Uber 2.0: Human Self-Driving Cars

There was one line that jumped out of the San Francisco Chronicle’s coverage of the decision of U.S. District Judge Edwin Chen to grant class-action status to drivers seeking tips they claim they are owed by Uber (emphasis mine):1

In deciding whether workers are employees, courts look at how much control the company exerts over them, and how integral the workers are to the company’s business, [Maggie Grover, an Oakland employment attorney] said.

Obviously, you can’t have Uber without drivers,” Grover said. “The court really hit on that.”

That’s certainly the case today, but Uber CEO Travis Kalanick for one has been quite clear that the long-term future for Uber is driverless cars. At the 2014 Code Conference Kalanick had the following exchange with Kara Swisher:2

KS: What did you think of the self-driving car?

TK: Love it. All day long. I mean, look, I’m not going to be manufacturing cars. That’s not what I plan on doing. Somebody’s got to make them. And when those bad boys are made, look, the way to think about it, the magic of self-driving vehicles, is that the reason Uber [is] expensive is because you’re not just paying for the car, you’re paying for the other dude in the car.

KS: Who’s driving.

TK: Who’s driving, right. And so, when there’s no other dude in the car the cost of taking an Uber anywhere becomes cheaper than owning a vehicle. Even if you wanted to go on a road trip it would be cheaper. And so, the magic there is that you basically bring the cost down below the cost of ownership for everybody, and then car ownership goes away. And of course that means safer rides, that means more environmentally friendly, that means a lot of things.

It’s an exciting vision, but even the most optimistic projections for self-driving cars put them several years into the future; today we are still served by what I’m calling Uber 1.0: cars driven by professional drivers. And, this lawsuit notwithstanding, there’s no question that Uber 1.0 is a huge success. I explained last fall why Uber was already on its way to dominating its competition with Lyft in particular, and the company has only pulled further ahead since then.

Still, Uber 1.0 is basically a better, and sometimes cheaper, taxi that is primarily used for taxi-type use cases:3 moving around urban areas, getting home from the bar, going to the airport, etc. To Uber’s credit the service’s coverage and liquidity is often far better than taxis ever were, and the convenience of hailing and paying your driver makes it viable for those who live in urban areas to get rid of their cars completely (as Megan Quinn did).

Trunks and Branches

However, as Kalanick acknowledged, this isn’t a viable option for the vast majority of people. The problem is that there are two types of driving: call them “trunk” and “branch.” The latter happens when there is a critical mass of people and destinations — basically large cities. The former, on the other hand, is about much longer trips: think commuting from a suburb to said big city. It is critical to distinguish these different types of driving behavior for two reasons:

  • The average cost/mile is likely to vary significantly. Specifically, branch (urban) driving is much more expensive due to worse gas mileage, increased wear-and-tear, and especially much higher parking costs. Trunk (commute) driving, on the other hand, likely gets better gas mileage, reduced wear-and-tear, and likely has free parking on at least one end of the trip.
  • The relative cost of identical actions varies significantly due to different trip length. For example, suppose it takes 5 minutes to find parking; if that happens at the end of a 30-minute commute, that means 14% of your total trip time is spent finding parking. On the other hand, if you have to find parking after a 10-minute trip to lunch, that means 33% of your total trip time is spent finding parking.

Given this, you can see why Uber is increasingly a viable alternative to private cars in urban areas: it’s cost-per-mile is much more competitive even as its convenience advantage increases significantly. But, on the flipside, you can also see why most can’t follow Quinn’s lead: Uber simply doesn’t work for commutes.

Look at the commute data for the average American:4

  • The average American commutes 12.6 miles in 22.8 minutes one-way5
  • The average American works 1,789 hours a year, which translates to 224 8-hour days; 224 days X 25.2 miles per day = 5,645 miles/year6
  • Private cars (not including parking costs) cost about $0.50/mile for the average American.7 Uber, meanwhile, prices based on a combination of per-trip flat-fees, a price/mile, and a price/minute; taking a basket of cities8 the cost-per-mile for an average commute is $1.80/mile

Add it all up and commuting with a private car costs $2,823/year, while an Uber costs $10,161. However, this doesn’t include parking: the average American pays $1,300 a year for parking,9 which bumps up the cost of a private car to $4,123/year, which is still a lot less than Uber.


To this point most folks, including those doing these cost analyses, seem to view UberPool as a bit of a novelty at best. Uber promises that the service can save you between 20% and 50% off your fare, which means an annual commute cost of between $5,081 and $8,129; the lower fare is at least in the ballpark of a private car, albeit nearly $1,000 more expensive (and that’s presuming you get the full 50% savings every trip). But seriously, do people really want to go out of their way to pick up another passenger?

Actually, maybe yes, particularly for commutes: I noted above that searching for parking at the end of a long commute requires relatively less time (even if the absolute time is the same); the same principle applies to time spent picking up and dropping off another passenger. An extra minute or two tacked onto a 25 minute commute is much less of problem relatively speaking than the same minute or two on a short trip. Moreover, the absolute cost savings of UberPool are significantly greater on long trips than they are on short ones. All things being equal I would expect UberPool to be more attractive on “trunk” routes than it is on “branch” routes.

The problem, though, is that all things aren’t equal: UberPool by definition requires lots of riders, which means the service may be doing quite well in San Francisco where, as noted, Uber is already cost competitive with private cars; however, as long as Uber is too expensive for commuting there won’t be enough UberPool potential riders to make UberPool on commutes a reality.

Maybe we’re stuck waiting for self-driving cars.

Uber 2.0

Here’s the thing, though: Uber could have self-driving cars within a year! It just depends on how you define a self-driving car. To a private car owner a self-driving car is a car that, well, drives itself, and as I noted above, the technology is several years off at best.

Uber, though, has a different definition; look again at Kalanick’s comment to Swisher: “The reason Uber [is] expensive is because you’re not just paying for the car, you’re paying for the [driver] in the car.” In other words, from Uber’s perspective, a self-driving car is a car where they don’t have to pay for a driver; the implementation details don’t matter.

With that in mind, think again about the commute problem: right now approximately 75% of Americans drive alone to work. Every one of those solo commuters is a potential UberPool driver, and not just that: because they are making the trip whether they are an UberPool driver or not, they are, from Uber’s perspective, self-driving cars. They are drivers Uber would not need to pay for. This, I believe, will be Uber 2.0: human-powered self-driving cars primarily focused on commutes.

On the surface this is basically car-pooling, but there are some essential differences with this new kind of UberPool:

  • Uber has solved (or is solving) the coordination problem that plagues any highly dispersed set of actors; instead of finding a carpool rider and arranging pick-ups simply open the app
  • Uber has a ready-made network of potential drivers and riders who already use and, more importantly, already trust Uber. Moreover, the (human) self-driving UberPool network doesn’t need a huge number of riders to ensure liquidity: after all, all of those (human) self-driving cars are making the commute regardless
  • Uber 1.0 — the urban branch network — solves a major problem with carpooling: the fact that the rider doesn’t have a car at their destination. But as long as their destination is an urban area, that’s ok — they don’t want a private car anyways!

What is even more impressive, though, are the economics of this potential service:

  • 80% of the cost of an Uber 1.0 ride goes to the driver. Take that away and Uber’s $1.80/mile cost plummets to $0.36/mile
  • Uber needs to then give some of those savings back to the UberPool self-driver, but significantly less than it needs to pay a professional driver. After all, the UberPool self-driver is making the drive anyways: whatever payments they receive from carpool passengers is effectively found money

Let’s presume Uber pays UberPool self-drivers $0.36/mile (basically, Uber takes half of the total fare): that means for UberPool passengers the cost of a trip is $0.72/mile, or $4,064/year for their commute. That is less than the cost of a private car once you include parking!

Moreover, Uber would likely be a lot more aggressive in pricing; after all, people who start using (human) self-driving UberPool cars are also more likely to use Uber 1.0 in the short-run, and completely give up private cars in the long run. Ultimately, the more that Uber can make (human) self-driving UberPool cars cheaper than private cars the more the company stands to gain in the long run.

Whither Google?

Back in February there were a flurry of stories about Google potentially competing with Uber, with the presumption that their self-driving cars would be the trump card. As I wrote at the time:

Google could build their own Uber. True, they would start way behind when it comes to consumer liquidity, but if their cars are all driverless, that doesn’t matter. The entire reason consumer liquidity is important is because it attracts drivers to the service, but a driverless car simply does what it’s told. And, given that >70% of the cost of an Uber goes to the driver, Google’s service could have significantly lower prices right off the bat, and, as I noted in Why Uber Fights, truly lower prices are one of the ways that Uber’s network advantages could be overcome.

Here’s the thing, though: a (human) self-driving UberPool car is cheaper than a Google self-driving car. Remember, all of the costs associated with a (human) self-driving UberPool car are sunk: the car and driver are making their commute whether or not they have a passenger, which means all of the various costs should not be ascribed to Uber (in contrast to a professional driver who should discount all of their depreciation, gas, and maintenance costs from their earnings). Basically, (human) self-driving UberPool cars have zero cost from Uber’s perspective (obviously, as noted above, Uber needs to provide an incentive to the driver to pick someone up, but it’s very reasonable to presume that could lower on a per-mile basis than Google’s costs).

Google’s self-driving cars, on the other hand, would have all of the costs associated with professionally-driven cars: depreciation, gas, and maintenance. After all, those are costs that are accrued for the sole purpose of providing a transportation service. And while it’s true that Google could afford to eat those costs, they would still have to build cars at scale and overcome Uber’s built-in network.

To be sure, self-driving cars would be a superior alternative to Uber 1.0’s professional drivers providing branch service; were Google to compete they could obviously start there. Ultimately, though, I expect them to ultimately back off: a technological advantage, which Google likely has, is by definition temporary; a network advantage, though, only grows with time.

Public Transport?

Last week BuzzFeed reported that Uber was experimenting with “smart routes”:

The idea is drivers will be able to both pick up and drop off passengers along a specific route, which in turn allows them to quickly pick up their next passenger…Uber Smart Routes are similar to traditional bus routes in that they follow a predetermined path between two points, but they differ by allowing passengers to request rides on demand. The catch, of course, is that customers get themselves to a Smart Route before they can use it. So it’s not exactly door-to-door service. For this reason Uber is discounting Smart Route rides by $1 or more.

First off, this concept is clearly applicable to the (human) self-driving UberPool network: one could imagine a 101 smart route down Silicon Valley, or another on El Camino Real. Many people, though, objected to the fact that, well, smart routes look like bus routes, and wouldn’t it be better if we spent more money on public transportation?

The answer, in my opinion, is no. I am a long-time supporter of public transportation, and feel blessed to live in a city with an extensive, efficient, and reliable subway and bus system. I wish that the U.S. in particular had invested more over the years in its infrastructure. However, if everything in this article comes to pass — which in the long run, will mean scores of people giving up private cars — many of the benefits of public transportation will be a reality: less pollution, less need for parking, fewer drunk drivers. Moreover, there will be some real advantages to a car-based network: Uber will offer far better service to less dense suburbs and exurbs than would ever be feasible for public transportation.

That leaves the less fortunate, which in itself is telling. Joseph Stromberg wrote a compelling piece on Vox that argued that the entire reason U.S. public transportation is so deficient is because the U.S. has treated public transportation investment as basically a welfare program, resulting in too-low fares that make efficient service impossible. Stromberg concludes:

Nowadays, many local politicians don’t see transit as a vital transportation function — instead, they think of it as a government aid program to help poor people who lack cars.

In the future I’m describing, though, no one owns cars! Wouldn’t it be much simpler and more efficient to simply subsidize the needy directly so they could use the same transportation network as everyone else?

That, of course, gets to the ultimate Uber end-game: I more than ever believe they have the potential to completely transform transportation in the United States if not the world, and it’s difficult to see them doing so without extensive regulation. One suspects Uber’s courtroom drama is only beginning.

  1. Class-action status was not granted with regard to the question of expenses, although the plaintiffs can resubmit their request []
  2. If you’ve never watched the video, the exchange immediately after this about Google is genuinely funny. It’s at the 19:20 mark []
  3. I absolutely do not believe that Uber succeeds simply by being cheaper; the experience is significantly better []
  4. This post that attempted to model when it would be viable to go Uber-only was particularly helpful, especially when it came to linking to original sources. However, that article did double-count the commute distance, throwing off its conclusions []
  5. Source: U.S. Department of Transportation Federal Highway Administration (FHWA) []
  6. Source: OECD []
  7. Source: the American Automobile Association and FHWA []
  8. Specifically, Los Angeles, San Francisco, Houston, Chicago, and New York City []
  9. Although obviously significantly more in large cities: $4,500 in San Francisco, for example, and $2,520 in Los Angeles []

Aggregation and the New Regulation

This article isn’t about the New York Times’ exposé on Amazon’s workplace (I covered that on Monday). Nor is it about the polarized reaction to that exposé (I covered that on Tuesday). Rather, it’s about the fact I’m writing about it for the third day in a row.1

Whatever your feelings about the New York Times’ article, there’s no question it’s a blockbuster. It has dominated Twitter for going on five days, and is the most commented story in New York Times history. Just as in days gone by nearly every other news organization in the country, including TV, spent the early part of this week following up on the story, and perhaps most consequentially, Amazon founder and CEO Jeff Bezos felt compelled to respond via a company-wide email. It’s obvious why: not only did the story have the potential to damage Amazon’s ability to recruit talent, the way in which the story resonated broadly threatened the willingness of people to visit Amazon at all.

This was almost the exact opposite of what happened in New York City a few weeks previously. Mayor Bill de Blasio had over the course of several months been setting the stage to cap the growth of for-hire car companies so that the city could study the effect on Manhattan’s traffic; critics, including Uber — the company most hurt by the proposal — argued that in actuality the mayor was paying back taxi companies for their support of his campaign. Just days before the cap was set to be implemented, de Blasio and his aides were confident; BuzzFeed reported:

City Hall doesn’t buy the notion that Uber is growing fast enough for a cap to disrupt the service…And the mayor’s circle also doesn’t believe that Uber is broadly popular, or represents anything most New Yorkers care about.

“It’s a boutique side issue,” said a top City Hall ally. “There’s a small set of excited tech people who are reading Mashable and might think the mayor isn’t innovative enough.”

Three days after that quote was published, de Blasio backed down, withdrawing the proposal in the face of crumbling poll numbers and rival politicians taking advantage of the reality that there were a huge number of New Yorkers that cared greatly about having access to their favorite car-sharing service. It turned out that politics as usual — get some money, make some promises, get elected, and then make good on those donations — didn’t really apply, at least for this issue: Uber had aggregated public opinion in its favor.

I wrote last month about Aggregation Theory, and both Amazon and Uber are examples of the theory in action: Amazon doesn’t make the stuff they sell (mostly), but they sell everything to a huge number of customers in the market with whom they have an ongoing relationship. Uber is even more distinct: the company doesn’t own the cars that provide its service but instead owns the customer relationship. Both are enabled by the Internet’s radical lowering of transaction costs and the possibilities for scale that result.

The point of leverage for these Internet companies is those consumer relationships: Amazon attracts a wide range of suppliers and merchants eager to sell to their customer base, and the company is not shy about leveraging said customer base to extract value from its suppliers. Similarly, Uber continually squeezes drivers with lower prices and higher fees, even as it remains the top choice for drivers because of its rider liquidity.

This last point is key: under aggregation theory the winning aggregators have strong winner-take-all characteristics. In other words, they tend towards monopolies. Google is perhaps the best aggregation theory example of all — the company modularized individual pages from the publications that housed them even as it became the gateway to said pages for the vast majority of people2 — and so, given their success, perhaps it shouldn’t be a surprise that the company is under formal investigation by the European Union.3

Still, as this excellent feature in Bloomberg Businessweek explains, in some respects what has happened has been a shock:

[In February 2014 European Commissioner for Economic and Financial Affairs Joaquín] Almunia stood at the podium in an auditorium on the ground floor of the Berlaymont, the 50-year-old institutional headquarters of the European Commission, and announced [a deal with Google]. Google’s long-running antitrust ordeal in Europe, it seemed, was finally over…

On April 15, 2015, Almunia’s successor, Margrethe Vestager, a 47-year-old former finance minister from Denmark, approached the same Berlaymont podium in the same auditorium. “Dominant companies can’t abuse their dominant position to create advantage in related markets,” she said bluntly, formally accusing Google of exploiting its supremacy in general search to dominate the market for online product searches — the equivalent of an indictment, the very move that Almunia had sought to avoid through the private settlement at Davos…

In the span of just 15 months, Google somehow lost Europe.

It turns out that there was one event that stood out in that 15 months; one event that may very well end up costing Google up to $6 billion and a dangerous loss of focus: a newspaper column. From the Bloomberg Businessweek article:

In April 2014, Mathias Döpfner, CEO of Axel Springer, wrote an open letter to Schmidt for the Frankfurter Allgemeine Zeitung titled: “Why We Fear Google”…When Google favors its own services, he [wrote], “It is not even clearly pointed out to the user that these search results are the result of self-advertising. … This is called the abuse of a market-dominating position.” Of the proposed settlement with Almunia, he says: “This is not a compromise,” because of the requirement that Google’s rivals bid in an auction for placement in the new search box. “This is the introduction, sanctioned by an EU authority, of that kind of business practice which in less honorable circles is called extortion.”

Soon after the letter ran, Axel Springer and Lagardere Group, the French media syndicate and owner of the Hachette Livre publishing company, launched a trade organization called the Open Internet Project to oppose the Google deal. At the same time, Deutsche Telekom, the German phone company, filed its own antitrust complaint against Google, becoming one of the first large European companies to join the fight. The case against Google no longer seemed like a conspiracy led by Microsoft. European Big Business didn’t like the settlement either.

The trouble with accusing Google of abusing its position is that, as the company is fond of pointing out, “Competition is only a click away.” In other words, unlike monopolists of old, Google is not in any way locking you in to their platform. Nor, for that matter, are Amazon or Uber. Rather, each of them, along with the other Internet companies whose business models fit Aggregation Theory, compete on the basis of the user experience, because once they have the users the suppliers of whatever it is those users want will have no choice but to fall into line.

It follows, then, that to the degree that governments answer to the people, effective control and regulation of these companies will be even more difficult than regulating the monopolies of old: that’s why Google got its first deal, and it’s why Uber was able to stare down de Blasio. What changed in Google’s case, though, was the Axel Springer article and the widespread attention it received. Similarly, while Amazon is not being accused of antitrust (for now anyways), at least in some small way the company was this weekend forced to respond in a way they usually avoid because of an article. Meanwhile, Uber, seemingly in a worse position politically, emerged from its crisis stronger than ever, confident in its ability to wield the collective influence of its customers to accomplish its political ends.

In other words, the regulation situation for these massive winner-take-all companies is not hopeless, but it has changed: their strength derives from the customer relationships they own, which means quiet backroom deals and straight-up arm wrestling of the Google and Uber varieties are liable to backfire in the face of overwhelming public opinion; it is in shaping that public opinion that the real battle will be fought. And while it’s true that the direct relationship aggregation companies have with their users is an advantage in this fight, the overwhelming power of social media is the new counterweight: it is easier than ever to reach said users with a report or column that resonates deeply. Your average writer or reporter has more (potential) power, not less.

I do think, on balance, this shift is a positive one. While it’s true that absolute power leads to ruin, up until that point aggregation companies win by maximizing the user experience, a big positive for consumers. Moreover, unlike old supply or physical distribution-based monopolies, the Google argument — competition is only a click (or app download) away — largely holds: I think it unlikely most of these companies, having won by delivering more consumer surplus than anyone else, will have that much latitude to suddenly start keeping most of that surplus for themselves.4

There is certainly an argument that the seeming haphazard nature of what breaks through on social media and what doesn’t ought to be a concern, and it’s one I share, but perhaps for different reasons than most: I’m certainly worried about the truth being suppressed, or blatantly false stories making the rounds, but even more insidious is a seemingly objective story that mostly gets the facts right but the context wrong.

It’s arguable the New York Times’ Amazon piece fits here: not only are there legitimate arguments to be made that hard-driving and criticism-intensive workplaces drive progress in a very real way,5 it’s also true that Amazon’s white-collar employees have plenty of options; the treatment of the company’s factory workers is a far greater outrage in my opinion. That said, several of the anecdotes in the New York Times’ story are clearly awful and indefensible and the reason for Amazon’s quick response: should said anecdotes turn out to be true the story will have already done a great deal of good (and while the New York Times story didn’t draw attention to warehouse conditions, much of the follow-up has).

Still, I think the situation is better than a past that people remember as being far better than it actually was: local newspapers certainly used to expose scandals, and the financial freedom driven by a geographic advertising monopoly helped in that regard. Today, though, the day-to-day existence of customers is not only better with instant access to the world’s information, all the world’s books and retail goods, and transportation services anytime and anywhere, but there is also the fact that market forces driving said providers to compete first-and-foremost by the customer experience are far more effective in reducing bad behavior broadly than a local journalistic gumshoe could ever be.

On the flipside, the size and stature of these companies makes for a big target, and the New York Times just showed that an investment in pursuing that target is likely to pay off. That is ultimately a good incentive and an important counter-weight that is not only good for society broadly but, in the long run, good for the companies under investigation as well.

Stratechery will be on vacation next week

  1. So meta []
  2. Although the company has now been passed by Facebook when it comes to the amount of traffic driven to publishers []
  3. Or maybe it should, given the reality of the previous footnote []
  4. For example, to use two commonly made arguments that happen to be relevant to this article, I don’t think either Amazon or Uber will be able to one day simply jack up prices; their value, should they achieve it, will come from having superior cost structures that scale in the truest sense of the word — every additional customer lowers the cost/per/customer for the company as a whole — which by extension will result in radically larger volumes than today []
  5. Not just in tech but also all industries []

Do You Trust Larry Page?

Given the fact that Alphabet née Google is the second most valuable enterprise in the world, it’s striking to consider Larry Page’s 2014 assessment of the company he co-founded with Sergey Brin:

I think we’ve not succeeded as much as we’d like.

As you might suspect there is more context in the original Financial Times interview:

Page, however, is not shrinking an inch from the altruistic principles or the outsized ambitions that he and co-founder Sergey Brin laid down in seemingly more innocent times. “The societal goal is our primary goal,” he says. “We’ve always tried to say that with Google. I think we’ve not succeeded as much as we’d like.”

Even Google’s famously far-reaching mission statement, to “organise the world’s information and make it universally accessible and useful”, is not big enough for what he now has in mind. The aim: to use the money that is spouting from its search advertising business to stake out positions in boom industries of the future, from biotech to robotics.

Asked whether this means Google needs a new mission statement, he says: “I think we do, probably.” As to what it should be: “We’re still trying to work that out.”

It was only a few weeks ago that I had pretty much the opposite reaction to Page: Google turned in fantastic quarterly results that drove the largest ever one-day market cap gain, and what impressed me was the way that Google had seemingly re-focused itself around its core competencies — and around its mission statement. I wrote in The Daily Update about universal app campaigns:

Google is making the same pitch to advertisers that they are investors: don’t look at our portfolio as a group of separate products that you invest in individually; instead, simply spend your money with “Google” and we will dynamically determine the best way to allocate it — and give you evidence that we’re right with our increased ability to track buyers from impression to (offline) purchase.

What is so exciting about this pitch for a strategy nerd such as myself is how aligned it is. Google at its core is a machine learning company that has a stated goal of “organizing the world’s information”…Instead of trying — and failing — to compete with Facebook on fuzziness, Google is going in the exact opposite direction: doubling down on what it does best and betting its algorithm and efficiency, this time applied to programmatic advertising, will make the advantages of Facebook and the other natural brand destinations insignificant.

After yesterday’s surprise announcement that a “slightly slimmed down” Google would become a wholly-owned subsidiary of the new Alphabet, which would also own the newly spun out Calico, Fiber, Nest, Google Ventures, Google Capital, and Google X, Google’s focus is tighter than ever, and just in time: the long awaited shift in advertising from legacy media, most notably TV, seems to have finally begun in earnest, and Google (along with Facebook) is primed to be a chief beneficiary. As I noted, I find this very exciting.

The problem for Page, though, is that he is not a strategy and business nerd. Page is, for lack of a better description, a change-the-world nerd, and it seems clear that he found the day-to-day business of managing a very profitable utility to be not only uninteresting but a distraction from what he truly wanted to do. Page declared in Google’s 2004 Founders IPO Letter that “We aspire to make Google an institution that makes the world a better place”, a rather large departure from aspiring to capture a greater share of global advertising, and I suspect the strongest driver behind this change was that in Page’s mind “making the world a better place” was increasingly in conflict with “Google the institution”. With the establishment of Alphabet Page has prioritized the former at the cost of abandoning the continued making and maintenance of the institution Google has become to the very capable hands of Sundar Pichai.1

To be sure, there are legitimate business reasons for Page’s move: when Google bought Nest I wrote at the time that the acquisition should be thought of as Google diversifying into a new business model based on selling software-differentiated hardware, not advertising, and from day one Nest has been operated independently from Google proper. The same logic applies to all of Alphabet’s non-Google companies: none are likely to be monetized through advertising, or benefit from Google’s shared infrastructure and sales and marketing organization, so why should they be a part of the same company? It makes a great deal of sense to have different companies with different business models — that result in different incentives — as separate entities with clear accountabilities. (Note that this logic does not apply to non-spun off divisions like Android or YouTube: the former is both a moat for Google’s business and a provider of data for advertising, while the latter is both a significant advertising vehicle and a major beneficiary of Google’s infrastructure and sales and marketing organization; I’m not surprised both remain a part of Google.)

That, though, leads to a bigger question: why should all of these disparate ventures be a part of the same company at all? While conglomerates were in vogue in the late 60s and early 70s,2 over the last thirty years the accepted wisdom has been it is better for companies to specialize and for investors to diversify on their own, a viewpoint I agree with: one need only look at Microsoft’s litany of failed acquisitions to appreciate how wasteful many companies can be, and how justified investors usually are in demanding a return of their money. What right does Alphabet have to buck this trend?

That is actually an easy one to answer: Page and Brin can do whatever they want because of Google’s dual-class structure. From Google’s IPO letter:

We believe a dual class voting structure will enable Google, as a public company, to retain many of the positive aspects of being private. We understand some investors do not favor dual class structures. Some may believe that our dual class structure will give us the ability to take actions that benefit us, but not Google’s shareholders as a whole. We have considered this point of view carefully, and we and the board have not made our decision lightly. We are convinced that everyone associated with Google — including new investors — will benefit from this structure. However, you should be aware that Google and its shareholders may not realize these intended benefits.

And so we’ve come full circle: Page may be abandoning day-to-day responsibilities at Google, but he has no intention of abandoning Google’s profits. Alphabet’s plan to report Google’s results on a standalone basis will likely reveal that the search-and-advertising company investors have bought stock in is, absent the financial blackhole of Google’s moonshots, doing even better than most suspected. Unfortunately for said investors the additional clarity will only serve to illuminate just how much money is not being returned to shareholders and is instead being spent by Page and Brin on what they think matters. Will investors trust Page to spend it wisely?

Page is certainly convinced of his righteousness; from that Financial Times interview:

As Page sees it, it all comes down to ambition – a commodity of which the world simply doesn’t have a large enough supply. In the midst of one of its periodic booms, Silicon Valley, still the epicentre of the tech business world, has become short-sighted, he says…

Page estimates that only about 50 investors are chasing the real breakthrough technologies that have the potential to make a material difference to the lives of most people on earth. If there is something holding these big ideas back, it is not a shortage of money or even the barrier of insurmountable technical hurdles. When breakthroughs of the type he has in mind are pursued, it is “not really being driven by any fundamental technical advance. It’s just being driven by people working on it and being ambitious,” he says. Not enough institutions – particularly governments – are thinking expansively enough about these issues: “We’re probably underinvested as a world in that.”

To the question of whether a private company, rather than governments, should be throwing its weight behind some of the world’s most long-range and ambitious science projects, he retorts: “Well, somebody’s got to do it.”

That right there gets exactly to my mixed feelings about Alphabet and the formalization of Page and Brin’s role as sole investors of Google’s profits. I care about changing the world too, but I tend to think that said change is more often wrought through market mechanisms that reward the productization of audacious R&D. Google’s moonshot efforts are often compared to the legendary Bell Labs, but while the latter created the transistor, it was Intel specifically and early Silicon Valley3 broadly that actually made transistors and the computers that were built from them widely available; similarly, Bell Labs invented Unix, but it was Apple and Google, via Android, that put the operating system in the hands of nearly every person on earth.

On the other hand, there are times when the market doesn’t work: broadband, for example, tends towards a natural monopoly which ideally is regulated in a way that benefits society broadly. In reality, though, it is Fiber, an Alphabet company, that has consistently improved the situation in every market it enters or threatens to enter.

Self-driving cars are another example: the technology is in the long run threatening to existing car makers (because it facilitates sharing vehicles instead of individual ownership), but the technological and regulatory issues are such that it would be unlikely that a startup would take on the challenge. Surely it’s a good thing that Alphabet is pushing the envelope here. Then again Uber is investing in exactly the same thing, with the added bonus of having the sort of aligned business model incentives that are often critical to ultimate success. Would some of Google’s profits be better off being directed via the market to similarly impactful startups instead of being spent by Page and Brin?

Credit Page with this: he may not be a strategy or business nerd, but in the process of ensuring his freedom to pursue his vision for how the world should be, he is challenging in a very profound way many of the assumptions about how business should be conducted, and the means through which progress is achieved. It’s now up to investors to decide just how much they trust him, while the rest of us go along for the ride.

  1. I don’t buy the rumor that Google made this move to keep Pichai from going to Twitter. You don’t transform your company’s structure in just a couple of weeks, nor to simply keep one employee; moreover, why would Pichai even want the Twitter CEO job? The fact of the matter is that Pichai has performed fantastically and deserved this promotion fair-and-square []
  2. Marginal Revolution has a useful rundown of studies examining their efficiency []
  3. Thus the name! []

Why Disney and ESPN Will Be OK

TV is fascinating: the content is compelling enough that Americans spend an average of five and a half hours a day consuming it (in various formats), but it’s also exceptionally intriguing from a business perspective.

Two weeks ago I laid out Aggregation Theory, which posited that the general pattern for value capture on the Internet was modularizing suppliers and integrating consumers and distribution. It’s a framework that explains Google, Amazon, Facebook, Uber, Airbnb and more.

TV, though, seems to be going in the opposite direction: over the last few weeks in particular discussion about “unbundling” has reached a fever pitch, culminating in Disney’s earnings call yesterday where the vast majority of time was spent on ESPN, the lynchpin of the pay-TV bundle. The trigger was this report in the Wall Street Journal early last month:

A decline in subscribers as customers trim their cable bills, coupled with rising content costs and increased competition, has ESPN in belt-tightening mode, people familiar with the situation say.

The company, majority owned by Walt Disney Co., has lost 3.2 million subscribers in a little over a year, according to Nielsen data, as people have “cut the cord” by dropping their cable-TV subscriptions or downgraded to cheaper, slimmed-down TV packages devoid of expensive sports channels like ESPN.

On the earnings call Disney CEO Bob Iger sought to make clear that the actual number of lost subscribers wasn’t that high, and was adamant that very few were lost to “skinny” bundles; rather ESPN’s decrease was due to fewer households subscribing to the pay-TV bundle. That, though, is precisely the problem, thanks to Netflix especially.

Netflix’s Limitation

Back in 2008 Netflix was primarily a DVD-by-mail operation with a just-launched streaming service that let you watch C-list movies on your computer. Starz, a premium television channel, saw the service as an easy way to make a few extra bucks on their vast library of movie rights, including the Disney and Sony catalogs. Bill Meyers, then Starz Entertainment’s president, said at the time a deal with Netflix was signed:

Over the next several years we clearly don’t expect to see people leaving their big televisions and big screens to watch Starz Play. This is a complementary service.

It turned out Netflix was not just competitive but downright superior. Starz’ offering, like every other TV channel, was constrained by time: only one movie could show on any one channel at a time, meaning the effective size of the Starz catalog at any given time was one. Netflix, on the other hand, made every movie in the catalog available instantly; the Netflix catalog, identical to the Starz’ catalog in theory, was in practice 10,000x the size. Meanwhile, the 2nd generation of the Apple TV, which had Netflix built in, had been launched the month before, and the first Roku box a few months before that: suddenly Netflix streaming was no longer constrained to your computer but could be enjoyed on the same “big televisions and big screens” as Starz and the rest of TV.

It truly was a fantastic deal for Netflix, and Netflix’s built-in customer base quickly took to the streaming service and convinced a whole lot of new customers to come on board, and while these new customers kept their pay-TV bundles, time is zero-sum, so they gave said bundle less of their attention.

It was the exact pattern you would expect from Aggregation Theory: Netflix delivered a superior user experience even as it commoditized time, but there was one small problem on the way to Netflix completely taking over your TV — that Starz contract had an expiration date, and for all the superiority of the Netflix user experience, customers would not be interested without compelling content.

Differentiation: Aggregation’s Kryptonite

The problem solved by Google, the biggest and most powerful aggregator of all, is right there in its mission: organize the world’s information and make it universally accessible and useful. It is the very scale of the problem that makes Google so valuable and, in contrast, the purveyors of said information far less valuable than they had been previously. It’s a matter of supply-and-demand: there is an effectively infinite supply of information on the Internet, which meant that Google could satisfy the demand of its users for answers without needing to compensate the information providers at all. Indeed, every time information providers have demanded money from Google — the latest example is news providers in Spain — within months if not weeks said information providers have come crawling back asking to again be included in Google’s results, no payment necessary.

A similar dynamic is enjoyed by the other aggregators I mentioned: retail goods for Amazon, people for Facebook, cars for Uber, and empty rooms for Airbnb. In every case the discovery problem solved by the aggregator is of far more value than any one unit of supply, which has freed the aggregators to focus on owning the end user relationship, confident that suppliers will have no choice but to tag along.

When it comes to TV, though, the equation is different: there simply isn’t that much compelling content out there. That is why Netflix’s response to the end of the Starz contract was not to brandish its subscriber base and wait for content providers to sign up for free, but rather the opposite: Netflix had to go and get content first, and pay a hefty price to do so, and only then turn its attention to attracting and retaining end users. It’s a fundamentally different dynamic, and it’s hard to imagine a company that is better at managing that dynamic than Disney.

ESPN’s Differentiation

Iger is widely considered one of the top CEOs in the world, and for good reason: Disney has enjoyed unprecedented success under his leadership, particularly in movies. Iger’s first major move upon assuming the CEO role was to acquire Pixar, and he followed that up with the acquisitions of Marvel and LucasFilm. The goal of these acquisitions was the establishment of what Iger called tentpoles: must-see movies that made money not only for the company’s studio division but also powered merchandise sales, theme park attractions, video games, televised spinoffs, etc. The entire premise of the strategy — and what makes Disney Disney — is highly differentiated content.

It’s becoming clear that over the last few years ESPN has adopted a similar approach. To be sure, the network has long carried popular sports, which has made ESPN the very profitable centerpiece of the pay TV bundle. Recently, though, ESPN’s appetite for exclusive rights to the most popular leagues and events has increased tremendously. The common assumption has been that this increased focus on rights was meant to secure that position in the bundle — and to secure the bundle itself — and perhaps that’s all there is to it. However, I found Iger’s characterization of ESPN on yesterday’s call striking:

[When] you think ESPN, you have to think about the NFL, the NBA, Major League Baseball, the best package available on College Football, College Football Championships, College Basketball, events like Wimbledon and U.S. Open et cetera.

To a greater extent than even before, ESPN is sports. It’s the only channel you need. In fact, its biggest problem is that there simply isn’t enough time in the day to view all of the inventory the network has rights to. That, though, is a solved problem: Netflix showed 7 years ago that streaming makes time constraints immaterial. Iger noted:

Those new deals all provide for more programming, more opportunity for content on digital platforms, which will enable us to increase consumption on digital platforms and grow that business even more and generally more flexibility in terms of how we distribute this product. So the NBA’s a great example. You can have a huge increase in essentially inventory on ESPN across its platforms. So while there is definitely increasing costs, there is a huge increase in terms of opportunity as well to reach more people, to serve advertisers more effectively and to grow our digital platforms.

For now Iger and ESPN are emphasizing digital content as an addition to the bundled network, but in my estimation ESPN is far better positioned for a world where they must go over the top to consumers than people give them credit for. The afore-linked Wall Street Journal article said that in order to maintain current revenue levels ESPN would need to charge $30/subscriber if the company abandoned the pay-TV bundle, which implies a customer base of ~20 million people. That’s a little over 20% of ESPN’s current pay-TV subscriber base, and if ESPN really does have all the sports that matter, I think it’s a very realistic target.

To be sure, ESPN still has work to do: they only have half the NBA rights, only one NFL game a week, missed out the World Cup and EPL, and have never had the NCAA tournament. Some of this, particularly the NFL, is remedied by the fact that the rest of the games are available on old-fashioned broadcast TV. That may go away eventually, but then again, ESPN’s competitors may falter eventually as well, allowing ESPN to snap up what they’re missing. Most importantly, though, “eventually” marks this entire discussion: the cord-cutting trend may be accelerating but I think Iger is right that there are at least a few years of viability left.

There’s one more question: might sports leagues go over the top directly, a la the WWE? It’s certainly possible, but I suspect most leagues benefit more from being available — and paid for — by “sports fans” broadly as opposed to hard core fans only; it’s the same “socialism that works” angle from the current bundle applied to a narrower sports bundle. Still, this is an important area where ESPN differs from Disney’s other properties: the network doesn’t own the content. Then again, said content has a relatively limited shelf life — and most sports fans like multiple sports.1

The Future of Paid Content

That’s not to say that everything is rosy in pay-TV land. If anything, to fixate on the fate of ESPN is akin to journalism observers only caring about how the New York Times is managing the transition away from print to first the Internet and now mobile. Things aren’t going perfectly but the company is surviving and continues to produce an incredible amount of compelling journalism. However, things are considerably worse for regional papers without the cachet or resources of the Times: publications are going out of business all over the place, and the number of working journalists has been cut nearly in half over the last 25 years.

I suspect a similar shakeout is coming in TV: as the pay TV bundle erodes an entire slew of cable channels will whither away, their targeted content replaced by online video, particularly YouTube. Meanwhile there will be an intense competition waged by a few streaming giants — ESPN, HBO (a long-time master of differentiated content), Netflix, Amazon Prime Video (a particularly challenging competitor because of its orthogonal business model), and perhaps BAM Media — for consumer attention and dollars. That competition will largely work in the favor of content creators, who ultimately create the differentiation that end users are willing to pay for. Said end users, though, at least those with wide-ranging tastes, may not see much gain in their pocketbooks: ESPN at $30, HBO at $15, and Netflix at $9 isn’t far off from what consumers pay today for the pay-TV bundle.

Still, such an outcome should provide hope to content creators of all types: there is a way to escape from the commodification effect of Aggregation Theory, and that is through differentiation. In other words, the more things change, the more they stay the same.

  1. Most leagues do have over-the-top offerings, but only make the full slate of games available to fans who do not otherwise have access to the broadcasts. This is because ESPN and regional networks pay significantly more than do said fans collectively, and I don’t see any reason why that would change for ESPN in particular. Regional networks, which are the most responsible for rising pay-TV prices, are another matter, but that’s more a problem for the sports leagues than ESPN — if anything ESPN’s guaranteed payments will become more valuable, not less []

The Case for Jack Dorsey, Twitter CEO

If you spend enough time listening to Silicon Valley folks, you’d be forgiven for assuming that all tech companies, particularly startups, originated in Lake Wobegon: they are all strong, good looking, and above average. And, to be sure, there are a lot of benefits that come from the instinctual optimism that inhabits the place: the fact that seemingly outlandish ideas that (according to conventional wisdom) will never work can receive funding and the full-on commitment of thousands of exceptionally talented people is a big part of why the region churns out company after company that does in fact change the world.

Twitter is a classic example: a description of the product in 2006 would have had most people shaking their heads at the very premise of a service based on broadcasting 140 character micro-posts (the word “tweet” wouldn’t come till later), but here we sit 9 years later discussing a product and eponymous company that has, in a very real way, changed the world broadly and the world of its users dramatically.

The trouble with optimism, though, is that it can blind you to real areas of concern, and again Twitter is the perfect example. While early skepticism centered on Twitter’s ability to monetize, by the time the company filed for its IPO in 2013 it was obvious the company had fantastic revenue potential but a real problem retaining new users (I wrote about this at the time). Unfortunately, as best I can tell, Twitter’s product strategy basically consisted of optimism that the company would magically improve its ability to retain new users while the attention of the executive team focused on monetization, culminating in Q4 2014 earnings that showed barely any user growth but impressive revenue numbers — and a 16 percent stock jump.

On the associated February phone call with analysts, then-CEO Dick Costolo led with the great results and declared that Twitter’s user problem was headed in the right direction as well:

Financially we had another great quarter with strong revenue growth and very strong profit…Importantly, I want to highlight that the user numbers we saw in January of this year indicate that our MAU trend has already turned around and our Q1 trend is likely to be back in the range of absolute net adds that we saw during the first three quarters of 2014.

Everything was going to be fine.

Of course, everything was not fine; the following quarter Twitter showed even slower user growth and this time revenue missed as well, and the stock gave back January’s gains and more, plummeting 25% in just two days. That’s when I wrote that Twitter Needed New Leadership, and the motivation wasn’t so much the then just-released earnings as it was all the earnings and public pronouncements that came before: if an executive team continually says that everything is great when it clearly is not, then in my mind they lose credibility. It just happened to take an earnings miss for Wall Street to share my assessment.

This, then, is why yesterday’s Twitter earnings call was so important — and so impressive. Just as in January Twitter beat financial expectations handily, and the stock quickly jumped in after-hours trading. It would have been plausible, and even understandable, if interim CEO Jack Dorsey and CFO Anthony Noto had taken the opportunity to reiterate that Twitter’s plan was working and that the stock did indeed deserve to be worth more.

In fact, though, Dorsey and Noto did the exact opposite: instead of focusing on revenue they focused on users, and were brutally honest that Twitter had fallen short. Dorsey stated right at the top:

We’ve been very successful at monetization, with a strong Q2, delivering over $500 million in revenue and more than $120 million in EBITDA. However, product initiatives we’ve mentioned in previous earnings calls like instant timelines and logged out experiences have not yet had meaningful impact on growing our audience or participation. This is unacceptable and we’re not happy about it.

The stock tanked, but that’s because it was too high to begin with: it’s not that Dorsey and Noto presented poorly, it’s that they presented honestly, and while that hurts now, it’s the only way to rebuild the credibility that Twitter has lost through too many quarters of insisting things were strong, good-looking, and always, always, above-average.1

Just before the earnings call Kara Swisher reported that Dorsey and Adam Bain, President of Global Revenue and Partnerships at Twitter, were finalists to replace Costolo, who stepped down in June. It was great timing, because said call laid out why, in my opinion, Dorsey should be the choice — and why it’s not at all an obvious one.

The fact of the matter is that Bain has done a phenomenal job at Twitter: the company had only $28 million in revenue in 2010, the year he started, yet just this quarter delivered over $500 million; that’s a 70x increase on an annualized basis. Were the CEO job based simply on past performance, no one would be more deserving. However, to make the decision in such a way — to effectively prioritize revenue generation — would be to make the exact same mistake Twitter made over the past several years: putting advertisers and money ahead of users and product. In the long run the former depend on the latter — and in a disclosure that clearly spooked the market, Noto noted that Twitter could soon be in danger of not having sufficient inventory — because of a lack of engaged users — for all of the ads it was selling.2

The question, then, is who can best rebuild the product, and it’s difficult to come up with anyone better than Dorsey:

  • Product development requires vision. When you keep in mind the “vision” Twitter presented at last fall’s analyst day — Reach the largest daily audience in the world by connecting everyone to their world via our information sharing and distribution platform products and be one of the top revenue generating Internet companies in the world. — Dorsey’s clarity on yesterday’s call was profound:

    You should expect Twitter to be as easy as looking out your window to see what’s happening. You should expect Twitter to show you what’s most meaningful in the world to live it first before anyone else and straight from the source. And you should expect Twitter to keep you informed and updated throughout your day.

    But Twitter can’t just be the best window to the world; Twitter also has to be the most powerful microphone in the world. You should expect Twitter to increase your reach and you should expect Twitter to encourage live and direct conversation and participation around whatever you share.

    If we meet these expectations, and we will, Twitter will become the first thing everyone in the world checks to start their day and the first thing people turn to when they want to share ideas, commentary, or simply what’s happening.

    More importantly, if Twitter meets those expectations, revenue and advertisers will follow; the relationship is a one-way street, and for too long Twitter has been trying to back into what must come first.

  • Product development requires authority. Twitter has long been captive to its best users who rail against any change on the margins, much less even a rumor of changes to the core product; I suspect this hesitancy has been in large part driven by the fact that everyone in Twitter’s leadership was ultimately a hired gun. Dorsey, though, is a founder, and however controversial his first stint at the company may have been, there is no denying the authority this fact gives him when it comes to making changes.

    Dorsey is already indicating that there will be no sacred cows, stating in his opening remarks:

    You will see us continue to question our reverse chronological timeline and all of the work it takes to build one by finding and following accounts through experiences like ‘While You Were Away’ and Project Lightning which launches this fall. Our goal is to show more meaningful tweets and conversations faster, whether that’s logged in or out of Twitter.

    Dorsey noted later on that the traditional reverse chronological timeline would still be available, but he again made clear the strictly chronological timeline wasn’t gospel; it’s doubtful anyone else could say so so brazenly.

  • Product development requires buy-in. Perhaps the most severe issue facing Twitter is employee retention, particularly in light of the increasingly depressed stock. Two more executives left yesterday, on top of the 450+ employees that The Financial Times reported have left in the past year. Stemming that flow will require both vision as well as a reason to believe that vision is attainable, and here again Dorsey is the obvious choice.

    First off — and as evidence clichés exist for a reason — it should be noted again that Dorsey is a founder, granting him not only authority but also legitimacy. Twitter head of product Kevin Weil told The Verge:

    Jack brings the vision of the founder of the product back, so he has a very strong sense of Twitter’s place in the world. He’s bringing his perspective to how we develop products, and honestly it’s been a great experience so far.

    Secondly, whether by circumstance or not Dorsey’s time at Twitter (2006-2008) is very highly correlated with the times the product evolved the most; Dorsey was also a proponent of Twitter’s original API-centric model and isn’t tainted by the developer drama of 2012. Bain may be as likable as Swisher asserted, but likability does not translate into buy-in, particularly in an arena (product) where Bain doesn’t claim to have any particular expertise.

    Perhaps most important, though, was yesterday’s call: Dorsey reportedly told Twitter employees he would be blunt, and he was. He was, as I noted, honest, and honesty is the foundation of trust, something the next Twitter CEO will desperately need.

To be sure, there are plenty of arguments against Dorsey. For one, he has another job as CEO of Square, which late last week was reported to have filed for an IPO. Then again, there are whispers Dorsey is less involved with Square than you might think, especially as the company has pivoted away from a consumer focus (Dorsey’s passion) towards small business financial services, and if he were ever going to leave pre-IPO would probably be better than post (although both options aren’t great).

For another, while Dorsey supervised much of Twitter’s early innovation, it was innovation that was all too often barely accessible due to Twitter’s operational problems. Moreover, by all accounts the fail whale symbolized more than the fact that the servers couldn’t stay up: the entire company seems to have had very little structure or discipline. That said, people grow and mature: Dorsey would now be a CEO with proven CEO experience, not simply an engineer with a good idea and little else to go on.

And, of course, there is the famous Twitter dysfunction: according to Swisher Twitter’s other iconic co-founder, Ev Williams, is against a Dorsey return, small surprise given the fact both managed to help fire the other during their respective go-arounds as CEO. Indeed, that there is yet another reason why Twitter has such a significant hill to climb: not only do they need a new CEO, they probably need a new board as well. Having a mixture of former CEOs and folks who don’t use Twitter doesn’t exactly suggest that the CEO decision will be based on what is best for the product. And that makes me pretty pessimistic.

  1. To be fair, Dorsey and Noto were simply seizing the opportunity presented to all new CEOs: that is they implicitly threw the old leadership under the bus and dramatically lowered expectations for themselves. Still, in my mind the opportunism doesn’t make their honesty any less impressive (particularly when you remember it cost both of them millions of dollars personally) []
  2. This is a point I got slightly wrong in my piece calling for new leadership: I focused on the possibility that advertisers would desert Twitter for being too small, while Noto warned about Twitter not having sufficient inventory to satisfy demand; both, though, are driven by the fact that Twitter needs more active users (and I believe my concern remains warranted in the long run) []

Aggregation Theory

The last several articles on Stratechery have formed an unintentional series:

  • Airbnb and the Internet Revolution described how Airbnb and the sharing economy have commoditized trust, enabling a new business model based on aggregating resources and managing the customer relationship
  • Netflix and the Conservation of Attractive Profits placed this commodification/aggregation concept into Clay Christensen’s Conservation of Attractive Profits framework, which states that profits are earned by the integrated provider in a value chain, and that profits shift when another company successfully modularizes the incumbent and integrates another part of the value chain
  • Why Web Pages Suck was primarily about the effect of programmatic advertising on web page performance, but in the conclusion I noted that the way in which ad networks were commoditizing publishers also fit the “Conservation of Attractive Profits” framework

In retrospect, there is a clear thread. In fact, I believe this thread runs through nearly every post on Stratechery, not just the last three. I am calling that thread Aggregation Theory.

The value chain for any given consumer market is divided into three parts: suppliers, distributors, and consumers/users. The best way to make outsize profits in any of these markets is to either gain a horizontal monopoly in one of the three parts or to integrate two of the parts such that you have a competitive advantage in delivering a vertical solution. In the pre-Internet era the latter depended on controlling distribution.

For example, printed newspapers were the primary means of delivering content to consumers in a given geographic region, so newspapers integrated backwards into content creation (i.e. supplier) and earned outsized profits through the delivery of advertising. A similar dynamic existed in all kinds of industries, such as book publishers (distribution capabilities integrated with control of authors), video (broadcast availability integrated with purchasing content), taxis (dispatch capabilities integrated with medallions and car ownership), hotels (brand trust integrated with vacant rooms), and more. Note how the distributors in all of these industries integrated backwards into supply: there have always been far more users/consumers than suppliers, which means that in a world where transactions are costly owning the supplier relationship provides significantly more leverage.

The fundamental disruption of the Internet has been to turn this dynamic on its head. First, the Internet has made distribution (of digital goods) free, neutralizing the advantage that pre-Internet distributors leveraged to integrate with suppliers. Secondly, the Internet has made transaction costs zero, making it viable for a distributor to integrate forward with end users/consumers at scale.

stratechery Year One - 220

This has fundamentally changed the plane of competition: no longer do distributors compete based upon exclusive supplier relationships, with consumers/users an afterthought. Instead, suppliers can be aggregated at scale leaving consumers/users as a first order priority. By extension, this means that the most important factor determining success is the user experience: the best distributors/aggregators/market-makers win by providing the best experience, which earns them the most consumers/users, which attracts the most suppliers, which enhances the user experience in a virtuous cycle.

The result is the shift in value predicted by the Conservation of Attractive Profits. Previous incumbents, such as newspapers, book publishers, networks, taxi companies, and hoteliers, all of whom integrated backwards, lose value in favor of aggregators who aggregate modularized suppliers — which they don’t pay for — to consumers/users with whom they have an exclusive relationship at scale. For example:


  • Previously, publishers integrated publications and articles. Google modularized individual pages and articles, making them directly accessible via search
  • Google integrated search results with search and profile data about users, enabling it to sell highly effective advertising

Facebook (and Ad Networks)

  • Previously, publishers integrated content and advertisements. Facebook modularized advertisements by allowing advertisers to target customers directly, not via proxy
  • Facebook integrated News feed ad inventory and profile data, enabling it to sell highly effective advertising


  • Previously, book publishers integrated editing, marketing and distribution. Amazon modularized distribution first via e-commerce and then via e-books
  • Amazon integrated customer data and payment information with e-book distribution and its Amazon publishing initiative (the framework is clearest when it comes to books, but the integration of distribution and the customer relationship also applies to most of Amazon’s business)


  • Previously, networks integrated broadcast availability and content purchases. Netflix modularized broadcast availability by making its entire library available at any time in any order
  • Netflix integrated content purchases and customer management, enabling a virtuous cycle of increased subscription demand and increased content purchase capability


  • Previously, networks integrated mass-market advertising and general interest programming. Snapchat (and many other services) modularized attention
  • Snapchat is integrating individually interesting content with mass market advertising inventory, giving brand advertisers a new way to reach a large audience efficiently


  • Previously, taxi companies integrated dispatch and fleet management. Uber modularized fleet management by working with independent drivers
  • Uber is integrating dispatch with customer management, enabling it to scale worldwide


  • Previously, hotels integrated vacant rooms and trust (via brand). Airbnb modularized vacant properties by building a reputation system for trust between hosts and guests
  • Airbnb is integrating property management and customer management, enabling it to scale worldwide

It’s interesting to consider the order of these examples: the pioneer of this model was Google which modularized content providers. It’s easy to see why this is the case: content has always been monetized by proxy, whether it be paying for newspapers (or advertising space in those newspapers), paying for CDs, or paying for cable TV. The shift to digital has exposed these proxies for the rent-collection mechanisms they are.1

Facebook, though, has built in some respects an even stronger position: its suppliers are its users, so while it, like Google, aggregates content that it gets for free, it also has exclusive access to that content. Snapchat and other user-generated content networks are similar.

The third wave are industries that don’t have such an obvious digital component. Airbnb, for example, deals with vacant rooms; what makes it work is the way it has digitized — and thus commoditized — trust. Uber deals with cars; it has digitized both trust and dispatch. More importantly, both have nailed the user experience in a way that incumbents have been sorely lacking. Both companies also sit in a sort of middle ground between Facebook and Google: their suppliers are not exclusive in theory, but increasingly are exclusive in reality as both benefit from a virtuous cycle of more users leading to increased utilization of suppliers.

What is important to note is that in all of these examples there are strong winner-take-all effects. All of the examples I listed are not only capable of serving all consumers/users, but they also become better services the more consumers/users they serve — and they are all capable of serving every consumer/user on earth. This, above all else, is why consumer technology companies are so highly valued both in the public and private markets.

Looking forward, I believe that Aggregation Theory will be the proper framework to both understand opportunities for startups as well as threats for incumbents:

  • What is the critical differentiator for incumbents, and can some aspect of that differentiator be digitized?
  • If that differentiator is digitized, competition shifts to the user experience, which gives a significant advantage to new entrants built around the proper incentives
  • Companies that win the user experience can generate a virtuous cycle where their ownership of consumers/users attracts suppliers which improves the user experience

The Uber and Airbnb examples are especially important: vacant rooms and taxis have not been digitized, but they have been disrupted. I suspect that nearly every industry will belatedly discover it has a critical function that can be digitized and commodified, precipitating this shift. The profound changes caused by the Internet are only just beginning; aggregation theory is the means.

  1. This is, first and foremost, why Stratechery spends a lot of time covering the media. It is simply the first example of the disruption that is happening everywhere []

Why Web Pages Suck

John Gruber had strong words about Apple news site iMore:1

I love iMore. I think they’re the best staff covering Apple today, and their content is great. But count me in with Nick Heer — their website is shit-ass. Rene Ritchie’s response acknowledges the problem, but a web page like that — Rene’s 537-word all-text response — should not weigh 14 MB.1.

It’s not just the download size, long initial page load time, and the ads that cover valuable screen real estate as fixed elements. The fact that these JavaScript trackers hit the network for a full-minute after the page has completed loaded is downright criminal. Advertising should have minimal effect on page load times and device battery life. Advertising should be respectful of the user’s time, attention, and battery life. The industry has gluttonously gone the other way. iMore is not the exception — they’re the norm. 10+ MB page sizes, minute-long network access, third-party networks tracking you across unrelated websites — those things are all par for the course today, even when serving pages to mobile devices. Even on a site like iMore, staffed by good people who truly have deep respect for their readers.

It’s that last line that should give Gruber, or anyone else complaining about crappy websites, pause. After all, if iMore respects their readers, the only alternative explanation is that their development team is incompetent. Unless, of course, iMore, along with the vast majority of ad-supported sites on the web, has basically no choice in the matter.

Advertisers and the Early Web

Gruber talks about publishers and readers, but if you begin with the premise that web pages need to be free,2 then the list of stakeholders for most websites is incomplete without the inclusion of advertisers. After all, they’re the ones that pay the bills.

Back when the web first became an important medium it actually wasn’t particularly great for advertisers. In the pre-Internet days an advertiser could buy ads in the local paper, perhaps a TV spot or two, put up a billboard and call it a day, confident they were reaching their entire target segment as well as they could. To do the same with web ads, on the other hand, required somehow knowing what websites your target customers were visiting, which could number in the hundreds or thousands, and then buying ads on those websites and crossing your fingers your customers actually saw your ad (although you would never know if they did). It was a mess.

The problem was one of scale, and in two dimensions:

  • There were way more places to advertise than before, which sounds great in theory but actually stunk in practice, because who has the time and resources to deal with hundreds or thousands of different ad sales teams?
  • Any one website only knew what its visitors were interested in on that particular website, which meant the targeting ability a website could sell to advertisers was scarcely better than a physical newspaper selling a spot in the Sports section to a gym

The result is that as late as 2010, when Mary Meeker for the first time used the following slide in her annual Internet Trends report, the Internet’s share of advertising was significantly less than its share of attention:


Ad networks and programmatic advertising, though, changed everything.

The Rise of Ad Networks

Ad networks solved both scale problems:

  • Instead of buying ads on a plethora of (relatively-speaking) little websites, advertisers could centralize their buying with an ad network that promised to place their ads across said plethora.
  • By virtue of having ads — and their associated trackers — across the aforementioned plethora of sites, networks could get a much richer picture of individual visitors giving advertisers the ability to much more finely target their ads.

The way it actually works is a little complicated: unlike print ads, which were delivered days ahead of time and inserted along with editorial copy before going to press, ads today are delivered “programmatically”. The process is actually kind of amazing, and consists of several different pieces (my reference to “ad networks” has been a bit simplistic):

  • When a user requests a URL, the publisher checks to see if they have any directly sold ads available (because of the scale problems noted above, fewer and fewer publishers have fewer and fewer directly-sold ads; advertisers just aren’t interested)
  • If they don’t, the publisher asks an ad exchange for an ad
  • The ad exchange, which has built up a profile of the user across all the different sites where the ad exchange is used, sends the (anonymized) user profile and website description to a variety of demand-side platforms (DSPs) (which actually sell the ads)
  • The DSPs examine the user profile and website description and a host of other factors and offers up the price they are willing to pay to serve an ad to the user
  • The ad exchange selects the highest price, retrieves the ad, and sends it to the publisher to display

All of this happens on a just-in-time basis, and you can see why advertisers love it: to a greater extent than ever before they are reaching exactly who they want to reach at the most efficient price possible. The result has been a huge increase in advertising on the Internet; look at Meeker’s equivalent slide from 2015:


Advertisers’ strong preference for programmatic advertising is why it’s so problematic to only discuss publishers and users when it comes to the state of ad-supported web pages: if advertisers are only spending money — and a lot of it — on programmatic advertising, then it follows that the only way for publishers to make money is to use programmatic advertising.

The Modularization of Publishing

From publishers’ perspective, the fixed cost of a printing press not only provided a moat from competition, it also meant that publishers displayed ads on their terms. To use the Conservation of Attractive Profits model that I discussed last week, publishers were exceptionally profitable for having integrated content and ads in this way:


As the description of programmatic advertising should make clear, though, that is no longer the case. Ad spots are effectively black boxes from the publisher perspective, and direct windows to the user from the ad network’s perspective. This has both modularized content and moved ad networks closer to users:


Here’s the simple truth: if you’re competing in a modular market, as today’s publishers are, profits are slim at best, and you generally take what you can get from a revenue perspective. To put it another way, publishers today have about as much bargaining power as do Uber drivers, and we’ve seen how that has gone.

So What Now?

To this point I’ve discussed ad networks from the advertisers’ perspective; Gruber’s critique, though, was that of a user: he is absolutely correct that the price of efficiency for advertisers is the user experience of the reader. The problem for publishers, though, is that dollars and cents — which come from advertisers — are a far more scarce resource than are page views, leaving publishers with a binary choice: provide a great user experience and go out of business, or muddle along with all of the baggage that relying on advertising networks entails.3

Again, the solution is not that publishers should try harder to have better ads. The New York Times, arguably the gold standard when it comes to both brand and quality impressions, noted in its annual report:

Digital advertising networks and exchanges, real-time bidding and other programmatic buying channels that allow advertisers to buy audiences at scale are also playing a more significant role in the advertising marketplace and causing downward pricing pressure.

If the New York Times cannot resist programmatic advertising, what chance does iMore or the vast majority of online publications have? If anything this puts Facebook’s Instant Articles initiative in a far more positive light: the social network is offering to not only improve the user experience by displaying articles instantly — thanks, primarily, to the lack of programmatic advertising cruft — but also to help monetize said content by selling ads against it and sharing 70%, backed by profile data that is far superior to even the ad networks.

Indeed, arguably the biggest takeaway should be that the chief objection to Facebook’s offer — that publishers are giving up their independence — is a red herring. Publishers are already slaves to the ad networks, and their primary decision at this point is which master — ad networks or Facebook — is preferable?

This too provides additional context to Apple’s new News app, which looks an awful lot like Facebook’s offer: publishers put their articles in a common repository that is monetized collectively through iAd, thus achieving advertising scale (and, it should be noted, more user data than Apple’s rhetoric would suggest). Apple, of course — and this is what prompted this entire discussion — is providing not only a carrot but a stick. Gruber concludes:

With Safari Content Blockers, Apple is poised to allow users to fight back. Apple has zeroed in on what we need: not a way to block ads per se, but a way to block obnoxious JavaScript code. A reckoning is coming.

It absolutely is, as I noted when Facebook’s Instant Articles launched. The future for most publishers is likely that of pure content production only, save for the few — like Gruber — who are destination sites capable of selling native advertising in stream (or selling subscriptions, like this site). What is very much in question is exactly how users will feel when they finally get what they claim they wish for.

  1. I excerpted most of Gruber’s post — his writing is impressively tight! — with permission []
  2. The experience of the vast majority of publishers is that readers will not pay for content; the exception are sites like this one that keep costs extremely low and focus on primarily analysis, not original reporting []
  3. Advertisers and ad networks, unfortunately, don’t really have an incentive to improve the user experience; there is an effectively unlimited amount of inventory on the web []