Lessons from Spotify

Posted on

The two dominant business models for venture-backed startups are advertising for consumer-focused companies, and Software-as-a-Service (SaaS) for business-focused ones. On one level, these business models are quite different: the former gives away software for free with the hope of convincing a third party to pay for access to users; the latter charges some portion of users directly. The underlying economics of both, though, are more similar than you might think — indeed, both are very much in line with venture-backed startups of the past.

Venture Outcomes

Silicon Valley is, unsurprisingly given the name, built on silicon-based computer chips, and that goes for Silicon Valley venture capital, as well. Silicon-based chips have minimal marginal costs — sand is cheap! — but massive fixed costs: R&D on one hand, and the equipment to actually make the chips on the other. And while those two costs live on different parts of the income statement — the latter is a cost of revenue that impacts gross margins, while the former is “under the line” and an operational cost that only impacts overall profitability — the fundamental economic rationale for taking on venture capital is the same: spend a lot of money up-front to develop and build a product, and take advantage of minimal marginal costs to make it up in volume.

You can see how this model translated perfectly to software: marginal costs were even lower, and an even greater percentage of costs were R&D. Companies needed lots of money to get started, but those that succeeded could generate returns that vastly exceeded the amount of investment. This is certainly the case for today’s business models.

Advertising-based consumer companies spend huge amount of R&D building products that appeal to users, although usually not a lot on sales and marketing to acquire users; consumer companies that break through to the scale necessary to support advertising rely on viral network effects. Where the sales and marketing spend comes is in courting advertisers; however, the most valuable consumers companies of all — the super-aggregators — generate the same sort of network effects allowing them to add advertisers in a scalable way as well.

This produces the ideal venture outcome: a company where users and revenue grow far more quickly than costs.

Graph of a Venture Company's Costs

Again, this is possible because there are minimal marginal costs — more users are not necessarily more expensive. Of course fixed costs grow over time, but they only grow linearly — earning ever-increasing revenue on a relatively stable cost basis is the definition of scale.

SaaS businesses have the same sort of profile — the big difference is that revenue comes from users, and thus sales and marketing expenses are spent on gaining said users, not advertisers, but minimal marginal costs are the common thread.

Spotify’s Operational Costs

In The Business of SaaS, one of the guides offered by Stripe Atlas, Patrick McKenzie writes:

Margins, to a first approximation, don’t matter. Most businesses care quite a bit about their cost-of-goods-sold (COGS), the cost to satisfy a marginal customer. While some platform businesses (like AWS) have material COGS, at the typical SaaS company, the primary source of value is the software and it can be replicated at an extremely low COGS. SaaS companies frequently spend less than 5~10% of their marginal revenue per customer on delivering the underlying service.

This allows SaaS entrepreneurs to almost ignore every factor of their unit economics except customer acquisition cost (CAC; the marginal spending on marketing and sales per customer added). If they’re quickly growing, the company can ignore every expense that doesn’t scale directly with the number of customers (i.e. engineering costs, general and administrative expenses, etc), on the assumption that growth at a sensible CAC will outrun anything on the expenses side of the ledger.

In other words, operational costs don’t matter in the long run, which is good news for Spotify, a venture-backed company with definite SaaS characteristics that filed for a direct listing last week. Spotify has increased monthly active users by 43% over the last three years and revenue by 448% over the last five; its fixed costs have largely tracked revenue:

SPOTIFY REVENUE AND FIXED COSTS (IN MILLIONS OF EUROS)
Revenue R&D (% Rev) S&M (% Rev) G&A (% Rev) Total (% Rev)
2013 746 73 (10%) 111 (15%) 42 (6%) 226 (30%)
2014 1,085 114 (11%) 184 (17%) 67 (6%) 365 (34%)
2015 1,940 136 (7%) 219 (11%) 106 (5%) 461 (26%)
2016 2,952 207 (7%) 368 (12%) 175 (6%) 750 (25%)
2017 4,090 396 (10%) 567 (14%) 264 (6%) 1,227 (30%)

This looks like a well-managed SaaS company:

Spotify Revenue and Operational Costs

There’s just one problem: Spotify’s marginal costs.

Spotify’s Marginal Cost Problem

It is not exactly groundbreaking analysis to note that Spotify has significant marginal costs — specifically, the royalties it pays the music industry (not just record labels but also songwriters and publishers). Those are represented by Spotify’s Cost of Revenue:

Spotify Revenue and Cost of Revenue

Spotify negotiated new deals with the record labels last summer that resulted in lower royalty rates in exchange for guaranteed subscriber growth and the ability for the labels to make some releases exclusive to Spotify’s paid tier; you can see those lower rates reflected in Spotify’s increased margins.

Spotify’s Missing Profit Potential

That, though, is precisely the problem: Spotify’s margins are completely at the mercy of the record labels, and even after the rate change, the company is not just unprofitable, its losses are growing, at least in absolute euro terms:

Spotify Gross and Net Profit

Moreover, it seems highly unlikely Spotify’s Cost of Revenue will improve much in the short-term: those record deals are locked in until at least next year, and they include “most-favored nation” provisions, which means that Spotify has to get Universal Music Group, Sony Music Entertainment, Warner Music Group, and Merlin (the representative for many independent labels), which own 85% of the music on Spotify as measured by streams, to all agree to reduce rates collectively. Making matters worse, the U.S. Copyright Royalty Board just increased the amount to be paid out to songwriters; Spotify said the change isn’t material, but it certainly isn’t in the right direction either.

That leaves two options:

  • Most obviously Spotify could try and lower its operational costs. This, though, is harder than it might seem for two reasons: first, Spotify is already a pretty frugal company; Dropbox, for example, which filed its S-1 the same week, spends 77% of revenue on operational costs as compared to Spotify’s 30%.
  • Spotify could grow its revenue without increasing its operational costs. How, though, will it grow revenue if it cannot increase its spending on R&D and Sales & Marketing? The typical pattern for non-social network companies is for Sales & Marketing to grow less efficient over time, which means it would need to increase as a percentage of revenue, not decrease (and remember, Spotify can’t afford to miss its growth numbers or its royalty rates go up).

There is one more possibility: Spotify could one day cut out the labels altogether — the idea certainly makes sense on a conceptual level. Spotify is in one sense an aggregator, in that it increasingly controls access to music listeners, and to the company’s credit, it has demonstrated the ability to exercise power via its control of music discovery and popular playlists.

The problem is that the music labels, as I wrote in The Great Unbundling, have been strengthened by Spotify as well:

The music industry, meanwhile, has, at least relative to newspapers, come out of the shift to the Internet in relatively good shape; while piracy drove the music labels into the arms of Apple, which unbundled the album into the song, streaming has rewarded the integration of back catalogs and new music with bundle economics: more and more users are willing to pay $10/month for access to everything, significantly increasing the average revenue per customer. The result is an industry that looks remarkably similar to the pre-Internet era:

Notice how little power Spotify and Apple Music have; neither has a sufficient user base to attract suppliers (artists) based on pure economics, in part because they don’t have access to back catalogs. Unlike newspapers, music labels built an integration that transcends distribution.

Spotify is an impressive product and company, and CEO Daniel Ek and team deserve credit for reaching this point. Being a true aggregator, though, means gaining power over supply; Spotify doesn’t have that — the company doesn’t even have control over its marginal costs — and it’s hard to see where the profits come from.

Lessons from Spotify

The power of the record labels and the resultant linkage of Spotify’s marginal costs to its overall revenue certainly makes Spotify a unique case compared to most zero marginal cost venture-backed companies:

Graph of Company with Marginal Costs Linked to Revenue

It’s worth noting, though, that Spotify is hardly the only well-known startup that has its cost of revenue linked to total revenue — at least from a certain perspective. Over the last few years there has been a third model of startup that has emerged: the so-called sharing economy, or Assets-as-a-Service (AaaS). When you spend $10 on an Uber or Lyft ride, around $7 goes to the driver; when you spend $100 on an Airbnb, $85 goes to the host,1 and so on and so forth.

This isn’t how these companies necessarily keep their books, to be clear: the top line number should exclude whatever is paid out to the driver or host etc. When thinking about how these companies should be managed, though, the situation isn’t much different than Spotify. Specifically:

  • AaaS companies can’t assume that operational expenses are “free”, because gross marginal costs are going to eat up a huge portion of gross revenue growth.
  • AaaS companies should focus Sales & Marketing spending on increasing demand, and allow demand to draw supply. Doing it the other way — spending Sales & Marketing to increase supply in the hope of drawing demand — may make sense competitively, but it is a disaster financially, as the company is basically spending to increase its costs (imagine if Spotify were paying millions to court the record labels!)
  • AaaS companies that can’t lower their operational costs or grow revenue relatively faster than Sales & Marketing will be left rolling the dice on eliminating marginal costs entirely. Granted, self-driving cars or owned-and-operated apartments may both be more viable than getting rid of the record labels, but it still seems a better bet to become far more disciplined when it comes to operational costs.

I still believe in a future where Everything is a Service, and there’s no question that creating networks for everything will need a lot of venture capital. And make no mistake — there will continue to be capital available, because a network, once made, absolutely offers the sort of scalable revenue generation that makes generating significant profits an inevitability.

To that end, it is surely Spotify’s hope that the streaming market ends up being so big that the company’s low gross margin in percentage terms ends up large in absolute ones; even then those profits will come from operational excellence and efficient customer acquisition, not simply top-line growth.

  1. Minus service fees to cover payment processing [↩]

The Dropbox Comp

Posted on

I am usually quite conservative when it comes to how much time, data, and effort I am willing to put into a product from a new startup: too many go out of business or are acquired-and-sunset, and who wants to go to the effort twice?

Dropbox, though, was something else entirely: the initial release in 2008 was so good, and filled such a need, that I switched all of my most important data there immediately and I’ve never left, even though I have lots of free data storage included with other SaaS software plans. Indeed, I was so convinced that Dropbox wasn’t going anywhere that I felt no compunction about using Dropbox (plus a bit of Apple Script) as a de facto syncing system for a school I was working at; it has been ten years, the school has expanded to multiple locations, and every classroom still has the exact same set of files thanks to a product that does exactly what it promises. And now the company behind it is going public — I knew it!

Still, even if the utility and durability of Dropbox’s product was immediately apparent, the long-run trajectory of its business is, even with the release of the company’s S-1, less so.

Dropbox Versus Box and the Question of Lifetime Value

Dropbox and Box have always been compared, and for a rather obvious reason: the core offering of both companies is cloud storage. Said comparison, though, mostly serves to highlight that while the two companies might have similar products, there are so many other ways to be different.

First and foremost, Box has, since the earliest days of the company, been focused on enterprise customers, while Dropbox started out as a consumer product. I explained why this mattered in 2014’s Battle of the Box:

Dropbox’s model makes sense theoretically, but it ignores the messy reality of actually making money. After all, notably absent from my piece on Business Models for 2014 was consumer software-as-a-service. I’m increasingly convinced that, outside of in-app game purchases, consumers are unwilling to spend money on intangible software. That is likely why Dropbox has spent much of the last year pivoting away from consumers to the enterprise.

There are multiple reasons why the latter is a more attractive target for all software-as-a-service companies, especially those focused on data:

  • Consumers need to be convinced of the value of their data…
  • Consumers have multiple free options…
  • Consumers are hard to market to…
  • For consumers, collaboration is an edge case…
  • Building a platform for consumers is incredibly difficult…

I concluded by arguing that $10 million invested in Box at its-then $2 billion valuation was a better bet than the same $10 million invested in Dropbox at its-then $10 billion valuation; given that Box has a $3.2 billion market capitalization while Dropbox is hoping its IPO will clear that same $10 billion mark, I’m (fake) rich!

Dropbox, though, has indeed pivoted: the company said in its S-1:

Of our 11 million paying users, approximately 30% use Dropbox for work on a Dropbox Business team plan, and we estimate that an additional 50% use Dropbox for work on an individual plan, collectively totaling approximately 80% of paying users.

Still, significant differences remain: Dropbox’s customer base, thanks to all those consumers, is over 500 million users (Dropbox announced 500 million signups last March, but explained in its S-1 that it had culled what were apparently ~100 million inactive accounts over the last year), while Box, as of last quarter, had only 57 million registered accounts. On the other hand, 17% of Box’s users had paid accounts; only 2% of Dropbox’s did. This contrast in efficiency gets at the biggest difference between the two companies: to whom they sell, and how they go about doing so.

Box sells to big companies using a traditional sales force; free accounts exist primarily to enable temporary collaboration with paid accounts, as well as trials. There is a self-
serve option, but that’s not the point: Box notes in its financial filings that “Our marketing strategy also depends in part on persuading users who use the free version of our service to convince decision-makers to purchase and deploy our service within their organization”. In other words, when it comes to Box’s ideal customer, the CIO decides for everyone all at once.

For Dropbox, on the other hand, self-serve is the most important channel by far. The company brags that “We generate over 90% of our revenue from self-serve channels — users who purchase a subscription through our app or website.” Dropbox has a sales team, but as it notes in its S-1, the team “focuses on converting and consolidating these separate pockets of usage into a centralized deployment. Nearly all of our largest outbound deals originated as smaller self-serve deployments.”

There are pros and cons to both approaches. Start with the obvious difference: customer acquisition cost. While the two companies spent a comparable amount on sales and marketing in the third quarter of 2017 ($81.7 million for Box, and $74.7 million for Dropbox1), for Box that represented 63% of revenue; for Dropbox it was only 26%.2

However, the two numbers aren’t as comparable as they seem: specifically, Box’s Sales and Marketing includes the infrastructure and support costs of those free users; Dropbox’s doesn’t. Rather, the company includes those costs in its Cost of Revenue, which is a big reasons Dropbox’s gross margin of 68% trails Box’s 73%.3 And, by extension, we don’t really know what Dropbox’s customer acquisition cost is.

There is another advantage of selling to top-down decision-makers: the opportunity to build solutions for specific needs, and charge accordingly. This has enabled Box to achieve negative churn: in all of its cohorts the company is increasing its revenue-per-user by a faster rate than it is losing users overall, which means revenue-per-cohort increases over time. The company explained this in its amended S-1:

Our business model focuses on maximizing the lifetime value of a customer relationship. We make significant investments in acquiring new customers and believe that we will be able to achieve a positive return on these investments by retaining customers and expanding the size of our deployments within our customer base over time…

We experience a range of profitability with our customers depending in large part upon what stage of the customer phase they are in. We generally incur higher sales and marketing expenses for new customers and existing customers who are still in an expanding stage…For typical customers who are renewing their Box subscriptions, our associated sales and marketing expenses are significantly less than the revenue we recognize from those customers.

box1

Box went on to give numbers for specific cohorts; Dropbox, unfortunately, was significantly less specific:

As we continue to innovate and optimize our go-to-market strategy, we have successfully increased monetization for subsequent cohorts. Comparing January cohorts from the last three years, at virtually every point in time after signup, the January 2017 cohort generated a higher monthly subscription amount than the January 2016 cohort, which in turn generated a higher monthly subscription amount than the January 2015 cohort.

This sounds good, until you actually try to figure out what it means. Is the January 2017 cohort monetizing more because users are paying more quickly, or because there are more users? How many of those users are churning, and is there an increase in revenue-per-customer to counteract that?

Dropbox’s S-1 doesn’t give the answer to the first two questions, but the answer to the third seems to be “no”. Average revenue per paying user is actually down from 2015 ($113.54 to $111.91), although slightly up from 2016 ($110.54). Given the model, though, this isn’t a surprise: the only way to serve a massive user-base efficiently is to have a fairly standardized offering; creating and selling differentiating features that increase the average revenue per paying customer doesn’t scale.

There is one other big advantage in terms of Dropbox’s model, at least from a founder and early investor perspective: the tradeoff of Box earning ever-increasing amounts of revenue per paying customer is the amount it takes to land that customer in the first place. This is why Box’s losses were so large, and why founder and CEO Aaron Levie was so diluted by the time the company finally IPO’d (Levie owned just over 5% of Box at the time of IPO). Dropbox founder and CEO Drew Houston, on the other hand, still owns 25%, and early investor Sequoia Capital another 23%; a founder retaining that much ownership is much more characteristic of a consumer company than an enterprise one — which is exactly how Dropbox started.

Dropbox Versus Atlassian and the Question of Market Size

Still, Houston’s ownership stake pales in comparison to Scott Farquhar and Mike Cannon-Brookes, co-founders and co-CEOs of Atlassian, who owned 37.7% of the company each when it IPO’d two years ago. Not coincidentally, Atlassian was very much a pioneer in the self-serve model when it comes to enterprise software, and as I wrote at the time of their S-1, it helped that the company was selling to developers:

Agile was largely developer-driven, another factor that worked in JIRA and Atlassian’s favor. Developers are, quite obviously, much more willing to do their own research on products, download and trial software from the Internet, and if they like it, proselytize to other developers even if they don’t work for the same company. In other words, of all the different types of enterprise software, development tools are uniquely suited to spreading somewhat virally without the need for a traditional sales force.

One of the big questions at the time of Atlassian’s IPO was just how big their market was — specifically, could the company start selling beyond its developer base? So far the results are encouraging: JIRA Service Desk, the company’s attempt to expand its JIRA project management software to non-developer teams, is in over 25,000 organizations, and the company overall continues to grow both by adding new customers and by selling more products to existing customers.

This is the second question for Dropbox, beyond the uncertainty around its customer acquisition costs and churn: to what extent can it expand its market? On the positive side, those 500 million users are all potential customers; on the other, the vast majority of them have avoided paying for ten years — the proportion of paid users has barely budged over time. And again, Dropbox hasn’t developed ways for its already paying customers to pay it more.

The potential is certainly there: note that Atlassian’s growth, with a similar model to Dropbox’s, is far out-pacing Box’s — 42% in 3Q 2017 (Atlassian’s FY Q1 2018), compared to 26% — but then again it is far out-pacing Dropbox’s 30% as well. That Dropbox’s revenue growth is slowing suggests the company is ultimately a niche player.

Dropbox Versus Slack and the Question of the Enterprise OS

I once thought that Dropbox — and Box, for that matter — could be more than that; in 2014 I wrote Box, Microsoft, and the Next Enterprise Platform:

Pure storage isn’t a great business. The cost is trending towards zero, as noted by Levie himself. Data, though, is priceless; it can’t be replaced, and it’s the essence of what makes a particular organization unique…Just because the operating system is no longer the platform does not mean that the need – and opportunity – for a platform does not exist. Something needs to tie together all those computing devices, and data, which needs to be everywhere, is the logical place to start.

Dropbox made a similar argument in its S-1:

Our modern economy runs on knowledge. Today, knowledge lives in the cloud as digital content, and Dropbox is a global collaboration platform where more and more of this content is created, accessed, and shared with the world. We serve more than 500 million registered users across 180 countries…

Our market opportunity has grown as we’ve expanded from keeping files in sync to keeping teams in sync. Today, Dropbox is well positioned to reimagine the way work gets done. We’re focused on reducing the inordinate amount of time and energy the world wastes on “work about work” — tedious tasks like searching for content, switching between applications, and managing workflows.

The shift in focus from data to people is one I made myself in 2015; commenting on that Box OS article above, I wrote:

I think, in retrospect, I outsmarted myself: companies aren’t made of data, they’re made of people, just like every other single institution on earth. And, as I noted in the context of Facebook, what people love to do, more than anything else in the world, is communicate. Why wouldn’t you start there?

To that end Dropbox is marketing itself to investors as a collaboration company, and heavily emphasizing Dropbox Paper. In the meantime, though, another company — the one I was writing about in that excerpt — has entered the scene: Slack.

It’s hard to see anyone — including Microsoft — having a bigger opportunity than Slack.4 The trend in every aspect of computing is higher and higher levels of abstraction, and that doesn’t apply just to things like programming languages. In the case of platforms, the operating system of the PC used to really matter, and then the Internet came along and it didn’t. Similarly, in mobile, the operating system, whether that be iOS or Android, used to really matter, but now it doesn’t. In the consumer space, Facebook or WeChat runs on both, and that is far more important to the day-to-day experience of the vast majority of people.

It turns out that “mobile” is not about devices, but rather, at a fundamental level, about computing anywhere; to differentiate between PCs or phones is an ultimately meaningless exercise. They are simply different form factors of effectively identical devices, the purpose of which is to connect us to the cloud (consumer or enterprise). And, by extension, if the device is simply an implementation detail, then the operating system that runs on that device is a detail of a detail.

What matters — what always matters! — is what actual users want to do, and what jobs they want to accomplish. And, whatever they want to do almost certainly involves communicating, which means Slack and its competitors are the best-placed to be the foundational platform of the cloud epoch. More broadly, humans are social creatures: why should we be surprised that social networks are primed to be the most important businesses of all?

It’s been two years since I wrote that, and while Slack is still growing, albeit more slowly, the question of which company controls the future of enterprise computing remains an open one. Is it Amazon via infrastructure, Microsoft via infrastructure and identity and email, Slack via chat? Google via all-of-the-above?

What seems clear is that it won’t be Dropbox — both because files weren’t the right route and also because the company spent far too much time and energy chasing a non-existent consumer opportunity — but that’s ok. There is still value — at least $10 billion in value, I’d bet — in doing a job and doing it well, whether that be as a startup in 2008 or a public company in 2018. We still need to share files (and yes, collaborate on them), and will need to do so for a very long time, and Dropbox does it better than anyone. I just wish Dropbox’s S-1 didn’t make it so difficult to figure out just how much value there might be.

  1. This number jumped to $102.9 million in the fourth quarter, which is a much larger jump than any previous fourth quarter, perhaps in anticipation of the IPO filing [↩]
  2. Per the previous footnote, in the fourth quarter sales and marketing was 34% of revenue [↩]
  3. More on Dropbox’s dropping Cost of Revenue tomorrow [↩]
  4. Note that I said “opportunity”; opportunity means it’s possible, not that it’s necessarily going to happen [↩]

The Aggregator Paradox

Posted on

Which one of these options sounds better?

  • Fast loading web pages with responsive designs that look great on mobile, and ads that are respectful of the user experience
  • The elimination of pop-up ads, ad overlays, and autoplaying videos with sounds

Google is promising both; is the company’s offer too good to be true?

Why Web Pages Suck Redux

2015 may have been the nadir in terms of the user experience of the web, and in Why Web Pages Suck, I pinned the issue on publishers’ broken business model:

If you begin with the premise that web pages need to be free, then the list of stakeholders for most websites is incomplete without the inclusion of advertisers…Advertisers’ strong preference for programmatic advertising is why it’s so problematic to only discuss publishers and users when it comes to the state of ad-supported web pages: if advertisers are only spending money — and a lot of it — on programmatic advertising, then it follows that the only way for publishers to make money is to use programmatic advertising…

The price of efficiency for advertisers is the user experience of the reader. The problem for publishers, though, is that dollars and cents — which come from advertisers — are a far more scarce resource than are page views, leaving publishers with a binary choice: provide a great user experience and go out of business, or muddle along with all of the baggage that relying on advertising networks entails.

My prediction at the time was that Facebook Instant Articles — the Facebook-native format that the social network promised would speed up load times and enhance the reading experience, thus driving more engagement with publisher content — would become increasingly important to publishers:

Arguably the biggest takeaway should be that the chief objection to Facebook’s offer — that publishers are giving up their independence — is a red herring. Publishers are already slaves to the ad networks, and their primary decision at this point is which master — ad networks or Facebook — is preferable?

In fact, the big winner to date has been Google’s Accelerated Mobile Pages (AMP) initiative, which launched later that year with similar goals — faster page loads and a better reading experience. From Recode:

During its developer conference this week, Google announced that 31 million websites are using AMP, up 25 percent since October. Google says these fast-loading mobile webpages keep people from abandoning searches and by extension drive more traffic to websites.

The result is that in the first week of February, Google sent 466 million more pageviews to publishers — nearly 40 percent more — than it did in January 2017. Those pageviews came predominantly from mobile and AMP. Meanwhile, Facebook sent 200 million fewer, or 20 percent less. That’s according to Chartbeat, a publisher analytics company whose clients include the New York Times, CNN, the Washington Post and ESPN. Chartbeat says that the composition of its network didn’t materially change in that time.

This chart doesn’t include Instant Articles specifically, but most accounts suggest the initiative is faltering: the Columbia Journalism Review posited that more than half of Instant Articles’ launch partners had abandoned the format, and Jonah Peretti, the CEO of BuzzFeed, the largest publisher to remain committed to the format, has taken to repeatedly criticizing Facebook for not sharing sufficient revenue with publications committed to the platform.

Aggregation Management

The relative success of Instant Articles versus AMP is a reminder that managing an ecosystem is a different skill that building one. Facebook and Google are both super-aggregators:

Super-Aggregators operate multi-sided markets with at least three sides — users, suppliers, and advertisers — and have zero marginal costs on all of them. The only two examples are Facebook and Google, which in addition to attracting users and suppliers for free, also have self-serve advertising models that generate revenue without corresponding variable costs (other social networks like Twitter and Snapchat rely to a much greater degree on sales-force driven ad sales).

Super-Aggregators are the ultimate rocket ships, and during the ascent ecosystem management is easy: keep the rocket pointed up-and-to-the-right with regards to users and publishers and suppliers will have no choice but to clamor for their own seat on the spaceship.

The problem — and forgive me if I stretch this analogy beyond the breaking point — comes when the oxygen is gone. The implication of Facebook and Google effectively taking all digital ad growth is that publishers increasingly can’t breathe, and while that is neither company’s responsibility on an individual publisher basis, it is a problem in aggregate, as Instant Articles is demonstrating. Specifically, Facebook is losing influence over the future of publishing to Google in particular.

A core idea of Aggregation Theory is that suppliers — in the case of Google and Facebook, that is publishers — commoditize themselves to fit into the modular framework that is their only route to end users owned by the aggregator. Critically, suppliers do so out of their own self-interest; consider the entire SEO industry, in which Google’s suppliers pay consultants to better make their content into the most Google-friendly commodity possible, all in the pursuit of greater revenue and profits.

This is a point that Facebook seems to have missed: the power that comes from directing lots of traffic towards a publisher stems from the revenue that results from said traffic, not the traffic itself. To that end, Facebook’s too-slow rollout of Instant Articles monetization, and continued underinvestment (if not outright indifference) to the Facebook Audience Network (for advertisements everywhere but the uber-profitable News Feed) has left an opening for Google: the search giant responded by iterating AMP far more quickly, not just in terms of formatting but especially monetization.

Critically, that monetization was not limited to Google’s own ad networks: from the beginning AMP has been committed to supporting multiple ad networks, which sidestepped the trap Facebook found itself in. By not taking responsibility for publisher monetization Google made AMP more attractive than Instant Articles, which took responsibility and then failed to deliver.1

I get Facebook’s excuse: News Feed ads are so much more profitable for the company than Facebook Audience Network ads, that from a company perspective it makes more sense to devote the vast majority of the company’s resources to the former; from an ecosystem perspective, though, the neglect of Facebook Audience Network has been a mistake. And that, by extension, is why Google’s approach was so smart: Google has the same incentives as Facebook to focus on its own advertising, but it also has the ecosystem responsibility to ensure the incentives in place for its suppliers pay off. Effectively offloading that payoff to third party networks both ensures publishers get paid even as Google’s own revenue generation is focused on the search results surrounding those AMP articles.

Google’s Sticks

Search, of course, is the far more important reason why AMP is a success: Google prioritizes the format in search results. Indeed, for all of the praise I just heaped on AMP with regards to monetization, AMP CPMs are still significantly lower than traditional mobile web pages; publishers, though, are eager to support the format because a rush of traffic from Google more than makes up for it.

Here too Facebook failed to apply its power as an aggregator: if monetization is a carrot, favoring a particular format is a stick, and Facebook never wielded it. Contrary to expectations the social network never gave Instant Articles higher prominence in the News Feed algorithm, which meant publishers basically had the choice between more-difficult-to-monetize-but-faster-to-load Instant Articles or easier-to-monetize-and-aren’t-our-resources-better-spent-fixing-our-web-page? traditional web pages. Small wonder the latter won out!

In fact, for all of the criticism Facebook has received for its approach to publishers generally and around Instant Articles specifically, it seems likely that the company’s biggest mistake was that it did not leverage its power in the way that Google was more than willing to.

That’s not the only Google stick in the news: the company is also starting to block ads in Chrome. From the Wall Street Journal:

Beginning Thursday, Google Chrome, the world’s most popular web browser, will begin flagging advertising formats that fail to meet standards adopted by the Coalition for Better Ads, a group of advertising, tech and publishing companies, including Google, a unit of Alphabet Inc…

Sites with unacceptable ad formats—annoying ads like pop-ups, auto-playing video ads with sound and flashing animated ads—will receive a warning that they’re in violation of the standards. If they haven’t fixed the problem within 30 days, all of their ads — including ads that are compliant — will be blocked by the browser. That would be a major blow for publishers, many of which rely on advertising revenue.

The decision to curtail junk ads is partly a defensive one for both Google and publishers. Third-party ad blockers are exploding, with as many as 615 million devices world-wide using them, according to some estimates. Many publishers expressed optimism that eliminating annoying ads will reduce the need for third-party ad blockers, raise ad quality and boost the viability of digital advertising.

Nothing quite captures the relationship between suppliers and their aggregator like the expression of optimism that one of the companies actually destroying the viability of digital advertising for publishers will actually save it; then again, that is why Google’s carrots, while perhaps less effective than its sticks, are critical to making an ecosystem work.

Aggregation’s Antitrust Paradox

The problem with Google’s actions should be obvious: the company is leveraging its monopoly in search to push the AMP format, and the company is leveraging its dominant position in browsers to punish sites with bad ads. That seems bad!

And yet, from a user perspective, the options I presented at the beginning — fast loading web pages with responsive designs that look great on mobile and the elimination of pop-up ads, ad overlays, and autoplaying videos with sounds — sounds pretty appealing!

This is the fundamental paradox presented by aggregation-based monopolies: by virtue of gaining users through the provision of a superior user experience, aggregators gain power over suppliers, which come onto the aggregator’s platforms on the aggregator’s terms, resulting in an even better experience for users, resulting in virtuous cycle. There is no better example than Google’s actions with AMP and Chrome ad-blocking: Google is quite explicitly dictating exactly how it is its suppliers will access its customers, and it is hard to argue that the experience is not significantly better because of it.

At the same time, what Google is doing seems nakedly uncompetitive — thus the paradox. The point of antitrust law — both the consumer-centric U.S. interpretation and the European competitor-centric one — is ultimately to protect consumer welfare. What happens when protecting consumer welfare requires acting uncompetitively? Note that implicit in my analysis of Instant Articles above is that Facebook was not ruthless enough!

The Ad Advantage

That Google might be better for users by virtue of acting like a bully isn’t the only way in which aggregators mess with our preconceived assumptions about the world. Consider advertising: many commentators assume that user annoyance with ads will be the downfall of companies like Google and Facebook.

That, though, is far too narrow an understanding of “user experience”; The “user experience” is not simply user interface, but rather the totality of an app or web page. In the case of Google, it has superior search, it is now promising faster web pages and fewer annoying ads, and oh yeah, it is free to use. Yes, consumers are giving up their data, but even there Google has the user experience advantage: consumer data is far safer with Google than it is with random third party ad networks desperate to make their quarterly numbers.

Free matters in another way: in disruption theory integrated incumbents are thought to lose not only because of innovation in modular competing systems, but also because modular systems are cheaper: the ad advantage, though, is that the integrated incumbents — Google and Facebook — are free to end users. That means potential challengers have to have that much more of a superior user experience in every other aspect, because they can’t be cheaper.2

In other words, we can have our cake and eat it too — and it’s free to boot. Hopefully it’s not poisonous.

  1. Instant Articles allows publishers to sell their own ads directly, but explicitly bans third party ad networks [↩]
  2. This, as an aside, is perhaps the biggest advantage of cryptonetworks: I’ve already noted in Tulips, Myths, and Cryptocurrencies that cryptonetworks are “probably the most viable way out from the antitrust trap created by Aggregation Theory”; that was in reference to decentralization, but that there is money to be made is itself an advantage when the competition is free. More on this tomorrow. [↩]

Apple’s Middle Age

Posted on

Forgive the personal aside, but our family bought some furniture yesterday, and it wasn’t half bad. We’re moving house, and I’m hopeful it will be the last time for a while; given my personal history that is saying something.

By my count this will be my 12th apartment since I graduated from college, and it never made much sense to invest in anything beyond Ikea. Sure, that number is a bit extreme, but from my perspective the optionality that comes from the willingness to move around was worth the packing pain; now that my kids are in school and my career die cast — at least for the time being — the prospect of staying put for more than a year or two comes as a relief.

In other words, I’m hitting middle age, with the change in circumstances and priorities that entails.

iPod on Windows

Apple, at least in human terms, is officially over the hill: the company’s 40th birthday was last April. In truth, though, the first Apple died and was reborn in 1997 with the return of Steve Jobs, at a time when the company was weeks away from bankruptcy.

The cover of the June, 1997 edition of Wired

What happened next is certainly familiar to everyone reading this: after slashing products and re-focusing the company around a dramatically simplified product line, Jobs shepherded the introduction of the iMac and, three years after that, the iPod. Perhaps no decision looms larger, though, than releasing iTunes — the software yin to the iPod’s hardware yang — for Windows. Erstwhile Apple analyst Gene Munster told the San Francisco Chronicle:

For Apple, the Windows version of iTunes is part of a “very slow but real shift” in strategy, said Gene Munster, senior research analyst with U.S. Bancorp Piper Jaffray. “They’ve tried everything to get their installed base to grow, but it just doesn’t grow. What you’re going to see in the coming years is a different Apple.” Ironically, Munster said iTunes for Windows may ultimately help sell more iPods but fewer Macintoshes, because it works well enough with a PC.

In fact, the opposite occurred — at least in the long run. The iPod took off like a rocket, dominating the portable music industry until it was killed by the smartphone, specifically the iPhone. And, over time, more and more satisfied iPod and iPhone customers began considering Macs; macOS devices have outgrown the overall market (which is shrinking) nearly every quarter for years.

That’s a side story though: while the iPod and the first few editions of the iPhone needed a PC, the latter eventually became independent, an effectively full-fledged computer in its own right. Indeed, most consumer electronics devices now presume that the customer has a smartphone, which makes sense: nearly everyone that has a PC has a smartphone, but there are around a billion people who only have the device in their pocket.

And, come Friday, there will be at least one prominent device for sale that requires not just a smartphone but an iOS device specifically: HomePod.

The HomePod Strategy

The strategy around the HomePod, at least from my perspective, is far more fascinating than the device itself; while it does sound great (at least in the controlled press briefing where I heard it), I have an Echo Dot (and a Google Home-controlled Chromecast, for that matter) connected to my living room stereo that sounds better.

To get a full music library with either, though, requires a separate music subscription — Spotify in my case. And while I am the sort of profitable (for the music industry) idiot that pays for effectively the same service twice,1 most people only subscribe to one music service. And, for iPhone users, which service is that likely to be? Unsurprisingly, given its prominence on the device combined with Apple customer loyalty, the answer, at least in the United States, is increasingly Apple Music. From the Wall Street Journal:

Apple Inc.’s streaming-music service, introduced in June 2015, has been adding subscribers in the U.S. more rapidly than its older Swedish rival — a monthly growth rate of 5% versus 2% — according to people in the record business familiar with figures reported by the two services. Assuming that clip continues, Apple will overtake Spotify in the world’s biggest music market this summer. Apple’s music-streaming service has been quietly gaining ground in part thanks to the popularity of the company’s devices: Apple Music comes preloaded on all iPhones, Apple Watches and other hardware the company sells.

That last sentence explains why this isn’t a surprise; my criticism of Apple Music when it launched was not a statement on whether or not the service would be successful, but whether or not it was worth the trouble, particularly in terms of focus. I wrote in a Daily Update later that year:

One interesting angle to [a Taylor Swift exclusive] is that the fact Apple Music exists for Android likely makes it much more palatable for Swift than an Apple-specific service would be. But, that leads to the natural question: what ultimate benefit is Apple deriving from however much they are paying Swift, or from Apple Music as a whole? I know many of you are sick of me asking this question, and, in fact, I am an Apple Music subscriber myself: I find the integration with the Apple Watch to be particularly useful when driving around with two music-loving kids in the backseat of my car. My issue, rather, is about opportunity cost: why can’t Apple architect their platform so that other services can fulfill this low-margin middle-person role, freeing up resources to focus on the sorts of things that only Apple can do?

HomePod is the best answer yet, and I have to admit, I’m pretty impressed by Apple’s foresight.

The Apple Music Bridge

One more important piece of background: CEO Tim Cook and CFO Luca Maestri have been pushing the narrative that Apple is a services company for two years now, starting with the 1Q 2016 earnings call in January, 2016. At that time iPhone growth had barely budged year-over-year (it would fall the following three quarters), and it came across a bit as a diversion; after all, it’s not like the company was changing its business model. I wrote at the time:

As I’ve written innumerable times, services (horizontal) and hardware (vertical) companies have very different strategic priorities: the former ought to maximize their addressable market (by, say, making a cheaper iPhone), while the latter ought to maximize their differentiation. And, Cook’s answer made clear what Apple’s focus remains:

Our strategy is always to make the best products…We have the premium part of our line is the 6s and the 6s Plus. We also have a mid-price point, with the iPhone 6 and the iPhone 6 Plus. And we continue to offer the iPhone 5s in the market and it continues to do quite well. And so we offer all of those and I don’t see us deviating from that approach.

To be clear, I think this is the exact right approach for Apple…But let’s be honest: that means Apple is not a services company; they have a nice services revenue stream, but the company is rightly judged now and for the foreseeable future on the performance of its hardware.

I still think this was the right strategic analysis — Apple’s services differentiate its hardware, as opposed to its hardware existing to push Apple’s services — but it was the wrong financial analysis: Apple’s services may be exclusive to Apple devices,2 but Apple’s install base is so large — 1.3 billion devices, according to Thursday’s 1Q 2018 earnings call — that Services revenue will inevitably rise with a user base that is both growing in terms of numbers and usage, and that is meaningful indeed ($8.5 billion last quarter alone).

Apple Music, though, simply isn’t that meaningful financially, though, no matter how fast it has grown: 36 million at $10/month each is just over $1 billion in revenue a quarter (likely less, given that user number includes folks on family plans); more importantly, actual profit may very well be negative, given that the vast majority of revenue goes to record labels and publishers (as a point of comparison, Spotify is reported to operate in the red). It simply isn’t a part of the Services financial story (which is first and foremost the App Store, followed by Google search payments).

What HomePod shows, though, is that Apple Music is part of the strategy story. Remember, strategically speaking, the point of services is to differentiate hardware. To that end, HomePod is not exclusive to Apple devices to prop up Apple Music; rather, Apple Music is exclusive to HomePod to sell speakers.3 Most commentary has assumed that:

  1. Customer wants HomePod
  2. Therefore, customer subscribe to Apple Music
  3. Apple profits

Again, this doesn’t make sense because Apple Music isn’t profitable!

Instead, I think the order goes like this:

  1. Customer owns an iPhone
  2. Customer subscribes to Apple Music because it is installed by default on their iPhone
  3. As an Apple Music subscriber, customer only has one choice in smart speakers: HomePod (and to make the decision to spend more money palatable, Apple pushes sound quality),4 from which Apple makes a profit

In this view, Apple Music serves as a “bridge” to translate iPhone market share into smart speaker share; services is a means, not an end, which is exactly what we should expect from a company with Apple’s vertical business model.

The Apple Squeeze

This fact — that Apple is a vertical company that makes money by selling hardware at a profit — explains two comments by Cook that stood out on last week’s earnings call.

First was the insistence that analysts evaluate Apple according to iPhones sold per week, not per quarter, the reason being that 1Q 2018 had 13 weeks while 1Q 2017 had 14. That’s fine as far as it goes: Apple sold fewer iPhones last quarter than it did a year ago, but more per week. A year ago, though, Apple was bragging about “all-time unit and revenue records for iPhone”, when in fact the per-week number was lower than 1Q 2016.

Apple’s sudden insistence on per-week numbers is like a company complaining about currency: sure, it matters, but executives only make a big deal out of it when they are trying to divert attention from something else — in this case, stagnant iPhone unit growth.

Why, then, was Apple’s iPhone revenue growth up? Well, when you raise prices and a segment of your customer base will only buy the best, you can achieve higher average selling prices — over $100 higher year-over-year ($796 versus $694) — which means higher revenue.

Charging its best customers more for iPhones wasn’t the only reason Apple’s revenue was higher, though: remember that Apple is making more off of every customer over time via Services. And there is one more piece: Apple is selling its best customers more and more devices.

Devices > Users

This was the second Cook comment that stood out, in response to a question about how many users Apple had (emphasis mine):

We’re not releasing a user number, because we think that the proper way to look at it is to look at active devices. It’s also the one that is the most accurate for us to measure. And so that’s our thinking behind there.

Cook — who repeated the sentiment later in the call — couldn’t have given a more strident example of how every company is best viewed according to the dictates of their business model. If companies are what they measure, then what matters to Apple is the number of devices sold, not the number of users. Indeed, the user is a means to the end of selling a device — and ideally more than one at a time!

Consider nearly every major Apple product announcement of the last decade:

  • iPad: Standalone, but thanks to Apple’s push for unified apps, is immediately rendered more valuable if a customer already owns an iPhone and has bought multiple apps
  • Apple TV: Standalone, but thanks to Apple’s push for unified apps and AirPlay protocol, is immediately rendered more valuable if a customer already owns an iPhone
  • Apple Watch: Only works with an iPhone, which means by definition it can only be sold to an existing Apple customer
  • AirPods: Work with all phones, but better on iPhone, which, conveniently enough, dropped the headphone jack the same time AirPods were announced
  • HomePod: Only works with an iOS device, which means by definition it can only be sold to an existing Apple customer (with Apple Music as a push)

Apple’s growth is almost entirely inwardly-focused when it comes to its user-base: higher prices, more services, and more devices.

Apple’s Middle Age

This is by no means a condemnation of Apple. Every single move I’ve described above is justified by two circumstances in particular.

First, as a general rule, challengers pursue interoperability while incumbents strive for incompatibility. This is Strategy 101: seek to fight battles where you have the greatest advantage. When Apple was making the iPod, its advantage was a superior device; making that device interoperable with Windows let Apple fight the portable music player battle on its terms. Today, though, Apple already has dominant market share: better to make its devices exclusive to its ecosystem, preventing rivals from bringing their own advantage (superior voice assistants, in the case of Alexa and Google Assistant) to bear.

Secondly, the high-end smartphone market — that is, the iPhone market — is saturated. Apple still has the advantage in loyalty, which means switchers will on balance move from Android to iPhone, but that advantage is counter-weighted by clearly elongating upgrade cycles. To that end, if Apple wants growth, its existing customer base is by far the most obvious place to turn.

In short, it just doesn’t make much sense to act like a young person with nothing to lose: one gets older, one’s circumstances and priorities change, and one settles down. It’s all rather inevitable.

Keep in mind, the swashbuckling Apple — the one led by Steve Jobs, not Tim Cook — that looms so large in everyone’s imaginations, couldn’t have had more different circumstance. Jobs was a product and execution genius, but in truth we have no idea how he would deal with the strategy questions facing Cook. Making iTunes for Windows was as correct strategically as is making HomePod exclusive to iOS devices; that the former fits ones’ mental model of how a company “should” operate is a matter of circumstance, not principle.

So it was for every Jobs decision: expanding the iPod market with the Mini wasn’t disrupting itself, it was a means of making more money. An even starker example is the iPhone: cannibalizing oneself is a whole lot less impressive when the cannibalizing product has a higher ASP and higher margins. This is to take nothing away from either decision, simply to note that it’s a lot easier to make decisions everyone loves when the overall market is growing.

The fact of the matter is that Apple under Cook is as strategically sound a company as there is; it makes sense to settle down. What that means for the long run — stability-driven growth, or stagnation — remains to be seen.

  1. My reasoning: Apple Music for the car (Siri integration), and Spotify for everywhere else; Spotify Connect is excellent [↩]
  2. Except for Apple Music on Android [↩]
  3. Sonos does not count! You can’t use voice. In usage it is no different than using another smart speaker via Bluetooth [↩]
  4. You can play other streaming service on HomePod, but only via the increasingly archaic AirPlay protocol; similarly, you can play Apple Music on an Echo or Google Home, but only via the similarly limited Bluetooth protocol [↩]

Amazon Health

Posted on

It’s pretty rare for the same company to feature in two consecutive Weekly Articles; yesterday’s announcement of a health care initiative involving Amazon, though, is not only incredibly intriguing, it also fits directly into some of the most important themes on Stratechery. I couldn’t resist.

The Announcement

From a joint press release:

Amazon, Berkshire Hathaway and JPMorgan Chase & Co. announced today that they are partnering on ways to address healthcare for their U.S. employees, with the aim of improving employee satisfaction and reducing costs. The three companies, which bring their scale and complementary expertise to this long-term effort, will pursue this objective through an independent company that is free from profit-making incentives and constraints. The initial focus of the new company will be on technology solutions that will provide U.S. employees and their families with simplified, high-quality and transparent healthcare at a reasonable cost.

Tackling the enormous challenges of healthcare and harnessing its full benefits are among the greatest issues facing society today. By bringing together three of the world’s leading organizations into this new and innovative construct, the group hopes to draw on its combined capabilities and resources to take a fresh approach to these critical matters…

The effort announced today is in its early planning stages, with the initial formation of the company jointly spearheaded by Todd Combs, an investment officer of Berkshire Hathaway; Marvelle Sullivan Berchtold, a Managing Director of JPMorgan Chase; and Beth Galetti, a Senior Vice President at Amazon. The longer-term management team, headquarters location and key operational details will be communicated in due course.

I’ve gotten more and more questions from readers about the possibilities of Amazon and health care, even before this announcement. I’ve been surprised, to be honest, but perhaps I shouldn’t be: I was the one who declared on The Bill Simmons Podcast that “Amazon’s goal is to basically take a skim off of all economic activity”, and given that health care was 17.9% of GDP in 2016, well, I guess that means I predicted this!

Amazon Health Marketplace

What is “this”, though? It certainly is tempting to jump immediately to a possible end game predicated on the ideas I have laid out in The Amazon Tax, Amazon’s New Customer, and Amazon Go and the Future:

  • Amazon builds out “interfaces” for its employees (as well as those of Berkshire Hathaway and J.P. Morgan Chase — I’ll just refer to Amazon from here on out), both digital and physical, to access basic healthcare needs; these sit in front of pharmacy benefit managers (PBMs), insurance administrators, wholesale distributors and pharmacies.
  • Amazon starts building out infrastructure for those healthcare suppliers, requiring them to serve Amazon’s employees using a standard interface.

Amazon could then go in one of two directions. First, Amazon could start to backwards integrate into its suppliers’ business; there are hints the company is already exploring pharmaceutical sales, and the Wall Street Journal says the idea was broached. That said, I actually think this is less likely; insurance operates best at more scale, not less: first and foremost, the larger the pool, the more risk can be spread, as well as obvious efficiency gains in administration. More scale also gives more bargaining power over other parts of the healthcare chain. Three companies, large though they may be, aren’t going to be as effective as large insurers, no matter how well-managed they may be.

What would make more sense to me is that, having first built an interface for its employees, and then a standardized infrastructure for its health care suppliers, is that Amazon converts the latter into a marketplace where PBMs, insurance administrators, distributors, and pharmacies have to compete to serve employees. And then, once that marketplace is functioning, Amazon will open the floodgates on the demand side, offering that standard interface to every large employer in America.

Aggregation and Suppliers

This is certainly ambitious enough — basically intermediating U.S. employers and the U.S. healthcare industry — but in fact this only sets the stage for the wholesale disruption of American healthcare. First, Amazon could not only open up its standard interface to other large employers, but small-and-medium sized businesses, and even individuals; in this way the Amazon Health Marketplace could aggregate by far the most demand for healthcare.

Consolidating demand by offering a superior user experience is how aggregators gain power; given the scenario I just sketched out, Aggregation Theory has a prediction about what might happen next:

Once an aggregator has gained some number of end users, suppliers will come onto the aggregator’s platform on the aggregator’s terms, effectively commoditizing and modularizing themselves. Those additional suppliers then make the aggregator more attractive to more users, which in turn draws more suppliers, in a virtuous cycle.

This means that for aggregators, customer acquisition costs decrease over time; marginal customers are attracted to the platform by virtue of the increasing number of suppliers. This further means that aggregators enjoy winner-take-all effects: since the value of an aggregator to end users is continually increasing it is exceedingly difficult for competitors to take away users or win new ones.

The key words there are “commoditize and modularize”, and this is where the option I dismissed above comes into play, but not in the way most think: Amazon doesn’t create an insurance company to compete with other insurance companies (or the other pieces of healthcare infrastructure); rather, Amazon makes it possible — and desirable — for individual health care providers to come onto their platform directly, be that doctors, hospitals, pharmacies, etc.

After all, if Amazon is facilitating the connection to patients, what is the point of having another intermediary? Moreover, by virtue of being the new middleman, Amazon has the unique ability to consolidate patient data in a way that is not only of massive benefit to patients and doctors but also to the application of machine learning.

Of course that leaves the insurance piece, which makes Berkshire Hathaway a useful partner; conveniently, Berkshire Hathaway is not in the health insurance business, but rather the health reinsurance business — that is, they insure the insurers. Or, to put it another way, they don’t provide any of the services that Amazon Health Marketplace might make obsolete, and specialize in the one thing Amazon Health Services would need.

Oh, and this will be really expensive, and take years to get off the ground. It certainly would be helpful to have access to financing and capital markets, which means it would be very helpful to partner with JPMorgan Chase & Company. The skills these three companies bring to bear seems far more relevant than the number of employees (and besides, the company alliance approach to traditional health care has been done).

Is This Happening?

Needless to say, what I just sketched out is extremely ambitious; it is easy to let one’s mind run wild when it comes to a company without a name, a management team, or a location. Moreover, the press release was quite modest in its ambitions; I quoted it above, but here is the relevant piece again:

The three companies, which bring their scale and complementary expertise to this long-term effort, will pursue this objective through an independent company that is free from profit-making incentives and constraints. The initial focus of the new company will be on technology solutions that will provide U.S. employees and their families with simplified, high-quality and transparent healthcare at a reasonable cost.

Ah yes, “technology solutions”. We’ve certainly seen that before, and it hasn’t worked.

That, though, is where the previous line comes in: the scenario that I sketched out above is wildly profitable, to be sure, but only years down the road when demand is fully aggregated and Amazon Health Marketplace is taking a skim off of every transaction; if short-term profit isn’t the goal, long-term goals become much more realistic.

And there it is, in the first sentence: “this long-term effort.” These three companies are clear up-front that this isn’t a one-off effort; there is the commitment to the long-term, and while “technological solutions” seems like a short-term play, I just explained why that is the place the start. Aggregators win with products that are simple, high-quality, and easy to understand — exactly what this press release promised.

Is This Possible?

I’m not a healthcare expert by any means; I know enough to know that the U.S. system is incredibly complex, bedeviled by incentive problems, and tied up in all kinds of messy ways with regulations (mostly justified!).

At the same time, the U.S. healthcare system is inextricably tied up with the post-World War 2 order; indeed, the entire reason employers are so important to the system is because of World War 2 regulations that instituted price controls on wages, incentivizing employers to use benefits as a means of attracting workers (this was further enshrined by making healthcare benefits tax-exempt).

That system, though, is under more duress than ever. I wrote in TV Advertising’s Surprising Strength — and Inevitable Fall:

What should be terrifying to television executives is that all of those pieces that make television advertising the gold mine that it has been are under the exact same threat that TV watching itself is: the threat of the Internet. Start with the top 25 advertisers in the U.S.…

Notice that the vast majority of the industries on on this list are dominated by massive companies that compete on scale and distribution. CPG is the perfect example: building a “house of brands” allows a company like Procter & Gamble to target demographic groups even as they leverage scale to invest in R&D, bring down the cost of products, and most importantly, dominate the distribution channel (i.e. retail shelf space). Said retailers, meanwhile, are huge in their own right, not only so they can match their massive suppliers at the bargaining table but also so they can scale logistics, inventory management, store development, etc. Automobile companies, meanwhile, are not unlike CPG companies: they operate a “house of brands” to serve different demographics while benefitting from scale in production and distribution; the primary difference is that they make money through one large purchase instead of over many smaller purchases over time.

Note [that nearly all] of the companies on this list are threatened by the Internet.

My thesis in that article — repeated in Dollar Shave Club and the Disruption of Everything and The Sports Linchpin — is that the post-World War 2 economic system was deeply intertwined and interdependent, and that the root of everything was control of distribution. The Internet, though, made the distribution of information free, upsetting not just information providers like publishers, but all industries; it follows, then, that to the extent that the current health care system is built on that post-World War 2 order, such is the extent to which it is vulnerable.

That is not to say its collapse is imminent — quite the opposite, in fact. Each seemingly distinct industry, by virtue of being interdependent on others, supports each other. My expectation, then, is not that the Internet methodically disrupts industry after industry in some sort of chronological order, but rather that the entire edifice lasts far longer than technologists think, only to one day collapse far quicker than anyone expected.

The ultimate winners of this shakeout, then, are not only companies that are building businesses predicated on the Internet, but just as importantly, are willing and able to build those businesses with the patience that will be necessary to wait for the old order to collapse, particularly if that collapse happens years or decades after the underlying business models are rotten.

There is no more patient company than Amazon.

Amazon Go and the Future

Posted on

Amazon Go is the story of technology, and so is this tweet:

Yesterday the Amazon Go concept store in Seattle opened to the public, filled with sandwiches, salads, snacks, various groceries, and even beer and wine (Recode has a great set of pictures here). The trick is that you don’t pay, at least in person: a collection of cameras and sensors pair your selection to your Amazon account — registered at the door via smartphone app — which rather redefines the concept of “grab-and-go.”

The economics of Amazon Go define the tech industry; the strategy, though, is uniquely Amazon’s. Most of all, the implications of Amazon Go explain both the challenges and opportunities faced by society broadly by the rise of tech.

The Economics of Tech

This point is foundational to nearly all of the analysis of Stratechery, which is why it’s worth repeating. To understand the economics of tech companies one must understand the difference between fixed and marginal costs, and for this Amazon Go provides a perfect example.

A cashier — and forgive the bloodless language for what is flesh and blood — is a marginal cost. That is, for a convenience store to sell one more item requires some amount of time on the part of a cashier, and that time costs the convenience store operator money. To sell 100 more items requires even more time — costs increase in line with revenue.

Fixed costs, on the other hand, have no relation to revenue. In the case of convenience stores, rent is a fixed cost; 7-11 has to pay its lease whether it serves 100 customers or serves 1,000 in any given month. Certainly the more it serves the better: that means the store is achieving more “leverage” on its fixed costs.

In the case of Amazon Go specifically, all of those cameras and sensors and smartphone-reading gates are fixed costs as well — two types, in fact. The first is the actual cost of buying and installing the equipment; those costs, like rent, are incurred regardless of how much revenue the store ultimately produces.

Far more extensive, though, are the costs of developing the underlying systems that make Amazon Go even possible. These are R&D costs, and they are different enough from fixed costs like rent and equipment that they typically live in another place on the balance sheet entirely.

These different types of costs affect management decision-making at different levels (that is, there is a spectrum from purely marginal costs to purely fixed costs; it all depends on your time frame):

  • If the marginal cost of selling an individual item is more than the marginal revenue gained from selling the item (i.e. it costs more to pay a cashier to sell an item than the gross profit earned from an item) then the item won’t be sold.
  • If the monthly rent for a convenience store exceeds the monthly gross profit from the store, then the store will be closed.
  • If the cost of renovations and equipment (in the case of small businesses, this cost is usually the monthly repayments on a loan) exceeds the net profit ex-financing, then the owner will go bankrupt.

Keep in mind, most businesses start out in the red: it usually takes financing, often in the form of a loan, to buy everything necessary to even open the business in the first place; a company is not truly profitable until that financing is retired. Of course once everything is paid off a business is not entirely in the clear: physical objects like shelves or refrigeration units or lights break and wear out, and need to be replaced; until that happens, though, money can be made by utilizing what has already been paid for.

This, though, is why the activity that is accounted for in R&D is so important to tech company profitability: while digital infrastructure obviously needs to be maintained, by-and-large the investment reaps dividends far longer than the purchase of any physical good. Amazon Go is a perfect example: the massive expense that went into developing the underlying system powering cashier-less purchasing does not need to be spent again; moreover, unlike shelving or refrigerators, the output of that expense can be duplicated infinitely without incurring any additional cost.

This principle undergirds the fantastic profitability of successful tech companies:

  • It was expensive to develop mainframes, but IBM could reuse the expertise to build them and most importantly the software needed to run them; every new mainframe was more profitable than the last.
  • It was expensive to develop Windows, but Microsoft could reuse the software on all computers; every new computer sold was pure profit.
  • It was expensive to build Google, but search can be extended to anyone with an Internet connection; every new user was an opportunity to show more ads.
  • It was expensive to develop iOS, but the software can be used on billions of iPhones, every one of which generates tremendous profit.
  • It was expensive to build Facebook, but the network can scale to two billion people and counting, all of which can be shown ads.

In every case a huge amount of fixed costs up front is overwhelmed by the ongoing ability to make money at scale; to put it another way, tech companies combine fixed costs with marginal revenue opportunities, such that they make more money on additional customers without any corresponding rise in costs.

This is clearly the goal with Amazon Go: to build out such a complex system for a single store would be foolhardy; Amazon expects the technology to be used broadly, unlocking additional revenue opportunities without any corresponding rise in fixed costs — of developing the software, that is; each new store will still require traditional fixed costs like shelving and refrigeration. That, though, is why this idea is so uniquely Amazonian.

The Strategy of Technology

The most important difference between Amazon and most other tech companies is that the latter generally invest exclusively in research and development — that is, to say, in software. And why not? As I just explained software development has the magical properties of value retention and infinite reproduction. Better to let others handle the less profitable and more risky (at least in the short term) marginal complements. To take the three most prominent examples:

  • Microsoft builds the operating system (and eventually, application software) and leaves the building of computers to OEMs
  • Google builds the search engine and leaves the creation of web pages to be searched to the rest of the world
  • Facebook builds the infrastructure of the network, and leaves the creation of content to be shared to its users

All three companies are, at least in terms of their core businesses, pure software companies, which means the economics of their businesses align with the economics of software: massive fixed costs, and effectively zero marginal costs. And while Microsoft’s market, large though it may have been, was limited by the price of a computer, Google and Facebook, by virtue of their advertising model, are super-aggregators capable of scaling to anyone with an Internet connection. All three also benefit (or benefited) from strong network effects, both on the supply and demand side; these network effects, supercharged by the ability to scale for free, are these companies’ moats.

Apple and IBM, on the other hand, are/were vertical integrators, particularly IBM. In the mainframe era the company built everything from components to operating systems to application software and sold it as a package with a long-term service agreement. By doing so all would-be competitors were foreclosed from IBM’s market; eventually, in a(n unsuccessful) bid to escape antitrust pressure, application software was opened up, but that ended up entrenching IBM further by adding on a network effect. Apple isn’t nearly as integrated as IBM was back in the 60s, but it builds both the software and the finished products on which it runs, foreclosing competitors (while gaining economies of scale from sourcing components and two-sided network effects through the App Store); Apple is also happy to partner with telecoms, which have their own network effects.

Amazon is doing both.

In market after market the company is leveraging software to build horizontal businesses that benefit from network effects: in e-commerce, more buyers lead to more suppliers lead to more buyers. In cloud services, more tenants lead to great economies of scale, not just in terms of servers and data centers but in the leverage gained by adding ever more esoteric features that both meet market needs and create lock-in. As I wrote last year the point of buying Whole Foods was to jump start a similar dynamic in groceries.

At the same time Amazon continues to vertically integrate. The company is making more and more products under its own private labels on one hand, and building out its fulfillment network on the other. The company is rapidly moving up the stack in cloud services, offering not just virtual servers but microservices that obviate the need for server management entirely. And in logistics the company has its own airplanes, trucks, and courier services, and has promised drones, with the clear goal of allowing the company to deliver products entirely on its own.

To be both horizontal and vertical is incredibly difficult: horizontal companies often betray their economic model by trying to differentiate their vertical offerings; vertical companies lose their differentiation by trying to reach everyone. That, though, gives a hint as to how Amazon is building out its juggernaut: economic models — that is, the constraint on horizontal companies going vertical — can be overcome if the priority is not short-term profit maximization.

Amazon’s Triple Play

In 2012 Amazon acquired Kiva Systems for $775 million, the then-second largest acquisition in company history.1 Kiva Systems built robots for fulfillment centers, and many analysts were puzzled by the purchase: Kiva Systems already had a plethora of customers, and Amazon was free to buy their robots for a whole lot less than $775 million. Both points argued against a purchase: continuing to sell to other companies removed the only plausible strategic rationale for buying the company instead of simply buying robots, but to stop selling to Kiva Systems’ existing customers would be value-destructive. It’s one thing to pay 8x revenue, as Amazon did; it’s another to cut off that revenue in the process.

In fact, though, that is exactly what Amazon did. The company had no interest in sharing Kiva Systems’ robots with its competitors, leaving a gap in the market. At the same time the company ramped up its fulfillment center build-out, gobbling up all of Kiva Systems’ capacity. In other words, Amazon made the “wrong” move in the short-term for a long-term benefit: more and better fulfillment centers than any of its competitors — and spent billions of dollars doing so.

This willingness to spend is what truly differentiates Amazon, and the payoffs are tremendous. I mentioned telecom companies in passing above: their economic power flows directly from massive amounts of capital spending; said power is limited by a lack of differentiation. Amazon, though, having started with a software-based horizontal model and network-based differentiation, has not only started to build out its vertical stack but has spent massive amounts of money to do so. That spending is painful in the short-term — which is why most software companies avoid it — but it provides a massive moat.

That is why, contra most of the analysis I have seen, I don’t think Amazon will license out the Amazon Go technology. Make no mistake, that is exactly what a company like Google would do (and as I expect them to do with Waymo), and for good reason: the best way to get the greatest possible return on software R&D is to spread it as far and wide as possible, which means licensing. The best way to build a moat, though, is to actually put in the effort to dig it, i.e. spend the money.

To that end, I suspect that in five to ten years the countries Amazon serves will be blanketed with Amazon Go stores, selling mostly Amazon products, augmented by Amazon fulfillment centers. That is the other point many are missing; yes, the Amazon Go store took pains to show that it still had plenty of workers: shelf stockers, ID checkers, and food preparers, etc.

Workers as seen from a sidewalk window as they assemble sandwiches in an Amazon Go store Monday, Jan. 22, 2018, in Seattle. More than a year after it introduced the concept, Amazon opened its artificial intelligence-powered Amazon Go store in downtown Seattle on Monday. The store on the bottom floor of the company’s Seattle headquarters allows shoppers to scan their smartphone with the Amazon Go app at a turnstile, pick out the items they want and leave. (AP Photo/Elaine Thompson)

Unlike cashiers, though, none of these jobs have to actually be present in the store most of the time. It seems obvious that Amazon Go stores of the future will rarely have employees in store at all: there will be a centralized location for food preparation and a dedicated fleet of shelf stockers. That’s the thing about Amazon: the company isn’t afraid of old-world scale. No, sandwich preparation doesn’t scale infinitely, but it does scale, particularly if you are willing to spend.

Marx Versus Bezos

The political dilemma embedded in this analysis is hardly new: Karl Marx was born 200 years ago. Technology like Amazon Go is the ultimate expression of capital: invest massive amounts of money up front in order to reap effectively free returns at scale. What has fundamentally changed, though, is the role of labor: Marx saw a world where capital subjugated labor for its own return; technologies like Amazon Go have increasingly no need for labor at all.

Some, certainly, see this as a problem: what about all the cashiers? What about all the truck drivers? What about all of the other jobs that will be displaced by automation? Well, I would ask, what about the labor of Marx’s day, the factory workers borne of the industrial revolution that he thought should overthrow the bourgeoisie?

In fact, they are all gone, replaced by automation. And, in the meantime, nearly all of humanity has been lifted out of abject poverty. As Nicholas Kristof wrote in the New York Times:

2017 was probably the very best year in the long history of humanity. A smaller share of the world’s people were hungry, impoverished or illiterate than at any time before. A smaller proportion of children died than ever before. The proportion disfigured by leprosy, blinded by diseases like trachoma or suffering from other ailments also fell…

Every day, the number of people around the world living in extreme poverty (less than about $2 a day) goes down by 217,000, according to calculations by Max Roser, an Oxford University economist who runs a website called Our World in Data. Every day, 325,000 more people gain access to electricity. And 300,000 more gain access to clean drinking water.

I don’t seek to minimize real struggles, much less the real displacement that will come from technologies like Amazon Go writ large. For decades technology helped the industrial world work better; more and more, technology is replacing that world completely, and there will be pain. That, though, is precisely why it is worth remembering that the world is not static: to replace humans is, in the long run, to free humans to create entirely new needs and means to satisfy those needs. It’s what we do, and the faith to believe it will happen again will be the best guide in figuring out how.

As for Amazon, the company’s goal to effectively tax all economic activity continues apace. Surely the company is grateful about the attention Facebook is receiving from the public, even as it builds a monopoly with a triple moat. The lines outside Amazon Go, though, are a reminder of exactly why aggregator monopolies are something entirely new: these companies are dominant because people love them. Regulation may be as elusive as Marx’s revolution.

  1. The original version of this article mistakenly said then-largest; Zappos was acquired for $900 million in 2009 [↩]