Podcasts: Exponent 027 – Regulation, Stagnation, and Culture, The Jay and Farhad Show

Posted on

On the newest episode of Exponent, the podcast I co-host with James Allworth:

We follow up on last week’s Uber discussion, talk about the problem with regulation, and worry about stagnation and the different cultures of Europe, America, and Asia.

Links

  • Nicole Campbell: What Was Said at the Uber Dinner – Huffington Post
  • Lane Wood: Here Ego Again – Medium
  • Chase Madar: Why It’s Impossible to Indict a Cop – Nation
  • Peter Sterne: Jack Schafer on Losing his Job and the State of Things – Capital New York
  • Ben Thompson: Why Uber Fights – Stratechery
  • Zenefits Faces Shutdown In Utah For Giving Its Cloud-Based HR Software Away For Free – Techcrunch
  • So You Think You Can Be a Hair Braider – New York Times
  • Note: A federal judge eventually gave the right for the Utah hair-braider to work. In addition, the Utah governor has pledged to look into the law affecting Zenefits, but no concrete changes have been implemented.
  • James Allworth: How Corruption is Strangling U.S. Innovation – Harvard Business Review
  • StartupLJackson: “Dammit Utah, it’s shit like this that drives people into the arms of Ayn Rand.” – Twitter
  • Blake Ross: Uber.gov – Medium
    Jenna Wortham: Ubering While Black – Medium

Listen to the episode here

Podcast Information: Feed | iTunes | SoundCloud | Twitter | Feedback

The Jay and Farhad Show – Tim Cook’s $100 Billion ‘Mistake’ (Not)

Earlier this week I was also a guest on the Jay and Farhad show, where I debated Jay Yarow and Eric Jackson about Best, the article I wrote earlier this week in response to Jackson. You can check it out here.

Best

Posted on

One of the challenges of writing on the Internet – of writing in general, in fact – is the understandable propensity of readers to draw but one conclusion from what you intend to be a nuanced piece. I was reminded of this the past few weeks as Philip Elmer-DeWitt wrote Apple and the Crisis of Disruption and Jean-Louis Gassée Clayton Christensen Becomes His Own Devil’s Advocate. Both cited my piece from last year What Clayton Christensen Got Wrong as a primary piece of evidence that the theory of disruption was fundamentally flawed.

That, though, is the nuance. I do think the theory is flawed, but not fundamentally. It’s simply incomplete.

As I’ve noted, I fully subscribe to the theory of new market disruption: the idea that new entrants can meet the needs of previously unaddressed customers with a seemingly inferior and cheaper solution. And, over time, that solution improves to the point where it meets the needs of the incumbent’s customers as well. A wonderful example of this is how cloud companies have eviscerated IBM (members-only) with solutions that IBM originally dismissed out of hand as being wildly impractical for their customers.

It’s the other branch of disruption theory that I took – take – issue with, namely, low-end disruption (for long-time readers, forgive this brief digression). Briefly, the idea is that an integrated solution, where a single company makes all of the major components, will win in the market when a market is new. This is because, to put it bluntly, all of the solutions suck, but the integrated solution sucks less by virtue of being integrated and working better as a unit. However, over time, products improve in quality more quickly than customers add needs – or jobs-to-be-done, to use the preferred parlance. This means that the integrated solution soon becomes too good: it adds too many features, which means increased complexity and higher prices, while modular solutions, optimized at each layer through competition, deliver at first a “good-enough” cheaper product, and eventually, as they gain share, a superior one, still at lower prices. And thus, the integrated incumbent is doomed.

In fact, I too find low-end disruption powerfully illuminating. The power of integration is why companies like BuzzFeed and Vox are remaking journalism (members-only), and the power of modularity is why Intel and Samsung are under so much pressure. My only beef is with that last sentence – the idea that integrated incumbents are inevitably doomed.1

The primary flaw in this conclusion, as I detailed last year, is that the Christensen evaluation of “good enough” only considers technical capabilities. Christensen did later add the idea of emotional jobs-to-be-done – this covers things like luxury bags, for example, which confer status – but that doesn’t fully explain Apple in particular. Instead, my position is there is a third component of product capability: the user experience. Moreover, the user experience is unique in that, like emotional jobs-to-be-done, a product can never be “too good,” and, like technical jobs-to-be-done, it is always possible to improve – or to fall behind.

Moreover, integrated solutions will just about always be superior when it comes to the user experience: if you make the whole thing, you can ensure everything works well together, avoiding the inevitable rough spots and lack of optimization that comes with standards and interconnects. The key, though, is that this integration and experience be valued by the user. That is why – and this was the crux of my criticism of Christensen’s development of the theory – the user experience angle only matters when the buyer of a product is also the user. Users care about the user experience (surprise), but an isolated buyer – as is the case for most business-to-business products, and all of Christensen’s examples – does not. I believe this was the root of Christensen’s blind spot about Apple, which persists. From an interview with Henry Blodget a month ago:

You can predict with perfect certainty that if Apple is having that extraordinary experience, the people with modularity are striving. You can predict that they are motivated to figure out how to emulate what they are offering, but with modularity. And so ultimately, unless there is no ceiling, at some point Apple hits the ceiling. So their options are hopefully they can come up with another product category or something that is proprietary because they really are good at developing products that are proprietary. Most companies have that insight into closed operating systems once, they hit the ceiling, and then they crash.

That’s the thing though: the quality of a user experience has no ceiling. As nearly every other consumer industry has shown, as long as there is a clear delineation between the top-of-the-line and everything else, some segment of the user base will pay a premium for the best. That’s the key to Apple’s future: they don’t need completely new products every other year (or half-decade); they just need to keep creating the best stuff in their categories. Easy, right?

Last week Eric Jackson wrote a piece entitled, Apple’s $100 Billion Waste: Tim Cook’s Single Biggest Mistake As CEO.

I believe the capital return program has been a total waste of Apple’s hard-earned $100 billion. I believe – although this is impossible to prove – that Apple’s stock price would be just as high as it is today (or more likely higher) had they spent that $100 billion on a combination of smart M&A and smart R&D that would have continued to extend Apple’s lead over other Android phone makers.

Jackson’s shopping list includes Tesla, Twitter, Pinterest, battery R&D, and a cool $10 billion to make iCloud work.

Altogether, this M&A and R&D spree would cost Apple $119 billion. Their cash levels would be $136 billion today instead of $155 billion. They wouldn’t have much revenue to show for that $119 billion but how much higher would Apple’s market cap be than the $700 billion it is today? If Apple owned Tesla, Twitter and Pinterest? That would be worth at least another $50 – 100 billion in stock value.

Full disclosure: while we have not met in person, I like Jackson, and interact with him regularly on Twitter. He also did this nice interview with me back when I was just getting started, which I really appreciated. That said, this argument isn’t just wrong-headed, it’s wrong-headed on multiple levels, and would, in the long run, be the doom of Apple.

The most basic mistake Jackson makes is the assumption that more R&D money would result in better batteries and better iCloud. While Apple’s percentage spend on R&D isn’t extraordinary, that’s a function of their extraordinary revenue: on an absolute basis Apple spends an incredible amount, and there are numerous examples of their willingness to spend ridiculous amounts of money to gain the slightest of improvements in their products. Were money the gating factor for battery technology, I’m fully confident Apple would already be spending it. As for iCloud, Jackson’s prescription sounds an awful lot like The Mythical Man Month; in fact, the issue there is a cultural and organizational one (more on this in a moment).

At a deeper level, it’s not clear what on earth Apple would do with Twitter or Pinterest. You can certainly argue that Twitter especially isn’t reaching its potential, and can absolutely ascribe that to its current management, but it does not follow that Tim Cook and company would do a better job. In fact, Jackson is making the exact same mistake that most of Wall Street made when Steve Jobs died: too many assumed that Apple’s success was due solely to their charismatic founder, ergo, Apple’s success today must be because Cook is just as good a CEO as Jobs. And, given that he’s such a superhero, surely he can fix Twitter! It’s silly. Cook may be a good CEO, but he’s not a magician able to transmogrify a company different from Apple in nearly every respect.

Most problematic of all, though, and the reason why Jackson’s advice would ultimately doom Apple, is something Jackson takes special pains to mock: focus. Jackson compares Apple’s refusal to make major acquisitions to an inability to walk and chew gum at the same time; leaving aside the absurdity of comparing the difficulty of integrating multiple companies with fundamentally different business models (as would be the case with any web services company), if you actually wanted to be the best gum chewer in the world, wouldn’t you actually be well advised to stand still and focus on chewing gum?

This is the precise point that Jackson and so many others miss: the overriding value for Apple, and the fundamental reason the company has thrived even with Jobs’ untimely death, is the total commitment to building the best possible personal computers (all of the iOS devices, including the Watch, fit here). Being competent at wildly disparate businesses just because you have the financial wherewithal to do so is in direct opposition to this ethos. It is a perfect example of trying to kill the goose laying golden eggs.

Because here’s the thing: the reason I started with disruption is because I think Christensen is 95% right. Low end disruption is real, and it is a threat, and Apple’s only defense is to be the best. And being the best at anything requires total dedication and yes, focus.

What makes Jackson’s article intriguing and worth more than your average Apple clickbait is that he makes some very fair points: Apple spends time on iAds, so why not a real ad-based business?2 Apple stinks at cloud services, so why not buy a cloud company? And while stock buybacks increase a stock’s earnings-per-share one could make the argument that the stock price would be just as high had Apple not done a thing.

My response, though, is to in fact argue that Apple should do the precise opposite of what Jackson suggests: they should do less. I still believe that, on balance, Apple offers superior products in their core product categories, and that their lead is still fairly substantial. Moreover, Apple benefits from the fact their main competitors – particularly Google – have horizontal business models that dictate they offer best-of-breed services on Apple’s own platform. That said, it’s hard to make the “best” argument when it comes to Apple’s web services and the quality of both Apple’s recent operating systems releases and their first-party software.

  • Apple’s web services suffer from Apple’s organizational dedication to building great products. Aligning teams and schedules around the big unveil makes sense for hardware, but it’s a disaster for web services (The Information recently confirmed many of the points I made in iCloud and Apple’s Founding Myth, specifically, cloud teams are siloed and constantly build everything from scratch on an outdated stack)
  • Similarly, iOS releases are tied to the device’s yearly update schedule, quality concerns be damned. And OS X releases are tied to iOS releases. Both iOS 8 and Yosemite have shown what happens when the controlling constraint for software is a ship date
  • First party software like the iWork and iLife suites is completely understaffed because of the number of folks needed to get the aforementioned OS releases out the door. Moreover, both teams have been forced to readjust their priorities from superior PC software to tablet-compatible software, to the original product’s detriment

The answer is to do less:

  • Apple’s web services should be built on shared infrastructure that is primarily standards-based and conventional. The only “innovation” that should happen is in areas where it actually makes a difference that Apple owns the device as well. Fortunately, it seems that Apple is moving in this direction: CloudKit is a lot more “normal” than iCloud Core Data and similar services ever were, while many of the neatest Continuity features use the cloud in a way that only Apple can. Moreover, there are strong hints (members only) that Apple is building a centralized cloud team in a new Seattle office (as an aside, I love the fact that this team – if it exists – won’t be in Cupertino; a new location is one way to counteract the tremendous cultural issues working against Apple’s cloud teams)3
  • iOS releases – and thus OS X releases – should be decoupled from hardware releases, marketing be damned. Every crash, every failed rotation, every single bug chips away at that hard-to-measure-until-it’s-gone user experience that protects Apple from disruption, and we’re going on three years of disappointing software releases
  • Apple should disband the first party software teams, or spin them out into a different company. Both iLife and iWork – and the pro apps – served very important functions for Apple: they gave a reason to buy a Mac at a time when the lack of 3rd party software was the primary reason not to. Today, though, Apple has the best developer ecosystem in the world, and Apple is actually hurting themselves by competing with it. Not only are any resources spent on apps better spent on the OS, but also the presence of free Apple apps depresses the segments in which they compete. Instead Apple should look for ways to improve developer monetization and sustainability; to put it another way, Apple should focus on building a better platform, not on building on top of it

As for the money, well, I think this advice would result in even more in the long run. And it’s not like Apple isn’t making smart purchases: TouchID, arguably Apple’s most important innovation in years and something that has put the company years ahead of Android was the result of an acquisition, as was Siri. Beyond that, well, sure, give it back to the shareholders: it ultimately is theirs. If I sound blasé, it’s only because I’m trying to channel the sentiment that Jony Ive in particular has articulated again and again:

Our goal isn’t to make money. Our goal absolutely at Apple is not to make money. This may sound a little flippant, but it’s the truth…Our goal and what gets us excited is to try to make great products. We trust that if we are successful people will like them, and if we are operationally competent we will make revenue, but we are very clear about our goal.

Here’s an idea for Jackson, and everyone else who thinks they know what Apple should do instead: what if you took Ive at his word? What if you realized that Apple, for its entire 38 year existence, has been focused on building the best possible personal computers?4 Sure, those computers have become ever more personal, but the drive to be the best is a constant. Would you really advocate something different?

If so, then, I guess, and despite my reputation, you are a far greater skeptic of disruption than I.

  1. To be specific, Christensen wrote, “When that happens, the disruptors are on a path that will ultimately crush the incumbents.” ↩

  2. I actually don’t get to iAds, but I think Apple should dump it (members-only)  ↩

  3. This is another area I agree with Jackson: Apple should have bought Dropbox. The fact that Jobs wasn’t willing to pay up (all companies can be had if the price is high enough) for a team that combined Apple’s consumer ethos with real cloud capabilities was the result of undervaluing what the cloud and the skills it takes to succeed there ↩

  4. This, more than anything, is why I think the Tesla argument is absurd. I suppose there are surface similarities – batteries, operational competence, software – but it’s a completely different industry ↩

Why Uber Fights

Posted on

In his, to my mind, fair defense of Uber, Mark Suster made a very important observation about the reality of business:

Let’s put this into perspective. As somebody who has to rub shoulders with big tech companies often I can tell you that there is much blood spilled in the competitive trenches of Apple, Twitter, Facebook, Google and so on. Changes to algorithms. Clamping down on app ecosystems. Changing how third-parties monetize. Kicking ecosystem partners in the nuts.

Be real.

It’s a brutally competitive world out there because there are extreme amounts of money at stake. I’ve been on the sharp end of it and it doesn’t feel nice. And I pick myself back up, dust off and think to myself that I need to think through the realpolitik of power and money and competition and no matter how unpleasant it is – it’s a Hobbesian world out there. It ain’t pretty – but it’s all around us.

This is particularly relevant to Uber: the company is looking to raise another $1 billion at a valuation of over $30 billion, and, as I wrote when the company raised its last billion, they are likely worth far more than that. Still, though, skeptics about both the size of the potential market and the prospects of Uber in particular are widespread, so consider this post my stake in the ground1 for why Uber – and their market – is worthy of so many sharp elbows. I expect to link to it often!

There are three perspectives with which to examine the competitive dynamics of ride-sharing:

  1. Ride-sharing in a single city
  2. Ride-sharing in multiple cities
  3. Tipping points

I will build up the model that I believe governs this market in this order; ultimately, though, they all interact extensively. In addition, for these models I am going to act as if there are only two players: Uber and Lyft. However, the same principles apply no matter how many competitors are in a given market.

Ride Sharing in a Single City

Consider a single market: Riderville. Uber and Lyft are competing for two markets: drivers and riders.

uber

There are a few immediate takeaways here:

  • The number of riders is far greater than the number of drivers (far greater, in fact, than the percentage difference depicted by this not-to-scale sketch)
  • On the flip side, drivers engage with Uber and Lyft far more frequently than do riders
  • Ride-sharing is a two-sided market, which means there are two places for Uber and Lyft to compete – and two potential opportunities for winner-take-all dynamics to emerge

It’s important to note that drivers in-and-of-themselves do not have network dynamics, nor do riders: Metcalfe’s Law, which states that the value of a network is proportional to the square of the number of connected users, does not apply. In other words, Uber having more drivers does not increase the value of Uber to other drivers, nor does Lyft having more riders increase the value of Lyft to other riders, at least not directly.

However, the driver and rider markets do interact, and it’s that interaction that creates a winner-take-all dynamic. Consider the case in which one of the two services – let’s say Uber – gains a majority share of riders (we’ll talk about how that might occur in the next section):

  • Uber has a majority of riders (i.e. more demand)
  • Drivers will increasingly serve Uber customers (i.e. more supply)
  • More drivers means that Uber’s service level (i.e. car liquidity) will improve
  • Higher liquidity means that Uber has a better service, which will gain them more riders

In this scenario Lyft by necessity moves in the opposite direction:

  • Lyft has fewer riders (i.e. less demand)
  • Drivers will face increasing costs to serve Lyft riders:
    • If there are fewer Lyft riders, than the average distance to pick up a Lyft rider will be greater than the average distance to pick up an Uber driver; drivers may be better off ignoring Lyft pickups and waiting for closer Uber pickups
    • Every time a driver picks up a rider on one service, they need to sign out on the other; if the vast majority of rides are with one service, this, combined with the previous point, may make the costs associated with working for multiple services too high2
  • Drivers will increasingly be occupied serving Uber customers and be unavailable to serve Lyft customers (i.e. less supply)
  • Fewer drivers means that Lyft’s service level (i.e. car liquidity) will decrease
  • Lower liquidity means that Lyft has an inferior service, which will cause them to lose more riders

The end result of this cycle, repeated over months, looks something like this:

uber2

There are three additional points to make:

  • It doesn’t matter that drivers may work for both Uber and Lyft. If the majority of the ride requests are coming from Uber, they are going to be taking a significantly greater percentage of driver time, and every minute a driver spends on a rider job is a minute that driver is unavailable to the other service. Moreover, this monopolization of driver time accelerates as one platform becomes ever more popular with riders. Unless there is a massive supply of drivers, it is very difficult for the 2nd-place car service to ever get its liquidity to the same level as the market leader (much less the 3rd or 4th entrants in a market)

  • The unshaded portion of the “Riders” pool are people who regularly use both Uber and Lyft. The key takeaway is that that number is small: most people will only use one or the other, because ride-sharing services are relatively undifferentiated. This may seem counterintuitive, but in fact in markets where:

    • Purchases are habitual
    • Prices are similar
    • Products are not highly differentiated

    …Customers tend to build allegiance to a brand and persist with that brand unless they are given a good reason to change; it’s simply not worth the time and effort to constantly compare services at the moment of purchase3 (in fact, the entire consumer packaged goods industry is based on this principle).

    In the case of Uber and Lyft, ride-sharing is (theoretically) habitual, both companies will ensure the prices are similar, and the primary means of differentiation is car liquidity, which works in the favor of the larger service. Over time it is reasonable to assume that the majority player will become dominant

  • I briefly mentioned price: clearly this is the easiest way to differentiate a service, particularly for a new entrant with relatively low liquidity (or the 2nd place player, for that matter). However, the larger service is heavily incentivized to at least price match. Moreover, given that the larger service is operating at greater scale, it almost certainly has more latitude to lower prices and keep them low for a longer period of time than the new entrant. Or, as is the case with ride-sharing, a company like Uber has as much investor cash as they need to compete at unsustainably low prices

In summary, these are the key takeaways when it comes to competition for a single-city:

  • There is a strong “rich get richer” dynamic as drivers follow riders which increases liquidity which attracts riders. This is the network effect that matters, and is in many ways similar to app ecosystem dynamics (developers follow users which which increases the number and quality of apps which attracts users)

  • It doesn’t matter if drivers work for both services, because what matters is availability, and availability will be increasingly monopolized by the dominant service

  • Riders do not have the time and patience to regularly compare services; most will choose one and stick with it unless the alternative is clearly superior. And, because of the prior two points, it is almost certainly the larger player that will offer superior service

Ride Sharing in a Multiple Cities

It is absolutely true that all of the market dynamics I described in the previous section don’t have a direct impact on geographically disperse cities, which is another common objection to Uber’s potential. What good is a network effect between drivers and riders if it doesn’t travel?

There is, however, a relationship between geographically disperse cities, and it occurs in the rider market, which, as I noted in the previous section, is the market where the divergence between the dominant and secondary services takes root. Specifically:

  • Pre-existing services launch with an already established brand and significant mindshare among potential riders. Uber is an excellent example here: the company is constantly in the news, and their launch in a new city makes news, creating a pool of riders whose preference from the get-go is for Uber

  • Travelers, particularly frequent business travelers, are very high volume users of ride-sharing services. These travelers don’t leave their preferences at home – when they arrive at an airport they will almost always first try their preferred service, just as if they were at home, increasing demand for that service, which will increase supply, etc. In this way preference acts as a type of contagion that travels between cities with travelers as the host organism

Most important of all, though, is the first-mover effect. In any commodity-type market where it is difficult to change consumer preference there is a big advantage to being first. This means that when your competitor arrives, they are already in a minority position and working against all of the “rich get richer” effects I detailed above.

uber3

This explains Uber and Lyft’s crazy amounts of fundraising and aggressive roll-out schedules, even though such a strategy is incredibly expensive and results in a huge number of markets that are years away from profitability (Uber, for example, is in well over 100 cities but makes almost all its money from its top five). Starting out second is the surest route to finishing second, and, given the dynamics I’ve described above, that’s as good as finishing last.

Tipping Points

What I’ve described up to this point explain what has happened between Uber and Lyft to-date. Still, while I’ve addressed many common objections to Uber’s valuation in particular, there remains the question of just how much this market is worth in aggregate. After all, as Aswath Damodaran, the NYU Stern professor of finance and valuations expert detailed, the taxi market is worth at most $100 billion which calls into question Uber’s rumored $30 billion valuation.

However, as Uber investor Bill Gurley and others have noted, Damodaran’s fundamental mistake in determining Uber’s valuation is to look at the world as it is, not as it might be.4 Moreover, this world that could be is intimately tied to the dynamics described above. I like to think of what might happen next as a series of potential tipping points (for this part of the discussion I am going to talk about Uber exclusively, as I believe they are – by far – the most likely company to reach these tipping points):

  • Tipping Point #1: Liquidity is consistently less than 5 minutes and surge pricing is rare – Once Uber becomes something you can count on both from a time and money perspective, rider behavior could begin to change in fundamental ways. Now, Uber is not just for a business meeting or a night out; instead, Uber becomes the default choice for all transportation. This would result in dramatically increased rider demand, resulting in complete Uber domination of driver availability. This would have several knock-on effects:
    • Driver utilization would increase significantly, increasing driver wages to a much more sustainable level
    • Competitor liquidity would decrease precipitously, leading to rider desertion and an Uber monopoly; this would allow Uber to raise rates to a level that is more sustainable for drivers, further increasing supply and liquidity

    By all accounts Uber is already close to this level in San Francisco, and there are lots of anecdotes of people all but giving up cars.5 The effect of this change in rider behavior cannot be overstated, especially when it comes to Uber’s potential valuation: taxis have a tiny share of the world’s transportation market, which means to base the company’s valuation on the taxis is to miss the vast majority of Uber’s future market opportunity

  • Tipping Point #2: Uber transports not just people – Uber has already done all kinds of experiments with delivering things other than people, including Christmas trees, lunch, a courier service, even drugstore items. However, any real delivery service would need to have some sort of service-level agreement when it comes to things like speed and price. Both of those rely on driver liquidity, which is why an Uber logistics service is ultimately waiting for the taxi business to tip as described above.

    However, once such a delivery service is launched, its effect would be far-reaching. First, driver utilization would increase even further, particularly when it comes to serving non centrally located areas. This would further accentuate Uber’s advantage vis-à-vis potential competitors: Uber service would be nearly instant, and drivers – again, even if they nominally work for multiple services – would be constantly utilized.

    Moreover, there is a very good chance that Uber could come to dominate same-day e-commerce and errands like grocery shopping: most entrants in this space have had a top-down approach where they set up a retail operation and then figure out how to get it delivered; the problem, though, is that delivery is the bottleneck. Uber, meanwhile, is busy building up the most flexible and far-reaching delivery-system, making it far easier to move up the stack if they so choose. More likely, Uber will become the delivery network of choice for an ecosystem of same-day delivery retailers. Needless to say, that will be a lucrative position to be in, and it will only do good things for Uber’s liquidity.

Why Uber Fights

The implications of this analysis cannot be underestimated: there is an absolutely massive worldwide market many times the size of the taxi market that has winner-take-all characteristics. Moreover, that winner is very unlikely to be challenged by a new entrant which will have far worse liquidity and an inferior cash position: Uber (presuming they are the winner) will simply lower prices and bleed the new entrant dry until they go out of business.

To put it another way, I think that today’s environment where multiple services, especially Lyft, are competing head-on with Uber is a transitional one. Currently that competition is resulting in low prices and suppressed driver wages, but I expect Uber to have significant pricing power in the long run and to be more generous with drivers than they are now, not for altruistic reasons, but for the sake of increasing liquidity and consistent pricing.

In short, Uber is fighting all out for an absolutely massive prize, and, as Suster noted, such fights are much more akin to Realpolitik. As Wikipedia defines it:

Realpolitik is politics or diplomacy based primarily on power and on practical and material factors and considerations, rather than explicit ideological notions or moral or ethical premises

It’s ethics – or, to be more precise, Uber’s alleged lack of them – that has been dominating the news most recently, and is what inspired Suster’s post. And, to be very clear, I can understand and share much of the outrage: in my Daily Update I have compared Uber to Wall Street and said that Emil Michael should be fired (both links members-only) for his comments suggesting Uber might investigate journalists – Sarah Lacy in particular – who disparage the company.6

However – and one of the reasons I’m writing this article – I am also very aware of just how much is at stake in this battle. Lyft has raised $332.5 million from some very influential investors, and I don’t for a minute believe that they don’t want to win just as badly as Uber does. It’s perfectly plausible, if not probable, that Lyft and its backers, overmatched in a head-on battle with Uber, are conducting a guerrilla campaign with the aim of inspiring so much disgust in riders that Uber’s liquidity advantages start to slip (and to be clear, such a campaign – if it exists – is only possible because Uber’s management speaks and acts poorly frequently).7

To be perfectly clear, I don’t know anything further about this situation – or other recent Uber PR fiascos, like this Verge piece about stealing Lyft drivers – beyond the size of the potential prize, as detailed here, and the reality of human beings and their incentives in the presence of such outsized rewards. In my experience the truth ends up being far more gray than the press – which really hates threats to journalists – has characterized this most recent episode.

In fact, in some ways I’m actually far more concerned about Uber’s perceived lack of ethics than most, because if I’m right, then Uber is well on its way to having monopoly power over not just taxi services but a core piece of worldwide infrastructure, and nothing about this crisis gives me confidence in the company’s ability to manage that gracefully.8 I get that Uber’s willingness to fight unjust laws is what got them to this point, but as James Allworth and I discussed on the most recent episode of Exponent, there is a deeper moral code that ought to govern Uber’s actions. Moreover, Uber needs rider goodwill to prevail in the many markets where it is facing significant regulatory resistance: it is local citizens who determine whether or not local laws and regulations will be changed to accommodate Uber, and Uber is making it very difficult to rationalize advocating for them, or, if my Twitter account is any indication, to even ride with them.

Ultimately, this blog generally seeks to analyze business, not render moral judgment or tell anyone what products or services they should or should not use. I myself am mixed: I plan on spending some time in the white part of that graph above, at a minimum. I hope, though, that you now appreciate exactly what is at stake and why so many elbows are being thrown.

  1. I’ve attempted to articulate Uber’s potential multiple times in the Daily Update – it’s one of my most frequent topics. This is my attempt to tie everything together that I have written there ↩

  2. Originally, this bullet stated “Drivers will increasingly be occupied serving Uber customers and be unavailable to serve Lyft customers (i.e. less supply).” However, this was incorrect because drivers utilized on any service are unavailable to every service, incurring no advantage ↩

  3. Lots of people have suggested to me that Uber will be doomed as soon as someone creates an app that serves as a front-end to all of the services allowing you to book the one with the lowest price and/or fastest availability; however, such an app would realistically need the cooperation of the largest player (which would not be forthcoming, and there is no public API) plus need to gain meaningful traction in a given market while competition still exists. It’s not happening ↩

  4. To Damodaran’s immense credit, he was very gracious in his response to Gurley’s post (which, to be clear, was respectful of Daodaran as well)  ↩

  5. The broader effects of Uber on adjacent industries will have to wait for another post ↩

  6. That said, no reporting has suggested a threat to Lacy or her family as many seem to believe; that came from Lacy herself ↩

  7. I am not making any allegations, and it should be noted that Pando Daily shares investors with both Uber and Lyft ↩

  8. First off, Michael’s comments, whether in jest or not, were incredibly stupid. Secondly, Kalanick’s tweetstorm was a terrible idea. You can’t admit that Michael’s “remarks showed a lack of leadership, a lack of humanity, and a departure from our values and ideals” and not fire him. Either stand your ground and insist Michael was misrepresented or let him go ↩

Podcast: Exponent 026 – GROW GROW GROW FIGHT FIGHT FIGHT

Posted on

On the newest episode of Exponent, the podcast I co-host with James Allworth:

We briefly discuss my belief in the Internet opportunity for content creators, and then dive in to the recent Uber controversy.

Links

Listen to the episode here

Podcast Information: Feed | iTunes | SoundCloud | Twitter | Feedback

Differentiation and Value Capture in the Internet Age

Posted on

It’s hard to have a conversation with anyone in tech without the word “scale” entering the conversation; “Internet scale” is a particularly popular variation of the term. Scale is a concept that is at the root of most venture investing: because software has zero marginal cost – one copy costs just as much as 100, or one million – there are massive profits to be gained from reaching huge numbers of customers on a uniform product or service.

The idea of scale, though, isn’t something unique to the 21st century; in fact, it was the key driver of the 20th, and it all started with Henry Ford and the assembly line.1

Henry Ford didn’t invent the car; before the Model T there were all kinds of automakers producing cars that were mostly custom-built and only available to the very wealthy. However, they were notoriously unreliable and very difficult to repair. Ford changed all that by building one model in one color with interchangeable parts at scale: this allowed Ford to charge a shockingly low price of $825 upon the Model T’s introduction in 1909 ($21,650 in today’s dollars). What was even more impressive was that, over the following years, Ford continued to decrease the price: a Model T in 1925 cost a mere $260 ($3,500 today). This had a massive impact on the adoption of the automobile, and the entire world began to adapt, paving roads, building gas stations, establishing diners and garages, etc.

Over time, though, the Model T was very much a victim of its own success: by massively expanding the market for cars and triggering the development of car-friendly infrastructure, Ford created openings for other car manufacturers that previously didn’t exist. A company like General Motors didn’t need to compete with Ford by building a Model T clone; instead they could develop multiple brands at different price points to capture particular segments of the market. The market was so big that scale could be brought to bear in a much more finely-grained way.

Today, few if any of us drive the exact same car with the exact same color with the exact same interchangeable parts. In the United States you can buy the Nissan Versa for $12,800 or a Lamborghini Veneno Roadster for $4.5 million. Admittedly, the latter isn’t produced at scale (there will be only 9 built in 2014), but the Mercedes-Benz CL-Class is, and it costs over $100,000. A huge percentage of people have a car that fits their preferences and lifestyle, and while they all do the same thing in a technical sense, you can pay for exactly the type of experience that you prefer.

A few weeks ago I wrote about the smiling curve and how value would increasingly flow from publishers to aggregators operating at scale:

The Smiling Curve for publishing
The Smiling Curve for publishing

However, I didn’t spend much time on the left side of this graph, beyond noting that readers will often be loyal to a specific writer, or to a focused publication. That writer or publication has one unique superpower: they are the only one of their kind. To use the strategic term, they are differentiated, and differentiated people – or products – can charge far more than their marginal cost. And no one is more differentiated than Taylor Swift.

A few weeks ago, in a widely discussed move, Taylor Swift pulled her music off of Spotify, and then proceeded to become the first artist in history to sell more than 1 million records in a week three albums in a row.2 In an interview with Yahoo Music, Swift argued that Spotify devalued music:

Music is changing so quickly, and the landscape of the music industry itself is changing so quickly, that everything new, like Spotify, all feels to me a bit like a grand experiment. And I’m not willing to contribute my life’s work to an experiment that I don’t feel fairly compensates the writers, producers, artists, and creators of this music. And I just don’t agree with perpetuating the perception that music has no value and should be free.

The thing is, though, given that music has a marginal cost of zero – to create one more copy doesn’t cost a cent – its natural price is, well $0. Free by a different name. And, when you look at the industry from this perspective, Spotify is the positive force for music that its CEO, Daniel Ek, believes it is:

Our whole reason for existence is to help fans find music and help artists connect with fans through a platform that protects them from piracy and pays them for their amazing work. Quincy Jones posted on Facebook that “Spotify is not the enemy; piracy is the enemy”. You know why? Two numbers: Zero and Two Billion. Piracy doesn’t pay artists a penny – nothing, zilch, zero. Spotify has paid more than two billion dollars to labels, publishers and collecting societies for distribution to songwriters and recording artists.

It’s a compelling argument, and Ek is justified in making it. In fact, I’d go so far as to say he is completely correct when it comes to any random song. But here’s the thing: Swift is completely correct too, especially when it comes to her music in particular. Swift herself explained why earlier this year in an op-ed in the Wall Street Journal:

In mentioning album sales, I’d like to point out that people are still buying albums, but now they’re buying just a few of them. They are buying only the ones that hit them like an arrow through the heart or have made them feel strong or allowed them to feel like they really aren’t alone in feeling so alone…There are always going to be those artists who break through on an emotional level and end up in people’s lives forever. The way I see it, fans view music the way they view their relationships. Some music is just for fun, a passing fling (the ones they dance to at clubs and parties for a month while the song is a huge radio hit, that they will soon forget they ever danced to). Some songs and albums represent seasons of our lives, like relationships that we hold dear in our memories but had their time and place in the past.

However, some artists will be like finding “the one.” We will cherish every album they put out until they retire and we will play their music for our children and grandchildren. As an artist, this is the dream bond we hope to establish with our fans. I think the future still holds the possibility for this kind of bond, the one my father has with the Beach Boys and the one my mother has with Carly Simon.

By all accounts, Swift is describing the relationship she herself has with her fans. Her deeply personal and well-written songs speak to adolescent girls in particular in a way few artists ever have; for her (many) fans, Swift is “the one.” She is, to put it in economic terms, highly differentiated.

That’s why I loved her decision to pull out of Spotify.3 Taylor Swift is not some sort of Luddite futilely standing against the forces of modernity; rather, she is a highly differentiated content creator capturing the immense value she is creating instead of ceding it to an aggregator that treats every piece of content the same.

There are other examples of content creators realizing and capturing their value. When it comes to publications, the Wall Street Journal has long led the way in putting much of its content behind a paywall, betting that its focus on finance and business would make its content worth paying for. Other examples are the Financial Times and more recently, the New York Times. To be fair, the results have been mixed, in part because all of the paywalls have varying degrees of leakiness. This, though, gets at one of the most important tradeoffs any content creator has to make: when it comes to capturing the value created through differentiation, reach and profit are inversely correlated.

In fact, this is the exact dynamic that explains how Apple captures such a huge percentage of the profit in the markets they compete in, even as they have a relatively small market share. iPhones, Macs, etc. are differentiated by Apple’s software and ecosystem, and the company charges accordingly. Those higher prices, though, preclude Apple from ever being the majority player.4

There are examples in software too. Developers have decried the App Store “race to the bottom”, when in reality the market is behaving exactly as you would expect: software, like music, has zero marginal cost, which means that absent differentiation the fair price of an app is $0. Omni Group, though, sells iOS apps for a whole lot more: OmniFocus for iPhone, for example, is $19.99; the iPad version is $29.99, and, according to founder and CEO Ken Case, Omni is more than satisfied with the company’s foray onto iOS.

The math is obvious: one customer buying both versions of OmniFocus is worth 50 customers buying one copy at $0.99, and worth an order of magnitude more customers were the app free with ads. Moreover, fewer customers mean lower support costs on one hand, and more ardent evangelists on the other. Customers who are willing to pay for a superior product are valuable in all sorts of ways, and Omni is spot-on in pricing their highly-differentiated apps in such a way that they capture a good part of the value they create.

It’s easy to wonder why more developers don’t take the same route as Omni – or singers like Swift, or publications like the Wall Street Journal – but the truth is creating differentiation is hard. Case told me:

Not every app becomes profitable just because it’s priced reasonably with respect to its value. With OmniGraphSketcher, for example, we didn’t find as large a market as we were hoping to, and though its simplicity was great, as a simple app it didn’t offer enough value to justify raising its price to sustain development in its small market. So we stopped selling it (and released it to the public for free as open source, where it also hasn’t found much traction). The lesson I’ve drawn is that it’s important for us to build higher-value apps

It’s a tough standard, to be sure, but as a consumer, it’s actually pretty great news. Only the best will succeed.

It’s easy to think that the Internet Age is well-established, but the truth is we’re only getting started. Remember, it took nearly two decades for the Model T to develop the car ecosystem to the point where new opportunities emerged to offer differentiated vehicles at much higher prices and much greater per-unit profit (Mercedes-Benz, for example, wasn’t founded until 1926, right about the time that the Model T reached its lowest price). I strongly believe that we are at a similar turning point when it comes to Internet-enabled businesses.

The thing about Internet scale is it doesn’t just have to mean you strive to serve the most possible people at the lowest possible price; individuals and focused publications or companies can go the other way and charge relatively high prices but with far better products or services than were possible previously. It’s working for Apple, it’s working for Taylor Swift, it’s working for Omni Software, and I can’t wait to see the sort of companies and products it will work for in the future.5

  1. I previously used Henry Ford and the Model T as an analogy here; I hope you’ll excuse the recycling as 1) I didn’t have any readers then and 2) The focus and takeaway here is totally different ↩

  2. I discussed Swift vs Spotify at length in this Daily Update (members-only)  ↩

  3. According to the New Yorker, Swift would have stayed had Spotify been willing to limit her songs to the paid tier ↩

  4. Which, contra conventional wisdom, is ok, because absolute numbers matter more than percentages  ↩

  5. I’m burying this in a footnote because I’m sheepish, but I’m hopeful that it’s working for me as well ↩

Podcast: Exponent Episode 025 – Twitter and Taylor

Posted on

On the newest episode of Exponent, the podcast I co-host with James Allworth:

We discuss Twitter and its strategic options, as well as YouTube’s new music service, Taylor Swift and Spotify, plus the special return of the garbage truck song.

Links

  • Twitter Sharpens Its Strategy to Win Over Investors – Wall Street Journal
  • Ben Thompson: There are Two Twitters; Only One is Worth Investing In – Stratechery
  • Ben Thompson: Twitter’s Marketing Problem – Stratechery
  • Daniel Ek: $2 Billion and Counting – Spotify
  • Taylor Swift: For Taylor Swift, the Future of Music Is a Love Story – Wall Street Journal
  • Ben Thompson: What Taylor Swift Gets Right – Stratechery (members-only)

Listen to the episode here

Podcast Information: Feed | iTunes | SoundCloud | Twitter | Feedback

An Update on the Stratechery Membership Program

Posted on

Last spring I wrote a series about the future of journalism:

  • Part 1: FiveThirtyEight and the End of Average – link
  • Part 2: The Stages of Newspapers’ Decline – link
  • Part 3: Newspapers Are Dead; Long Live Journalism – link

In the third installment I wrote:

More and more journalism will be small endeavors, often with only a single writer. The writer will have a narrow focus and be an expert in the field they cover. Distribution will be free (a website), and most marketing will be done through social channels. The main cost will be the writer’s salary.

Monetization will come from dedicated readers around the world through a freemium model; primary content will be free, with increased access to further discussions, additional writing, data, the author, etc. available for-pay.

A few weeks later I launched Stratechery 2.0, my perhaps quixotic attempt to put my quite literal money where my mouth was.

That was a little over six months ago, and since that time I’ve gotten questions about how things are going. I tend to be private about such things, so I haven’t replied, and truthfully, I feel a bit sheepish right now. But I think if any number is worth celebrating it is the number 1,000. I passed that number of active subscribers earlier this month.

Back in 2008 Kevin Kelly wrote:

A creator, such as an artist, musician, photographer, craftsperson, performer, animator, designer, videomaker, or author – in other words, anyone producing works of art – needs to acquire only 1,000 True Fans to make a living.

Making a living is about right. I’m not getting rich by any means, but I’m doing ok financially by doing what I love professionally, and that’s pretty awesome. So that’s my answer to all those asking: I’m doing great.

More broadly, while nothing is assured, it looks like I might have been on to something when it comes to the viability of writing on the web. There is a lot of doom and gloom among journalists especially about how the Internet has profoundly disrupted publications built on an analog business model, but I think to focus on what has been lost is to overlook what has been gained. There is a flora of new journalism that is only possible because of the web, and I truly believe we are only getting started.

Most importantly, for anyone reading this who believes they truly have something unique to say, please go for it. It is possible to make it on your own, and the world needs your voice.

The foundation of Stratechery remains free posts on the main blog, and five Daily Updates a week with 12~15 pieces of analysis about topical tech news. You can sign up here.

I did want to share a few important updates about the membership program:

  • I have consolidated the membership program down to one level: $10 a month or $100 a year. Now all members not only get the Daily Update every weekday, but also access to the (very active) Stratechery Forum
  • Speaking of the Stratechery Forum, it has been relaunched as a Stratechery-hosted (responsive) message board for all members, with hundreds of posts in less than two weeks. Relatedly, I am ending on-post comments
  • I have ended the sponsored post program. While I am a believer in native advertising, I wanted to focus my incentives behind the membership program both in regards to post frequency as well as customer service. My thanks to the sponsors who supported Stratechery over the last six months

Now, more than ever, this site and the members who subscribe to the Daily Update are my livelihood (although I do offer strategic consulting). I truly feel blessed and would like to sincerely thank every member who has signed up to date, and anyone who signs up in the future.

As always, I aim to make it worth your while.

Two Microsofts

Posted on

My well-chronicled frustration with Microsoft’s corporate strategy comes down to one point: I don’t think any company should have both horizontal (i.e. services) and vertical (i.e. devices) businesses. It creates conflicting incentives: a horizontal business should be great on every platform, while a vertical business should be differentiated.

Thus, I was quite pleased when Satya Nadella’s first major move as CEO was the announcement of Office for iPad with an Office 365 subscription: finally the company was prioritizing services over its devices. True, convincing consumers to pay for software doesn’t seem to be a viable business model for 2014, but I was eager – and hopeful, for the sake of developers everywhere – for Microsoft to give it a shot.1

I suspect it was my enthusiasm for this new model that led to my shock at the news that the Microsoft Office iPad apps would no longer need an Office 365 subscription to unlock most of their functionality: what good is a services business that isn’t actually trying to make money? Over the last few days, though, a different model for Microsoft has emerged, and it’s one I’m pretty excited about; the company just hasn’t gone far enough.

Two Microsofts

So strongly do I believe in the importance of incentives – and the problems of bad ones – that this summer I called for Microsoft to split itself in two to ensure that the Services side of the company could grow unfettered. Much to my surprise, though, last week’s announcement reveals that a fundamental cleavage has in fact occurred: today’s Microsoft is, more than ever, two different companies. The line of demarcation, though, is not services and devices, but rather enterprise and consumer.

First, though, a quick aside: Microsoft will continue to make money from traditional Windows and Office licensing for both enterprise and consumer for a good long time; that money, though, is a result of previous strategic decisions. For the rest of this article I am focused solely on growth opportunities – the areas where today’s strategic decisions impact tomorrow’s top and bottom lines.

And, in that light, by making Office for iOS and Android (mostly) free, Microsoft is effectively giving up on for-pay consumer services. Sure, the company will continue to offer Office 365 for both Mac and PC, but the potential growth has always been on mobile.

That decision, though, brings some welcome rationality to Microsoft, at least if you look at the consumer and enterprise sides of the business in isolation:

Microsoft's business makes much more sense if you think of there being two completely separate entities.
Microsoft’s business makes much more sense if you think of there being two completely separate entities.

On the consumer side, Microsoft hopes to make money from devices and advertising: they sell Surfaces, Lumias, and Xboxes with differentiated OS’s, hardware, and services, and they have ad-supported services like Bing and Outlook. The enterprise side is the exact opposite: here the focus is 100% on services, especially Azure and Office 365 (to use the Office iPad apps for business still requires a subscription).

This actually makes all kinds of sense: enterprise and consumer markets not only require different business models, but by extension require very different companies with different priorities, different sales cycles, different marketing, so on and so forth. Everything that makes Office 365 a great idea for the enterprise didn’t necessarily make it the best idea for consumers, just as the model for selling Xbox’s hardly translates to big business. From this perspective, I love the idea of Office on iOS and Android being free for consumers: get people into the Microsoft ecosystem even as you keep them in the Office orbit.

Microsoft Should Go All the Way

When I think about Microsoft as two separate businesses, my primary concern with last week’s announcement is that Microsoft didn’t go far enough: specifically, the Office apps aren’t totally free. From the announcement on the Microsoft blog:

Of course Office 365 subscribers will continue to benefit from the full Office experience across devices with advanced editing and collaboration capabilities, unlimited OneDrive storage, Dropbox integration and a number of other benefits.

This leaves this decision neither here nor there, and reeks of short-sightedness: by releasing most of the functionality of Office for free, Microsoft is giving up on the iPad as a growth driver for Office 365, but it seems like they can’t quite wean themselves of incremental income from Office diehards. The problem, though, is that not only could this limitation manifest itself as incremental annoyance, it also limits the defensive utility of this move (members-only). If the worry is people getting in the habit of not using Office at all, why tempt them?

The more interesting question is how long this cleavage will be sustainable. Enterprise Microsoft is doing exceptionally well: its Windows, Office and on-premise Server businesses are throwing off cash, while Office 365 and Azure grow like gangbusters. The consumer side of things is the opposite: Lumia and Surface continue to bleed cash2, the Xbox One is struggling, and while Bing is improving, it’s still not a moneymaker.

None of this should be a surprise: Microsoft has always been an enterprise company that primarily succeeded in the consumer space by dint of its Windows monopoly. There’s no reason for them to be any more successful with consumers than they are today, and one wonders whether Nadella has made the same determination. Regardless, the clarity in business models is good news.

  1. And, on the flip side, I was less pleased to see Microsoft pushing ahead with its device strategy just a few months later ↩

  2. I detailed how badly the tech press blew the reporting on last quarter’s Surface numbers here (members-only)  ↩

Podcast: Exponent Episode 024 – A Celebratory Goblet of Champagne

Posted on

On the newest episode of Exponent, the podcast I co-host with James Allworth:

In this week’s episode…

The idea for Exponent was hatched when Ben and James were arguing about Ben’s article What Clayton Christensen Got Wrong a year ago. In this episode, we finally reach a resolution to the question about how Apple escapes disruption. Plus, whether or not Xiaomi is a threat to Apple, personal development philosophies, and more (sorry, we went a bit long…)

Links

  • Ben Thompson: How Apple Creates Leverage, and the Future of Apple Pay – Stratechery
  • John Siracusa: OS X 10.10 Yosemite: The Ars Technica Review (Conclusion) – ArsTechnica
  • Ben Thompson: What Clayton Christensen Got Wrong – Stratechery
  • Ben Thompson: Growing Apple at WWDC – Stratechery

Listen to the episode here

Podcast Information: Feed | iTunes | SoundCloud | Twitter | Feedback

How Apple Creates Leverage, and the Future of Apple Pay

Posted on

Tim Cook said something very revealing on last quarter’s earnings call:

Last month we introduced two new categories; the first is Apple Pay, an entirely new way to pay for things in stores and in apps…The second new category is Apple Watch, our most personal device ever and one that has already captured the world’s imagination.

Did you catch that? Cook put Apple Pay on the same level as Apple Watch. It is no hobby.

Something that has characterized most of Apple’s recent successes is the degree to which they have depended on partnerships with normally intractable industries.1 The two most obvious examples are iPod/iTunes and the music industry, and most obviously, the iPhone and the phone carriers. This perhaps seems counterintuitive: Apple is famous for being difficult to deal with, working diligently to ensure it always has the upper hand, even as it holds its partners to impossible standards.

This reading of Apple’s partnership abilities, though, mistakenly rests on the assumption that business deals grow out of personal affinity. The truth is that while personal likability may help on the margins, the controlling force in Apple’s negotiations is cold hard business logic. Thus, in order to understand why Apple has been so successful in previous partnerships – and, looking forward, to better estimate the chances of Apple Pay becoming widespread – it is essential to understand how the company acquires and uses leverage.

The most important term in the study of negotiation is BATNA: Best Alternative to a Negotiated Agreement. Your BATNA defines the point at which you are willing to walk away from a deal. In order to “win” a negotiation, you want to make your BATNA as high as possible, so it’s easy for you to walk away, even as you work to make your counterparty’s BATNA as low as possible, so that they will concede more than they would like. Leverage is the means by which you change your counterparty’s BATNA.

When the iTunes Store née iTunes Music Store launched in early 2003,2 Apple was a very different company than they are today. The iPod had been on the market for a year-and-a-half, but it only worked with a Mac, which was still stuck at well under 5% of the market. This, though, worked to Apple’s advantage in their negotiations with the music labels: not only did Apple not have much to lose, but the labels didn’t really see Apple as being a major player. The labels were far more concerned about the widespread sharing of music online; suing Napster to oblivion simply made music sharing more distributed and harder to control, which, of course, benefited Apple: their customers had alternate means with which to fill their iPods. So when Apple showed up with an offering to build a music store for their small audience, well, why not?

Just a few months later, Apple expanded iTunes to Windows, and what could the labels say? Despite the fact it only existed on the Mac, the iTunes Music Store was already the number one music download service in the world. It turned out Apple had another ace in the hole: a customer base that, while small, had an outsized willingness and ability to spend. After all, they had already dropped at least $1,500 on a Mac and iPod (and likely a lot more), what was an extra $0.99? At a more basic level, said customers were loyal to Apple not because it made sense from a feature or price perspective, but simply because they loved and valued the experience of using Apple products. That, ultimately, was the key to Apple’s favorable position: they had the best customers because they had the best user experience; if the labels wanted access to them, they had to agree to Apple’s terms.

Over time the labels’ addiction to iTunes revenues only deepened, and by 2008 iTunes was their biggest source of revenue. Music executives would rant and rave about Apple’s power, and try to increase their own leverage by, for example, allowing DRM-free songs on Amazon but not Apple, but it didn’t matter because Apple had the best experience, and thus the best customers.

Apple’s negotiations with the music labels was just a warmup for the phone carriers. While Apple in 2006 (in the runup to the iPhone) was in a much stronger position than 2003, they were still much smaller ($60.6 billion market cap) than AT&T ($102.3 billion) or Verizon ($93.8 billion) on an individual basis, much less the carrier industry as a whole. More importantly, carriers weren’t facing a collective existential threat like piracy, which significantly increased their BATNA relative to the music labels.

The music labels, though, benefitted from a relatively low elasticity of substitution: if I wanted one particular band that wasn’t on the iTunes Music Store, I wouldn’t be easily satisfied by the fact another band happened to be available. The carriers, on the other hand, largely offered the same service: voice, SMS, and data, all of which was interoperable. This increased elasticity of substitution gave Apple an opportunity to pursue a divide-and-conquer strategy: they just needed one carrier.

Apple reportedly started iPhone negotiations with Verizon, but it turned out that Verizon was already kicking AT&T’s (then Cingular’s) butt through aggressive investment and technology choices, resulting in increasing subscriber numbers largely at AT&T’s expense. Verizon saw no need to change their strategy, which included strong branding and total control over the experience on phones on their network. AT&T, meanwhile, was on the opposite side of the coin: they were losing, and that in turn had a significant effect on their BATNA – they were a lot more willing to compromise when it came to branding and the user experience, and so the iPhone launched on AT&T to Apple’s specifications.

That is when Apple’s user experience advantage and corresponding customer loyalty took over: for the first time ever customers were willing to endure the hassle and expense of changing phone carriers just so they could have access to a specific device. Over the next several years Verizon began to bleed customers to AT&T even though their service levels were not only better, but actually widening the gap thanks to the iPhone’s impact on AT&T. Four years after launch the iPhone did finally arrive on Verizon with the same lack of carrier branding and control over the user experience; in other words, Verizon eventually accepted the exact same deal they rejected in 2006 because the loyalty of Apple customers gave them no choice.3

Apple followed the same playbook in country after country: insistence on total control (and over time, significant marketing investments and a guaranteed number of units sold) with a willingness to launch on second or third-place carriers if necessary. Probably the starkest example of the success of this strategy was in Japan. Softbank was in a distant third place in the Japanese market when they began selling the iPhone in 2008; finally after four years second-place KDDI added the iPhone, but only after Softbank had increased its subscriber base from 19 million to 30 million. NTT DoCoMo, long the dominant carrier and a pioneer in carrier-branded services finally caved last year after seeing its share of the market slide from 52% in 2008 to 46%. Apple had all the leverage, because they had customers who cared more about the iPhone than they did their carrier.

Apple is certainly not shy about proclaiming their fealty towards building great products. And I believe Tim Cook, Jony Ive, and the rest of Apple’s leadership when they say their focus on the experience of using an Apple device comes from their desire to build something they themselves would want to use. But I also believe the strategic implications of this focus are serially undervalued.

Last year I wrote a piece called What Clayton Christensen Got Wrong that explored the idea that the user experience was the sort of attribute that could never be overshot; as long as Apple provided a superior experience, they would always win the high-end subset of the consumer market that is willing to pay for nice things.

However, this telling of the story of iTunes and the iPhone suggests that this focus on the user experience not only defends against disruption, but it also provides an offensive advantage as well: namely, Apple increases its user experience advantage through the leverage it gains from consumers loyal to the company. In the case of iTunes, Apple was able to create the most seamless music acquisition process possible: the labels had no choice but to go along. Similarly, when it comes to smartphones, Apple devices from day one have not been cluttered with carrier branding or apps or control over updates. If carriers didn’t like Apple’s insistence on creating the best possible user experience, well, consumers who valued said experience were more than happy to take their business elsewhere. In effect, Apple builds incredible user experiences, which gains them loyal customers who collectively have massive market power, which Apple can then effectively wield to get its way – a way that involves maximizing the user experience. It’s a virtuous circle:

Apple's focus on creating a great user experience builds consumer loyalty. Consumers then put market pressure on Apple's potential partners, which result in concessions to Apple, further enhancing the user experience
Apple’s focus on creating a great user experience builds consumer loyalty. Consumers then put market pressure on Apple’s potential partners, which result in concessions to Apple, further enhancing the user experience

Understanding this circle and how it interacts with the relevant actors is the key to evaluating the prospects of Apple Pay.

When it comes to Apple Pay adoption, there are five collective players that matter: Apple, Apple customers, credit card networks (Visa, Mastercard and American Express4), banks, and merchants.

  • Apple has, as is their wont, spent a significant amount of time on the Apple Pay experience. Over the last several years they have built the various pieces of Apple Pay, including Touch ID, their own chips (which include the secure enclave), an experimental NFC antenna design, as well as the software to make it work, with the bonus of 800 million credit cards stored in iTunes ready to be potentially added

  • Apple customers continue to have higher amount of income as well as a demonstrated willingness to spend. Apple customers are also very willing to use new technology offered by Apple, including Apple Pay

  • Credit card networks are the closest parallel to the music labels in that their overriding concern is the existential threat posed by potential networks or payment options that cut them out of the loop entirely. No one particularly likes them or the fees they charge. Thus, when Apple declared its willingness to build Apple Pay on top of credit cards, they jumped at the opportunity to take part

  • Banks are the carriers in this story. In the long run Apple Pay completely obscures their role in a customer’s payment activity, and the inevitable end for any invisible service is competition on price. However, banks have two problems when it comes to Apple Pay:

    • Banks are involved with every single Apple Pay transaction, which means if your bank does not support Apple Pay, it simply won’t work
    • Banks are easily substitutable. Sure, switching banks can be a bit of a pain, and you might have been with the same one forever, but if Apple customers were willing to switch carriers to get the iPhone, surely many would be willing to switch banks to be able to use Apple Pay

    Moreover, the banks benefit from Apple Pay’s increased security and correspondingly lower fraud rates – just as, I might add, carriers benefitted from iPhone customer’s higher average revenue per user (ARPU). Sure, it’s just as bad being a dumb bank as it is a dumb pipe, but better a dumb bank that makes money instead of one that customers simply leave

  • Merchants are much more difficult, and there is no real corresponding analogy in Apple’s previous dealings. Apple has much less leverage for a few reasons:

    • Merchants have a lower elasticity of substitution: on the low end, day-to-day purchases aren’t worth the hassle of a longer trip simply to use Apple Pay, and on the high end, retailers are highly differentiated by the products they offer
    • Merchants see much less direct benefit from Apple Pay. True, it’s likely that over time total transactions from Apple Pay-using customers will increase due to the decrease in friction relative to credit cards, but in the short term merchants are paying the exact same fees regardless of how a payment is made5
    • On the flip side, the anonymized nature of an Apple Pay transaction deprives merchant of valuable customer data that can be used to better target marketing campaigns and/or be sold for a profit

This explains the situation that Apple’s payment initiative is in today: Apple Pay as an experience works incredibly well, Apple’s customers are eager to use it, the credit card networks fully support it, banks are falling over themselves to not only sign up but to pay Apple 0.15% of every transaction for the privilege, but retailers, particularly big chains that pay the most in credit card fees and reap the most benefits from data collection, are much more hesitant.6

So now what?

It turns out that Apple has acquired a few more pieces of leverage through this process:

  • In the U.S.,7 October 2015 brings the liability shift in which the less secure party in a transaction (i.e. a magnetic swipe card used at a payment terminal that accepts chip-enabled cards, or swipe-only terminal accepting a chip-enabled card) assumes liability for that transaction. This should spur the purchase of new credit card terminals at the vast majority of merchants; most of those new terminals will likely have NFC

  • By adopting industry-standard NFC, Apple has ensured that Apple Pay will “just work” at any NFC-enabled payment terminal that is not explicitly configured to not accept Apple Pay. This means that by the end of next year it’s likely that Apple Pay will work in a large part of the “long tail” of retail

  • For retailers that are still holding out, Apple has two new bargaining chips:

    • The 0.15% that Apple is receiving from the banks for each Apple Pay transaction could be funneled back to the retailers, resulting in an immediate impact on the bottom line. Keep in mind retail is a very low margin business; turning down any reduction in credit card fees will be difficult to do
    • Apple Pay could incorporate retailer loyalty programs, helping close the loop when it comes to data collection. This could work similarly to the offering Apple has for Newsstand publishers: customers opt in to sharing data, an offer that most will likely accept in exchange for the various discounts that typically accompany such programs. In fact, it seems that such an offering is already in the works

In short, Apple could very well soon have an offer that might be too good for the vast majority of retailers to refuse: get the lift that comes with seamless transactions, plus a reduction in credit card fees, along with the seamless inclusion of pre-existing loyalty programs. Oh-and-by-the-way, if a particular retailer or three still wishes to hold out, then Apple’s loyal customers will sooner rather than later have a huge number of alternatives willing to take their business.

Presuming this works out as well for Apple as I expect it to, there are two key lessons to be drawn. First, all of Apple’s leverage ultimately – either directly or indirectly – stems from consumer loyalty, which itself is based on Apple’s focus on the user experience. Second, the reason why Tim Cook so confidently called out Apple Pay as a new category is that he knew it was an area where Apple could bring that leverage to bear, just as they did in music and telephony. This is in marked contrast to the Apple TV, which is still a hobby: TV remains a much stronger business that is far more resistant to disruption than most people in tech appreciate, and until Apple has a means of obtaining leverage it will only ever remain so.

  1. Benedict Evans touched on this theme last week ↩

  2. Yes, I just called April early ↩

  3. Apple did originally sign a five-year exclusive agreement with AT&T, but that deal was negotiated several times and Apple likely could have moved to Verizon sooner had the carrier been willing to make the necessary concessions ↩

  4. American Express is also effectively a bank ↩

  5. This analysis applies to off-line retailers; I expect Apple Pay to immediately get significant penetration in apps for online purchases simply because the lift resulting from fewer customers falling off at the payment form will be significant ↩

  6. I covered MCX and CurrentC in-depth in this daily update (members-only)  ↩

  7. Apple Pay is only available in the U.S. currently, so that is the center of this analysis ↩