Shopify’s Evolution

Posted on Author by Ben Thompson

Tobi Lütke, who famously started Shopify when he realized that the software he built to run his snowboard shop was a much bigger opportunity than the shop itself, was reminiscing on Twitter about how cheap it used to be to run digital advertising:

This isn’t just a fun story: it’s a critical insight into the conditions that enabled Shopify to become the company that it is today; understanding how those conditions have changed give insight into what Shopify needs to become.

Shopify’s Evolution

Back in 2004 a lot of the pieces that were necessary to run an e-commerce site existed, albeit in rudimentary and hard-to-use forms. One could, with a bit of trouble, open a merchant account and accept credit cards; 3PL warehouses could hold inventory; UPS and Fedex could deliver your goods. And, of course, you could run really cheap ads on Google. What was missing was software to tie all of those pieces together, which is exactly what Lütke built for Snowdevil, his snowboard shop, and in 2006 opened up to other merchants; the software’s name was called Shopify:

Shopify started as the center of multiple third party services

This idea of Shopify as the hub for an e-commerce shop is one that has persisted to this day, but over the ensuing years Shopify has added on platform components as well; a platform looks like this (from The Bill Gates Line):

A drawing of Platform Businesses Attract Customers by Third Parties

The first platform was the Shopify App Store, launched in 2009, where developers could access the Shopify API and create new plugins to deliver specific functionality that merchants might need. For example, if you want to offer a product on a subscription basis you might install Recharge Subscriptions; if you want help managing your shipments you might install ShipStation. Shopify itself delivers additional functionality through the Shopify App Store, like its Facebook Channel plugin, which lets you easily sync your products to Facebook to easily manage your advertising.

A year later Shopify launched the Shopify Theme Store, where merchants could buy a professional theme to make their site their own; now the hub looked like this:

Shopify added two platforms for apps and themes

At the same time Shopify also vertically integrated to incorporate features it once left to partners; the most important of these integrations was Shopify Payments, which launched in 2013 and was rebranded as Shop Pay in 2020. Yes, you could still use a clunky merchant account, but it was far easier to simply use the built-in Shop Pay functionality. Shop Pay was also critical in that it was the first part of the Shopify stack to build a consumer brand: users presented with a myriad of payment options know that if they click the purple Shop Pay button all of their payment and delivery information will be pre-populated, making it possible to buy with just one additional tap.

Shopify integrated into payments with Shop Pay

Even with this toehold in the consumer space, though, Shopify has remained a company that is focused first-and-foremost on its merchants and its mission to “help people achieve independence by making it easier to start, run, and grow a business.” That independence doesn’t just mean one-person entrepreneurs either: good-size brands like Gymshark, Rebecca Minkoff, KKW Beauty, Kylie Cosmetics, and FIGS leverage Shopify to build brands that are independent of Amazon in particular.

Apple and Facebook

In 2020’s Apple and Facebook I explained the symbiotic relationship between the two companies when it came to the App Store:

Facebook’s early stumbles on mobile are well-documented: the company bet on web-based apps that just didn’t work very well; the company completely rewrote its iOS app even as it was going public, which meant it had a stagnating app at the exact time mobile was exploding, threatening the desktop advertising product and platform that were the basis of the company’s S-1.

The re-write turned out to be not just a company-saving move — the native mobile app had the exact same user-facing features as the web-centric one, with the rather important detail that it actually worked — but in fact an industry-transformational one: one of the first new products enabled by the company’s new app were app install ads. From TechCrunch in 2012:

Facebook is making a big bet on the app economy, and wants to be the top source of discovery outside of the app stores. The mobile app install ads let developers buy tiles that promote their apps in the Facebook mobile news feed. When tapped, these instantly open the Apple App Store or Google Play market where users can download apps.

The ads are working already. One client TinyCo saw a 50% higher click through rate and higher conversion rates compared to other install channels. Facebook’s ads also brought in more engaged users. Ads tech startup Nanigans clients attained 8-10X more reach than traditional mobile ad buys when it purchased Facebook mobile app install ads. AdParlor racked up a consistent 1-2% click through rate.

Facebook’s App Install product quickly became the most important channel for acquiring users, particularly for games that monetized with Apple’s in-app purchase API: the combination of Facebook data with developer’s sophisticated understanding of expected value per app install led to an explosion in App Store revenue. 

It’s worth underlining this point: the App Store would not be nearly the juggernaut it is today, nor would Apple’s “Services Narrative” be so compelling, were it not for the work that Facebook put in to build out the best customer acquisition engine in the industry (much to the company’s financial benefit, to be clear); Apple and Facebook’s relationship looked like this:

Apple and Facebook's symbiotic relationship

Facebook was by far the best and most efficient way to acquire new users, while Apple was able to sit back and harvest 30% of the revenue earned from those new users. Yes, some number of users came in via the App Store, but the primary discovery mechanism in the App Store is search, which relies on a user knowing what they want; Facebook showed users apps they never knew existed.

Facebook and Shopify

Facebook plays a similar role for e-commerce, particularly the independent sellers that exist on Shopify:

Shopify's dependence on Facebook

What makes Facebook’s approach so effective is that its advertising is a platform in its own right. Just as every app on a smartphone or every piece of software on a PC shares the same resources and API, every advertiser on Facebook, from app maker to e-commerce seller and everyone in-between, uses the same set of APIs that Facebook provides. What makes this so effective, though, is that the shared resources are not computing power but data, especially conversion data; I explained how this worked in 2020’s Privacy Labels and Lookalike Audiences, but briefly:

  • Facebook shows a user an ad, and records the unique identifier provided by their phone (IDFA, Identifier for Advertisers, on iOS; GAID, Google Advertising Identifer, on Android).
  • A user downloads an app, or makes an e-commerce purchase; Facebook’s SDK, which is embedded in the app or e-commerce site, again records the IDFA or notes the referral code that led the user to the site, and charges the advertiser for a successful conversion.
  • The details around this conversion, whether it be which creative was used in the ad, what was purchased, how much was spent, etc., is added to the profile of the user who saw the ad.
  • Advertisers take out new ads on Facebook asking the company to find users who are similar to users who have purchased from them before (Facebook knows this from past purchases seen by its SDK, or because an advertiser uploads a list of past customers).
  • Facebook repeats this process, further refining its understanding of customers, apps, and e-commerce offerings in the process, including the esoteric ways (only discoverable by machine learnings) in which they relate to each other.

The critical thing to understand about this process is that no one app or e-commerce seller stands alone; everyone has collectively deputized Facebook to hold all of the pertinent user data and to figure out how all of the pieces fit together in a way that lets each individual app maker or e-commerce retailer acquire new customers for a price less than what that customer is worth to them in lifetime value.

This, by extension, means that Shopify doesn’t stand alone either: the company is even more dependent on Facebook to drive e-commerce than Apple ever was to drive app installs.1 That’s why it’s not a surprise that Facebook’s recent plunge in value was preceded (and then followed) by Shopify’s own:

Shopify and Facebook's faltering stocks

Part of Shopify’s decline is likely related to the fact that it is another pandemic stock: the sort of growth the company saw while customers were stuck at home with nothing to do other than shop online couldn’t go on forever. Moreover, the company announced big increases in spending (more on this in a moment). However, the major headwind the company shares with Facebook is Apple.

ATT’s Impact

I have been writing regularly about Apple’s App Tracking Transparency (ATT) initiative since it was announced two years ago, so I won’t belabor the point; the key thing to understand is that ATT broke the Facebook advertising collective. On the app install side this was done by technical means: Apple made the IDFA an opt-in behind a scary warning about tracking, which most users declined.

The e-commerce side is more interesting: while Apple can’t technically limit what Facebook collects via its Pixel on a retailer’s website, ATT bans said broad collection all the same. To that end Facebook originally announced plans to not show the ATT prompt and abandon the IDFA; a few months later the company did an about-face announcing that it would indeed show the ATT prompt, and also limit what it collected in its in-app browser via the Facebook Pixel.

It’s unclear what happened to change Facebook’s mind; had they continued on their original path then their app advertising business would have suffered from a loss of data, but the e-commerce advertising would have been relatively unaffected (the loss of IDFA-related app install data would have decreased the amount of data available for that machine learning-driven targeting). What seems likely — and to be clear, this is pure speculation — is that Apple threatened to kick Facebook and its apps out of the App Store if it didn’t abide by ATT’s policies, even the parts that were technically unenforceable.

Regardless, the net impact is that it was suddenly impossible for Facebook to tie together all of the various pieces of that virtuous cycle I described above deterministically. Ads were hard to tie to conversions, conversions were hard to tie to users, which meant that users and advertisers were hard to tie to each other, resulting in less relevant ads for the former that cost more money for the latter.2 The monetary impact is massive: Facebook forecast a $10 billion hit to 2022 revenue, and as noted, its market value has been cut by a third.

Note, however, that ATT didn’t hurt all advertisers: companies like Google and Amazon are doing great; I explained why in Digital Advertising in 2022:

Amazon’s advertising business has three big advantages relative to Facebook’s.

  1. Search advertising is the best and most profitable form of advertising. This goes back to the point I made above: the more certain you are that you are showing advertising to a receptive customer, the more advertisers are willing to bid for that ad slot, and text in a search box will always be more accurate than the best targeting.
  2. Amazon faces no data restrictions. That noted, Amazon also has data on its users, and it is free to collect as much of it as it likes, and leverage it however it wishes when it comes to selling ads. This is because all of Amazon’s data collection, ad targeting, and conversion happen on the same platform — Amazon.com, or the Amazon app. ATT only restricts third party data sharing, which means it doesn’t affect Amazon at all.
  3. Amazon benefits from ATT spillover. That is not to say that ATT didn’t have an effect on Amazon: I noted above that Snap’s business did better than expected in part because its business wasn’t dominated by direct advertising to the extent that Facebook’s was, and that more advertising money flowed into other types of advertising. This almost certainly made a difference for Amazon as well: one of the most affected areas of Facebook advertising was e-commerce; if you are an e-commerce seller whose Shopify store powered-by Facebook ads was suddenly under-performing thanks to ATT, then the natural response is to shift products and advertising spend to Amazon.

All of these advantages will persist: search advertising will always be effective, and Amazon can always leverage data, and while some degree of ATT-related pullback was likely due to both uncertainty and the fact that Facebook hasn’t built back its advertising stack for a post-ATT world, the fact that said future stack will never be quite as good as the old one means that there is more e-commerce share to be grabbed than there might have been otherwise.

This last point is not set in stone: Shopify is already making major investments to compete with Amazon; it has the opportunity to do even more.

The Shopify Fulfillment Network

In 2019 I wrote about Shopify and its orthogonal competition with Amazon in Shopify and the Power of Platforms:

The difference is that Shopify is a platform: instead of interfacing with customers directly, 820,000 3rd-party merchants sit on top of Shopify and are responsible for acquiring all of those customers on their own.

A drawing of The Shopify Platform

[…]

This is how Shopify can both in the long run be the biggest competitor to Amazon even as it is a company that Amazon can’t compete with: Amazon is pursuing customers and bringing suppliers and merchants onto its platform on its own terms; Shopify is giving merchants an opportunity to differentiate themselves while bearing no risk if they fail.

The context of that Article was Shopify’s announcement of yet another platform initiative: the Shopify Fulfillment Network.

From the company’s blog:

Customers want their online purchases fast, with free shipping. It’s now expected, thanks to the recent standard set by the largest companies in the world. Working with third-party logistics companies can be tedious. And finding a partner that won’t obscure your customer data or hide your brand with packaging is a challenge.

This is why we’re building Shopify Fulfillment Network—a geographically dispersed network of fulfillment centers with smart inventory-allocation technology. We use machine learning to predict the best places to store and ship your products, so they can get to your customers as fast as possible.

We’ve negotiated low rates with a growing network of warehouse and logistic providers, and then passed on those savings to you. We support multiple channels, custom packaging and branding, and returns and exchanges. And it’s all managed in Shopify.

The first paragraph explains why the Shopify Fulfillment Network was a necessary step for Shopify: Amazon may commoditize suppliers, hiding their brand from website to box, but if its offering is truly superior, suppliers don’t have much choice. That was increasingly the case with regards to fulfillment, particularly for the small-scale sellers that are important to Shopify not necessarily for short-term revenue generation but for long-run upside. Amazon was simply easier for merchants and more reliable for customers.

Notice, though, that Shopify is not doing everything on their own: there is an entire world of third-party logistics companies (known as “3PLs”) that offer warehousing and shipping services. What Shopify is doing is what platforms do best: act as an interface between two modularized pieces of a value chain.

A drawing of Shopify as an Interface

On one side are all of Shopify’s hundreds of thousands of merchants: interfacing with all of them on an individual basis is not scalable for those 3PL companies; now, though, they only need to interface with Shopify. The same benefit applies in the opposite direction: merchants don’t have the means to negotiate with multiple 3PLs such that their inventory is optimally placed to offer fast and inexpensive delivery to customers; worse, the small-scale sellers I discussed above often can’t even get an audience with these logistics companies. Now, though, Shopify customers need only interface with Shopify.

Over the intervening three years, though, Shopify has moved away from this vision: Shopify Fulfillment Network (SFN) is not going to be a platform like the Shopify App Store but rather an integrated part of Shopify’s core offering like Shop Pay. President Harley Finkelstein explained on the company’s recent earnings call:

We are consolidating our network to larger facilities. We’ll operate more of them ourselves, and we’ll unify the warehouse management software that we’ve been building and testing over the past 18 months. We expect that these changes will enable us to deliver packages in 2 days or less to more than 90% of the U.S. population, while minimizing the inventory investment for SFN merchants. While Amy will go into more detail as to what our evolved vision looks like from a financial perspective, I can tell you, from a merchant’s perspective, Shopify Fulfillment can be life-changing for their businesses. We hear from merchants that fulfillment is only something you think about when it isn’t working well, and they are thrilled that they now never have to think about it. The stockouts and pre-orders that took the shine off strong demand for the new releases, largely became, I think, in the past, with Shopify Fulfillment. And just recently, I heard from a merchant who tells me that he sleeps even better because Shopify Fulfillment just works. Comments like these fuel our ambition, and we’ll continue to explore opportunities to give merchants more visibility and control over their most important assets.

Building and managing warehouses itself is a major commitment: Shopify is going to spend a billion dollars in capital expenditures in 2023 and 2024 building out the Shopify Fulfillment Network, and it seems safe to assume that that spending will only increase over time. I think, though, that this makes sense: Shopify learned from Shop Pay that it can decrease complexity for merchants and deliver a better experience for customers by doing essential functionality itself, and those same needs exist in logistics as well, particularly given Amazon’s massive investment in its own integrated operations.

Keep in mind, though, logistics isn’t the only advantage that Amazon has.

Shopify Advertising Services

Remember the fundamental challenge that ATT presents to Facebook: the company can no longer pool the conversion and targeting data of all of its advertisers such that the sum of effectiveness vastly exceeds what any one of those advertisers could accomplish on their own. The response of the gaming market has been a wave of consolidation to better pool and leverage data. Amazon, as noted, is well ahead of the curve here: because the company’s third-party merchant ecosystem lives within the Amazon.com website and app, Amazon has full knowledge of conversions and the ability to target consumers without any interference from Apple.

Shopify is halfway there: a massive number of e-commerce retailers are on Shopify, but today Shopify mostly treats them all as individual entities, having left the pooling of data for advertising to Facebook. Now that Facebook is handicapped by Apple, Shopify should step up to provide substitute functionality and build its own advertising network.

This advertising network, though, would look a bit different than what you might expect. First, Shopify doesn’t have any major customer-facing properties to display ads; it could potentially build some cross-shop advertising, but that doesn’t seem very ideal for either merchants or customers. The reality is that Shopify merchants still need to find customers on other sites like social networks; the challenge is doing so without knowing who is actually seeing the ads.

Here Shopify’s ability to act on behalf of the entire Shopify network provides an opening: instead of being an advertising seller at scale, like Facebook, Shopify the company would become an advertising buyer at scale. Armed with its perfect knowledge of conversions it could run probabilistically-targeted campaigns that are much more precise than anyone else, using every possible parameter available to advertisers on Facebook or anywhere else, and over time build sophisticated cohorts that map to certain types of products and purchase patterns. No single Shopify merchant could do this on their own with a similar level of sophistication, which Facebook indirectly admitted on its recent earnings call; COO Sheryl Sandberg said:

On measurement, there were 2 key areas within measurement, which were impacted as a result of Apple’s iOS changes. And I talked about this on the call last quarter as you referenced. The first is the underreporting gap. And what’s happening here is that advertisers worry they’re not getting the ROI they’re actually getting. On this part, we’ve made real progress on that underreporting gap since last quarter, and we believe we’ll continue to make more progress in the years ahead. I do want to caution that it’s easier to address this with large campaigns and harder with small campaigns, which means that part will take longer, and it also means that Apple’s changes continue to hurt small businesses more.

Sandberg’s comment was primarily about the sheer amount of data produced by larger campaigns, but the same principle applies to the sheer number of campaigns as well: any one advertiser is, thanks to ATT, limited in the data points they can get from Facebook, making it more difficult to run multiple campaigns to better understand what works and what doesn’t. However, Shopify could in theory run campaigns for each of its individual merchants and collate the data on the back-end; this is the inverse of Amazon’s advantage of being one website, because in this case Shopify benefits from having a hand in such a huge number of them.

I suspect the response of many close Shopify watchers is that such an initiative is not in the company’s DNA; that, though, is why the evolution of the Shopify Fulfillment Network is so notable: building and operating warehouses wasn’t really in the company’s DNA either, but it is the right thing to do if the company is going to continue to power The Anti-Amazon Alliance. The same principle applies to this theoretical ad network, particularly given that it is Amazon who is a big winner from Apple’s changes.

What is interesting is that it appears that Shopify is already flirting with this idea:3 Last summer the company quietly introduced the concept of Shopify Audiences during an invite-only presentation; Tanay Jaipuria fleshed out the concept on Substack:

Shopify Audiences is a data exchange network, which uses aggregated conversion data (i.e., data around which people bought a merchant’s product) across all opted-in merchants on Shopify to generate a custom audience for a given merchant’s product. This audience is essentially a set of people Shopify believes are likely to be interested in your product given the data around all transactions that have taken place across all opted-in merchants on Shopify.

Merchants can then use these audiences when advertising on FB, Snap, Twitter, and other ad platforms1 either as custom audiences or lookalike audiences which should result in higher-performing ads and lower cost per conversion to acquire customers/sales.

This is a big step, and is very valuable for Facebook advertising in particular; however, it doesn’t address the Apple issue, because ATT bans custom and lookalike audiences from external data sources. That means that Data Exchange can’t be used in any campaign targeting iOS users. That is why Shopify Audiences is only the first step: to make this work Shopify Audiences needs to become Shopify Advertising Services, where Shopify doesn’t just collect the targets but buys the ads to target them as well, in a way no one else in the world can.

The Conservation of Attractive Profits

Shopify Advertising Services, Shopify Fulfillment Network, and Shop Pay would, without question, result in a very different looking company than the one I sketched out at the beginning of this Article:

Shopify with integrated payments, fulfillment, and advertising

This sort of monolith, though, makes sense not only because of the specifics of what is happening in the market, but from a theoretical perspective as well. I wrote another article about Shopify a year ago called Market-Making on the Internet, highlighting how major consumer-facing platforms were increasingly incorporating Shopify into their sites and apps:

What makes the Shopify platform so fascinating is that over time more and more of the e-commerce it enables happens somewhere other than a Shopify website. Shopify, for example, can help you sell on Amazon, and in what will be an increasingly important channel, Facebook Shops. In the latter case Facebook and Shopify are partnering to create a fully-integrated market: Facebook’s userbase and advertising tools on one side, and Shopify’s e-commerce management and seller base on the other. The broader takeaway, though, is that Shopify’s real value proposition is working across markets, not creating an exclusive one.

Facebook’s motivations are clear: conversions in Facebook Shops can be tracked in a way conversions on websites no longer can be, which will result in in more effective advertising; it is to Shopify’s credit that they are seen as such an important and credible partner that Facebook is going as far as incorporating Shop Pay as well. Even so, this is very much an example of Facebook integrating and Shopify, as it must, modularizing to accommodate them. That is a recipe for long run commoditization.

That is why it is a good thing that Shopify is integrating elsewhere in its business: profits in a value chain follow integration, and the more that Shopify is intertwined with the biggest players the more it needs to find other ways to differentiate. Shop Pay is already a massive win, and fulfillment has the chance to be another one; advertising shouldn’t be far behind.

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

  1. While you can make purchases from brands in the Shop Pay app, it’s an insignificant channel that isn’t at all comparable to Apple’s own direct route to customers via the App Store. ↩

  2. Facebook’s advertising is sold on an auction basis, and advertisers often bid against desired outcomes, like conversions; the more difficult it is to target users the more users there are who need to be showed an ad, which increases demand for inventory, increasing prices. ↩

  3. Thanks to Eric Seufert for tipping me off to this. ↩

Digital Advertising in 2022

Posted on Author by Ben Thompson

Six years ago tomorrow, in The Reality of Missing Out, I wrote that the digital advertising market was settled, and Google and Facebook won:

I have been arguing for a while that in the aggregate the tech sector is fine, and the state of advertising-based services is a perfect example of what I mean: taken as a basket the six companies in this article (Google, Facebook, Yahoo, Twitter, LinkedIn, and Yelp) are up 19% over the last year, even though the latter four companies are down a collective 53%; the fact that Google and Facebook are up a combined 31% more than makes up for it.

This makes sense: while advertising as a whole is a zero-sum game, there is a secular shift from not just print but also radio and TV to digital, which is why this basket of digital advertising companies is up. Digital, though, is subject to the effects of Aggregation Theory, a key component of which is winner-take-all dynamics, and Facebook and Google are indeed taking it all.

The Article was prescient for a time; Yahoo has been passed around for peanuts, LinkedIn was bought by Microsoft a few months later, and while Yelp and Twitter’s stock have more-or-less doubled since then,1 that gain pales in comparison to that of Google and Facebook:

Google, Facebook, Twitter, and Yelp's market gains over the last six years

That chart, though, only runs through last Wednesday; here is the new chart post-Facebook earnings:

Google, Facebook, Twitter, and Yelp's market gains over the last six years, including Facebook's recent earnings

It turns out that, for now anyways, buying $TWTR on the day I wrote that article would have provided a better return than $FB.

Direct Response and the Collapse of the Funnel

In that Article I painted an idealized picture of the traditional marketing funnel and how Google and Facebook’s advertising products mapped onto it:

What Sandberg is detailing here is really quite extraordinary: Facebook helped Shop Direct move customers through every part of the funnel: from awareness through Instagram video ads to consideration through retargeting and finally to conversion with dynamic product ads on Facebook (and, in the not too distant future, a direct customer relationship to build loyalty via Messenger).

A drawing of Digital Advertising 2.0

Google is promising something similar: awareness via properties like YouTube, consideration via DoubleClick, and conversion via AdSense. Just as importantly, both companies are promising that leveraging their respective platforms will provide benefits on both sides of the ROI equation: the return will be better given the two companies’ superior targeting capabilities and ability to measure conversion, and the investment will be smaller because you can manage your entire funnel from a single ad-buying interface.

Herein lies the first thing that I got wrong: the traditional marketing funnel made sense in a world where different parts of the customer journey happened in different places — literally. You might see an advertisement on TV, then a coupon in the newspaper, and finally the product on an end cap in a store. Every one of those exposures was a discrete advertising event that culminated in the customer picking up the product in question in putting it in their (literal) shopping cart.

On the Internet, though, that journey is increasingly compressed into a single impression: you see an ad on Instagram, you click on it to find out more, you login with Shop Pay, and then you wonder what you were thinking when it shows up at your door a few days later. The loop for apps is even tighter: you see an ad, click an ‘Install’ button, and are playing a level just seconds later. Sure, there are things like re-targeting or list building, but by-and-large Internet advertising, particularly when it comes to Facebook, is almost all direct response.

This can make for an exceptionally resilient business model: because the return-on-investment (ROI) of direct response advertising is measurable to a fantastically greater degree than traditional advertising measurement, advertisers can spend right up to the level they place on a particular customer or transaction’s value; Facebook, of course, is willing to help them do that as easily as possible, squeezing out margin in the process. Moreover, because these ads are sold at auction, the company is insulated from events like COVID or boycotts; I explained in 2020’s Apple and Facebook:

This explains why the news about large CPG companies boycotting Facebook is, from a financial perspective, simply not a big deal. Unilever’s $11.8 million in U.S. ad spend, to take one example, is replaced with the same automated efficiency that Facebook’s timeline ensures you never run out of content. Moreover, while Facebook loses some top-line revenue — in an auction-based system, less demand corresponds to lower prices — the companies that are the most likely to take advantage of those lower prices are those that would not exist without Facebook, like the direct-to-consumer companies trying to steal customers from massive conglomerates like Unilever.

In this way Facebook has a degree of anti-fragility that even Google lacks: so much of its business comes from the long tail of Internet-native companies that are built around Facebook from first principles, that any disruption to traditional advertisers — like the coronavirus crisis or the current boycotts — actually serves to strengthen the Facebook ecosystem at the expense of the TV-centric ecosystem of which these CPG companies are a part.

The problem for Meta is in the title of that article: Apple. The latter’s App Tracking Transparency (ATT) initiative severed the connection amongst e-commerce sellers, app developers, and Facebook by which Facebook achieved that ROI, and while the company is better positioned than anyone else to build a replacement, it is important to note that the impairment entailed in probabilistically measuring ad effectiveness instead of deterministically is a permanent one.

This isn’t just a Facebook problem: Snap said on its earnings call:

Our advertising partners who prefer to leverage lower-funnel goals such as in-app purchases, have been most impacted by [ATT]. We are seeing these advertisers migrate to mid-funnel goals where they have greater visibility such as install or click. Advertisers who optimize via web-based goal-based bids or GBBs have been less impacted, given that many of them have adopted the Snap pixel.

Snap’s direct response business is not nearly as good as Facebook’s, and is a much smaller business both overall and in terms of the overall company’s revenue; that left a lot more cushion to absorb ATT, both because Snap’s performance had less to lose, and also because the company’s brand-business could help pick up the slack. This, paradoxically, led many investors to overfit Facebook’s disappointing forecast to Snap’s outlook; the reality is that advertising dollars will find a way to be spent, and the alternatives to direct response on Snap were more impactful to the bottom line than they are on Facebook, in part because the latter was so dominant in direct response until now.

The Amazon Advertising IPO

What made the Facebook model tick was the way in which the company could convert conversion tracking to targeting: because Facebook knew a lot about someone who saw an ad and then converted, they could easily find other people who were similar — lookalike audiences — and show them similar ads, continually optimizing their targeting and increasing their understanding along the way.

Google Search, though, has a built-in advantage: Google doesn’t have to figure out what you are interested in because you do the company the favor of telling it by searching for it. The odds that you want a hotel in San Francisco are rather high if you search for “San Francisco hotels”; it’s the same thing with life insurance or car mechanics or e-commerce.

Google is not the only search engine that monetizes e-commerce effectively. Back in 2015 I described the breakout of Amazon Web Services’ financials as The AWS IPO:

This is why Amazon’s latest earnings were such a big deal: for the first time the company broke out AWS into its own line item, revealing not just its revenue (which could be teased out previously) but also its profitability. And, to many people’s surprise, and despite all the price cuts, AWS is very profitable: $265 million in profit on $1.57 billion in sales last quarter alone, for an impressive (for Amazon!) 17% net margin.

Those numbers pale in comparison to what I guess we might call the Amazon Advertising IPO, given that the company broke out its advertising for the first time this quarter, revealing $9.7 billion in revenue, a 32% increase year-over-year (Amazon did not break out the unit’s profitability). While that is still a fraction of Google’s $61.2 billion last quarter, or Facebook’s $32.6 billion, it is a larger fraction than you might expect, and several multiples of Snap’s $1.3 billion in revenue. Indeed, given the fact that Amazon is closer in revenue to Facebook than Facebook is to Google it seems fair to characterize the advertising market as dominated not by a big two but a big three.

Amazon’s advertising business has three big advantages relative to Facebook’s.

  1. Search advertising is the best and most profitable form of advertising. This goes back to the point I made above: the more certain you are that you are showing advertising to a receptive customer, the more advertisers are willing to bid for that ad slot, and text in a search box will always be more accurate than the best targeting.

  2. Amazon faces no data restrictions. That noted, Amazon also has data on its users, and it is free to collect as much of it as it likes, and leverage it however it wishes when it comes to selling ads. This is because all of Amazon’s data collection, ad targeting, and conversion happen on the same platform — Amazon.com, or the Amazon app. ATT only restricts third party data sharing, which means it doesn’t affect Amazon at all.

  3. Amazon benefits from ATT spillover. That is not to say that ATT didn’t have an effect on Amazon: I noted above that Snap’s business did better than expected in part because its business wasn’t dominated by direct advertising to the extent that Facebook’s was, and that more advertising money flowed into other types of advertising. This almost certainly made a difference for Amazon as well: one of the most affected areas of Facebook advertising was e-commerce; if you are an e-commerce seller whose Shopify store powered-by Facebook ads was suddenly under-performing thanks to ATT, then the natural response is to shift products and advertising spend to Amazon.

All of these advantages will persist: search advertising will always be effective, and Amazon can always leverage data, and while some degree of ATT-related pullback was likely due to both uncertainty and the fact that Facebook hasn’t built back its advertising stack for a post-ATT world, the fact that said future stack will never be quite as good as the old one means that there is more e-commerce share to be grabbed than there might have been otherwise.

Google’s Dominance

Of course you could just as easily make an argument that when it comes to digital advertising there is Google and everyone else. Google clearly faces competition from Amazon for e-commerce search advertising — the European Commission’s Google Shopping case is only surpassed by the FTC’s Facebook lawsuit when it comes to overly narrow market definitions that ignore reality — but is dominant in terms of nearly every other vertical. Moreover, that dominance is shored up by the same factors favoring Amazon, at least in part.

The first one is obvious: search advertising works great, and Google is the best at it.

The second one, about data collection, is more interesting, particularly in the context of ATT. Facebook CFO Dave Wehner groused on the company’s recent earnings call:

We believe the impact of iOS overall as a headwind on our business in 2022 is on the order of $10 billion, so it’s a pretty significant headwind for our business. And we’re seeing that impact in a number of verticals. E-commerce was an area where we saw a meaningful slowdown in growth in Q4. And similarly, we’ve seen other areas like gaming be challenged. But on e-commerce, it’s quite notable that Google called out, seeing strength in that very same vertical. And so given that we know that e-commerce is one of the most impacted verticals from iOS restrictions, it makes sense that those restrictions are probably part of the explanation for the difference between what they were seeing and what we were seeing.

And if you look at it, we believe those restrictions from Apple are designed in a way that carves out browsers from the tracking prompts Apple requires for apps. And so what that means is that search ads could have access to far more third-party data for measurement and optimization purposes than app-based ad platforms like ours. So when it comes to using data, that it’s not really apples-to-apples for us. And as a result, we believe Google’s search ads business could have benefited relative to services like ours that face a different set of restrictions from Apple. And given that Apple continues to take billions of dollars a year from Google Search ads, the incentive clearly exists for this policy discrepancy to continue.

Apple, it should be noted, has always treated the browser as a carve-out from its App Store restrictions (not that it has any choice: Apple, in contrast to the App Store, doesn’t have any points of leverage over the open web), so it is fair to dismiss Wehner’s conspirational musings about the iPhone maker’s motivations.

At the same time, the broader observation is a smart one: Google, thanks to the combination of being the default search engine on Safari and having a business built on the web, basically has first-party privileges on the iPhone when it comes to data. It can show ads to iPhone users on the default browser and track how those ads perform on third-party websites to a much greater extent than an app like Facebook directing users to the exact same third-party websites can.

In terms of ATT, it is notable that the only part of Google’s business that fell short of Wall Street expectations was YouTube; I suspect it is not a coincidence that YouTube has a significant app-install business of its own, and ATT’s restrictions on what those installed apps can report back to Google may have hurt business a bit. At the same time, the same dynamics that drove advertising to other parts of Snap’s business and to Amazon advertising likely benefited Google as well, including Android.

Facebook Risk

There is no question that Facebook has been significantly impaired, but the company is by no means doomed, in large part because while search is very effective at finding what you want, there remains the need to make you aware of what you didn’t know existed. This is what Facebook excels at more than any other platform: by knowing who you are and what you have liked or purchased in the past, Facebook can place ads for products or apps you have never heard of in the Feed, in Stories, or, going forward in Reels.

This, in my opinion, is actually a far more important form of advertising than search ads: yes, there are scenarios where a firm can surface something that fits exactly what you are searching for, but oftentimes search ads feel like a rake on organic results that would have given you what you were looking for anyways. Facebook-style display advertising, on the other hand, is the foundation upon which an entirely new host of Internet-only businesses are built. These niche-focused companies are only possible when the entire world is your market, but they would founder without a way to find the customers who are looking for exactly what they have to offer; Facebook ads solve that problem.

That discovery mechanism, though, doesn’t just depend on data; it also depends on attention. This is where the TikTok challenge looms large: Apple and ATT may have had the largest financial impact on Facebook, but TikTok and the loss of attention are the more existential risk.

Illustrating the Ad Market

Still, Facebook’s forecast, disappointing as they were to investors, was for $27-29 billion in revenue this quarter; this is still a major player in an advertising market dominated by the three companies mentioned in this article, with one looming dark horse. To illustrate the market — and with the caveat that this is a massive oversimplification of what is a large and varied opportunity — consider a two-by-two defined by apps and commerce (both physical and digital) on one axis, and search and display on the other:

A two-by-two graph with search and display on one axis, and apps and commerce on the other

This is what that market looked like back in 2016:

The 2x2 graph in 2016, when Google and Facebook were dominant

This is what the market looks like in 2022:

The 2x2 graph in 2022, with challenges from Amazon and Apple

First off, note that this illustration doesn’t include a huge part of Google’s market, which is basically search for anything other than e-commerce. It also doesn’t include the still substantial market for brand advertising. Direct response advertising, though, is the truly Internet-native advertising form, and while Google and Facebook are important, note the two new entrants who have substantial advantages:

Amazon:

Amazon has the best fulfillment and logistics operation in e-commerce,2 which it uses to not only drive its own first-party retail but also third-party merchant services. Indeed, this is another way to think about how Amazon is insulated from ATT: it’s not that the company doesn’t have a multitude of third-party merchants on its platform, it is that by taking on the role of an Aggregator instead of a platform it gets to fold all of those third party merchants into its app and website, beyond the limitations enforceable by Apple. Then it effectively gives those third party merchants no choice but to buy ads if they want to be noticed by customers.

Apple:

Apple launched its App Store advertising business in the fall of 2016, starting with the most obvious place: search. Apple hasn’t disclosed how much it makes in advertising, but there are analyst estimates of $5 billion annually. Not all of this is search — Apple has since added inventory in the App Store’s “Suggested” section as well as owned-and-operated apps like Apple News — but most of it is; Apple is confined to the top right corner…for now.

One of the biggest questions about the advertising landscape going forward is if Apple is going to move down to the “Apps + Discovery” quadrant that remains Facebook’s purview. If the company did they would have an unbeatable advantage: remember, Apple has made clear through its App Store policies and testimony in the Epic case that it views apps on the App Store as first party for Apple (this is how the company justifies its anti-steering provisions, likening links to websites to putting up signs in its own store for another, even though the signs in question are in the app and not the App Store). It follows, then, that Apple would see no inconsistency in denying Facebook the ability to have knowledge about installation and conversions derived from a Facebook ad, even as Apple has perfect knowledge of those installations and conversions from its own ads.

This isn’t a hypothetical! Apple’s Advertising & Privacy page states:

We may use information such as the following to assign you to segments:

  • Account Information: Your name, address, age, gender, and devices registered to your Apple ID account. Information such as your first name in your Apple ID registration page or salutation in your Apple ID account may be used to derive your gender. You can update your account information on the Apple ID website.
  • Downloads, Purchases & Subscriptions: The music, movies, books, TV shows, and apps you download, as well as any in-app purchases and subscriptions. We don’t allow targeting based on downloads of a specific app or purchases within a specific app (including subscriptions) from the App Store, unless the targeting is done by that app’s developer.
  • Apple News and Stocks: The topics and categories of the stories you read and the publications you follow, subscribe to, or enable notifications from.
  • Advertising: Your interactions with ads delivered by Apple’s advertising platform.

When selecting which ad to display from multiple ads for which you are eligible, we may use some of the above-mentioned information, as well as your App Store searches and browsing activity, to determine which ad is likely to be most relevant to you. App Store browsing activity includes the content and apps you tap and view while browsing the App Store. This information is aggregated across users so that it does not identify you. We may also use local, on-device processing to select which ad to display, using information stored on your device, such as the apps you frequently open.

As you can see, Apple does not currently allow developers to target downloads or purchases from within a specific app the developer does not own,3 but that doesn’t mean Apple cannot; again, the company has made clear it sees every app on the iPhone — especially their purchases — as Apple data, and this document makes very clear that Apple only sees data collection as problematic when it involves third parties. To that end, Apple could set up an auction-based advertising network that monetized on a per-install basis and run those ads within an Apple-controlled network that is available to third-party apps. It would basically be a better version of Facebook — well, in theory, Apple has admittedly never been really good at this sort of thing — but since only Apple sees the data (just as only Facebook sees the data from third-party apps), Apple gets to pat itself on the back all of the way to the bank.

This would, needless to say, be a breathtaking example of anti-competitive behavior; kneecapping your competitor via platform control and then taking over their business is what one would think antitrust law would be designed to stop. But then you look up and Apple has gotten away with its App Store policies for years, and Facebook is getting sued for limiting competition even as it faces an existential threat from TikTok, and who knows, maybe it would work.

I hinted at one of the objections to this happening above: Apple has tried to do advertising before, and failed miserably. As any Apple aficionado will tell you, ads aren’t in their nature, products are. But then again, had you told those same aficionados that Apple would be facing developer ire, antitrust lawsuits, and regulatory obstacles all over the world because of its insistence that it is owed 15-30% of all digital content consumed on the iPhone, they probably would have said that was impossible too. What is clear is that the $10 billion in revenue that Facebook won’t see this year will go somewhere, and Apple’s Services Narrative has never felt like a bigger opportunity.

There is a broader takeaway to this discussion; I wrote in the conclusion of 2020’s The End of the Beginning:

In other words, today’s cloud and mobile companies — Amazon, Microsoft, Apple, and Google — may very well be the GM, Ford, and Chrysler of the 21st century. The beginning era of technology, where new challengers were started every year, has come to an end; however, that does not mean the impact of technology is somehow diminished: it in fact means the impact is only getting started.

There was one company conspicuous in its absence, and that was Facebook. Real power in technology comes from rooting the digital in something physical: for Amazon that is its fulfillment centers and logistics on the e-commerce side, and its data centers on the cloud side. For Microsoft it is its data centers and its global sales organization and multi-year relationships with basically every enterprise on earth. For Apple it is the iPhone, and for Google is is Android and its mutually beneficial relationship with Apple (this is less secure than Android, but that is why Google is paying an estimated $15 billion annually — and growing — to keep its position). Facebook benefited tremendously from being just an app, but the freedom of movement that entailed meant taking a dependency on iOS and Android, and Apple has exploited that dependency in part, if not yet in full.

This, more than anything, is the way to understand the Meta bet, and why it matters so much to CEO Mark Zuckerberg. Investors may want the company to focus on what it is best at; Zuckerberg wants to build a company that is truly independent of anyone.

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

  1. Twitter did have a large run-up a year ago that has since disappeared ↩

  2. ex-China, anyways ↩

  3. This is why I have been intrigued by AppLovin’s approach. ↩

Gaming the Smiling Curve

Posted on Author by Ben Thompson

Another week, another gaming acquisition. First Take-Two acquired Zynga, then Microsoft acquired Activision-Blizzard, and now Sony just announced the acquisition of Bungie.1 Each of these acquisitions is interesting in its own right, but taken as a set they paint a picture of industry evolution that extends far beyond gaming.

Take-Two and Mobile Consolidation

The straightforward explanation for Take-Two’s acquisition of Zynga is the fact that mobile captures more than 50% of gaming industry revenue and it is growing much faster (7% last year) than PC and console gaming (the gaming industry grew 1.4% as a whole); that is a problem for Take-Two given that nearly all of the company’s revenue comes from PC and console series like Grand Theft Auto, NBA 2K, Red Dead, Bordlerlands, and more.

Zynga, meanwhile, was among the least prepared of the major mobile gaming companies for the changes wrought by Apple’s App Tracking Transparency (ATT) policy, which was introduced with iOS 14 and rolled out over the first half of 2021. In the pre-ATT world everyone from e-commerce sellers to app developers could effectively offload the collection and analysis of conversion data and subsequent targeting of advertising to Facebook, to the benefit of everyone involved: individual developers and retailers did not need to bear the risk or expense of collecting and analyzing data, and could instead collectively outsource that job to the Facebook data factory, which had the benefit of making Facebook advertising that much more effective, not only to the benefit of Facebook’s bottom line but also to that of those that relied on its advertising platform.

ATT, meanwhile, didn’t ban data collection or analysis or targeting or any of the other aspects of advertising that many of its supporters object to; what it targeted was doing so collectively. That means that the policy has been a huge boon for fully integrated advertisers (i.e. advertisers that collect data, target, and show advertisements) like Google and Amazon. In this world the natural response has been consolidation; compare Zynga’s stock price over the last year to a company like AppLovin which was ahead of the curve in buying up multiple parts of the ad stack and combining them with its own titles to maximize the value of first party data:

Zynga versus AppLovin stock performance over the last year

AppLovin is down a bit with the general market drawdown, but it’s not an accident the company increased in price last fall while Zynga plummeted (the stock is up from its depths because of the not-yet-closed acquisition): one of the keys to Zynga’s turnaround was buying small independent studios and letting them stay independent; that’s no longer a viable approach in a post-ATT world, and Take-Two will have to centralize Zynga and only then leverage Zynga’s expertise to bring its valuable IP to mobile platforms in a much more complete way than it has previously.

Microsoft and Xbox Game Pass

Take-Two wasn’t the only company taking advantage of a company with a plummeting stock price; Microsoft did the same with Activision Blizzard:

Activision's stock price over the last year

Activision Blizzard does own King Digital, which still provides over $2 billion in revenue from Candy Crush and its various spin-offs, but in this case the stock price decline was primarily due to major issues regarding Activision Blizzard’s internal culture, including a lawsuit by the state of California. Microsoft, though, was well positioned to take advantage of Activision Blizzard’s troubles thanks to Xbox Game Pass.

Whenever a major platform acquires a developer on that platform, the first question users ask is if the platform owner will make the developer’s content exclusive. It’s an obvious question — why else would the platform owner buy it, given that they can still collect revenue from the developer, both directly via platform fees and indirectly via licensing fees? — but the answer is not always straightforward, thanks to the nature of software.

Software, including games, entails a massive investment in upfront development costs. You have to build (or license and adapt to) a game engine, write and build out the story, draw and develop the assets, etc. All of this is work that is both expensive and also only needs to be done once; it follows, then, that it is in the software developer’s economic interest to make the game available as widely as possible; after all, every additional copy of a game has zero marginal costs, which means that every additional copy of a game sold provides nothing but leverage on those fixed costs, and, once covered, pure profit (that noted, there are significant costs associated with supporting multiple platforms — I have seen estimates around 25~40% of extra costs, depending on the game — so going exclusive is not an entirely deadweight cost).

This makes the math around developer acquisitions a bit tricky for platform acquirers: to buy a gaming studio in order to make its games exclusive to the platform entails destroying a significant part of the game studio’s economic value; after all, you are acquiring a property like Call of Duty based on the revenue it grosses from PC, Xbox, and PlayStation — cutting off the latter means you overpaid. This is why it is not a surprise that Microsoft has already committed to keeping Activision Blizzard’s and ZeniMax’s most popular cross-platform games on PlayStation.

What makes Microsoft’s acquisition spree particularly compelling, though, is that Microsoft is trying to create a new business model for gaming: for $15/month you can play all of the games Microsoft owns, and those of any third-party developer who wishes to join up, on any platform that supports them. This includes not only the Xbox console and Windows PCs,2 but also the nascent Xbox streaming service, which makes console-level games available on mobile and PC and, soon enough, smart TVs or a potential Xbox streaming stick. This is a business model that not only makes sense given the evolution of technology towards cloud-centric services, but is also in-line with Microsoft’s core competency and fundamental nature.

More importantly, at least in the context of this Article, is the freedom of movement this gives Microsoft when it comes to acquisitions: all of ZeniMax’s titles, and many of Activision Blizzard’s titles in the future, are still available on PlayStation and Steam as individual purchases; if that is how you want to pay then Microsoft will accept your money, and avoid the loss of cutting you off. All of those games, though, are also available on Xbox Game Pass, because Microsoft is betting that many gamers will realize it’s a pretty good deal, even as it aligns with the company’s corporate goal of creating lifelong customers paying via subscription.

Sony and Exclusives

Major deals like Sony’s acquisition of Bungie, the once-makers of Halo (while owned by Microsoft) and current developers of Destiny (for which they negotiated their freedom), obviously don’t come together in two weeks. It’s tempting, though, to view it as defensive: if Microsoft were to withdraw a property like the afore-mentioned Call of Duty, well, Sony can always take away Destiny.

The truth, though, is that this is simply the most visible of a long line of acquisitions, going back two decades to Sony’s 2001 acquisition of Naughty Dog, of studios that make content for consoles that is worth switching over. Naughty Dog has made Crash Bandicoot, Uncharted, and The Last of Us; Incognito made the Twisted Metal series; Guerrilla Games made the Killzone and Horizon series; Sucker Punch made Sly Cooper, Infamous, and the Ghost of Tsushima; Insomniac made Ratchet and Clank and Spider-Man; Bluepoint Games made Shadow of the Colossus and Demon’s Souls; all were PlayStation exclusives, credited with Sony’s dominance over the last two console generations.

Sony, rather than chasing Microsoft, appears set for a more Nintendo-like trajectory: customers will buy their consoles because they have exclusive games that you can’t get anywhere else; unlike Nintendo, Sony consoles are on the cutting edge technologically, which means that the remaining 3rd-party publishers like EA will continue to support them. Sure, Microsoft has a good subscription, but Sony has games you can’t get anywhere else (and, rumors suggest, a new subscription service of its own, although it may not have the best titles available immediately, which makes sense given Sony’s strategy).

That is why I expect Bungie to continue to support Destiny across multiple platforms (PlayStation, Xbox, and PC), while new content beyond the upcoming Witch Queen expansion is probably going to come out on PlayStation first; whatever title lies beyond that, meanwhile, has a good chance of being PlayStation only (if you haven’t spent the money on supporting multiple platforms, it is an easier choice to be an exclusive).

Update: Bungie made clear in an FAQ that future Destiny content would be available on the first day on all platforms, which makes sense given that Destiny supports cross-play. Moreover, the same FAQ states that any IP beyond Destiny would also be cross-platform; this doesn’t detract from the general point about Sony and exclusives, but it certainly suggests that doesn’t apply in this case. This was an error on my part and I apologize.

Gaming and the Smiling Curve

The Smiling Curve, as I first explained in this 2014 Article, was a concept created by Acer founder Stan Shih to explain where the profits were in technological manufacturing; from Wikipedia:

A smiling curve is an illustration of value-adding potentials of different components of the value chain in an IT-related manufacturing industry…According to Shih’s observation, in the personal computer industry, both ends of the value chain command higher values added to the product than the middle part of the value chain. If this phenomenon is presented in a graph with a Y-axis for value-added and an X-axis for value chain (stage of production), the resulting curve appears like a “smile”.

I argued at the time that this framework was applicable to the publishing industry:

When people follow a link on Facebook (or Google or Twitter or even in an email), the page view that results is not generated because the viewer has any particular affinity for the publication that is hosting the link, and it is uncertain at best whether or not their affinity will increase once they’ve read the article. If anything, the reader is likely to ascribe any positive feelings to the author, perhaps taking a peek at their archives or Twitter feed.

Over time, as this cycle repeats itself and as people grow increasingly accustomed to getting most of their “news” from Facebook (or Google or Twitter), value moves to the ends, just like it did in the IT manufacturing industry or smartphone industry:

The Publishing Smiling Curve

I think this framework is also the best way to think about all of these acquisitions. To generalize the concept, the top right of the curve are companies that have a direct connection with customers, including the Aggregators; the top left are highly differentiated content makers:

The Smiling Curve in gaming

When it comes to mobile gaming, the dominant Aggregators on the top right side of the curve are Apple and Google and their respective App Stores; the most cynical interpretation of ATT is that Facebook was superseding both to become the most important way in which people discovered apps, and Apple, thanks to its OS-level control, cut them off at the knees, pushing Facebook down to the middle. The response from content makers, then, has been to consolidate and increase the leverage that comes from differentiated content.

Xbox Game Pass, meanwhile, is an attempt to build a position as an Aggregator; the initiative will be successful to the extent that gamers play games because they are in Game Pass, and increasingly shun games that have to be purchased individually (incentivizing holdouts to join Microsoft’s subscription). Microsoft is kick-starting this effort by buying its own differentiated content and overlaying their long-term incentives over any individual game studio’s incentives to maximize their short-term revenue by selling a game individually.

Sony is pursuing a similar strategy, but with a different business model: whereas Microsoft is increasingly device-agnostic (of course it helps that they sell both Xbox consoles and Windows), Sony is doubling down on the integration of hardware and software. Their best content is designed to not only make money in its own right but to also persuade customers to buy PlayStation consoles; the more PlayStation consoles there are the more attractive the platform is to 3rd-party developers.

What is much less viable is anything in the middle. The original PlayStation was almost completely dependent on 3rd-party games, relying on technical superiority to build its user base and attract developers; that approach reached its limit with the relative disappointment that was the PlayStation 3, and Sony has been focused on exclusives ever since. Content developers like Zynga, meanwhile, can’t depend on companies in the middle either: Apple’s rules have ensured that anyone who is not an Aggregator has to figure out how to make money on their own. There is still a market for 3rd-party developers on consoles and PCs — Steam is a major Aggregator on the latter, challenged by not just Microsoft but also Epic, who all are competing for the best developers — but it is increasingly important that content be highly differentiated and costs tightly contained.

The Upside of Acquisitions

There are a lot of seemingly scary implications in this analysis, including concepts like exclusives, lock-in, and the sense that the big are getting bigger. I think there is a strong argument, though, that the overall impact on consumers is on balance a positive one. Gaming, to a much greater extent than many other industries, is a zero sum game: time spent playing one title is time not spent playing another one. Moreover, the total cost of ownership for any particular gaming platform, relative to the time spent playing games, is a very favorable one. With regards to the latter point, the price of having access to everything is not an overwhelming one; with regards to the former the incentives to make a game that is truly exceptional, and thus truly differentiated, are higher than ever.

Phil Spencer, CEO of Microsoft Gaming, made an argument along these lines when I challenged him in a Stratechery interview about a potential loss of competition entailed in the company’s Activision Blizzard acquisition:

Phil Spencer: Ah. I mean, that’s maybe where we’ll differ in opinion. Some of this just comes down to the teams that become part of our team and our cultural journey with them that starts long ago. This will sound a little bit like a kind of gaming person, but I’ll say the thing that I have found that drives the teams internally to our organization is they want to do things they’ve never been able to do before. They want to reach more players of their creations than they’ve ever been able to create before. And I might argue the opposite, that the churn of “I need another holiday release next year” and then the year after and then the year after can be more stifle on creativity than the freedom that we’re able to give that says, “It’s not about one business model that works for us, it’s actually about multiple business models. It’s not about one screen that people will consume your game on. You pick the screen that’s right for you. And the input, if you want keyboard or mouse, you want touch, you want controller, you pick. You pick the subject matter that you want to work on.”

And frankly, when I look at the portfolio of games that we’ve been shipped over the last two or three years and some of the subject matter that our creators have decided to tackle, not always in the thinnest definition of what’s marketable at that time, I think those innovations and that kind of risk taking comes from having amazing teams that are thinking about what’s possible or even what’s not possible and how our tools and distribution can help them in creating things that they’ve never been able to create before. That’s what I feel.

Today, what I did after we announced this morning is I got to sit down with our studio leaders. The amount of energy they had for learning from other teams, because creators can get isolated because they’re so focused on the thing they’re doing right now. Now we get to sit there at the broadest level and have discussions about what people are thinking about, whether they’re challenging each other with sharing the learning that they have, what they aspire to go do. The energy in the room was awesome, it was a virtual room in a Teams call, but it was still awesome. I would say that that freedom to innovate, to try new things, because it’s not just down to one business model or one screen or even one device that somebody might buy is the thing that I found is most liberating for the teams here.

Of course that’s the answer I would expect.

PS: (laughing)

I think that one of the early questions about this deal is basically — the big company doesn’t think competition is particularly useful or valuable. “We want to give people freedom to explore.”

PS: Well, let me hit on that one. Sorry, I didn’t mean to interrupt, but let me hit on competition really quick, because I see competition as a little bit different. There’s a ton of competition in the games business. If I rewind 30 years ago, the video game business was dictated by who had shelf space at Egghead because there was such a constriction on distribution and funding and marketing of games that the portfolio of games I could choose from was so limited. I love the fact that when I look at the top 10 games that are being played, how many come from traditional places versus how many now are coming from creators that didn’t even exist 10 years ago. I love that there’s that creative turnover or just the diversity in where great games come from.

And then when I think about the platform side, the largest platforms for playing games or mobile devices, distribution on those devices are controlled by two companies. So for us, it’s how do we go invest in content and community so that we can actually have our distribution through our own content engagement that we have because the competition is out there and it’s so strong? I think the competition you talk about between individual teams and the competition to make the next paycheck, I understand maybe that’s motivating to certain teams, I’ve just found with our teams that they do much better work when our motivation is more about how many customers can we reach.

Forgive the extended excerpt, but I think this is essential, particularly the second part: so much of our thinking about competition is rooted in the analog world, a world of scarcity where there really was limited shelf space or limited telephone lines or limited railroad access; that just isn’t the case on the Internet, where anyone has access to everyone. This has dramatically increased the power of creators, who can not only go direct, but also plays Aggregators off against each other — that is the realm of competition that matters. If we must accept a world where platforms like the App Store have total power within their domains, then the answer is to build up alternative Aggregators that have compelling content of their own, waging a proper fight for the only scarce resource there is on the Internet: time.

  1. I will save the Wordle acquisition for another day! ↩

  2. Each of which has a standalone $10/month plan ↩

The Intel Split

Posted on Author by Ben Thompson

Intel’s earnings are not until next Wednesday, but whatever it is that CEO Pat Gelsinger plans to discuss, it seems to me the real news about Intel came from the earnings of another company: TSMC.

From the Wall Street Journal:

Taiwan Semiconductor Manufacturing Co., the world’s largest contract chip maker, said it would increase its investment to boost production capacity by up to 47% this year from a year earlier as demand continues to surge amid a global chip crunch. TSMC said Thursday that it has set this year’s capital expenditure budget at $40 billion to $44 billion, a record high, compared with last year’s $30 billion.

Tim Culpan at Bloomberg described the massive capex figure as a “warning” to fellow chipmakers Intel and Samsung:

From a technology perspective, Samsung is the nearest rival. Yet a comparison is skewed by the fact that the South Korean company also makes display screens and puts most of its semiconductor spending toward commodity memory chips that TSMC doesn’t even bother to make.

Then there’s Intel, the U.S. would-be challenger that’s decided to join the foundry fray. In addition to manufacturing chips under its own brand, Intel Chief Executive Officer Pat Gelsinger last year decided he wants to take on TSMC and Samsung — and a handful of others — by offering to make them for external clients.

But Intel trails both of them in technology prowess, forcing the California company into the ironic position of relying on TSMC to produce its best chips. Gelsinger is confident that he can catch up. Maybe he will, but there’s no way the firm will be able to expand capacity and economies of scale to the point of being financially competitive.

It’s worse than that, actually: by becoming TSMC’s customer Intel is not only denying itself the scale of its own manufacturing needs, but also giving that scale to TSMC, improving the economics of their competitor in the process.

Gelsinger’s Design Tools

One of my favorite quotes from Michael Malone’s The Intel Trinity is about how “Moore’s Law” — the observation by Intel co-founder and second CEO Gordon Moore that transistor counts for integrated circuits doubled every two years — was not a law, but a choice:

[Moore’s Law] is a social compact, an agreement between the semiconductor industry and the rest of the world that the former will continue to strive to maintain the trajectory of the law as long as possible, and the latter will pay for the fruits of this breakneck pace. Moore’s Law has worked not because it is intrinsic to semiconductor technology. On the contrary, if tomorrow morning the world’s great chip companies were to agree to stop advancing the technology, Moore’s Law would be repealed by tomorrow evening, leaving the next few decades with the task of mopping up all of its implications.

Moore made that observation in 1965, and for the next 50 years that choice fell to Intel to make. One of the chief decision-makers was a young man in his 20s named Patrick Gelsinger. Gelsinger joined Intel straight out of high school, and worked on the team developing the 286 processor while studying electrical engineering at Stanford; he was the 4th lead for the 386 while completing his Masters. After he graduated Gelsinger became the lead of the 486 project; he was only 25.

The Intel 486 die
The Intel 486 die

Intel was, at this time, a fully integrated device manufacturer (IDM); while that term today refers to a company that designs and fabricates its own chips (in contrast to a company like Nvidia, which designs its own chips but doesn’t manufacture them, or TSMC, which manufactures chips but doesn’t design them), the level of integration has decreased over time as other companies have come to specialize in different parts of the manufacturing process. Back in the 1980s, though, Intel still had to figure out a lot of things for the first time, including how to actually design ever more microscopic chips. Gelsinger, along with three co-authors, described the problem in a 2012 paper entitled Coping with the Complexity of Microprocessor Design at Intel — a CAD History:

In his original 1965 paper, Gordon Moore expressed a concern that the growth rate he predicted may not be sustainable, because the requirement to define and design products at such a rapidly-growing complexity may not keep up with his predicted growth rate. However, the highly competitive business environment drove to fully exploit technology scaling. The number of available transistors doubled with every generation of process technology, which occurred roughly every two years. As shown in Table I, major architecture changes in microprocessors were occurring with a 4X increase of transistor count, approximately every second process generation. Intel’s microprocessor design teams had to come up with ways to keep pace with the size and scope of every new project.

Processor Intro Date Process Transistors Frequency
4004 1971 10 um 2,300 108 KHz
8080 1974 6 um 6,000 2 MHz
8086 1978 3 um 29,000 10 MHz
80286 1982 1.5 um 134,000 12 MHz
80386 1985 1.5 um 275,000 16 MHz
Intel486 DX 1989 1 um 1.2 M 33 MHz
Pentium 1993 0.8 um 3.1 M 60 MHz

This incredible growth rate could not be achieved by hiring an exponentially-growing number of design engineers. It was fulfilled by adopting new design methodologies and by introducing innovative design automation software at every processor generation. These methodologies and tools always applied principles of raising design abstraction, becoming increasingly precise in terms of circuit and parasitic modeling while simultaneously using ever-increasing levels of hierarchy, regularity, and automatic synthesis. As a rule, whenever a task became too painful to perform using the old methods, a new method and associated tool were conceived for solving the problem. This way, tools and design practices were evolving, always addressing the most labor-intensive task at hand. Naturally, the evolution of tools occurred bottom-up, from layout tools to circuit, logic, and architecture. Typically, at each abstraction level the verification problem was most painful, hence it was addressed first. The synthesis problem at that level was addressed much later.

This feedback loop between design and implementation is exactly what is necessary at the cutting edge of innovation. Clayton Christensen explained in The Innovator’s Solution:

When there is a performance gap — when product functionality and reliability are not yet good enough to address the needs of customers in a given tier of the market — companies must compete by making the best possible products. In the race to do this, firms that build their products around proprietary, interdependent architectures enjoy an important competitive advantage against competitors whose product architectures are modular, because the standardization inherent in modularity takes too many degrees of design freedom away from engineers, and they cannot not optimize performance.

This is what Gelsinger did with the 486; from the afore-linked paper:

While the 386 design heavily leveraged the logic design of the 286, the 486 was a more radical departure with the move to a fully pipelined design, the integration of a large floating point unit, and the introduction of the first on-chip cache – a whopping 8K byte cache which was a write through cache used for both code and data. Given that substantially less of the design was leveraged from prior designs and with the 4X increase in transistor counts, there was enormous pressure for yet another leap in design productivity. While we could have pursued simple increases in manpower, there were questions of the ability to afford them, find them, train them and then effectively manage a team that would have needed to be much greater than 100 people that eventually made up the 486 design team…For executing this visionary design flow, we needed to put together a CAD system which did not exist yet.

To make a new chip, Intel needed to make new tools, as part of an overall integrated effort that ran from design to manufacturing.

Intel’s Ossification

Fast forward three decades and Intel is no longer on the cutting edge; instead the leading chip manufacturer in the world is TSMC, a company built on the idea that it does not do design; Morris Chang told the Computer History Museum:

When I was at TI and General Instrument, I saw a lot of IC [Integrated Circuit] designers wanting to leave and set up their own business, but the only thing, or the biggest thing that stopped them from leaving those companies was that they couldn’t raise enough money to form their own company. Because at that time, it was thought that every company needed manufacturing, needed wafer manufacturing, and that was the most capital intensive part of a semiconductor company, of an IC company. And I saw all those people wanting to leave, but being stopped by the lack of ability to raise a lot of money to build a wafer fab. So I thought that maybe TSMC, a pure-play foundry, could remedy that. And as a result of us being able to remedy that then those designers would successfully form their own companies, and they will become our customers, and they will constitute a stable and growing market for us.

This was skating to Christensen’s puck; again from The Innovator’s Solution:

Overshooting does not mean that customers will no longer pay for improvements. It just means that the type of improvement for which they will pay a premium price will change. Once their requirements for functionality and reliability have been met, customers begin to redefine define what is not good enough. What becomes not good enough is that customers can’t get exactly what they want exactly when they need it, as conveniently as possible. Customers become willing to pay premium prices for improved performance along this new trajectory of innovation in speed, convenience, and customization. When this happens, we say that the basis of competition in a tier of the market has changed.

TSMC was willing to build any chip that these new fabless companies could come up with; what is notable is that it was Gelsinger and Intel who made this modular approach possible, thanks to the tools they built for the 486. Again from that paper:

The combination of all these tools was stitched together into a system called RLS1 which was the first RTL2 to layout system ever employed in a major microprocessor development program…RLS succeeded because it combined the power of three essential ingredients:

  • CMOS (which enabled the use of a cell library)
  • A Hardware Description Language (providing a convenient input mechanism to capture design intent)
  • Synthesis (which provided the automatic conversion from RTL to gates and layout)

This was the “magic and powerful triumvirate”. Each one of these elements alone could not revolutionize design productivity. A combination of all three was necessary! These three elements were later standardized and integrated by the EDA3 industry. This kind of system became the basis for all of the ASIC4 industry, and the common interface for the fabless semiconductor industry.

The problem is that Intel, used to inventing its own tools and processes, gradually fell behind the curve on standardization; yes, the company had partnerships with EDA companies like Synopsys and Cadence, but most of the company’s work was done on its own homegrown tools, tuned to its own fabs. This made it very difficult to be an Intel Custom Foundry customer; worse, Intel itself was wasting time building tools that once were differentiators, but now were commodities.

This bit about tools isn’t new; Gelsinger announced Intel’s support for Synopsis and Cadence at last March’s announcement of Intel Foundry Services (IFS), and of course they did: Intel can’t expect to be a full-service foundry if it can’t use industry-standard design tools and IP libraries.

What I have come to appreciate, though, is exactly why Gelsinger announced IFS as only one part of Intel’s broader “IDM 2.0” strategy:

  • Part 1 was Intel’s internal manufacturing of its own designs; this was basically IDM 1.0.
  • Part 2 was Intel’s plan to use 3rd-party manufacturers like TSMC for its cutting edge products.
  • Part 3 was Intel Foundry Services.

I had been calling for something like IFS since the beginning of Stratechery, and had even gone so far as to advocate a split of the company a month before Gelsinger’s presentation. “IDM 2.0” suggested that Intel wasn’t going to go quite that far — and understandably so, given the history of Part 1 — but the more I think about Part 2, and how it connects to the other pieces, I wonder if I was closer to the mark than I realized.

Microsoft and Intel

In 2018, when I traced the remarkable turnaround Satya Nadella had led at Microsoft in an article entitled The End of Windows, I noted that Nadella’s first public event was to announce Office on iPad. This was an effort that was launched years previously under former CEO Steve Ballmer, but hadn’t launched because the Windows Touch version wasn’t ready. That, though, was precisely why Nadella’s launch was meaningful: he was signaling to the rest of the company that Windows would no longer be the imperative for Office; that same week Nadella renamed Windows Azure to Microsoft Azure, sending the exact same message.

I thought of this timing when Gelsinger spoke about TSMC making chips for Intel; that too was an initiative launched under a predecessor (Bob Swan). The assumption made by nearly everyone, though, was that Intel’s partnership with TSMC would only be a stopgap while the company got its manufacturing house in order, such that it could compete directly; indeed, that is the assumption underlying the opening of this Article.

This, though, is why TSMC’s announcement about its increased capital expenditure was such a big deal: a major driver of that increase appears to be Intel, for whom TSMC is reportedly building a custom fab. From DigiTimes:

TSMC plans to have its new production site in the Baoshan area in Hsinchu, northern Taiwan make 3nm chips for Intel, according to industry sources. TSMC will have part of the site converted to 3nm process manufacturing, the sources said. The facilities of the site, dubbed P8 and P9, were originally designed for an R&D center for sub-3nm process technologies. The P8 and P9 of TSMC’s Baoshan site will be capable of each processing 20,000 wafers monthly, and will be dedicated to fulfilling Intel’s orders, the sources indicated.

TSMC intends to differentiate its chip production for Intel from that for Apple, and has therefore decided to separate its 3nm process fabrication lines dedicated to fulfilling orders from these two major clients, the sources noted. The moves are also to protect the customers’ respective confidential products, the sources said. Intel’s demand could be huge enough to persuade TSMC to modify the pure-play foundry’s manufacturing blueprints, the sources indicated. The pair’s partnership is also likely to be a long-term one, the sources said.

Intel and Microsoft are bound by history, of course, but obviously their businesses are at the opposite ends of the computing spectrum: Intel deals in atoms and Microsoft in bits. What was common to both, though, was an unshakeable belief in the foundations of their business model: for Microsoft, it was the leverage over not just the desktop, but also productivity and enterprise servers, delivered by Windows; for Intel it was the superiority of their manufacturing. Nadella, before he could change tactics or even strategy, had to shake the Windows hangover that had corrupted the culture; Gelsinger needed to do the same to Intel, which meant taking on his own factories.

Think about the EAD issue I explained above: it must have been a slog to cajole Intel’s engineers into abandoning their homegrown solutions in favor of industry standards when the only beneficiaries were potential foundry customers — that is one of the big reasons why Intel Custom Foundry failed previously. However, if Intel were to manufacture its chips with TSMC, then it would have no choice but to use industry standards. Moreover, just as Windows needed to learn to compete on its own merits, instead of expecting Office or Azure to prop it up, Intel’s factories, denied monopoly access to cutting edge x86 chips, will now have to compete with TSMC to earn not just 3rd-party business, but business from Intel’s own design team.

The Intel Split

When I wrote that Intel should be broken up I focused on incentives:

This is why Intel needs to be split in two. Yes, integrating design and manufacturing was the foundation of Intel’s moat for decades, but that integration has become a strait-jacket for both sides of the business. Intel’s designs are held back by the company’s struggles in manufacturing, while its manufacturing has an incentive problem.

The key thing to understand about chips is that design has much higher margins; Nvidia, for example, has gross margins between 60~65%, while TSMC, which makes Nvidia’s chips, has gross margins closer to 50%. Intel has, as I noted above, traditionally had margins closer to Nvidia, thanks to its integration, which is why Intel’s own chips will always be a priority for its manufacturing arm. That will mean worse service for prospective customers, and less willingness to change its manufacturing approach to both accommodate customers and incorporate best-of-breed suppliers (lowering margins even further). There is also the matter of trust: would companies that compete with Intel be willing to share their designs with their competitor, particularly if that competitor is incentivized to prioritize its own business?

The only way to fix this incentive problem is to spin off Intel’s manufacturing business. Yes, it will take time to build out the customer service components necessary to work with third parties, not to mention the huge library of IP building blocks that make working with a company like TSMC (relatively) easy. But a standalone manufacturing business will have the most powerful incentive possible to make this transformation happen: the need to survive.

Intel is obviously not splitting up, but this TSMC investment sure makes it seem like Gelsinger recognizes the straitjacket Intel was in, and is doing everything possible to get out of it. To that end, it seems increasingly clear that the goal is to de-integrate Intel: Intel the design company is basically going fabless, giving its business to the best foundry in the world, whether or not that foundry is Intel; Intel the manufacturing company, meanwhile, has to earn its way (with exclusive access to x86 IP blocks as a carrot for hyperscalers building their own chips), including with Intel’s own CPUs.

Gelsinger’s Grovian Moment

It’s not clear that this will work, of course; indeed, it is incredibly risky, given just how expensive fabs are to build, and how critical it is that they operate at full capacity. Moreover, Intel is making TSMC stronger (while TSMC benefits from having another tentpole customer to compete with Apple). Given Intel’s performance over the last decade, though, it might have been more risky to stick with the status quo, in which Intel’s floundering fabs take down Intel’s design as well. In that regard it makes sense; in fact, one is reminded of the famous story of Moore and Gelsinger’s mentor, Andy Grove, deciding to get out of memory, which I wrote about in 2016:

Intel was founded as a memory company, and the company made its name by pioneering metal-oxide semiconductor technology in first SRAM and then in the first commercially available DRAM. It was memory that drove all of Intel’s initial revenue and profits, and the best employees and best manufacturing facilities were devoted to memory in adherence to Intel’s belief that memory was their “technology driver”, the product that made everything else — including their fledgling microprocessors — possible. As Grove wrote in Only the Paranoid Survive, “Our priorities were formed by our identity; after all, memories were us.”

The problem is that by the mid-1980s Japanese competitors were producing more reliable memory at lower costs (allegedly) backed by unlimited funding from the Japanese government, and Intel was struggling to compete…

Grove explained what happened next in Only the Paranoid Survive:

I remember a time in the middle of 1985, after this aimless wandering had been going on for almost a year. I was in my office with Intel’s chairman and CEO, Gordon Moore, and we were discussing our quandary. Our mood was downbeat. I looked out the window at the Ferris Wheel of the Great America amusement park revolving in the distance, then I turned back to Gordon and asked, “If we got kicked out and the board brought in a new CEO, what do you think he would do?” Gordon answered without hesitation, “He would get us out of memories.” I stared at him, numb, then said, “Why don’t you and I walk out the door, come back in and do it ourselves?”

Gelsinger was once thought to be next-in-line to be Intel’s CEO; he literally walked out the door in 2009 and for a decade Intel floundered under business types who couldn’t have dreamed of building the 486 or the tools that made it possible; now he has come back home, and is doing what must be done if Intel is to be both a great design company and a great manufacturing company: split them up.

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

  1. RTL to Layout Synthesis ↩

  2. Register-Transfer Level ↩

  3. Electronic Design Automation ↩

  4. Application-specific Integrated Circuit ↩

OpenSea, Web3, and Aggregation Theory

Posted on Author by Ben Thompson

This was originally sent as a subscriber-only Update.

From Eric Newcomer:

The NFT-marketplace OpenSea is in talks to raise at a $13 billion valuation in a deal led by Coatue, sources tell me. Paradigm will also co-lead the $300 million funding round, according to a spokesperson for the firm. Kathryn Haun’s new crypto fund, which is currently operating under Haun’s initials “KRH,” is also participating in the funding round, sources tell me. Dan Rose at Coatue is spearheading the round and may take a board observer seat.

OpenSea confirmed the news on their blog:

In 2021, we saw the world awaken to the idea that NFTs represent the basic building blocks for brand new peer-to-peer economies. They give users greater freedom and ownership over digital goods, and allow developers to build powerful, interoperable applications that provide real economic value and utility to users. OpenSea’s vision is to become the core destination for these new open digital economies to thrive, building the world’s friendliest and most trusted NFT marketplace with the best selection.

This is, of course, a story about NFTs, at least in part, and by extension, a story about the so-called Web 3 née crypto economy that its fiercest advocates say is the future. But there are two other parts of this story that are very much at home on the Internet as it exists in the present: $13 billion, and “core destination.”

OpenSea’s Value

First, two more OpenSea stories from over the break. From Be In Crypto:

NFT marketplace OpenSea has frozen $2.2 million worth of Bored Ape (BAYC) NFTs after they were reported as being stolen. The NFTs on the marketplace now have a warning saying that it is “reported for suspicious activity.” Buying and selling of such items are suspended…

Meanwhile, there is a bit of a squabble happening over OpenSea over the Phunky Ape Yacht Club (PAYC). The NFT platform banned this NFT series because it was based on the Bored Ape Yacht Club NFTs. PAYC is virtually identical to BAYC, except for the fact it is mirrored.

This excerpt isn’t technically complete: buying and selling of the stolen NFTs — or of the PAYC NFTs — are suspended on OpenSea. The fact of the matter is that (references to) NFTs are, famously, stored on the blockchain (Ethereum in this case), and once those BAYC NFTs were transferred, by consent of their previous owner or not, the transaction cannot be undone without the consent of their new owner; said owner can buy or sell the NFTs to someone else, but not on OpenSea. It’s the same thing with with the BAYC rip-offs: they exist on the blockchain, whether or not OpenSea lists them for sale or not.

This, according to crypto advocates, is evidence of the allure of Web 3: because the blockchain is open and accessible by anyone, the stolen BAYC NFTs and the PAYC rip-offs can be sold on another market, or if one cannot be found, in a private transaction (leave aside, for the sake of argument and the brevity of this update, the question as to whether the fact that these transactions are irreversible is a feature or a bug).

Here’s the thing, though: this isn’t a new concept. What is the first answer given to anyone who is banned from Twitter, or demonetized on YouTube — two of the go-to examples Web 3 advocates give about the problem of centralized power on the Internet today? Start your own Twitter, or start your own blog, or set up a Substack. These answers are frustrating because they are true: the web is open.

Indeed, if this frustration sounds familiar, it is because it is the frustration of the regulator insisting that Aggregators are monopolies, that Google is somehow forcing users to not use Bing like some sort of railroad baron extorting farmers simply seeking to move grain to market, or that Facebook has a monopoly on social networking, ignoring the fact that we have far more ways to communicate than ever before.

In fact, what gives Aggregators their power is not their control of supply: they are not the only way to find websites, or to post your opinions online; rather, it is their control of demand. People are used to Google, or it is the default, so sites and advertisers don’t want to spend their time and money on alternatives; people want other people to see what they have to say, so they don’t want to risk writing a blog that no one reads, or spending time on a social network that because it lacks the network has no sense of social.

This is why regulations focused on undoing the control of supply are ineffective: the marginal cost nature of computing and the zero distribution cost of the Internet made it viable for the first time — and far more profitable — to control demand, not by forcing people to act against their will, but by making it easy for them to accomplish whatever it is they wished to do, whether that be find a website, buy a good, talk to their friends, or give their opinion. And now, to buy or sell NFTs.

This, then, is the reason that OpenSea received its $13 billion valuation: it is by far the dominant market for NFTs; should the market exist in the long run, the most likely entryway for end users will be OpenSea. This is a very profitable position to be in, even if alternatives are only a click away. It’s not like that reduces the profitability of a Google or a Facebook.

It is also why OpenSea’s bans have some amount of teeth to them: as I noted, you can still buy and sell these stolen and rip-off NFTs, just as you can still go to a website that is not listed in Google, communicate with a friend kicked off of Facebook, or state your opinions somewhere other than Twitter. The reduced demand, though, lowers the price, whether that price be traffic, convenience, or attention. Or, in the case of NFTs, ETH: not having access to OpenSea means there is less demand for these NFTs, and less demand means lower prices.

In short, OpenSea has power not because it controls the NFTs in question, but because it controls the vast majority of demand.

Crypto’s Aggregators

One of the reasons that crypto is so interesting, at least in a theoretical sense, is that it seems like a natural antidote to Aggregators; I’ve suggested as such. After all, Aggregators are a product of abundance; scarcity is the opposite. The OpenSea example, though, is a reminder that I have forgotten one of my own arguments about Aggregators: demand matters more than supply.

To that end, which side of the equation is impacted by the blockchain? The answer, quite obviously is supply. Indeed, one need only be tangentially aware of crypto to realize that the primary goal of so many advocates is to convert non-believers, the better to increase demand. This has the inverse impact of OpenSea’s ban: increased demand increases prices for scarce supply, which is to say, in terms that are familiar to any Web 3 advocate, that the incentives of Web 3’s most ardent evangelists are very much aligned.

The most valuable assets in crypto remain tokens; Bitcoin and Ethereum lead the way with market caps of $874 billion and $451 billion, respectively. What is striking, though, is that the primary way that most users interact with Web 3 are via centralized companies like Coinbase and FTX on the exchange side, Discord for communication and community, and OpenSea for NFTs. It is also not a surprise: centralized companies deliver a better user experience, which encompasses everything from UI to security to at least knocking down the value of your stolen assets on your behalf; a better user experience leads to more users, which increases power over supply, further enhancing the user experience, in the virtual cycle described by Aggregation Theory.

That Aggregation Theory applies to Web 3 is not some sort of condemnation of the idea; it is, perhaps, a challenge to the insistence that crypto is something fundamentally different than the web. That’s fine — as I wrote before the break, the Internet is already pretty great, and its full value is only just starting to be exploited. And, as I argued in The Great Bifurcation, the most likely outcome is that crypto provides a useful layer on what already exists, as opposed to replacing it.

Moreover, as I explained in a follow-up to The Great Bifurcation, this view of crypto’s role relative to the web places it firmly in an ongoing progression away from technical lock-in and towards network effects:

Technical lock-in has decreased while network lock-in has increased

This is a dramatic simplification, to be clear, but I think it is directionally correct; the long-term trend, all of the hysteria around tech notwithstanding, is towards more openness and less lock-in. At the same time, this doesn’t mean that companies are any less dominant; rather, their means of dominance has shifted from the technical to the sociological.

Crypto, still largely valued on nothing more than the collective belief of its users, is the ultimate example to date of the power of a network, in every sense of the word. That that collective belief is a point of leverage for companies that can aggregate believers is the most natural outcome imaginable, even if it means that the lack of technical lock-in will likely prove to be more of an occasionally invoked escape hatch (and a welcome one at that) as opposed to the defining characteristic for the majority of users.

The 2021 Stratechery Year in Review

Posted on Author by Ben Thompson

There is a perspective in which 2021 was an absolute drag: COVID dragged on, vaccines became politicized, new variants emerged, and while tech continued to provide the infrastructure that kept the economy moving, it also provided the infrastructure for all of those things that made this year feel so difficult.

At the same time, 2021 also provided a glimpse of a future beyond our current smartphone and social media-dominated paradigm: there was the Metaverse, and crypto, and my contention they are related. Sure, the old paradigm is increasingly dominated by regulation and politics, a topic that is so soul-sucking that it temporarily made me want to post less, but the brilliance of the Internet, and of business-models like that which undergirds Stratechery, is that freedom to not only write what you want, but build what you want, and be what you want, is greater than ever.

A drawing of Internet 3.0 and Open Protocols

This year Stratechery published 40 free Weekly Articles and 121 Daily Updates, including 13 interviews. I also launched Passport, the new back-end for Stratechery and Dithering, the twice-a-week for-pay podcast I host with John Gruber; Passport remains under development, so stay tuned for updates in 2022.

Passport is the new back-end for Stratechery

Today, as per tradition, I summarize the most popular and most important posts of the year on Stratechery.

You can find previous years here: 2020 | 2019 | 2018 | 2017 | 2016 | 2015 | 2014 | 2013

On to 2021:

The Five Most-Viewed Articles

The five most-viewed articles on Stratechery according to page views:

  1. Clubhouse’s Inevitability — I was very bullish on Clubhouse; unfortunately, it looks like I got this one completely wrong. I admitted to my error and explained my thinking in this Update.
  2. The Relentless Jeff Bezos — Jeff Bezos is retiring, and will go down as one of the great CEO’s in tech history, in part because of how he transformed Amazon into a tech company in every respect.
  3. Intel Problems — Intel is in much more danger than its profits suggest; the problems are a long time in the making, and the solution is to split up the company. See also, Intel Unleashed, Gelsinger on Intel, IDM 2.0 and Intel vs. TSMC, How Samsung and TSMC Won, MAD Chips.
  4. Internet 3.0 and the Beginning of (Tech) History — The actions taken by Big Tech have a resonance that goes beyond the context of domestic U.S. politics. Even if they were right, they will still push the world to Internet 3.0.
  5. Apple’s Mistake — While it’s possible to understand Apple’s motivations behind its decision to enable on-device scanning, the company had a better way to satisfy its societal obligations while preserving user privacy. See also, Apple Versus Governments, Apple’s Legitimate Privacy Claims, Privacy and Paranoia, Apple’s Point-of-View, NFTs and Status, NFTs and Standard Formats, and Facebook Messenger Updates, WhatsApp vs. Apple, Facebook’s CSAM Approach.

The Next Revolution

Several posts throughout the year wrestled with the theory of the next revolution, from memes to metaverses:

  • Internet 3.0 and the Beginning of (Tech) History — The actions taken by Big Tech have a resonance that goes beyond the context of domestic U.S. politics. Even if they were right, they will still push the world to Internet 3.0.
  • Mistakes and Memes — Information on the Internet is conveyed by memes, which can be anything and everything. The real world impacts are only now being understood.
  • The Death and Birth of Technological Revolutions — Carlota Perez documents technological revolutions, and thinks we’re in the middle of the current one; what, though, if we are nearing its maturation? Is crypto next?
  • Sequoia Productive Capital — Sequoia’s transformation of its venture capital model is actually a shift from financial capital to productive capital.
  • The Great Bifurcation — Tracing the evolution of tech’s three eras, and why the fourth era — the Metaverse — is defined by its bifurcation with the physical world.

The Metaverse

Several posts this year worked to define the Metaverse and understand its role in the future:

A drawing of Unity and Weta's Convergence

Politics & Regulation

A lot of time — perhaps too much — was spent on politics and regulation:

A drawing of Clubhouse's Similarity to Twitter, Instagram, and TikTok

The App Store

The regulatory question that received the most attention this year was the App Store, thanks in large part to Apple’s legal tussle with Epic:

Creator Power

A yearly theme on Stratechery is creator power, and the opportunities unlocked by the Internet:

A drawing of the Creator Carrying Audiences to Different Mediums

Company Analysis

While most Stratechery company analysis happens in the Update, there were a number of relevant Articles as well:

A drawing of Cloudflare's Modular Cloud

Stratechery Interviews

This year’s Stratechery interviews included:

A drawing of Authoritarianism Hill, Dime-Store Ditch, and Freedom Mountain

Plus, an interview of me on the Good Time Clubhouse Show.

The Year in Daily Updates

Fifteen of my favorite Daily Updates:

A drawing of The Square/Afterpay Network Effect

I am so grateful to the Stratechery (and Dithering!) subscribers that make it possible for me to do this as a job. I wish all of you a Merry Christmas and Happy New Year, and I’m looking forward to a great 2022!

The Great Bifurcation

Posted on Author by Ben Thompson

For the first several years of Stratechery I would write a year end article about “The State of Consumer Technology”; the last one I wrote, though, was in 2018, because consumer technology, dominated as it was by Apple and Google on the device side, and Google and Facebook on the services side, seemed rather stale and destined to descend into the world of politics and regulation (I was more optimistic about the enterprise, both in terms of the ongoing shift to the public cloud and the opportunity for SaaS companies).

That has largely proven to be the case, but it’s not the first time this has happened to technology; the pattern has happened twice before, and in each case the seeds of the next era were planted — usually by incumbents — while the previous era stagnated. And, in every case, the transition was marked by a reduction in lock-in and the devolvement of increasing amounts of autonomy to the individual user.

Tech 1.0: From Invention to IBM

The transistor, the foundation of modern computing, was invented at Bell Labs in 1947 by the solid state physics group led by William Shockley; nine years later Shockley moved to Mountain View, California to be close to his ailing mother in Palo Alto, where he started Shockley Semiconductor Laboratory. Eight of the researchers he hired, led by Bob Noyce, left the increasingly erratic Shockley a year later to found Fairchild Semiconductor, and in 1968 founded Intel with the support of Arthur Rock, one of the first venture capitalists.

The West Coast, though, was a sideshow compared to New York, where IBM had switched to transistors for the 7000 Series mainframe (as opposed to the 700 Series’ vacuum tubes); the real breakthrough was the modular and expandable System/360, which was the first computer bought by most companies, including the fictional SC&P from Mad Men:

There certainly was a connection to be drawn between IBM and the moon: IBM helped develop and track NASA’s initial exploratory flights and the eventual lunar mission. Here on earth, though, the Justice Department decided in 1969 that the company was in violation of antitrust laws; the case would be dropped 13 years later, but not before IBM voluntarily unbundled its software and services from its hardware, creating the first market for software.

Tech 2.0: King of the Hill

Notice those dates: by the time the Department of Justice sued IBM in 1969, Intel had already been founded; two years later an Intel engineer named Frederico Faggin designed the first microprocessor, the Intel 4004, which shrunk many of the functions of IBM’s room-sized computers to a single chip. Ten years after that IBM released the IBM PC, powered by Intel’s 8088 microprocessor.

The open nature of the IBM PC platform — at least once Compaq backward-engineered IBM’s BIOS — commoditized PCs; the real points of leverage in the PC value chain were Intel for chips and Windows for the operating system. The latter was a two-sided market: because so many businesses bought the Windows DOS-powered IBM PC, developers were motivated to make software for DOS; the more software for DOS, and later Windows (which was backwards compatible), the more that businesses sought out DOS/Windows-based computers. Over time more and more people who first used computers at work wanted similar functionality at home, which meant that DOS/Windows dominated the consumer market as well.

Thus was born another Justice Department lawsuit, this time against Microsoft’s alleged monopoly; that case was also eventually dismissed (although it lived on in various forms in the E.U. for years). Once again, though, the next paradigm that rendered the seeming monopolist’s lock-in immaterial was already in place: the Internet could be accessed from any computer, no matter its operating system. Moreover, in an echo of IBM’s voluntary unbundling of hardware and software, which created the conditions for tech’s next evolution, it was Microsoft that introduced the XMLHttpRequest API to Internet Explorer, which undergirded the Ajax web app architecture and Tech 3.0.

Tech 3.0: Software Eats the World

If Tech 1.0 was about hardware, and 2.0 software, 3.0 was about services. On the enterprise side this meant the development of the public cloud and software-as-a-service applications that required nothing more than a browser and a credit card; Marc Andreessen’s famous 2011 essay, Software Is Eating the World, is really about this transformation from software you installed on your computer to software you accessed over the Internet:

Companies in every industry need to assume that a software revolution is coming. This includes even industries that are software-based today. Great incumbent software companies like Oracle and Microsoft are increasingly threatened with irrelevance by new software offerings like Salesforce.com and Android (especially in a world where Google owns a major handset maker).

In some industries, particularly those with a heavy real-world component such as oil and gas, the software revolution is primarily an opportunity for incumbents. But in many industries, new software ideas will result in the rise of new Silicon Valley-style start-ups that invade existing industries with impunity. Over the next 10 years, the battles between incumbents and software-powered insurgents will be epic. Joseph Schumpeter, the economist who coined the term “creative destruction,” would be proud.

One way to think about this is that tech, for the first 50 years of its existence, mostly competed with itself: who could make the best operating system, the best database, the best ERP system. All of these were then adopted by legacy businesses who saw large efficiency gains. The SaaS revolution, though, saw tech turning its sights on the markets those legacy businesses served, bringing to bear entirely new ways of solving problems that started with the malleability and scalability of software as a core principle, not simply as a tool to do the same thing more efficiently.

The consumer space, meanwhile, has arguably been a decade behind the enterprise; e-commerce, for example, was primarily an Amazon story, and social media was all about Facebook. Both took analog concepts and digitized them: Amazon was the Sears and Roebucks catalog with far more products and far faster delivery; Facebook was literally named after a physical artifact, Harvard House face books.

What made Facebook so popular — and why the product retains its stickiness, even today — is that it is first and foremost the online representation of your offline relationships, whether those be family, classmates, friends, or co-workers. This also explains why the most successful Facebook add-ons, like Marketplace and Groups, are themselves often rooted in the physical world. These relationships represent a network effect — the more people you know who are on Facebook, the more valuable it is to you — and once again regulators have come knocking, in this case the FTC.

Note, though, that these cases are, if anything, becoming weaker over time, at least in terms of traditional antitrust concerns: while IBM’s market power was based on top-to-bottom integration that completely foreclosed competitors, Microsoft’s was about a two-sided network that was wide open for developers and users. Facebook, meanwhile, only has its users and their relationships to each other; that is the only thing preventing anyone from using another service.1

Which, of course, they are.

Social Networking 2.0

Last December I wrote what was, in retrospect, an important precursor to this piece (consider it my 2020 State of Technology article): Social Networking 2.0.

[My Bucks DM group is] not my only online community: while the writing of Stratechery is a solo affair, building new features like the Daily Update Podcast or simply dealing with ongoing administrative affairs requires a team that is scattered around the world; we hang out in Slack. Another group of tech enthusiast friends is in another Slack, and a third, primarily folks from Silicon Valley, is in WhatsApp. Meanwhile, I have friends and family centered in Wisconsin (we use iMessage), and, of course Taiwan (LINE for family, WhatsApp for friends). The end result is something I am proud of:

A drawing of Ben's Communities

The pride arises from a piece of advice I received when I announced I was moving back to Taiwan seven years ago: a mentor was worried about how I would find the support and friendship everyone needs if I were living halfway around the world; he told me that while it wouldn’t be ideal, perhaps I could piece together friendships in different spaces as a way to make do. In fact, not only have I managed to do exactly that, I firmly believe the outcome is a superior one, and reason for optimism in a tech landscape sorely in need of it.

The argument in that piece is that Facebook and Twitter represented Social Networking 1.0, where you were expected to be your whole self online; that expectation, though, was like a legacy company using computers to run their analog business model: it may have been more efficient, but it wasn’t at all an optimal use of technology. The entire magic of software is that it is malleable and scalable, and those qualities extend to users creating completely different personas and experiences based on the particular online community that they have joined.

Facebook, incidentally, like IBM and Microsoft in previous eras, has contributed to this evolution, particularly its acquisition and continued support of WhatsApp: while groups exist on all sorts of platforms, from Twitter to Facebook Groups to iMessage, WhatsApp seems to have a major share of these ad hoc private groups, particularly internationally but increasingly in the U.S. as well. What is notable about WhatsApp is that the key identifier is not your account, but rather your phone number; any sort of technological lock-in has completely disappeared.

Tech 4.0: The Metaverse

One of the biggest topics of 2021 has been the Metaverse, thanks in large part to Facebook’s pivot to Meta (even if Microsoft was first). It has been tricky, though, to define exactly what the Metaverse is: everyone has a different definition.

I think, though, I have settled on mine, and it starts with this comment from Meta CEO Mark Zuckerberg:

I think that the phrase “the real world” is interesting. I think that there’s a physical world and there’s a digital world, and increasingly those are sort of being overlaid and coming together, but I would argue that increasingly the real world is the combination of the digital world and the physical world and that the real world is not just the physical world. That, I think, is an interesting kind of frame to think about this stuff going forward.

I both agree and disagree with Zuckerberg; on one hand, I think he is absolutely correct that using “the real world” to only apply to the physical world is a mistake. Think back to those communities I described above that provide so much meaning to my life: those are almost completely online, but the sense of belonging is very real to me. Or think of this Article you are reading: it is nothing but endlessly replicable bits on the Internet, yet it is my career.

Where I disagree is with the idea that the physical world and the digital world are increasingly “being overlaid and coming together”; in fact, I think the opposite is happening: the physical world and digital world are increasingly bifurcating. Again, to use myself as an example, my physical reality is defined by my life in Taiwan with my family; the majority of my time and energy, though, is online, defined by interactions with friends, co-workers, and customers scattered all over the world.

For a long time I felt somewhat unique in this regard, but COVID has made my longstanding reality the norm for many more people. Their physical world is defined by their family and hometown, which no longer needs to be near their work, which is entirely online; everything from friends to entertainment has followed the same path.

Thus my definition: the Metaverse is the set of experiences that are completely online, and thus defined by their malleability and scalability, which is to say that the Metaverse is already here. Sure, today’s experience is largely denominated by text and 2D, but video is already a major medium, first in the form of entertainment and now a vital tool for work. This is a trajectory that, in my estimation, inexorably leads to virtual reality: if all that matters is digital, why wouldn’t you want the most immersive experience possible?

Crypto’s Role

This also explains why crypto is interesting. Stephen Diehl, in a scathing article entitled Web3 is Bullshit, writes:

At its core web3 is a vapid marketing campaign that attempts to reframe the public’s negative associations of crypto assets into a false narrative about disruption of legacy tech company hegemony. It is a distraction in the pursuit of selling more coins and continuing the gravy train of evading securities regulation. We see this manifest in the circularity in which the crypto and web3 movement talks about itself. It’s not about solving real consumer problems. The only problem to be solved by web3 is how to post-hoc rationalize its own existence.

The first part isn’t entirely unfair; scams and ponzi schemes are everywhere, and it seems clear that we are in the middle of an ever-inflating bubble. It’s also the case that an entire set of legitimate use cases are in reality regulatory arbitrage; crypto advocates are far too quick to ascribe all of the issues with the current monetary system to greed and corruption, without acknowledging that complex systems arise for very good reasons. And, along those same lines, Web3 evangelists often sound like overbearing regulators ascribing the dominance of the biggest tech companies to illegal lock-in, without acknowledging that Aggregators win because they provide the user experience consumers want (and which crypto applications currently sorely lack).

The second part, though, is less compelling to me, even if it is a restatement of the most common crypto criticism: “None of this digital stuff has any real world value.” The real world, of course, is the physical world, and I get the critique; I am very skeptical that crypto currencies are going to replace fiat currencies, or be otherwise useful in the physical world, or that DAOs are going to replace LLCs or corporations for real world companies.

Remember, though, my definition of the Metaverse as a set of experiences that are completely online. It is here that physical world constraints don’t make any sense. I can’t, for example, have a conversation with multiple, distinct groups of people at the same time, yet I do exactly that every day — I even have an entire monitor on my desktop devoted to nothing but chat clients! In this world having one account that represents my whole self, like that offered by Facebook, is a pain in the rear end; for now I have multiple accounts for each individual service, but as I noted, some of them are already based on my unique phone number. How much better if every account were based on a digital identifier unique to me and owned by no one, and now you understand the case for crypto wallets.

This gets to the other mistake Diehl makes in that article, which, ironically, echoes a similar mistake made by many crypto absolutists: there is no reason why the Metaverse, or any web application for that matter, will be built on the blockchain. Why would you use the world’s slowest database when a centralized one is far more scalable and performant? It is not as if WhatsApp or Signal are built on top of the plain old telephone service; they simply leverage the fact that phone numbers are unique and thus suitable as identifiers. This is the type of role blockchains will fill: provide uniqueness and portability where necessary, in a way that makes it possible to not just live your life entirely online, but as many lives simultaneously as your might wish, locked in nowhere.

The Great Bifurcation

I noted above that the physical and digital worlds are bifurcating, and this is happening to tech as well. Yesterday Elon Musk was named TIME’s 2021 Person of the Year, and while he is known for his tweets about Dogecoin and on-and-off-again support of Bitcoin, his biggest contributions to the world — electrical cars and reusable rockets — are very much physical. In fact, you could make the case that Tesla and SpaceX aren’t tech companies at all, but rather another example of tech-first companies set on remaking industries that only ever saw computers as a tool, not the foundation.

The Metaverse, in contrast, is not about eating the world; it’s about creating an entirely new one, from entertainment to community to money to identity. If Elon Musk wants to go to the moon, Mark Zuckerberg wants to create entirely new moons in digital space. This is a place where LLCs make no sense, where regulations are an after-thought, easily circumvented even if they exist. This is a place with no need for traditional money, or traditional art; the native solution is obviously superior. To put it another way, “None of this real world stuff has any digital world value” — the critique goes both ways.

In the end, the most important connection between the Metaverse and the physical world will be you: right now you are in the Metaverse, reading this Article; perhaps you will linger on Twitter or get started with your remote work. And then you’ll stand up from your computer, or take off your headset, eat dinner and tuck in your kids, aware that their bifurcated future will be fundamentally different from your unitary past.

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

  1. When it comes to e-commerce, the shift is similar: not only are other large e-commerce providers like Walmart a click away, individual merchants, largely powered by Shopify, are growing even faster than Amazon. ↩

The Amazon Empire Strikes Back

Posted on Author by Ben Thompson

It seems like a Christmas miracle. From CNBC:

For years, Amazon has been quietly chartering private cargo ships, making its own containers, and leasing planes to better control the complicated shipping journey of an online order. Now, as many retailers panic over supply chain chaos, Amazon’s costly early moves are helping it avoid the long wait times for available dock space and workers at the country’s busiest ports of Long Beach and Los Angeles…

By chartering private cargo vessels to carry its goods, Amazon can control where its goods go, avoiding the most congested ports. Still, Amazon has seen a 14% rise in out-of-stock items and an average price increase of 25% since January 2021, according to e-commerce management platform CommerceIQ…

Amazon has been on a spending spree to control as much of the shipping process as possible. It spent more than $61 billion on shipping in 2020, up from just under $38 billion in 2019. Now, Amazon is shipping 72% of its own packages, up from less than 47% in 2019 according to SJ Consulting Group. It’s even taking control at the first step of the shipping journey by making its own 53-foot cargo containers in China. Containers are in short supply, with long wait times and prices surging from less than $2,000 before the pandemic to $20,000 today.

The intended takeaway of this article — which originated as a digital special report — is clear: Amazon is better and smarter and richer than any other retailers, and isn’t suffering the same sort of supply chain challenges that everyone else is this Christmas.

I’ll get to who the intended target for this message is in a moment, but there is an important question that needs to be asked first: is this even true?

Shipping and the Supply Chain

Start with those containers; the vast majority of shipping containers come in two sizes: 20 foot (i.e. 1 TEU — twenty-foot equivalent unit) and 40 foot (2 TEUs); there are a small number of 45 foot containers, but there is one number that does not exist — 53 foot containers. This isn’t simply a matter of will; what made containers so revolutionary was their standardization, which not only extends to ships but also the gantry cranes used to load and unload them, the truck chassis used to move them around ports, and the storage racks that hold them until they can be unloaded and their contents transferred onto semi tractor-trailers.

Guess, by the way, how long those trailers are? 53 feet. In other words, yes, Amazon has been making a whole bunch of containers, but those containers are not and can not be used for shipping; they are an investment into Amazon’s domestic delivery capability.

This investment is vast: Amazon is also leasing planes, just opened a new Air Hub in Cincinnati (Amazon was previously leasing DHL’s package hub during off hours), built (or is building) over 400 distribution and sortation centers in the United States alone, and has farmed out a huge delivery fleet to independent operators who exist only to serve Amazon, all with the goal of cost efficiently getting orders to customers within two days, and eventually one.

This vertical integration, though, stops at the ocean, for reasons that are obvious once you think through the economics of shipping. While container ships can range as high as 18,000 TEUs, a typical trans-Pacific ship is about 8,000 TEUs (which is around 6,500 fully loaded containers), and costs around $100 million. Right off the bat you can see that shipping has a massive fixed cost component that dictates that the asset in question be utilized as much as possible. More than that, the marginal costs per trip — it takes around seven weeks to do a trans-Pacific round trip in normal times — is significant as well, around $5 million. This means that the ship has to be as fully loaded as possible.

The only way that this works is if a smaller number of shipping companies are serving a larger number of customers, and doing so on a set schedule such that those customers can easily coordinate their logistics (which means that all of those capex and opex numbers have be multiplied by 7, to guarantee a sailing-per-week). Amazon couldn’t profitably leverage an investment of this magnitude any more than Apple could profitably run its own foundry; in that case TSMC can justify an investment in a $20 billion fab because its broad customer base gives the company confidence it can fully utilize that investment not just in 2023 but for many years into the future. It’s the same thing with shipping, which is to say that Amazon is in the same boat as everyone else — mostly.

Amazon Freight-Forwarding

That CNBC story follows on a similar story in Bloomberg last month that opens with an anecdote about one of Amazon’s workarounds:

Most cargo ships putting into the port of Everett, Washington, brim with cement and lumber. So when the Olive Bay docked in early November, it was clear this was no ordinary shipment. Below decks was rolled steel bound for Vancouver, British Columbia, and piled on top were 181 containers emblazoned with the Amazon logo. Some were empty and immediately used to shuffle inventory between the company’s warehouses. The rest, according to customs data, were stuffed with laptop sleeves, fire pits, Radio Flyer wagons, Peppa Pig puppets, artificial Christmas trees and dozens of other items shipped in directly from China — products Amazon.com Inc. needs to keep shoppers happy during a holiday season when many retailers are scrambling to keep their shelves full.

This actually isn’t quite as meaningful as it seems; these multi-purpose ships (which are usually used for commodities) carry a fraction of the cargo of those big container ships anchored off the coast (and the costs are extremely high); airplanes that cross the Pacific, which Amazon is also leasing, carry even less (and cost even more):

Still, even if these stories get some specifics wrong, they do get the big picture right: Amazon is one of the best ways to get your goods to customers. The key thing is that this capacity is not due to last minute ship charters or airplane leases, but rather investments and initiatives Amazon undertook years ago.

In the case of the trans-Pacific trade the key move was Amazon’s 2016 establishment of a freight-forwarding business. A freight-forwarder is basically a middleman in the supply chain which buys a guaranteed amount of space on ships, often via multi-year contracts at guaranteed rates with guaranteed space, and then re-sells that space to people who need it. This means that Amazon could, if they wanted to, make massive profits by reselling space they negotiated last year, but instead it appears that the company is offering space at cost to its resellers; this is the most important part of that Bloomberg article:

This logistical prowess hasn’t been lost on the merchants who sell products on Amazon’s sprawling marketplace. For years, they resisted using the company’s global shipping service because doing so means sharing information about pricing and suppliers, data they fear the company could use to compete with them. But container shortages in the leadup to the holiday season persuaded many of them to overcome their qualms and entrust their cargos to the world’s largest online retailer. “Amazon had space on ships and I couldn’t say no to anyone,” says David Knopfler, whose Brooklyn-based Lights.com sells home décor and lighting fixtures. “If Kim Jong Un had a container, I might take it, too. I can’t be idealistic.” Knopfler says Amazon’s prices were “phenomenal,” $4,000 to ship a container from China compared with the $12,000 demanded by other freight forwarders.

This gets at the real challenge facing smaller merchants: getting delayed outside of Los Angeles is preferable to not even getting on a ship in the first place, and while no one, not even Amazon, can unsnarl the ports, the e-commerce giant is ready to take care of everything else (including working around the edges for high margin goods).

This also gets at the question I raised at the beginning: who is the target for these stories, which have all the hallmarks of being planted by Amazon PR? The Bloomberg piece concludes:

“Amazon will stick to its guns and get things to customers,” says David Glick, a former Amazon logistics executive who is now chief technology officer at Seattle logistics startup Flexe. “It’s going to be expensive but, in the long term, builds customer trust.”

That is certainly a big benefit: to the extent that Amazon has goods in stock this Christmas, and other retailers don’t, the more likely it is that customers will start their shopping at Amazon.com. This is critical because aggregating customer demand is the foundation of Amazon’s moat. I think though, that is secondary; Amazon’s more important target are those third party merchants benefiting from the company’s investment, who were previously incentivized to go it alone.

The Empire Strikes Back

I wrote about Amazon’s logistics integration in the context of 3rd-party merchants in 2019:

In 2006 Amazon announced Fulfillment by Amazon, wherein 3rd-party merchants could use those fulfillment centers too. Their products would not only be listed on Amazon.com, they would also be held, packaged, and shipped by Amazon. In short, Amazon.com effectively bifurcated itself into a retail unit and a fulfillment unit…

A drawing of Amazon and Aggregation

Despite the fact that Amazon had effectively split itself in two in order to incorporate 3rd-party merchants, this division is barely noticeable to customers. They still go to Amazon.com, they still use the same shopping cart, they still get the boxes with the smile logo. Basically, Amazon has managed to incorporate 3rd-party merchants while still owning the entire experience from an end-user perspective.

That article was about Shopify and the Power of Platforms, and the point was to explain how Shopify was taking a very different approach: by being in the background the Canadian company was enabling merchants to build their own brands and own their own customers; this was the foundation of the Anti-Amazon Alliance, which by 2020, in light of news that Amazon was leveraging 3rd-party merchant data for its own products, seemed more attractive than ever:

3rd-party merchants, particularly those with differentiated products and brands, should seek to leave Amazon’s platform sooner-rather-than-later. It is hard to be in the Anti-Amazon Alliance if you are asking Amazon to find you your customers, stock your inventory, package your products, and deliver your goods; there are alternatives and — now that Google is all-in — the only limitation is a merchant’s ability to acquire and keep customers in a world where their products are as easy to buy as bad PR pitches are easy to find.

These supply chain challenges, though, are enabling the empire to strike back; again from the Bloomberg article:

Amazon also simplifies the process since it oversees the shipment from China to its U.S. warehouses. Other services have lots of intermediaries where cargo swaps hands, presenting opportunities for miscommunication and delays. “It’s a one-stop-shop from Asia to Amazon,” says Walter Gonzalez, CEO of Miami-based GOJA, which sells various products on Amazon including Magic Fiber cleaner for glasses. “It reduces the gray areas where the shipping process might fail.” Gonzalez says his company, which has been using Amazon’s global logistics service, has about 95% of the inventory it needs to meet holiday demand.

It’s more than that: it’s a one-stop shop from Chinese ports to customers’ front doors, thanks to all of those domestic investments in logistics, and as long as the supply chain is a challenge, the Anti-Amazon Alliance will be at a big disadvantage.

This isn’t the only area where Amazon is increasingly attractive to third-party merchants: Apple’s App Tracking Transparency (ATT) changes favor Amazon in a big way as well. What makes a modular ecosystem possible is platforms that allow disparate parts to work together, such that the sum is greater than the whole. This very much applies to Facebook’s ad ecosystem, where disparate e-commerce sellers effectively pool all of their conversion data in one place — Facebook — such that they all benefit from better targeting. ATT, though, is targeted at this sort of cooperation, while Amazon is immune because of its integration. Sure, the company collects plenty of data about consumers (often to the consternation of those 3rd party merchants), but because Amazon controls both ad inventory on its site and apps, and also the conversion, it isn’t covered by ATT (or other privacy laws like GDPR).

This doesn’t apply to just Amazon: Google has similar advantages on the web, and Apple with apps. The reality is that the more that information (in the case of advertising) and goods (in the case of the supply chain) are able to move freely, the better chance smaller competitors have against integrated giants. The world, though, both online and off, is moving in the opposite direction.

Twitter Has a New CEO; What About a New Business Model?

Posted on Author by Ben Thompson

From CNBC:

Twitter CEO Jack Dorsey is stepping down as chief of the social media company, effective immediately. Parag Agrawal, Twitter’s chief technology officer, will take over the helm, the company said Monday. Shares of Twitter closed down 2.74% on the day.

Dorsey, 45, was serving as both the CEO of Twitter and Square, his digital payments company. Dorsey will remain a member of the board until his term expires at the 2022 meeting of stockholders, the company said. Salesforce President and COO Bret Taylor will become the chairman of the board, succeeding Patrick Pichette, a former Google executive, who will remain on the board as chair of the audit committee.

“I’ve decided to leave Twitter because I believe the company is ready to move on from its founders,” Dorsey said in a statement, though he didn’t provide any additional detail on why he decided to resign.

On one hand, congratulations to Twitter for its first non-messy CEO transition in its history; on the other hand, this one was a bit weird in its own way: CNBC broke the news at 9:23am Eastern, just in time for the markets to open and the stock to shoot up around 10% as feverish speculation broke out about who the successor was; two hours and 25 minutes later Dorsey confirmed the news and announced Agrawal as his successor, and the sell-off commenced.

The missing context in Dorsey’s announcement was Elliott Management, the activist investor that took a stake in Twitter in early 2020 and demanded that Dorsey either focus on Twitter (instead of Square, where he is still CEO) or step down; Twitter gave Elliott and Silver Lake, who was working with Elliott, two seats on the board a month later. That agreement, though, came with the condition that Twitter grow its user base, speed up revenue growth, and gain digital ad market share.

Twitter has made progress: while the company’s monthly active users have been stagnant for years — which is probably why the company stopped reporting them in 2019 — its “monetizable daily active users” have increased from 166 million in Q1 2020 to 211 million last quarter, and its trailing twelve-month revenue has increased from $3.5 billion in Q1 2020 to $4.8 billion in Q3 2021. The rub is digital ad market share: Snap, for example, grew its TTM revenue from $1.9 billion to $4.0 billion over the same period, as the pandemic proved to be a massive boon for many ad-driven platforms.

That boon was driven by the surge in e-commerce, which is powered by direct response marketing, where there is a tight link between seeing an ad and making a purchase; Twitter, though, has struggled for years to build a direct response business, leaving it dependent on brand advertising for 85% of its ad revenue. That meant the company was not only not helped by the pandemic, but hurt worse than most (and, on the flip side, was less affected by Apple’s iOS 14 changes). If in fact Dorsey’s job depended on taking digital ad market share, he didn’t stand a chance.

That perhaps explains yesterday’s weird timing; Casey Newton speculated that the board may have leaked the news to ensure that Dorsey didn’t get cold feet. It also, I suspect, explains the market’s cool reaction to the appointment of an insider: Agrawal was there for all of those previously failed attempts to build a direct response marketing business, so it’s not entirely clear what is going to be different going forward.

Twitter’s Advertising Problem

The messiness I alluded to in Twitter’s previous CEO transitions is merely markers on a general run of mismanagement from the company’s earliest days. I’ve long contended that Twitter’s core problem is that the product was too perfect right off the bat; from 2014’s Twitter’s Marketing Problem:

One of the most common Silicon Valley phrases is “Product-Market Fit.” Back when he blogged on a blog, instead of through numbered tweets, Marc Andreessen wrote:

The only thing that matters is getting to product/market fit…I believe that the life of any startup can be divided into two parts: before product/market fit (call this “BPMF”) and after product/market fit (“APMF”).

When you are BPMF, focus obsessively on getting to product/market fit.

Do whatever is required to get to product/market fit. Including changing out people, rewriting your product, moving into a different market, telling customers no when you don’t want to, telling customers yes when you don’t want to, raising that fourth round of highly dilutive venture capital — whatever is required.

When you get right down to it, you can ignore almost everything else.

I think this actually gets to the problem with Twitter: the initial concept was so good, and so perfectly fit such a large market, that they never needed to go through the process of achieving product market fit. It just happened, and they’ve been riding that match for going on eight years.

The problem, though, was that by skipping over the wrenching process of finding a market, Twitter still has no idea what their market actually is, and how they might expand it. Twitter is the company-equivalent of a lottery winner who never actually learns how to make money, and now they are starting to pay the price.

Seven years on and Twitter has finally started to implement some of the proposals from that article, including leaning heavily into recommendations and topics; in theory the machine learning understandings driving those recommendations should translate into more effective advertising as well. That hasn’t really happened, though, and I’m not sure it ever will, for reasons that go beyond the effectiveness of Twitter’s management (or lack thereof).

Think about the contrast between Twitter and Instagram; both are unique amongst social networks in that they follow a broadcast model: tweets on Twitter and photos on Instagram are public by default, and anyone can follow anyone. The default medium, though, is fundamentally different: Twitter has photos and videos, but the heart of the service is text (and links). Instagram, on the other hand, is nothing but photos and video (and link in bio).

The implications of this are vast. Sure, you may follow your friends on both, but on Twitter you will also follow news breakers, analysts, insightful anons, joke tellers, and shit posters. The goal is to mainline information, and Twitter’s speed and information density are unparalleled by anything in the world. On Instagram, though, you might follow brands and influencers, and your chief interaction with your friends is stories about their Turkey Day exploits. It’s about aspiration, not information, and the former makes a lot more sense for effective advertising.

It’s more than just the medium though; it’s about the user’s mental state as well. Instagram is leisurely and an escape, something you do when you’re procrastinating; Twitter is intense and combative, and far more likely to be tied to something happening in the physical world, whether that be watching sports or politics or doing work:

Instagram is a lean-back experience; on Twitter you lean forward

This matters for advertising, particularly advertising that depends on a direct response: when you are leaning back and relaxed why not click through to that Shopify site to buy that knick-knack you didn’t even know you needed, or try out that mobile game? When you are leaning forward, though, you don’t have either the time or the inclination.

Someone is wrong on the Internet

That ties into Twitter’s third big problem: the number of people who actually want to experience the Internet this way is relatively small. There is a reason that Twitter’s userbase is only a fraction of Instagram’s, and it’s not a lack of awareness; the reality is that most people are visual, and Twitter is textual. Which, of course, is exactly why Twitter’s most fervent users can’t really imagine going anywhere else.

Twitter’s Place in Culture

What makes Twitter such a baffling company to analyze is that the company’s cultural impact so dramatically outweighs its financial results; last quarter Twitter’s $1.3 billion in revenue amounted to 4.4% of Facebook’s $29.0 billion, and yet you can make the case — and I believe it — that Twitter’s overall impact on the world is just as big, if not larger than its drastically larger peer. Facebook hollowed out the gatekeeper position of the media, but that void was filled by Twitter, both in terms of news being made, and just as critically, elite opinion and narrative being shaped.

Given that impact, I can see why Elliott Management would look at Twitter and wonder why it is that the company can’t manage to make more money, but the fact that Twitter is the nexus of online information flow reflects the reality of information on the Internet: massively impactful and economically worthless, particularly when ads — which themselves are digital information — can easily be bought elsewhere.

Twitter is more than just news, though: I wrote last year in Social Networking 2.0 about the rise of private networks that supplemented and, for many use cases, replaced Facebook and Twitter.

A drawing of v1 vs v2 Social Networks

Twitter, even more than Facebook, remains crucial to this new ecosystem: what WhatsApp group or Telegram chat isn’t filled with tweets posted for the purpose of discussion or disparagement, or links discovered via Twitter? It is as if these private groups are a fortress on the frontier; Twitter is the wild where you forage for content morsels, and, of course, where you do battle with the enemy.

Don’t underrate that last part: one of the biggest challenges facing would-be Twitter clones is not simply that a complete lack of moderation leads to an overwhelming amount of crap, but also that the sort of person who thrives on Twitter very much wants to know everything that is happening in the world, including amongst those outside of their circle. Being stuck on a text-based social network that only has some of the information to be consumed is lame; having access to anyone and everything, for better or worse, is a value prop that only Twitter can provide.

This, then, is the other thing that often baffles analysts: Twitter has one of the most powerful moats on the Internet. Sure, Facebook has ubiquity, Instagram has influencers, and TikTok has homegrown stars, but I find it easier to imagine any of those fading before Twitter’s grip on information flow disappears (in part, of course, because Twitter has shown that it’s a pretty crappy business).

A Paid Social Network

So let’s review: there is both little evidence that Twitter can monetize via direct response marketing, and reason to believe that the problem is not simply mismanagement. At the same time, Twitter is absolutely essential to a core group of users who are not simply unconcerned with the problems inherent to Twitter’s public broadcast model (including abuse and mob behavior), but actually find the platform indispensable for precisely those reasons: Twitter is where the news is made, shaped, and battled over, and there is very little chance of another platform displacing it, in large part because no one is economically motivated to do so.

Given this, why not charge for access?

This may seem obvious to you, but it’s a huge leap for me; back when Stratechery first started it was fairly popular to argue that social networks should charge users instead of selling ads, which never made sense. I wrote in 2014’s Ello and Consumer-Friendly Business Models:

When it comes to social networks, on the other hand, advertising is clearly the best option: after all, a social network is only as good as the number of friends that are on it, and the best way to get my friends on board is to offer a kick-ass product for free. In other words, the exact opposite of the feature-limited product that Ello is proposing…

If…you care about making a successful social network that users will find useful over the long run, then actually build something that is as good as you can possibly make it and incentivize yourself to earn and keep as many users as possible.

I still stand by that analysis generally, but I increasingly question whether or not it applies to Twitter. Twitter has long since penetrated the awareness of just about everyone on earth; the vast majority gave the platform a try and never came back, content to consume the tweets that show up everywhere from news articles to cable news. The core that remains, meanwhile, simultaneously bemoans that Twitter is terrible even as they can’t rip their eyes away, addicted as they are to that flow of information that is and will for the foreseeable future be unmatched by any other service.

And yet, despite this impact and indispensability and impenetrable moat, Twitter makes an average of $22.75 per monetizable daily active user per year (and given that some of Twitter’s most hard core users use third-party Twitter clients, and thus aren’t monetizable, the revenue per addicted daily active user is even lower). That’s just under $2/month, an absolutely paltry sum.

Actually charging for Twitter would, of course, reduce the userbase to some degree; moreover, there are a lot of users with multiple accounts, and plenty of non-human users on Twitter. And, of course, Apple and Google would take their share. Still, even if you cut the userbase by a third to 141 million daily addicted users — which I think vastly overstates Twitter’s elasticity of demand amongst its core user base — Twitter would only need to charge $4/month (including App Store fees) to exceed the $4.8 billion in revenue it made over the last twelve months.

And, in fact, that overstates the situation for another reason: only $4.2 billion of Twitter’s last twelve months of revenue came from ads; the rest came from data licensing and other revenue. There is an alternate world where data licensing is Twitter’s primary revenue model: just think about how valuable it is to be the primary protocol for real time information sharing, particularly if you can package and distribute that information in an intelligent way?

Twitter could still do that, and pursue other initiatives like its revitalized API, offering developers the opportunity to build entirely new experiences on Twitter’s information flow (including unmoderated ones). The difference from the first go-around is that Twitter won’t have an advertising business to protect, and thus will have its interests much better aligned with developers who can pay for access. After all, that would be Twitter’s business model.

I also think this makes Twitter’s other subscription offerings, like Super Follows, Revue, etc., more attractive, not less; the biggest challenge in running a subscription business is earning that first dollar, but once a user is paying it’s relatively easy to charge for more.

This could certainly all go horribly wrong; the absolute fastest way to get your users to explore alternatives is to ask them to pay for your service, and there is the matter of acquiring new users, users who can’t afford to pay, etc. Growth matters, fewer users means less vitality, and I’m honestly getting cold feet even proposing this! Certainly existing users would howl and insist they were leaving and never coming back. I think, though, that Twitter is so unique, and its userbase is so locked in, that it is the one social networking service that could potentially pull this off.

Moreover, the fact of the matter is that Twitter has now had one business model and five CEOs (counting Dorsey twice); maybe it’s worth changing the former before the next activist investor demands yet another change to the latter.

Follow-up: Why Subscription Twitter Is a Terrible Idea

Unity, Weta, and Faceless Platforms

Posted on Author by Ben Thompson

At the beginning of a video announcing Unity’s acquisition of Weta Digital, Peter Jackson, filmmaker extraordinaire and the founder of Weta, and Prem Akkaraju, the CEO of Weta Digital, explained why they were excited to hand Weta Digital over (beyond, of course, the $1.63 billion):

Peter Jackson: We knew that digital effects offered so much possibility for us to be able to create the worlds and the creatures that we were imagining.

Prem Akkaraju: Now we’re taking those tools that we have created and are handing them over the Unity to market them for the entire world.

Peter Jackson: Together Unity and Weta Digital can create a pathway for any artist in any industry who will now be able to leverage these incredible creative tools.

The creation, development, and now sale of Weta Digital is a great example of how the ideal approach to innovation in an emerging field changes over time; understanding that journey also explains why Unity is a great home for Weta.

Weta’s Integrated History

Peter Jackson has said that he was inspired to start Weta Digital after seeing Jurassic Park and realizing that CGI was the future of movies; the first movie Weta worked on was Heavenly Creature, which Jackson says didn’t even need CGI. From an oral history of Weta Digital:

We used the film as an excuse to buy one computer, just to put our toe in the water. And we had a guy, one guy, who could figure out how to work it, and we got a couple of bits of software, and we did the effects in Heavenly Creatures really just for the sake of doing some CGI effects so we’d actually just start to figure it out. And then on The Frighteners, which was the next movie we [did], we went from one computer to 30 computers. It was a pretty big jump.”

Weta, as you would expect given how nascent computer graphics were, was integrated from top-to-bottom: Jackson’s team didn’t make software to make graphics for Jackson’s films; Jackson actually made a scene in a film that needed graphics to give his team a reason to get started on making software. That bet paid off a few years later when Weta played a pivotal role in the Lord of the Rings trilogy. The feedback loop between movie-making and software-development was tight in a way that is only possible with a fully integrated approach, resulting in dramatic improvements from film to film. Jackson said of Gollum:

Now the first Lord of the Rings film, Fellowship of the Ring, which has Gollum in about two shots, he’s just a little glimpse, and it’s completely different to the Gollum that’s in the next film, The Two Towers. [That first] version of Gollum was pretty gnarly, pretty crude. It was as good as we could do at that time, and we had to have something in the movie, but we put a very deep shadow, and you know that was on purpose because he didn’t look very good. But, nonetheless, we ran out of time, and that was what we had to have in the movie. We still had another year to get him really good for the Two Towers, where he was half the film, so the Two Towers Gollum was a complete overhaul of the one from the first film. It finally got to the place that we wanted to go.”

Over the intervening years, though, Weta gradually branched out, working on films beyond Jackson’s personal projects, including Avatar and Avengers. This too makes sense: developing software is both incredibly capital intensive and benefits from high rates of iteration; that means there is both an economic motive to serve more customers, increasing the return on the initial investment, and a product motive, since every time the software is used there is the potential for improvement. Still, software development and software application were still integrated, because there was so much more improvement to be had; Jackson again:

Over the years, we’ve written about a hundred pieces of code for a wide variety of different things, and it drives me a little bit crazy because we keep writing code for the same things every time. Like, we do Avatar a few years ago, and we wrote software to create grass, and trees, leaves, that can blow with the wind, that sort of stuff. And then I come along with The Hobbit, and I want some grass or some shrubs or some trees, so I [ask], Why can’t we use the stuff that we wrote [already]? I mean it was fine for the [prior] film, but we wanted to be better. I mean there was some kind of code, unspoken code – and it’s not anything to do with the ownership of the software, because it belongs to us – but the guys themselves, wanna do everything better than they did the last time. So they don’t want the Avatar grass, or the leaves; they want to do grass and leaves better than last time. They set about writing a whole new grass software, whole new leaf software, and it happens over and over again, all the time. It sort of drives me crazy.

What is interesting, though, is that in that same oral history Jackson starts to signal that the plane of improvement was starting to shift; he says at the end:

We live in in an age where everything is possible, really, with CGI. There’s nothing that you cannot imagine in your head or read on a script, or whatever, that you can’t actually do now. What you’ve got now is you’ve simply got faster – faster and cheaper. In terms of computers, you know, every year they get cheaper, and they get twice as fast. It is important because when you’re doing visual effects, it’s like any form of filmmaking, you often want a take two, take three, take four. You do the fire shot with a little flame once and you know you’re not necessarily gonna get it looking great on the first time, so it’s good to have a second go, and maybe a third go, maybe a fourth go. So when you’ve actually got computers that are getting quicker and faster, it gives you more goes at doing this stuff. Ultimately you get a better looking result.

Notice the transition here; at the beginning everything was integrated from the movie shot to the development process to the software to the individual computer:

Weta's integration

Over the ensuing 28 years, though, each of these pieces has been broken off and modularized, increasing the leverage that can be gained from the software itself; Unity’s approach of selling tools to the world is the logical endpoint.

Unity’s Modular History

When 3D games first became possible in the 1990s 3D game engines were developed for a specific game; the most famous developer was id Software, which was founded in 1991, and id’s most famous engine was built for its Quake series of games; id’s rival was Epic, which built the Unreal engine for Unreal Tournament. These were integrated efforts: the engine was built for the game, and the game was built for the engine; once development was completed then the engine was made available to other developers to build their own games, without having to recreate all of the work that id or Epic had already done.

Unity, though was different: its founders started with the express goal of “democratizing game development”; the company’s only game, GooBall, was intended as a proof of concept. It also, like Unity, only ran on the Mac, which wasn’t a great recipe for commercial success in the games business. That all flipped in 2008, though, with the opening of the iPhone App Store: that was one of the greatest gold rushes of all time, and a tool at home on Apple’s technologies was particularly well-placed to profit. Unity was off to the races, quickly becoming the most used engine on iOS specifically and mobile gaming broadly, a position it still holds today: 71% of the top 1000 mobile games on the market run on Unity, and over 3 billion people play games it powers.

Mobile was a perfect opportunity for Unity for reasons that went beyond its Apple roots. Phones, particularly back then, were dramatically underpowered relative to PCs with dedicated graphics cards; that meant that the primary goal for an engine was not to produce cutting edge graphics, but to deliver good enough graphics in a power-constrained environment. Moreover, most of the developers taking advantage of the mobile opportunity were small teams and independents; they couldn’t afford the big PC engines even if they could fit in an iPhone’s power envelope. Unity, though, wasn’t just Apple friendly, but also built from the ground-up for independent developers, both in terms of usability and also pricing.

Over time, as mobile gaming has become the largest part of the market, and as the power of mobile phones has grown, Unity has grown its capabilities and performance; the company has made increasing in-roads into console and PC gaming (albeit mostly with casual games), and has invested significantly in virtual reality. What remains a constant, though, is Unity’s position as a developer’s partner, not a competitor.

Unity’s Business Model

This has opened up further opportunities for Unity: it turned out that mobile gaming had a completely different business model than PC or console gaming as well, which traditionally sold a game for a fixed price. Mobile, though, thanks to its always connected nature and massive market size, moved towards a combination of advertising and in-app purchases. Unity found itself perfectly placed to support both: first, all mobile game developers had the same problem that Unity could solve once and make available to all of its customers, and second, advertising in particular requires far more scale than any one game developer could build on its own. Unity, though, could build an advertising market across all of the games it supported — which again, was most of them — and its customers could rely on Unity knowing that their interests were aligned: if developers made money, Unity made money.

Today it is actually Unity’s Operate Solutions, including its advertising network and in-app purchase support, plus other services like hosting and multiplayer support, that makes up 65% of Unity’s revenue; Create Solutions, which is primarily monetized via a SaaS-subscription to Unity’s development tools, is only 29%. The latter, though, is an on-ramp to the former; CEO John Riccitiello said on Unity’s most recent earnings call:

We can hook [creators] at the artist level when they’re just building out their first visual representation of what they want to do. We can hook them lots of different ways. And at Unity, it almost always seems the same. They start as some sort of a experimental customer doing not a lot. And then we get inside and they do a lot more and then they do a lot more, then they write bigger contracts, they start moving more of our services. I would hate to say this in front our customers although they know it, land and expand is like endemic to Unity. It’s exactly what we’re doing.

This has resulted in a net expansion rate of 142%; that means that Unity has negative churn because its existing customers increase their spending with Unity so substantially. I love a good cohort analysis and Unity had a great one in their S-1:

Unity's S-1 cohort analysis

This shows just how important it is that Unity’s tools attract customers: the company has the ability to grow revenue from its existing customers indefinitely; the primary limiting factor to the company’s growth rate is how many new customers it can bring on board.

Enter Weta.

Unity + Weta

It is striking how the fundamental strengths and weaknesses of Weta and Unity are mirror images of each other: Weta has cutting edge technology, but it’s only available to Weta; Unity’s technology, meanwhile, continues to improve, but its biggest asset is the number of developers on its platform and integration with all of the other components a developer needs to build a business.

What you see in this acquisition, then, is the intersection of these two paths:

  • Weta’s software is increasingly mature and ready to be productized and leveraged across as many customers who wish to use it.
  • Unity’s developer offering is increasingly full-featured and only limited by its ability to acquire new customers.

The logic should be obvious: Weta increases Unity’s market from not just developers but to artists, who can be plugged into Unity’s land-and-expand model. Weta, meanwhile, immediately gains leverage on all of the investment it has made in its software tools.

The convergence of Unity and Weta's paths

There is also a third path flowing through this intersection: the convergence and increase of computing power across devices of all sizes. Unity benefited at the beginning from serving an underpowered mobile market; Weta, in contrast, was so limited by underpowered computers that its developers had to be tightly integrated with artists to make things that were never before possible.

Today, though, phones and computers are increasingly comparable in power, to the benefit of Unity; from Weta’s perspective, that power makes it possible to use its tools iteratively, lowering the learning curve and increasing the market of artists who can figure them out on their own.

That’s why Unity leaped at this opportunity; CEO John Riccitiello told me in an interview:

It’s an incredible opportunity for the world’s artist to get to something that this incredible collection of tools that they’re going to want to use, and they’re going to want to use it in the film industry. But we’ve got thousands of engineers inside of Unity and we’re going to work at making these tools. Some of them already are real time and usable in video games, make most all of them real time so they can be used in video games, but they can be used in many vertical industry circumstances, whether it’s the auto industry for car configurators or design or architecture, engineering construction, or in digital twins.

These tools are pretty darned amazing, I’m proud that we were able to come to an agreement with Peter and the team around him. I’m also excited about the prospect of bringing these tools to a global marketplace…But what I would tell you is this is one of those things where you write down the strategy and then there’s something that accelerates you multiple years, and this is exactly that. We’re thrilled.

It’s going to take time to see all of this come to fruition, and there are obvious challenges in bringing together two companies that are so different; it is precisely those differences, though, that make this acquisition so compelling.

Faceless Platforms

One additional point: to me the most analogous company to Unity is not Epic, its biggest competitor in the game engine business, but TSMC. TSMC, like Unity, was built from the beginning to be a partner to chip designers, not a competitor, in large part because the company had no other route to market. In the process, though, TSMC democratized chip development and then, with the rise of smartphones, gained the volume necessary to overtake integrated competitors like Intel.

By 2019 it was TSMC that was the first to bring chips to market based on Extreme Ultraviolet (EUV) lithography technology; EUV was devilishly difficult and exceptionally expensive, requiring not just years of development by ASML, but also customers like Apple willing to pay for the absolute most cutting edge chips at massive volume. Now TSMC is the most advanced fab in the industry and the 10th most valuable company in the world, and, absent geopolitical risk, a clear winner in a world increasingly experienced via technology.

The ultimate manifestation of that is the metaverse, and here Unity is particularly well-placed; Nvidia CEO Jenson Huang at last week’s GTC keynote described today’s web as being 2D, and the future as being 3D, and now Unity owns the best 3D tools in the world. More importantly, unlike Metaverse aspirants like Facebook or Microsoft, Unity isn’t competing for end users, which means it can partner with everyone building those new experiences — including Facebook and Microsoft and Apple — just as TSMC can build chips for everyone, even Intel.

It is companies like Unity and TSMC — other examples include Stripe or Shopify or the public clouds — that are the most important to the future. The most valuable prize in technology has always been platforms, but in the beginning era of technology the most important platforms were those that interfaced directly with users; in technology’s middle era the most important platforms will be faceless, empowering developers and artists and creators of all types to create completely new experiences on top of the best technology in the world, created and maintained and improved on by companies that aren’t competing with them, but partnering to achieve the scale necessary to accelerate the future.