Everything as a Service

Last month Benedict Evans observed that The Best is the Last:

A technology often produces its best results just when it’s ready to be replaced — it’s the best it’s ever been, but it’s also the best it could ever be. There’s no room for more optimisation — the technology has run its course and it’s time for something new, and any further attempts at optimisation produce something that doesn’t make much sense.

The development of technologies tends to follow an S-Curve: they improve slowly, then quickly, and then slowly again. And at that last stage, they’re really, really good. Everything has been optimised and worked out and understood, and they’re fast, cheap and reliable. That’s also often the point that a new architecture comes to replace them. You can see this very clearly today in devices such as Apple’s new Macbook or Windows ‘ultrabooks’ — they’ve taken Intel’s x86 and the mouse and window-based GUI model as far as they can go, and reached the point that everything possible has been optimised. Smartphones are probably at the point that the curve is starting to flatten…

Evans’ post was particularly timely as only days later Apple released quarterly results and an earnings forecast that were well under expectations,1 and the primary reason cited by Apple CEO Tim Cook was a significantly slower iPhone upgrade rate.2

It is certainly reasonable to argue that this slowdown is temporary — an artifact of the iPhone 6 pulling forward upgrades from iPhone users clamoring for larger screens — and that the iPhone 7 will return the franchise to growth; personally, I tend to agree with Neil Cybart that iPhone growth has indeed peaked — structural growth factors like new countries and carriers are largely tapped out,3 and while Apple will still draw switchers, they won’t draw enough to make up for existing customers not upgrading — but even if you disagree, your disagreement by definition must be one of timing.4 As we’ve seen with first PCs and then tablets, as hardware matures upgrade cycles inevitably lengthen and choke off growth. That the iPhone grew far beyond either of these product categories — far beyond any product ever, at least in revenue and profit terms — is a testament to the incredible market that was smartphones, and the incredible product that was the iPhone.

Indeed, it was the best market — and best product — we’ve ever seen; the question is if it is the last.

The Manufacturing Model

From the industrial revolution on, the dominant business model has been manufacturing goods and selling them at (hopefully) a profit. This had a huge number of knock-on effects, including the shift in population from rural areas to urban ones, in cities created around transportation hubs and markets. Manufactured goods (or food produced on increasingly mechanized farms) were transported to a central location, made available for purchase, and carried home by individual buyers, themselves primarily occupied in the creation of said goods. Over time, as economies matured, new types of businesses sprang up like professional services (lawyers, doctors, etc.), transportation, or luxuries like grooming or dining, but it was manufacturing that led to the creation of the critical mass of people necessary to make these sorts of businesses viable.

Over the past thirty years, this way of organizing people (in developed countries) has been increasingly hollowed out; thanks to improved communication and transportation links a wave of globalization has shifted manufacturing to the developing world and made services an increasingly central part of the economy (78% of U.S. GDP in 2015). This, though, has made companies capable of working and selling across borders more valuable than ever before, and chief amongst these is Apple.

Apple has arguably perfected the manufacturing model: most of the company’s corporate employees5 are employed in California in the design and marketing of iconic devices that are created in Chinese factories built and run to Apple’s exacting standards (including a substantial number of employees on site), and then transported all over the world to consumers eager for best-in-class smartphones, tablets, computers, and smartwatches.

What makes this model so effective — and so profitable — is that Apple has differentiated its otherwise commoditizable hardware with software. Software is a completely new type of good in that it is both infinitely differentiable yet infinitely copyable; this means that any piece of software is both completely unique yet has unlimited supply, leading to a theoretical price of $0. However, by combining the differentiable qualities of software with hardware that requires real assets and commodities to manufacture, Apple is able to charge an incredible premium for its products.

The results speak for themselves: this past “down” quarter saw Apple rake in $50.6 billion in revenue and $10.5 billion in profit. Over the last nine years the iPhone alone has generated $600 billion in revenue and nearly $250 billion in gross profit. It is probably the most valuable — the “best”, at least from a business perspective — manufactured product of all time.

Apple and Services

Yesterday Tim Cook appeared on CNBC’s Mad Money with Jim Cramer to defend the iPhone’s prospects. Cook said:

Let’s look at how did we do in this quarter, and what you would find is $50 billion and $10 billion in profit. No one else is earning anywhere near this.

They’re the best!

But, the real answer to your question, is that the thing that is different is that customers love Apple products. And the relationship with Apple doesn’t stop when you buy an iPhone. It continues. You might buy apps across the App Store. You might subscribe to Apple Music. You might use iCloud to buy additional storage. You might buy songs. You might rent movies. And so there’s a significant number of things. You might use Apple Pay every day now. Or at least several times a week. And so that relationship continues.

This, though, is a subtle shift: Cook is not talking about Apple’s ability to sell new iPhones — to make money with the old model — he is referring to the fact that Apple can (and does) make a significant amount of revenue from people using the iPhone. This is the “services” business model and the fact it shares a name with the economic activity that rose up around manufacturing over the last century is not an accident.6

The fundamental difference between manufacturing and services is that one entails the creation and transfer of ownership of a product, while the other is much more intangible: you visit a doctor or hire a lawyer, and you don’t get a widget to take home. Moreover, if you want more of a service, you have to pay more — when your hair grows back you don’t get credit from the hairdresser for having visited just a few weeks or months prior.

Manufacturing can and does undergird services: your lawyer owns computers and has office space in a building that was constructed, and your doctor buys medical devices and prescribes drugs. Even your hairdresser buys scissors and clippers and hair rollers. Similarly, Apple’s services by and large depend on you having bought an iPhone on which you can then subscribe to music or leverage the App Store or make a payment with Apple Pay. In most services business, though, what is manufactured is a modular component of the overall offering, subject to an ongoing cost-benefit comparison with competitors that drives down profits over time.7

To be sure, these transactions are much smaller on an individual basis, at least compared to an iPhone: you would need to buy more than $1000 worth of apps for Apple to earn the same gross profit as the entry-level iPhone 6S, or subscribe to Apple Music for nearly 10 years, or make over $215,000 in purchases with Apple Pay. What makes services so attractive, though, is that that is possible! Because services revenue is recurring and not tied to the delivery of a physical item it can scale indefinitely; Apple, on the other hand, faces a limit based on the number of people who can both afford their devices and are willing to upgrade.

Software and the Services Model

In this, services sound a lot like software: both are intangible, both scale infinitely, and both are infinitely customizable. It follows that a services business model — payment in exchange for service rendered, without the transfer of ownership — is a much more natural fit for software than the transaction model characteristic of manufacturing. It better matches value generated and value received — customers only pay if they use it, and producers are rewarded for making their product indispensable — and more efficiently allocates fixed costs: occasional users may be charged nothing at all, while regular users who find your software differentiated pay more than the marginal cost of providing it.

These advantages have always been obvious (along with other consumer-centric ones like the need to not install updates, or to move costs from capital to operational expenses), but when the software industry first emerged the model simply wasn’t practical: there was no way to measure how often software was used, or to seamlessly add and remove users. There were, in short, significant distribution and transactional costs that were characteristic of the old manufacturing world, so a manufacturing business model was used.

The Internet has changed that: it is possible to run software on a central server for multiple clients (spreading the fixed costs amongst them), and there are zero transactional costs involved in calculating usage or in supporting new users (even free ones);8 the result is that nearly all software now is now sold on a service model (or based on advertising, which is the same concept of pricing based on usage), including software that used to be sold like physical goods (like Adobe and Microsoft’s offerings).

Hardware as a Service

What happens, though, if we apply the services business model to hardware? Consider an airplane: I fly thousands of miles a year, but while Stratechery is doing well, I certainly don’t own my own plane! Rather, I fly on an airplane that is owned by an airline9 that is paid for in part through some percentage of my ticket cost. I am, effectively, “renting” a seat on that airplane, and once that flight is gone I own nothing other than new GPS coordinates on my phone.

Now the process of buying an airplane ticket, identifying who I am, etc. is far more cumbersome than simply hopping in my car — there are significant transaction costs — but given that I can’t afford an airplane it’s worth putting up with when I have to travel long distances.

What happens, though, when those transaction costs are removed? Well, then you get Uber or its competitors: simply touch a button and a car that would have otherwise been unused will pick you up and take you where you want to go, for a price that is a tiny fraction of what the car cost to buy in the first place. The same model applies to hotels — instead of buying a house in every city you visit, simply rent a room — and Airbnb has taken the concept to a new level by leveraging unused space.

The enabling factor for both Uber and Airbnb applying a services business model to physical goods is your smartphone and the Internet: it enables distribution and transactions costs to be zero, making it infinitely more convenient to simply rent the physical goods you need instead of acquiring them outright.

Services and the Future

This idea of a new service-based economy that deprioritizes ownership in favor of renting what you need when you need it isn’t a new one: people have been speculating about this for a few years, and in many cases experimenting with building such businesses out. Still, outside of Uber, success has been limited. I’m reminded, though, of one of my favorite Bill Gates quotes:

We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten.

It was less than ten years ago that the iPhone was launched — that’s how quickly the world can change. And while changing the status quo is hard, in the grand scheme of things, the fact that Uber and Airbnb only launched only seven and eight years ago respectively is pretty amazing. Moreover, it may be the case that some models require generational changes, or may first spring up in other geographies where people simply have less stuff.10

With regards to the iPhone, it’s hard to see its record revenues and profits ever being surpassed by another product, by Apple or anyone else: it is in many respects the perfect device from a business perspective, and given that whatever replaces it will likely be significantly less dependent on a physical interface and even more dependent on the cloud (which will help commoditize the hardware), it will likely be sold for much less and with much smaller profit margins.11

More broadly, I suspect it is going to be increasingly difficult to analyze the future with any lens based on the past. The two companies that dominated earnings in a largely gloomy quarter — Facebook and Amazon — are both uniquely enabled by the Internet; Amazon lets you rent compute power without buying a server, and Facebook serves 1.6 billion people customized content from an effectively infinite number of sources.

Just as importantly, both companies are enabling new business models in their own right: I wrote last fall about how Amazon Web Services has dramatically lowered the barrier to entry for startups, and as I wrote last week Facebook may very well do the same when it comes to advertising: it is easier, cheaper, yet more measurable (and thus justifiable) for a small business to advertise on Facebook than any other medium ever. Indeed, for all the billions that Apple has extracted from the App Store by virtue of owning distribution onto iPhones, it is Facebook that is actually “earning” the billions it is paid by app developers thanks to the disruptive nature of its advertising product. No, neither company has Apple’s profits, and will not for a long time if ever, but then again, they are at the beginning of something new, not the best of the last.


The line it is drawn, the curse it is cast
The slow one now, will later be fast
As the present now, will later be past
The order is rapidly fadin’
And the first one now, will later be last
For the times they are a-changin’.

— Bob Dylan, The Times They Are A-Changin’

Ironically, and tellingly as to the difficulty of this transition, only available on a transactional basis in iTunes

  1. Not just Wall Street’s but also Apple’s; while Apple does not release forecast numbers more than a quarter out, as I noted in the Daily Update the Q1 2016 earnings call included several allusions to Apple’s full-year expectations that clearly did not countenance what is now forecast for the next quarter []
  2. This is another thing that Apple got wrong; last year Cook suggested on every earnings call that there was nothing particularly remarkable about the iPhone 6 upgrade rate, in direct contrast to this call []
  3. And China is a real concern []
  4. And please, note the distinction between noting that iPhone growth may have peaked and saying that the iPhone is dead or that Apple is doomed []
  5. I.e. not retail []
  6. To be very clear, as I laid out two weeks ago, services are much more than just online services like email or search; they are any sort of recurring activity that does not entail a transfer of ownership []
  7. A challenge — and opportunity! — for Apple will be in maintaining its selling prices and margins even as it ramps up its services businesses []
  8. Yes, I am talking about Aggregation Theory []
  9. Or leased []
  10. This, for example, is why car-sharing services are so huge in China: many people don’t have a car at all, and the car in your garage has always been Uber et al’s biggest competitor []
  11. Implicit in that statement is that Apple will continue to sell a lot of iPhone for the foreseeable future []

Antitrust and Aggregation

Fifteen years on, perhaps the most pertinent takeaway from Microsoft’s antitrust battles with both the United States and Europe is how little it seems to have mattered. From a financial perspective, Microsoft grew revenue unimpeded from $15 billion in 1998 when the case was initiated to $95 billion last year.1 Internet Explorer, meanwhile, peaked at 95% market share in 2004, two years after the U.S. case was settled; in Europe, Windows XP N, which excluded Windows Media Player, sold only a few thousand copies, and browser choice did nothing to change underlying market trends.

What ultimately undid Microsoft — and why that $95 billion revenue figure was a peak; the current trailing twelve month number is $87 billion — was that even as Windows continued to have a monopoly on laptops and desktops the definition of a computer was dramatically expanded to include smartphones (and, to a lesser extent, tablets). And while many Microsoft partisans argue that the antitrust-related restrictions caused the company to miss mobile, the truth is Apple’s iPhone succeeded by being a very different product than Windows, and Android leveraged a very different business model; if anything Microsoft’s PC dominance meant their mobile failure was inevitable as the company was ill-equipped to think differently.

Antitrust and the Google Play Store

This history is pertinent in light of the news that the European Commission has sent a Statement of Objections to Google alleging antitrust violations in how the company has leveraged monopolies in smartphone operating systems (Android), app stores (the Google Play Store), and search (Google Search). As I detailed on Thursday my preliminary takeaway is that Google is very likely to lose the case, not necessarily because of Android’s dominance or even search, but rather because of the Google Play Store; that is the linchpin on which the Commission’s case turns. The Play Store is the one part of the Google Mobile Services suite that is irreplaceable and thus the leverage enforcing the various requirements the Commission objected to, like making Google Search and Chrome defaults, and forbidding AOSP forks.

To be sure, Google Mobile Services has other world class apps. The difference, though, is that those other apps are products, not platforms. In the case of Google Maps, for example, the quality of the service is solely under the control of Google; by extension, the quality of a competitor like HERE Maps is similarly controlled by its owners. Presuming HERE invests sufficiently OEMs will have alternatives when it comes to mapping apps.

What makes the Play Store indispensable, on the other hand, are the millions of apps that reside there; to build an equivalent is not simply a matter of will and resources but of network effects: the more customers who use a particular app store, the more likely developers are to put their apps in that store, which will attract more customers and thus more developers in a virtuous cycle. And while the biggest factor in Google Play Store achieving this dominant position was its default inclusion in Android from the beginning, the effect I just described is a familiar one: aggregation theory.

Aggregation Theory and Antitrust

To briefly recap, Aggregation Theory is about how business works in a world with zero distribution costs and zero transaction costs; consumers are attracted to an aggregator through the delivery of a superior experience, which attracts modular suppliers, which improves the experience and thus attracts more consumers, and thus more suppliers in the aforementioned virtuous cycle. It is a phenomenon seen across industries including search (Google and web pages), feeds (Facebook and content), shopping (Amazon and retail goods), video (Netflix/YouTube and content creators), transportation (Uber/Didi and drivers), and lodging (Airbnb and rooms, Booking/Expedia and hotels).

The first key antitrust implication of Aggregation Theory is that, thanks to these virtuous cycles, the big get bigger; indeed, all things being equal the equilibrium state in a market covered by Aggregation Theory is monopoly: one aggregator that has captured all of the consumers and all of the suppliers.

This monopoly, though, is a lot different than the monopolies of yesteryear: aggregators aren’t limiting consumer choice by controlling supply (like oil) or distribution (like railroads) or infrastructure (like telephone wires); rather, consumers are self-selecting onto the Aggregator’s platform because it’s a better experience. This has completely neutered U.S. antitrust law, which is based on whether or not there has been clear harm to the consumer (primarily through higher prices, but also decreased competition), and it’s why the FTC has declined to sue Google for questionable search practices.

The European Commission, on the other hand, is much more concerned about protecting competitors with the assumption that will, in the long run, benefit consumers; it sounds like the same thing but as I noted last year, the way these approaches manifest themselves differ tremendously when it comes to aggregators:

Given that [aggregators’] “monopoly” is based on consumer choice it is highly unlikely that any of them will ultimately have antitrust problems in the U.S. absent a substantial shift in antitrust doctrine. And, on the flipside, it is very possible that all of them will ultimately have problems in Europe: Europe’s doctrine of prioritizing competition isn’t so much challenging U.S. tech company dominance as it is challenging the very structure of Internet-enabled markets.

That last line seems like an invitation to slam “Europe’s anti-tech thinking”, but actually I have a lot of sympathy for the Commission’s approach. One more implication of aggregation-based monopolies is that once competitors die the aggregators become monopsonies — i.e. the only buyer for modularized suppliers. And this, by extension, turns the virtuous cycle on its head: instead of more consumers leading to more suppliers, a dominant hold over suppliers means that consumers can never leave, rendering a superior user experience less important than a monopoly that looks an awful lot like the ones our antitrust laws were designed to eliminate.

The Microsoft Remedy

The problem is that by the time aggregators establish monopolies worth investigating under today’s antitrust laws there is little that can be done to change the facts on the ground. Whatever happens in this Android case, for example, will do nothing to diminish Google’s dominant position, just as prior action against Microsoft didn’t really diminish Windows, at least not in terms of browsers or media players.

It should be noted, though, that there was one remedy from the European Commission settlement with Microsoft that actually worked out quite well: Windows was required to document interoperability protocols for work group servers, which while designed for the benefit of established competitors like Sun, was actually more important for the open-source Samba project. Samba made it possible for non-Windows PCs and servers to be fully compatible with Windows-based networks, making it viable to use a Mac or Linux machine in corporate environments, or (more importantly) in corporate data centers, one of the first areas where the Windows monopoly started to come apart.

Of course Windows remained dominant on the desktop thanks to its application lock-in (i.e. a monopoly on suppliers); in an interesting what-if the U.S. nearly upended this as well. Originally the government demanded that Microsoft fully disclose and document all of its APIs, which would allow alternative operating systems to recreate them and thus run Windows applications with no modifications, removing the application lock-in. Instead the final settlement was much narrower:

Microsoft shall disclose to [relevant developers and other industry participants] for the sole purpose of interoperating with a Windows Operating System Product, … the APIs and related Documentation that are used by Microsoft Middleware to interoperate with a Windows Operating System Product.

Basically, Microsoft agreed to not favor their own software on Windows, leaving open source compatibility layers like Wine to reverse engineer Windows APIs, ensuring they would never achieve the degree of reliability Samba did.

The Problem of Implementation

Both of these approaches — interoperability and API disclosure — could be solutions when it comes to defusing the market power of aggregators:

  • Mandated interoperability would significantly reduce the switching costs for consumers as they could more easily compare services. For example, a meta ride-hailing app would significantly weaken Uber’s lockin, and the ability to export your social graph could better enable social competitors to arise.
  • API disclosure would have a similar effect on the supply side. Imagine if you could export your host ratings from Airbnb to a competitor, or your driver rating from Uber to Lyft (Albert Wenger has proposed something similar)

What, though, should be the standard that ensure these measures are effective before it’s too late? Perhaps a 200 million user threshold would trigger interoperability and API disclosure, which leads to the question of how do you define a user? Who audits that? And shouldn’t different industries have different numbers? Who exactly is going to figure that out and what assurances do we have they won’t suffer from regulatory capture? And then there’s enforcement — who ensures that the aggregators are actually opening up in good faith? After all, it took years and hundreds of millions of Euros to extract the interoperability standards undergirding Samba from a recalcitrant Microsoft insistent its intellectual property rights were being violated. And to be fair, Microsoft had a point: the company was being asked to not simply stop bad behavior or pay a fine but to effectively empower a competitor with their own IP.

Remember, though, that the entire point of enshrining intellectual property in the law is to spur innovation: as I’ve argued previously with regards to patents, technology with its high fixed costs and strong network effects has massive incentives that drive innovation; there is enough reward for being first that the preservation of intellectual property is less important than it may be in other industries. On the flipside, the danger of slow-moving regulators is even greater.

Is This Necessary?

Given that, perhaps the biggest question is whether or not we will look back in 15 years and wonder what the point was. Microsoft’s revenue may have had a long ways to grow back in 1998, but the truth is the company’s relevance to the industry had already peaked; that year their successor on top of the industry and — via the browser, on top of Windows — was founded in Palo Alto. It was named Google.

Similar, I have made the case that while Google may still grow, the company has peaked in relevance as well, eclipsed by Facebook. So sure, the European Commission can prosecute Google, but it won’t dent Android’s dominance, and it won’t deter whoever else has the problematic monopoly in the future.2 The incentives and feedback loops that drive towards domination are simply too strong (one could make the case that the most effective monopoly killer is the next monopoly).

To that end, there is no question that the broader point underlying Aggregation Theory holds: the (metaphorical) rules have changed, and it’s fair to believe that at some point the laws may have to as well. It won’t be easy, though, and the possibility of unintended consequences will be strong, particularly given the self-corrective resiliency tech has shown to date that provides a compelling argument for leaving well enough alone.

  1. Both figures on a trailing twelve-month basis []
  2. Maybe Facebook should hope that VR isn’t as mainstream as they claim it will be []

Apple’s Organizational Crossroads

Apple is unique, and I mean that objectively.

Forget about products for a moment, about which reasonable people can disagree. Leave aside the financial results, which certainly are unprecedented. And ignore the people you know so well: folks like Jony Ive or Jeff Williams or Phil Schiller, and the many talented workers underneath them. Rather, the very structure of Apple the organization — the way all those workers align to create those products that drive those exceptional results — is distinct from nearly all its large company peers.

The Unitary Organizational Form

Apple employs what is known as a “unitary organizational form” — U-form for short — which is also known as a “functional organization.” In broad strokes, a U-form organization is organized around expertise, not products: in the case of Apple, that means design is one group (under Ive), product marketing is another (under Schiller), and operations a third (under Williams, who is also Chief Operating Officer). Other areas of expertise represented by the members of Apple’s executive team include Software Engineering (Craig Federighi), Hardware Engineering (Dan Riccio), and Hardware Technologies (Johny Srouji).

What is most striking about that list is what it does not include: the words iPhone, iPad, Mac, or Watch. Apple’s products instead cut across the organization in a way that enforces coordination amongst the various teams:

functional

The benefits of this approach are well-known at this point, and captured in the name itself: “unitary” is a synonym for “integrated”. CEO Tim Cook has repeatedly extolled Apple’s ability to create integrated products that deliver a superior user experience, and former CEO Steve Jobs made clear in one of his final keynotes that to do so required more than wishful thinking:

[iPads] are post-PC devices that need to be even more intuitive and easier to use than a PC, and where the software and the hardware and the applications need to be intertwined in an even more seamless way than they are on a PC. We think we have the right architecture not just in silicon, but in our organization, to build these kinds of products.

This is why the very first thing that Jobs did when he returned to Apple, even before he famously pared the product line down, was to reorganize the company functionally; then again, perhaps the distinction is meaningless — a functional organization and a simplified product line go hand-in-hand.

Why the Multi-Divisional Form Was Invented

Back in 2013 when Steve Ballmer reorganized Microsoft to be (somewhat more) functional, I criticized the move in a piece entitled Why Microsoft’s Reorganization is a Bad Idea;1 as an introduction I described how the “multi-divisional form” — M-form, or divisional organization — came about:

DuPont, the famous chemical company, was actually built on gunpowder. Founded in the early 1800s, DuPont was a small family concern until the early 1900s, when Pierre DuPont modernized and organized the company around functions: primarily sales and manufacturing. The structure served DuPont well, particularly in World War I, when in response to overwhelming demand DuPont vertically integrated its supply chain, and grew to become one of the largest companies in the world.

After the war, DuPont needed to diversify, and paint, which involved a similar compound to gunpowder, was the area they chose to focus on. Yet, despite the fact DuPont was perhaps the most professionally run corporation in America, losses soared. Eventually, a disconnect between sales and manufacturing was identified as the root cause, and the cure was a new organization around two separate gunpowder and paint divisions.

The deeper details of Dupont are quite interesting, and worth getting into: in short, the entire reason Dupont started making paint was that the manufacturing process was very similar to gunpowder; the problem is that gunpowder sold on a tonnage basis to huge buyers (like the army), while paint was sold to individual customers in stores. The product may have been very similar but the business model was entirely different. The end result was that Dupont was using a sales and marketing organization that was built around selling to large customers to get their paint into retail stores, and it was massively inefficient; the more paint Dupont sold, the more money they lost.

The solution was, as noted in the excerpt, divisions organized around gunpowder and paint, each with their own sales and marketing teams, their own manufacturing heads, and their own quasi-CEOs with their own profit-and-loss responsibilities. And, as you might suspect, it was a massive success that has since been copied by nearly every large organization.

Except, of course, Apple.

Apple the Services Company

In January, in their Q1 2016 earnings call, the prepared remarks of Apple CEO Tim Cook and CFO Luca Maestri took a surprising turn: an extended amount of time was spent making the case that Apple was a services company. Cook stated:

Especially during a period of economic uncertainty, we believe it is important to appreciate that a significant portion of Apple’s revenue recurs over time…a growing portion of our revenue is directly driven by our existing install base. Because our customers are very satisfied and engaged, they spend a lot of time on their devices and purchase apps, content, and other services.

Maestri was much more to the point — these were the first words out of his mouth:

Each quarter, we report results for our Services category, which includes revenue from iTunes, the App Store, AppleCare, iCloud, Apple Pay, licensing, and some other items. Today, we would like to highlight the major drivers of growth in this category, which we have summarized on page three of our supplemental material.

That supplemental material is here, and the fact it even exists underscores how serious Apple is about this narrative. And frankly, they have reason to be: while the iPhone remains in a very strong position that I believe will return to growth next fiscal year, that growth will be far more tepid than it has been to date: all of the “low-hanging fruit” — new markets, new carriers, new screen-sizes — is gone, and the real competition for Apple are the still very-good iPhones their customers already have. To that end, making more and more money off of those preexisting customers is the natural next step in Apple’s growth.

The problem for Apple is that while iPhones may be gunpowder — the growth was certainly explosive! — services are paint. And, just as Dupont learned that having a similar manufacturing process did not lead to similar business model, the evidence is quite clear in my mind that having iPhone customers does not mean Apple is necessarily well-equipped to offer those customers compelling services. At least not yet.

The Difference Between Devices and Services

I suggested at the beginning of this piece that to objectively claim that Apple is unique you needed to think beyond products, but in fact I do believe that Apple’s products — their devices anyways — are superior, particularly if you value the finer details of industrial design, build quality, and little UI details like scrolling and responsiveness that seem so simple but are so hard to get right.2 And, frankly, it’s not surprising that Apple is good at this stuff for the exact reasons laid out above: everything about the company is designed to produce integrated devices that don’t sacrifice perfection for the sake of modularity.

The problem is that everything that goes into creating these jewel-like devices works against being good at services:

  • You only get one shot to get a device right, so all of Apple’s internal rhythms and processes are organized around delivering as perfect a product as possible at a specific moment in time.

    Services, on the other hand, which are subject to an effectively infinite number of variables ranging from bandwidth to device capability to hacking attempts to data integrity to power outages — the list goes on and on — can never be perfect; the ideal go-to-market is releasing a minimum viable product that is engineered for resiliency and then updated multiple times a week if not multiple times a day. The rhythms and processes are the exact opposite of what is required to build a great device.

  • As Apple is happy to tell you, a superior experience on a device comes from integration: the software can be tailored to the hardware, all the way down to the component level; this is why Apple designs their own system-on-a-chip hand-in-hand with iOS. Integration to this degree, though, is only possible when there is a static endpoint: the device that goes on sale to the public.

    In the case of services, though, which develop organically and iteratively, an integrated approach is unworkable: you can’t build everything from scratch multiple times a day. Rather, an effective set of services are modular in the extreme: different capabilities snap together like lego blocks to deliver different types of experiences, and each of those capabilities can be iterated on without disrupting the end product.

  • The fact that smartphones are such an important part of people’s lives, combined with the fact that physical objects can have additional consumer benefits like status, enables Apple to sell each iPhone with a huge amount of margin. However, not everyone values smartphones that much, or has the willingness to pay, which means Apple has to be ok with not serving the entire market; after all, to make a single iPhone costs money that has to be made up for in the purchase price.

    Services, though, have a very different business model. First, there is precious little evidence that consumers are willing to pay more than a nominal amount for services (if that!), which means the most profitable services make money through volume. Secondly, services are effectively free on a marginal basis; the real costs are fixed, which means that services business have a strong economic imperative to reach as many people as possible.

These differences get at the very fundamental reasons why Apple struggles with services: it’s not that the company is incompetent, but rather that the company is brilliant — brilliant at making devices, which require completely different business structures and incentives.

Apple’s Services Problem

Late last week news broke that Apple was considering adding search ads to the App Store. I detailed yesterday why I think this is less of a big deal for the industry than either advocates or detractors believe, but I do think this is a very big deal for what is says about Apple: namely, that the company is serious about building out its services business.

The question, though, is how serious; App Store search ads will be a relatively easy thing to implement, just as the App Store itself was in many respects an obvious — yet still revolutionary — addition to the iPhone.3 It’s worth noting, though, how poorly the App Store is generally run: Apple is not, in my estimation, deriving nearly the amount of strategic value they should be from the App Store. The iPhone and iPad should be home to an increasingly sophisticated and exclusive cadre of high-powered applications that make the idea of choosing another platform unthinkable, but sadly, such applications have no business model because of App Store policies.

Apple Music is in worse shape: the extent to which the product is succeeding is largely due to its tie-in with Apple’s hardware; however, were the service held to the same ease-of-use, fit-and-finish, and profitability standards of said hardware there would be panic in Cupertino.

Cloud services, meanwhile, are still less reliable than Apple’s competition, and the integration — Apple’s supposed strength! — with Apple’s software is at best a source of irritation and at worst very worrisome from a security perspective: little things like constantly being prompted to enter one’s password are not only annoying but also corrosive when it comes to what should be a healthy skepticism about sharing the keys to your life.

The problem in all these cases is that Apple simply isn’t set up organizationally to excel in these areas:

  • Apple values integration and perfection, which results in too many services being over-built and thus more difficult to iterate on or reuse elsewhere
  • Service releases (and software) are not iterative but rather tied to hardware releases
  • Apple’s focus on secrecy means many teams end up building new services from scratch instead of reusing components

The root problem in all these cases is the lack of accountability: as long as the iPhone keeps the money flowing and the captive customers coming, it doesn’t really matter if Apple’s services are as good as they could be. People will still use the App Store, Apple Music, and iCloud, simply because the iPhone is so good.

What they won’t do, though, is use Apple Pay: an extension of Apple’s unitary vision (and another manifestation of the problems underlying my critique of the App Store) is a struggle to partner effectively, particularly with vast ecosystems driven by incentives, not backroom deals. Apple Pay could be the foundation for a tremendous amount of value but Apple isn’t doing the grunt work to get it off the ground (iMessage fits here as well).

You can see the same pattern with HomeKit, or Siri: the Amazon Echo is quietly taking over the home automation market with a simple API that is easy-to-integrate with and easy-to-understand; Apple, meanwhile, has yet to announce a Siri API even as it struggles to deliver natural language interaction that is simply not what the company is good at.

Both examples are even more worrisome when you consider Apple Watch: the Watch will truly realize its value when it becomes the key to interacting with your environment; getting there, though, means nailing services, partnerships, and APIs that are good, not perfect.

How Apple Can Excel at Services

The solution to all these problems — and the key to Apple actually delivering on its services vision — is to start with the question of accountability and work backwards: Apple’s services need to be separated from the devices that are core to the company, and the managers of those services need to be held accountable via dollars and cents.

This last point is surely anathema to Apple: the company famously only has one P&L4 — the number it delivers to Wall Street — and I absolutely agree that is foundational to Apple’s success. Removing the position of Senior Vice President of iPod made it far easier to obsolete it with the iPhone,5 and the fact there was no Senior Vice President of the Mac made it easier to come out with the iPad. Apple has displayed a remarkable unity of purpose that is only truly possible with a unitary organization, which is exactly why restoring that structure was Jobs’ first move upon his return.

But again, Jobs’ next move was slashing the product line, and that wasn’t only for reasons of focus and customer confusion: the fact is that unitary organizations do not scale to different business models, and if Apple is truly serious about services — and the existence of the relatively cheap yet full-featured iPhone SE suggests they are — they need to follow Dupont’s example.

Apple will not fix the services it already has, or deliver on the promise of the services its hardware might yet enable, unless a new kind of organization is built around these services that has a fundamentally different structure, different incentives, and different rhythms from Apple’s device teams. You don’t make great products because you want to make great products; you make great products by creating the conditions where great products can be produced.

Apple’s Dupont Moment

To be honest, I’m not sure Apple has it in them; indeed, Dupont nearly didn’t. Listen to these passages from Richard Tedlow’s book Denial and see if they ring familiar:

Irénée du Pont did not like this proposal [to organize the company by divisions], despite the fact that it came from his top people — seasoned executives all. It violated the “principle of specialization,” which had served DuPont so well. Irénée was still wedded to the idea of functional rather than product specialization…

Middle management — the men closest to the problems and seeking practical solutions for them — felt one way. Top management — which had created the modern DuPont company and seen that creation grow to un-imagined wealth and size — felt another…

Four years ago, Cook told a Goldman Sach’s investment conference:

They’re not things where we run separate [profits and losses] on, because we don’t do that — we don’t believe in that. We manage the company at the top and just have one [profit and loss] and don’t worry about the iCloud team making money and the Siri team making money. We want to have a great customer experience, and we think measuring all these things at that level would never achieve such a thing…

Apple is this unique company, unique culture that you can’t replicate. And I’m not going to witness or permit the slow undoing of it, because I believe in it so deeply. Steve grilled in all of us, over many years, that the company should revolve around great products, and that we should stay extremely focused on few things. Rather than try to do so many that we did nothing well.

Unlike many, I’m not bothered that Apple sells multiple variations of iPhone, iPads, etc. Scaling to variations is simply a matter of money and experience, which Apple has in spades. Services, though, are a fundamentally different problem that require a fundamentally different organization. If Apple is serious about services, then Cook’s promise that Apple would stay “extremely focused” is an empty one, and the insistence on a single type of organizational structure changes from enhancing Apple’s quality to actively detracting.6

Tedlow concluded:

It is extraordinarily difficult to bring about change in a big company. Leadership, it has been said, consists of using minimum problems to create maximum positive change. By that standard, DuPont did well, but it could have done better. Only when the firm was on the brink of disaster, in the midst of a crisis produced by one of the worst years in its history, was it able to reconcile itself to the fact that yesterday’s structure was acting as a barrier against rather than an avenue toward tomorrow’s strategy.

Something has to give: either what makes Apple Apple, or Apple’s newfound ambitions; the measure of Cook’s leadership will be how long it takes for him to stop straddling the fence.

  1. If you’re interested in this topic you can also read the followup: The Uncanny Valley of a Functional Organization []
  2. If you disagree, that’s ok! I also believe that if you value things like flexibility and integration with services — which I’m getting to — that Android phones (which I own and use regularly) are better; furthermore, I am well aware of and have written extensively about what I and many others perceive as Apple’s declining software quality. Please bear with me here. []
  3. To clarify, the implementation of the App Store was brilliant; the idea of allowing 3rd-party apps was obvious []
  4. Profit and loss, the metric on which divisional managers are measured []
  5. Tony Fadell left (with, reportedly, not much effort to keep him) after losing out to Scott Forstall’s vision of the iPhone, and it is telling that Apple has not had a product-centric executive member since []
  6. One important thing to note: Apple’s Retail division is a separate division with its own organizational structure and own P&L; Ron Johnson knew that was necessary to make the division work []

Facebook, Phones, and Phonebooks

It was a bit surreal to see Facebook founder and CEO Mark Zuckerberg traipsing around the F8 stage carrying an “engine pod” for a Facebook drone designed to beam the Internet to the one billion people Zuckerberg said could not be online due to a lack of access. Zuckerberg himself clearly felt the same way, remarking that “If you had told me 12 years ago that one day Facebook was going to build a plane, I would have told you that you were crazy.”

Still, it makes sense: Facebook has from day one been about getting people online.

Thefacebook

Twelve years ago Zuckerberg started Thefacebook — the company would switch its name a year later — at Harvard as the online version of the freshman facebook that Harvard distributed in print; to join you had to have a Harvard email address and use your own name. But of course you wanted to do exactly that: as Amelia Lester, who would go on to be the long-time managing editor of The New Yorker, wrote in a remarkably insightful column in The Harvard Crimson:

The thefacebook.com scene includes reams of carefully coiffed, immaculately manicured, evening-garbed Harvard students grinning eagerly on page after page as we present our own ideal image of selfhood to fellow browsers…every profile is a carefully constructed artifice, a kind of pixelated Platonic ideal of our messy, all-too organic real-life selves who don’t have perfect hair and don’t spend their weekends snuggling up with the latest Garcia Marquez…There are plenty of other primal instincts evident at work here: an element of wanting to belong, a dash of vanity and more than a little voyuerism probably go a long way in explaining most addictions (mine included). But most of all it’s about performing — striking a pose, as Madonna might put it, and letting the world know why we’re important individuals.

For the next several years, that’s all Thefacebook was: a collection of profile pages that gave individuals the opportunity to present their best selves for the perusal and approval of those in their network. And people could not get enough: Thefacebook methodically spread from college to college, usually signing up the vast majority of students in a matter of weeks if not days.

The phenomenon, according to The Facebook Effect author David Kirkpatrick, was surprisingly one that didn’t appeal that much to Zuckerberg. Kirkpatrick wrote:

Ironically, Zuckerberg was not a heavy user of Thefacebook. Nor, in fact, were any of its founders and early employees. [The summer of 2004] the interns, working with Moskovitz, started to gather data on how people actually used the site. They found that some users were looking at hundreds and even thousands of profiles every day. These were the users they were designing for.

Kirkpatrick noted that Zuckerberg was splitting his time between Thefacebook and a service called Wirehog that enabled peer-to-peer sharing amongst Thefacebook users, something that Zuckerberg was much more interested in personally. Zuckerberg would eventually be persuaded to give up the side project, but this would not be the last time Zuckerberg’s interest in sharing would seem to run counter to Thefacebook’s focus on enabling people to put themselves — their best selves — online.

The Power of Identity

As Lester astutely noted, the identity we build for ourselves on Facebook is our own projection of how we want others to see us, and it has been core to the service from the beginning. Kirkpatrick writes:

Perfecting the details of your own profile in order to make yourself a more attractive potential friend occupied a considerable amount of time for many of these newly networked Ivy Leaguers. Find exactly the right picture. Change it regularly. Consider carefully how you describe your interests. Since everyone’s classes were listed, some students even began selecting what they studied in order to project a certain image of themselves. And many definitely selected classes based on who Thefacebook indicated would be joining them there…Your “facebook,” as profiles on the service began to be called, increasingly became your public face. It defined your identity.

Moreover, Zuckerberg was insistent from the beginning that said identity not be split. Kirkpatrick again:

“You have one identity,” [Zuckerberg] says emphatically three times in a single minute during a 2009 interview. He recalls that in Facebook’s early days some argued the service ought to offer adult users both a work profile and a “fun social profile.” Zuckerberg was always opposed to that. “The days of you having a different image for your work friends or co-workers and for the other people you know are probably coming to an end pretty quickly.”

The power of this approach cannot be overstated: as Lester observed, from a product perspective both vanity and voyeurism are powerful drivers of engagement. It’s also a goldmine when it comes to advertising: the lead that Facebook has over everyone, including Google, when it comes to targeting advertisements is huge. The service knows exactly who you are, exactly what you like, exactly where you live, work, and went to school, all because you told them yourself. And yes, some of your “interests”, particularly in those early days, may have been more aspirational than realistic, but from an advertiser’s perspective, all the better: aspiration is exactly what they sell.

The News Feed Rubicon

It was ten years ago, in September 2006, that Facebook became the product we know today: that is when the News Feed was introduced. Now, instead of needing to proactively visit the profile pages of all your friends to discover what had changed, Facebook would use an algorithm to proactively tell you what changes you might be interested in.

The effect of the News Feed was massive: engagement immediately skyrocketed from already unseen levels, and I have previously argued that the algorithmic nature of Facebook’s feed was a core reason why the service squashed Twitter. Even more important is what the News Feed meant to the bottom line: a feed is the best place to place advertising, especially on mobile, and Facebook has spent the last several years drawing down its old display ad inventory even as News Feed ads continue to grow both in inventory and in price.

The News Feed, though, came at a cost: while Facebook information had always been public to your network,1 the fact that what you posted was being pushed out to people who were “Facebook Friends” but not necessarily real friends was a wake-up call to Facebook users. There were immediate protests, which Facebook rather astutely tamped down, but the longer-term repercussions were real. Kirkpatrick notes:

When people can see what you are doing, that can change how you behave. The reason the News Feed evoked something as intrusive as stalking was that each individual’s behavior was now more exposed. It was as if you could see every single person you knew over your backyard fence at all times. Now they could more easily be called to account for their actions.

Over the next several years a rash of incidents in which people lost their jobs, were denied entry to college, or simply got in hot water with someone close to them were a common media trope. President Obama told a group of high school students in 2009, “I want everybody here to be careful about what you post on Facebook.”

Facebook’s Closed Door

The core of Facebook’s value is its ownership of identity of every person online. To that end, while a drone plane may have been unimaginable in 2004, it fits: the only thing lacking when it comes to Facebook’s role as the Internet phone book are the missing entries for the 4 billion people who are not yet online.

In fact, the most unbelievable part of Zuckerberg’s presentation came a few minutes later, when he discussed Live Video:

People love going live because it’s so unfiltered and person and you feel like you’re just there hanging out with your friends. In a funny way, we’ve found that Live takes some of the pressure off of having to find that perfect photo or video, because everyone knows that it’s live and it’s not curated.

There is, in the subtext of Zuckerberg’s description, an acknowledgment of the need to project your best self that has always been at the root of Facebook, something the News Feed changed from an incentive to an imperative. It is the very thing that fueled the rise of Snapchat, and make no mistake, the selfie-sharing app has Facebook spooked.

Last week The Information reported that Facebook was struggling to stop the decline in “original” sharing — content that users generate themselves, as opposed to sharing a link or a viral video. Bloomberg added a day later:

People have been less willing to post updates about their lives as their lists of friends grow…Instead, Facebook’s 1.6 billion users are posting more news and information from other websites. As Facebook ages, users may have more than a decade’s worth of acquaintances added as friends. People may not always feel comfortable checking into a local bar or sharing an anecdote from their lives, knowing these updates may not be relevant to all their connections.

According to one of the people familiar with the situation, Facebook employees working on the problem have a term for this decline in intimacy: “context collapse.” Personal sharing has shifted to smaller audiences on Snapchat, Facebook’s Instagram and other messaging services.

This is the price of owning identity — of owning all the value that Facebook generates from advertising in its News Feed — and there is no going back.

The Bifurcation of Social

It is increasingly clear that there are two types of social apps: one is the phone book, and one is the phone. The phone book is incredibly valuable: it connects you to anyone, whether they be a personal friend, an acquaintance, or a business. The social phone book, though, goes much further: it allows the creation of ad hoc groups for an event or network, it is continually updated with the status of anyone you may know or wish to know, and it even provides an unlimited supply of entertaining professionally produced content whenever you feel the slightest bit bored.

The phone, on the other hand, is personal: it is about communication between you and someone you purposely reach out to. True, telemarketing calls can happen, but they are annoying and often dismissed. The phone is simply about the conversation that is happening right now, one that will be gone the moment you hang up.

In the U.S. the phone book is Facebook and the phone is Snapchat; in Taiwan, where I live, the phone book is Facebook and the phone is LINE. Japan and Thailand are the same, with a dash of Twitter in the former. In China WeChat handles it all, while Kakao is the phone in South Korea. For much of the rest of the world the phone is WhatsApp, but for everywhere but China the phone book is Facebook.

This isn’t a bad thing; indeed, it is an incredibly valuable thing: Facebook’s status as a utility is exactly what makes the company so valuable. It has the data to target advertising and the feed in which to place it, and it is difficult to imagine any of the phone companies overtaking it in value.

This is why I wrote almost exactly a year ago that Facebook should embrace its position as being something more than just a social network. From Facebook and the Feed:

It’s not inconceivable that, at some point in the relatively near future, it is Facebook that is the default advertising medium, commanding dollars that exceed its already dominant share of attention. Still, this outcome depends on Facebook driving ever-more engagement, and I’m not convinced that more “content posted by the friends [I] care about” is the best path to success.

Everyone loves to mock Paul Krugman’s 1998 contention about the limited economic impact of the Internet:

The growth of the Internet will slow drastically, as the flaw in “Metcalfe’s law”–which states that the number of potential connections in a network is proportional to the square of the number of participants–becomes apparent: most people have nothing to say to each other!

It’s worth considering, though, just how much users value what their friends have to say versus what professional media organizations produce…Was Krugman wrong because he didn’t appreciate the relative worth people put on what folks in their network wanted to say, or because he didn’t appreciate that people in their network may not have much to say but a wealth of information to share?

I suspect that Zuckerberg for one subscribes to the first idea: that people find what others say inherently valuable, and that it is the access to that information that makes Facebook indispensable. Conveniently, this fits with his mission for the company. For my part, though, I’m not so sure. It’s just as possible that Facebook is compelling for the content it surfaces, regardless of who surfaces it. And, if the latter is the case, then Facebook’s engagement moat is less its network effects than it is that for almost a billion users Facebook is their most essential digital habit: their door to the Internet.

In that piece I said that Facebook had a choice: try to restore its ownership of personal updates, or embrace its status as a utility. Here’s the funny thing about choices, though: all too often the choice is not about choosing one path or another, but about accepting reality sooner rather than later.

The truth is that Facebook chose its path way back in 2004, and cemented it in 2006: it was the place you publicly shared your identity with the world, and you had best take care exactly what that identity was. No amount of live video or original sharing prompts will change that reality, and that’s ok. If anything the real danger to Facebook is that the act of banging their collective head on a closed door will start to damage the utility of, well, their utility.

Clearly there are parts of Facebook that get this: David Marcus, for example, is pursuing a very smart strategy in his attempt to position Messenger as a transaction medium between businesses and individuals. It plays perfectly to Facebook’s strengths, and as WeChat has demonstrated in China, it can be very lucrative. Still, though, for all of the brilliance and strategic acumen he has shown to date, I worry about Zuckerberg. He opened his keynote with a surprisingly political plea to avoid the Trump-ian rhetoric around building walls:

If the world starts to turn inwards, then our community will just have to work even harder to bring people together. That’s why I think that the work that we’re all doing is so important, because we can actually give more people a voice. Instead of building walls we can help people build bridges, and instead of dividing people we can help bring people together. We do it one connection at a time; one innovation at a time; day after day after day. And that’s why I think the work that we’re all doing together is more important now than it’s ever been before.

Leaving aside the irony that Facebook has arguably played a role in Trump’s rise, the reality is that not everyone wants to build bridges all the time. Zuckerberg’s insistence that every individual on Facebook have one identity may have been a masterstroke when it comes to building value, but the truth is each of us contains multitudes: there are parts we want to show the world, and parts we want to show only our closest friends, and the sooner Facebook accepts they can’t have everything the more valuable the parts they own will become.

  1. And Facebook actually included relatively granular privacy controls from the start []

It’s a Tesla

Let’s start with the caveats: no, Tesla did not sell 276,000 Model 3’s in three days;1 that is the number of fully refundable pre-orders that required a deposit of “only” $1,000.2 And yes, Tesla has a history of delivering cars late and with a higher price than expected. Moreover, given the fact that Tesla only delivered just over 50,000 cars last year, no matter how quickly Tesla scales it will almost certainly be years before this first week of reservations is fulfilled, and even then Tesla will only control a fraction of the car market.

With that out of the way, can we marvel at what Tesla and CEO Elon Musk have accomplished? Nearly 300,000 people have willingly parted with $1,000 despite the fact they will not have a chance to purchase a car for years; an astounding 115,000 of them sent in their deposit before they even knew what the car looked like. A friend got in line to make his reservation at 6:45am and there were 123 people in front of him. This is, no matter how you measure it, a phenomenon that is nearly unprecedented; the only possible comparison is Apple and its iPhone.

Long lines and fans committed to ordering new products sight-unseen are not the only things Tesla and Apple have in common: both companies have been doubted for allegedly not understanding Disruption Theory; both, though, are proving that Disruption Theory does not have all the answers, particularly when it comes to consumer markets.

The iPhone and Disruption

Back in 2013 I wrote What Clayton Christensen Got Wrong, specifically about Apple and the iPhone:

Christensen’s theory is based on examples drawn from buying decisions made by businesses, not consumers. The reason this matters is that the theory of low-end disruption presumes:

  • Buyers are rational
  • Every attribute that matters can be documented and measured
  • Modular providers can become “good enough” on all the attributes that matter to the buyers

All three of the assumptions fail in the consumer market, and this, ultimately, is why Christensen’s theory fails as well…

My conclusion was that the iPhone was, contrary to the then-conventional wisdom, not likely to suffer from low-end disruption, and not only has that proven to be correct, Apple has in fact expanded its global marketshare. And now, with the iPhone SE, Apple is expanding the high end to a price point accessible to customers in developing markets who very much want an iPhone but simply don’t have the means to afford top-of-the-line prices.

It’s this latter point — that a high-end approach can drive growth at lower price points — that seems particularly pertinent to the Model 3.

Tesla’s Master Plan

During Thursday’s Model 3 introduction Musk referenced Tesla’s “secret master plan,” which he laid out in a blog post back in 2006. Musk wrote:

The initial product of Tesla Motors is a high performance electric sports car called the Tesla Roadster. However, some readers may not be aware of the fact that our long term plan is to build a wide range of models, including affordably priced family cars…Critical to making that happen is an electric car without compromises, which is why the Tesla Roadster is designed to beat a gasoline sports car like a Porsche or Ferrari in a head to head showdown. Then, over and above that fact, it has twice the energy efficiency of a Prius…

The strategy of Tesla is to enter at the high end of the market, where customers are prepared to pay a premium, and then drive down market as fast as possible to higher unit volume and lower prices with each successive model…The second model will be a sporty four door family car at roughly half the $89k price point of the Tesla Roadster and the third model will be even more affordable.

In keeping with a fast growing technology company, all free cash flow is plowed back into R&D to drive down the costs and bring the follow on products to market as fast as possible. When someone buys the Tesla Roadster sports car, they are actually helping pay for development of the low cost family car.

Leaving aside the fact that the “sporty four door family car” costs $25,000 more than Musk’s promise,3 the strategy seems to have worked: Tesla, with a detour to build the Model X crossover along the way, has moved down the cost curve culminating in the announcement of the affordable Model 3.

A closer look, though, suggests that Musk painted too rosy a picture when it comes to the Master Plan’s funding: while Tesla’s cars have, from 2009 on, been sold at a profit, the company has still lost significant amounts of money every year. The reality is the company’s significant research and development costs have been paid for by issuing stock and incurring debt, not the profits of high-end models.

Low End Dogma

Given Tesla’s finances, it’s tempting to ask why the company didn’t simply start with the low-end; indeed, researchers at Christensen’s Forum for Growth and Innovation argued last year that a better approach to the electric vehicle market would be exactly that. From a Harvard Business Review article entitled Tesla’s Not as Disruptive as You Might Think:

It [is] clear that Tesla is not a disrupter. It’s a classic “sustaining innovation” — a product that, according to Christensen’s definition, offers incrementally better performance at a higher price…because it’s a sustaining innovation, theory predicts that competitors will emerge. Our analysis concludes that a competitive response won’t happen until Tesla expands outside its current niche of people who prefer electric vehicles to gas-powered cars — but if it expands by creating more variety (such as SUVs) and more-affordable vehicles, competition will be fierce.

Instead the research team suggested the better route for electric vehicles would be “neighborhood electric vehicles”, which are pretty much the exact opposite of a Tesla: the article describes them as “a low-speed vehicle that resembles a souped-up golf cart.”

Don’t feel bad if you haven’t heard of neighborhood electric vehicles: Global Electric Motorcars, featured in the article’s sidebar, have only sold 50,000 vehicles in 17 years, despite the fact they cost around a tenth as much as a Model S. Tesla, meanwhile, sold over 50,000 Model S’s last year alone; its growth rate relative to its competitors was especially impressive. This table about large luxury vehicles in the U.S. is from the company’s February 2016 letter to investors:

Screen Shot 2016-04-05 at 9.08.36 PM

One would think the other car companies in this table would be incentivized to respond, no? Yet Tesla is not being out-competed, and they sure as heck aren’t selling glorified golf carts:

The truth is that the HBS Growth and Innovation Forum team is right: Tesla is not disruptive. Rather, their error was a repeat of the mistake Christensen made with the iPhone; first, they don’t understand why people buy Teslas, and two, they assume that disruption is the only viable strategy to enter a new market.

The Power of Best

When it comes to the iPhone I have argued that Apple’s smartphone was, relative to the phones on the market, Obsoletive: the iPhone effectively reduced the phones that came before it to apps on a general purpose computer, justifying a higher price even as it made cheaper incumbents obsolete.4

This doesn’t quite work for Tesla: at the end of the day a Model S is still doing the same job as a traditional BMW or Mercedes-Benz. It just does it better: a Model S accelerates faster, it has more storage, it has innovative features like limited auto-pilot and a huge touch-screen interface, and you don’t have to stop at the gas station. Most importantly, though, it is a Tesla.

The real payoff of Musk’s “Master Plan” is the fact that Tesla means something: yes, it stands for sustainability and caring for the environment, but more important is that Tesla also means amazing performance and Silicon Valley cool. To be sure, Tesla’s focus on the high end has helped them move down the cost curve, but it was Musk’s insistence on making “An electric car without compromises” that ultimately led to 276,000 people reserving a Model 3, many without even seeing the car: after all, it’s a Tesla.

From Clean Slates to Free Passes

Last month Wired wrote an article entitled How GM Beat Tesla to the First True Mass-Market Electric Car:

The electric car business has taken the form of an old-fashioned race for a prize…but now it looks pretty clear who the winner will be. And it ain’t Tesla.

General Motors first unveiled the Chevy Bolt as a concept car in January 2015, billing it as a vehicle that would offer 200 miles of range for just $30,000 (after a $7,500 federal tax credit). Barring any unforeseen delays, the first Bolts will roll off the production line at GM’s Orion Assembly facility in Michigan by the end of 2016. As Pam Fletcher, GM’s executive chief engineer for electric vehicles, recently put it to me with a confident grin: “Who wants to be second?”

Good for GM, but I’m afraid the company — and Wired — missed the plot; as the article notes an optimistic goal for the Bolt is 50,000 units a year, and I’d bet the under: at the end of the day the company is still selling a relatively slow and ugly Chevrolet. Brand and reputation matters far more than being “first” to a product category where every model on the market has fallen short of expectations — except for Tesla.

To that end, the significance of electric to Tesla is that the radical rethinking of a car made possible by a new drivetrain gave Tesla the opportunity to make the best car: there was a clean slate. More than that, Tesla’s lack of car-making experience was actually an advantage: the company’s mission, internal incentives, and bottom line were all dependent on getting electric right.

Again the iPhone is a useful comparison: people contend that Microsoft lost mobile to Apple, but the reality is that smartphones required a radical rethinking of the general purpose computer: there was a clean slate. More than that, Microsoft was fundamentally handicapped by the fact Windows was so successful on PCs: the company could never align their mission, incentives, and bottom line like Apple could.

To be sure, what Tesla and Apple have accomplished is not easy, and ongoing success is not guaranteed, particularly at lower price points. I think, though, Tesla, like Apple before them, has more control of their destiny than it may appear. Writing about Apple in an article called Best I said:

As nearly every other consumer industry has shown, as long as there is a clear delineation between the top-of-the-line and everything else, some segment of the user base will pay a premium for the best. That’s the key to Apple’s future: they don’t need completely new products every other year (or half-decade); they just need to keep creating the best stuff in their categories. Easy, right?

It is, in fact, devilishly hard; indeed Apple’s software quality has, in the eyes of many observers, declined the last few years. The company, though, has been synonymous with “best” for so long that they have time to get it right, and millions of new customers who can’t wait to buy their first iPhone; Tesla will likely receive similar grace when and if the Model 3 comes in late and over its promised price. After all, it will still be a Tesla.

  1. Elon Musk has promised an update on first week reservations tomorrow []
  2. Obviously $1,000 is a fairly substantial amount of money; it is, though, a mere 3% of the promised base price of $35,000 (before any applicable tax credits) []
  3. Although the Model S was originally available for $59,900, “only” $15,000 more than Musk’s promise; then again, the Tesla Roadster ended up costing $20,000 more too []
  4. Yes, smartphones were disruptive to PCs, as Christensen later acknowledged; this, though, does not explain why Nokia and Blackberry in particular were so devastated []

Snapchat’s Ladder

The idea that Asian messaging apps are a model for Western social media companies is widespread at this point.1 As I noted two years ago in Messaging: Mobile’s Killer App:

While the home telephone enabled real-time communication, and the web passive communication, messaging enables constant communication. Conversations are never ending, and friends come and go at a pace dictated not by physicality, but rather by attention. And, given that we are all humans and crave human interaction and affection, we are more than happy to give massive amounts of attention to messaging, to those who matter most to us, and who are always there in our pockets and purses.

This, by extension, dictates that messaging is incredibly valuable: in a world of effectively infinite content and zero distribution costs the only scarce resource is attention, and if messaging is indeed the recipient of “massive amounts of attention” it has massive value.

That excerpt may look familiar: I used it just a few months ago to discuss Slack. In the enterprise the application where workers live has an excellent opportunity to be the layer that ties increasingly disparate cloud services together, and there’s even an outside chance Slack could be the rare enterprise product that crosses over into the consumer space. Unless, of course, Snapchat gets there first.

Messaging in the United States

I wrote about Snapchat’s huge market opportunity just over a year ago in a piece called Old-Fashioned Snapchat. At that point Snapchat was already very entrenched with teens in the United States in particular, but over the last year — particularly the last few months — it seems the service has started to cross-over to a broader audience.

The big challenge in getting a messaging service off the ground in the United States is that, unlike the rest of the world, text messaging has long been free. The reason this matters is that while it is very difficult to get even one person to change their habit or workflow, it is exponentially harder to get a critical mass of people to change all at the same time. However, if there is a fantastic benefit that appeals to everyone the challenge is a lot easier, and there is no better benefit than offering for free a service that used to cost money.

This, above all, is why WhatsApp in particular was able to become the fastest growing social network of all time, even with a skeletal team of engineers: the company basically offered text messaging for free just as people were getting their first smartphones,2 which was a delta of improvement that significantly exceeded the cost of changing how you and your family and friends communicated. LINE and Kakao did the same in parts of Asia3, and WeChat quickly came to dominate China. Note too that the latter three services offer significantly more functionality than WhatsApp, but in fact little has changed when it comes to which service dominates which countries: whatever improvements the Asian apps offered relative to WhatsApp weren’t significant enough to overcome the barrier of changing people’s habits en masse.

image

Meanwhile, as I noted, the United States had free text messaging: it is not a coincidence that none of the messaging services have made much of an impact. Except, of course, Snapchat. You know, the teen sexting app.

Snapchat’s Opening

I obviously say “teen sexting app” tongue-in-cheek, but it’s worthwhile to understand just how it was that Snapchat got off the ground. In a world dominated by Facebook (and to a smaller extent Twitter) Snapchat offered something unique that couldn’t be easily copied by the existing services: chats that disappeared immediately.

Beyond the fact this is much more akin to how we actually talk in the real world, disappearing messages were particularly attractive to teens put off by the prospect of their parents, future admissions officers, future employers, and whoever else spying on what they said.

Moreover, the primary means of communication was not text but rather a picture, usually a selfie. Again, this more closely corresponded to how people actually communicate — non-verbal communication with our face is even more important than verbal — and also appealed particularly strongly to teenagers: while everyone is ultimately mostly concerned about themselves, teenagers don’t even bother to pretend otherwise!

These two factors worked together to magnify Snapchat’s initial differentiation: the fact snaps disappeared removed whatever reticence teenagers may have had about sending their selfies, and the result was messaging that was far more personal than Facebook’s preening or Twitter’s broadcasting.

The problem, as pundits far and wide would tell you, is that disappearing chats do not an advertising platform make. Snapchat’s entire point was in not tracking you like Facebook, and who was going to put up with advertisements stuffed in your selfies?

This brings me to Netflix. You know, the DVD-by-mail company.

Netflix and the Ladder-Up Strategy

In January, when Netflix expanded its service to an additional 130 countries with the flip-of-a-switch, I wrote how the company had expertly executed a “ladder-up” strategy:

Netflix started by using content that was freely available (DVDs) to offer a benefit — no due dates and a massive selection — that was orthogonal to the established incumbent (Blockbuster). This built up Netflix’s user base, brand recognition, and pocketbook

Netflix then leveraged their user base and pocketbook to acquire streaming rights in the service of a model that was, again, orthogonal to incumbents (linear television networks). This expanded Netflix’s user base, transformed their brand, and continued to increase their buying power

With an increasingly high-profile brand, large user base, and ever deeper pockets, Netflix moved into original programming that was orthogonal to traditional programming buyers: creators had full control and a guarantee that they could create entire seasons at a time

Each of these intermediary steps was a necessary prerequisite to everything that followed, culminating in yesterday’s announcement: Netflix can credibly offer a service worth paying for in any country on Earth, thanks to all of the IP it itself owns. This is how a company accomplishes what, at the beginning, may seem impossible: a series of steps from here to there that build on each other. Moreover, it is not only an impressive accomplishment, it is also a powerful moat; whoever wishes to follow has to follow the same time-consuming process.

Back when Netflix first got traction it was easy to dismiss it: DVDs were not long for this world, and the company had a nice niche but would ultimately fade away. But that was to focus on the first rung of the ladder, even as founder and CEO Reed Hastings was thinking several rungs ahead.

Snapchat’s Ladder

What is so impressive about Snapchat’s rise has been how founder and CEO Evan Spiegel has shepherded the service along a similar path: today’s Snapchat, which received a major update yesterday, is a far different and richer product than it was when it launched, one that is appealing to far more people, that demands far more attention, and, critically, is far better placed to capture the value it generates.

There have been three major rungs to date:

Rung 1: Stories

In October 2013, two years after the company’s founding, Snapchat added “Stories.” These collections of snaps (or short videos, added in 2012) were not exactly ephemeral — they lasted for 24 hours — but they weren’t permanent either: they were user-generated “shows” that forced you to use the app daily to not miss, and they could be private or public.

Much like Netflix’s initial streaming service, stories were a natural extension of Snapchat’s original value proposition, but a fundamental change in the nature of the service all the same: whereas chats were reactive, based on notifications, consuming stories was more of a “sit-back” experience. I explained why these sorts of experiences are so valuable in The Facebook Epoch:

Mobile is a great market. It is the greatest market the tech industry, or any industry for that matter, has ever seen, and the reason why is best seen by contrasting mobile with the PC: first, while PCs were on every desk and in every home, mobile is in every pocket of a huge percentage of the world’s population. The sheer numbers triple or quadruple the size, and the separation is increasing. Secondly, though, while using a PC required intent, the use of mobile devices occupies all of the available time around intent. It is only when we’re doing something specific that we aren’t using our phones, and the empty spaces of our lives are far greater than anyone imagined.

Stories fill that void, and as I further recounted in that article, that void is particularly attractive to brand advertisers; add on the fact that, as I recounted last year, advertisers are desperate to reach teenagers, and suddenly Snapchat had the outline of a real money-making opportunity.

Rung 2: Discover

Fast forward a year-and-a-half and Snapchat launched Discover, a place for media companies to post professionally-produced content, specifically tailored for Snapchat. This too was a natural extension of what came before: Stories were by users, and Discover was by the professionals. Moreover, Discover doubled-down on the benefits brought by Stories: first, they were another way to occupy more and more attention, and second, they were an even more natural advertising vehicle.

Both of these points were important for similar reasons: first, Discover provided instant benefit for new users who didn’t yet have friends on the service. In this respect Discover resembled Instagram’s filters: they gave a reason to use the app without a network in place. Secondly, Discover was a natural place to experiment with the brand advertising that is Snapchat’s future: professional content has long been associated with professional ads.

Rung 3: Feeds and Optionality

This brings us to yesterday’s release: Snapchat added (better) video chat, including an innovative one-way option; audio calls; audio notes; and stickers. The latter is particularly notable given that Snapchat just bought Bitmoji, an app that creates stickers that look like you.

First off, many of the features Snapchat added build on the sort of functionality the company has added on previous rungs: specifically, video and audio calling not only cement Snapchat’s hold on communication but are also much more accessible to a much broader audience than inscrutable teenagers.

Stickers, meanwhile, are a much bigger deal than people realize:

  • Stickers are a fantastic money-maker in their own right. LINE, the most famous sticker purveyor (and for good reason: they are fantastic) made around $212 million in revenue from sticker sales last year, including nearly $100 million from its “Creators Market” selling 3rd-party created sticker packs
  • Secondly, as I described in the afore-linked Messaging: Mobile’s Killer App article, the potential for stickers goes beyond direct sales. LINE made significantly more (~$318 million) from sponsored stickers, in which advertisers sponsor free sticker packs that can be acquired by following the company in question, thus establishing a direct marketing channel

Granted, these revenue numbers are relatively small, but then again LINE is smaller than Snapchat already (in Daily Active Users), and its markets have significantly fewer advertising dollars available. On the other hand, no company has mastered stickers like LINE has (including Kakao and WeChat), but this is why the Bitmoji acquisition is so intriguing: from day one Snapchat has tapped into the fact that our perspective is fundamentally selfish,4 and the potential to create stickers that are predicated on the same idea could be a lot more powerful than folks realize.

Regardless, rung three has further increased Snapchat’s optionality, both in regards to its potential user base and its revenue stream.

Snapchat versus Facebook

All of these rungs are climbing to a very lucrative destination: owning messaging in the United States. As I recounted above, unlike the rest of the world, there were no shortcuts to this market, which meant Snapchat has had to ladder its way up: first, by delivering an orthogonal product that appealed to an underserved market, and then leveraging that position into an array of products that have both expanded the addressable market and increased the service’s monetization potential.

That’s not to say success is guaranteed: the development of the Snapchat product has been far more impressive than the development of Snapchat as a business. As I snarked a few weeks ago “‘turnover’ in the context of Snapchat has been more about executives than it has been about revenue.” Does Spiegel have the discipline and commitment to build a real business around his deeply considered app?

It is here the parallel to Facebook is particularly interesting. What has made CEO Mark Zuckerberg’s leadership so exemplary is the degree to which the founder has been willing to not only surround himself with experienced executives but also learn and grow in areas in which he has no experience. The result is a company that not only delivers compelling products but is also deeply committed to its advertising business and, by extension, the success of those using Facebook to reach consumers.

There’s no question Snapchat is a threat to Facebook: both trawl for attention, and that is a zero-sum game. Facebook, though, has become much more than a social network: it is the front-door to the Internet for one, and, as Alex Muir put it, the new Excel for any number of online activities. Anyone who uses Snapchat will also use Facebook, however begrudgingly, and that, in conjunction with Facebook’s already good and still improving targeting and tracking capabilities, ensures Facebook’s revenue potential is still in its adolescence.

Moreover, Facebook is far stronger internationally than is Snapchat: all of those countries dominated by WhatsApp (a Facebook property) and LINE are equally dominated by Facebook;5 it seems there is a role for communications, a role for general browsing (which Facebook dominates), and a role for escapism (and here Instagram, another Facebook property, is a strong contender, albeit challenged by Snapchat).

Still, that doesn’t make me bearish on Snapchat: as TV moves inexorably to a subscription-based on-demand model more and more advertising will move online, including lucrative brand advertising. Both Facebook and Snapchat will capture their fair share, and I’m with Zuckerberg: I’d love to own both.

  1. Although the concept was rather new when I first wrote about it in 2013 []
  2. And, to the company’s credit, it bent over backwards to support non-iOS and non-Android devices as well []
  3. LINE in Japan, Thailand, and Taiwan, and Kakao in South Korea []
  4. This isn’t a criticism! []
  5. Japan is a bit of an exception here []

Andy Grove and the iPhone SE

Andy Grove died yesterday. He is widely considered the greatest CEO in tech history.

The Andy Grove Impact

Grove’s remarkable backstory certainly plays a role in his reputation: a survivor of the Holocaust and the Soviet occupation of Hungary, Grove née Gróf arrived in the United States a penniless refugee and taught himself English while studying chemistry at the City College of New York; he later received his Ph.D. in chemical engineering from the University of California-Berkeley and then moved across the Bay to join Fairchild Semiconductor. When Robert Noyce and Gordon Moore (originally part of the Traitorous Eight who left transistor-inventor William Shockley) resigned from Fairchild Semiconductor to found Intel, Grove was their first hire1 and it fell to Grove to build the culture and processes that would scale to support the memory business upon which Intel would be built. And so it was that the Hungarian refugee became the poster child for Silicon Valley’s idealized view of itself: a place where anyone can make it thanks to nothing more than their talent and determination.

Beyond Grove’s personal background, the importance of Intel to the technology industry — and, by extension, to the world — cannot be overstated. While Moore is immortalized for having created “Moore’s Law”, the truth is that the word “Law” is a misnomer: the fact that the number of transistors in an integrated circuit doubles approximately every two years is the result of a choice made first and foremost by Intel to spend the amount of time and money necessary to make Moore’s Law a reality. This choice, by extension, made everything else in technology possible: the PC, the Internet, the mobile phone. And, the person most responsible for making this choice was Grove (and, I’d add, his presence in management was the biggest differentiator between Intel and its predecessors, both of which included Noyce and Moore).

That wasn’t Intel and Grove’s only contribution to Silicon Valley, either: Grove created a culture predicated on a lack of hierarchy, vigorous debate, and buy-in to the cause (compensated with stock). In other words, Intel not only made future tech companies possible, it also provided the template for how they should be run, and how knowledge workers broadly should be managed. Grove also helped establish the idea of “paying it forward”: the CEO was famous for his willingness to mentor young founders (most famously Steve Jobs), and he wrote multiple books as CEO focused on how to manage and dealing with strategic inflection points.

Grove’s Most Famous Decision

The basis of that latter book was Grove’s most famous decision and, by extension, the greatest contributor to his legendary status. Intel was founded as a memory company, and the company made its name by pioneering metal-oxide semiconductor technology in first SRAM2 and then in the first commercially available DRAM.3 It was memory that drove all of Intel’s initial revenue and profits, and the best employees and best manufacturing facilities were devoted to memory in adherence to Intel’s belief that memory was their “technology driver”, the product that made everything else — including their fledgling microprocessors — possible. As Grove wrote in Only the Paranoid Survive, “Our priorities were formed by our identity; after all, memories were us.”

The problem is that by the mid-1980s Japanese competitors were producing more reliable memory at lower costs (allegedly) backed by unlimited funding from the Japanese government, and Intel was struggling to compete. Grove wrote:

We tried a lot of things. We tried to focus on a niche of the memory market segment, we tried to invent special-purpose memories called value-added designs, we introduced more advanced technologies and built memories with them. What we were desperately trying to do was to earn a premium for our product in the marketplace as we couldn’t match the Japanese downward pricing spiral…as memories became a uniform worldwide commodity.

Grove soon persuaded Moore, who was still CEO4 to get out of the memory business, and then proceeded on the even more difficult task of getting the rest of Intel on board; it would take nearly three years for the company to fully commit to the microprocessor, even though said microprocessor was already a smashing success thanks to IBM’s decision to use it in their first PC.

Over the next two decades Intel would not only reap the benefits of IBM’s decision but also greatly increase their profits through more shrewd moves by Grove. As part of selecting Intel in the first place IBM insisted that Intel share their design with another chip manufacturer called Advanced Micro Devices (AMD) to ensure multiple suppliers, but once IBM’s position was weakened through the rise of IBM-compatible manufacturers like Compaq, Intel reneged and eventually renegotiated the deal, allowing the company to leverage its technical superiority5 into the sort of differentiation it had not been able to achieve in memory.

Equally important was the groundbreaking “Intel Inside” campaign that recognized end users were increasingly the market for computer manufacturers, and that they could be persuaded to care more about who made their computer’s processor than who made the computer itself. It was again a move that resulted in increased differentiation and, by extension, increased profits. By the time Grove stepped down as CEO in 1998 Intel was earning $6.9 billion profit on $25.0 billion in revenue, thanks to a gross margin of 60.3%.

Intel’s Big Miss

Intel today is still a very profitable company: last year the chip-maker earned $11.4 billion on $55.4 billion in revenue, with a gross margin of 62.6%. There is a sense, though, that the company’s strategic position is much less secure than its financials indicate, thanks to Intel’s having missed mobile.6

The critical decision came in 2005; Apple had just switched its Mac lineup to Intel x86 processors, but Steve Jobs was interested in another Intel product: the XScale ARM-based processor.7 The device it would be used for would be the iPhone. Then-CEO Paul Otellini told Alexis Madrigal at The Atlantic what happened:

“We ended up not winning it or passing on it, depending on how you want to view it. And the world would have been a lot different if we’d done it,” Otellini told me in a two-hour conversation during his last month at Intel. “The thing you have to remember is that this was before the iPhone was introduced and no one knew what the iPhone would do…At the end of the day, there was a chip that they were interested in that they wanted to pay a certain price for and not a nickel more and that price was below our forecasted cost. I couldn’t see it. It wasn’t one of these things you can make up on volume. And in hindsight, the forecasted cost was wrong and the volume was 100x what anyone thought.”

It was the opposite of Grove’s memory-to-microprocessor decision: Otellini prioritized Intel’s current business (x86 processors) instead of moving to what was next (Intel would go on to sell XScale to Marvell in 2006), much to the company’s long-term detriment.

And yet, for all of the deserved praise that Grove has received over the years, and as difficult as his memory-to-microprocessor decision may have been, Otellini’s decision was in my estimation far more difficult. Grove had to change Intel’s culture and perception of itself, and that is incredibly difficult, but at the end of the day he was making the choice that made financial sense: microprocessors were already more profitable and offered far greater potential for sustainable differentiation. Otellini, on the other hand, was choosing between maintaining Intel’s margins and pursuing unknown volume, and while it’s easy to sit here in 2016 and say he got it wrong, it’s only right to wonder who in 2005 would have gotten it right.

The Intel-Apple Parallel

Coincidentally Grove passed away the same day that Apple held one of its oddest events in some time: the company introduced two new devices, both derivatives of products that are already on the market. The new 9.7″ iPad Pro is better than its larger sibling when it comes to the camera and display, but from the perspective of most consumers it’s the same device in a form factor that has been around for a while; the iPhone SE, meanwhile, is a clone of the two-and-a-half year-old 5S with mostly-iPhone 6S innards.

There are definite parallels between Apple and Intel, particularly when it comes to Grove’s fateful decision: Apple’s biggest business shifted from computers to iPods, and shifted again from iPods to iPhones; the company even changed its name from Apple Computer to simply Apple. Both shifts are impressive in their own right: focusing on the iPod was to in some sense abandon Apple’s founding identity, while making the iPhone meant the cannibalization of Apple’s most profitable product ever.

Still, just as Grove’s decision to abandon memory and focus on microprocessors was in some senses “easy” given the fact microprocessors was a growing business that offered more margin, not less, Apple’s shift to the iPhone has been an “easy” one as well: the iPhone is nearly as profitable on a gross margin basis as Intel’s processors are. Make no mistake, overruling internal culture and hierarchies is hard, but giving away margin tends to be a lot harder.

The Celeron and the iPhone SE

That’s why the Grove decision that actually impresses me the most is Intel’s launch of the Celeron processor in 1998.8 Grove had been introduced to a then-relatively-unknown Harvard Business School professor named Clayton Christensen, who told him about research for an upcoming book (The Innovator’s Dilemma) that explained how companies in their pursuit of margin allowed themselves to be beat on the low-end. Grove took the lesson to heart and directed Intel to create a low-end processor (Celeron) that certainly cannibalized Intel’s top-of-the-line processor to an extent but also dominated the low-end, quickly gaining 35% market share.

To date Apple has declined to make a similar move; the iPhone 5C was thought, particularly before launch, to be the fabled “low-price iPhone,” but it turns out it was simply a substitute for an iPhone 5 that had significant manufacturing problems. It certainly wasn’t low-price: it started at $549, exactly where the year-old iPhone 5 would have been, and like every iPhone before it stepped down to $449 the following year before being discontinued.

To me the pricing made perfect sense, and unlike Christensen, I wasn’t worried about the iPhone being disrupted by the low-end. Indeed, I’m still not worried: the iPhone’s hold on the top-end of the market is as strong as ever.

The problem is growth: specifically, how many high-end customers are there, and how many of those customers find their current iPhones to be good-enough? And, if Apple believed their market to be increasingly saturated, would the company be willing to cannibalize its high-margin iPhone?

The iPhone SE suggests the answer is yes, and that fact alone made yesterday’s event far more important than it seems.9 Specifically, Apple is offering top-of-the-line specs for an unprecedented price of $399. In other words, the SE is no 5C. In fact, it seems likely Apple learned some inadvertent lessons from the 5C: I am not at all surprised that the SE looks identical to a 5S;10 when an integral part of the iPhone value proposition is status what customer wants to advertise that they bought a model that was never a flagship?

This price point will likely expand the market in the developed world, particularly given the replacement of subsidies with installment plans, but it’s most interesting in developing markets, especially India. It’s tempting to compare the second-largest phone market in the world to China, but in fact the latter is significantly richer and has a much larger high-end that primarily values status; the former, meanwhile, is very well-informed about things like processor and camera specifications, and is likely to be particularly appreciative of the SE’s aggressive feature set. I’m not at all surprised that the SE is going on sale in India only a week after the U.S., which is noteworthy considering the 6S launched in India in very limited quantities a full four weeks after the U.S.11

The implications for Apple, though, are more profound than any one phone or any one market: the real long-term danger of occupying the high-end is falling in love with margin or average selling price at the expense of what makes sense strategically. Grove is to be admired for avoiding that trap, and it is encouraging that Apple CEO Tim Cook seems to be doing the same. And, fortunately for the Apple CEO, he, like Grove, can likely leave the truly devastating but ultimately understandable mistake for a successor.

  1. Due to an administrative error Grove was given employee number 4 instead of 3 which reportedly rankled Grove for years, not unlike Steve Jobs’ irritation at being employee number 2 behind Steve Wozniak []
  2. Static Random Access Memory, which is faster and more reliable than DRAM but more expensive, and is today used for on-processor cache []
  3. Dynamic Random Access Memory, which is simple and cheap relative to SRAM and is still used as the main memory for computers []
  4. It speaks of Grove’s influence on Intel that he is widely credited for this decision even though he was not yet CEO []
  5. Which AMD briefly interrupted by being the first to introduce a 64-bit extension to the x86 instruction set []
  6. This isn’t entirely fair: Intel supplies the overwhelming majority of server processors which power the cloud; the cloud is an integral part of mobile []
  7. Which was derived from one of Grove’s last deals as CEO (the acquisition via settlement of StrongARM from DEC) []
  8. The Celeron launched a month before Grove stepped down as CEO, although obviously the decision was made well before then []
  9. To be clear, I’m not saying the SE is a Celeron; the smartphone market is different. I’m just noting Apple is undercutting itself to a degree []
  10. Except for the matte-chamfered edges []
  11. The India pricing is interesting: in a rather bizarre screwup Apple first announced that the SE would cost Rs 30,000, only to issue a new press release correcting the cost to Rs 39,000. This seems unusually high given the fact the 6S is widely available at only Rs 49,500.

    In fact, though, the 6S official price is Rs 62,500, which is 1.44x as expensive as the U.S. retail price; Rs 39,000 is 1.46x the U.S. retail price for the SE, so that makes sense.

    What I suspect happened is that, given India’s unique retail market that is dominated by small shops, Apple has built in a cushion to the official retail price that it expects to disappear in the market. As I noted, the 6S is widely available for Rs 49,500, which translates to $742 US; this is 1.14x the U.S. price (which pays for import duties, sales taxes, etc.). It turns out that 1.14x the U.S. price for the SE is Rs 30,419, almost exactly what Apple first put in its press release.

    In other words, I think Apple is saying that the SE will cost Rs 39,000, but they expect to sell it for Rs 30,000; they just accidentally put the latter number in the press release []