley Fool count? I don't recall offhand seeing any Fool articles lately claiming that RNWK was overvalued, but one could replace this last criterion - concern over valuation - with the irrational fear that the company has a one-way ticket to Netscapeville. To be fair, TMF is not alone in this. CNET, having a long history of giving its RNWK coverage an unfavorable slant, kept the tradition alive with its multi-part story of the MSFT-RNWK battle, titled "Swimming With Sharks".

Back to valuation: Shortly before the market crash Forbes and Red Herring were among several to call RNWK overvalued. The slow recovery of the stock since the crash suggests that most on Wall Street still share that sentiment, proving once again the typical analyst's inability to see the forest for the trees.

This concludes the RB portion of the analysis.
----------------------------------------------

Okay, as promised I am now going to deal with this Netscape nonsense. For those who wonder if RNWK's situation vis-�-vis MSFT is similar to NSCP's a few years back, and wonder if perhaps the same thing will happen in this instance, I urge you to pay close attention to what I am about to say.

The comparison between RNWK and NCSP is an utterly specious one. NSCP was crushed by MSFT for a few very simple reasons. To begin with, NSCP's sole source of revenue was the sale of their web browser, a relatively uncomplicated consumer software application. The file format (HTML) accessed and read by NSCP's browser is not proprietary, and the same content in the same format can easily be made available elsewhere. Needless to say, this is a siren call for "me-too" copycat initiatives. The barriers to entry in the browser software market were pretty low, and therefore the only advantage NSCP had at the time was simply a market lead over everyone else. So along came MSFT, who foresaw in NSCP's innovation a potential threat to their operating system, and promptly pounced on the new market. They developed their own web browser and incorporated it into their Windows OS, giving it away for free. Since they have an almost perfect monopoly on operating systems for PC's, their browser shared in that monopoly as well, and it wasn't long before nearly everyone was using MSFT's browser by default. Basically, the battle was over client machines (PC's) exclusively, and the tools of battle were pieces of software that read an open standard that anyone could serve. Under these circumstances NSCP never stood a chance.

RNWK, by contrast, is operating with a completely different set of circumstances. It is useful for the sake of clarity to list them one-by-one:

(1) RNWK has many different revenue streams, as healthy as they are diverse: Software sales, server licensing (broadcast and edge), advertising revenues, revenue from content providers, media hosting fees, and more. There is a robust ecosystem of value chains formed around the company.

(2) They have proprietary media formats via their codecs, which allow them direct control over content and aspects of its consumption like encoding (bit-rate, compression, etc.). This provides the opportunity for them to offer consumers a substantially differentiated and higher quality product than their competitors.

(3) In addition to their own media format they also support every other major media format in the industry (including QuickTime, Liquid Audio, MP3, and others) which is a level of versatility no one else can offer. They are format agnostic when need be, thus making themselves a "one-stop shop" of sorts and further solidifying their position as a universal player and media portal.

(4) As mentioned previously, they are well-entrenched in all three facets of the media-delivery model: Content; Distribution; and Consumption. Their ubiquity on multiple levels means that they are operating with more than one business model concurrently. Having long since evolved beyond the mere enabling of consumption, they are now positioned firmly in the "soft" delivery space by creating a true media portal for content aggregation, and in the "hard" delivery space with their edge server network infrastructure.

(5) They have extended themselves beyond the PC market into the market for wireless handheld devices, where MSFT has little leverage and poor traction.

(6) And last, but most importantly, is the reality that the most significant source of strength in the streaming-media industry is not in the media player (end-user software), but in the servers used for streaming. The overwhelming majority of professional, "mission-critical" streaming media operations are run on UNIX or UNIX-based platforms (e.g. Sun Solaris, LINUX, Apache, etc.), since they are far more stable and reliable (and cost-effective in the long run) than Windows NT. Yet MSFT's streaming servers are only compatible with NT, while RNWK's servers, on the other hand, can run on any of these platforms (including Windows NT), making theirs the only viable choice for most professional audio/video operations over the net. In short, cross-platform compatibility is king. This is the main reason RNWK enjoys such dominant market share. The core of the Internet architecture is UNIX, and MSFT's servers are simply incapable of running on that platform. So, RNWK continues to dominate the market for streaming servers, which in turn ensures the dominance of its patented streaming formats, which in turn ensures its player and portal dominance. Voila.

This tide is virtually incapable of changing, because the possibility that MSFT will ever offer a streaming server of their own that is compatible with any platform other than Windows is utterly incomprehensible. Why? Because the Windows operating system is the heart of the company. Everything else is peripheral and thus must be geared to promote that OS. There's the rub. They simply cannot put forth a product that potentially undercuts their OS revenues. It's as clear as day. Their reason for entering the streaming media market in the first place was the same reason they entered the web browser market - to protect their OS from any competitive advantage that others might offer thru integration of such features. Only the media delivery market is a bit more complex than the web browser market, and their protectionist agenda actually works against them. As a result they deny themselves the lion's share of the streaming server market, and will therefore ultimately be marginalized.

The most important thing to remember is that for all the noise MSFT makes about its front end software and services, they simply cannot compete with RNWK on the back end (servers) - and the back end is the ground on which the war will be won or lost.

"But wait," you say. "Crazier things have happened�what if MSFT goes against all probability (and reason) and does make their servers cross-platform?"

For the sake of argument, RNWK has diversified their revenue streams to such a degree that they could conceivably give away their servers for free, were this to happen. If RNWK matched MSFT's offer of free servers it would effectively kill any chance MSFT might have for growing their server market share. Gone would be the one advantage they rely upon to try to lure broadcasters into using (buying) their Windows NT OS, so what incentive would there be then for companies to make a costly and time-consuming conversion to an inferior platform? The answer is none whatsoever. So if MSFT actually were to go cross-platform (and I were to flap my arms and fly across town), RNWK would continue to make money from other sources, while MSFT on the other hand makes absolutely none if their free software runs on existing UNIX platforms. The only way they can afford to give the stuff away for free like they have been is by selling their OS. Take that away and you may as well bring down the curtain. Even MSFT is not immune to a war of attrition, because their separate divisions must ultimately be able to support themselves. If they can't�well, to paraphrase good ol' Jerry Lee, there'll be a whole lotta tent-foldin' goin' on.

In conclusion then, there is a lot more to consider about this skirmish than meets the eye. When it is examined closely and coolly, one should see that the RNWK-NSCP comparison is a load of lazy sophistry. Of course, debunking the comparison doesn't make for nearly as sexy a story as does using it to play up the battle between RNWK and MSFT for maximum drama. But, that's par for the course I guess. The fact is that RNWK may never make it into the Rule Breaker portfolio, or even be acknowledged as such by David Gardner...but the story has been told. Whether we're talking about Rule Breakers, Gorillas, or what have you, RNWK is breaking the rules and the media's perpetual misconceptions, and quietly winning the game.

Dave


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