On Exponent, the weekly podcast I host with James Allworth, we discuss Dick Costolo stepping down as CEO of Twitter, Apple’s seeming war on Google, and the concerning launch of Apple Music.
Listen to it here.
Apple Music and Apple’s Focus
In a spot-on introduction to a spot-on piece, Dr. Drang nails why, at least in the context of yesterday’s WWDC keynote, Apple Music was such a disaster:
Endings are important, which is, unfortunately, why today’s WWDC keynote will be remembered as a flop.
Two weeks ago I wrote about how Google I/O (members-only) was two separate keynotes: the beginning was about Google doing stuff primarily, at least as far as I could tell, because they were big; the second part was about Google furthering their original mission and doing what they do best — “Organize the World’s Information” — and it was incredibly compelling and exciting.
WWDC went in the other direction. The first 90 minutes were excellent: very tight, with excellent clarity and momentum, well-rehearsed speakers delivering mostly iterative announcements with the occasional surprise. The final 60, on the other hand — the “one more thing” — were the exact opposite: unclear and dragging, with unprepared speakers delivering…well, I’m honestly not sure what most of them were saying. If there was a surprise the lack of a coherent message has to be top of the list.
After all, as Apple CEO Tim Cook so frequently reminds us, “Apple loves music”. Most of us, including myself, have for years given Apple the benefit of the doubt when it comes to such statements, even as the company’s flagship music product, iTunes, has fallen into an increasingly unusable state, and even as the App Store has long since surpassed the iTunes Music Store as a source of not only revenue but more importantly differentiation. When Apple’s annual music event was switched to a grab-all product announcement in the face of plummeting iPod sales, itself reduced to an app, no one questioned Cook’s insistence that music is “in our DNA”.
There is no question that music was in Steve Jobs’ DNA, and you could certainly argue that that specific aspect of Jobs’ DNA was a key component in transforming Apple from a barely solvent niche computer maker to one capable of creating an iPhone, an App Store, and everything else that makes Apple the most valuable company in the world. None of the latter happened without the iPod, without the iTunes Music Store, without that DNA.
Moreover, to be perfectly clear, the ending of the annual music event, the diminution of the iPod, the eclipse of the iTunes Music Store — each of these was the natural order of things. An important part of what makes Apple so impressive as a company is its willingness to destroy its own businesses, an approach that requires always looking forward to the way the world will be, not backwards to the world as it once was (not to mention an organizational design and incentive structures that remove the very real human tendency to preserve and protect). Recall what Tim Cook said about Steve Jobs at the Apple founder’s memorial:
“Among his last advice he had for me, and for all of you, was to never ask what he would do. ‘Just do what’s right,’” Cook said. Jobs wanted Apple to avoid the trap that Walt Disney Co. fell into after the death of its iconic founder, Cook said, where “everyone spent all their time thinking and talking about what Walt would do.”
Here is my question about Apple Music: it certainly is what most of us think Jobs would do. But is it right?
We know streaming is the future (and, for all intents and purposes, especially when you include YouTube — as you must — the present). Sure, iTunes music is DRM-free, and pirated content is as easy to access as ever, but on mobile devices where space, bandwidth, and time are limited, actual music files you have to move from device to device are as obsolete as physical CDs were once the iPod came along.
The business and strategic implications of this shift are profound: the labels would have never made the original deal with Apple had the Cupertino company not been so clearly the lesser of two evils, which means Apple would never have come to dominate their revenue (and thus to gain monopsony power). But now that the piracy threat is inconsequential the labels are unencumbered in their ability to exact monopoly rents from their music collections, ensuring any streaming service operates at their pleasure, on their terms. Including Apple.
Moreover, the fact that the iPod became just an app is symbolic of a far more profound shift: Apple has become a platform company in a way they never were even in the Mac’s heyday, and certainly unlike they were when the iPod was king. Perhaps the right thing to do is to enable — and extract rents from — services with not just the DNA but also the incentives and focus to deliver a compelling music experience.
I can hear the pushback now: A streaming service is table stakes, it’s an essential part of the ecosystem, Apple needs to diversify into services (Android app!). I get it. It makes no strategic sense to not have a music service. On paper anyway. The great thing about Apple, though, what has made the company so unlike every other, is another lesson Cook learned from Jobs. From the Goldman Sachs Technology and Internet Conference earlier this year:
We are the most focused company that I know of, or have read of, or have any knowledge of. We say no to good ideas every day. We say no to great ideas in order to keep the amount of things we focus on very small in number, so that we can put enormous energy behind the ones we do choose, so that we can deliver the best products in the world…
That is not from just saying “Yes” to the right product which gets a lot of focus. It’s saying no to many products that are good ideas, but just not nearly as good as the other ones. And so I think that this is so ingrained in our company that this hubris that you talk about which happens to companies that are successful but then decide that their sole role in life is to get bigger, and they start adding this and that and this and that. I can tell you the management team of Apple would never let that happen. That’s not what we’re about.
“That” sure sounds like Apple Music: there is this (streaming music) and that (curated lists) and this (BeatsOne radio) and that (Ping Connect) and no cogent thread to tie them together beyond the assumption that Apple must do a music service because that is what they do. That’s what big companies do.
Moreover, it’s not like this was the only example of Apple failing to question its assumptions and subsequently losing focus. Yesterday’s demonstration of native Watch apps was very good, but in a very “Why does WatchKit even exist?” sort of way. When the Watch came out most reviews concluded that the Watch made a lot of sense in the long run, but few could get over just how poor the app experience was, with many concluding customers ought to wait.
Imagine an alternate reality where the Watch had the exact same Watch face functionality (including complications), the exact same notifications and communications capabilities, the exact same performant Apple apps, the exact same unexpectedly strong battery life, but no apps beyond a promise they were “coming soon.” Surely reviewers would gripe, but with a “It’s already great, and it’s going to get better” sort of vibe. Yet Apple couldn’t bring themselves to say “no”.
Indeed, what made the first half of yesterday’s keynote so compelling wasn’t just the speakers’ delivery; rather, the clarity of the delivery flowed from the fact Apple was doing what they do best: iterating on products that, once upon a time, were minimum viable products from a feature perspective delivered with a maximum focus on the user experience. John Gruber perfectly captured this quality of Apple in a 2010 piece called This is How Apple Rolls:
Apple has released many new products over the last decade. Only a handful have been the start of a new platform. The rest were iterations. The designers and engineers at Apple aren’t magicians; they’re artisans. They achieve spectacular results one year at a time. Rather than expanding the scope of a new product, hoping to impress, they pare it back, leaving a solid foundation upon which to build. In 2001, you couldn’t look at Mac OS X or the original iPod and foresee what they’d become in 2010. But you can look at Snow Leopard and the iPod nanos of today and see what they once were. Apple got the fundamentals right.
Maybe Apple Music will be great. Maybe the fundamentals are spot on. But the messaging certainly was not, and as I noted after the Watch unveiling, muddled messaging often stems from a muddled product, and muddled products come from a lack of focus. Maybe it’s time for Cook to spend less time talking about how “the management team of Apple would never let that happen” and make absolutely sure that a loss of focus is not, in fact, happening.
Tomorrow’s Daily Update for Stratechery members will include a point-by-point analysis of the rest of yesterday’s keynote
Exponent Podcast: Apple, Google, and Privacy
On Exponent, the weekly podcast I host with James Allworth, we discuss Jony Ive’s promotion, the future of Apple, Google I/O, and Tim Cook’s speech on privacy.
Listen to it here.
The Funnel Framework
For folks who weren’t there, it’s difficult to describe just how dominant Microsoft was at the end of the 20th century. It wasn’t just that the company and its products were everywhere, both literally and figuratively, but also the longevity of said domination: Microsoft and Windows were the most important company and product in the industry for 23 years.1
Platforms Versus Ecosystems
That longevity was built on the fact that Windows was not only a platform but also the cornerstone of a massive ecosystem. These two terms are often used interchangeably, but I think it’s important to draw a clear distinction:
- A platform is something that can be built upon. In the case of Windows, the operating system had (has) an API that allowed 3rd-party programs to run on it. The primary benefit that this provided to Microsoft was a powerful two-sided network: developers built on Windows, which attracted users (primarily businesses) to the platform, which in turn drew still more developers. Over time this network effect resulted in a powerful lock-in: both developers and users were invested in the various programs that ran their businesses, which meant Microsoft could effectively charge rent on every computer sold in the world.
-
An ecosystem is a web of mutually beneficial relationships that enhances the value of all of the participants. This is a more under-appreciated aspect of Microsoft’s dominance: there were massive sectors of the industry built up specifically to support Windows, including value-added resellers, large consultancies, and internal IT departments. In fact, IDC has claimed that for every $1 Microsoft made in sales, partner companies made $8.70. Indeed, ecosystem lock-in is arguably even more powerful than platform lock-in: not only is there a sunk-cost aspect, but also a whole lot more money and people pushing to keep things exactly the way they are.
Microsoft’s dominance had a big impact on everyone, and today most people in technology still talk in the language of platforms and ecosystems. However, in today’s era I’m not so sure either holds the sway it once did, particularly in the consumer market. Consider today’s dominant operating systems: Android and iOS. According to platform logic, Android should have long ago achieved total dominance thanks to the network effect that is supposed to accrue to whichever platform has the most users. Android’s advantage is arguably even stronger when it comes to its ecosystem: nearly every non-Apple OEM in the world and every carrier has good reason to push Android, and while it is by a comfortable margin the largest operating system and the closest thing we have to a modern Windows, it is nowhere near as dominant, powerful, or profitable.
The fundamental ideas of platforms and ecosystems also don’t translate well to today’s other giants: Internet companies like Google, Facebook, and Tencent. The latter two clearly benefit from network effects, but it is a one-sided network: users connecting to each other. As for Google, by platform and ecosystem logic, they should be the most vulnerable of all: competing search engines are simply a URL away. Clearly there is another factor at work.
Scarcity Versus Abundance
It’s common to think of the modern computing era as having been launched by Windows and the IBM PC back in 1981 (or the Apple II in 1977): for the first time computers were for individuals, not just departments (minicomputers) or back-end offices (mainframes). The individual nature of computers has only intensified now that we carry them everywhere.
The structure of the PC business, though, while an order of magnitude larger than previous eras, wasn’t that much different from minicomputers or mainframes: there was a defined market to sell to (primarily enterprise), and limited distribution channels. In other words, the opportunity for software companies was scarce, which is why the biggest providers — Lotus, Ashton-Tate, Borland, etc. — all relied on large sales teams. Smaller outfits relied on getting shelf-space at hobbyist stores or a friendly contact with a value-added reseller.
This reality greatly magnified Microsoft’s platform and ecosystem advantages by tying them together: the ecosystem, heavily invested in Windows’ continued success, was the channel for the applications built on Microsoft’s platform; application providers, forced to invest heavily in sales, could hardly spare the money to build for another platform (i.e. the Macintosh) that didn’t have an ecosystem to sell their products anyways.
What ultimately broke Microsoft’s stranglehold was the Internet: specifically, the fact that it made distribution free and freely available. While this didn’t necessarily matter to Microsoft’s core enterprise customers, there was an entirely new market developing: consumers. This, though, was a completely different kind of market: you couldn’t reach consumers through a sales team — there were simply too many of them, and they were only valuable in the aggregate. To put it another way, the shift to Internet distribution and consumer markets meant a shift from scarcity to abundance. Instead of constricted channels and known customers there was a new world of free distribution and an effectively infinite-sized market.
This didn’t affect Microsoft immediately: all those Internet applications ran on a browser that ran on Windows. But while the PC-era Microsoft was king, the post-Internet Microsoft was the proverbial emperor with no clothes: its old platform and ecosystem lock-in were gone, even if the company didn’t know it. That reality would only manifest itself after both consumers and enterprise customers abandoned Windows Mobile as soon as something better came along.
The Rise of “User-First”
Referring to iOS (as well as Android) as “something better” may sound blasé, but the idea of a new offering winning on the substance of its user experience was a profound change: instead of convincing a centralized buyer via a limited distribution channel, winning products had to appeal directly to widely dispersed independent users. And, as I’ve discussed at length, in the case of Apple and the iPhone in particular, the implications of winning via the user experience were profound: no matter how much cheaper “good-enough” modular Android alternatives have become, the integrated iPhone retains a (growing) hold on the high end.
What is interesting, though, is the impact on platforms and ecosystems of a user-first approach. iOS has maintained a platform lead, just as Windows did, but unlike Windows said lead is not based on owning the ecosystem (and thus distribution);2 rather, iOS owns the best customers, i.e. the customers who are most willing to pay. This is hardly a revelation, but I think there is a larger lesson to be drawn: success no longer depends on platforms or ecosystems; rather, platforms and ecosystems themselves depend on access to desirable customers. By extension, the companies who own that access — who own the funnel, to use a marketing term — are the ones who gain outsized influence and, in the long run, outsized profits.
Consider Google; the basis of the company’s success is very simple: their search engine was, and is, superior. They didn’t have a sales team pushing their product to CIOs, or a revenue-sharing plan with resellers; they built an Internet application that was available to everyone and that everyone (eventually) used because it was the best. And, now that they own access to the most consumers looking to buy something online — now that they own the funnel — they have outsized influence and outsized profits.
Facebook fits the same mold: the company built a superior product that connected an extraordinary number of people, all generating content that made the product even more attractive and able to capture even more attention. And, now that they own an outsized amount of consumer attention — now that they own the funnel — they have outsized influence and outsized profits.
The Funnel Framework
All three companies succeed with very different product focuses, but all share the ability to capture a specific type of customer and funnel them to someone who is willing to pay:
| Product Focus | Captures | Funnels To | |
|---|---|---|---|
| Apple | Superior UX | Willingness-to-pay | Apple (and developers) |
| Superior Search | Motivated Users | Direct Marketers | |
| Personally Important Content | User Attention | Direct and Brand Marketers |
Note the critical link is first delivering a superior user experience and then leveraging that into owning a funnel to a specific type of customer. To put it another way, in contrast to the PC era, distribution and access is no longer the means of control but the end result.
If you look around you can see the funnel framework everywhere:
- Taxis used to dominate because they owned distribution; Uber delivered a superior user experience, captured the most desirable customers, and leveraged that into dominance of the transportation market
- Hotels used to dominate because they owned supply; Airbnb delivered superior value to end users and created a virtuous cycle that resulted in a two-sided network
- Messaging apps deliver huge value to end users and monopolize attention; LINE and WeChat are leveraging that by pushing users to pay-to-play games in particular, while Snapchat is delivering advertising
- Newspapers used to dominate because they had geographic dominance; BuzzFeed and other successful Internet publishers attract readers by first figuring out what they want and then giving it to them, and then sell either that skill (in the case of BuzzFeed and Vice) or the attention they gather (everyone else)
- Broadcast channels used to dominate because they owned the airwaves; Netflix and HBO earn consumers’ attention by delivering superior programming and capture the value directly via subscriptions
It’s hard to not be excited about the long-term implications of the funnel framework; I know that a lot of pre-Internet companies are struggling, and I sympathize with employees caught out by failing business models, but it’s worth noting that most of these doomed enterprises were based on something other than providing a superior product. On the Internet, on the other hand, being the best is a first order concern; as a consumer — and as a wholly independent entrepreneur — that makes me pretty happy.
Discuss this Article in the Stratechery Forum (members-only)
21 Inc. and the Future of Bitcoin
It seems like no one has been talking about Bitcoin, at least for quite a while. That is what happens when the price of a seemingly magical currency plummets from a high of $1,242 in December, 2013 to a mere $238 as I write this, a drop of 81%. That means the total Bitcoin market cap is about $3.4 billion — far more than perhaps many expected even a few years ago, but a tiny number in the grand scheme of things (for the sake of comparison, Apple sold $3.9 billion worth of iPhones every week last holiday quarter).
That’s why many were shocked back in March when 21 Inc., a Bitcoin-focused startup co-founded by Andreessen Horowitz board partner Balaji Srinivasan, announced that it had raised a shockingly large $116 million in funding for…well, no one knew exactly. Srinivasan’s co-founder Matthew Pauker said at the time, according to the Wall Street Journal:
“Bitcoin is going to change the way that people and businesses and even machines interact with each other,” he says. “But for Bitcoin to realize that vision we need mass adoption. It can’t just be for Silicon Valley.”
Indeed. Perhaps the single biggest obstacle facing Bitcoin is that most folks don’t really understand exactly what it is, or why it’s so interesting.
Bitcoin in Three Bullet Points
Here’s my best attempt to explain Bitcoin in three bullet points:
- Using cryptographic keys, I can convey to you X amount of Bitcoin (fractions or multiples). This is cool because I’m transferring something digitally — no real-world analog (and associated clearinghouse, like a bank) required.
- Our transaction is submitted to a global peer-to-peer network, which verifies the transaction and enters it into a public record (the blockchain). Because the blockchain is a ledger of every Bitcoin ever made, any one Bitcoin, or fraction thereof, can only ever be owned by one person. This is cool because it prevents me from double-spending — transferring something multiple times. In other words, Bitcoin makes digital goods rivalrous — uncopyable.
- That global peer-to-peer network isn’t verifying transactions out of the goodness of its heart; rather, you may know of this verification process by a different name: mining. About every ten minutes one of the verifying computers is awarded with 25 Bitcoins for its effort (a current value of $5,950). This is cool because it means Bitcoin is a self-supporting system: transactions are verified with absolute certainty for free.
Note that only the third bullet point really seems to have anything to do with money: what is most exciting about Bitcoin, at least from my perspective, are the first two points — that Bitcoin specifically, and the applications enabled by the Blockchain broadly, are digital (with all its attendant advantages, including worldwide instantaneous transferability, divisibility, tracking, etc.) yet scarce — in stark contrast to everything on the Internet that can be copied at no cost, much to the detriment of content producers in particular. This means Bitcoin could theoretically be used for all sorts of transactions, including messages, contracts, identity verification, etc., and, of course, monetary ones, where today’s digital applications just don’t work.
Mining and Money
It is monetary transactions that dominate discussion of Bitcoin, not only because that application is the easiest to understand, but also because money is the driving force behind mining. While mining first took place on personal PCs, the fact it is an embarrassingly parallel computational problem meant it was well-suited to graphics cards. Soon, though, as the price of Bitcoin increased, miners began investing in Application-Specific Integrated Circuits (ASIC), chips custom-built for Bitcoin and placing them in data-centers wherever electricity was cheap.
While ASICs represent the fixed cost of Bitcoin mining, the expense of electricity is the marginal cost; indeed, Bitcoin is, for all intents and purposes, the digital representation of electricity. This presents a downside of Bitcoin — it is “free” in part because many of the externalities of its production are borne by society broadly in the form of pollution — but also highlights that even when it comes to mining money is only tangential. Were Bitcoin to go to $1 the vast majority of miners in the world would stop production tomorrow, yet Bitcoin the protocol would continue, automatically changing the difficulty of its algorithm to keep up the same steady pace of transaction verification on whatever processing was available to the network.
Let me be explicit on this point: Bitcoin inherently has nothing to do with money, all of its representations as a digital currency to the contrary. Rather, it is a protocol that enables rivalrous (non-copyable) digital goods.
21 and Mining Everywhere
Last week 21 Inc. finally announced exactly what they were working on. Well, not “exactly,” but at least they said something. Here’s Srinivasan on Medium:1
21 is now officially open for business — and business development. After much hard work, we’ve created an embeddable mining chip which we call the BitShare that comes in a variety of form factors. The 21 BitShare can be embedded into an internet-connected device as a standalone chip or integrated into an existing chipset as a block of IP to generate a continuous stream of digital currency for use in a wide variety of applications. You can request a dev kit by signing up on our website to get started.
That’s right, with the BitShare chip, your Internet-of-Things toaster can mine Bitcoin, along with your cell-phone, and your refrigerator, and, well, your USB charger, which 21 Inc. is starting with.2 Srinivasan lists a whole hosts of potential benefits from this “free” revenue stream, including micropayments from a “free” revenue source,3 subsidized devices, even subsidized chips with 21 Inc. IP.
Frankly, I think Srinivasan massively overstates his case with these examples — the economics for consumers simply don’t add up, for now:4
- A single BitShare chip, given its minuscule processing capabilities, would need around 93 years to “win” a Bitcoin award
- Thus, 21 Inc. will operate all of the BitShare chips it sells as a pool: Bitcoin income will be shared across all BitShare-installed devices, but only some — 21 Inc. will keep 75% of the revenue
- Meanwhile, remember what Bitcoin is — digital electricity. And the consumers who own all of those BitShare-enabled devices will be paying 100% of the cost of that electricity
Indeed, it makes far, far more sense for consumers to simply buy Bitcoin that has been harvested by the sort of industrial mining operations I talked about above on the open market.
But that brings us full circle: what consumers, and why? Read that Pauker quote again:
“Bitcoin is going to change the way that people and businesses and even machines interact with each other,” he says. “But for Bitcoin to realize that vision we need mass adoption. It can’t just be for Silicon Valley.”
Indeed, all the benefits of Bitcoin are right now mostly theoretical: making it real requires a massive journey from here to there, to a world where everyone uses Bitcoin just as they use the Internet, and I think 21 Inc. is best understood as a massive bridge-building project from today’s speculative curiosity to tomorrow’s essential trust network.
A (Digital) Wallet in Every Device
When 21 Inc. first began in 2013, it was as a traditional mining operation: they brought on chip designers and built at least two generations of mining chips, earning 5,700 Bitcoins in 2013, and 69,000 Bitcoins in 2014. While it’s possible the company is pivoting to BitShare chips, I don’t think so; rather, 21 Inc.’s traditional mining pool gives it flexibility in making Srinivasan’s promises a reality. The company will actually have sufficient Bitcoin to guarantee an OEM that they will get a certain return for having placed a BitShare chip in the hardware they build, long before 21 Inc. achieves the sort of scale necessary to even fantasize about meaningful returns. 21 Inc. could also ensure consumers are compensated for the electricity they use, although I’m a bit skeptical about this — I think the play is primarily focused on getting manufacturers on board and hoping that future scale eventually ensures consumers get their fair share.
That may be dubious ethically, but the payoff could be huge: the dynamics of Bitcoin and its application for a variety of trusted transfers shifts tremendously when everyone has multiple hardware-based digital wallets — whether they know it or not! For example, if your phone has a hardware-based digital wallet, applications for trusted messaging or contract signing or a whole host of applications no one has yet thought of become approachable not only for those capable of setting up a Bitcoin wallet but also those able to simply download an app. Identification depends not on usernames or passwords but on unique digital signatures. The possibilities are endless, and, I think, good — and they only rely on a single Satoshi (0.00000001 Bitcoin, the smallest amount that can be transferred).
This is what I think Srinivasan means when he says “we are less concerned with bitcoin as a financial instrument and more interested in bitcoin as a protocol” and that “embedded mining will ultimately establish bitcoin as a fundamental system resource on par with CPU, bandwidth, hard drive space, and RAM.” It turns out lots of people are willing to spend electricity for essential functionality: nearly all of us run routers 24/7, whether we are using them or not, because instant access to the Internet is worth the electrical cost. A more extreme example are DVRs: our set-top boxes are the biggest power drains in our houses, costing $3 billion annually in electricity in the U.S. alone — nearly the entire worth of Bitcoin! — all in the service of making watching TV just a little bit more convenient. Why wouldn’t we eventually be ok with using just a bit of electricity not for profit but for mining the Satoshis we need to use an entirely new class of apps?
Bitcoin the Network
This, then, is the bridge I believe 21 Inc. is building, and why they specifically and Bitcoin broadly deserve more attention: Bitcoin at a conceptual level is not about money, and neither is 21 Inc., at least not directly.5 It’s about dispersed trust and digital scarcity, and the massive number of new applications that can be built on such concepts both similar yet wildly different from what is enabled by today’s Internet. And, while many of those applications are unimaginable — just as Facebook and Google were unimaginable at the birth of the Internet — what is very much certain is that step one is getting everyone, somehow, connected. As Coindesk reported, 21 Inc. is seeking to learn from the best:
“The AOL CD of bitcoin,” the document called the strategy. “Give every user a free trial of bitcoin at near-zero marginal cost. A proven model to onboard millions.”
Best keep an eye on your mailbox — and electricity meter.
Discuss this Article on the Stratechery Forum (members-only)
Has Medium replaced Tumblr for the default startup blog? ↩
That is a slide from the 21 Inc. pitch deck; it’s quite old (note the reference to 21e6, 21 Inc.’s original name), and possibly not accurate ↩
Journalism’s unicorn ↩
Unless otherwise cited, 21 Inc. facts and figures come from this report from Coindesk ↩
Indeed, an under-appreciated part of 21 Inc.’s approach is that all of these embedded chips will verify transactions without the incentive of monetary reward, allowing Bitcoin the protocol to survive even when there is no more Bitcoin to mine ↩
Podcast: Exponent 046 — Everything Has a Price
On the newest episode of Exponent, the podcast I co-host with James Allworth:
In this week’s episode, we discuss ad-blockers, both personal ones and the rumored carrier-implemented one, as well as Internet.org and the moral quandary that is the Internet.
Links
- Ben Thompson: Carriers to Implement Ad-Blocking — Stratechery Daily Update (members-only)
- Laura McGann: How Ars Technica’s “experiment” with ad-blocking readers built on its community’s affection for the site — Nieman Lab
- Ben Thompson: Open Source Apps — Stratechery
- Ben Thompson: The Changing — and Unchanging — Structure of TV — Stratechery
Listen to the episode here
Podcast Information: Feed | iTunes | SoundCloud | Twitter | Feedback
Discuss this podcast in the Stratechery Forum (members-only)
Apple Watch and Continuous Computing
From day one of this blog I have insisted that I don’t do product reviews: I don’t buy every phone or, in this case, watch on the market, and I happily defer to publications that specialize in exactly that.1 That’s not to claim ignorance: I read voraciously, including reviews, talk to as many “normal” people as I can in as many places as I can, and think I have a sense for where various categories are at. And given that, I can’t quite shake the feeling that the Apple Watch is being serially underestimated. Nor, I think, is the long term threat to Apple’s position being fully appreciated.
The Wrist is Interesting
Back in 2013, at AllThingsD, Tim Cook said, “I see [wearables] as a very key branch of the tree,” and that “The wrist is interesting. The wrist is natural.” I fully agreed, and that, more than anything, was the basis for my optimism about the Watch over a year before its release. Over the long arc of technology, the fundamental characteristic of every new wave of devices that eclipses what came before is that they are smaller and (thus) more convenient:2
- Minicomputers were smaller and more convenient than mainframes, meaning various departments in a corporation could have their own computers, instead of time-sharing
- Desktop PCs were smaller and more convenient than minicomputers, meaning individuals could have their own computers
- Laptops were smaller and more convenient than desktops, meaning individuals could have their own computers in more places
- Phones were smaller and more convenient than laptops, meaning individuals could have their own computers with them nearly all of the time
“Nearly all the time” is pretty amazing, and I get the arguments that the smartphone is the pinnacle of computer evolution: it’s portable, but readable, and multi-touch works and works well. But any interaction with your phone is still a cloistered one — you, your phone, and nothing else — which to my mind leaves at least one more evolutionary jump: continuous computing, no matter your context. Indeed, when it comes to ensuring a computer is always present and always accessible, the wrist is both natural and interesting.
Still, success isn’t guaranteed: the ability of a watch, or in this case the Apple Watch, to enable a new area of continuous computing depends on three factors:
- The physical design of the Watch
- The interaction model for the Watch
- The ability of the Watch to interact with its environment
Apple and its competitors’ ability to deliver on each of these factors will determine whether the category ends up being a nice side business to phones, or the next step in the trend towards ever smaller and ever more convenient personal computers. And, for what it’s worth, after a few weeks with the Apple Watch, I’m increasingly bullish that it is the latter.
Physical Design
It may seem odd to declare that physical design is of equal import to the other factors that will determine a computer’s success, but a Watch is no ordinary computer: it’s one you wear. At Apple’s second Watch event Tim Cook said:
Apple Watch is the most personal device we have ever created. It’s not just with you, it’s on you. And since what you wear is an expression of who you are, we’ve designed Apple Watch to appeal to a whole variety of people with different tastes and different preferences. But the one thing that is consistent is that we crafted each one of them with the care that you would expect from Apple and used incredibly beautiful materials.
I added in How Apple Will Make the Wearable Market:
There has been a bit of consternation about Apple’s focus on “fashion” and all that entails, but there is a very practical aspect to this focus: people need to be willing to actually put the wearable on their body. While “form may follow function” for tools, the priorities are the exact opposite when it comes to what we wear: function is irrelevant without a form we find appealing. In this case, design actually is how it looks.
I’m not going to convince you that the Apple Watch is attractive or not, but to my eyes at least, it is significantly ahead of anything else on the market. And, frankly, I don’t think that surprises anyone. Apple’s industrial design is generally superior, but that superiority is maximized when a product or manufacturing technique is new: given that smartphones like the Xiaomi Mi Note, HTC One, or Samsung S6 are only just now approaching the iPhone, it’s reasonable to expect a substantial head start for the Watch.
I get why most reviews only spent a sentence or at best a small section on the Watch’s appearance: it seems so shallow, and beauty is in the eye of the beholder. One’s skin, though, is as “shallow” as technology has ever gotten, at least compared to the depths of an office, a bag, or even a pocket. Each step towards the light increases the importance of aesthetics, and Apple’s advantage here can’t be overstated.
On the other hand, “beauty being in the eye of the beholder” accentuates the downside of Apple’s integrated approach: what people wear is an expression of who they are, and while even the most idiosyncratic individual may be willing to have a phone that looks the same as everyone else’s, that may be a bridge too far when it comes to something on their body. This is why Apple launched with such a wide array of straps and case materials,3 and why the company has already opened the door to 3rd-party bands.
For now, though, I think Apple Watch checks this box in a way other wearables to date have not: more people than not will be willing to wear it.
The Interaction Model
There is a hierarchy when it comes to actually interacting with the Watch, something Horace Dediu laid out in The Battle for the Wrist:
The Apple Watch offers a hierarchy of surfaces onto which software can compete for attention:
- The Complication Layer
- The Notification Layer
- The Glances Layer
- The App Screen
These surfaces are arranged in a hierarchy where the highest is the most accessible and the lowest is the least accessible.
The ranking is not just about accessibility: it’s also the order in which the Apple Watch executes, from best to worst.
- Complications4 are invaluable, and the delta between pulling out your phone to check your calendar, or the weather, versus looking at your wrist is massive5
- The Taptic Engine is a revelation when it comes to notifications; in fact, I think Apple should have the sound turned off by default to accentuate the utility of an outwardly imperceptible tap of your wrist. The way a notification is displayed when you lift your wrist in response works well, and it’s easy enough to scroll through what you have missed6
- Glances are where you put things you need to know that don’t merit a complication7 (or, in the case of 3rd-party apps, aren’t allowed — for now); they also serve as a more easily accessible app launcher
- The App Screen is a place you only visit deliberatively, when you need a specific function. My favorites to date include Authy, for two-factor authentication, the New York Times app, with bite-sized stories, and Twitterific, for browsing mentions and direct messages. There’s no question, though, that hybrid apps are slow to load and often frustrating to use; one wonders if Apple wouldn’t have been better served keeping the doors shut until native apps are possible
What is missing in Dediu’s hierarchy, though, is the most important feature of the Watch: Siri specifically, and the cloud broadly. Siri in particular impacts every other part of the hierarchy:
- You can have, at most, 4.5 complications.8 To get any other information, you need to either use a Glance, an app, or, most efficiently, Siri:
The virtual assistant is fantastic when it works, like in the first two examples. The third, though, pushed me to my phone — a terrible experience that far too many apps are mimicking — and to Bing at that, which was entirely unuseful (in stark contrast to Google):
-
Notifications are all well-and-good, but many, particularly messages, require a response, and Siri is the only option beyond a few canned responses, and a ghastly set of emoticons and mime hands. That’s not a bad thing! I already find speaking into my wrist to be a far more natural activity than speaking into my phone ever was, and truthfully, Siri on the Watch somehow seems vastly improved over Siri on the iPhone.
More broadly, it’s clear that what the mouse was to the Mac and multi-touch was to the iPhone, Siri is to the Watch. The concern for Apple is that, unlike the others, the success or failure of Siri doesn’t come down to hardware or low-level software optimizations, which Apple excels at, and which ensures that Apple products have the best user interfaces. Rather, it depends on the cloud, and as much as Apple has improved, an examination of their core competencies and incentives argues that the company will never be as good as Google.9 That was acceptable on the phone, but is a much more problematic issue when the cloud is so central to the most important means of interacting with the Watch.
There’s a second issue with notifications: in contrast to many reviewers, I’ve had no problem with the number of notifications being pushed to my wrist. In part this is because I long ago limited the number of notifications that I received, and I pruned the list still further when it came to the Watch. It’s fair to ask, though, how many customers will go to the effort? Indeed, here Google in particular may have a significant advantage with their efforts around Google Now: the very premise of the cloud service is to intelligently notify you about what you need to know when you need to know it, a proposition that is particularly compelling when it comes to something so intimate as literally tapping your wrist.
-
Both Siri and Google Now can launch apps, and again, both are essential to input in particular. I’m very frustrated at apps that don’t bother to include Siri input (LINE, I’m looking at you), but Siri itself is still frustrating, particularly because whenever it does screw up the transcription, there is no way to edit what you said. Probably the best solution is to simply continue to get better at transcription, but again, Google is ahead here and it impacts the experience far more deeply than it does on a phone
Ultimately, the interaction model is the mirror image of physical design: Apple is playing catch-up, but it’s not out of the question that Siri becomes good enough, if it’s not already.
Interacting With Your Environment
This was the primary focus of the aforelinked article, How Apple Will Make the Wearables Market:
It’s increasingly plausible to envision a future where…our physical environment are fundamentally transformed by software: locks that only unlock for me, payment systems that keep my money under my control, and in general an adaptation to my presence whether that be at home, at the concert hall, or at work.
To fully interact with this sort of software-enabled environment, I will of course need some way to identify myself; for all the benefits of the human body, projecting a unique digital signature is not one of them. The smartphone clearly works, but it’s not perfect: the more you need it for interacting with your environment, the more noticeable is the small annoyance of retrieving it from your pocket or handbag.
A wearable is different, particularly if it’s on your wrist: simply raising your arm is trivial. This makes it much more likely you will actually interact in a meaningful way with software-enabled objects around you, which makes even having said objects much more likely. To put it another way, I don’t think it’s an accident that the two hot new technologies are wearables and the Internet of Things; they are related such that each is made better by the other.
As I noted in that article, this vision has a bit of a chicken-and-egg conundrum: software-enabled objects won’t be built for a Watch that isn’t widely available, which is why I suggested that Apple has a big advantage — the company has millions of loyal customers who will buy an Apple Watch simply because it’s made by Apple. This is further accentuated by point number one: Apple’s superior physical design makes it significantly more likely that a critical mass of Apple Watches will be sold.
Still, Apple’s success with initiatives like Apple Pay and HomeKit is not assured: I’m bullish about the former, but it’s not a slam dunk, and the latter depends on Apple delivering on an API that the company itself doesn’t depend on, a situation that hasn’t always ended well.
Looking Ahead
It’s important to note that the factors I listed matter in order: you first have to build a wearable people are willing to wear, then deliver a usable interaction model, and finally catalyze a world of smart objects that interact with your wearable.
Indeed, for now I think it likely that one of Apple’s oldest and most cherished skills — its ability to make beautiful, desirable objects — will make the Watch exactly what Tim Cook promised: another tentpole product that rivals the Mac, the iPod, the iPad, and even the iPhone. Framed as nothing more than A Watch that Does Stuff — and that you actually don’t mind wearing — Apple will rightly sell enough to kick-start a world that gets just a little bit smarter and little bit better when it knows who and where we are.
Moreover, the Watch may even help Apple to rival Google when it comes to Siri and the cloud: the best way to improve a service like Siri is to have millions of customers using it constantly, and I for one have used Siri more in the last two weeks than I have the last two years. Multiply that by millions of Watch users and you have the ingredients for a rapidly improving service. Perhaps more importantly, the fact that Siri is critical to the Watch’s success in a way it isn’t to the iPhone’s may finally properly align Apple’s incentives around improving its cloud services.
Ultimately, the Apple Watch has exceeded my quite high expectations. The complications and notifications fit into all the slivers of my life the iPhone has not, and the criticism I’ve levied at Siri has been primarily fueled by the appreciation of just how powerful it is to have a virtual assistant on my wrist instead of my pocket. As for apps, speed is the most easily solved issue in technology, thanks to Moore’s Law. I’m confident apps will be fully performant sooner rather than later.
That said, I suspect there will be a bifurcation when it comes to the Watch’s relative importance vis-à-vis the smartphone between developed and developing countries: in the long run I do think that convenience trumps all, but there’s no denying a smartphone is already pretty darn convenient. To put it another way, if you can afford it there is a sufficient delta between Watch and iPhone functionality to make the former worth owning despite its dependence on the latter. I also think that when the Watch inevitably gains cellular functionality10 I will carry my iPhone far less than I do today.11 Indeed, just as the iPhone makes far more sense as a digital hub than the Mac, the Watch will one day be the best hub yet.
Until, of course, physical devices disappear completely:
That is the ultimate Apple bear case.12
Discuss this article in the Stratechery Forum (members-only)
They are also, in the long run, cheaper, in part because of scale. Indeed, the Apple Watch packs in an amazing amount of functionality for a mere $350 ↩
I suspect had you told Tim Cook in 1998 that he would eventually oversee a product launch that included 38 models and 56 SKUs, he would have assumed he was having a nightmare — and certainly the number of SKU’s contributed to the Watch’s uneven launch ↩
Complications are the “extra” features on a watch face beyond the time ↩
Windows Phone tried to differentiate on this point, but the delta between a live tile and opening an app was far smaller than the delta between pulling out a phone and lifting up your wrist ↩
And there’s an easy way to clear all notifications finally ↩
For example, this is where I have my battery meter: the truth is I haven’t worried once about the battery running low ↩
Modular and Simple (ironically) offer 4 complications plus the date ↩
Nathan Taylor nailed this point on his excellent Praxtime blog two years ago ↩
I agree it is several years off, but it’s clearly not impossible: several standalone smart watches exist today, not that I would want to wear any of them ↩
Developers: heed this: don’t always assume the phone will be there! My biggest complaint about apps, outside of the terrible loading times, is that few outside of RSS readers (natch) let me read full articles. I read tens of thousands of words on this — I’ll do the same on the Watch ↩
Yes, I know much of Her is not realistic; that doesn’t mean it’s not pointed in a broadly realistic direction ↩
Exponent Podcast: It’s a Watch that Does Stuff
On Exponent, the weekly podcast I host with James Allworth, I finally have an Apple Watch: James has lots of questions about it.
Listen to it here.
Verizon-AOL, Facebook Instant Articles, and the Future of Digital Advertising
At first glance, Tuesday’s two big stories — Verizon’s acquisition of AOL, and Facebook’s official announcement of Instant Articles — have little in common. A deeper look, though, suggests that both are a consequence of an ongoing transformation of digital advertising that will affect nearly every consumer-focused services company.
Facebook’s Advertising Strength
There’s no need for me to dwell on the Facebook news; I covered it at length in March in an article called The Facebook Reckoning. In that piece I noted a significant problem with Internet advertising: ad inventory is ever-increasing, which means the rates for an undifferentiated ad spot are ever-decreasing; the best way to combat that trend is through better ads, better placement, better targeting, and better measurement.
Facebook is progressing on all these fronts: the company’s ad units are best-in-class, the targeting is frighteningly specific, and with its overhaul of Atlas the company is working to draw a line from Facebook ads to offline purchases. The vast majority of publishers, though, are in the opposite boat: mobile ads mostly stink, there’s no room for them on the screen (which leads to audience-antagonizing interstitials), and perhaps most problematically, it is much more difficult to target and track mobile users than it ever was on the desktop.
Cookies and the Rise of Programmatic Advertising
On the desktop, tracking is relatively easy: various ad networks will set a cookie in your browser that collects information about your travels around the Internet, and then use that information to serve advertisements based on your browsing history. That information was sufficiently useful that said ad networks were able to charge advertisers rates well above those charged by publishers who knew nothing about their audience, meaning the ad networks, with a few notable exceptions, could offer publishers more money for their ad inventory than the publishers could make on their own. This was a fundamental shift: instead of focusing on specific sites as a proxy to reach specific types of people — a model that was very much in-line with non-digital advertising like television — advertisers could instead focus on specific types of people directly.
This process has only grown more advanced: today users are identified not only by their browsing history, but also offline data like loyalty cards and other purchase histories, creating incredibly precise profiles. Advertisers can reach people based on those profiles through automated exchanges that use auction pricing and serve up ads in real-time, allowing for the collection of nearly immediate feedback on the campaign, making rapid iteration possible for the advertiser.
The Mobile Advertising Challenge
Programmatic advertising is not perfect: while the advertiser can specify the sort of content they don’t want their advertisement to be associated with, it’s questionable how well this works in practice; there’s also a mismatch between impressions (when an ad is loaded) versus the number of times an ad is actually seen (Google says 56% of ad impressions are never seen). Mobile, though, has presented the biggest challenge: apps don’t share cookies.
Advertising networks have searched for some sort of common denominator that would allow them to track users in different apps; originally most settled on using a phone’s Unique Device Identifier (UDID), which the Wall Street Journal exposed as a privacy disaster in 2010:
“The great thing about mobile is you can’t clear a UDID like you can a cookie,” says Meghan O’Holleran of Traffic Marketplace, an Internet ad network that is expanding into mobile apps. “That’s how we track everything.”
Here’s a useful rule of thumb: the more giddy a quote from an ad network employee, the bigger the privacy violation for end users. To that end, both Apple and Google soon banned the use of unique identifiers, instead offering ad IDs that could be reset by users — or even turned off completely.1 Advertisers have adapted, but the reality is that tracking users and measuring campaigns on mobile remains a lot more difficult than on the desktop, and that’s even before you consider multiple devices.
Tracking Users Effectively
This reality is at the core of Facebook’s value proposition to advertisers: target users, not devices. Sheryl Sandberg said on Facebook’s Q4 2014 earnings call in January:
If you look at how digital ads are being measured, they are being measured based on a cookie based world that assumes that people have one device, largely a PC. And that is not real, consumers have a phone, they have a tablet, they have PC’s as well and [we have] the ability to understand that one person to serve an ad and measure all the way through [to purchase] correctly.
Note the transition Sandberg is highlighting: the locus of tracking and measurement is shifting from devices to users. It echoes the shift in advertising from publishers to ad networks, which is to say from content to users. Targeting and serving ads to individual users is the goal, and, as Ms. O’Holleran excitedly declared in 2010, the holy grail is some sort of “super-cookie” that a user can’t turn off.
Facebook has this: it’s your name, and most of us have gladly handed over not only that but also our birthday, our history, our address, all of our friends, what we like, and more. Of course we’re logged in on our PCs, so that all of those Facebook ‘Like’ buttons can track our movement around the web, and Facebook is aggressively pushing developer products — including relatively highly paying ad units — so that our apps can keep an eye on us as well.
Google is dominant as well; I’ve long maintained that Google+ was more of a success than people appreciate: it unified IDs across Google’s properties and ensured most of us are always logged in. Google may not have the explicit user-provided data that Facebook does, but the company makes up for that with their extensive ad networks across both the web and inside of apps that not only display ads but also track said users.
Still, while both Facebook and especially Google have 3rd-party ad offerings, both — especially Facebook — are more focused on monetizing on their own sites. A whole plethora of ad-tech companies have risen up to fill in the rest of the web’s inventory, but no dominant player has emerged: until, potentially, now.
Why the Verizon-AOL Deal Makes Sense
AOL was a part of that plethora: while most people remember the eponymous dial-up service and “You Got Mail,” or perhaps know that the company is also the 4th biggest digital media property in the United States with nearly 200 million unique monthly users, Verizon was almost certainly interested in a much newer part of AOL’s business: its ad network. Over the last several years AOL has invested heavily, both through M&A and R&D, into its programmatic advertising offering both for its own sites and, more importantly, 3rd-party ones; it has also developed a particular expertise in video. This has made the company competitive in its ability to allow advertisers to target users instead of content, but the lack of an “AOL ID” puts a cap on upside, at least relative to Google or Facebook.
Verizon, meanwhile, knows a lot about its users:
- By virtue of being a paid service, Verizon knows users’ names, addresses, and even social security numbers (gotta run those credit checks!)
- Because they are a phone carrier, Verizon knows your location, something that is useful not just for serving ads but also for ascertaining whether or not they were effective (seeing a McDonald’s ad and visiting the Golden Arches soon after is a powerful signal)
- Because they are the ISP for your mobile phone (and for many customers, their home as well), Verizon doesn’t need a cookie or device identifier: they can set a “super-cookie” on their servers to track everything you do on the Internet, and that’s exactly what they’ve done2
This is why the deal makes so much sense: AOL provides the technology to target individuals instead of content, and Verizon the ability to track those individuals — at least the over 100 million customers they already have — at arguably a deeper level than anyone else in digital advertising (for non-Verizon customers, AOL’s ad platform is still useful, albeit not as targeted; rates would be commensurately lower). The talk of this mashup joining Facebook and Google to form a “Big 3” of digital advertising is not unrealistic.
That said, this isn’t a grand slam either. While there is a lot to like about this deal, it’s doubtful Verizon would be doing it were they not facing long-term growth questions, and that’s not always the best motivation to enter an entirely new kind of business. Moreover, there is a very real culture question: an infrastructure company and an online media company couldn’t have more different approaches to business, based on a history of solving fundamentally different problems. This clash will only compound the difficulty in realizing the vision I just painted — a vision that Facebook and Google have still only partially realized despite having the best software engineers in the world. And, of course, there is the potential for consumer backlash: if my skin crawled while describing a dystopian future of perfectly tailored ads based on perfect information about my activities, I trust your reading it inspired a similar sensation.
The Re-ordering of Advertising
Describing what Verizon and AOL are shooting for is another way of depicting just how much trouble most publishers are in. Beyond the fact most publishers know precious little about their users, few are must-reads that attract users to their streams (as opposed to their links). Worse, even those with compelling streams don’t have scale even remotely comparable to what programmatic ad networks offer: for now the most prestigious sites are looking to monetize on direct sales to brands, but if programmatic offerings ever figure out how to guarantee premium placement that is actually viewed by the exact right customer those revenue streams could dry up.
Subscriptions remain an attractive proposition, but as the Toronto Star recently discovered, not all publishers are the New York Times or Wall Street Journal, which means many publishers will have to take what they can get. And, frankly, it’s hard to see them getting a better deal than Facebook’s Instant Articles offering:
- Publishers use their own publishing tools, meaning no interruption to their workflow; Facebook makes it look good (although publishers can augment the post) to the publishers’ specification — a New York Times article won’t look like a BuzzFeed article
- Facebook will share analytics data from Google Analytics and Omniture, and ComScore will count Instant Article visits as visits to the publisher
- Facebook is giving publishers the opportunity to sell their own ads and keep 100% of the revenue (although, given Facebook’s superior targeting capabilities, I wouldn’t be surprised if 70% of a Facebook sale ends up being worth more)
Meanwhile, most publisher websites will be increasingly reliant on programmatic offerings that care only about the site’s ability to attract a specific type of customer who a particular advertiser has bid on, a sure route to a meager existence predicated on driving page views.
It’s not just publishers who might struggle, though: two weeks ago I chronicled Twitter’s cloudy future given their relative lack of scale and under-developed ad offering, and while I stand by that, it’s kind of amazing that a few hundred million active users might not be enough; that certainly has to be a sobering thought not only for unicorns like Pinterest and Snapchat (although I’m bullish on both), but for any startup looking to monetize through advertising. It wouldn’t surprise me to see more and more companies taking yet another page from Asia and increasing their focus on e-commerce and online-to-offline transactions, but it might take a few failures to fully presage such a shift. Hopefully there will be sufficient publishers to document the change in approach.
Discuss this Article on the Stratechery Forum (members-only)
The AWS IPO
One of the technology industry’s biggest and most important IPOs occurred late last month, with a valuation of $25.6 billion dollars. That’s more than Google, which IPO’d at a valuation of $24.6 billion, and certainly a lot more than Amazon, which finished its first day on the public markets with a valuation of $438 million.1 Don’t feel too bad for the latter, though: the “IPO” I’m talking about was Amazon Web Services, and it just so happens to still be owned by the same e-commerce company that went public nearly 20 years ago.
I’m obviously being facetious; there was no actual IPO for AWS, just an additional line item on Amazon’s financial reports finally breaking out the cloud computing service Amazon pioneered nine years ago. That line item, though, was almost certainly the primary factor in driving an overnight increase in Amazon’s market capitalization from $182 billion on April 23 to $207 billion on April 24.2 It’s not only that AWS is a strong offering in a growing market with impressive economics, it also may, in the end, be the key to realizing the potential of Amazon.com itself.
Understanding Amazon, Part 1
Much of the analysis of Amazon tends to fall in two diametrically opposed camps that are strangely united in their lack of rigor and in-depth appreciation of the economics driving Amazon’s business. On one hand are the ardent skeptics, who see Amazon’s lack of paper profits as prima facie evidence that the company is dramatically over-valued by the stock market; on the other are the true believers who point to Amazon’s ever-increasing revenue numbers as equally obvious evidence that the company is undervalued and primed for ever bigger and better things.
A more nuanced approach considers the fact that Amazon is not a monolithic operation, but rather a collection of businesses sharing resources, including a channel (Amazon.com), logistics, and a common technological foundation. These businesses range from bookshops to video game stores to home furniture to clothes to shoes to consumer electronics to auto accessories…the list is quite extensive at this point! True, consumers experience all of these different businesses as a unified Amazon.com, but inside the company some of these businesses are mature and (theoretically) throwing off cash, while others are reliant on investment as they work to get off the ground.
This view is a more sophisticated take on the aforementioned bull argument: it’s not that Amazon is not making money, it’s that the company is reinvesting every dollar it makes into growing new businesses; were the company to stop investing, it would start throwing off cash. This is exactly how Jeff Bezos has represented the company — except for the stop investing and throw off cash part, of course.
Why Amazon Started with Books
In The Everything Store, Brad Stone explains that while Jeff Bezos had always planned to build a site that sold, well, everything, he started with books for a very particular reason:
Bezos concluded that a true everything store would be impractical — at least at the beginning. He made a list of twenty possible product categories, including computer software, office supplies, apparel, and music. The category that eventually jumped out at him as the best option was books. They were pure commodities; a copy of a book in one store was identical to the same book carried in another, so buyers always knew what they were getting. There were two primary distributors of books at that time, Ingram and Baker and Taylor, so a new retailer wouldn’t have to approach each of the thousands of book publishers individually. And, most important, there were three million books in print worldwide, far more than a Barnes & Noble or a Borders superstore could ever stock.
If he couldn’t build a true everything store right away, he could capture its essence — unlimited selection — in at least one important product category. “With that huge diversity of products you could build a store online that simply could not exist in any other way,” Bezos said. “You could build a true superstore with exhaustive selection, and customers value selection.”
There was one more critical factor, though, that Stone only mentioned in passing a few chapters later: despite the fact that books were a commodity, they were exceptionally high-priced. The list price of a new book contained a 50 percent markup for the retailer, which meant Bezos — who a few years later would coin the famous phrase, “Your margin is my opportunity” — could sell books at a significant discount while still making money on each transaction (and over time, Amazon would not only bypass the wholesalers but eventually become large enough to dictate terms to publishers).
Moreover, the nature of Amazon’s business — customers paid for books with credit cards immediately, while Amazon paid book wholesaler invoices months after delivery — resulted in a negative cash conversion cycle that freed up much more cash for investment than would otherwise be warranted by Amazon’s margins, an effect that was greatly magnified by Amazon’s growth rate.
This made books, over the long-run, a truly profitable business for Amazon, and the company repeated the trick for many of the exact same reasons in CDs, DVDs, and video games: commodity products with massive selections traditionally sold at a significant markup and paid for 90 days later allowed Amazon to have a superior selection and lower prices and make money to boot.3
Understanding Amazon, Part 2
The problem with the bull case for Amazon is the assumption that all of Amazon’s different businesses are essentially the same: selling books is like selling DVDs is like selling clothes is like selling TVs, etc. However, while that may be true from an infrastructure perspective (same channel, logistics network, and technology stack), it’s absolutely not the case from an economic one.
Consider books versus TVs: there are an effectively infinite number of books, but a relatively small number of TVs, which means it’s more likely a competitor will have the same TV, leading to lower prices and reduced margins. TVs are also relatively infrequent purchases, and customers are likely to research the best price, leading again to lower prices and reduced margins. Moreover, while an individual book is a commodity, that same book is highly differentiated from another book; not so with TVs, where the most expensive TV still accomplishes the same thing as a cheaper one, which leaves little room for luxurious 50% retail markups. This again leads to lower prices and reduced margins. And, on the flip side, while a book is a book is a book, so you can buy it anywhere with confidence, many consumers consider a TV worth checking out in person, and it’s expensive to ship to boot.
That said, TVs are, relative to books anyways, expensive, as are computers, furniture, car accessories, and all the other businesses that Amazon has been developing over the last decade. In other words, all of this stuff that Amazon is selling is perfect for increasing revenue, but not so great at producing profit (that said, the benefits of a negative cash conversion cycle very much apply to these items as well; they are not being added in vain).
That leaves the old stand-bys — books, CDs, DVDs, and video games — to produce the actual profit that funds all of the new businesses Amazon wants to build, and they have done just that for 20 years now. The problem, though, is obvious: each of these categories is being replaced by digital distribution, and Amazon has only been successful in reaping the benefits of that shift in the case of books and the Kindle (although they’re competing in all four areas with Amazon Music, Amazon Prime Video, and the Amazon App Store). Moreover, the impact of digital distribution is showing up in the financial results; Amazon has long broken out the sales of ‘Media’ and ‘Electronics and General Merchandise’ in their financial reports, and in the last quarter ‘Media’ declined three percent even as ‘Electronics and General Merchandise’ increased 20%. This raises the long-run question for Amazon: if ‘Media’ is in secular decline, how will they fuel eternal investment into their business, much less the fabled returns that at least theoretically underpin their sky-high stock price?
Enter Amazon Web Services
The incredible potential of Amazon Web Services is as clear as its initial prospects in 2006 were, well, cloudy. AWS only came about after Amazon had experimented with more full-service offerings like powering the websites of Target or Toys-R-Us,4 and there were plenty of skeptics as to whether companies would entrust critical operations to a 3rd party. It soon became apparent, though, that both economics and simplicity were overwhelmingly in the public cloud’s favor, and Amazon was years ahead of everyone.
Today, public clouds are the future for the vast majority of businesses; the economics of scale achieved by Amazon (and its closest competitors, Google and Microsoft) are so incredible that multi-billion dollar companies like Netflix view it as more efficient to pay Amazon than to build their own data centers. The calculus is even more stark when it comes to any sort of startup: it’s so much easier and cheaper to get started with AWS that the idea of buying your own server infrastructure — an expense that consumed the majority of venture capital in the dot-com bubble era — is preposterous. This is great from Amazon’s perspective: the company effectively has a stake in nearly every significant startup, and for free; if the company succeeds, Amazon will be paid, handsomely, and if they fail, well, Amazon covered their own costs of providing cloud services along the way.
The big question about AWS, though, has been whether Amazon can keep their lead. Data centers are very expensive, and Amazon has a lot less cash and, more importantly, a lot less profit than Google or Microsoft. What happens if either competitor launches a price war: can Amazon afford to keep up?
To be sure, there were reasons to suspect they could: for one, Amazon already has significantly more scale, which means their costs on a per-customer basis are lower than Microsoft or Google. And perhaps more importantly is the corporate culture that results from a “your-margins-are-my-opportunity” mindset: Amazon can stomach a few percentage points of margin on a core business far more comfortably than Microsoft or Google, both fat off of software and advertising margins respectively. Indeed, when Google slashed prices in the spring of 2014, Amazon immediately responded and proceeded to push prices down further still, just as they had ever since AWS’s inception (the price cuts in response to Google were the 42nd for the company). Still, the question remained: was this sustainable? Could Amazon afford to compete?
This is why Amazon’s latest earnings were such a big deal: for the first time the company broke out AWS into its own line item, revealing not just its revenue (which could be teased out previously) but also its profitability. And, to many people’s surprise, and despite all the price cuts, AWS is very profitable: $265 million in profit on $1.57 billion in sales last quarter alone, for an impressive (for Amazon!) 17% net margin.
A New Foundation for Amazon
The profitability of AWS is a big deal in-and-of itself, particularly given the sentiment that cloud computing will ultimately be a commodity won by the companies with the deepest pockets. It turns out that all the reasons to believe in AWS were spot on: Amazon is clearly reaping the benefits of scale from being the largest player, and their determination to have both the most complete and cheapest offering echoes their prior strategies in e-commerce.
Moreover, Amazon has cleverly found a way to approximate the negative cash conversion cycle trick: instead of paying billions to build data centers up-front, before they are ever used to earn revenue, Amazon is building its data centers with capital leases that effectively let the company pay for the data centers as they use them. True, this is a riskier strategy, and one that casts a pessimistic hue on Amazon’s admonition that investors look at free cash flow,5 but it’s also a strategy that presumes growth, an excellent assumption to make when it comes to AWS — provided the company’s investment can keep up. Contrary to my initial skepticism (members-only), I think the capital leases are a win-win.
Perhaps the biggest implication of AWS, though, is its impact on Amazon.com. Last summer I lost my patience with the company, wondering when if ever Amazon would fully focus on seizing what looked to be a massive e-commerce opportunity, instead of dallying with devices and video. More importantly, would they do so before the ‘Media’ money train ran out of steam?
Today that is a moot point: the sky is the limit for AWS, and if the service is profitable at its current scale, what expectations should we have for five years from now, or ten? More importantly, that profitability can over time replace the role of ‘Media’ in the Amazon engine: cash to build new e-commerce businesses, or to explore what is next (a la AWS), or both of the above. Or, in the fantasy of Amazon’s investors, to actually provide a return to shareholders.6
Discuss this post in the Stratechery Forum (subscribers-only)
With an ‘m’! ↩
Amazon’s market cap has since decreased to $197 billion; like I said, I’m being facetious — this isn’t a real proxy for AWS’s value — but the spike was meaningful ↩
This was the foundation of my bullish article on Amazon in 2013 called Amazon’s Dominant Strategy ↩
but ultimately, why help your competitors? ↩
Amazon is now reporting “Free Cash Flow Less Finance Principal Lease Repayments and Capital Acquired Under Capital Leases” which is what their cash flow would be if they purchased data centers up-front; it’s significantly lower than the number the company trumpets publicly ↩
So yes! As predicted, I am changing my mind about Amazon. Again. ↩