On the newest episode of Exponent, the podcast I co-host with James Allworth:

We briefly discuss my belief in the Internet opportunity for content creators, and then dive in to the recent Uber controversy.


Listen to the episode here

Podcast Information: Feed | iTunes | SoundCloud | Twitter | Feedback

Differentiation and Value Capture in the Internet Age

It’s hard to have a conversation with anyone in tech without the word “scale” entering the conversation; “Internet scale” is a particularly popular variation of the term. Scale is a concept that is at the root of most venture investing: because software has zero marginal cost – one copy costs just as much as 100, or one million – there are massive profits to be gained from reaching huge numbers of customers on a uniform product or service.

The idea of scale, though, isn’t something unique to the 21st century; in fact, it was the key driver of the 20th, and it all started with Henry Ford and the assembly line.1

Henry Ford didn’t invent the car; before the Model T there were all kinds of automakers producing cars that were mostly custom-built and only available to the very wealthy. However, they were notoriously unreliable and very difficult to repair. Ford changed all that by building one model in one color with interchangeable parts at scale: this allowed Ford to charge a shockingly low price of $825 upon the Model T’s introduction in 1909 ($21,650 in today’s dollars). What was even more impressive was that, over the following years, Ford continued to decrease the price: a Model T in 1925 cost a mere $260 ($3,500 today). This had a massive impact on the adoption of the automobile, and the entire world began to adapt, paving roads, building gas stations, establishing diners and garages, etc.

Over time, though, the Model T was very much a victim of its own success: by massively expanding the market for cars and triggering the development of car-friendly infrastructure, Ford created openings for other car manufacturers that previously didn’t exist. A company like General Motors didn’t need to compete with Ford by building a Model T clone; instead they could develop multiple brands at different price points to capture particular segments of the market. The market was so big that scale could be brought to bear in a much more finely-grained way.

Today, few if any of us drive the exact same car with the exact same color with the exact same interchangeable parts. In the United States you can buy the Nissan Versa for $12,800 or a Lamborghini Veneno Roadster for $4.5 million. Admittedly, the latter isn’t produced at scale (there will be only 9 built in 2014), but the Mercedes-Benz CL-Class is, and it costs over $100,000. A huge percentage of people have a car that fits their preferences and lifestyle, and while they all do the same thing in a technical sense, you can pay for exactly the type of experience that you prefer.

A few weeks ago I wrote about the smiling curve and how value would increasingly flow from publishers to aggregators operating at scale:

The Smiling Curve for publishing

The Smiling Curve for publishing

However, I didn’t spend much time on the left side of this graph, beyond noting that readers will often be loyal to a specific writer, or to a focused publication. That writer or publication has one unique superpower: they are the only one of their kind. To use the strategic term, they are differentiated, and differentiated people – or products – can charge far more than their marginal cost. And no one is more differentiated than Taylor Swift.

A few weeks ago, in a widely discussed move, Taylor Swift pulled her music off of Spotify, and then proceeded to become the first artist in history to sell more than 1 million records in a week three albums in a row.2 In an interview with Yahoo Music, Swift argued that Spotify devalued music:

Music is changing so quickly, and the landscape of the music industry itself is changing so quickly, that everything new, like Spotify, all feels to me a bit like a grand experiment. And I’m not willing to contribute my life’s work to an experiment that I don’t feel fairly compensates the writers, producers, artists, and creators of this music. And I just don’t agree with perpetuating the perception that music has no value and should be free.

The thing is, though, given that music has a marginal cost of zero – to create one more copy doesn’t cost a cent – its natural price is, well $0. Free by a different name. And, when you look at the industry from this perspective, Spotify is the positive force for music that its CEO, Daniel Ek, believes it is:

Our whole reason for existence is to help fans find music and help artists connect with fans through a platform that protects them from piracy and pays them for their amazing work. Quincy Jones posted on Facebook that “Spotify is not the enemy; piracy is the enemy”. You know why? Two numbers: Zero and Two Billion. Piracy doesn’t pay artists a penny – nothing, zilch, zero. Spotify has paid more than two billion dollars to labels, publishers and collecting societies for distribution to songwriters and recording artists.

It’s a compelling argument, and Ek is justified in making it. In fact, I’d go so far as to say he is completely correct when it comes to any random song. But here’s the thing: Swift is completely correct too, especially when it comes to her music in particular. Swift herself explained why earlier this year in an op-ed in the Wall Street Journal:

In mentioning album sales, I’d like to point out that people are still buying albums, but now they’re buying just a few of them. They are buying only the ones that hit them like an arrow through the heart or have made them feel strong or allowed them to feel like they really aren’t alone in feeling so alone…There are always going to be those artists who break through on an emotional level and end up in people’s lives forever. The way I see it, fans view music the way they view their relationships. Some music is just for fun, a passing fling (the ones they dance to at clubs and parties for a month while the song is a huge radio hit, that they will soon forget they ever danced to). Some songs and albums represent seasons of our lives, like relationships that we hold dear in our memories but had their time and place in the past.

However, some artists will be like finding “the one.” We will cherish every album they put out until they retire and we will play their music for our children and grandchildren. As an artist, this is the dream bond we hope to establish with our fans. I think the future still holds the possibility for this kind of bond, the one my father has with the Beach Boys and the one my mother has with Carly Simon.

By all accounts, Swift is describing the relationship she herself has with her fans. Her deeply personal and well-written songs speak to adolescent girls in particular in a way few artists ever have; for her (many) fans, Swift is “the one.” She is, to put it in economic terms, highly differentiated.

That’s why I loved her decision to pull out of Spotify.3 Taylor Swift is not some sort of Luddite futilely standing against the forces of modernity; rather, she is a highly differentiated content creator capturing the immense value she is creating instead of ceding it to an aggregator that treats every piece of content the same.

There are other examples of content creators realizing and capturing their value. When it comes to publications, the Wall Street Journal has long led the way in putting much of its content behind a paywall, betting that its focus on finance and business would make its content worth paying for. Other examples are the Financial Times and more recently, the New York Times. To be fair, the results have been mixed, in part because all of the paywalls have varying degrees of leakiness. This, though, gets at one of the most important tradeoffs any content creator has to make: when it comes to capturing the value created through differentiation, reach and profit are inversely correlated.

In fact, this is the exact dynamic that explains how Apple captures such a huge percentage of the profit in the markets they compete in, even as they have a relatively small market share. iPhones, Macs, etc. are differentiated by Apple’s software and ecosystem, and the company charges accordingly. Those higher prices, though, preclude Apple from ever being the majority player.4

There are examples in software too. Developers have decried the App Store “race to the bottom”, when in reality the market is behaving exactly as you would expect: software, like music, has zero marginal cost, which means that absent differentiation the fair price of an app is $0. Omni Group, though, sells iOS apps for a whole lot more: OmniFocus for iPhone, for example, is $19.99; the iPad version is $29.99, and, according to founder and CEO Ken Case, Omni is more than satisfied with the company’s foray onto iOS.

The math is obvious: one customer buying both versions of OmniFocus is worth 50 customers buying one copy at $0.99, and worth an order of magnitude more customers were the app free with ads. Moreover, fewer customers mean lower support costs on one hand, and more ardent evangelists on the other. Customers who are willing to pay for a superior product are valuable in all sorts of ways, and Omni is spot-on in pricing their highly-differentiated apps in such a way that they capture a good part of the value they create.

It’s easy to wonder why more developers don’t take the same route as Omni – or singers like Swift, or publications like the Wall Street Journal – but the truth is creating differentiation is hard. Case told me:

Not every app becomes profitable just because it’s priced reasonably with respect to its value. With OmniGraphSketcher, for example, we didn’t find as large a market as we were hoping to, and though its simplicity was great, as a simple app it didn’t offer enough value to justify raising its price to sustain development in its small market. So we stopped selling it (and released it to the public for free as open source, where it also hasn’t found much traction). The lesson I’ve drawn is that it’s important for us to build higher-value apps

It’s a tough standard, to be sure, but as a consumer, it’s actually pretty great news. Only the best will succeed.

It’s easy to think that the Internet Age is well-established, but the truth is we’re only getting started. Remember, it took nearly two decades for the Model T to develop the car ecosystem to the point where new opportunities emerged to offer differentiated vehicles at much higher prices and much greater per-unit profit (Mercedes-Benz, for example, wasn’t founded until 1926, right about the time that the Model T reached its lowest price). I strongly believe that we are at a similar turning point when it comes to Internet-enabled businesses.

The thing about Internet scale is it doesn’t just have to mean you strive to serve the most possible people at the lowest possible price; individuals and focused publications or companies can go the other way and charge relatively high prices but with far better products or services than were possible previously. It’s working for Apple, it’s working for Taylor Swift, it’s working for Omni Software, and I can’t wait to see the sort of companies and products it will work for in the future.5

  1. I previously used Henry Ford and the Model T as an analogy here; I hope you’ll excuse the recycling as 1) I didn’t have any readers then and 2) The focus and takeaway here is totally different
  2. I discussed Swift vs Spotify at length in this Daily Update (members-only)
  3. According to the New Yorker, Swift would have stayed had Spotify been willing to limit her songs to the paid tier
  4. Which, contra conventional wisdom, is ok, because absolute numbers matter more than percentages
  5. I’m burying this in a footnote because I’m sheepish, but I’m hopeful that it’s working for me as well

Podcast: Exponent Episode 025 – Twitter and Taylor

On the newest episode of Exponent, the podcast I co-host with James Allworth:

We discuss Twitter and its strategic options, as well as YouTube’s new music service, Taylor Swift and Spotify, plus the special return of the garbage truck song.


  • Twitter Sharpens Its Strategy to Win Over Investors – Wall Street Journal
  • Ben Thompson: There are Two Twitters; Only One is Worth Investing In – Stratechery
  • Ben Thompson: Twitter’s Marketing Problem – Stratechery
  • Daniel Ek: $2 Billion and Counting – Spotify
  • Taylor Swift: For Taylor Swift, the Future of Music Is a Love Story – Wall Street Journal
  • Ben Thompson: What Taylor Swift Gets Right – Stratechery (members-only)

Listen to the episode here

Podcast Information: Feed | iTunes | SoundCloud | Twitter | Feedback

An Update on the Stratechery Membership Program

Last spring I wrote a series about the future of journalism:

  • Part 1: FiveThirtyEight and the End of Average – link
  • Part 2: The Stages of Newspapers’ Decline – link
  • Part 3: Newspapers Are Dead; Long Live Journalism – link

In the third installment I wrote:

More and more journalism will be small endeavors, often with only a single writer. The writer will have a narrow focus and be an expert in the field they cover. Distribution will be free (a website), and most marketing will be done through social channels. The main cost will be the writer’s salary.

Monetization will come from dedicated readers around the world through a freemium model; primary content will be free, with increased access to further discussions, additional writing, data, the author, etc. available for-pay.

A few weeks later I launched Stratechery 2.0, my perhaps quixotic attempt to put my quite literal money where my mouth was.

That was a little over six months ago, and since that time I’ve gotten questions about how things are going. I tend to be private about such things, so I haven’t replied, and truthfully, I feel a bit sheepish right now. But I think if any number is worth celebrating it is the number 1,000. I passed that number of active subscribers earlier this month.

Back in 2008 Kevin Kelly wrote:

A creator, such as an artist, musician, photographer, craftsperson, performer, animator, designer, videomaker, or author – in other words, anyone producing works of art – needs to acquire only 1,000 True Fans to make a living.

Making a living is about right. I’m not getting rich by any means, but I’m doing ok financially by doing what I love professionally, and that’s pretty awesome. So that’s my answer to all those asking: I’m doing great.

More broadly, while nothing is assured, it looks like I might have been on to something when it comes to the viability of writing on the web. There is a lot of doom and gloom among journalists especially about how the Internet has profoundly disrupted publications built on an analog business model, but I think to focus on what has been lost is to overlook what has been gained. There is a flora of new journalism that is only possible because of the web, and I truly believe we are only getting started.

Most importantly, for anyone reading this who believes they truly have something unique to say, please go for it. It is possible to make it on your own, and the world needs your voice.

The foundation of Stratechery remains free posts on the main blog, and five Daily Updates a week with 12~15 pieces of analysis about topical tech news. You can sign up here.

I did want to share a few important updates about the membership program:

  • I have consolidated the membership program down to one level: $10 a month or $100 a year. Now all members not only get the Daily Update every weekday, but also access to the (very active) Stratechery Forum
  • Speaking of the Stratechery Forum, it has been relaunched as a Stratechery-hosted (responsive) message board for all members, with hundreds of posts in less than two weeks. Relatedly, I am ending on-post comments
  • I have ended the sponsored post program. While I am a believer in native advertising, I wanted to focus my incentives behind the membership program both in regards to post frequency as well as customer service. My thanks to the sponsors who supported Stratechery over the last six months

Now, more than ever, this site and the members who subscribe to the Daily Update are my livelihood (although I do offer strategic consulting). I truly feel blessed and would like to sincerely thank every member who has signed up to date, and anyone who signs up in the future.

As always, I aim to make it worth your while.

Two Microsofts

My well-chronicled frustration with Microsoft’s corporate strategy comes down to one point: I don’t think any company should have both horizontal (i.e. services) and vertical (i.e. devices) businesses. It creates conflicting incentives: a horizontal business should be great on every platform, while a vertical business should be differentiated.

Thus, I was quite pleased when Satya Nadella’s first major move as CEO was the announcement of Office for iPad with an Office 365 subscription: finally the company was prioritizing services over its devices. True, convincing consumers to pay for software doesn’t seem to be a viable business model for 2014, but I was eager – and hopeful, for the sake of developers everywhere – for Microsoft to give it a shot.1

I suspect it was my enthusiasm for this new model that led to my shock at the news that the Microsoft Office iPad apps would no longer need an Office 365 subscription to unlock most of their functionality: what good is a services business that isn’t actually trying to make money? Over the last few days, though, a different model for Microsoft has emerged, and it’s one I’m pretty excited about; the company just hasn’t gone far enough.

Two Microsofts

So strongly do I believe in the importance of incentives – and the problems of bad ones – that this summer I called for Microsoft to split itself in two to ensure that the Services side of the company could grow unfettered. Much to my surprise, though, last week’s announcement reveals that a fundamental cleavage has in fact occurred: today’s Microsoft is, more than ever, two different companies. The line of demarcation, though, is not services and devices, but rather enterprise and consumer.

First, though, a quick aside: Microsoft will continue to make money from traditional Windows and Office licensing for both enterprise and consumer for a good long time; that money, though, is a result of previous strategic decisions. For the rest of this article I am focused solely on growth opportunities – the areas where today’s strategic decisions impact tomorrow’s top and bottom lines.

And, in that light, by making Office for iOS and Android (mostly) free, Microsoft is effectively giving up on for-pay consumer services. Sure, the company will continue to offer Office 365 for both Mac and PC, but the potential growth has always been on mobile.

That decision, though, brings some welcome rationality to Microsoft, at least if you look at the consumer and enterprise sides of the business in isolation:

Microsoft's business makes much more sense if you think of there being two completely separate entities.

Microsoft’s business makes much more sense if you think of there being two completely separate entities.

On the consumer side, Microsoft hopes to make money from devices and advertising: they sell Surfaces, Lumias, and Xboxes with differentiated OS’s, hardware, and services, and they have ad-supported services like Bing and Outlook. The enterprise side is the exact opposite: here the focus is 100% on services, especially Azure and Office 365 (to use the Office iPad apps for business still requires a subscription).

This actually makes all kinds of sense: enterprise and consumer markets not only require different business models, but by extension require very different companies with different priorities, different sales cycles, different marketing, so on and so forth. Everything that makes Office 365 a great idea for the enterprise didn’t necessarily make it the best idea for consumers, just as the model for selling Xbox’s hardly translates to big business. From this perspective, I love the idea of Office on iOS and Android being free for consumers: get people into the Microsoft ecosystem even as you keep them in the Office orbit.

Microsoft Should Go All the Way

When I think about Microsoft as two separate businesses, my primary concern with last week’s announcement is that Microsoft didn’t go far enough: specifically, the Office apps aren’t totally free. From the announcement on the Microsoft blog:

Of course Office 365 subscribers will continue to benefit from the full Office experience across devices with advanced editing and collaboration capabilities, unlimited OneDrive storage, Dropbox integration and a number of other benefits.

This leaves this decision neither here nor there, and reeks of short-sightedness: by releasing most of the functionality of Office for free, Microsoft is giving up on the iPad as a growth driver for Office 365, but it seems like they can’t quite wean themselves of incremental income from Office diehards. The problem, though, is that not only could this limitation manifest itself as incremental annoyance, it also limits the defensive utility of this move (members-only). If the worry is people getting in the habit of not using Office at all, why tempt them?

The more interesting question is how long this cleavage will be sustainable. Enterprise Microsoft is doing exceptionally well: its Windows, Office and on-premise Server businesses are throwing off cash, while Office 365 and Azure grow like gangbusters. The consumer side of things is the opposite: Lumia and Surface continue to bleed cash2, the Xbox One is struggling, and while Bing is improving, it’s still not a moneymaker.

None of this should be a surprise: Microsoft has always been an enterprise company that primarily succeeded in the consumer space by dint of its Windows monopoly. There’s no reason for them to be any more successful with consumers than they are today, and one wonders whether Nadella has made the same determination. Regardless, the clarity in business models is good news.

  1. And, on the flip side, I was less pleased to see Microsoft pushing ahead with its device strategy just a few months later
  2. I detailed how badly the tech press blew the reporting on last quarter’s Surface numbers here (members-only)

Podcast: Exponent Episode 024 – A Celebratory Goblet of Champagne

On the newest episode of Exponent, the podcast I co-host with James Allworth:

In this week’s episode…

The idea for Exponent was hatched when Ben and James were arguing about Ben’s article What Clayton Christensen Got Wrong a year ago. In this episode, we finally reach a resolution to the question about how Apple escapes disruption. Plus, whether or not Xiaomi is a threat to Apple, personal development philosophies, and more (sorry, we went a bit long…)


  • Ben Thompson: How Apple Creates Leverage, and the Future of Apple Pay – Stratechery
  • John Siracusa: OS X 10.10 Yosemite: The Ars Technica Review (Conclusion) – ArsTechnica
  • Ben Thompson: What Clayton Christensen Got Wrong – Stratechery
  • Ben Thompson: Growing Apple at WWDC – Stratechery

Listen to the episode here

Podcast Information: Feed | iTunes | SoundCloud | Twitter | Feedback

How Apple Creates Leverage, and the Future of Apple Pay

Tim Cook said something very revealing on last quarter’s earnings call:

Last month we introduced two new categories; the first is Apple Pay, an entirely new way to pay for things in stores and in apps…The second new category is Apple Watch, our most personal device ever and one that has already captured the world’s imagination.

Did you catch that? Cook put Apple Pay on the same level as Apple Watch. It is no hobby.

Something that has characterized most of Apple’s recent successes is the degree to which they have depended on partnerships with normally intractable industries.1 The two most obvious examples are iPod/iTunes and the music industry, and most obviously, the iPhone and the phone carriers. This perhaps seems counterintuitive: Apple is famous for being difficult to deal with, working diligently to ensure it always has the upper hand, even as it holds its partners to impossible standards.

This reading of Apple’s partnership abilities, though, mistakenly rests on the assumption that business deals grow out of personal affinity. The truth is that while personal likability may help on the margins, the controlling force in Apple’s negotiations is cold hard business logic. Thus, in order to understand why Apple has been so successful in previous partnerships – and, looking forward, to better estimate the chances of Apple Pay becoming widespread – it is essential to understand how the company acquires and uses leverage.

The most important term in the study of negotiation is BATNA: Best Alternative to a Negotiated Agreement. Your BATNA defines the point at which you are willing to walk away from a deal. In order to “win” a negotiation, you want to make your BATNA as high as possible, so it’s easy for you to walk away, even as you work to make your counterparty’s BATNA as low as possible, so that they will concede more than they would like. Leverage is the means by which you change your counterparty’s BATNA.

When the iTunes Store née iTunes Music Store launched in early 2003,2 Apple was a very different company than they are today. The iPod had been on the market for a year-and-a-half, but it only worked with a Mac, which was still stuck at well under 5% of the market. This, though, worked to Apple’s advantage in their negotiations with the music labels: not only did Apple not have much to lose, but the labels didn’t really see Apple as being a major player. The labels were far more concerned about the widespread sharing of music online; suing Napster to oblivion simply made music sharing more distributed and harder to control, which, of course, benefited Apple: their customers had alternate means with which to fill their iPods. So when Apple showed up with an offering to build a music store for their small audience, well, why not?

Just a few months later, Apple expanded iTunes to Windows, and what could the labels say? Despite the fact it only existed on the Mac, the iTunes Music Store was already the number one music download service in the world. It turned out Apple had another ace in the hole: a customer base that, while small, had an outsized willingness and ability to spend. After all, they had already dropped at least $1,500 on a Mac and iPod (and likely a lot more), what was an extra $0.99? At a more basic level, said customers were loyal to Apple not because it made sense from a feature or price perspective, but simply because they loved and valued the experience of using Apple products. That, ultimately, was the key to Apple’s favorable position: they had the best customers because they had the best user experience; if the labels wanted access to them, they had to agree to Apple’s terms.

Over time the labels’ addiction to iTunes revenues only deepened, and by 2008 iTunes was their biggest source of revenue. Music executives would rant and rave about Apple’s power, and try to increase their own leverage by, for example, allowing DRM-free songs on Amazon but not Apple, but it didn’t matter because Apple had the best experience, and thus the best customers.

Apple’s negotiations with the music labels was just a warmup for the phone carriers. While Apple in 2006 (in the runup to the iPhone) was in a much stronger position than 2003, they were still much smaller ($60.6 billion market cap) than AT&T ($102.3 billion) or Verizon ($93.8 billion) on an individual basis, much less the carrier industry as a whole. More importantly, carriers weren’t facing a collective existential threat like piracy, which significantly increased their BATNA relative to the music labels.

The music labels, though, benefitted from a relatively low elasticity of substitution: if I wanted one particular band that wasn’t on the iTunes Music Store, I wouldn’t be easily satisfied by the fact another band happened to be available. The carriers, on the other hand, largely offered the same service: voice, SMS, and data, all of which was interoperable. This increased elasticity of substitution gave Apple an opportunity to pursue a divide-and-conquer strategy: they just needed one carrier.

Apple reportedly started iPhone negotiations with Verizon, but it turned out that Verizon was already kicking AT&T’s (then Cingular’s) butt through aggressive investment and technology choices, resulting in increasing subscriber numbers largely at AT&T’s expense. Verizon saw no need to change their strategy, which included strong branding and total control over the experience on phones on their network. AT&T, meanwhile, was on the opposite side of the coin: they were losing, and that in turn had a significant effect on their BATNA – they were a lot more willing to compromise when it came to branding and the user experience, and so the iPhone launched on AT&T to Apple’s specifications.

That is when Apple’s user experience advantage and corresponding customer loyalty took over: for the first time ever customers were willing to endure the hassle and expense of changing phone carriers just so they could have access to a specific device. Over the next several years Verizon began to bleed customers to AT&T even though their service levels were not only better, but actually widening the gap thanks to the iPhone’s impact on AT&T. Four years after launch the iPhone did finally arrive on Verizon with the same lack of carrier branding and control over the user experience; in other words, Verizon eventually accepted the exact same deal they rejected in 2006 because the loyalty of Apple customers gave them no choice.3

Apple followed the same playbook in country after country: insistence on total control (and over time, significant marketing investments and a guaranteed number of units sold) with a willingness to launch on second or third-place carriers if necessary. Probably the starkest example of the success of this strategy was in Japan. Softbank was in a distant third place in the Japanese market when they began selling the iPhone in 2008; finally after four years second-place KDDI added the iPhone, but only after Softbank had increased its subscriber base from 19 million to 30 million. NTT DoCoMo, long the dominant carrier and a pioneer in carrier-branded services finally caved last year after seeing its share of the market slide from 52% in 2008 to 46%. Apple had all the leverage, because they had customers who cared more about the iPhone than they did their carrier.

Apple is certainly not shy about proclaiming their fealty towards building great products. And I believe Tim Cook, Jony Ive, and the rest of Apple’s leadership when they say their focus on the experience of using an Apple device comes from their desire to build something they themselves would want to use. But I also believe the strategic implications of this focus are serially undervalued.

Last year I wrote a piece called What Clayton Christensen Got Wrong that explored the idea that the user experience was the sort of attribute that could never be overshot; as long as Apple provided a superior experience, they would always win the high-end subset of the consumer market that is willing to pay for nice things.

However, this telling of the story of iTunes and the iPhone suggests that this focus on the user experience not only defends against disruption, but it also provides an offensive advantage as well: namely, Apple increases its user experience advantage through the leverage it gains from consumers loyal to the company. In the case of iTunes, Apple was able to create the most seamless music acquisition process possible: the labels had no choice but to go along. Similarly, when it comes to smartphones, Apple devices from day one have not been cluttered with carrier branding or apps or control over updates. If carriers didn’t like Apple’s insistence on creating the best possible user experience, well, consumers who valued said experience were more than happy to take their business elsewhere. In effect, Apple builds incredible user experiences, which gains them loyal customers who collectively have massive market power, which Apple can then effectively wield to get its way – a way that involves maximizing the user experience. It’s a virtuous circle:

Apple's focus on creating a great user experience builds consumer loyalty. Consumers then put market pressure on Apple's potential partners, which result in concessions to Apple, further enhancing the user experience

Apple’s focus on creating a great user experience builds consumer loyalty. Consumers then put market pressure on Apple’s potential partners, which result in concessions to Apple, further enhancing the user experience

Understanding this circle and how it interacts with the relevant actors is the key to evaluating the prospects of Apple Pay.

When it comes to Apple Pay adoption, there are five collective players that matter: Apple, Apple customers, credit card networks (Visa, Mastercard and American Express4), banks, and merchants.

  • Apple has, as is their wont, spent a significant amount of time on the Apple Pay experience. Over the last several years they have built the various pieces of Apple Pay, including Touch ID, their own chips (which include the secure enclave), an experimental NFC antenna design, as well as the software to make it work, with the bonus of 800 million credit cards stored in iTunes ready to be potentially added

  • Apple customers continue to have higher amount of income as well as a demonstrated willingness to spend. Apple customers are also very willing to use new technology offered by Apple, including Apple Pay

  • Credit card networks are the closest parallel to the music labels in that their overriding concern is the existential threat posed by potential networks or payment options that cut them out of the loop entirely. No one particularly likes them or the fees they charge. Thus, when Apple declared its willingness to build Apple Pay on top of credit cards, they jumped at the opportunity to take part

  • Banks are the carriers in this story. In the long run Apple Pay completely obscures their role in a customer’s payment activity, and the inevitable end for any invisible service is competition on price. However, banks have two problems when it comes to Apple Pay:

    • Banks are involved with every single Apple Pay transaction, which means if your bank does not support Apple Pay, it simply won’t work
    • Banks are easily substitutable. Sure, switching banks can be a bit of a pain, and you might have been with the same one forever, but if Apple customers were willing to switch carriers to get the iPhone, surely many would be willing to switch banks to be able to use Apple Pay

    Moreover, the banks benefit from Apple Pay’s increased security and correspondingly lower fraud rates – just as, I might add, carriers benefitted from iPhone customer’s higher average revenue per user (ARPU). Sure, it’s just as bad being a dumb bank as it is a dumb pipe, but better a dumb bank that makes money instead of one that customers simply leave

  • Merchants are much more difficult, and there is no real corresponding analogy in Apple’s previous dealings. Apple has much less leverage for a few reasons:

    • Merchants have a lower elasticity of substitution: on the low end, day-to-day purchases aren’t worth the hassle of a longer trip simply to use Apple Pay, and on the high end, retailers are highly differentiated by the products they offer
    • Merchants see much less direct benefit from Apple Pay. True, it’s likely that over time total transactions from Apple Pay-using customers will increase due to the decrease in friction relative to credit cards, but in the short term merchants are paying the exact same fees regardless of how a payment is made5
    • On the flip side, the anonymized nature of an Apple Pay transaction deprives merchant of valuable customer data that can be used to better target marketing campaigns and/or be sold for a profit

This explains the situation that Apple’s payment initiative is in today: Apple Pay as an experience works incredibly well, Apple’s customers are eager to use it, the credit card networks fully support it, banks are falling over themselves to not only sign up but to pay Apple 0.15% of every transaction for the privilege, but retailers, particularly big chains that pay the most in credit card fees and reap the most benefits from data collection, are much more hesitant.6

So now what?

It turns out that Apple has acquired a few more pieces of leverage through this process:

  • In the U.S.,7 October 2015 brings the liability shift in which the less secure party in a transaction (i.e. a magnetic swipe card used at a payment terminal that accepts chip-enabled cards, or swipe-only terminal accepting a chip-enabled card) assumes liability for that transaction. This should spur the purchase of new credit card terminals at the vast majority of merchants; most of those new terminals will likely have NFC

  • By adopting industry-standard NFC, Apple has ensured that Apple Pay will “just work” at any NFC-enabled payment terminal that is not explicitly configured to not accept Apple Pay. This means that by the end of next year it’s likely that Apple Pay will work in a large part of the “long tail” of retail

  • For retailers that are still holding out, Apple has two new bargaining chips:

    • The 0.15% that Apple is receiving from the banks for each Apple Pay transaction could be funneled back to the retailers, resulting in an immediate impact on the bottom line. Keep in mind retail is a very low margin business; turning down any reduction in credit card fees will be difficult to do
    • Apple Pay could incorporate retailer loyalty programs, helping close the loop when it comes to data collection. This could work similarly to the offering Apple has for Newsstand publishers: customers opt in to sharing data, an offer that most will likely accept in exchange for the various discounts that typically accompany such programs. In fact, it seems that such an offering is already in the works

In short, Apple could very well soon have an offer that might be too good for the vast majority of retailers to refuse: get the lift that comes with seamless transactions, plus a reduction in credit card fees, along with the seamless inclusion of pre-existing loyalty programs. Oh-and-by-the-way, if a particular retailer or three still wishes to hold out, then Apple’s loyal customers will sooner rather than later have a huge number of alternatives willing to take their business.

Presuming this works out as well for Apple as I expect it to, there are two key lessons to be drawn. First, all of Apple’s leverage ultimately – either directly or indirectly – stems from consumer loyalty, which itself is based on Apple’s focus on the user experience. Second, the reason why Tim Cook so confidently called out Apple Pay as a new category is that he knew it was an area where Apple could bring that leverage to bear, just as they did in music and telephony. This is in marked contrast to the Apple TV, which is still a hobby: TV remains a much stronger business that is far more resistant to disruption than most people in tech appreciate, and until Apple has a means of obtaining leverage it will only ever remain so.

  1. Benedict Evans touched on this theme last week
  2. Yes, I just called April early
  3. Apple did originally sign a five-year exclusive agreement with AT&T, but that deal was negotiated several times and Apple likely could have moved to Verizon sooner had the carrier been willing to make the necessary concessions
  4. American Express is also effectively a bank
  5. This analysis applies to off-line retailers; I expect Apple Pay to immediately get significant penetration in apps for online purchases simply because the lift resulting from fewer customers falling off at the payment form will be significant
  6. I covered MCX and CurrentC in-depth in this daily update (members-only)
  7. Apple Pay is only available in the U.S. currently, so that is the center of this analysis