Facebook’s Privacy Cake

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What was striking about the reaction to Mark Zuckerberg’s latest missive about the future of Facebook, A Privacy-Focused Vision for Social Networking, were the two very distinct reactions that, in my estimation, made the same mistake, but in opposite directions; one set of folks didn’t take Zuckerberg seriously at all:

Another set took Zuckerberg entirely too seriously:

In fact, what Zuckerberg announced is quite believable, precisely because it makes perfect sense for Facebook: this is a privacy cake that Facebook can have — and eat it too.

The Social-Communications Map

Zuckerberg began by describing two distinct kinds of social networks:

Over the last 15 years, Facebook and Instagram have helped people connect with friends, communities, and interests in the digital equivalent of a town square. But people increasingly also want to connect privately in the digital equivalent of the living room. As I think about the future of the internet, I believe a privacy-focused communications platform will become even more important than today’s open platforms. Privacy gives people the freedom to be themselves and connect more naturally, which is why we build social networks.

Today we already see that private messaging, ephemeral stories, and small groups are by far the fastest growing areas of online communication. There are a number of reasons for this. Many people prefer the intimacy of communicating one-on-one or with just a few friends. People are more cautious of having a permanent record of what they’ve shared. And we all expect to be able to do things like payments privately and securely.

Public social networks will continue to be very important in people’s lives — for connecting with everyone you know, discovering new people, ideas and content, and giving people a voice more broadly. People find these valuable every day, and there are still a lot of useful services to build on top of them. But now, with all the ways people also want to interact privately, there’s also an opportunity to build a simpler platform that’s focused on privacy first.

I first explored the idea of there being different types of social networks in 2013 when I created The Social/Communications Map:

A drawing of the Social/Communications Map

Keep in mind, this image is from 2013, but there are still some important points worth calling out:

  • First, the axes are about user perception, not technical implementations; back then tweets were very much experienced as being ephemeral; now they have more permanence, leading to people both being called-out for old tweets and/or deleting their archives.
  • That Twitter and Instagram should have perhaps been on the “permanent” side of the axis is further emphasized by the success of Instagram Stories, which is much more ephemeral than Instagram posts, along with the rise of tweet threads replacing blogging.
  • I noted in the post that LINE was representative of multiple chat networks, including WeChat and WhatsApp; obviously I should have illustrated both instead.

The most important thing to note, though, are the relative positions of Facebook and Snapchat (it was Facebook’s attempted acquisition of Snapchat that inspired the map in the first place).

Facebook Versus Snapchat

Perhaps the most important moment in Facebook’s history was its shift from the private to public space on the Social/Communications Map with the introduction of the News Feed. Again, to be clear, this map is about public perception, not technical reality, and this is a perfect example: data on Facebook was public to everyone in your network from day one. What the News Feed did, though, was change Facebook data from a pull to a push model: instead of needing to seek out your friends’ profiles Facebook would push their updates to you directly.

This inspired a strong backlash amongst users, who not only complained online but actually organized rallies in person; ultimately, though, it turned out that people loved the News Feed, and once Facebook embraced mobile, it turned out the News Feed was perfect for advertising.

Still, that transition exposed a soft underbelly in Facebook’s product: private ephemeral communication that allowed users to be their true selves. This was the premise undergirding Snapchat, which I described in Facebook, Phones, and Phonebooks:

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.

Make no mistake, the phonebook has been more valuable: it lends itself better to both data collection and advertising. Snapchat, though, threatened to break out of the phone space into the phonebook space with Stories — a product that shifted Snapchat out of the private space into the public one.

To that end, it is instructive that it is Stories where Facebook finally mounted its Snapchat defense: I wrote in The Audacity of Copying Well:

Instagram and Facebook are smart enough to know that Instagram Stories are not going to displace Snapchat’s place in its users lives. What Instagram Stories can do, though, is remove the motivation for the hundreds of millions of users on Instagram to even give Snapchat a shot.

That is exactly what happened: Snap retained its place as the core of 1×1 communication for young people, but the segments more removed from Snapchat’s core use case of chat were suddenly far less likely to even give the service a try, thanks to Instagram’s intelligent leveraging of its network.

By the same token, though, just because Facebook capped Snapchat’s growth doesn’t mean that Snapchat’s core insight about the desire for private, ephemeral communication was wrong: what Zuckerberg wrote yesterday is basically Snapchat’s reason-for-existing. In other words, while Instagram Stories built a wall around Snapchat by copying Snapchat’s secondary feature, this “Privacy-Focused Vision for Social Networking” is a clear attempt to build the core of Snapchat for everyone else.

Zuckerberg’s Vision

Look again at what Zuckerberg outlined:

  • Private interactions
  • Encryption
  • Reducing Permanence
  • Safety
  • Interoperability
  • Secure data storage

The first three are all about owning the 1×1 private ephemeral space; critically, none of them have anything to do with Facebook’s core feed-based products. Facebook is going to continue to exist as it has to date, as will Instagram, including all of the data collection and ad targeting that currently exist. The “Privacy-Focused Vision for Social Networking” is in addition to Facebook’s current products, not in place of. This is the mistake made by those that took Zuckerberg too seriously.

As for those who didn’t take Zuckerberg seriously enough, why wouldn’t Facebook want to move in this direction? There are multiple benefits:

  • First, this is a valuable space to own for all of the reasons that Snapchat succeeded in the first place. People want a place to communicate freely without fear of snooping or a historical record.
  • Second, to the extent the rise of 1×1 networking is inexorable, it is better for Facebook that it happen on their properties. Not only does Facebook preserve the ability to advertise on privacy-focused platforms — the company can leverage data from Facebook to advertise in its messaging products (although I am skeptical that messaging products are well-suited to advertising) — it also prevents would-be competitors from capturing leverageable attention.
  • Third, as we have seen over the last 24 hours, there are tremendous PR benefits from a privacy-focused service. Facebook has changed nothing about its core service or data collection policies, yet the assumption is that the company is pivoting and the only debate is whether to believe them or not.

Perhaps most compelling, though, is the degree to which this move locks in Facebook’s competitive position. As I noted above, Snapchat already showed that Facebook is vulnerable in the realm of private ephemeral communications, but soon that will no longer be the case. Moreover, given Facebook’s focus on end-to-end encryption, the company has made it that much harder to even get off the ground: not even Snapchat is fully end-to-end encrypted (pictures are, but not text messages).

There is an even more important benefit to Facebook voluntarily forgoing the data within messages and limiting the time it keeps surrounding metadata (make no mistake, end-to-end encryption is a real thing — Facebook will not be able to see encrypted messages); as Zuckerberg told Wired:

Certainly, ad targeting can benefit from having access to as much content or signal as possible. You know, I’m more optimistic about this for a few reasons. One is that we aren’t really using the content of messages to target ads today anyway. So we weren’t planning on doing that. So it’s not like building a system and making it end-to-end encrypted and now we can’t see the messages is really going to hurt ads that much because of the way we were already thinking about that. Keeping metadata around for less time will have some impact, although I’m optimistic that we’ll build systems that can basically deliver most of the value with a fraction of the amount of data.

Why can Facebook deliver most of the value? Because they are still Facebook! They still have the core Facebook app, Instagram, ‘Like’-buttons scattered across the web — none of that is going away with this announcement. They can very much afford a privacy-centric messaging offering in a way that any would-be challenger could not. Privacy, it turns out, is a competitive advantage for Facebook, not the cudgel the company’s critics hoped it might be.

Safety, Interoperability, and Strategy Credits

The last three items in Zuckerberg’s list are interesting in their own right; to take them one-by-one:

Safety: This is about the very real trade-offs that come with end-to-end encryption. One obvious issue is law-enforcement: Apple has already been down this road with the FBI when it comes to phone security; end-to-end encryption is both more challenging and yet simpler, simply because it is, properly implemented, truly unbreakable.

Another issue is misinformation: for all of the issues surrounding misinformation on Facebook, at least misinformation is traceable; that is not the case if messages are encrypted, which has already been an issue with WhatsApp in India. One could certainly make the cynical argument that, in the process of cloaking itself in privacy, Facebook is washing its hands of misinformation.

To be sure, Facebook is confident it can leverage its ability to analyze metadata to stop bad actors; that the exact same sort of audience analysis is perfectly portable to advertising is a rather happy benefit as far as Facebook is concerned.

Interoperability: This is perhaps the feature that is easiest to be cynical about; while it can certainly be frustrating to have to balance multiple messaging apps, for much of the world consolidating Facebook-owned messaging will not fully address the problem, thanks to alternatives like Messages, LINE, Kakao, etc. Moreover, even in areas where Facebook owns both the Phone (via WhatsApp) and the phonebook (via Facebook and Instagram), exactly how much consumer demand is there for integration?

There is, to be sure, a business argument: Facebook has already unified much of the ad infrastructure underlying its services, and unifying messaging is, to the extent Facebook wants to build a business platform on messaging, a natural next step. There is also a regulatory argument: while it is difficult to make the argument that Facebook has broken antitrust laws, the remedy, should that be accomplished, is obvious — split off Instagram and WhatsApp. That will be harder to do if they are fully integrated with Facebook, not simply on the advertising side but also the user side.

Secure Data Storage: This is an interesting addition to this piece, as it has little to do with messaging in the communications sense, but a lot to do with messaging in the political sense. This is what Zuckerberg wrote:

There’s an important difference between providing a service in a country and storing people’s data there. As we build our infrastructure around the world, we’ve chosen not to build data centers in countries that have a track record of violating human rights like privacy or freedom of expression. If we build data centers and store sensitive data in these countries, rather than just caching non-sensitive data, it could make it easier for those governments to take people’s information.

Upholding this principle may mean that our services will get blocked in some countries, or that we won’t be able to enter others anytime soon. That’s a tradeoff we’re willing to make. We do not believe storing people’s data in some countries is a secure enough foundation to build such important internet infrastructure on.

The most obvious country worth avoiding is China, which means this is clearly a Strategy Credit:

A strategy credit is an uncomplicated decision that makes a company look good relative to other companies who face much more significant trade-offs.

Facebook is already banned in China, so not putting data centers in China costs the company nothing (it may soon cost the company in Russia; one imagines Facebook will not mind being banned there of all places). This is in sharp contrast to Facebook’s most vociferous critic in tech, Tim Cook and Apple; the latter absolutely stores customer data in China along with encryption keys, because that is the law for companies that wish to operate in the country.

To be clear, this is understandable, but that is what makes that Strategy Credit article rather ironic; I coined the term in response to Apple’s posturing about user data in the wake of the Snowden revelations, noting that forgoing data wasn’t really a tradeoff given Apple’s business model. Now Apple is on the other side of the coin.

Privacy Moats

Ultimately there are three broad takeaways from Zuckerberg’s article:

  • Stop expecting companies to act against their interests. Facebook isn’t killing their core business anymore than Apple, to take a pertinent example, is willing to go to the mat to protect user data in China.
  • Facebook doing something that benefits itself is not inherently bad for end users. It is perfectly reasonable that the company can be instituting genuinely user-friendly changes like end-to-end encryption even as it furthers its own self-interests.
  • Relatedly, and most importantly, there needs to be much more appreciation for the anti-competitive trade-offs inherent in an absolutist approach to privacy. Facebook is doing what its fiercest critics supposedly want, and enhancing its competitive position as a result.

This was a point I made last year in Open, Closed, and Privacy:

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.

This is a debate that is woefully lacking. The reality is that the only user-friendly way to enforce privacy — which is another way of saying the only scalable way in a demand-driven world — is to severely limit inter-operability and over-burden would-be challengers. Regulators need to be far more aware of this and either choose another approach to privacy — i.e. entrust it to individuals — or regulate data-platforms, at least in terms of competition on top of their platforms, even more severely.

The Value Chain Constraint

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On June 16, 2017, minutes after Amazon announced it was buying Whole Foods Market Inc. for $13.7 billion, grocery store stocks fell through the floor; from MarketWatch (emphasis mine):

Shares of grocery stores took an unexpected hit Friday as investors reeled from the news that Amazon.com Inc. was moving into their space by acquiring Whole Foods Market Inc. After Amazon announced that it was buying Whole Foods in a $13.7 all-cash deal, shares of grocery store chain Kroger Co. slid to close down 9.2%, shares of Costco Wholesale Corp closed down 7.2%, Target Corp.’s stock closed down 5.2% and shares of Wal-Mart Stores Inc. closed down 4.6%…

The stock prices of grocers when Amazon bought Whole Foods

Mark Hamrick, a senior economic analyst at Bankrate.com, said Amazon’s technological innovation in traditional retail is a “earthquake” for the sector, which it may have hinted at with its recent launches of brick-and-mortar Amazon bookstores. “We can only imagine the technological innovation that Amazon will bring to the purchasing experience for the consumer,” Hamrick said.

This is why I found Walmart’s recent earnings so interesting: the company cited groceries as the biggest drivers of its ecommerce business, both last year and going forward — the company plans to expand grocery pickup to an additional 1,000 stores — because, as Walmart CEO Doug McMillon put it on the company’s earnings call:

We strive to make every day easier for busy families as we increase convenience and save them money and time. Part of our strategy is to build on our existing strengths, such as having a broad assortment including fresh and perishable foods within 10 miles of 90% of the U.S. population.

Amazon, meanwhile, appears to be struggling; from Bloomberg:

The number of Amazon Prime members who shop for groceries at least once a month declined in 2018 compared with 2017, according to the results of an annual consumer survey released Wednesday by UBS analysts. The drop was surprising given the company’s Whole Foods investment and expansion of two hour delivery service Prime Now, the analysts wrote in a note to investors.

A separate study by research firm Brick Meets Click found that households using grocery delivery and pickup services from physical retailers spend about $200 per month and place orders more frequently than Amazon grocery shoppers, who spend $74 a month.

So where is the promised technological innovation?

The Conservation of Groceries

I have written several times about the Conservation of Attractive Profits, most notably with regards to Netflix, Facebook and BuzzFeed, and Zillow. To put it in generic terms, profit in a value chain flows to whatever company is able to successfully integrate different component pieces of that value chain; the other parts of the value chain then modularize and are driven into commodity competition.

For example, this is what Walmart’s traditional value chain looked like:

Walmart's value chain

Walmart was able to integrate wholesale purchasing with an expansive network of stores; this provided a moat of sustainably lower prices for customer driven by purchasing power over suppliers.

Amazon, though, thanks to technological innovation — specifically, the Internet — was able to build a different integration in the value chain:

Amazon's value chain

Amazon integrated wholesale purchasing and fulfillment centers with Amazon.com, relying on modularized delivery services for distribution; this provided a moat of superior selection and, at least at the beginning, lower prices, and with Prime, superior convenience, at least for non-perishable goods.

Walmart has worked for years to respond to Amazon’s threat; the problem, though, as I explained in 2016’s Walmart and the Multichannel Trap, is that an integration built around stores was fundamentally unsuited to offering the sort of selection and convenience that Amazon does. The company needed to build up an entirely new set of capabilities and integrations, even as Amazon was leveraging theirs to integrate forward into logistics, adding on a 3rd-party marketplace to expand selection even more, and integrating backwards into their own brands. The result is that Amazon has around 50% share in e-commerce while Walmart has less than 5%.

That, though, is precisely why groceries is worth examining: as I explained when Amazon bought Whole Foods, perishable goods are not well-suited to Amazon’s value chain. Superior selection has diminishing returns, quality varies on an item-by-item basis within a single SKU, and, most importantly, the quality of items degrades with time and transport. In other words, they are a great fit for stores, not distribution centers.

In this view, Amazon’s purchase of Whole Foods was an attempt to acquire a first best customer for its grocery delivery operation, one that would efficiently store and sell perishable goods that weren’t suitable for Amazon’s traditional e-commerce model. And, to be clear, this strategy may yet succeed, but only to the extent Amazon builds a completely new set of capabilities and integrations that will probably end up looking a lot like Walmart, which has a massive head start it is clearly taking advantage of.

In other words, what matters is not “technological innovation”; what matters is value chains and the point of integration on which a company’s sustainable differentiation is built; stray too far and even the most fearsome companies become also-rans.

Google Cloud Struggles

Consider Google, a company that, more than any other, has been predicated on “technological innovation”. This was possible because the company’s core product — Internet search — entered a value chain with no integrations whatsoever. On the supply side there were countless websites and even more individual web pages, increasing exponentially, and on the demand side were a similarly increasing number of Internet users looking for specific content.

Crucially, all of the supply was easily accessible — just link to it — and all of the demand was capturable — they only needed to type in google.com. This meant that the best search engine — and by best, I mean the purest form of the word, i.e. best performing — could win, and so it did. Google was leaps and bounds better than the competition, thanks to its focus on understanding links — the fabric of the web — instead of simply pages, and consumers flocked to it.

This set off the positive cycle I have described in Aggregation Theory: owning demand gave Google increasing power over supply, which came onto Google’s platform on the search engine’s terms, first by optimizing their web pages and later by delivery content directly to Google’s answer boxes, AMP program, etc., all of which increased demand, resulting in a virtuous cycle.

At the same time Google was building out two critical pieces of the value chain in integration with Search: the first was infrastructure — supporting that much demand required huge investments in servers, fiber optic cables, etc. — and the second was advertising. Ultimately the company’s model looked like this:

Google's value chain

Note how Google is so dramatically optimized on all three sides of this integration: users, suppliers, and advertisers interact with Google through their own volition, thanks to the infrastructure Google has built to facilitate that interaction, with almost no person-to-person contact with anyone from Google. It is a model that works very, very well — for search and digital advertising, anyways.

Things have not gone so well for Google Cloud. At first glance, selling infrastructure seems like an obvious opportunity for Google, and much ink has been spilled about how the company — any day now! — will threaten Amazon or Microsoft. After all, Google was building out worldwide infrastructure before anyone else, and the company remains at the forefront of technological innovation.

The problem, though, is that the company’s value chain is completely wrong. The world of enterprise software is not a self-serve world (and to the extent it is, AWS dominates the space); what is necessary is an intermediary layer to interact with relatively centralized buyers with completely different expectations from consumers when it comes to product roadmap visibility, customer support, and pricing.

It has taken Google many years to learn this lesson: Google Cloud remains a distant third to AWS and Microsoft with a strategy that simply wasn’t working. I wrote in a November Daily Update upon the occasion of Google Cloud changing CEOs:

A strategy predicated on being “better” on specific product attributes, though, may fit the culture of Google, but it doesn’t necessarily lead to a winning enterprise strategy. To that end, Google Cloud faces three major problems:

  • First, Google has not made an effective case about how specifically machine learning can benefit business that is appreciably different than traditional business analytics. That is not to say it can’t, just that the company hasn’t really made the case.
  • Second, Google isn’t competing with Lycos and Yahoo: AWS and Microsoft have machine learning offerings of their own, and Microsoft in particular is much more accomplished at productizing offerings in a way that are understandable and approachable to CIOs.
  • Third, and most importantly, the technical attributes of a product are only one piece of what matters to success in the enterprise. Just as important are customization, support, and the ability to sell. Google is widely regarded as being the worst in all three areas.

In short, what Google Cloud needs is not a CEO that fits the culture, because the culture of Google is about making the best product technologically and waiting for customers to line-up. That may have worked for Search and for VMWare, but it’s not going to work for Google Cloud. Instead the company needs to actually get out there and actually sell, develop the capability and willingness to tailor their offering to customers’ needs, be willing to build features simply because they move the needle with CIOs, and actually offer real support.

In short, Google Cloud is competing in a different value chain than is Google search, and it needs to build new integrations accordingly. To that end, note the strategy chosen by Thomas Kurian, Google Cloud’s new CEO; from the Wall Street Journal:

The new leader of Google’s cloud-computing business plans to dramatically expand its sales team, addressing one of the biggest challenges he faces as rivals Amazon.com Inc. and Microsoft Corp. race ahead in the market…While Google has long offered cloud technology, it has seen Amazon and Microsoft surge ahead to become the leaders in providing computing power and storage services for rent over the web. Those companies have robust sales and service staffs that large corporate customers demand to support their technology needs, an area where Google has trailed, analysts have said.

In other words, Google Cloud needs to look a lot more like Microsoft.

Microsoft’s Enterprise Value Chain

Microsoft, unlike Google, has always been first-and-foremost an enterprise company. That means its integration was between its operating system and the associated APIs on which enterprise apps were built:

Microsoft's value chain

Note, though, that unlike Google’s value chain, Microsoft is much further from the end-user: devices were built and sold by OEMs, sometimes to end users, but especially to enterprise IT departments by dedicated sales forces. Similarly, Microsoft developers were by-and-large enterprise software developers, working not for end users but for management.

This had obvious downsides in the consumer market: products in the Microsoft value chain were typically feature rich and user experience poor, exactly what you would expect from a world run by top-down purchase order, not individual consumer choice. To the extent Microsoft did succeed in the consumer space, the reason was a spillover from their dominance in enterprise; by the time pure consumer markets like the web or mobile came along, Microsoft was woefully unprepared to compete. They were basically the opposite of Google.

That, though, is also why Microsoft is succeeding with Azure even as Google struggles with Google Cloud: the company is used to value chains that include sales forces and top-down decision-making, and has the right business model and integrations to take advantage.

The Netflix Exception

Perhaps the most famous example of a prominent company “pivoting” and succeeding is Netflix, but that is very much the proverbial exception that proves the rule. Netflix built its initial customer base and IPO’d through a business model predicated on renting DVDs via mail. The value chain looked like this:

Netflix's value chain

What was critical to making this value chain work was the first-sale doctrine: when a DVD was sold the rights of the copyright holder were exhausted; that means that Netflix could buy all of the DVDs it wanted and rent them to customers without copyright owners restricting them in any way. Critically, this meant that Netflix could integrate the customer relationship with content ownership.

Notice that that is the exact same integration that Netflix enjoys today: more and more of the company’s content catalog — particularly the portions that attract new customers — is original content owned by Netflix. In other words, the point of integration — the customer relationship and content ownership — is the same as in the DVD days.

To be sure, it took time for Netflix to transition to this model, and the company was absolutely helped along by hapless studio executives more interested in bumping up their annual profit than in considering their long-term position in the content value chain. There are any number of points in the early days of streaming when Netflix — because it was, if only temporarily, in a vulnerable non-integrated position in its value-chain — could have been stopped. I suspect, though, those days have past, which is why Netflix Flexes.

More generally, from a value chain perspective, Netflix’s transformation was less of a pivot than it might have first appeared: sure, the technology of DVDs by mail and streaming video are fundamentally different, but the value chain is the same. That is a far more viable transition than trying to leverage broadly similar technology into completely new markets and value chains.

The Solipsism Trap

It is understandable why the Internet giants in particular move into seemingly adjacent territories: the growth imperative is strong, both for financial and strategic reasons, and the technology seems easy enough, particularly given the resources these companies bring to bear. And yet, the truth is that those massive resources do not stem, at least in the long run, from technical excellence, but rather integration in specific value chains that produces positive feedback loops and outsize profits.

It follows, then, that without that integration, the positive feedback loops quickly disappear, along with the profits, which is the exact pattern we see again and again. Microsoft spent billions on phones and consumer Internet services, Amazon spent billions on Whole Foods, Google has spent billions on not just Google Cloud but a whole host of initiatives that have nothing to do with Search, Facebook has spent billions on Watch and VR, and now Apple is getting in the game with billions spent on Video, and the expected outcome of all these should be that they will fail.

To be sure, failure takes time: these companies do have nearly unlimited resources thanks to their core business models, and the reckless optimism bred by structural success. And, I suppose, sometimes they can actually push products across the line to profitability, kind of. Bing, for example is profitable — if you exclude traffic acquisition costs, which makes my point.

The reality is that technology has an amplification effect on business models: it has raised the Internet giants to unprecedented heights, and their positions in their relevant markets — or, more accurately, value chains — are nearly impregnable. At the same time, I suspect their ability to extend out horizontally into entirely different ways of doing business — new value chains — even if those businesses rely on similar technology, are more limited than they appear.

What does work are (1) forward and backwards integrations into the value chain and (2) acquisitions. This makes sense: further integrations simply absorb more of the value chain, while acquisitions acquire not simply technology but businesses that are built from the ground-up for different value chains. And, by extension, if society at large wants to limit just how large these companies can be, limiting these two strategies is the obvious place to start.

I wrote a follow-up to this article in this Daily Update.

The Cost of Apple News

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Apple is, according to the Wall Street Journal, driving a hard bargain with publishers ahead of the launch of its rumored News subscription service:

Apple Inc.’s plan to create a subscription service for news is running into resistance from major publishers over the tech giant’s proposed financial terms, according to people familiar with the situation, complicating an initiative that is part of the company’s efforts to offset slowing iPhone sales. In its pitch to some news organizations, the Cupertino, Calif., company has said it would keep about half of the subscription revenue from the service, the people said. The service, described by industry executives as a “Netflix for news,” would allow users to read an unlimited amount of content from participating publishers for a monthly fee. It is expected to launch later this year as a paid tier of the Apple News app, the people said.

The rest of the revenue would go into a pool that would be divided among publishers according to the amount of time users spend engaged with their articles, the people said. Representatives from Apple have told publishers that the subscription service could be priced at about $10 a month, similar to Apple’s streaming music service, but the final price could change, some of the people said…

Another concern for some publishers is that they likely wouldn’t get access to subscriber data, including credit-card information and email addresses, the people said. Credit-card information and email addresses are crucial for news organizations that seek to build their own customer databases and market their products to readers.

Probably the most obvious way to understand this story is that it, along with the report that Apple would have a launch event on March 25, appear to be attempts to negotiate through the media. I’m reminded of the January 2010 report in the Wall Street Journal that Apple’s impending tablet would cost $1,000; when Steve Jobs announced the iPad three weeks later, the $499 starting price seemed like a bargain. Perhaps leaking a 50/50 revenue share, along with an impending deadline for negotiations, is a way to make a 60/40 or 70/30 revenue share seem like a reasonable compromise?

The Growth of Apple News

Let’s back up for a moment: Apple News has grown to be a major force in publishing, at least in terms of traffic. According to a New York Times story that Apple cooperated with, the service “is read regularly by roughly 90 million people.” That has translated into traffic for news publishers that, according to Slate, often outpaces Facebook post-last January’s algorithm change.

The problem, as Digiday explained, is that traffic — which is almost completely realized within the Apple News app, not on publisher’s web pages — comes with minuscule amounts of revenue. Yes, Apple News allows for advertising, but that advertising is either sold (poorly) by Apple or sold directly by the publisher with no allowance for either programmatic ads nor data about users.

So why do publishers bother?

Apple News and Aggregation

There are a number of factors that should ring familiar to anyone familiar with the travails of publishers on the Internet.

To start, Apple News readers visit Apple News and, for the most part, read what Apple News presents to them; the front-page may be human-selected, as Apple sought to make clear in that New York Times article, but just as is the case with algorithmic selection (which is what determines what users see for the rest of Apple News, it just happens to be called “Suggested by Siri”), no one publication is favored:

Apple News Today view

On one hand, this is obviously not good for publishers: there is limited wherewithal to build brand affinity, there is no customer data shared (for purposes of follow-up, much less ads), and as noted above, there really isn’t much money to be made.

On the other hand, what are publishers really giving up? Readers going to the Apple News app have already made the decision to not visit a particular publisher’s website directly, and, given that digital content has zero marginal cost, why not support Apple News on the off chance some article hits it big?

It should be noted that publisher pages within Apple News complicate this narrative a bit: on one hand, they are a place to build brand affinity; on the other hand, they are more likely to cannibalize direct visits to the publisher’s website. But how many Apple News users are likely to switch to a browser for a particular publisher should they leave Apple News?

What is happening is Aggregation: Apple News attracts the users, which means publishers are coming onto Apple’s platform on Apple’s terms, which makes Apple News more attractive to users, making publishers ever more reticent to leave even though they aren’t getting much out of the deal.

Apple News and Publisher Subscriptions

For suppliers, the antidote for Aggregation is to go direct to consumers; the key is to embrace the same forces that drive Aggregation. First, the addressable market should be the entire world, not just a limited geographic area. Second, the same sort of automated payment tools available to advertisers on Aggregators can be leveraged for consumers; indeed, the tools for consumers, particularly given the lower dollar amounts and decreased need for paperwork, can be as simple as Apple Pay, and they can scale indefinitely. Third, a freemium approach to content means that social networks can be used for user-generated marketing.

Apple News as currently construed is actually somewhat helpful in this regard: publishers can push subscription-only content (as well as free content) into Apple News, and give users the option to subscribe using the App Store. For example, the Wall Street Journal elected to make the piece that triggered this Article free:

Free Wall Street Journal article in Apple News

However, the next story over, about Google Cloud, requires a subscription:

Subscription story in Apple News

It’s not perfect: clicking on that subscription link means the publisher has to pay Apple 30% the first year and 15% after that, and they don’t get any customer data (unless the customer creates an account in order to use their subscription on other platforms). Still, to my mind it is somewhat less egregious than Apple’s restrictions on in-app purchase; Apple News is driving the customer to a publisher’s content and charging accordingly (as opposed to taking a tax simply because there is no alternative to the App Store), but at the end of the day the publisher is still establishing a direct paying relationship with a subscriber.

The Spotify of News

What Apple is reportedly building now, though, is decidedly different. The so-called “Netflix of News” — although, given that Apple will pay out on a marginal basis as opposed to buying content, a better descriptor would be the Spotify of News — would entail customers paying one monthly fee to Apple which Apple distributes to publishers based on what subscribers read.

Publishers should be very clear about the implications of this model: it is not a direct-to-consumer model. Rather, it is an Aggregation model that happens to monetize via subscriptions instead of ads. That means it has all of the same problems for publishers that are posed by Aggregators:

  • Publishers do not form a direct connection with users; that connection is with Apple News
  • Publishers get no meaningful data (including no email addresses); there is no means to increase engagement or monetization down the road
  • Publishers must compete with every other publisher for attention

That last point is the most important, and should weigh heavily on publishers that have committed to the subscription model. What makes subscriptions work is an alignment between editorial and business model: the former is incentivized by quality and differentiation because the payoff is a customer with a high lifetime value; the New York Times put this succinctly in their 2020 Report:

We are, in the simplest terms, a subscription-first business. Our focus on subscribers sets us apart in crucial ways from many other media organizations. We are not trying to maximize clicks and sell low-margin advertising against them. We are not trying to win a pageviews arms race. We believe that the more sound business strategy for The Times is to provide journalism so strong that several million people around the world are willing to pay for it. Of course, this strategy is also deeply in tune with our longtime values. Our incentives point us toward journalistic excellence.

The proposed Apple News model, on the other hand, which pays out according to reader engagement, pushes in the opposite direction — the Facebook direction. The motivation is “to maximize clicks” and “win a pageviews arms race”, with some “time-spent” variables mixed in; sure, the driver isn’t low-margin advertising, but shifting the means of monetization doesn’t change the ends as far as incentives go.

The Cost of Apple News

It is absolutely worth noting what a great deal for consumers an Apple News subscription bundle would be: I totally get the idea of subscription fatigue, and having one place to get all of the best journalism would be amazing. That, though, doesn’t mean that Apple News wouldn’t be an Aggregator: that confirms it! Aggregators win because consumers prefer them, leaving publishers no choice but to go where the consumers are.

To that end, I am sure that a significant number of publications will sign up for Apple’s offering; clearly the company is confident enough to leak a date. And, frankly, many publications should: most publishers are already locked into the volume game when it comes to their editorial direction, and Apple News subscription payouts will be additive to the bottom line.

Publishers that have truly committed to subscriptions, though, should say no: not only will it be difficult to make up revenue that will be cannibalized lower per-customer payouts from Apple News, but more importantly a reversion to a model predicated on page views will hurt their business in the long run. This is especially the case if Apple News becomes a major revenue driver; yes, digital content can be distributed with zero marginal cost, but the incentive cost should not be discounted — it works directly against the quality imperative that is the critical factor in making the Aggregator-avoiding direct-to-consumer business model work.

I wrote a follow-up to this article in this Daily Update.

Spotify’s Podcast Aggregation Play

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Credit Spotify CEO Daniel Ek with honesty; in a blog post announcing a major move into the podcast space, Ek wrote:

More than 10 years ago we founded Spotify to give consumers something they couldn’t get — music any time, anywhere, and at the right price. Along the way, we broke the grip piracy had on our industry and restored the growth of global music through paid on-demand streaming. I’m proud of what we’ve accomplished, but what I didn’t know when we launched to consumers in 2008 was that audio — not just music — would be the future of Spotify.

There is a lot packed into this paragraph. First and foremost, Ek is absolutely justified in taking a victory lap: as I noted last month music revenue is growing sharply; over the next few years the industry’s total revenue will likely exceed the peak of the CD era, something that seemed unthinkable a decade ago.

U.S. music industry sales over time

What happened is that Spotify dragged the record labels into a completely new business model that relied on Internet assumptions, instead of fighting them: if duplicating and distributing digital media is free (on a marginal basis), don’t try to make it scarce, but instead make it abundant and charge for the convenience of accessing just about all of it.

The problem for Spotify is that the company’s financial returns are not nearly representative of its impact on the music industry. The company did make its first operating profit of last quarter on revenues of €1.5 billion, but the biggest driver was the fact its operating costs were down 17% due to lower “accrued social costs” in Sweden that resulted from Spotify’s stock price going down. To be fair, Spotify said it would have made a small profit even without that adjustment, but the long-term outlook is tough when the company’s gross profit is, as it was last quarter, only 27%.1

The issue, as I laid out last year in Lessons From Spotify, is that Spotify’s primary cost driver is not, like most tech companies, fixed investments in R&D or Sales & Marketing, but rather marginal payouts to record labels. Basically, the more revenue Spotify makes the more its costs increase, which can be overcome at large enough revenue numbers — see last quarter — but limits the company’s long-term upside.

At least, that is, as long as Spotify was a music company; thus the new declaration from Ek that Spotify is now about audio — the honesty was his admission that he didn’t originally see this coming.

Podcasts Versus Music

The shift in purpose from “music” to “audio” is, for now anyways, about podcasts. And, at least from a user perspective, it is a natural extension: playing music and playing podcasts entail downloading or streaming some sort of digital file, decoding it on a device, and playing it back through some sort of speaker. That one involved melodies and harmonies and the other primarily the spoken word (although there are plenty of music podcasts) is, from a technical perspective, a distinction without meaning.

From a value chain perspective, though, music and podcasts could not be more different:

The music value chain versus the podcast value chain

  • Music is primarily controlled by three large labels; podcasts are controlled by individual podcasters
  • Music can only be played legally through licensed services or via licensed downloads; podcasts can be played by anyone
  • Music generated $8.7 billion in revenue in the U.S. in 2017; podcasts generated only around $300 million in the U.S.

This last point is directly related to the first two: the money that can be made from a value chain is directly related to the degree of friction and centralization in that value chain. Consider Spotify’s two primary business models:

  • Subscriptions capture money directly from consumers who, as noted above, are paying for the convenience of accessing all of the music they want (i.e. overcoming friction) in one centralized place.
  • Advertisements capture money from advertisers who wish to reach listeners; effectively selling advertising, though, means having one place for advertisers to go to reach a large number of listeners.

This importance of centralization to an advertising business model is best seen by the fact that Spotify drove €542 million ($616 million) in advertising revenue last year, far outpacing all of podcasting, even though half of the company’s users didn’t hear any ads at all. Moreover, the total amount of advertising revenue driven by music is even greater when you add in YouTube.

Podcasts and the Web

The current state of podcast advertising is a situation not so different from the early web: how many people remember this?

The old "punch the monkey" display ad

These ads were elaborate affiliate marketing schemes; you really could get a free iPod if you signed up for several credit cards, a Netflix account, subscription video courses, you get the idea. What all of these marketers had in common was an anticipation that new customers would have large lifetime values, justifying large payouts to whatever dodgy companies managed to sign them up.

The parallels to podcasting should be obvious: why is Squarespace on seemingly every podcast? Because customers paying monthly for a website have huge lifetime values. Sure, they may only set up the website once, but they are likely to maintain it for a very long time, particularly if they grabbed a “free” domain along the way. This makes the hassle of coordinating ad reads and sponsorship codes across a plethora of podcasts worth the trouble; it’s the same story with other prominent podcast sponsors like ZipRecruiter or SimpliSafe.

The problem is that the affiliated marketing for large lifetime-value purchases segment is not a particularly large one; that meant that the amount of consumer attention paid to the Internet far exceeded the amount of advertising spend. From Mary Meeker’s 2005 Internet Trends report:

A slide from Mary Meeker's 2005 Internet trends report showing how the Internet was under-monetized

It seems very likely that were a similar slide to be made about podcasting it would look very similar: according to Edison Research 73 million people in the U.S. listen to podcasts monthly, and 48 million weekly; the average listener listens to seven podcasts a week. That seems like it should be worth a lot more than $300 million or so!

Ad Centralization

Again, what happened to the web is likely instructive: in 2003 Google launch AdSense, an advertising network for websites. Now advertisers could buy ads in one centralized place, and those ads could be better targeted by one company that spread its cookies across the entire Internet (and, of course, combined them with data from search, email, etc.).

By 2010, five years after the above slide, Meeker had an update:

A slide from Mary Meeker's 2010 report showing how web monetization had improved

Internet attention still outpaced monetization, but the gap was significantly closer: yes, the ad formats were still mostly the same, but increased centralization brought far more advertisers on board.

To be sure there have been attempts to centralize podcast advertising as well: a company called Midroll, which was acquired by E.W. Scripps in 2015, is the largest player in the space. Midroll sits between advertisers and mostly larger podcasts like the Bill Simmons Podcast or WTF with Marc Maron, and handles the nitty gritty of coordinating ad reads and distributing discount codes and specialized URLs in exchange for about a third of revenue.

Three years ago Midroll also acquired a podcast player called Stitcher; as I explained at the time there was a lot of value to be gained from controlling both the listening experience and ad sales, particularly in terms of data: with better data Midroll could more easily sell podcast advertising inventory to companies with business models that did not rely on generating outsized lifetime values.

The problem for Midroll, though, is that Stitcher never gained a meaningful share of the market, which meant Midroll never achieved the sort of data necessary to expand the podcast advertising market. Sure, some brand advertisers are dipping their toes in the market, but the leading advertisers are the same sort of companies they have always been, and while users no longer need to punch any monkeys, they do still need to punch in those discount codes and specialized URLs.

Meanwhile Apple, which does have the users thanks to the dominance of the iOS Podcast app,2 has shown little inclination of being that centralized player. I wrote about the company’s opportunities in the space two years ago, but despite the shift in strategy to services nothing has changed.

The Value of Gimlet Media

All of this is critical context for understanding Spotify’s strong interest in the podcasting space. Spotify needs (1) a way to differentiate its service from Apple Music in particular, and (2) content that it does not have to pay for on a marginal cost basis.

Gimlet Media fits the bill in both cases. While the company’s current roster of podcasts will remain freely available, future podcasts will almost certainly be exclusive to Spotify. More importantly, it seems likely that Spotify bought the company not simply for its library but also its management: expect a big jump in output with additional investment.

It’s worth considering why it is exclusivity in podcasts will likely play out differently in podcasts than in music. CEO Daniel Ek said on the company’s earnings call yesterday:

I think these are two very, very different businesses. We’ve spoken in the past about the music industry and not being a space, where exclusivity makes sense for a number of different reasons, but including one of them, that music, radio can put any piece of music up. So exclusivities won’t have the same effect, as you won’t be able to keep it exclusive.

And the second thing obviously is the artists and the label have the incentive to push the content out in many places as possible, because so much of an artist revenue derives from touring. I think in audio and certainly in podcast, the dynamics is very, very different, and what we’re doing here and what we’re excited about is really building the market, it’s at a very, very different stage of maturity. So we’re investing in that and we think we can be one of the tent-pole players in that space.

Basically, the wall that Spotify can put up around podcasts is much stronger than the one it can put up around music, and podcasters have fewer alternatives. Or, to put it another way, podcasts are a market where Spotify — to the extent they are willing to pay — actually has power over supply.

Meanwhile, for Spotify podcasts are fixed costs: that means that driving more listening flows directly to the company’s bottom line in a way that increased music listening does not. This is a very big deal — it is entirely possible that if Spotify succeeds in the space that podcasts will drive a relatively small percentage of revenue and a much larger percentage of profit.

Spotify’s Aggregation Play

At the same time, the Gimlet Media acquisition on its own does not seem like a sustainable strategy: paying three-quarters of the amount generated in annual revenue by an entire industry for 25 or so podcasts does not scale. That, though, is where the Anchor acquisition comes in: Anchor is a service for easily making and distributing podcasts, with a nascent advertising service for monetization.

To put it another way, Anchor is a means of generating supply, and it is supply that has always stood in the way of Spotify’s ambitions to be an Aggregator. Aggregators bring suppliers onto the platform on their terms; Spotify, on the other hand, has had to scratch and claw to get labels to give them the music they needed to be viable. And again, the acquisition of Gimlet Media, while better from a long-term leverage perspective, is not a big improvement: Spotify almost certainly overpaid if the only goal was to obtain supply.

What I think Spotify senses, though, is that while podcasts, at least in theory, solve many of their business model problems, Spotify is also uniquely positioned to solve the problems of many podcasters/suppliers. To wit:

  • Increasing advertising revenue for the entire industry requires a centralized player that can leverage a large userbase. Spotify is still a distant second to Apple in podcasts, but they are growing fast. Just as importantly, Spotify already has a strongly growing advertising business — again, larger than the entire podcast market — that it can extend to podcasts.
  • The open nature of podcasts means it is very difficult to monetize users directly; Spotify, though, has already built an entire infrastructure around monetizing users directly. Podcasts exclusive to Spotify can likely make meaningful money from Spotify subscribers that still gives Spotify far higher margin than music.

This explains Spotify’s multi-prong approach:

  • Anchor provides a way to capture new podcasters, leading them either to Spotify advertising or, in the case of rising stars, to Spotify exclusives. Critically, because Spotify has access to all of the data, they can likely bring those suppliers on board at a far lower rate than they have to pay for established creators like Gimlet Media.
  • Spotify Advertising, as I just suggested, makes a strong play to be the dominant provider for the entire podcasting industry. Spotify Advertising is already operating at a far larger scale than Midroll, the incumbent player, and Spotify has access to the data of the second largest podcast player in the market.
  • Gimlet Media becomes an umbrella brand for a growing stable of Spotify exclusive podcasts. Critically, as I noted above, the majority of these podcasts come to Spotify not because Spotify pays them millions of dollars but simply because Spotify is better at monetizing than anyone else.

This will be the determinant as to whether or not Spotify’s podcast gambit succeeds: being an Aggregator doesn’t simply mean acquiring a large pool of captive customers, it means controlling the value chain such that suppliers come on to your platform on your terms because you monetize them better than anyone else, even as you capture the excess value.

To that last point, it’s worth highlighting this comment from Gimlet Media co-founder Matt Lieber to Peter Kafka on the Recode Media podcast:

We did tell [Gimlet Media employees] that based on what we were talking about this would be a great thing for the company because really what everyone here is motivated by is making amazing shows for listeners who crave more, and…being acquired by Spotify puts us with the world’s largest audio platform that’s reaching more than 200 million people globally, so it’s a way for our storytelling and our work to have a lot more impact. So generally people are really excited about it.

This is the Aggregator’s advantage: particularly when it comes to media, whether it be print, video, or audio, suppliers are often motivated to simply reach the most people and make a living doing so. It is a fundamentally short-term outlook that is entirely understandable and defensible. That, though, leaves the Aggregator with an arbitrage advantage: by controlling access to customers and, by extension, the most attractive means of monetization, Aggregators can offer the best relative deal to suppliers that is still, in absolute terms, a great deal for the Aggregator.

To that end, it is worth considering if this is good for the podcasting industry generally. After all, to return to the web analogy, the price of the Internet finally monetizing effectively was the shift of content to centralized platforms like Facebook. Is the web better today than it was when we were punching monkeys?

I do think the answer is yes, but I don’t mind if you disagree: granted, most supply has moved to Facebook and other social networks; it is no longer possible to build a viable web business with display ads. At the same time, the web is still as open as can be, which means there is room for new business models like subscriptions, a model that has only gotten started and is already producing far better content than the old mass market media model ever did (I’m obviously biased in this regard!).

I can see a similar future for podcasts: Spotify, if they are successful, may end up being the biggest player, but that doesn’t mean new and different business models that directly link suppliers and consumers won’t emerge. It will, in other words, look like everything else touched by the Internet: very large winners on one end, and small niche winners on the other.

  1. This number was slightly inflated due to a one time accounting change ↩

  2. iTunes is very important to podcasting, but it is only a directory of podcasts that are hosted elsewhere; that means it is not a means to collect user data ↩

The BuzzFeed Lesson

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If you remove the societal impact, just for a moment, the story of publishers’ demise — first newspapers, and now digital-only companies like BuzzFeed and Huffington Post, which both announced significant layoffs last week — is rather banal: infinite competition combined with an inferior product resulted in failed business models.

Infinite competition is the result of the Internet: any piece of content is only a tap away, a far cry from a world where geographic areas were dominated by a small number of newspapers. The inferior product is advertising: when newspapers were the only option, advertising inventory was scarce; now advertisers — which only paid for newspaper space as a matter of convenience, not principle — can reach the exact customers they want exactly where they spend most of their time and attention, namely Facebook and Google. And thus the failed business model: is it any surprise that commoditized content and non-competitive ad inventory did not work?

The BuzzFeed Disappointment

Still, the BuzzFeed layoffs in particular are disappointing, precisely because of the societal importance of journalism. Back in 2015 I wrote that BuzzFeed [Was] the Most Important News Organization in the World:

Perhaps the single most powerful implication of an organization operating with Internet assumptions is that iteration – and its associated learning – is doable in a way that just wasn’t possible with print. BuzzFeed as an organization has been figuring out what works online for over eight years now, and while “The Dress” may have been unusual in its scale, its existence was no accident. What’s especially exciting about BuzzFeed, though, is how it uses that knowledge to make money…

More importantly, with this model BuzzFeed has returned to the journalistic ideal that many — including myself — thought was lost with the demise of newspapers’ old geographic monopolies: true journalistic independence. Just as journalists of old didn’t need to worry about making money, just writing stories that they thought important, BuzzFeed’s writers simply need to write stories that people find important enough to share; the learning that results is how they make money. The incentives are perfectly aligned…The world needs great journalism, but great journalism needs a great business model. That’s exactly what BuzzFeed seems to have, and it’s for that reason the company is the most important news organization in the world.

So what went wrong?

BuzzFeed’s Pivot

It was only two weeks after that post that CEO Jonah Peretti announced a pivot; from an interview with Peter Kafka of Recode:

JP: As [full-stack media companies] started to become received wisdom, it started to stop being true, that it was the best way to build a company, and that happened largely because there was this jump to mobile and to mobile apps, and probably the majority of content consumption is happening inside of mobile apps. You think “Facebook traffic”, but in a way that’s people opening Facebook, seeing a BuzzFeed story, clicking a BuzzFeed story…That has started to create an environment where media is much more distributed…

PK: So you built this system that was optimized for generating traffic and making money from stuff that happened on BuzzFeed.com and now you’re realizing that’s not what you want to do.

JP: What we realized is that that was just one piece of our business…What I’ve been doing is meeting with every team in BuzzFeed with this little chart that is our model for making content that people love — News, Buzz, Life, Video, Lists, Quizzes, all different types of content, and have great tools for making content that people love — and then we send that content to various places. We send it to our own websites and to our own apps, which are owned-and-operated properties and remain important to us, where we have a certain ability to get data and learn from what we’re doing, but we also send it natively to other platforms like YouTube, or Facebook.

2015 was the year that Facebook unveiled Instant Articles: publishers could put their content directly on Facebook, and Facebook, at least in theory, would help them monetize it. That seemed like a great deal! Facebook, for reasons I laid out in Popping the Publishing Bubble, was much better at advertising than any publishing company could hope to be:

In the pre-Internet era publishers had it easy: on one hand, they employed journalists whose goal it was to reach as many readers as possible. On the other, they were largely paid by advertisers, whose goal was to reach as many potential customers as possible. The alignment — reach as many X as possible — was obvious, and profitable for the publishers in particular.

A drawing of Pre-Internet Publishing

[…]

The shift from paper to digital meant publications could now reach every person on earth (not just their geographic area), and starting a new publication was vastly easier and cheaper than before…The increase in competition destroyed the monopoly, but it was the divorce of “readers” from “potential customers” that prevented even the largest publishers from profiting much from the massive amounts of new traffic they were receiving. After all, advertisers don’t really care about readers; they care about identifying, reaching, and converting potential customers. And, by extension, this meant that differentiating ad inventory depended less on volume and much more on the degree to which a particular ad offered superior targeting, a superior format, or superior tracking.

A drawing of The Post-Internet Bifurcation of Incentives of Publishers and Advertisers

[…]

The above graph shows the inefficiency of this arrangement: publishers and ad networks are locked in a dysfunctional relationship that doesn’t serve readers or advertisers, and it’s only a matter of time until advertisers — which again, care only about reaching potential customers, wherever they may be — desert the whole mess entirely for new, more efficient and effective advertising options that put them directly in front of the people they care about. That, first and foremost, is Facebook…

A drawing of Facebook As a More Efficient Advertising Option

With Instant Articles it appeared that the social network would share the spoils: Facebook collects the advertising money, and publishers that embrace the platform share in the reward.

The core problem for BuzzFeed is that never really happened: Instant Articles relied on the Facebook Audience Network, not Facebook’s core News Feed ad product, and nearly all of Facebook’s energy went into the latter. Companies that embraced Instant Articles — and, in the case of BuzzFeed, built their business models around them — were left earning pennies, mostly on programmatic advertising.

Complete Commoditization

For the record, I was completely wrong about the degree to which Facebook would help publishers monetize Instant Articles: it seemed to me that it was in Facebook’s interest to create sustainable models for quality content that lived directly on its platform. Sure, the company would be giving up a slice of its revenue, but the impact on the overall user experience generally and establishing Facebook as the center of not just the consumption of content but the monetization of content specifically would be powerful moats.

The truth, though, is that the short-term incentives to maximize revenue, primarily through News Feed ads that Facebook kept for itself, were irresistible, and besides, the company had other fish to fry: Snapchat was looming as a threat through 2015, and by 2016 the company was starting to warn that ad loads were saturating. Quarterly growth was very much the priority, and once Snapchat was neutralized, was a content-based moat really necessary?

I suspect, thought, that there is a more fundamental reason why BuzzFeed’s strategy was untenable. I wrote about the Conservation of Attractive Profits in the context of Netflix back in 2015:

The Law of Conservation of Attractive Profits,1 [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. 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.2

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.

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.

This is the theoretical explanation of what happened to publishers: newspapers previously integrated editorial and advertising:

A drawing of The Old Media Model

Then Facebook came along and integrated users and advertising:

A drawing of The New Publication Media Model

The result was the commoditization of content that I described above, which is exactly what you would predict given the integration elsewhere in the value chain. What I think is important, though, and under-appreciated by me (which is why I got Instant Articles wrong) is that the scale of integration — and correspondingly, the scale of commoditization — matters as well.

In the case of Facebook the integration is absolute: the social network has two billion users, which gives the company not only a network effect, but also a gargantuan amount of user-generated content to populate the News Feed where the ads targeted with an even larger set of user data can be placed. It follows, then, that content suppliers are absolutely commoditized: Facebook doesn’t need to do anything to keep them on the platform, because where else will they go? Might as well keep the money for itself.

Aggregation and Commoditization

You see a similar dynamic with other large aggregators: Google’s Answer Box trades away the long-term viability of sites generating the content that makes Google useful in exchange for a short-term benefit that, yes, accrues to users, but accrues even more to Google, keeping those users on Google properties. And why not? It is not as if the web is running out of content — indeed, most website owners are paying Google supply sourcing agents SEO specialists to figure out how to get their content into those Answer Boxes in pursuit of whatever crumbs of traffic result.

Amazon is following the same playbook: the company is ramping up its private label business, producing products that compete directly with companies that both sell to Amazon and are on the platform as 3rd-party merchants. After all, Amazon has integrated users and logistics: if suppliers pull their goods they will not pull customers away from Amazon; they’ll simply lose sales.

It’s the same thing with Apple and the App Store: the most valuable customers in most markets are on the iPhone, which is why Apple can get away with charging 30% on digital goods that have nothing to do with the iPhone. Customers are not abandoning iOS just so they can have a better experience buying digital books, and Apple’s management certainly can’t afford a hit in Service revenue, particularly right now.

That’s the thing, though: all of the big aggregators have been pursuing similar policies for years. To point to short-term pressure, whether that be falling China iPhone sales or Facebook ad load saturation is to miss the broader point: the more dominant an aggregator the more powerless the supply, and none of these companies are in the charity business.

Avoiding Aggregators

While I know a lot of journalists disagree, I don’t think Facebook or Google did anything untoward: what happened to publishers was that the Internet made their business models — both print advertising and digital advertising — fundamentally unviable. That Facebook and Google picked up the resultant revenue was effect, not cause. To that end, to the extent there is concern about how dominant these companies are, even the most extreme remedies (like breakups) would not change the fact that publishers face infinite competition and have uncompetitive advertising offerings.

What is clear, though, is that the only way to build a thriving business in a space dominated by an Aggregator is to go around them, not to work with them. In the case of publishers, that means subscriptions, or finding ways to monetize, like the Ringer, beyond text.3 For web properties it means building destination sites that are not completely reliant on Google. For manufacturers it means building relationships with retailers other than Amazon and building brands that compel customers to go elsewhere. And for digital content providers…well, this is why I view Apple’s policies as the most egregious of all.

As for BuzzFeed, it is not as if the company is dead: there is talk of mergers (which makes sense to reduce costs), and multi-pronged monetization strategies that emulate the success of the Tasty cooking videos: the company not only earns video advertising, but creates branded videos, has a line of branded cooking ware, and yes, takes programmatic advertising dollars on the companies owned-and-operated sites. Advertising can augment a publisher, but it’s hard to believe it can support one, even one expressly built for the Internet. That is now the realm of Aggregators.

I wrote a follow-up to this article in this Daily Update.

  1. Later renamed the Law of Conservation of Modularity ↩

  2. 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, including Christensen’s  ↩

  3. The Ringer is following the exact strategy I laid out in Grantland and the (Surprising) Future of Publishing  ↩