Tim Cook said something very revealing on last quarter’s earnings call:
Last month we introduced two new categories; the first is Apple Pay, an entirely new way to pay for things in stores and in apps…The second new category is Apple Watch, our most personal device ever and one that has already captured the world’s imagination.
Did you catch that? Cook put Apple Pay on the same level as Apple Watch. It is no hobby.
Something that has characterized most of Apple’s recent successes is the degree to which they have depended on partnerships with normally intractable industries.1 The two most obvious examples are iPod/iTunes and the music industry, and most obviously, the iPhone and the phone carriers. This perhaps seems counterintuitive: Apple is famous for being difficult to deal with, working diligently to ensure it always has the upper hand, even as it holds its partners to impossible standards.
This reading of Apple’s partnership abilities, though, mistakenly rests on the assumption that business deals grow out of personal affinity. The truth is that while personal likability may help on the margins, the controlling force in Apple’s negotiations is cold hard business logic. Thus, in order to understand why Apple has been so successful in previous partnerships – and, looking forward, to better estimate the chances of Apple Pay becoming widespread – it is essential to understand how the company acquires and uses leverage.
The most important term in the study of negotiation is BATNA: Best Alternative to a Negotiated Agreement. Your BATNA defines the point at which you are willing to walk away from a deal. In order to “win” a negotiation, you want to make your BATNA as high as possible, so it’s easy for you to walk away, even as you work to make your counterparty’s BATNA as low as possible, so that they will concede more than they would like. Leverage is the means by which you change your counterparty’s BATNA.
When the iTunes Store née iTunes Music Store launched in early 2003,2 Apple was a very different company than they are today. The iPod had been on the market for a year-and-a-half, but it only worked with a Mac, which was still stuck at well under 5% of the market. This, though, worked to Apple’s advantage in their negotiations with the music labels: not only did Apple not have much to lose, but the labels didn’t really see Apple as being a major player. The labels were far more concerned about the widespread sharing of music online; suing Napster to oblivion simply made music sharing more distributed and harder to control, which, of course, benefited Apple: their customers had alternate means with which to fill their iPods. So when Apple showed up with an offering to build a music store for their small audience, well, why not?
Just a few months later, Apple expanded iTunes to Windows, and what could the labels say? Despite the fact it only existed on the Mac, the iTunes Music Store was already the number one music download service in the world. It turned out Apple had another ace in the hole: a customer base that, while small, had an outsized willingness and ability to spend. After all, they had already dropped at least $1,500 on a Mac and iPod (and likely a lot more), what was an extra $0.99? At a more basic level, said customers were loyal to Apple not because it made sense from a feature or price perspective, but simply because they loved and valued the experience of using Apple products. That, ultimately, was the key to Apple’s favorable position: they had the best customers because they had the best user experience; if the labels wanted access to them, they had to agree to Apple’s terms.
Over time the labels’ addiction to iTunes revenues only deepened, and by 2008 iTunes was their biggest source of revenue. Music executives would rant and rave about Apple’s power, and try to increase their own leverage by, for example, allowing DRM-free songs on Amazon but not Apple, but it didn’t matter because Apple had the best experience, and thus the best customers.
Apple’s negotiations with the music labels was just a warmup for the phone carriers. While Apple in 2006 (in the runup to the iPhone) was in a much stronger position than 2003, they were still much smaller ($60.6 billion market cap) than AT&T ($102.3 billion) or Verizon ($93.8 billion) on an individual basis, much less the carrier industry as a whole. More importantly, carriers weren’t facing a collective existential threat like piracy, which significantly increased their BATNA relative to the music labels.
The music labels, though, benefitted from a relatively low elasticity of substitution: if I wanted one particular band that wasn’t on the iTunes Music Store, I wouldn’t be easily satisfied by the fact another band happened to be available. The carriers, on the other hand, largely offered the same service: voice, SMS, and data, all of which was interoperable. This increased elasticity of substitution gave Apple an opportunity to pursue a divide-and-conquer strategy: they just needed one carrier.
Apple reportedly started iPhone negotiations with Verizon, but it turned out that Verizon was already kicking AT&T’s (then Cingular’s) butt through aggressive investment and technology choices, resulting in increasing subscriber numbers largely at AT&T’s expense. Verizon saw no need to change their strategy, which included strong branding and total control over the experience on phones on their network. AT&T, meanwhile, was on the opposite side of the coin: they were losing, and that in turn had a significant effect on their BATNA – they were a lot more willing to compromise when it came to branding and the user experience, and so the iPhone launched on AT&T to Apple’s specifications.
That is when Apple’s user experience advantage and corresponding customer loyalty took over: for the first time ever customers were willing to endure the hassle and expense of changing phone carriers just so they could have access to a specific device. Over the next several years Verizon began to bleed customers to AT&T even though their service levels were not only better, but actually widening the gap thanks to the iPhone’s impact on AT&T. Four years after launch the iPhone did finally arrive on Verizon with the same lack of carrier branding and control over the user experience; in other words, Verizon eventually accepted the exact same deal they rejected in 2006 because the loyalty of Apple customers gave them no choice.3
Apple followed the same playbook in country after country: insistence on total control (and over time, significant marketing investments and a guaranteed number of units sold) with a willingness to launch on second or third-place carriers if necessary. Probably the starkest example of the success of this strategy was in Japan. Softbank was in a distant third place in the Japanese market when they began selling the iPhone in 2008; finally after four years second-place KDDI added the iPhone, but only after Softbank had increased its subscriber base from 19 million to 30 million. NTT DoCoMo, long the dominant carrier and a pioneer in carrier-branded services finally caved last year after seeing its share of the market slide from 52% in 2008 to 46%. Apple had all the leverage, because they had customers who cared more about the iPhone than they did their carrier.
Apple is certainly not shy about proclaiming their fealty towards building great products. And I believe Tim Cook, Jony Ive, and the rest of Apple’s leadership when they say their focus on the experience of using an Apple device comes from their desire to build something they themselves would want to use. But I also believe the strategic implications of this focus are serially undervalued.
Last year I wrote a piece called What Clayton Christensen Got Wrong that explored the idea that the user experience was the sort of attribute that could never be overshot; as long as Apple provided a superior experience, they would always win the high-end subset of the consumer market that is willing to pay for nice things.
However, this telling of the story of iTunes and the iPhone suggests that this focus on the user experience not only defends against disruption, but it also provides an offensive advantage as well: namely, Apple increases its user experience advantage through the leverage it gains from consumers loyal to the company. In the case of iTunes, Apple was able to create the most seamless music acquisition process possible: the labels had no choice but to go along. Similarly, when it comes to smartphones, Apple devices from day one have not been cluttered with carrier branding or apps or control over updates. If carriers didn’t like Apple’s insistence on creating the best possible user experience, well, consumers who valued said experience were more than happy to take their business elsewhere. In effect, Apple builds incredible user experiences, which gains them loyal customers who collectively have massive market power, which Apple can then effectively wield to get its way – a way that involves maximizing the user experience. It’s a virtuous circle:
Understanding this circle and how it interacts with the relevant actors is the key to evaluating the prospects of Apple Pay.
When it comes to Apple Pay adoption, there are five collective players that matter: Apple, Apple customers, credit card networks (Visa, Mastercard and American Express4), banks, and merchants.
Apple has, as is their wont, spent a significant amount of time on the Apple Pay experience. Over the last several years they have built the various pieces of Apple Pay, including Touch ID, their own chips (which include the secure enclave), an experimental NFC antenna design, as well as the software to make it work, with the bonus of 800 million credit cards stored in iTunes ready to be potentially added
Apple customers continue to have higher amount of income as well as a demonstrated willingness to spend. Apple customers are also very willing to use new technology offered by Apple, including Apple Pay
Credit card networks are the closest parallel to the music labels in that their overriding concern is the existential threat posed by potential networks or payment options that cut them out of the loop entirely. No one particularly likes them or the fees they charge. Thus, when Apple declared its willingness to build Apple Pay on top of credit cards, they jumped at the opportunity to take part
Banks are the carriers in this story. In the long run Apple Pay completely obscures their role in a customer’s payment activity, and the inevitable end for any invisible service is competition on price. However, banks have two problems when it comes to Apple Pay:
- Banks are involved with every single Apple Pay transaction, which means if your bank does not support Apple Pay, it simply won’t work
- Banks are easily substitutable. Sure, switching banks can be a bit of a pain, and you might have been with the same one forever, but if Apple customers were willing to switch carriers to get the iPhone, surely many would be willing to switch banks to be able to use Apple Pay
Moreover, the banks benefit from Apple Pay’s increased security and correspondingly lower fraud rates – just as, I might add, carriers benefitted from iPhone customer’s higher average revenue per user (ARPU). Sure, it’s just as bad being a dumb bank as it is a dumb pipe, but better a dumb bank that makes money instead of one that customers simply leave
Merchants are much more difficult, and there is no real corresponding analogy in Apple’s previous dealings. Apple has much less leverage for a few reasons:
- Merchants have a lower elasticity of substitution: on the low end, day-to-day purchases aren’t worth the hassle of a longer trip simply to use Apple Pay, and on the high end, retailers are highly differentiated by the products they offer
- Merchants see much less direct benefit from Apple Pay. True, it’s likely that over time total transactions from Apple Pay-using customers will increase due to the decrease in friction relative to credit cards, but in the short term merchants are paying the exact same fees regardless of how a payment is made5
- On the flip side, the anonymized nature of an Apple Pay transaction deprives merchant of valuable customer data that can be used to better target marketing campaigns and/or be sold for a profit
This explains the situation that Apple’s payment initiative is in today: Apple Pay as an experience works incredibly well, Apple’s customers are eager to use it, the credit card networks fully support it, banks are falling over themselves to not only sign up but to pay Apple 0.15% of every transaction for the privilege, but retailers, particularly big chains that pay the most in credit card fees and reap the most benefits from data collection, are much more hesitant.6
So now what?
It turns out that Apple has acquired a few more pieces of leverage through this process:
In the U.S.,7 October 2015 brings the liability shift in which the less secure party in a transaction (i.e. a magnetic swipe card used at a payment terminal that accepts chip-enabled cards, or swipe-only terminal accepting a chip-enabled card) assumes liability for that transaction. This should spur the purchase of new credit card terminals at the vast majority of merchants; most of those new terminals will likely have NFC
By adopting industry-standard NFC, Apple has ensured that Apple Pay will “just work” at any NFC-enabled payment terminal that is not explicitly configured to not accept Apple Pay. This means that by the end of next year it’s likely that Apple Pay will work in a large part of the “long tail” of retail
For retailers that are still holding out, Apple has two new bargaining chips:
- The 0.15% that Apple is receiving from the banks for each Apple Pay transaction could be funneled back to the retailers, resulting in an immediate impact on the bottom line. Keep in mind retail is a very low margin business; turning down any reduction in credit card fees will be difficult to do
- Apple Pay could incorporate retailer loyalty programs, helping close the loop when it comes to data collection. This could work similarly to the offering Apple has for Newsstand publishers: customers opt in to sharing data, an offer that most will likely accept in exchange for the various discounts that typically accompany such programs. In fact, it seems that such an offering is already in the works
In short, Apple could very well soon have an offer that might be too good for the vast majority of retailers to refuse: get the lift that comes with seamless transactions, plus a reduction in credit card fees, along with the seamless inclusion of pre-existing loyalty programs. Oh-and-by-the-way, if a particular retailer or three still wishes to hold out, then Apple’s loyal customers will sooner rather than later have a huge number of alternatives willing to take their business.
Presuming this works out as well for Apple as I expect it to, there are two key lessons to be drawn. First, all of Apple’s leverage ultimately – either directly or indirectly – stems from consumer loyalty, which itself is based on Apple’s focus on the user experience. Second, the reason why Tim Cook so confidently called out Apple Pay as a new category is that he knew it was an area where Apple could bring that leverage to bear, just as they did in music and telephony. This is in marked contrast to the Apple TV, which is still a hobby: TV remains a much stronger business that is far more resistant to disruption than most people in tech appreciate, and until Apple has a means of obtaining leverage it will only ever remain so.
- Benedict Evans touched on this theme last week [↩]
- Yes, I just called April early [↩]
- Apple did originally sign a five-year exclusive agreement with AT&T, but that deal was negotiated several times and Apple likely could have moved to Verizon sooner had the carrier been willing to make the necessary concessions [↩]
- American Express is also effectively a bank [↩]
- This analysis applies to off-line retailers; I expect Apple Pay to immediately get significant penetration in apps for online purchases simply because the lift resulting from fewer customers falling off at the payment form will be significant [↩]
- I covered MCX and CurrentC in-depth in this daily update (members-only) [↩]
- Apple Pay is only available in the U.S. currently, so that is the center of this analysis [↩]