The Moat Map

A subtext to last week’s article, Tech’s Two Philosophies, was the idea that there is a difference between Aggregators and Platforms; this was the key section:

It is no accident that Apple and Microsoft, the two “bicycle of the mind” companies, were founded only a year apart, and for decades had broadly similar business models: sure, Microsoft licensed software, while Apple sold software-differentiated hardware, but both were and are at their core personal computer companies and, by extension, platforms…

Google and Facebook, on the other hand, are products of the Internet, and the Internet leads not to platforms but to aggregators. While platforms need 3rd parties to make them useful and build their moat through the creation of ecosystems, aggregators attract end users by virtue of their inherent usefulness and, over time, leave suppliers no choice but to follow the aggregators’ dictates if they wish to reach end users.

The distinction wasn’t entirely satisfying; first and foremost the power of both aggregators and platforms, however defined, ultimately rests on the size and strength of their userbase. Moreover, Google and Facebook have platform-type aspects to their business, and Apple has aggregator characteristics when it comes to its control of the App Store (that Microsoft does not is a symbol of the company’s mobile failure).

Moreover, what of companies like Amazon, or Netflix? In a follow-up Daily Update I classified the former as a platform and the latter as an aggregator, but clearly both have very different businesses — and supplier relationships — than either Google and Facebook on one side or Apple and Microsoft on the other, even as they both derive their power from owning the customer relationship.

Make no mistake, that bit about owning the customer relationship remains critical: that is the critical insight of Aggregation Theory. How that ownership of the customer translates into an enduring moat, though, depends on the interaction of two distinct attributes: supplier differentiation and network effects.

The Supplier Differentiation Spectrum

Consider the six companies I mentioned above: Facebook, Google, Amazon, Netflix, Apple, and Microsoft.1

The degree of differentiation of tech company suppliers varies

These companies exist on a spectrum in terms of supplier differentiation (and, by extension, supplier power):

  • Facebook has commoditized suppliers more than anyone: an article from the New York Times is treated no differently from a BuzzFeed quiz or the latest picture of your niece or an advertisement.
  • Google gives slightly more deference to established content providers, but not much; search results are presented the same regardless of their source (although Google increasingly presents results differently depending on the type of content).
  • Amazon is a little harder to classify — that’s kind of entailed in the name The Everything Store — but generally brands are much less important than they are in a world of limited shelf space, and few people even realize they are buying from the 3rd party merchants that make up over half of Amazon’s sales.
  • Differentiation matters more for Netflix, particularly when it comes to acquiring new users; still, users are transacting with Netflix and, the longer they stick with the streaming service, first opening Netflix and then looking for something to watch, as opposed to the other way around.
  • Apple first and foremost attracts and retains users through its integrated experience, but that experience would quickly be abandoned were there not third party apps.
  • Microsoft traditionally succeeded entirely because of its ecosystem, not just applications but also the entire universe of value-added resellers, systems integrators, etc.

The extremes make the point: Facebook could lose all of its third party content providers overnight and still be a compelling service; Microsoft without third parties would be, well, we already saw with Windows Phone.

The Network Effect Spectrum

Another way to consider this spectrum is in terms of user-related network effects. The idea of a network effect is that an additional user increases the value of a good or service, and indeed all of these companies depend on network effects. However, the type of network effect differs considerably, as well as the extent to which the network effect directly improves a company’s core product (what I am calling an “internalized” versus “externalized” network effect):

The internalization of network effects varies by tech company

Again there is a spectrum:

  • For Facebook the network effect that matters is users — a social network’s most important feature is whether your friends and family are using it. This network — given it is the product! — is completely internal to Facebook.
  • Google has network effects of its own, but they are less about users and more about data: more people searching makes for better search results, because of the system Google has built to relentlessly harvest, analyze, and iterate on data. Like Facebook, Google’s network effect is largely internal to Google.
  • Amazon’s network effect is more subtle: there is an aspect where your shopping on Amazon improves my experience through things like rankings, reviews, and data feedback loops. Just as important, though, are two additional effects: first, the more people that shop on Amazon, the more likely suppliers are to come onto Amazon’s platform, increasing price and selection for everyone. In other words, Amazon, particularly as it transitions to being more of a commerce platform and less of a retailer, is a two-sided network. There is one more factor though: Amazon’s incredible service rests on hundreds of billions of dollars in investments; that fixed cost investment has to be born by customers at some point, which means the more customers there are the less any one customer is responsible for those fixed costs (this manifests indirectly through lower prices and better service).
  • Netflix is a hybrid much like Amazon: there are certainly data network effects when it comes to what shows are made, what are cancelled, recommendations, ratings, etc. An essential part of Netflix’s competitive advantage going forward, though, rests on its differentiated ability to invest in new shows; this investment capability is driven by the company’s huge and still-growing user base, which is the biggest way that additional users benefit users already on the service.
  • Apple certainly benefits from a large user base over which to spread the significant fixed costs of its products, but on this end of the spectrum it is the two-sided network of developers and users that is most important. The more users that are on a platform, the more developers there will be, which increases the value of the platform for everyone.
  • Microsoft, befitting the point I made above about the expansiveness of its ecosystem, has the most “externalized” network effect of all: there is very little about Windows, for example, that produces a network effect (Office is another story), but the ecosystem on top of Windows produced one of the greatest network effects ever.

At this point, you may have noticed that these two spectrums run in roughly the same order: I don’t think that is a coincidence.

The Moat Map

Here are these two spectrums laid out on two orthogonal axis:

The Map Moat represents the relationship between supplier differentiation and network externalization

This relationship between the differentiation of the supplier base and the degree of externalization of the network effect forms a map of effective moats; to again take these six companies in order:

  • Facebook has completely internalized its network and commoditized its content supplier base, and has no motivation to, for example, share its advertising proceeds. Google similarly has internalized its network effects and commoditized its supplier base; however, given that its supply is from 3rd parties, the company does have more of a motivation to sustain those third parties (this helps explain, for example, why Google’s off-site advertising products have always been far superior to Facebook’s).
  • Netflix and Amazon’s network effects are partially internalized and partially externalized, and similarly, both have differentiated suppliers that remain very much subordinate to the Amazon and Netflix customer relationship.
  • Apple and Microsoft, meanwhile, have the most differentiated suppliers on their platforms, which makes sense given that both depend on largely externalized network effects. “Must-have” apps ultimately accrue to the platform’s benefit.

It is just as useful to think about what happens when companies find themselves outside of the Moat Map.

Missing Moats

Start with Apple and apps: in August 1997, Steve Jobs, having just returned to Apple, took the stage at Macworld Boston and proceeded to humble himself: first, he talked about how much Apple needed Adobe, and then he announced a settlement with Microsoft that entailed Microsoft investing in Apple and developing Office for Mac for at least five years. That was followed by Bill Gates’ grinning visage appearing via satellite over Jobs’ head:

An image from MacWorld Boston when Microsoft invested in Apple

I wrote in 2013 that I believe this experience resulted in Apple making poor strategic choices with the iPhone and iPad: the company never again wanted to have its suppliers become too powerful. The way this played out, though, is that Apple for years neglected the business model needs of developers building robust productivity apps that could have meaningfully differentiated iOS devices from Android.

To be sure, the company has been more than fine: its developer ecosystem is plenty strong enough to allow the company’s product chops to come to the fore. I continue to believe, though, that Apple’s moat could be even deeper had the company considered the above Moat Map: the network effects of a platform like iOS are mostly externalized,2 which means that highly differentiated suppliers are the best means to deepen the moat; unfortunately Apple for too long didn’t allow for suitable business models.

Some company's and models outside of the Moat Map

Another example is Uber: on the one hand, Uber’s suppliers are completely commoditized. This might seem like a good thing! The problem, though, is that Uber’s network effects are completely externalized: drivers come on to the platform to serve riders, which in turn makes the network more attractive to riders. This leaves Uber outside the Moat Map. The result is that Uber’s position is very difficult to defend; it is easier to imagine a successful company that has internalized large parts of its network (by owning its own fleet, for example), or done more to differentiate its suppliers. The company may very well succeed thanks to the power from owning the customer relationship, but it will be a slog.

On the opposite side of the map are phone carriers in a post-iPhone world: carriers have strong network effects, both in terms of service as well as in the allocation of fixed costs. Their profit potential, though, was severely curtailed by the emergence of the iPhone as a highly differentiated supplier. Suddenly, for the first time, customers chose their carrier on the basis of whether or not their preferred phone worked there; today, every carrier has the iPhone, but the process of reaching that point meant the complete destruction of carrier dreams of value-added services, and a lot more competition on capital-intensive factors like coverage and price.

Direction or Context?

It’s worth noting that maps can take two forms: some give direction, and others provide context for what has already happened; I’m not entirely sure which best describes the Moat Map. In the case of Apple and apps, for example, I absolutely believe the company could have made different strategic choices had it fully appreciated the interaction between supplier differentiation and network effects.

On the other hand, one could make a very strong case that the degree of supplier differentiation possible flows from the network effect involved: perhaps it was inevitable that Facebook and Google commoditized suppliers, for example, or that Amazon and Netflix would have to simultaneously pursue differentiated suppliers even as they sought to suppress them. What is always certain, though, is that there is no one perfect strategy: as always, it depends.

Thanks to James Allworth, my co-host on the Exponent podcast, for helping me conceptualize this framework

  1. In this article when I refer to “Amazon” I am primarily referring to the e-commerce company; Microsoft the PC company. I will cover AWS and Azure in a follow-up in the Daily Update. [↩︎]
  2. iMessage being an instructive exception [↩︎]

Tech’s Two Philosophies

Even though Apple’s developer conference is still a few weeks away, I think it’s safe to say that the demo of Google Duplex at yesterday’s Google I/O keynote will go down as the most impressive of the tech conference season. If you haven’t seen it, it is a must-watch:

Once I picked my jaw up off the floor, though, what struck me about Google CEO Sundar Pichai’s presentation was how he opened the segment:

Our vision for our assistant is to help you get things done.

And how he closed it:

A common theme across all this is we are working hard to give users back time. We’ve always been obsessed about that at Google. Search is obsessed about getting users to answers quickly and giving them what they want.

In Google’s view, computers help you get things done — and save you time — by doing things for you. Duplex was the most impressive example — a computer talking on the phone for you — but the general concept applied to many of Google’s other demonstrations, particularly those predicated on AI: Google Photos will not only sort and tag your photos, but now propose specific edits; Google News will find your news for you, and Maps will find you new restaurants and shops in your neighborhood. And, appropriately enough, the keynote closed with a presentation from Waymo, which will drive you.

The Google and Facebook Philosophy

Rewind a week, and there was a specific section in Mark Zuckerberg’s keynote at the Facebook F8 conference that stuck out to me:

I believe that we need to design technology to help bring people closer together. And I believe that that’s not going to happen on its own. So to do that, part of the solution, just part of it, is that one day more of our technology is going to need to focus on people and our relationships. Now there’s no guarantee that we get this right. This is hard stuff. We will make mistakes and they will have consequences and we will need to fix them. But what I can guarantee is that if we don’t work on this the world isn’t moving in this direction by itself.

Zuckerberg, as so often seems to be the case with Facebook, comes across as a somewhat more fervent and definitely more creepy version of Google: not only does Facebook want to do things for you, it wants to do things its chief executive explicitly says would not be done otherwise. The Messianic fervor that seems to have overtaken Zuckerberg in the last year, though, simply means that Facebook has adopted a more extreme version of the same philosophy that guides Google: computers doing things for people.

The Microsoft and Apple Philosophy

Earlier this week, while delivering Microsoft’s Build conference keynote, CEO Satya Nadella struck a very different tone; after describing how computing was becoming invisible, because it is everywhere, Nadella said:

That’s the opportunity that we have. It’s in some sense endless, but we also have responsibility. We have the responsibility to ensure that these technologies are empowering everyone, these technologies are creating equitable growth by ensuring that every industry is able to grow and create employment. But we also have a responsibility as a tech industry to build trust in technology.

In fact Hans Jonas was a philosopher who worked in the 50s, 60s, and he wrote a paper on technology and responsibility…he talks about act so that the effects of your action are compatible with permanence or genuine life. That’s something that we need to reflect on, because he was talking about the power of technology being such that it far outstrips our ability to completely control it, especially its impact even on future generations. And so we need to develop a set of principles that guide the choices we make because the choices we make is what’s going to define the future…

This opportunity and responsibility is what grounds us in our mission to empower every person and every organization on the planet to achieve more. We’re focused on building technology so that we can empower others to build more technology. We’ve aligned our mission, the products we build, our business model, so that your success is what leads to our success. There’s got to be complete alignment.

This is technology’s second philosophy, and it is orthogonal to the other: the expectation is not that the computer does your work for you, but rather that the computer enables you to do your work better and more efficiently. And, with this philosophy, comes a different take on responsibility. Pichai, in the opening of Google’s keynote, acknowledged that “we feel a deep sense of responsibility to get this right”, but inherent in that statement is the centrality of Google generally and the direct culpability of its managers. Nadella, on the other hand, insists that responsibility lies with the tech industry collectively, and all of us who seek to leverage it individually.

The Bicycle of the Mind

This second philosophy, that computers are an aid to humans, not their replacement, is the older of the two; its greatest proponent — prophet, if you will — was Microsoft’s greatest rival, and his analogy of choice was, coincidentally enough, about transportation as well. Not a car, but a bicycle:

Steve Jobs was exceptionally fond of this analogy: there are multiple clips of him making the point in mostly the same way; I usually link to this one because by the time this video was recorded1 Jobs had his delivery perfectly honed.

Interestingly, though, the earliest known clip of Jobs telling this story, from 1980, doesn’t include the famous phrase “Bicycle of the Mind”; it’s worth watching, though, all the same:

The best analogy I’ve ever heard is Scientific American, I think it was, did a study in the early 70s on the efficiency of locomotion, and what they did was for all different species of things in the planet, birds and cats and dogs and fish and goats and stuff, they measured how much energy does it take for a goat to get from here to there. Kilocalories per kilometer or something, I don’t know what they measured. And they ranked them, they published the list, and the Condor won. The Condor took the least amount of energy to get from here to there. Man was didn’t do so well, came in with a rather unimpressive showing about a third of the way down the list.

But fortunately someone at Scientific American was insightful enough to test a man with a bicycle, and man with a bicycle won. Twice as good as the Condor, all the way off the list. And what it showed was that man is a toolmaker, has the ability to make a tool to amplify an inherent ability that he has. And that’s exactly what we’re doing here.

This is precisely what Nadella was driving at: “to empower every person and every organization on the planet to achieve more” is to “amplify an inherent ability” those people and organizations have; the goal is not to do things for them, but to enable them to do things never before possible. And, I would hasten to add, Apple remains very much on the same side of this philosophical divide.

The Chicken and Egg Question

There is certainly an argument to be made that these two philosophies arise out of their historical context; it is no accident that Apple and Microsoft, the two “bicycle of the mind” companies, were founded only a year apart, and for decades had broadly similar business models: sure, Microsoft licensed software, while Apple sold software-differentiated hardware, but both were and are at their core personal computer companies and, by extension, platforms.

In a platform business model 3rd parties attract customers

Google and Facebook, on the other hand, are products of the Internet, and the Internet leads not to platforms but to aggregators. While platforms need 3rd parties to make them useful and build their moat through the creation of ecosystems, aggregators attract end users by virtue of their inherent usefulness and, over time, leave suppliers no choice but to follow the aggregators’ dictates if they wish to reach end users.

In the aggregator business model the aggregator owns customers and suppliers follow

The business model follows from these fundamental differences: a platform provider has no room for ads, because the primary function of a platform is provide a stage for the applications that users actually need to shine. Aggregators, on the other hand, particularly Google and Facebook, deal in information, and ads are simply another type of information.2 Moreover, because the critical point of differentiation for aggregators is the number of users on their platform, advertising is the only possible business model; there is no more important feature when it comes to widespread adoption than being “free.”

Still, that doesn’t make the two philosophies any less real: Google and Facebook have always been predicated on doing things for the user, just as Microsoft and Apple have been built on enabling users and developers to make things completely unforeseen.

Tech’s Yin and Yang

That there are two philosophies does not necessarily mean that one is right and one is wrong: the reality is we need both. Some problems are best solved by human ingenuity, enabled by the likes of Microsoft and Apple; others by collective action. That, though, gets at why Google and Facebook are fundamentally more dangerous: collective action is traditionally the domain of governments, the best form of which is bounded by the popular will. Google and Facebook, on the other hand, are accountable to no one. Both deserve all of the recent scrutiny they have attracted, and arguably deserve more.

That scrutiny, though, and whatever regulations that result, must keep in mind this philosophical divide: platforms that create new possibilities — and not just Apple and Microsoft! — are the single most important economic force when it comes to countering the oncoming wave of computers doing people’s jobs, and lazily written regulation that targets aggregators but constricts platforms will inevitably do more harm than good.

The truth is that the Divine Discontent that I wrote about last week is not only an antidote to low-end disruption, but also a reason for optimism: companies like Apple and Amazon can, as I noted, win in the long run by offering a superior user experience, but more importantly, the dividend of discontent is a greenfield of opportunities to build new businesses and new jobs alleviating that discontent. For that we need platforms on which to build those businesses, and yes, we will need artificial intelligence to do things for us so we have the time.

  1. 1990 I believe, but I’m not certain [↩︎]
  2. As I’ve written in the past, this is why mobile saved Facebook: the company desperately wanted to be a platform but being “just an app” left Facebook no choice but to be self-contained and thus a better ad company [↩︎]

Divine Discontent: Disruption’s Antidote

It is nothing but a number, no different than 999,999,999,999 for all practical purposes, but we humans are not practical creatures: we attach importance to all kinds of silly things, round numbers chief amongst them. To that end, an increasingly popular parlor question in the stocks as entertainment business is which company will be worth $1 trillion first?

The market caps of the top five companies over time

There are certainly cases to be made for Google and Microsoft and even Facebook, but most of the attention is focused on Amazon and Apple: the latter for being the closest, and the former for growing the fastest, at least recently:

The market cap of Apple and Amazon over time

It is interesting to consider these two companies in conjunction: they couldn’t be more different, but for the one thing that makes them both so valuable.

Apple Versus Amazon

I mean it when I say these companies are the complete opposite: Apple sells products it makes; Amazon sells products made by anyone and everyone. Apple brags about focus; Amazon calls itself “The Everything Store.” Apple is a product company that struggles at services; Amazon is a services company that struggles at product. Apple has the highest margins and profits in the world; Amazon brags that other’s margin is their opportunity, and until recently, barely registered any profits at all. And, underlying all of this, Apple is an extreme example of a functional organization, and Amazon an extreme example of a divisional one.

These points are all, of course, interrelated: Apple’s organizational structure, focus, and release-focused development cycle enable it to create highly differentiated products, even as the exact same structure, focus, and development cycle underly the company’s struggles in iterative services.1 Similarly, Amazon’s highly modular structure, varied businesses, and iterative approach to those businesses enable it to create services with itself as its first, best, customer, and then extend those services to developers and retailers, even as the exact same factors lead to product disasters like the Fire Phone.

Both, taken together, are a reminder that there is no one right organizational structure, product focus, or development cycle: what matters is that they all fit together, with a business model to match. That is where Apple and Amazon are arguable more alike than not: both are incredibly aligned in all aspects of their business. What makes them truly similar, though, is the end goal of that alignment: the customer experience.

The iPhone Versus Disruption

The first time Apple released two different iPhone form factors in the same year was 2013. There the new form factor was the iPhone 5C, but while the industrial design was new, the pricing wasn’t: the 5C slotted into the spot where the discontinued iPhone 5 would traditionally have gone — $100 less than the new flagship iPhone 5S. Analysts and pundits were aghast: how could Apple not produce a truly low-price iPhone? Didn’t they know this guaranteed disruption?

I argued to the contrary in a piece entitled What Clayton Christensen Got Wrong. After recounting the many predictions by the father of disruption that the iPhone would not be a success, I came up with three specific reasons why Apple seemed immune to disruptive gravity:

  • First, it was folly to presume that consumers were rational, at least to the extent that rationality could be reduced to easily articulable features balanced against price (or appreciating that round numbers aren’t anything special).
  • Second, there are many attributes of a product that can’t be easily measured, but only experienced, and that they loom large when the person using the product is the same as the person buying the product.
  • Third, that modular products, by virtue of their prioritization of standardization and interconnectivity, would inevitably fall short on attributes directly connected to the experience of using the device.

The key paragraph is here:

The attribute most valued by consumers, assuming a product is at least in the general vicinity of a need, is ease-of-use. It’s not the only one — again, doing a job-that-needs-done is most important — but all things being equal, consumers prefer a superior user experience. What is interesting about this attribute is that it is impossible to overshoot.

The term “overshoot” is right out of disruption theory. Christensen writes in his seminal book, The Innovator’s Dilemma:

The second element of the failure framework, the observation that technologies can progress faster than market demand…means that in their efforts to provide better products than their competitors and earn higher prices and margins, suppliers often “overshoot” their market: They give customers more than they need or ultimately are willing to pay for. And more importantly, it means that disruptive technologies that may underperform today, relative to what users in the market demand, may be fully performance-competitive in that same market tomorrow.

This was the basis for insisting that the iPhone must have a low-price model: surely Apple would soon run out of new technology to justify the prices it charged for high-end iPhones, and consumers would start buying much cheaper Android phones instead!

In fact, as I discussed in after January’s earnings results, the company has gone in the other direction: more devices per customer, higher prices per device, and an increased focus on ongoing revenue from those same customers. Yesterday’s results were mostly more of the same: wearables were up a lot (more devices per customer); ASP’s were down from last quarter but still 11% higher than a year ago;2 services revenue, meanwhile, shot through the roof for reasons that are still a bit unclear, but impressive nonetheless.

Also the same was a very modest increase in the number of iPhone sold: 3% more than a year ago. Apple seems to have mostly saturated the high end, slowly adding switchers even as existing iPhone users hold on to their phones longer; what is not happening, though, is what disruption predicts: Apple isn’t losing customers to low-cost competitors for having “overshot” and overpriced its phones. It seems my thesis was right: a superior experience can never be too good — or perhaps I didn’t go far enough.

Amazon and Divine Discontent

Jeff Bezos has been writing an annual letter to shareholders since 1997, and he attaches that original letter to one he pens every year. It included this section entitled Obsess Over Customers:

From the beginning, our focus has been on offering our customers compelling value. We realized that the Web was, and still is, the World Wide Wait. Therefore, we set out to offer customers something they simply could not get any other way, and began serving them with books. We brought them much more selection than was possible in a physical store (our store would now occupy 6 football fields), and presented it in a useful, easy-to-search, and easy-to-browse format in a store open 365 days a year, 24 hours a day. We maintained a dogged focus on improving the shopping experience, and in 1997 substantially enhanced our store. We now offer customers gift certificates, 1-Click shopping, and vastly more reviews, content, browsing options, and recommendation features. We dramatically lowered prices, further increasing customer value. Word of mouth remains the most powerful customer acquisition tool we have, and we are grateful for the trust our customers have placed in us. Repeat purchases and word of mouth have combined to make Amazon.com the market leader in online bookselling.

Over the last 20 years Amazon has dramatically changed, but Bezos’ annual focus on consumers has not. This year, after highlighting just how much customers love Amazon (answer: a lot), Bezos wrote:

One thing I love about customers is that they are divinely discontent. Their expectations are never static — they go up. It’s human nature. We didn’t ascend from our hunter-gatherer days by being satisfied. People have a voracious appetite for a better way, and yesterday’s ‘wow’ quickly becomes today’s ‘ordinary’. I see that cycle of improvement happening at a faster rate than ever before. It may be because customers have such easy access to more information than ever before — in only a few seconds and with a couple taps on their phones, customers can read reviews, compare prices from multiple retailers, see whether something’s in stock, find out how fast it will ship or be available for pick-up, and more. These examples are from retail, but I sense that the same customer empowerment phenomenon is happening broadly across everything we do at Amazon and most other industries as well. You cannot rest on your laurels in this world. Customers won’t have it.

Critically, when it comes to Internet-based services, this customer focus does not come at the expense of a focus on infrastructure or distribution or suppliers: while those were the means to customers in the analog world, in the online world controlling the customer relationship gives a company power over its suppliers, the capital to build out infrastructure, and control over distribution. Bezos is not so much choosing to prioritize customers insomuch as he has unlocked the key to controlling value chains in an era of aggregation.

Bezos’s letter, though, reveals another advantage of focusing on customers: it makes it impossible to overshoot. When I wrote that piece five years ago, I was thinking of the opportunity provided by a focus on the user experience as if it were an asymptote: one could get ever closer to the ultimate user experience, but never achieve it:

The asymptote version of the user experience

In fact, though, consumer expectations are not static: they are, as Bezos’ memorably states, “divinely discontent”. What is amazing today is table stakes tomorrow, and, perhaps surprisingly, that makes for a tremendous business opportunity: if your company is predicated on delivering the best possible experience for consumers, then your company will never achieve its goal.

The ever-changing version of the user experience

In the case of Amazon, that this unattainable and ever-changing objective is embedded in the company’s culture is, in conjunction with the company’s demonstrated ability to spin up new businesses on the profits of established ones, a sort of perpetual motion machine; I’m not sure that Amazon will beat Apple to $1 trillion, but they surely have the best shot at two.

The Disruption Antidote

This analysis applies to Facebook and Google, two of the other companies in that chart, more than you might expect. While the two companies’ revenues are based on advertising, the attractiveness to advertisers rests on consumers using both services.3 Both, though, are disadvantaged to an extent because their means of making money operate orthogonally to a great user experience; both are protected by the fact would-be competitors inevitably have the same business model.4

That is why, for all four companies, the first place to look for weaknesses is not in the supplier base or distribution or even regulation: it is with the end users. That is why it matters that Amazon is the most popular company in the United States, why Apple and Google continue to have two of the most respected brands, and why Facebook is right to be more concerned about the PR effect of its scandals than the regulatory ones. Owning the customer relationship by means of delivering a superior experience is how these companies became dominant, and, when they fall, it will be because consumers deserted them, either because the companies lost control of the user experience (a danger for Facebook and Google), or because a paradigm shift made new experiences matter more (a danger for Google and Apple).

In the meantime, though, disruption5 has its antidote.

  1. Yes, the company is crushing it with regards to “Services” revenue; that is mostly from the App Store and also iCloud Storage, that is to say, predicated on iPhone dominance. This reference is to things like Siri and Maps [↩︎]
  2. There was a lot of breathless speculation about iPhone X sales cratering, which clearly didn’t happen. That said, iPhone X sales clearly fell off a bit: iPhone ASP was down 9% sequentially, a much larger drop than the 6% drop a year ago. [↩︎]
  3. Microsoft is an enterprise company, a very different beast [↩︎]
  4. For a social network, the number one feature is how many of your friends are on it, which means a “free” service will always have an advantage; for a search engine, there is a weaker, but still significant, network effect that is based on data, which again augurs for a free service with the maximum number of users that entails. [↩︎]
  5. Low-end disruption, to be clear [↩︎]

Open, Closed, and Privacy

Note: This article has nothing to do with open or closed source code

It was eight years ago next month that Vic Gundotra, then-VP of Engineering at Google, delivered a blistering attack on Apple for not being open:1

A slide from Google's 2010 I/O keynote criticizing Apple

On [my] first day I met a man named Mr. Andy Rubin. Now I suspect most of you know who Andy Rubin is. At the time he was responsible for what was then a secret project codenamed Android, and on that first day Andy enthusiastically described to me the team’s mission and purpose. And as he spoke — I’ll level with you — I was skeptical. In fact, I interrupted Andy, and I said, “Andy, I don’t get it. Does the world really need another mobile operating system? Google is about advertising — shouldn’t we be on every phone?”

To this day I remember Andy’s response, and he made two points. The first point Andy made was that it was critically important to provide a free mobile operating system — an open-source operating system — that would enable innovation at every level of the stack. In other words, OEMs should be free to build all kinds of devices — devices with keyboards, without keyboards, with front-facing cameras, two inches, three inches, four inches — that operators should be able to compete on the strength and coverage of their network — 2G, 3G, 4G, LTE, CDMA — and that in the end, with innovation coming at every layer, it would be the consumer who would be able to benefit by getting the best device on the best network for them.

I remember Andy’s second point: he argued that if Google did not act, we faced a draconian future, a future where one man, one company, one device, one carrier, would be our only choice. That’s a future we don’t want! So if you believe in openness, if you believe in choice, if you believe in innovation from everyone, then welcome to Android.

Gundotra repeated the word “open” like a mantra, appealing to the sensibilities of not just people in technology but also its critics, opposed to so-called “walled gardens”; the two primary offenders were deemed to be Apple and Facebook.

This is what made Google’s low-key announcement of its latest plans for messaging on Android phones — an exclusive with The Verge about what it calls Chat — so striking: the company is introducing an open alternative to products like iMessage and WhatsApp, but only as a last resort, and the effort is being pilloried by critics to boot; Walt Mossberg was representative:

Of course Google’s critics are not criticizing Chat for being open; they are, like Mossberg, criticizing it for being “insecure” — that is, not end-to-end encrypted like iMessage or WhatsApp. That, though, is the rub: being “secure” and being “open” are incompatible.

How End-to-End Encryption Works

A quick primer on how end-to-end encryption works, using iMessage as an example; I’m going to dramatically simplify this explanation, but you can read Apple’s security white paper to get the specifics:

  • When iMessage is turned on, “keys” are generated; these are produced in pairs, one private and one public. These two keys are related: the public key encrypts content such that it can only be decrypted by a private key; to analogize them to a safe, the public key locks the door, and the private key unlocks it.
  • The relationship between these two keys is, well, the key to understanding how encryption works in messaging (and all communications): anyone sending an encrypted message “locks” the content using a public key, which means that the only person that can “unlock” and read the message is whoever has the corresponding private key.
  • To that end, the private key is, as the name implies private: it is kept on the device that generated it (in fact, every device with iMessage generates its own encryption keys). The public key, meanwhile, is public: for anyone to be able to send you an encrypted message means that everyone must be able to find the public key that corresponds to your private key.

This is the precise spot where “open” breaks down: you can, in fact, send encrypted content over open protocols like email. The problem is that the sender cannot just unilaterally decide to encrypt a message; rather, the receiver has to first generate a public-private key pair, then share the public key with the sender so that the email can be encrypted in a way that only the recipient — thanks to their private key — can read it. This is, needless to say, far beyond the capabilities of most users: not only do they not understand that there needs to be a conversation before the conversation, they don’t even know the language they need to use.

And yet, over 100 billion messages are sent per day on WhatsApp and iMessage alone, and the reason is because both are closed. To continue with the iMessage explanation, public keys are sent to Apple’s servers to be stored in a directory service; there they (along with the public keys from all of the user’s devices) are associated with the user’s phone number or email address. This is the critical piece to making iMessage encryption easy-to-use: senders need only know the recipients phone number or email address; Apple will silently pass the appropriate public keys to the sender to encrypt the message such that only the recipient can read it.2

In short, encryption is viable for the public at scale precisely because Apple controls everything: clients on both ends, and the server in the middle. It’s the same story with WhatsApp or any of the other encrypted messaging services: being closed makes end-to-end encryption actually usable at scale.

And, as I explained on Monday, this option is not available to Google when it comes to Android: OEMs don’t want to deepen their Google dependence, and carriers do not want to undercut their lucrative SMS business (and Google can’t force the issue because of its looming antitrust problems). The only option was the one Gundotra lauded in 2010: an open standard that no one controls, for better or, in the case of the desire for end-to-end encryption, worse.3

Encryption and Privacy

The ongoing debate about data and privacy is directly related to the question of encryption in some important ways, as Mossberg’s tweet notes: messaging content is data that users would like to keep private, and encryption accomplishes that.

Of course it is not the only data generated by messaging: entailed in the ease-of-use that comes from relying on centralized servers for key exchange is the necessary collection by those servers of metadata. Obviously email addresses and/or phone numbers and/or usernames have to be stored (so that they can be associated with public keys), and the very act of connecting two accounts will generate logs of who was communicating with whom and when, and often from where (through IP addresses). Services can and do differentiate based on how long they keep that metadata; Signal,4 for example, promises to flush metadata as soon as possible, whereas WhatsApp — which uses encryption developed by Signal — keeps such data indefinitely.

That gets at the more important way that the relationship between open/closed and encryption is relevant to data and privacy: just as encryption at scale is only possible with a closed service, so it is with privacy. That is, to the extent we as a society demand privacy, the more we are by implication demanding ever more closed gardens, with ever higher walls. Just as a closed garden makes the user experience challenge of encryption manageable, so does the centralization of data make privacy — of a certain sort — a viable business model.

The reality of digital services is that the amount of data each of us generates at basically all times is astronomical; your phone always knows where you are, but so does every app you use and every website you visit.

A map of Stratechery readers
Stratechery readers

Google, of course, knows one’s every search, for many people their every email, and thanks to the company’s ad network, control of Chrome and Google analytics, and, of course Android, pretty much everything else one does online. Facebook’s knowledge is slightly less broad but arguably deeper: your friends, your interests — both stated and revealed — and thanks to its ‘Like’ button, your web activity as well.

To focus on simply Google and Facebook, though, is to miss how much other data collection is going on: ad networks are tracking you on nearly every website you visit, your credit card company is tracking your purchases (and by extension your location), your grocery store is tracking your eating habit, the list goes on and on. Moreover, the further down you go down the data food chain, the more likely it is that data is bought and sold. That, of course, is as open as it gets.

Data Collection Versus Data Leakage

Still, the contrast between Google and Facebook is worth considering: Facebook is in hot water thanks to the revelation that some amount of the data it collects was sold to Cambridge Analytica, which bragged it helped elect Donald Trump president. One does wonder how much that allegation drives the outrage about the fact that Facebook shared that data to begin with, but leaving that aside, what is noteworthy is that the outrage stems from the sharing of the data, not its collection. Yes, some are outraged by that collection — but they were outraged before the current scandal, and their objections simply didn’t register with the broader public.

This view is buttressed by the fact that Google has been largely unscathed by the current controversy; what seems significant is not the fact that the company collects data, but rather that it has been careful to keep that data inside its walled garden. Indeed, that was always the irony with Gundotra’s attack on Apple: Google has always been anything but open when it came to its proprietary technology or its money-making ad apparatus (of which user data plays an important part). Its insistence that Android be open was based not on principle but on sound strategy: challengers always want to commoditize their complements, and for Google, smartphones themselves were complements to Search and ads.

The implication is quite far-reaching: being open, at least to the extent that openness involved user data of any sort, is increasingly unacceptable; that new companies and user benefits might result from that data no longer matters, a fate that all-too-often befalls the not-yet-created.

The Entrenchment of Google and Facebook

This entrenches Facebook and Google in three ways:

  • First, it is even more unlikely that a challenger to either will arise without meaningful access to their proprietary data. This, to be fair, was already quite unlikely: the entire industry learned from Instagram’s piggy-backing on Twitter’s social graph that sharing data with a potential competitor was a bad idea from a business perspective.
  • Second, Google and Facebook will increasingly be the only source of innovations that leverage their data; it will be too politically risky for either to share anything with third parties. That means new features that rely on user data must be built by one of the two giants, or, as is always the case in a centrally-planned system relative to a market, not built at all.
  • Third, Google and Facebook’s advertising advantage, already massive, is going to become overwhelming. Both companies generate the majority of their user data on their own platforms, which is to say their data collection and advertising business are integrated. Most of their competitors for digital advertising, on the other hand, are modular: some companies collect data, and other collect ads; such a model, in a society demanding ever more privacy, will be increasingly untenable.

There are increasing expectation that this is exactly what will happen with the European Union’s General Data Protection Regulation (GDPR). From the Wall Street Journal:

Brussels wants its new General Data Protection Regulation, or GDPR, to stop tech giants and their partners from pressuring consumers to relinquish control of their data in exchange for services. The EU would like to set an example for legislation around the world. But some of the restrictions are having an unintended consequence: reinforcing the duopoly of Facebook Inc. and Alphabet Inc.’s Google…

Digital advertising companies, known as ad tech firms, say Google and Facebook’s strict interpretation of GDPR squeezes their business. The ad tech firms embed their own technology in publishers’ websites and apps, putting them in competition with the tech giants. Unlike the giants, the ad tech firms have no direct relationship with consumers. They say Google’s and Facebook’s response pressures publishers to seek consent on behalf of dozens of ad tech firms that people have never heard of.

This is hardly a surprise — I predicted this months ago. And, while GDPR advocates have pointed to the lobbying Google and Facebook have done against the law as evidence that it will be effective, that is to completely miss the point: of course neither company wants to incur the costs entailed in such significant regulation, which will absolutely restrict the amount of information they can collect. What is missed is that the increase in digital advertising is a secular trend driven first-and-foremost by eyeballs: more-and-more time is spent on phones, and the ad dollars will inevitably follow. The calculation that matters, then, is not how much Google or Facebook are hurt in isolation, but how much they are hurt relatively to their competitors, and the obvious answer is “a lot less”, which, in the context of that secular increase, means growth.

Privacy and Regulation

There is a broader question from GDPR specifically and the idea that the tide is pushing towards walled gardens generally: what should the seemingly inevitable regulation of tech companies look like? It seems increasingly certain that privacy will be a major focus (it obviously already is in the European Union), but to stop there would be a mistake.

Specifically, if an emphasis on privacy and the non-leakage of data is a priority, it follows that the platforms that already exist will be increasingly entrenched. And, if those platforms will be increasingly entrenched, then the more valuable might regulation be that ensures an equal playing field on top of those platforms. The reality is that an emphasis on privacy will only increase the walls on those gardens; it may be fruitful to rule out the possibility of unfair expansion.

Note: I wrote a follow-up in the Daily Update that you can read in this footnote:5

  1. The picture is from his presentation [↩︎]
  2. Because private keys are associated with devices, iMessage actually encrypts a single message multiple times, each time using the public key for a different recipient device [↩︎]
  3. To be very clear, it is technically possible to layer encryption onto RCS, but it requires the cooperation of the carriers collectively and the addition of a trusted entity like certificate authorities for https; the entire point, though, is that carriers refuse to do this. [↩︎]
  4. An example of a open-source software that is a closed service [↩︎]
  5. So, I definitely messed up with yesterday’s article in a way none of you noticed; given that on Monday I wrote in-depth about Google’s new Chat initiative, I kind of skirted over the details in yesterday’s article, Open, Closed, and Privacy. Unfortunately, that meant I got a whole bunch of tweets and email from non-subscribers taking me to task for items, well, that I already explained (I didn’t get any from subscribers). The perils of paywalls!

    Probably the two biggest points of pushback were that Google could build an encrypted system if they wanted to (as I explained on Monday, they already tried, and they can’t really exercise Android leverage right now), and that carriers could build a federated key exchange system and/or something akin to the certificate authority framework that undergirds HTTPS. That is all true!

    My point, though — and the reality that Google had to accept, as The Verge feature explained — is that the carriers are not going to do that, full stop. The only way to achieve end-to-end encryption in the real world as it exists today is to build a separate centralized service that sits on top of phones (via apps) and runs over the Internet. To put it another way, Google wasn’t choosing whether to build an encrypted service or an open one; they were choosing whether to build something better than SMS or nothing at all.

    Now, does Google have a business interest in message content being unencrypted? I suppose, and as I noted on Monday, making Allo unencrypted by default was a bad look (although understandable for non-advertising related reasons, specifically the deep integration with Google Assistant). The truth, though, is that Google already knows plenty about everyone, especially those using Android. One could argue that Google didn’t fight hard enough for encryption, but to say the company actively didn’t want encryption isn’t quite right in my opinion.

    Still, the clarification is useful given the comparison I was trying to draw between encryption and privacy: just as one can, in theory, envision a standard that is both open and includes encryption (like HTTPS!), one can also envision a world where users truly own their data in a secure way and carry it from service-to-service. In reality, such systems are far more viable if built into the foundation of the technology (like HTTPS!) as opposed to being retrofitted over the objection of entrenched incumbents.

    Two more points of follow-up:

    • While I didn’t say so explicitly, I think I at least strongly implied on Monday that I would not expect Apple to support Chat. They certainly could — remember, this is basically SMS 2.0, and Apple obviously supports SMS — but it is difficult for me to imagine any scenario where Apple doesn’t hold its ground with the (very legitimate!) excuse that Chat is not encrypted. More importantly, it is even more difficult for me to see any way that carriers could exert leverage on Apple; their lack of leverage is why iMessage exists in the first place.
    • The blockchain is, of course, a theoretical solution, but as I’ve noted previously, the real blockchain upside with regards to this debate is the entire undoing of aggregators through decentralization. To be sure, that is by no means a sure thing, for many of the principles laid out in this article, particularly the trade-off between a user experience that scales and such decentralization. Regardless, any such solution is quite a ways in the future.

    As for the final bit about regulation, stay tuned. It has been top-of-mind for a long time. [↩︎]

Zillow, Aggregation, and Integration

Last Friday something truly remarkable happened: a public company that had grown its valuation from $539 million to nearly $7 billion in seven years announced it was changing its business model. The company was Zillow, and the stock market quickly put a price on how big of a risk the company was taking; from CNBC:

Zillow shares plunged 9 percent on Friday after the online real estate database company announced it will begin buying and selling homes, a capital-intensive endeavor. With Zillow’s new program, announced on Thursday, home sellers in the test markets of Phoenix and Las Vegas will be able to use Zillow’s platform to compare offers from potential buyers — and Zillow. When Zillow purchases a home, it will aim to quickly flip the home, making updates and repairs and listing it as soon as possible. An agent will represent Zillow in each transaction.

“We’re entering that market and think we have huge advantages because we have access to the huge audience of sellers and buyers,” Zillow CEO Spencer Rascoff said on CNBC’s “Squawk Alley.” “After testing for a year in a marketplace model, we’re ready to be an investor in our own marketplace.”

But investors are less enthusiastic. Flipping homes, a model that’s being utilized by start-up Opendoor, is very different than operating an internet marketplace. It carries additional risk associated with buying and selling homes and requires a hefty investment in operations. And it also potentially puts Zillow in direct competition with the realtors on its platform. Zillow sank $5, or 9.3 percent, to $48.77 as of mid-day on Friday, knocking more than $900 million off its stock market value.

That’s a lot of money to bet on…well, what exactly? What kind of company is Zillow today, and what kind of company does it hope to be in the future?

Zillow and Aggregation Theory

Last fall I refined Aggregation Theory by Defining Aggregators. To quickly summarize, I wrote that Aggregators as a whole share three characteristics:

  • A direct relationship with users
  • Zero marginal costs to serve those users
  • Demand-driven multi-sided networks that result in decreasing acquisition costs

This allows Aggregators to leverage an initial user experience advantage with a relatively small number of users into power over some number of suppliers, which come onto the platform on the Aggregator’s terms, enhancing the user experience and attracting more users, setting off a virtuous cycle of an ever-increasing user base leading to ever-increasing power over suppliers.

Not all Aggregators are the same, though; they vary based on the cost of supply:

  • Level 1 Aggregators have to acquire their supply and win by leveraging their user base into superior buying power (i.e. Netflix).
  • Level 2 Aggregators do not own their supply but incur significant marginal costs in scaling supply (i.e. Airbnb or Uber).
  • Level 3 Aggregators have zero supply costs (i.e. App Stores or social networks)

Where, then, does Zillow fit? It certainly has the hallmarks of an Aggregator: users go to Zillow directly to look for homes, Zillow incurs zero marginal costs to serve those users, and the company has created a two-sided market where its suppliers (home sellers) are incentivized to come onto the platform on Zillow’s terms in order to reach Zillow’s end users, thus making the platform more attractive to those end users.

The question of supply is more complicated; in North America real estate listings are gathered in hundreds of local multiple listing services (MLSs) run by local realtor associations, and access is restricted to brokers in that local region. Redfin got access to those listings by becoming a broker itself, but Zillow, at least at the beginning, relied on brokers uploading listings themselves — which they were willing to do, thanks to the userbase Zillow had already built up thanks in part to its Zestimate house valuation tool.

This was Aggregation Theory in action: gain users with a new kind of user experience, then leverage that user base to get suppliers to come onto your platform on your terms, further improving the user experience. And, eventually, Zillow was able to parlay that user base into direct access to those MLS services, first via the owners of Realtor.com, and then, when they pulled the agreement, via local MLSs and brokers directly who understood how important it was to stay on Zillow.

Interestingly, this means that Zillow arguably started out as a Level 3 Aggregator, and then stepped down to a hybrid of Level 1 and Level 2: cutting all of those deals is expensive, and the company does pay for the data, but it’s not exclusive by any means. And this, by extension, gets at why Zillow, despite having so many of the characteristics of an Aggregator, just doesn’t seem nearly as important as companies like Netflix or Airbnb or Facebook: it has accommodated itself to the real estate industry; it hasn’t transformed it.

The Real Estate Media Company

The first sentence in Zillow’s S-1 was its mission statement: “Our mission is to build the most trusted and vibrant home-related marketplace to empower consumers with information and tools to make intelligent decisions about homes.” In 2014, though, the company coined a new description for itself: a “real-estate media company.”

The occasion was the purchase of Trulia: both companies made money selling ads to real estate agents eager to get their listings at the top of the two real estate aggregators that were the top two starting points for real estate searches; by emphasizing they were both media companies Zillow could claim they both had many competitors and weren’t competitive with real estate agents all at the same time.

It also had the benefit of being true (until last week). The real estate business in North America has long been an expensive quagmire, for reasons I laid out when Zillow bought Trulia:

  • While real estate transactions in the aggregate are very frequent, for individual buyers and sellers they are very rare. Thus there is little incentive to push for a simpler solution.
  • A real estate transaction is usually the largest transaction most buyers and sellers will undertake, which makes them very risk averse and unwilling to try an unconventional service.
  • There is a lot of regulation and paperwork associated with a real estate transaction, where assistance is very valuable. And, as just noted, transactions are rare, which means there is little incentive to learn how to deal with said regulations and paperwork on your own.

Combine the reticence of consumers to push for change with the local realtor association-controlled MLSs, and a willingness by realtors to punish anyone changing the status quo (by not showing a house, or pointing out flaws that would kill a sale), and the best outcome for Zillow was to be an aggregator but not an integrator: the company was completely removed from the purchase process.

Integration and Aggregation

This gets at why Zillow, for all of its success, seems so underwhelming compared to other Aggregators. One of the key theories underpinning Aggregation Theory is Clayton Christensen’s Conservation of Attractive Profits, which I explored in the context of Netflix while developing the theory:

The Law of Conservation of Attractive Profits1 [was] first explained by Clayton Christensen in his 2003 book The Innovator’s Solution:

Formally, the law of conservation of attractive profits states that in the value chain there is a requisite juxtaposition of modular and interdependent architectures, and of reciprocal processes of commoditization and de-commoditization, commoditization, that exists in order to optimize the performance of what is not good enough. The law states that when modularity and commoditization cause attractive profits to disappear at one stage in the value chain, the opportunity to earn attractive profits with proprietary products will usually emerge at an adjacent stage.

That’s a bit of a mouthful, but the example that follows in the book shows how powerful this observation is:

If you think about it in a hardware context, because historically the microprocessor had not been good enough, then its architecture inside was proprietary and optimized and that meant that the computer’s architecture had to be modular and conformable to allow the microprocessor to be optimized. But in a little hand held device like the RIM BlackBerry, it’s the device itself that’s not good enough, and you therefore cannot have a one-size-fits-all Intel processor inside of a BlackBerry, but instead, the processor itself has to be modular and conformable so that it has on it only the functionality that the BlackBerry needs and none of the functionality that it doesn’t need. So again, one side or the other needs to be modular and conformable to optimize what’s not good enough.

Did you catch that? That was Christensen, a full four years before the iPhone, explaining why it was that Intel was doomed in mobile even as ARM would become ascendent.2 When the basis of competition changed away from pure processor performance to a low-power system the chip architecture needed to switch from being integrated (Intel) to being modular (ARM), the latter enabling an integrated BlackBerry then, and an integrated iPhone four years later.3

The PC is a modular system whose integrated parts earn all the profit. Blackberry (and later iPhones) on the other hand was an integrated system that used modular pieces.
The PC is a modular system whose integrated parts earn all the profit. Blackberry (and later iPhones) on the other hand was an integrated system that used modular pieces. Do note that this is a drastically simplified illustration.

More broadly, breaking up a formerly integrated system — commoditizing and modularizing it — destroys incumbent value while simultaneously allowing a new entrant to integrate a different part of the value chain and thus capture new value.

Commoditizing an incumbent's integration allows a new entrant to create new integrations -- and profit -- elsewhere in the value chain.
Commoditizing an incumbent’s integration allows a new entrant to create new integrations — and profit — elsewhere in the value chain.

This is exactly what is happening with Airbnb, Uber, and Netflix too.

This is the original piece of Aggregation Theory that was missing from last year’s Defining Aggregators: it is one thing to sit on top of an existing industry and, well, be a media company/lead generation tool. There have been a whole host of businesses that did exactly that, and while there is plenty of money to be made, without some sort of integration into the value chain of the industry itself they simply aren’t transformative. To put it another way, aggregation doesn’t transform value chains; integration does.

Why aggregation matters is that it is the means by which new integrations are achieved:

  • Netflix leveraged its position as an aggregator of video content into the integration of the customer relationship and content creation, undoing the integration of linear channels and content creation
  • Airbnb/Uber and other similar services integrate the customer relationship with the driver/homeowner relationship, undoing the integration of cars/property with payment
  • Google and Facebook integrated content discovery with advertising, undoing the integration of editorial and advertising

More broadly — and this really gets at why Zillow is different — Aggregators that change industries (including Aggregator-like Amazon and Apple that deal with physical goods) integrate the customer relationship with however it is their industry generates revenue; Zillow, on the other hand, was completely divorced from the home selling-and-buying process.

The Threat to Zillow — and the Opportunity

Again, not all companies need to be Aggregators, and as I noted at the beginning, Zillow has become a very successful company by getting half-way there. And, to return to that Daily Update about their purchase of Trulia, I didn’t think it was even possible for them to go all the way:

So then, perhaps this deal isn’t anticompetitive, but rather the key to building a company big enough to finally shake up the homebuying process? That’s Brad Stone’s argument in Bloomberg Businessweek…But remember, Zillow/Trulia are marketing tools; who is paying for that tool? Stone has the answer in the next paragraph:

The companies, which rely on advertising from real estate agents for the bulk of their revenues, are being careful about how they discuss the future of their combined efforts.

What Stone characterizes as “careful” I characterize “prudent” and “truthful”, because let’s be honest: Zillow/Trulia are not going to bite the hand that feeds them. Nor should they! It would be irresponsible to their shareholders, employees, and all their other stakeholders. It’s very easy to fantasize about disruption; it’s much more productive to simply follow the money. (This is why Redfin is the more interesting company in this space; they use their own network of real estate agents. It’s also why they are much smaller, despite having had a head start.)

This is why last week’s news was such a surprise, to me anyways; granted, Zillow had been experimenting with facilitating sales to investors, but to fundamentally change your capital structure, margin profile, and compete with your customers in one fell swoop feels like something else entirely — and Wall Street agreed!

I can, though, see where Zillow is coming from: no one thinks the North American real estate market is the way it is because that is somehow optimal or good for consumers; the only folks that benefit from the status quo are real estate agents that continue to collect 6% of the purchase price even as their responsibilities, particularly in the case of the buying agent, run in the opposite direction of their incentives. Zillow did well to capture a portion of that 6% for itself through its realtor ad model, but that only meant that Zillow was as dependent on the status quo as the realtors.

To be sure, Zillow has long been a better bet than Redfin, which has admirably IPO’d with a business that basically adds a tech layer (and thus superior lead generation) to a traditional real estate agency; the reality is that simply adding a tech layer doesn’t change industries — that requires new business models. This, though, is where Opendoor, the startup I wrote about in 2016, is compelling: buying houses with the click-of-a-button solves a major problem for sellers, the most disadvantaged party in the entire value chain under the status quo (and thus the most open to something new). And, by definition, it means the company (and competitors like OfferPad) are involved with the transaction that drives the value chain — the actual buying and selling of homes.

Make no mistake, the business model is risky, but that is another way of saying the potential return is massive as well: truly becoming a market maker for an industry that does $900 billion worth of transactions every year has massive upside. And, by extension, massive downside for the status quo — which again, includes Zillow. That is one reason to act.

Even so, that might not have been enough for Zillow to make such a shift: remember, this is a public company accountable to shareholders, and sometimes doubling down is the most prudent course of action. That, though, is why I spent so much time discussing integration: there is a massive amount of upside for Zillow in this move as well.

Remember, Zillow is in nearly every respect already an Aggregator: it is by far the number one place people go when they want to look for a new house, and at a minimum the starting point for research when they want to sell one. They own the customer relationship! What has always been missing is the integration with the purchase itself — until last week. Zillow is making a play to be a true Aggregator — one that transforms its industry by integrating the customer relationship with the most important transaction in its respective value chain — by becoming directly involved in the buying and selling of houses.

The Zillow Experiment

This absolutely could go sidewise: Zillow is already being hammered in the stock market — investors aren’t generally fans of high-margin companies entering low-margin businesses, with huge amounts of volatility risk to boot. Moreover, Zillow is embracing a model that, should it be successful, tears down the status quo: this will not only enrage Zillow’s customers, but also endanger Zillow’s primary revenue stream.

Here, though, Zillow’s status as an almost-Aggregator looms large: we now have years’ worth of evidence that realtors will do what it takes to ensure their listings appear on Zillow, because Zillow controls end users. It very well may be the case that realtors will find themselves with no choice but to continue giving Zillow the money the company needs to disrupt their industry.

I will certainly be watching closely: how Zillow fares will result in lessons that may be applicable broadly. Think of Spotify, for example: I was a bit bearish on the company last month because of the power of Spotify’s suppliers; the bull case is that Spotify’s ownership of the customer relationship will allow the company to build out the capability to sidestep the record labels even as the record labels can’t punish Spotify because they need them. That’s exactly what Zillow is testing right now: just how much power comes from being an Aggregator, and how much an industry can be transformed when that power is wielded.

  1. Later renamed the Law of Conservation of Modularity [↩︎]
  2. I have my differences with Christensen, but as I’ve said repeatedly my criticism comes from an attempt to build on his brilliant work, not tear it down [↩︎]
  3. As I’ve noted, the iPhone is in fact modular at the component level; the integration is between the completed phone and the software. Not appreciating that the point of integration (or modularity) can be anywhere in the value chain is, I believe, at the root of a lot of mistaken analysis about the iPhone in particular [↩︎]