Economic Power in the Age of Abundance

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At first, or second, or even third glance, it’s hard to not shake your head at European publishers’ dysfunctional relationship with Google. Just this week a group of German publishers started legal action against the search giant, demanding 11 percent of all revenue stemming from pages that include listings from their sites. From Danny Sullivan’s excellent Search Engine Land:

German news publishers are picking up where the Belgians left off, a now not-so-proud tradition of suing Google for being included in its listings rather than choosing to opt-out. This time, the publishers want an 11% cut of Google’s revenue related to them being listed.

As Sullivan notes, Google offers clear guidelines for publisher’s who do not want to be listed, or simply do not want content cached. The problem, though, as a group of Belgian newspapers found out, is that not being in Google means a dramatic drop in traffic:

Back in 2006, Belgian news publishers sued Google over their inclusion in the Google News, demanding that Google remove them. They never had to sue; there were mechanisms in place where they could opt-out.

After winning the initial suit, Google dropped them as demanded. Then the publications, watching their traffic drop dramatically, scrambled to get back in. When they returned, they made use of the exact opt-out mechanisms (mainly just to block page caching) that were in place before their suit, which they could have used at any time.

In the case of the Belgian publishers in particular, it was difficult to understand what they were trying to accomplish. After all, isn’t the goal more page views (it certainly was in the end!)? The German publishers in this case are being a little more creative: like the Belgians before them they are alleging that Google benefits from their content, but instead of risking their traffic by leaving Google, they’re instead demanding Google give them a cut of the revenue they feel they deserve.

The obvious reaction to this case, as with the Belgian one, is to marvel at the publisher’s nerve; after all, as we saw with the Belgians, Google is driving traffic from which the publishers profit. “Ganz im Gegenteil!” say the publishers. “Google would not exist without our content.” And, at a very high level, I suppose that’s true, but it’s true in a way that doesn’t matter, and understanding why it doesn’t matter gets at the core reason why traditional journalistic institutions are having so much trouble in the Internet era.

One of the great paradoxes for newspapers today is that their financial prospects are inversely correlated to their addressable market. Even as advertising revenues have fallen off a cliff – adjusted for inflation, ad revenues are at the same level as the 1950s – newspapers are able to reach audiences not just in their hometowns but literally all over the world.

Before the Internet, a newspaper like the New York Times was limited in reach; now it can reach anyone on the planet
Before the Internet, a newspaper like the New York Times was limited in reach; now it can reach anyone on the planet

The problem for publishers, though, is that the free distribution provided by the Internet is not an exclusive. It’s available to every other newspaper as well. Moreover, it’s also available to publishers of any type, even bloggers like myself.

The city-by-city view of Stratechery's readers over the last 30 days.
The city-by-city view of Stratechery’s readers over the last 30 days.

To be clear, this is absolutely a boon, particularly for readers, but also for any writer looking to have a broad impact. For your typical newspaper, though, the competitive environment is diametrically opposed to what they are used to: instead of there being a scarce amount of published material, there is an overwhelming abundance. More importantly, this shift in the competitive environment has fundamentally changed just who has economic power.

In a world defined by scarcity, those who control the scarce resources have the power to set the price for access to those resources. In the case of newspapers, the scarce resource was reader’s attention, and the purchasers were advertisers. The expected response in a well-functioning market would be for competitors to arise to offer more of whatever resource is scarce, but this was always more difficult when it came to newspapers: publishers enjoyed the dual moats of significant up-front capital costs (printing presses are expensive!) as well as a two-sided network (readers and advertisers). The result is that many newspapers enjoyed a monopoly in their area, or an oligopoly at worse.

The Internet, though, is a world of abundance, and there is a new power that matters: the ability to make sense of that abundance, to index it, to find needles in the proverbial haystack. And that power is held by Google. Thus, while the audiences advertisers crave are now hopelessly fractured amongst an effectively infinite number of publishers, the readers they seek to reach by necessity start at the same place – Google – and thus, that is where the advertising money has gone.

And so, the German publishers are both right and wrong. Without content generated by others, without the proverbial hay, Google would not exist. But at the same time, as the Belgian publishers learned eight years ago, any one publication is but a single haystalk, easily blown by the wind or trampled underfoot, and no one cries – or worse, even notices – when it is gone. Certainly not Google, and certainly none of the advertisers who provide the money to which the German publishers wrongly feel they are entitled.

Facebook Launches Google+, and the Week in Daily Updates

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The main page content on Stratechery is free for all readers, but I also offer the Daily Update via email and RSS for $10 per month/$100 per year.1 This is one of the items sent out in this week’s Daily Updates. To sign up, visit the Membership page

Facebook Launches Google+ Slingshot

I would love to go back in 2011 and have been a fly on the wall at Facebook HQ during the unveiling of Google+. Was Mark Zuckerberg nervous? Amused? Angry? It’s hard not to think of that comparison in light of Facebook’s latest product announcement. Consider this New York Times story about the launch of Google+:

At first, Google+ looks like a shameless Facebook duplicate. There’s a place for you to make Posts (your thoughts and news, like Facebook’s Wall); there’s a Stream (an endless scrolling page of your friends’ posts, like Facebook’s News Feed); and even a little +1 button (a clone of Facebook’s Like button), which may be where Google+ gets its peculiar name. But there’s one towering, brilliant difference: Circles.

Compare that to this Verge piece about Slingshot, Facebook’s new Snapchat competitor:

At first, Facebook’s new ephemeral messaging app, Slingshot, feels like yet another Snapchat clone. The free app, available now for iPhone and Android, lets you take a quick photo or video, mark it up with some colorful drawings, caption it with big white text, and then fire it off to a bunch of friends. But then you receive your first message, and you realize this is something completely different.

I promise you, I did not alter a single word in either quote. They sound the same because both products share an origin story: their parent companies need them to exist, not because there is some sort of consumer need. That is why both slavishly copy the products they are challenging, plus, of course, some random new feature that theoretically makes sense but in practice adds complexity; after all, both Google+’s Circles and Slingshot’s pay-to-play mechanic are quite literally complexity for complexity’s sake (or, as Google/Facebook would characterize it, “differentiation”).

More broadly, back in the day when businesses were the primary market for technology, a fast-follower strategy made a ton of sense: channel and distribution matter more than anything in those markets, and market leaders could leverage their assets in those areas to successfully bring rip-offs to market. Things are much different in the consumer market, though, especially if you are dealing with network effects. I cannot think of a single example of an incumbent company successfully displacing a startup’s social network; Facebook was onto something when they decided to simply open up the wallet for companies like Instagram and WhatsApp.

Probably the optimal strategy for incumbents, as pointed out by Hunter Walk on Twitter, is something more like Google Ventures: let startups do their thing, get an early view into what is going on, and then buy what looks promising. I suspect it’s not entirely coincidental that Goole tripled their annual investment into Google Ventures in 2012, at which time it was already clear that Google+ was a failure as a social network (as I’ve noted several times, it was still a great success as a unified identity system).

Anyhow, I’m looking forward to the upcoming onslaught of “Remember Slingshot” snark. In fact, let me go first: “Slingshot is so ephemeral it made itself disappear!”

Sorry, that was weak.

The full list of topics covered this week in the Daily Update include:

  • Bitcoin Breached
  • China to Crack Down on iMessage
  • Amazon’s PR Runup
  • Box Acquires Streem
  • Priceline Acquires OpenTable
  • Privacy is Dead Follow-up
  • Facebook Launches Google+
  • Praising Adobe
  • Yo
  • Facebook Wedge
  • Intel to Offer Customizable Chips
  • Fire Phone Follow-up
  • T-Mobile Test Drive
  • Adobe’s New Business Model Part 2

To read all of these updates and to receive future updates, please visit the membership page and sign up!

I’d like to thank all of Stratechery’s subscribers for their support, and for making this site possible.

  1. There is also an access option for $30 per month/$300 per year which gives you access to me personally to ask about the topic of your choosing, a private message board, and virtual and in-person meetups ↩

Podcast: Exponent 007 – "Growing Up" v "Hungry and Foolish"

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

There’s a bit of a consensus building post WWDC: Apple has grown up, and it’s great. Consider the conclusion from John Gruber’s excellent piece Only Apple:

New Apple didn’t need a reset. New Apple needed to grow up. To stop behaving like an insular underdog on the margins and start acting like the industry leader and cultural force it so clearly has become.

Apple has never been more successful, powerful, and influential than it is today. They’ve thus never been in a better position to succumb to their worst instincts and act imperiously and capriciously.

Instead, they’ve begun to act more magnanimously.

In my own reflection on WWDC – What Steve Jobs Wouldn’t Have Done – I noted that Apple was moving from a place of fear to one of confidence:

By “moving-on” I don’t mean moving-on from Jobs’ death, but rather moving-on from the darkest parts of Apple’s past. Apple is not about to go bankrupt, they hold the power in every partnership they enter, developers around the world desperately want to work with them. It is not 1997, and to make decisions with a 1997 mindset simply doesn’t make sense.

In short, perhaps my fears for Apple’s future were precisely backwards: Apple didn’t need to always remember 1997; in fact, they needed to forget. And so they have.

There is something deeply satisfying about this type of analysis. The idea of the brilliant but wayward adolescent, finally pulling together her immense talents, and truly reaching her potential. It’s something to which we can all relate, and, surprisingly, it’s something to which other companies can relate as well. From the New York Times in 2002:

Yet only after fighting the biggest antitrust case in a century has it begun to sink in with Ballmer that in most ways he has already won, and that with victory he might be expected to behave less like a petulant adolescent and more like a statesman, comfortable in his power. Recently, in the span of one week, Microsoft first received the news that a federal judge approved the company’s settlement with the Justice Department and rejected the remaining suits by individual states, then came out with a powerful new-product launch, its much hyped Tablet computers. Both of these developments indicate that the company is exiting the fog, legal and otherwise, of the last few years and is entering a period that will largely be shaped by Ballmer. With his schedule rigorously organized, his managerial duties more defined than ever and his personality in a state of self-imposed overhaul, he aims to prove that he can be a different person and that the Microsoft Bill Gates has essentially handed over to him can be a different company.

To be clear, Apple is not Microsoft. But why? And is it possible that something essential has been lost?

In this episode we examine what it is that makes Apple unique, and why things might turn out different this time – and why they might not.

(In addition, we discuss the end of privacy and what might be done about it.)

Links

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Amazon’s Whale Strategy

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A week before yesterday’s launch of the Fire Phone, Amazon sent all of the attendees a copy of the children’s book “Mr. Pines Purple House” with a note from Jeff Bezos stating:

I think you’ll agree that the world is a better place when things are a little bit different.

Beyond the book, the first thing different about the event was that it was open to the general public. Over 60,000 people ended up applying to attend, and Amazon opened the event with a video featuring several of those applicants. The message was clear: this event was about, and for, Amazon’s most loyal customers. And so is the Fire Phone.

It’s not the Phone that’s Different; It’s the Strategy

At first glance, there is very little about the phone that feels different, at least in the ways that matter. Firefly is compelling, while Dynamic Perspective feels like a whole lot more trouble that it’s worth – both for Amazon and for end users. The camera looks impressive, and unlimited cloud storage is indeed a feature all smartphones should have. Still, much of this is at the margins: what we expected from Amazon was along the lines of Jeff Bezos’s promise for the Fire tablet line: “Premium products at non-premium prices.”

Instead the Fire Phone is right up there with an iPhone 5S when it comes to price,1 and it’s sold with the exact same contract you would get with that iPhone.2 There is no margin compression, no subsidized data. There’s nothing different at all. Unlike the Fire tablets, which most assume are sold at near cost in order to drive usage of Amazon’s services – especially Prime video and Kindle books – the Fire phone seems unlikely to attract any new customers to the Amazon ecosystem. And perhaps, that is what makes it so different: the Fire Phone seems to be not only a different strategy for Amazon, but a new kind of smartphone strategy full-stop.

How Will Amazon Ultimately Make Money?

The chief question observers have about Amazon is when exactly they will start making profits, and, more importantly, how. Last quarter Amazon made a mere $108 million on $19.74 billion in sales, good for a price-to-earnings ratio of over 500. While some have suggested that Amazon is trying to eliminate competitors so it can raise prices, it seems much more likely that a significant raise in Amazon’s prices would cost them more customers than it would be worth.

A more plausible argument Amazon’s eventual profitability is predicated on their total revenue and gross margins; while Amazon’s net margin last quarter was only 0.5%, its gross margin was a healthier 28.8%, which comes out to $5.69 billion in gross profit. Were less of that gross profit invested in growth, Amazon could very quickly begin generating significant return for shareholders. Still, though, this suggestion isn’t entirely satisfactory either: slowing investment works in the short-term, but Jeff Bezos is famously long-term focused, and over time less investment would lessen Amazon’s competitive advantages.

The Whale Strategy

The Fire Phone’s high price highlights what may be a third way: call it the whale strategy, for it entails a disproportionate amount of profit being generated by the same sorts of loyal customers who opened yesterday’s Keynote. In this view, instead of the Fire Phone being a means of driving e-commerce, e-commerce is in fact a means of capturing customers and building loyalty; Prime deepens the connections, and the profitability; and at the final stage, the Fire Phone makes more profit in a single purchase than anything that came before, even as it drives an even deeper connection with the customer.

It helps to look at this strategy as a sort of funnel:

Amazon Whales are the top one percent: Prime subscribers who buy the Fire Phone
Amazon Whales are the top one percent: Prime subscribers who buy the Fire Phone

Looking at the actual numbers involved makes this implications of this strategy even clearer:

Screen Shot 2014-06-19 at 11.20.54 PM

Various reports suggest that Prime subscribers make up about 10% of all Amazon shoppers. Presuming that is the case, and that 10% of Prime subscribers buy the Fire Phone, Fire Phone buyers could make up 4% of Amazon’s gross profit despite being only 1% of Amazon’s customers.3 Moreover, nearly 40% of that additional profit would be derived solely from the phone itself. In fact, the incremental $150 dollars in annual phone profit (spreading out the expected $300 gross margin over two years) would have the same impact as converting 2.5 normal shoppers to Prime subscribers.

Ultimately, this may be Amazon’s endgame: unlike Apple, a vertical company which offers services to differentiate its phones, or Google, a horizontal one that offers services to everyone, and phone software for free to ensure access, Amazon is offering a phone to more fully monetize a segment of its broad base of e-commerce customers, and maybe, at long last, turn some sort of profit.

Will It Work?

I have admittedly gone out of my way here to paint a strategy that makes sense of Amazon’s announcement yesterday. In truth, I’m a bit more skeptical.

Amazon has always had a unique relationship to the physical world: from a consumer perspective they’re totally virtual, yet their primary business is things you can actually touch. In that sense something like the Fire phone is perfect for Amazon: it tightly binds the virtual to not only what is on your computer screen, but to what is on your hand, and with Firefly, most of the objects you interact with everyday.

The question, though, is if the Fire phone is perfect for Amazon’s customers. Just because someone loves Amazon doesn’t mean their entire life is about buying things. And while it’s true that Amazon has gone to great lengths to make the Fire Phone compelling as a phone, it’s still an inferior offering as compared to a high-end Android phone or especially an iPhone when it comes to things like apps. In this respect it’s fair to compare the Fire Phone to Facebook Home and the HTC First: just because people love Facebook didn’t mean they wanted Facebook to dominate their phone, and by extension, their lives.

Moreover, I was troubled by the faint sense of hubris in yesterday’s presentation; it was 45 minutes too long and included far too much self-congratulation and navel-gazing. We get that the design process for Dynamic Perspective was hard, but that doesn’t mean we care. More broadly, Amazon is a horizontal company: they ought to be serving everyone. Having their own phone introduces the wrong sort of incentives when it comes to Amazon’s efforts on Android and the iPhone; it’s the same danger I see in Microsoft focusing on both services and devices.

Ultimately, I think Amazon would have been better off investing the considerable time and effort it took to bring the Fire Phone to market into better marketing Prime, as well into a concerted campaign to get users to add and use an Amazon app – with Firefly functionality – on their smartphones. Those Apple-like phone margins may look attractive in the short term, but hasn’t Amazon always been the king of the long term?4

  1. The base model does have double the storage ↩

  2. Amazon is severely constrained by virtue of the fact they primarily compete in the US; because of subsidies, it is very impossible to undercut other phones in price, and mid-range phones are especially handicapped when iPhones are available for $200 out-of-pocket ↩

  3. Other assumptions and references:

    • The numbers for annual e-commerce spend for normal and Prime subscribers are from this Quartz article
    • I assumed the Fire Phone buyers would further increase their ecommerce spend by the same percentage as Prime subscribers relative to normal shoppers
    • I also assumed the Fire Phone shoppers buy a new phone every two years (and thus divided an estimated $300 gross margin by 2)
    • I did not calculate the profit from any other Fire devices, although Fire Phone buyers are much more likely to have a Fire tablet, Kindle e-reader, and/or Fire TV

     ↩

  4. Yes, you could argue that the Fire Phone is a long term investment ↩

Critiquing Disruption Theory

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Much of the Internet has been abuzz about The Disruption Machine, an essay by Jill Lepore in the New Yorker that seeks to refute Clayton Christensen’s Theory of Disruptive Innovation. From the article:

Most big ideas have loud critics. Not disruption. Disruptive innovation as the explanation for how change happens has been subject to little serious criticism, partly because it’s headlong, while critical inquiry is unhurried; partly because disrupters ridicule doubters by charging them with fogyism, as if to criticize a theory of change were identical to decrying change; and partly because, in its modern usage, innovation is the idea of progress jammed into a criticism-proof jack-in-the-box.

Sadly, Lepore’s criticism applies just as well to her own essay. While Lepore fairly points out problems with some of the studies underpinning Christensen’s work, much of the essay is filled with her own hand-picked examples, ridicule of theory adherents, and most troubling, a total conflation of not only the different types of disruption (new market versus low-end), but also of the theory as laid out by Christensen with the overuse of the word by all manner of commentators, consultants, and marketing executives.

In response there have been several good critiques of Lepore’s article, including:

  • “The Easy Target that is the Theory of Disruption” by Joshua Gans (link), which distinguishes between disruption as descriptor and disruption as predictor
  • “Disruption is a dumb buzzword. It’s also an important concept” by Timothy Lee (link), which takes Lepore to task for attempting to suggest journalism isn’t subject to disruption (which is where Lepore’s essay really lost its way)
  • “The New Yorker Thinks Disruptive Innovation Is a Myth” by Will Oremus (link), which is a bit more irreverent, but rightly calls out the other hand-waving aspects of Lepore’s essay

Still, though, Lepore is on to something; there is a critique to be made that avoids cheap lines like “Disruption is a theory of change founded on panic, anxiety, and shaky evidence” and instead carefully considers where the theory falls short and seeks to understand why. In fact, I made such a critique here on this blog, in a post entitled What Clayton Christensen Got Wrong:

Christensen has two theories of disruption.

The original theory of disruption, now known as new market disruption, was detailed in Christensen’s seminal paper Disruptive Technologies: Catching the Wave and expanded on in the classic book The Innovator’s Dilemma.1 Based primarily on a detailed study of the disk drive industry, the theory of new market disruption describes how incumbent companies ignore new technologies that don’t serve the needs of their customers or fit within their existing business models. However, as the new technology, which excels on completely different attributes than the incumbent’s product, continues to mature, it eventually takes over the market.

This remains an incredibly elegant and powerful theory, and I fully subscribe to it. We are, in fact, seeing it in action with Windows – the incumbent – and the iPad and other tablets; new technology that is inferior on attributes that matter to Windows’ best customers, but superior on other attributes that matter to many others. (My belief in this theory is why I have been, to my own personal surprise, more sympathetic to Steve Ballmer – here and here – than most).

It is Christensen’s second theory of disruption – low-end disruption – that I believe is flawed. Christensen first described this theory in Disruption, Disintegration and the dissipation of differentiability, and expanded on it in The Innovator’s Solution. It is this theory that is at the basis of Christensen’s critique of Apple.

Briefly, an integrated approach wins at the beginning of a new market, because it produces a superior product that customers are willing to pay for. However, as a product category matures, even modular products become “good enough” – customers may know that the integrated product has superior features or specs, but they aren’t willing to pay more, and thus the low-priced providers, who build a product from parts with prices ground down by competition, come to own the market. Christensen was sure this would happen with the iPod, and he – and his many adherents – are sure it will happen to the iPhone.

In other words, it’s not enough to say the iPhone has saturated the high end market and that growth will slow; rather, the iPhone will soon overshoot customers completely, and will in fact plummet in total sales in the face of good-enough Androids available for hundreds of dollars less than the overpriced iPhone 5C.

The Flaw in the Theory

Interestingly, Christensen himself laid out his theory’s primary flaw in the first quote excerpted above (from 2006):

You also see it in aircrafts and software, and medical devices, and over and over.

That is the problem: Consumers don’t buy aircraft, software, or medical devices. Businesses do.

Christensen’s theory is based on examples drawn from buying decisions made by businesses, not consumers.2 The reason this matters is that the theory of low-end disruption presumes:

  • Buyers are rational
  • Every attribute that matters can be documented and measured
  • Modular providers can become “good enough” on all the attributes that matter to the buyers

All three of the assumptions fail in the consumer market, and this, ultimately, is why Christensen’s theory fails as well. Let me take each one in turn:

You can read the entire critique here.

  1. Disclosure: Amazon Associate link ↩

  2. The original article looked at disk drives, PCs (more on those in a moment), mortgage banking, microprocessors, and software ↩

Privacy is Dead

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According to a new study, customers are very concerned about their privacy. From the New York Times write-up:

People around the world are thrilled by the ease and convenience of their smartphones and Internet services, but they aren’t willing to trade their privacy to get more of it.

That is the top-line finding of a new study of 15,000 consumers in 15 countries. The privacy paradox was surfaced most directly in one question: Would you be willing to trade some privacy for greater convenience and ease? Worldwide, 51 percent replied no, and 27 percent said yes. (The remainder had no opinion or didn’t know.) There were country-by-country differences, but there was a consistency to the results, especially in the developed nations…

When asked to name the leading threats to online privacy in the future, 51 percent of the global panel of consumers picked “businesses using, trading or selling my personal data for financial gain without my knowledge or benefit”…The survey seems to present a grim outlook for data-driven online businesses and marketers.

Coincidentally, on the same day it was revealed that Facebook will use your web browsing history for ad targeting. From Ad Age:

Through its ubiquitous “like” buttons on publisher sites across the web, Facebook has long been able to watch the web surfing behavior of its 1.28 billion monthly users. Soon it will begin to use that information for ad targeting on Facebook…

Facebook is using the passive data — where users go on their PCs and phones — to make its own ads smarter. Advertisers who want to reach Facebook users who are interested in camping, for example, will be able to reach that audience with greater accuracy. “There’s just a more robust set of information that informs that you’re interested in camping,” Mr. Boland said.

So is Facebook doomed? Hardly. The truth is few consumers would be willing to pay the price for true privacy. To understand that price, it is necessary to understand why privacy is dead.

Advertising is Lucrative, and Free Is Often Imperative

The first reason that many sites rely on advertising is that it is simply much more lucrative than charging on a per-user basis. Consider this site: the week I write this, Booking.com is sponsoring Stratechery for $500. If there is a sponsorship every week, that means ~$2,250 in monthly income. I also write the Daily Update for Stratechery members; membership costs $10/month, which means one month of sponsorship has the same income potential as 225 members.

To be clear, while I’m very grateful for my sponsors, I greatly enjoy writing the Daily Update and strongly believe in the member-supported model and am determined to make it work. But it shouldn’t be any surprise that for most sites, the advertisement versus member-support decision isn’t really a decision at all: advertising wins.

There are other services that can’t even realistically choose between advertising and member-supported. Facebook is a great example: the utility of Facebook is directly correlated with how many people you know who are also using Facebook, and the only way to maximize that number is to make the service free, supported by advertising. Google is in a similar boat: the efficacy of search is in many ways tied to how many people are using search. Queries and clicks are the raw grist for Google improving its algorithm, and the more the better, which means making queries free.

Targeting Information is the New Scarcity

The explosion of ad-supported content and ads on the Internet have created a glut of inventory; all things being equal, one piece of inventory is worth the same as another, which is to say worth $0. It’s pricing 101: if supply outstrips demand, the price drops; the flipside of infinite inventory is a price of $0.

When it comes to the price sites or apps can charge for ads, though, the key phrase is “all things being equal.” Some sites, like the New York Times, can charge more based on the the perceived quality of their audience and the prestigiousness of the New York Times brand; others, like Yahoo, can offer wide reach with one ad-buy (although this is worth increasingly less because programmatic buying offers the same scale benefits across a wide array of sites and apps).

The greatest amount of pricing power, though, is commanded by sites that target ads to specific groups. This is why Facebook is such a powerful player in online advertising, and why Google has spent so much time on the Google+ identity system (the social network aspect was only ever frosting on the cake). This means that any site that monetizes through advertising is heavily incentivized to know as much about their customers as possible, and to devise ways to leverage that knowledge into higher rates.1

Many Ad-Supported Apps and Sites Have Significant Consumer Benefit

I just noted that Facebook and Google, in order to function, must be free (and thus ad-supported) in order to offer meaningful social networking and better search, respectively. The biggest beneficiaries, though, are the people who actually use Facebook and Google. Facebook doesn’t seem to get much respect in tech circles, but the truth is it has had and continues to have a more meaningful impact on normal consumers lives than any of the various companies and products that actually get tech people excited. As for Google, I’ve used the product countless times just to write this article; it’s exceedingly difficult to imagine how any of us could function without it.

A whole host of other sites don’t have to be free, but as I noted above the economics lead them to the ad model; ultimately, though, consumers benefit by having access to an astonishing amount of information without paying anything. It’s fine to argue that content in particular should depend on subscribers, but no one person can subscribe to everything.

No Room for Privacy

The net result is an iron circle in which advertisers pay free apps and sites, who in turn provide significant benefit to consumers, who in exchange surrender targeting info about their demographics and preferences:

photo (4)

You cannot take away any one of these components without taking away all of them. Unless we as a society are willing to give up all of the benefits provided by search, social networks, and the free dissemination of information, then we will give up our privacy.

Towards Responsibility

The first step towards dealing with this new reality responsibly is coming to grips with the circle I just illustrated: demanding that all users have zero data collected about them necessarily means choking off much of the consumer benefit provided by the Internet. Those who truly wish to opt-out can opt-out of Facebook, Google, etc. (any objections that this would be unpleasant actually makes my point).

Secondly, there needs to be an industry standard for anonymizing and aggregating data. All of the relevant players claim they do this sort of anonymization and aggregation, but the effectiveness of their methods are a black box. It should be impossible to tie any of this lucrative information to an individual, and in return, apps and sites that ensure this is the case should receive some sort of imprimatur attesting to their responsibility.

Finally, there should be significant resources spent establishing this imprimatur as something worth “paying” for when it comes to consumer attention. Sites and apps should be rewarded for treating information responsibly, with meaningful fines if violations are found.

The devil is certainly in the details of this sort of verification system, but the danger of not working through these issues now are more government impositions along the lines of the recent “Right to be forgotten” decision handed down in the European Union. While that decision is not directly applicable to the issue of collecting and selling user data, it ought to serve as evidence that governments will effect change with the blunt instruments of regulation and judicial decree if we as an industry decline to wield our own scalpels.

A postscript: from what I’ve heard Apple is going to be making a significant marketing push around privacy; the rhetoric at WWDC certainly suggested this was the case. While this is primarily a strategy credit (i.e. the opposite of a strategy tax), it will be interesting to see just how much of an impact it makes on consumers.

  1. To be clear, I don’t collect any user information and don’t share any membership information – and never will. My only selling point to sponsors is the obvious sophistication of a Stratechery reader 🙂  ↩

Podcast: Electric Shadow – Irons in the Fire

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Late last week I joined Moisés Chiullan and Guy English for a podcast that built pretty directly on last week’s Stratechery article How Apple TV Might Disrupt Microsoft and Sony.

We went deep on many of the questions raised on Twitter about the piece, including console lifecycles, the Playstation TV, Metal, and more. Moisés has a lot of experience with the retail side of games, and Guy is a former games developer, which really made for a thoughtful discussion.

Check it out here.

Also, make sure to check out Guy’s latest piece on his blog about Metal, Apple’s new API for gaming.

Xiaomi’s Oversold Global Ambitions, and the Week in Daily Updates

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The main page content on Stratechery is free for all readers, but I also offer the Daily Update via email and RSS for $10 per month/$100 per year.1 This is one of the items sent out in this week’s Daily Updates. To sign up, visit the Membership page

Xiaomi’s Worldwide Ambitions

Bloomberg BusinessWeek has a fairly rapturous profile of the West’s favorite Chinese technology company:

Xiaomi (pronounced she-yow-mee) is one of the fastest-growing tech companies in the world. It’s the sixth-largest handset maker on earth and No. 3 in China, behind Samsung Electronics and Lenovo Group, according to research firm Canalys. Xiaomi’s recent growth is impressive, and its potential is even greater. In 2013, the company says, it sold 18.7 million smartphones almost entirely from its own website, bringing in $5 billion in revenue…

Xiaomi’s real invention is its business model. It sells online, never in stores, and avoids conventional advertising, devoting only about 1 percent of its revenue to marketing. (By comparison, Samsung earmarks 5.4 percent.) Instead, the company relies on China’s social networks, Weibo and WeChat, and the free press Lei gets as a national tech hero. The money Xiaomi saves on marketing lets it buy top-notch components while keeping retail prices down. The Mi 3 costs 1,699 yuan, or $270; the iPhone in China starts at more than twice that. A Mi 3, or any Xiaomi phone, is a great deal if you’re lucky enough to snag one—the latest models routinely sell out. Xiaomi sells handsets in batches, usually of around 100,000. The first Mi 3 release, the company trumpeted, was bought up in only 86 seconds. It’s the technology equivalent of Air Jordans.

Lei’s newest goal is to take Xiaomi beyond China and into Brazil, Mexico, Russia, Turkey, India, and five countries in Southeast Asia. “The creative economy here continues to rise, entrepreneurship is surging, and our innovation abilities are growing,” Lei said in an e-mail translated from Chinese, since he does not speak or write in English. “We’re the world’s largest consumer market. After several decades of effort, this is the trend. Chinese technology companies are coming to the rest of the world.”

There’s no question Xiaomi’s success has been very impressive, but they deserve a lot more scrutiny than this article delivers. A few points worth raising:

  • Xiaomi is not just forgoing retail and marketing expenditures; they are effectively selling phones at cost, which is what keeps their price low. They claim they will make profits on the sale of accessories and Internet services, but while that sounds good in theory (quite literally: Xiaomi is everyone’s example of a company that will disrupt Apple’s hardware-based profits), I would like to see more evidence that they can compete on the bottom line as well as they do on the top.

  • Xiaomi’s brand is very powerful in China, and they use China’s social networks to their advantage, but the flipside of China effectively having its own Internet ecosystem is that none of that extends outside of the country. If Xiaomi is going to compete effectively outside of China, marketing and retail costs will inevitably increase.

  • Note carefully the countries that Xiaomi is expanding to: the unifying feature of them is weak intellectual property regimes, at least relative to the United States or Europe. That is not an accident. IP costs for smartphones are significant even if you have your own patent portfolio to use in cross-licensing; if you don’t have any relevant IP, like Xiaomi doesn’t, then you can’t cross-license and your IP costs can quickly ruin your cost structure. Unless Xiaomi makes a significant acquisition for IP purposes, they won’t be entering the US or European markets any time soon.

I’ve noted this a few times, but that final point is why Lenovo is the more interesting Chinese manufacturer to watch. Their major rationale for doing the Motorola deal was not the brand or assets, but rather gaining cross-licensing rights to the Motorola patents such that their IP costs remain competitive. Xiaomi is absolutely a contender to be taken seriously in China especially, but Lenovo has much more potential in the West.

The full list of topics covered this week in the Daily Update include:

  • The Computex Contrast
  • Big Screens Dominate
  • Xiaomi’s Global Ambitions
  • Max Levchin and Affirm
  • Amazon Expands Payments
  • Facebook Messenger Poaches Paypal Head
  • Alibaba Buys UCWeb
  • Dropbox Buys Mobile Span
  • Will Microsoft Undercut AWS in Price?
  • Twitter’s World Cup Starter Kits
  • Amazon’s Dangerous Tactics
  • LINE Partners with Salesforce
  • Console Follow-up
  • AppleTV Follow-up
  • Twitter COO Resigns

To read all of these updates and to receive future updates, please visit the membership page and sign up!

I’d like to thank all of Stratechery’s subscribers for their support, and for making this site possible.

  1. There is also an access option for $30 per month/$300 per year which gives you access to me personally to ask about the topic of your choosing, a private message board, and virtual and in-person meetups ↩

How Apple TV Might Disrupt Microsoft and Sony

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Beyond the fact most of us had nothing better to do in the 1980s, a big reason to own a gaming console was that they were a phenomenally good deal. In 1985 Nintendo introduced the Famicom to North America as the Nintendo Entertainment System for a mere $199, a remarkably low price considering the average PC cost around $2,400.1 While PC prices soon began to fall, the Playstation/Nintendo 64 generation was still nearly $1,500 cheaper than the average PC.

Over the last two generations of consoles, however, prices have actually risen, and today a Playstation 4 or Xbox One is nearly the same price as an average PC.

PC prices have plummeted while console prices have slowly risen
PC prices have plummeted while console prices have slowly risen

In some respects, this makes no sense: why hasn’t Moore’s law had the same impact on consoles as it has had on PCs? Moreover, when you consider that consoles now compete with a whole host of new time-wasters like phones, tablets, social networks, dramatically expanded TV offerings, the Internet, etc., it’s downright bizarre.

I think the answer lies in a specific part of disruption theory. Specifically, incumbents are driven by their best customers to add more and more features that drive up the price, causing the incumbents’ product to move further and further away from the average customer’s needs (needs which have actually been decreasing as more entertainment options become available):

High-end and low-end customer needs have diverged, and Microsoft and Sony have chased the high-end
High-end and low-end customer needs have diverged, and Microsoft and Sony have chased the high-end

It’s hard to imagine an industry where high-end customers are more vocal and demanding than the console business, and there is no better example of this phenomenon than the Xbox One. Just before last year’s E3, Microsoft formally introduced the Xbox One with a heavy emphasis on its built-in Kinect and entertainment features. While their presentation featured trailers for a few upcoming games, it was clear that Microsoft was finally making a major play for the living room. And, excuse my French, gamers went apeshit.

Beyond the perceived lack of focus on games, gamers objected to the Xbox One’s always-on capabilities (meant to facilitate Kinect voice commands), its DRM, its price ($100 more expensive than the Playstation 4), and, especially, its perceived sacrifices in performance. Sony pounced on gamers’ disgust, using their E3 presentation and launch runup to position themselves as the anti-Microsoft pro-gamer alternative, and successfully so. The Playstation 4 beat the Microsoft One out of the gate, and has only increased its lead since then.

Microsoft, meanwhile, has been backtracking furiously, completely remaking their DRM, making the essential Kinect optional, lowering the price, and this week at E3 focusing on “nothing but games”. From CNet’s coverage of Microsoft’s press conference:

“You are shaping the future of Xbox and we are better for it,” said Xbox head Phil Spencer, the first Microsoft executive to take the stage before the conference launched into its first demo, a gameplay showing of Call of Duty: Advanced Warfare. “We are dedicating our entire briefing to games,” he added to strong applause.

So began a press conference where barely a sliver of time was dedicated to even acknowledging the existence of the Kinect camera and motion sensor, which was unbundled from the Xbox One last month, or any of Microsoft’s original television programming or entertainment features.

Let me be very clear: this is a perfectly rational response by Microsoft, and a strategic disaster, all at the same time. The reason the Xbox existed in the first place was to give Microsoft a toe-hold in the living room. Over time the expectation was that the entertainment aspects of the console would make it appeal to not just gamers, but normal consumers as well. Instead, Microsoft has (understandably) been captured by gamers, and the only purpose their original strategic intent has served has been to make them less competitive with said gamers (the Xbox was more expensive and made different processing choices in order to accommodate the Kinect-centric entertainment focus). Meanwhile, no rational non-gamer will buy an Xbox One for $499 $399 in the face of sub-$100 alternatives like the Apple TV, Kindle Fire TV, or Roku.

Here’s the thing though: I’m not sure that Microsoft’s strategy was wrong, broadly speaking. As I wrote in Black Box Strategy, the TV is worth fighting for:

As I’ve written multiple times, the scarcest resource for consumer tech companies, especially ad-supported ones, is user attention. There are only so many minutes in the day, and their consumption is zero-sum: a moment spent doing activity A is not spent doing activity B, and then that moment is gone.

Meanwhile, TV continues to monopolize a significant amount of that user attention. Although digital products have overtaken the amount of time spent on TV, primarily due to the accretive time spent on smartphones, the absolute time spent on TV has remained stubbornly persistent at about four-and-a-half hours per day per U.S. adult (source).

What Microsoft messed up is the exact thing they seem to always mess up: timing.

Back in 2001, when Xbox launched, console hardware was still not “good enough” for most gamers. The Xbox was big and bulky, with remarkably dated graphics that don’t even stand up to modern smartphones. It made sense to follow the standard console pattern: produce hardware just at the edge of possible, sell it at a loss, and make up the difference through game licensing and bending the cost curve. However, once Microsoft was committed to that pattern, they were stuck with it. And so, it’s 13 years later, and Microsoft (along with Sony and Nintendo) has only launched three consoles.

Compare that to Apple (or Samsung or Nokia), which has launched 8 new iPhones in the last 7 years (plus 7 different iPads in the last 4). True, for most of that time all of those phones and iPads have cost more than a console, and even if Apple has fewer fragmentation issues, there is still tremendous efficiencies to be gained from developers writing for one specific platform.

However, the developer environment has changed as well. In particular, the move to HD graphics increased the cost of development significantly, leading most developers to focus on cross-platform engines that let them easily develop games that ran on Xbox, Playstation and PC. These high costs also began to squeeze out smaller developers and increased the focus on blockbusters – often sequels and formula-type games – that were sure to earn back their investment. Prices of games increased as well – $60 is standard for the current generation – further turning off average consumers.

The net result is that traditional consoles are about as far removed from average consumers as they could be. There is clearly a core gamer market, and Sony and Microsoft are fighting ferociously for it, but no one is growing the pie. I think there is an opening.

Imagine a new TV product, with two models:

  • $99 with a full set of entertainment options, but no gaming
  • $179 with a full set of entertainment options, plus gaming

This TV product would be on an annual release cycle; average consumers would only upgrade every few years (the core OS and most games would support 3 generations), while more serious gamers would upgrade every year providing a nice bit of recurring revenue (this would be much more feasible today, as developers have long since developed the expertise to make games available across multiple architectures). Video games would be delivered not as packaged goods, but rather through an app store. Prices would likely be significantly lower than traditional consoles, but the aforementioned serious gamers would support a higher-price tier for AAA titles and ambitious indies. This console would also integrate seamlessly with the devices carried by many of its potential customers: video and photos could easily be transferred wirelessly, and you could even share screens or use the TV for video calling.

Unlike the current console model, these TV boxes would be sold at a profit. I’ll stop the charade – I’m clearly talking about Apple – so that I can get specific about costs. According to iSuppli, a 16GB iPad Air has a bill of materials of $269. However, that cost includes the following components that would be unnecessary in an Apple TV:

  • $90 Display
  • $43 Touch screen
  • $ 9 Cameras
  • $10 User interface and sensors
  • $ 7 Power management
  • $19 Battery
  • $42 Mechanical/Electro-Mechanical

That leaves a mere $49 in costs! I do think a console needs a controller (in fact, that’s largely the point),2 so let’s add $15, and mechanical/electro-mechanical is obviously not zero (but it’s likely less given there is less need for miniaturization); let’s put that at $25, plus $10 for a power supply. That comes out to $99; add in another $20 for IP, and you’re still talking about a box with a 33% margin. It’s a new growth driver for a company that could use one; more importantly, it increases the value of iPhones and iPads.

I’ve gone back and forth on the Apple TV as a console; there is certainly a strategic incentive to own the TV, and the way to do that is by doing the jobs TV does. Still, though, the timing needs to be right, and now the tech is there, the APIs are there, and more importantly, I believe the market is there:

There is a big market in meeting the needs of lower-end consumers (of which there are many more)
There is a big market in meeting the needs of lower-end consumers (of which there are many more)

Meanwhile, Sony3 and Microsoft will be stuck with increasingly old consoles that are too expensive and, sooner rather than later, less capable than the continually upgraded Apple TV. At that point they will lose the high end gamers as well, and the textbook disruption will be complete.

Update: I wrote a big follow-up to this article in Friday’s Daily Update (members-only), including talk about Nintendo, Playstation TV, the archaic console business model, pricing, and whether or not this will actually happen. Check it out or sign up for a membership.

Update 2: I have changed my mind about the inevitable disruption of consoles. Read Gaming and Good Enough

  1. PC Prices from 1985 to 1995 are from this paper; prices from 1995 to 2005 were found by searching CNet’s archives; prices from 2005 to present from information provided to me by Charles Arthur. I’d also like to thank @typistX for helping me search for data ↩

  2. I’ve gone back-and-forth as well as to whether an iPhone will be the default controller; I think that hurts the value prop, so I’m leaning towards no ↩

  3. To be fair, Sony has released the Playstation TV for $99; although it has some flaws, I think it’s a very smart move that shows some impressive strategic agility. However, I question how much traction they will get: both their traditional retail channels and Sony itself are incentivized to push the PS4, not the Playstation TV ↩

Podcast: Exponent 006 – Product Versus Profit

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

In this episode we discuss why James was less excited by WWDC than was Ben, why the Beats acquisition may actually be a textbook response to the Innovator’s Dilemma, whether Apple has every truly faced disruption, as well as James’ review of Michael Lewis’ Flash Boys.

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