Apple TV and the Future of the DVD player

| About: Apple Inc. (AAPL)

As iPhone excitement reaches a fever pitch, let’s take a moment to ponder what Steve Jobs called Apple’s (NASDAQ:AAPL) “hobby”, Apple TV. Jobs explained to Walt Mossberg that Apple TV is not another set top box or a set top box replacement, but is “sort of a new DVD player for the Internet age.” Jobs also said Apple TV is a product that will evolve over time.

Many people in the developed world have a DVD player. It’s not as big a market as cell phones, but it is a huge market. It’s historically been a pretty bad business, unless you’re the low cost manufacturer, because the format in which DVD discs are encoded is a standard that any manufacturer can create a device for.

Toshiba (OTCPK:TOSBF) and Sony (NYSE:SNE) each saw a solution to the commoditization of DVD players: create and control a new standard for a new type of DVD disc that carries a lot more data, enough to carry movies in high definition. Toshiba, with its HD DVD standard, and Sony, with its Blueray standard, are fighting a pitched battle over who gets to control that high definition DVD disc future. A good amount of their fight has been over convincing the movie studios to back their respective standards. Yet the confusion over which type of player to buy has kept many people from buying either type of player. And when hackers cracked the digital rights protection on high definition DVDs, Fox stopped distributing high definition movie discs.

Meanwhile, Apple and startups like Vudu (see my prior post on Vudu) are seeking to use Internet connected boxes that would replace the DVD player entirely. Is an Internet connected box a better approach than a high definition DVD player? For any type of content, to me it seems the Internet is a better medium than a physical disc in 4 ways and a worse environment in 3 ways.

The ways the Internet is superior are:

1. Marketing. It’s cheaper to do marketing. You can tease people with parts of content and it’s easier for people to share what they like. With community features like YouTube ratings and the Facebook social graph, you can let people know what content their communities prefer.
2. Upload, storage, distribution. It’s easier to allow people to upload. In the physical world, only a select few get DVDs made. In the Internet world, anyone can share their video. The technological costs of storing and distributing that video are rapidly decreasing as the Internet evolves.
3. Encryption. It’s technologically easier to create an encrypted environment on the Internet because you control the software on both the server, client, and data packet sides. In the physical world it’s harder to update broken encryption systems once part of the encryption scheme has been shattered.
4. Update the interface. The interface for Internet based solutions can be revised and updated, as we see in the rapid changes happening to websites. This advantage of the Internet will spread to Internet connected consumer devices.

The ways the Internet is inferior are:

1. Technologically it’s cheaper to move large amount of data by moving discs than by copying bits. High definition video takes up a lot of data space. For a long time it has been cheaper to move that data around by truck than by a network because each physical disc can store tremendous amounts of data. The advantage trucks enjoy is diminishing, however, because the Internet is evolving swiftly and peer to peer file sharing systems dramatically lower the technological costs of distribution.
2. Legally it’s cheaper to move discs then to copy bits. For professionally produced content it’s a bit more expensive to buy or rent movies than it is to share physical discs (thus the current disc through the mail business models of Netflix, Blockbuster, Gamestop, LaLa). This is because although technology makes it cheaper to copy bits electronically then to move them physically, the law of copyright requires you to obtain rights to copy bits electronically but often lets you move them around physically without seeking permission. Therefore, despite the greater technological costs of moving discs, they have less legal costs, and therefore potentially less total cost.
3. Painful to hook up. It’s a bit difficult to connect the Internet to your high definition television type displays. The interfaces on the devices currently used to make this hookup are generally pretty poor and keeping the Internet connection live adds a potential point of failure.

Yet that’s just where things are currently. In the spirit of Wayne Gretzky, let’s ask where the puck is going.

Are physical discs going to become better at marketing, upload (openness), storage, encryption, or changing their interface, than the Internet? No.

Is it going to get technologically and legally cheaper to move discs onto the Internet relative to the legal cost of moving physical discs? The discrepancy in technological and legal cost will likely diminish, but it’s unlikely for the legal cost advantage of physical distribution to disappear unless more and more content is unencrypted.

There are multiple approaches to dealing with the legal cost of moving content around. Apple is trying its best to get around this disadvantage by creating one environment (iTunes) to serve content (music, video, games, software) to a multitude of devices (the desktop, laptop, ipod, iphone, Apple TV). Internet stores selling professional content in a digital form may be able to leverage their growing market share (see story) to diminish their legal cost disadvantage. Like Apple, Joost has created an encrypted hard to upload environment, but there are also unencrypted easy to upload environment (think YouTube), or encrypted easy to upload environments (think Brightcove), which all circumvent some of the legal cost disadvantages that the Internet has over physical distribution. The growing size of the Internet advertising market also potentially will draw more professional content onto Internet based distribution systems.

Is it going to get less painful to hookup the Internet to your high definition television type display? Undoubtedly. User interface design in consumer devices is something that Apple is very good at, but it’s not beyond the capabilities of a TiVo, Microsoft, Google, or other party to innovate in such a space. And one significant advantage of using the Internet to distribute your media is that you can continuously upgrade the interface. We’ve seen this with websites, have seen hints of this with Apple TV, and will see it with the iPhone. This takes device development from a relatively slow iteration hardware model to a super fast iteration web site like model.

Although leadership in the Internet age can change rapidly (see my post on Murdoch’s statement “They’re all moving to Facebook now”), it is possible to create competitive advantage in the Internet? Apple has shown they can do it by coupling beautiful hardware, elegant software interfaces, a minimalist aesthetic approach to what a customer actually finds most useful, and a growing library of professional content that it has the rights to distribute (iTunes) and amateur content (YouTube through Apple).

It is certainly a better business than being a commodity DVD player manufacturer, if you can get traction with the consumer, and can maintain a proper pace of innovation. This is a point that Toshiba and Sony, with their massive initiatives on a waning medium, would do well to heed.

Disclosure: none