WATCH OUT FOR THE CD-ROM HYPE Some industry executives tout the luminescent disks as the hottest thing since the VCR. But that view rests on seven myths you should know about.
By Stephanie Losee

(FORTUNE Magazine) – Has the buzz about multimedia grown so loud it's drowning out the truth? Just about everybody with a computer seems to take for granted that CD-ROMs, the silvery disks that hold interactive games, books, and other state-of-the-art software, are the New Cool Thing. By Christmas, some 1,700 titles will be warring for space on retailers' shelves. Magazines like CD-ROM World, NewMedia, and Multimedia World number their subscribers in the hundreds of thousands. Gateway 2000, a major mail-order PC maker, recently announced that every machine it sells from now on will come with a CD-ROM drive built in. Sounds like a smoking-hot market. But the chilly reality is that the consumer CD-ROM craze is mainly wishful thinking on the part of hardware makers and software publishers, sustained for the most part by hopeful venture capital and giveaway products, not by booming demand. At the top of CD-ROM charts are games like Myst and The 7th Guest, capable of satisfying users and attracting attention to the technology. Below the thin tier of big sellers, however, are hundreds of products, many only second-rate, fighting for consumer interest that just isn't there. Most PC users are only beginning to react to a medium that's being thrust upon them, and so far their responses are mixed. This isn't the first consumer electronics trend to be driven by forces other than popular demand. Think back on the birth of the audio compact disk. Now the primary vehicles for recorded music, CDs started to displace vinyl records long before consumers ratified the new technology. "Suddenly, the only way to get access to new music was through CDs," recalls Patty Kim, senior marketing manager for CD-ROMs at Sony, which pioneered audio CD technology with Philips Electronics. For consumers, the CD's arrival wasn't an entirely happy affair: Though the disks were more compact and convenient than LPs, they were priced a lot higher and forced music lovers to repurchase their entire collection of records. Despite the technological improvement, consumers didn't get a medium that could be used for recording, like the videocassette. PC users find themselves in a similar position today, often buying computers equipped with CD-ROM drives because that's what manufacturers and stores are pushing. Apple Computer, for instance, sold over one million CD-ROM players in 1993, up from only 50,000 the year before. But to do this, Apple sacrificed a potential $100 million in gross margins by offering the drives at cost. Apparently the company's strategy is to establish a multimedia market so it can eventually sell its own CD-ROM software at a handsome profit. Nor is demand for CD-ROM titles as strong as it seems. So-called multimedia PCs are usually equipped with as many as 15 CD-ROM titles thrown in. Software publishers often include these freebies when they talk up the number of units their titles are selling. It's hard to see the market for the confusion and hype.

-- MYTH: The CD-ROM market is huge. The numbers that create this perception are pretty impressive. Depending on who is counting and by what criteria, the worldwide installed base of PCs with CD-ROM drives was between six million and 12 million at the beginning of 1994 and could more than double by year-end. Link Resources, a New York City market researcher, pegs this year's multimedia hardware market at $3.6 billion and the CD-ROM software market at $360 million. How's this for a hockey-stick growth curve: Link forecasts that software alone will hit $3.1 billion a year by 1998 -- an average annual growth rate of more than 70%. Such numbers don't even begin to portray the market accurately. Why? All CD- ROMs are not created equal. The installed base figures include multimedia PCs that are too old or too slow to play current titles and CD-ROM drives that are never used. Odyssey, a San Francisco research firm that specializes in consumer attitudes toward new technology, reports that of the 6% of U.S. households that have multimedia PCs, only one in three own systems powerful enough to run today's best software smoothly. Estimates of software sales are equally squishy. Most don't say how much of the spending represents the nominal value of disks that were "bundled," or thrown in free, with the purchase of a multimedia PC. Many PCs aimed at the home market include the CD-ROM drive and multiple disks at no apparent extra charge. Result: It's never clear why the consumer decided to buy. Says Denise Caruso, publisher of the newsletter Technology & Media: "If you can't tell me how many people buy computers with bundled titles and then put them in a closet, I can't judge if it's a real market." The lack of reliable information hobbles software publishers, who have a hard time gauging how much to invest in each title. says Bing Gordon, executive vice president at Electronic Arts, a San Mateo, California, producer of computer games: "It's hard to make money in the CD-ROM business because the market-size estimates are misleading."

-- MYTH: Consumer interest fuels CD-ROM market growth. What little data there are on consumer attitudes paint a contradictory picture. Odyssey recently completed the first large-scale study of CD-ROM customers; the results, based on a telephone survey of 1,520 households randomly chosen nationwide, are revealed here for the first time. Odyssey turned up 100 owners of CD- ROMequipped PCs. Fully two-thirds said they were very satisfied with the CD-ROM titles they owned -- an average of eight titles per family, of which three or four came free with the hardware. Families typically expected to buy another two or three by next Christmas. A market study in June by Dataquest, a research firm in San Jose, produced results that were far less sunny. In a nationwide survey of 305 households that have multimedia machines, the researchers found that 54% of the people who had bought multimedia PCs said they had no plans to acquire CD-ROMs in the next year, not even upgrades to disks they'd gotten free with their computers. Multimedia analyst Bruce Ryon says such responses are unusual: New owners of hardware such as videogame consoles tend to spend liberally on software in the first year. How did the market grow to where it is now -- wherever that may be? Manufacturers and software publishers have worked ceaselessly to sell America on CD-ROM. The blitz was kicked off by no less a promoter than Microsoft CEO Bill Gates, who staged the first major CD-ROM conference in 1986. At his urging, hundreds of software developers eagerly turned their talents to creating multimedia. Then came the venture capitalists. Says Bob Lloyd, CEO of Software Toolworks, a software publisher in Novato, California: "If you say you're trying to raise money to put together a multimedia company, that's like magic." Author and pundit John C. Dvorak phrases it less kindly: "There is a tonnage of companies starting up with decent financing to produce CD-ROMs, and I don't see that the market can sustain even a fraction of them. The fact is that CD-ROM is a low-tech aspect of a high-tech industry and thus can be easily understood by venture capitalists." Jacqueline Morby, a senior general partner at TA Associates, a large venture capital firm in Boston, has kept her company clear of the stampede. Says she: "There is a herd mentality in our industry. People get excited about an area and have to have one in their portfolio." The effect on the market: a proliferation of CD-ROMs that are ill conceived and sloppily executed, and that cost more to produce than they can ever hope to earn. Then there's "bundle fodder," disks jam-packed with information whose appeal seems limited. One disk, for example, features every Life magazine cover through 1972; another is filled with 1,000 of the "world's greatest" noises. The industry's next big boost came from TV and movie folk. Intrigued by the thought of being able to display digital video and film clips on computers, Hollywood production companies formed CD-ROM partnerships with gearheads (technospeak for nerdy programmers) from Silicon Valley. SiliWood -- pronounced Silly Wood -- was born. Bobby Kotick, CEO of Activision, moved his entertainment software company to Los Angeles to be closer to the Hollywood creative community. "The big studios are spending lots of money to figure out the business," he explains. "In the process, they'll up the ante for everybody else. We're working on a title with an animation studio now, and our entire $2 million budget was probably the catering bill for the last film they worked on."

NO WONDER state-of-the-art CD-ROMs now cost millions to produce. One best- seller, Activision's Return to Zork, involved 25 actors and ten programmers and cost $1.5 million. Big players like Activision and Electronic Arts each have several projects under way with budgets as high as $5 million. Even run- of-the-mill consumer titles typically cost $750,000, says Helen Rosen, multimedia analyst for Link Resources. A hit can earn millions -- Return to Zork brought a net profit of $2.3 million on sales of 600,000 units, more than half from bundled systems. But the vast majority of titles won't make a cent. Kotick guesses that only 25 of the 1,700 consumer multimedia titles hitting store shelves this Christmas will sell 100,000 units or more, and that only 200 will turn a profit. Even if the families surveyed by Odyssey bought all the titles they say they will -- a statistical improbability -- CEO Nick Donatiello estimates that the 1,690 titles that miss the top ten will sell an average of fewer than 7,000 copies each. That's not even close to breakeven levels. Denise Caruso figures that the interactive CD software and hardware industries combined have lost as much as $4 billion so far. So crowded is the market that consumers may never even see many of the new products. "I feel sorry for the new people getting into this, because it's going to be an uphill battle for shelf space," says Ron Gilbert, co-founder of Humongous Entertainment, a kids' adventure game publisher. Software stores aren't designed to display thousands of consumer CD-ROMs; even the largest stock 300 titles, tops. Wal-Mart and other mass retailers typically carry only the hottest 30. The shortage of shelf space forces publishers to fall back on bundling in an effort to recoup development dollars. But the economics are grim. Says Steve Podradchik, CEO of Medio Multimedia, publisher of Jets!, an interactive documentary, and Medio Magazine, a general-interest periodical, both on CD- ROM: "You're lucky to squeeze $2 per unit out of a bundling arrangement. You can't really count on bundling for revenue, just for getting your name out."

-- MYTH: Bundling CD-ROMs with computers will spur consumers to buy more. It's the software equivalent of razors and blades: Many suppliers think the profit may lie in selling sequels and upgrades to their CD-ROMs. Grolier Electronic Publishing of Danbury, Connecticut, was the first encyclopedia publisher to put out a multimedia edition. Today some two million copies of its disks have reached users' hands, mostly via bundling (the idea of getting a free CD-ROM encyclopedia is generally the strongest selling point for multimedia PCs, says Dataquest). Grolier's plan is to sell customers annual update disks. Says Joe Szczepaniak, vice president of sales: "We bundle more copies than we sell retail, but when customers buy the updates, they pay $75 a year." Grolier earns back its investment on its products, Szczepaniak says. But other companies whose sales depend on bundling aren't so lucky. The greatest danger of bundling for publishers is that consumers will begin seeing CD-ROMs as giveaways rather than as products to buy. A reflection of this mindset has already made it to the top of the CD-ROM charts, in the form of the current best-seller, 5Ft. 10 Pak. Although the name sounds like that of an exotic drinking game, 5Ft. 10 Pak is a literal description of the offering: a five- foot-long plastic case folded like an accordion, filled with ten CD-ROMs plus coupons from various manufacturers, that sells for just $29.95. In other words, the top-selling CD-ROM is itself a promotional bundle.

-- MYTH: You can buy a multimedia PC and enjoy all the latest CD-ROMs. Buy a VCR or an audio CD player, and you can play just about any movie or record in existence until your machine quits from wear and tear. Multimedia PCs, however, follow a nasty obsolescence cycle that delights hardware makers but can drive users wild: The memory and processing demands of software are increasing so fast that within 18 months your new PC can no longer run the hottest new games smoothly. No one who has tried playing a CD-ROM disk would be at a loss to explain why the consumers surveyed by Dataquest felt an aversion to buying more multimedia titles. Many CD-ROM titles are uninspired in content and hard to install, and play sluggishly on the average PC. For all the attention the disks get for their ability to store video clips, current technology generally limits video to a jerky, low-grade picture in a small window onscreen. Computer experts don't find the disks any easier to use than does the average consumer. Says Denise Caruso: "A CD-ROM loads tons of megabytes onto my computer's hard drive to make the title go faster, at least half the time it crashes and doesn't even run -- and companies send me their best stuff. Is this the dirty little secret that everybody has? 'I bought a CD-ROM drive and I can't get anything to work on it, but I don't want to tell anybody because they won't think I'm cool?' " The proliferation of CD-ROM game consoles that plug into TVs further mystifies buyers. Disks designed for Sega machines won't run on Nintendos, for example, or on multimedia PCs. Says Macromedia CEO Bud Colligan, whose company makes software that developers use to create CD-ROM titles: "There are so many different incompatible formats out there, consumers don't know what to do." Neither do software publishers, who watch helplessly as hardware companies launch incompatible machines with discomfiting regularity. There's Philips CD- I, the granddaddy of the category of CD-ROM players that hook up to a TV. Sega CD has an installed base of about 1.2 million machines aimed mostly at young videogame jockeys. 3DO's interactive system is struggling for consumer acceptance, and newcomers will include Atari's Jaguar and the Sony Play- Station. Software publishers complain that the lack of a standard lowers the odds of making a profit on a CD-ROM title. A game, say, that is developed for PCs can't simply be transferred to another disk for play on a Mac or Sega CD machine. In most cases each title must be rewritten from start to finish -- an expensive process that takes as long as six months.

-- MYTH: The CD-ROM market will eventually grow enough to make companies' investments pay. Software publishers have ulterior motives. Sure, they'd like each of their CD-ROM titles to earn back its costs. But there's more involved than a few million production dollars -- there's the lure of being positioned to supply content for the information highway. Former venture capitalist Gary Vickers is founder of Creative Programming & Technology Ventures, a company that develops multimedia titles for publishers like Viacom New Media. Says he: "I don't think any of us would be playing in this marketplace to get onto 15,000 retail shelves. I'm playing to get onto the electronic highway into the home. We're only three or four years away from massive growth in the number of consumers we can reach and sell to. I'm starting work now because I've got to stake my claim as a unique producer of this software." Like many developers, Vickers views the CD-ROM market as a low-risk way to practice making content for interactive television (ITV). Couch potatoes of tomorrow, the theory goes, will use their remote controls to enjoy a superduper version of multimedia on digital TV sets. Says Kotick of Activision: "We're shooting video at the highest resolutions and recording music at the highest sampling levels so ultimately, when there is the technology to support it, we'll be able to supply the video and audio. You expense it and explain it to the shareholders." Smaller publishers' eyes grow just as large when they look at the late Nineties. Says Medio's Podradchik: "If you're a medium-size company, you're not going to get to participate in ITV unless you get in early and make a name for yourself. That's why we do what we do today. It's a warm-up." Some are already contributing software to interactive TV tests. Broderbund, the profitable CD-ROM developer that many competitors hold up as a role model, shies away from dreaming about the interactive TV market. Says COO Bill McDonagh: "Maybe some of those companies obsessed with ITV aren't having much success in the market today, and they're thinking about how to get their investments back down the line."

-- MYTH: Consumer titles account for the bulk of revenues in the CD-ROM market. For all the hoo-ha, sales of consumer multimedia disks don't even approach those generated by so-called commercial CD-ROMs. These include workaday products of commercial publishers who churn out books-on-disk such as telephone directories. The government uses compact disks to distribute information like patent lists and Social Security rules. Corporations use CD- ROMs as a cost-saving alternative to paper and microfiche for parts catalogues, manuals, and technical documentation. It's not hard to understand why these CD-ROMs get little press: They're boring. But Infotech, a market research firm in Woodstock, Vermont, estimates that commercial titles account for over 80% of total CD-ROM software sales. By the end of 1994, the number of commercial titles should reach 9,000. "It's a quiet revolution," says Paul Saffo, a director at Institute for the Future, a think tank in Menlo Park, California. "Companies view CD-ROM as a competitive advantage, and they'd rather their competitors not know how useful it is." To program the titles and press the disks, corporations and the government usually turn to contractors like Dataware Technologies, a Cambridge, Massachusetts, company that is a market leader. Says CEO Kurt Mueller: "We can typically produce a title for between $10,000 and $80,000, and updates for up to $15,000 each. In the commercial market, a disk isn't put out to try to make a hit -- it's updated regularly and provides recurring income." Only a few thousand copies of most commercial titles are printed. Another unglamorous but lucrative side of the CD-ROM business is PC software distribution. Since a CD-ROM holds roughly 450 times as much data as a floppy disk and costs about $1 to make, vs. 75 cents each for multiple floppies, publishers have started to offer their traditional PC software on CD-ROM disks. For example, the latest upgrade of Microsoft Windows, the popular PC operating system, requires seven diskettes but can also be purchased on a single CD-ROM. Microsoft saves the cost of churning out all those floppies; the customer installing the program is spared having to sit in front of the machine swapping disks. Simple as this piece of the market sounds, it only contributes to the confusion about the true size of the total CD-ROM market. Says Bobby Kotick of Activision: "The majority of the growth we've seen over the last one or two years is coming as a result of a change in the delivery system, not from new users." Until recently, almost all computer software games were sold on easy- to-pirate floppy disks. Software publishers estimate that five times more people were using each title than the number actually sold. "A lot of the CD- ROM revenue increase," explains Kotick, "comes from some of those five people who used to copy software illegally but now can't and must buy it."

MYTH: We have seen the future, and its name is CD-ROM. Oddly, when most industry authorities discuss CD-ROM's prospects, they talk not about how much data a disk holds, but how little. Says Randy Komisar, CEO of LucasArts, filmmaker George Lucas's entertainment software company: "CD-ROM is not magic, it's just a storage medium. There will be others that will come down the pike, and there will be other versions of this medium. As the media get larger and allow you to add information, we can begin to approach the quality and expectations people have for our art." Technologies that will increase the amount of data that can fit on a disk are already emerging. Red, blue, and green lasers, which can pack more data on CD-ROMs than the infrared lasers currently in use, will multiply disk capacity by a factor of up to four. IBM is working on a way to layer disks, increasing data capacity another tenfold. And a new video standard will make fluid, full- screen moving images available to users with the money to upgrade their hardware and buy a slew of new disks. Any of these innovations would make current CD-ROM disks obsolete. Don't expect recordable data CDs anytime soon. Says Jerry Michalski, managing editor of the industry newsletter Release 1.0: "A read-and-write format might have more appeal than current CD technology, but content publishers are very afraid of massive-scale flawless duplication. They're afraid everyone will copy their artistic property." So CD-ROMs are a flawed stopgap, right? That doesn't mean they're doomed. Says Paul Saffo: "CD-ROMs are the quonset hut of media -- temporary structures that have a way of becoming permanent. Given the absence of competing technologies and the slowness of the arrival of the interactive highway, it looks like CD-ROM will be around awhile." Microsoft and others are mapping out a marriage of CD-ROM and communications technologies that Jerry Michalski thinks could help ensure the disks' longevity. Microsoft Complete Baseball, a $60 disk released in June, may signal the start of this trend. It not only holds thousands of statistics but can automatically dial the user into an on- line service for daily updates -- at $1.25 a call. To many students of the market, the biggest obstacle for CD-ROM is not its technical shortcomings or seller-fed hysteria. It's the fact that manufacturers' much-longed-for "killer app" -- the application that justifies the medium's existence -- has yet to emerge. Until that happens, Michalski has some advice for frustrated users whose multimedia purchases let them down. Says he: "CD-ROMs make great disks to throw."