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Watching the 'digital hand'

Venture capitalist J. William Gurley explains how the technology industry is being changed in subtle but real ways by larger economic forces.

    "We can't rewind; we've gone too far."--"Video Killed the Radio Star," Buggles

    In his famous 1776 work, "Wealth of Nations," Adam Smith proffered that an economic "invisible hand" ensures that if companies act in their own interest, the good of the public or individual will also be optimized.

    An equally powerful and unavoidable force controls high-technology markets today--the "digital hand."

    Like Smith's invisible hand, the digital hand is a true boon for the consumer, ensuring that fabulous products will be delivered in the most convenient way--and at ever lower prices. However, there is one big difference. The invisible hand suggests that both companies and customers can profit simultaneously. The digital hand is not nearly as charitable to the companies involved. In fact, it can be downright brutal.

    If you want proof, just ask the entertainment industry. The music industry says CD sales are down as much as 16 percent year over year, and clearly, digital technology--not the quality of the music--is the key culprit.

    Not only can users easily share digital content anonymously over the Web, but virtually every PC that rolls out of Best Buy or Wal-Mart Stores is equipped with all the technology you need to mass-produce copies of your favorite CDs. Need blank discs? Wal-Mart has those, too--50 for $15, or 30 cents each. The ease of duplication doesn't stop at just music. DVD writers are making their way into the market as well.

    If the media industry blames the hardware industry for these evil consumer technology gadgets, it can take solace in the fact that the digital hand's next strike will be against none other than the consumer electronics industry itself.

    Digitization is creeping its way across the entire consumer electronics industry, as we slowly remove analog media and components from our lives. While this is good news for consumers who benefit from the low prices the digital hand ensures, the quid pro quo for businesses is brutal competition.

    One clear indicator of this shift is the PC makers' recent entry into the consumer electronics industry. Last year, Gateway led the charge with its aggressive participation in the flat-panel TV market. This year, it launched a wireless, "connected" DVD player, currently back-ordered.

    Last week, Dell joined the parade, and Hewlett-Packard scrambled to declare that it had been at the parade all along. Many pundits cleverly noted that only a PC maker could covet the consumer electronics industry. But PC makers that are entering the market are merely symptoms of bigger issues the consumer electronics market faces due to digitization.

    Two critical dynamics are occurring in the consumer electronics industry as a result of digitization, and both unfortunately lead to commoditization. The first: Semiconductors are increasingly incorporating the majority of the features and functionalities by which any manufacturer would differentiate their product.

    If you want to become a consumer electronics manufacturer, simply call LSI Logic, Zoran, ESS Technology and MediaTek, and they will immediately deliver the goods you need. Don't know how to integrate chips? No problem. A reference design is on its way. Be it DVDs (digital video discs), HDTVs (high-definition televisions) or digital cameras, the barriers to entry for hardware providers are quickly approaching zero.

    The second key dynamic mirrors the binary code that underlies all digital goods.

    Digitization is creeping its way across the entire consumer electronics industry, as we slowly remove analog media and components from our lives.
    The cold fact of the matter is that most digital goods either work or don't work. You lose the subtle continuum of quality that exists in an analog world. The reason relates to the first dynamic in that most of the "value added" is now at the semiconductor level. The complicated motors and servomechanisms that inherently led to quality differentiation are slowly going away.

    Traditional TV tubes, which through tuning offered a path to differentiation are also on their way out, being replaced by semiconductor "brains" like Texas Instruments' DLP (Digital Light Processing) chip (consumers will see a rush of DLP-based TVs this Christmas that offer plasma quality at a fourth of the price).

    Eventually, even the rotor under the CD (compact disc) or DVD is likely to be replaced with solid-state electronics or a hard drive--and no consumer electronics company is likely to enter the hard drive business.

    Even more serious for the consumer electronics industry than pressure from PC makers is that from Chinese importers such as Apex Digital. Wal-Mart currently advertises an Apex Digital DVD player for $43.86. It plays DVDs, CDs and MP3s. It can decode Dolby Digital and Dolby DTS (Digital Theater Systems), and it supports S-video output. This product works, and it works well. So do all price-leading products Apex sells.

    After all, they use the same semiconductors as all the other manufacturers. And at $43, consumers will start to view these devices as disposable, a nice trade-off for the obsolescence that is an inherent part of any digitized industry. Remarkably, Apex has quietly leapt to the top of the U.S. DVD market.

    With product differentiation on the wane, distribution will play a greater role.

    Gateway has already leveraged its direct model with early success. This could bode resultantly well for Dell. Furthermore, do not be surprised if retailers like Wal-Mart and Best Buy create in-store brands similar to what Wal-Mart already does in every other line it sells.

    With product differentiation on the wane, distribution will play a greater role.
    Best Buy is already doing this in PCs, and it should be even easier in electronics because of lower support costs.

    Perhaps the best proof point of distribution's strength is the way EchoStar Communications, which owns Dish Network, catapulted from nowhere to lead the PVR (personal video recorder) market. The satellite service provider now has the market share lead in the most compelling new product category in consumer electronics.

    As we look toward the future of the consumer electronics industry, the digital hand will ensure two realties. First, consumers will be blown away by the incredible products they are able to buy at shockingly low prices. Second, companies will be blown away by how incredibly hard they have to work in a shockingly competitive industry. Never forget that the undisputed leader of the PC industry has a supply chain and distribution advantage, not a technological one.