iStockphoto COO Kelly Thompson says the company cannot keep growing profit at the old royalty rates, so they have to reduce what they are paying suppliers. The problem is not that the company does not have substantial profits. Rather, it is Getty Images’ arbitrary standard for what the gross profit margin in the stock photo industry should be that causes the problem.
Gross profit margin, often referred to as just gross margin, is the difference between the sales and the production costs, excluding overhead, payroll, taxation and interest payments. As a formula, it is expressed as:
gross margin percentage = (revenue-cost of goods sold) / revenue
The cost of goods sold includes the direct costs associated with the products and services driving that revenue. At iStock, this cost includes the royalties it pays contributors—currently about $1.7 million a week and growing steadily throughout the past year.For the year, the total cost of goods sold will be roughly $88 million. It is estimated that iStock’s gross revenue for 2010 will be about $300 million. So we have have:
(300 – 88 =212) / 300 = 70.6%
Getty has always thought its gross margin should be between 70% and 80%. It built the company on that theory. That is why investors paid so much for Getty’s stock when the company was public and why Hellman Friedman paid so much to purchase the company in 2007.
The argument for such a high gross margin is that Getty Images is an Internet company. When the cost of the product being offered is low compared to the price customers are willing to pay for it, then it is possible for a company selling through the Internet to have high gross margins due to the company’s low overhead and operating costs compared to a standard retail operation.
However, there are two other critical factors that must be taken into account. The first is the actual cost of producing the product and the second is whether the company making the sales is actually able to able to charge customers prices that are significantly higher than it costs to produce the products. The Getty model (and for that matter the whole stock photography model) fails on two points
Actual production costs are never considered by the seller. In fact, for the most part, the seller has no idea what it costs to manufacture the product and thus may be willing to sell it for far less than what would be required to cover its own operating expenses and profit plus the costs and profit of its producer-suppliers. Too often the assumption is that the producer-suppliers’ costs are negligible and all the seller must do is cover its own costs.
The system of paying producers a percentage of the gross fee collected in no way guarantees that they will be adequately compensated for their efforts. In most other lines of business the producer is paid immediately upon delivering the product, or at least knows what he will be paid, and at that point can determine if the compensation is adequate to cover his costs. If not, an intelligent producer seeking profits will stop producing, or insist on a higher price for the next job. With stock photography, it may be years before a producer can determine if his efforts generated a profit.
Gross margins of other technology companies
Like Getty, Apple Computer sells a lot of intellectual property, but it also sells hardware, which costs something to manufacture. Apple does not get to pay suppliers 15% of whatever price it is able to charge for that iPad or iPhone, even it costs the supplier a lot more to manufacturer those products. The supplier expects to make a profit. The supplier has fixed costs. The supplier establishes a price for its product to cover costs plus profit. Apple must pay the supplier the asking price, or at least enough to cover the supplier’s costs, or the supplier will stop producing. The supplier may be willing to operate at a loss for a while to try to sustain his business if it looks like it might have a promising future, but he will not indefinitely spend more to produce than he is being paid for his product. Apple will certainly push its suppliers to be more efficient and cut costs in order to lower its own prices, but at some point the supplier will find it impossible to further cut the price.
In the first quarter of 2010, Apple computers had a gross margin of 42%. Dell had a gross margin of 18%. Why does it cost Apple $583 and Dell $824 to buy the products that each sells for $1,000? Materials, equipment, manufacturing facilities, labor and transportation are necessary to create the product and get it where it can be delivered to the customer. All these things have costs that must be paid in order for Apple and Dell to have end products to sell.
Apple is able to charge a higher premium for its products than Dell because customers not only perceive Apple’s products as high quality, but also as unique in what they offer. High quality alone is often not enough to allow for a higher price multiple. To get the highest gross margin, the product must also be something the customer feels they cannot do without and which cannot be replaced with a different product at a more reasonable price.
Photographers would like to believe that their photos are unique and no one else can produce a photo that would match the quality of their photos. But from the customer’s point of view, a slightly different photo of a similar situation may be just as appealing. If that similar photo is available at a lower price, it may satisfy the customer’s need perfectly. Dell cannot charge as much of a premium as Apple, because there are many other brands selling at very similar prices. Nobody else sells computers with all the Apple features. If that’s what the customer wants, there is only one choice—at the asking price.
Is iStock profitable?
iStock revenue in 2010 will be up about 50% over what it was in 2009, due to price increases and despite the fact that the number of units licensed seems to have declined. However, rather than focusing on the fantastic revenue growth what bothers Getty is that more contributors have seen their canister levels rise and as a consequence a larger percentage of gross revenue is now being paid out than would have been the case if everyone were receiving the same royalty percentage as last year. Thus, iStock’s gross margin has been declining, and the only way to reverse that trend is to cut royalty percentages. Getty not only wants to see iStock’s revenues rise, it also wants to see a continually rising gross margin.
There is no immutable law that says gross profit margin for a company licensing rights to photography has to be between 70% and 80%. Gross margins for stock agencies used to be 50% a couple decades ago. Alamy operates on a gross margin of about 60%. If Getty were to lower iStock’s gross margin expectations to 60%, the company would have no trouble paying existing royalties and allowing many more of their top producing photographers to rise to levels where they could earn 40% of sales.
Thompson said of his company’s business model, “As a business model, it’s simply unsustainable: businesses should get more profitable as they grow. This is a long-term problem that needs to be addressed.” Unless, for some reason iStock’s sales, administrative and financial expenses are growing at some astronomical rate, its business is getting more profitable as it grows. Profit margin does not have to increase in order to realize an overall increase in profits. In accounting, the gross margin refers to sales minus cost of goods sold. It is not necessarily a measure of a distributor’s profit as other expenses such as sales, administrative, and financial must be deducted. If a company’s gross revenue is rising by 50% and the “other expenses” are not increasing by the same amount, then its profit is increasing.
Consider these numbers. In 2009 iStock’s gross revenue was believed to be slightly over $200 million, and it paid out about $60 million to contributors, leaving $140 million for operating expenses and profit. In 2010, it is expected that iStock’s gross revenue will be about $300 million; it will pay out $88 million to contributors, leaving $212 million.
Assume that in 2009, iStock’s operating costs were $70 million. This number is much higher than I expect operating costs really were, but give them the benefit of the doubt. Given the way the company is operated there should have been very little, if any, increase in costs in 2010 compared to 2009. It does not really cost iStock any more to sell images at a higher price. In fact, since the company is likely to end the year with fewer sales than in 2009, its 2010 costs might even be lower.
If we subtract $70 from $140 million in 2009, we end up with $70 million for profit, interest and taxes. If we subtract $70 from $212 million for 2010, we end up with $142 million, more than double the 2009 number. The gross margin number may be down a little, but certainly not real profits.
Real profits are much more dependent on gross revenue than the royalty percentage image suppliers are paid, particularly when the royalty is so low. But, if the only number they focus on is gross margin then the only way to improve it is to continually cut the share of revenue paid to suppliers.
iStock had a system of compensation that rewarded photographers when they generated a larger share of iStock’s revenue. This system encouraged photographers, who work on speculation with no guarantee of what they might earn for their efforts, to spend more on models, props, etc. in the hopes of creating more and better quality pictures of the type that are in greatest demand. Now, it is clear to these photographers that the percentage of sales revenue they receive will continually be cut as Getty drives for ever higher gross margins.
The net revenue each photographer receives may grow if prices can continue to be pushed up and sales volumes increase, but royalty percentages will always be cut making it harder and harder for a photographer to reach the next level.
Stock photography is a crazy business
Photographers will never convince Getty to aim for a lower gross margin because investors will not allow it. Any new company that purchases Getty or iStock will invest based on the expectations of similar gross margins. Therefore, a new owner is not likely to be satisfied with lower gross margins either.
Image suppliers must decide if they can continue to produce for such a small share of the total customers pay for their images. Supplier must also recognize that as the price of the product increases it is likely that fewer units will be sold.
What does this mean for those selling at traditional prices?
Some traditional photographers are cheering, because Thompson admitted that iStock is an “unsustainable business model.” Unfortunately, Getty has exactly the same problem as iStock. If iStock were to fail, microstock would not go away. If iStock were to fail, customers would not buy more imagery priced at traditional levels. They will buy from other microstock suppliers, spend more time looking for free images on the Web or do without. The sorry state in which many iStock photographers find themselves is nothing for any of us to cheer about.
One photographer commented that the “145 pages (on the iStock site) of whining and wanting things to go back to the way they were—it’s so pitiful.” In fact, a lot of traditional photographers have been whining for a long time, and that’s not doing much good either.