Andrewerose

The first video game was a 1952 research product called OXO — tic-tac-toe played on a computer the size of a large room:

Fifteen years later Ralph Baer produced “The Brown Box”; Magnavox licensed Baer’s device and released it as the Odyssey five years later — it was the first home video game console:

The Odyssey made Magnavox a lot of money, but not through direct sales: the company sued Atari for ripping off one of the Odyssey’s games to make “Pong”, the company’s first arcade game and, in 1975, first home video game, eventually reaping over $100 million in royalties and damages. In other words, arguments about IP and control have been part of the industry from the beginning.

In 1977 Atari released the 2600, the first console I ever owned:¹

All of the games for the Atari were made by Atari, because of course they were; IBM had unbundled mainframe software and hardware in 1969 in an (unsuccessful) attempt to head off an antitrust case, but video games barely existed as a category in 1977. Indeed, it was only four years earlier when Steve Wozniak had partnered with Steve Jobs to design a circuit board for Atari’s Breakout arcade game; this story is most well-known for the fact that Jobs lied to Wozniak about the size of the bonus he earned, but the pertinent bit for this Article is that video game development was at this point intrinsically tied to hardware.

That, though, was why the 2600 was so unique: games were not tied to hardware but rather self-contained in cartridges, meaning players would use the same system to play a whole bunch of different games:

The implications of this separation did not resonate within Atari, which had been sold by founder Nolan Bushnell to Warner Communications in 1976, in an effort to get the 2600 out the door. Game Informer explains what happened:

In early 1979, Atari’s marketing department issued a memo to its programing staff that listed all the games Atari had sold the previous year. The list detailed the percentage of sales each game had contributed to the company’s overall profits. The purpose of the memo was to show the design team what kinds of games were selling and to inspire them to create more titles of a similar breed…David Crane, Larry Kaplan, Alan Miller, and Bob Whitehead were four of Atari’s superstar programmers. Collectively, the group had been responsible for producing many of Atari’s most critical hits…

“I remember looking at that memo with those other guys,” recalls Crane, “and we realized that we had been responsible for 60 percent of Atari’s sales in the previous year – the four of us. There were 35 people in the department, but the four of us were responsible for 60 percent of the sales. Then we found another announcement that [Atari] had done $100 million in cartridge sales the previous year, so that 60 percent translated into ­$60 ­million.”

These four men may have produced $60 million in profit, but they were only making about $22,000 a year. To them, the numbers seemed astronomically disproportionate. Part of the problem was that when the video game industry was founded, it had molded itself after the toy industry, where a designer was paid a fixed salary and everything that designer produced was wholly owned by the company. Crane, Kaplan, Miller, and Whitehead thought the video game industry should function more like the book, music, or film industries, where the creative talent behind a project got a larger share of the profits based on its success.

The four walked into the office of Atari CEO Ray Kassar and laid out their argument for programmer royalties. Atari was making a lot of money, but those without a corner office weren’t getting to share the wealth. Kassar – who had been installed as Atari’s CEO by parent company Warner Communications – felt obligated to keep production costs as low as possible. Warner was a massive c­orporation and everyone helped contribute to the ­company’s ­success. “He told us, ‘You’re no more important to those projects than the person on the assembly line who put them together. Without them, your games wouldn’t have sold anything,’” Crane remembers. “He was trying to create this corporate line that it was all of us working together that make games happen. But these were creative works, these were authorships, and he didn’t ­get ­it.”

“Kassar called us towel designers,” Kaplan told InfoWorld magazine back in 1983, “He said, ‘I’ve dealt with your kind before. You’re a dime a dozen. You’re not unique. Anybody can do ­a ­cartridge.’”

That “anyone” included the so-called “Gang of Four”, who decided to leave Atari and form the first 3rd-party video game company; they called it Activision.

3rd-Party Software

Activision represented the first major restructuring of the video game value chain; Steve Wozniak’s Breakout was fully integrated in terms of hardware and software:

The Atari 2600 with its cartridge-based system modularized hardware and software:²

Activision took that modularization to its logical (and yet, at the time, unprecedented) extension, by being a different company than the one that made the hardware:

Activision, which had struggled to raise money given the fact it was targeting a market that didn’t yet exist, and which faced immediate lawsuits from Atari, was a tremendous success; now venture capital was eager to fund the market, leading to a host of 3rd-party developers, few of whom had the expertise or skill of Activision. The result was a flood of poor quality games that soured consumers on the entire market, leading to the legendary video game crash of 1983: industry revenue plummeted from $3.2 billion in 1983 to a mere $100 million in 1985. Activision survived, but only by pivoting to making games for the nascent personal computing market.

The personal computer market was modular from the start, and not just in terms of software. Compaq’s success in reverse-engineering the IBM PC’s BIOS created a market for PC-compatible computers, all of which ran the increasingly ubiquitous Microsoft operating system (first DOS, then Windows). This meant that developers like Activision could target Windows and benefit from competition in the underlying hardware.

Moreover, there were so many more use cases for the personal computer, along with a burgeoning market in consumer-focused magazines that reviewed software, that the market was more insulated from the anarchy that all but destroyed the home console market.

That market saw a rebirth with Nintendo’s Famicom system, christened the “Nintendo Entertainment System” for the U.S. market (Nintendo didn’t want to call it a console to avoid any association with the 1983 crash, which devastated not just video game makers but also retailers). Nintendo created its own games like Super Mario Bros. and Zelda, but also implemented exacting standards for 3rd-party developers, requiring them to pass a battery of tests and pay a 30% licensing fee for a maximum of five games a year; only then could they receive a dedicated chip for their cartridge that allowed it to work in the NES.

Nintendo’s firm control of the third-party developer market may look familiar: it was an early precedent for the App Store battles of the last decade. Many of the same principles were in play:

• Nintendo had a legitimate interest in ensuring quality, not simply for its own sake but also on behalf of the industry as a whole; similarly, the App Store, following as it did years of malware and viruses in the PC space, restored customer confidence in downloading third-party software.
• It was Nintendo that created the 30% share for the platform owner that all future console owners would implement, and which Apple would set as the standard for the App Store.
• While Apple’s App Store lockdown is rooted in software, Nintendo had the same problem that Atari had in terms of the physical separation of hardware and software; this was overcome by the aforementioned lockout chips, along with branding the Nintendo “Seal of Quality” in an attempt to fight counterfeit lockout chips.

Nintendo’s strategy worked, but it came with long-term costs: developers, particularly in North America, hated the company’s restrictions, and were eager to support a challenger; said challenger arrived in the form of the Sega Genesis, which launched in the U.S. in 1989. Sega initially followed Nintendo’s model of tight control, but Electronic Arts reverse-engineered Sega’s system, and threatened to create their own rival licensing program for the Genesis if Sega didn’t dramatically loosen their controls and lower their royalties; Sega acquiesced and went on to fight the Super Nintendo, which arrived in the U.S. in 1991, to a draw, thanks in part to a larger library of third-party games.

Sony’s Emergence

The company that truly took the opposite approach to Nintendo was Sony; after being spurned by Nintendo in humiliating fashion — Sony announced the Play Station CD-ROM add-on at CES in 1991, only for Nintendo to abandon the project the next day — the electronics giant set out to create their own console which would focus on 3D-graphics and package games on CD-ROMs instead of cartridges. The problem was that Sony wasn’t a game developer, so it started out completely dependent on 3rd-party developers.

One of the first ways that Sony addressed this was by building an early partnership with Namco, Sega’s biggest rival in terms of arcade games. Coin-operated arcade games were still a major market in the 1990s, with more revenue than the home market for the first half of the decade. Arcade games had superior graphics and control systems, and were where new games launched first; the eventual console port was always an imitation of the original. The problem, however, is that it was becoming increasingly expensive to build new arcade hardware, so Sony proposed a partnership: Namco could use modified PlayStation hardware as the basis of its System 11 arcade hardware, which would make it easy to port its games to PlayStation. Namco, which also rebuilt its more powerful Ridge Racer arcade game for the PlayStation, took Sony’s offer: Ridge Racer launched with the Playstation, and Tekken was a massive hit given its near perfect fidelity to the arcade version.

Sony was much better for 3rd-party developers in other ways, as well: while the company maintained a licensing program, its royalty rates were significantly lower than Nintendo’s, and the cost of manufacturing CD-ROMs was much lower than manufacturing cartridges; this was a double whammy for the Nintendo 64 because while cartridges were faster and offered the possibility of co-processor add-ons, what developers really wanted was the dramatically increased amount of storage CD-ROMs afforded. The Playstation was also the first console to enable development on the PC in a language (C) that was well-known to existing developers. In the end, despite the fact that the Nintendo 64 had more capable hardware than the PlayStation, it was the PlayStation that won the generation thanks to a dramatically larger game library, the vast majority of which were third-party games.

Sony extended that advantage with the PlayStation 2, which was backwards compatible with the PlayStation, meaning it had a massive library of 3rd-party games immediately; the newly-launched Xbox, which was basically a PC, and thus easy to develop for, made a decent showing, while Nintendo struggled with the Gamecube, which had both a non-standard controller and non-standard microdisks that once again limited the amount of content relative to the DVDs used for PlayStation 2 and Xbox (and it couldn’t function as a DVD player, either).

This period for video games was the high point in terms of console competition for 3rd-party developers for two reasons:

• First, there were still meaningful choices to be made in terms of hardware and the overall development environment, as epitomized by Sony’s use of CD-ROMs instead of cartridges.
• Second, developers were still constrained by the cost of developing for distinct architectures, which meant it was important to make the right choice (which dramatically increased the return of developing for the same platform as everyone else).

It was the Sony-Namco partnership, though, that was a harbinger of the future: it behooved console makers to have similar hardware and software stacks to their competitors, so that developers would target them; developers, meanwhile, were devoting an increasing share of their budget to developing assets, particularly when the PS3/Xbox 360 generation targeted high definition, which increased their motivation to be on multiple platforms to better leverage their investments. It was Sony that missed this shift: the PS3 had a complicated Cell processor that was hard to develop for, and a high price thanks to its inclusion of a Blu-Ray player; the Xbox 360 had launched earlier with a simpler architecture, and most developers built for the Xbox first and Playstation 3 second (even if they launched at the same time).

The real shift, though, was the emergence of game engines as the dominant mode of development: instead of building a game for a specific console, it made much more sense to build a game for a specific engine which abstracted away the underlying hardware. Sometimes these game engines were internally developed — Activision launched its Call of Duty franchise in this time period (after emerging from bankruptcy under new CEO Bobby Kotick) — and sometimes they were licensed (i.e. Epic’s Unreal Engine). The impact, though, was in some respects similar to cartridges on the Atari 2600:

In this new world it was the consoles themselves that became modularized: consumers picked out their favorite and 3rd-party developers delivered their games on both.

Nintendo, meanwhile, dominated the generation with the Nintendo Wii. What was interesting, though, is that 3rd-party support for the Wii was still lacking, in part because of the underpowered hardware (in contrast to previous generations): the Wii sold well because of its unique control method — which most people used to play Wii Sports — and Nintendo’s first-party titles. It was, in many respects, Nintendo’s most vertically-integrated console yet, and was incredibly successful.

Sony Exclusives

Sony’s pivot after the (relatively) disappointing PlayStation 3 was brilliant: if the economic imperative for 3rd-party developers was to be on both Xbox and PlayStation (and the PC), and if game engines made that easy to implement, then there was no longer any differentiation to be had in catering to 3rd-party developers.

Instead Sony beefed up its internal game development studios and bought up several external ones, with the goal of creating PlayStation 4 exclusives. Now some portion of new games would not be available on Xbox not because it had crappy cartridges or underpowered graphics, but because Sony could decide to limit its profit on individual titles for the sake of the broader PlayStation 4 ecosystem. After all, there would still be a lot of 3rd-party developers; if Sony had more consoles than Microsoft because of its exclusives, then it would harvest more of those 3rd-party royalty fees.

Those fees, by the way, started to head back up, particularly for digital-only versions, which returned to that 30% cut that Nintendo had pioneered many years prior; this is the downside of depending on universal abstractions like game engines while bearing high development costs: you have no choice but to be on every platform no matter how much it costs.

Sony bet correctly: the PS4 dominated its generation, helped along by Microsoft making a bad bet of its own by packing in the Kinect with the Xbox One. It was a repeat of Sony’s mistake with the PS3, in that it was a misguided attempt to differentiate in hardware when the fundamental value chain had long since dictated that the console was increasingly a commodity. Content is what mattered — at least as long as the current business model persisted.

Nintendo, meanwhile, continued to march to its own vertically-integrated drum: after the disastrous Wii U the company quickly pivoted to the Nintendo Switch, which continues to leverage its truly unique portable form factor and Nintendo’s first-party games to huge sales. Third party support, though, remains extremely tepid; it’s just too underpowered, and the sort of person that cares about third-party titles like Madden or Call of Duty has long since bought a PlayStation or Xbox.

The FTC vs. Microsoft

Forty years of context may seem like overkill when it comes to examining the FTC’s attempt to block Microsoft’s acquisition of Activision, but I think it is essential for multiple reasons.

First, the video game market has proven to be extremely dynamic, particularly in terms of 3rd-party developers:

• Atari was vertically integrated
• Nintendo grew the market with strict control of 3rd-party developers
• Sony took over the market by catering to 3rd-party developers and differentiating on hardware
• Xbox’s best generation leaned into increased commodification and ease-of-development
• Sony retook the lead by leaning back into vertical integration

That is quite the round trip, and it’s worth pointing out that attempting to freeze the market in its current iteration at any point over the last forty years would have foreclosed future changes.

At the same time, Sony’s vertical integration seems more sustainable than Atari’s. First, Sony owns the developers who make the most compelling exclusives for its consoles; they can’t simply up-and-leave like the Gang of Four. Second, the costs of developing modern games has grown so high that any 3rd-party developer has no choice but to develop for all relevant consoles. That means that there will never be a competitor who wins by offering 3rd-party developers a better deal; the only way to fight back is to have developers of your own, or a completely different business model.

The first fear raised by the FTC is that Microsoft, by virtue of acquiring Activision, is looking to fight its own exclusive war, and at first blush it’s a reasonable concern. After all, Activision has some of the most popular 3rd-party games, particularly the aforementioned Call of Duty franchise. The problem with this reasoning, though, is that the price Microsoft paid for Activision was a multiple of Activision’s current revenues, which include billions of dollars for games sold on Playstation. To suddenly cut Call of Duty (or Activision’s other multi-platform titles) off from Playstation would be massively value destructive; no wonder Microsoft said it was happy to sign a 10-year deal with Sony to keep Call of Duty on PlayStation.

Just for clarity’s sake, the distinction here from Sony’s strategy is the fact that Microsoft is acquiring these assets. It’s one thing to develop a game for your own platform — you’re building the value yourself, and choosing to harvest it with an ecosystem strategy as opposed to maximizing that games’ profit. An acquirer, though, has to pay for the business model that already exists.

At the same time, though, it’s no surprise that Microsoft has taken in-development assets from its other acquisition like ZeniMax and made them exclusives; that is the Sony strategy, and Microsoft was very clear when it acquired ZeniMax that it would keep cross-platform games cross-platform but may pursue a different strategy for new intellectual property. CEO of Microsoft Gaming Phil Spencer told Bloomberg at the time:

In terms of other platforms, we’ll make a decision on a case-by-case basis.

Given this, it’s positively bizarre that the FTC also claims that Microsoft lied to the E.U. with regards to its promises surrounding the ZeniMax acquisition: the company was very clear that existing cross-platform games would stay cross-platform, and made no promises about future IP. Indeed, the FTC’s claims were so off-base that the European Commission felt the need to clarify that Microsoft didn’t mislead the E.U.; from Mlex:

Microsoft didn’t make any “commitments” to EU regulators not to release Xbox-exclusive content following its takeover of ZeniMax Media, the European Commission has said. US enforcers yesterday suggested that the US tech giant had misled the regulator in 2021 and cited that as a reason to challenge its proposed acquisition of Activision Blizzard. “The commission cleared the Microsoft/ZeniMax transaction unconditionally as it concluded that the transaction would not raise competition concerns,” the EU watchdog said in an emailed statement.

The absence of competition concerns “did not rely on any statements made by Microsoft about the future distribution strategy concerning ZeniMax’s games,” said the commission, which itself has opened an in-depth probe into the Activision Blizzard deal and appears keen to clarify what happened in the previous acquisition. The EU agency found that even if Microsoft were to restrict access to ZeniMax titles, it wouldn’t have a significant impact on competition because rivals wouldn’t be denied access to an “essential input,” and other consoles would still have a “large array” of attractive content.

The FTC’s concerns about future IP being exclusive ring a bit hypocritical given the fact that Sony has been pursuing the exact same strategy — including multiple acquisitions — without any sort of regulatory interference; more than that, though, to effectively make up a crime is disquieting. To be fair, those Sony acquisitions were a lot smaller than Activision, but this goes back to the first point: the entire reason Activision is expensive is because of its already-in-market titles, which Microsoft has every economic incentive to keep cross-platform (and which it is willing to commit to contractually).

Whither Competition

It’s the final FTC concern, though, that I think is dangerous. From the complaint:

These effects are likely to be felt throughout the video gaming industry. The Proposed Acquisition is reasonably likely to substantially lessen competition and/or tend to create a monopoly in both well-developed and new, burgeoning markets, including highperformance consoles, multi-game content library subscription services, and cloud gaming subscription services…

Multi-Game Content Library Subscription Services comprise a Relevant Market. The anticompetitive effects of the Proposed Acquisition also are reasonably likely to occur in any relevant antitrust market that contains Multi-Game Content Library Subscription Services, including a combined Multi-Game Content Library and Cloud Gaming Subscription Services market.

Cloud Gaming Subscription Services are a Relevant Market. The anticompetitive effects of the Proposed Acquisition alleged in this complaint are also likely to occur in any relevant antitrust market that contains Cloud Gaming Subscription Services, including a combined Multi-Game Content Library and Cloud Gaming Subscription Services market.

“Multi-Game Content Library Subscription Services” and “Cloud Gaming Subscription Services” are, indeed, the reason why Microsoft wants to do this deal. I explained the rationale when Microsoft acquired ZeniMax:

A huge amount of discussion around this acquisition was focused on Microsoft needing its own stable of exclusives in order to compete with Sony, but it’s important to note that making all of ZeniMax’s games exclusives would be hugely value destructive, at least in the short-to-medium term. Microsoft is paying $7.5 billion for a company that currently makes money selling games on PC, Xbox, and PS5, and simply cutting off one of those platforms — particularly when said platform is willing to pay extra for mere timed exclusives, not all-out exclusives — is to effectively throw a meaningful chunk of that value away. That certainly doesn’t fit with Nadella’s statement that “each layer has to stand on its own for what it brings”…

Microsoft isn’t necessarily buying ZeniMax to make its games exclusive, but rather to apply a new business model to them — specifically, the Xbox Game Pass subscription. This means that Microsoft could, if it chose, have its cake and eat it too: sell ZeniMax games at their usual $60~$70 price on PC, PS5, Xbox, etc., while also making them available from day one to Xbox Game Pass subscribers. It won’t take long for gamers to quickly do the math: $180/year — i.e. three games bought individually — gets you access to all of the games, and not just on one platform, but on all of them, from PC to console to phone.

Sure, some gamers will insist on doing things the old way, and that’s fine: Microsoft can make the same money ZeniMax would have as an independent company. Everyone else can buy into Microsoft’s model, taking advantage of the sort of win-win-win economics that characterize successful bundles. And, if they have a PS5 and thus can’t get access to Xbox Game Pass on their TVs, an Xbox is only an extra $10/month away.

Microsoft is willing to cannibalize itself to build a new business model for video games, and it’s a business model that is pretty darn attractive for consumers. It’s also a business model that Activision wouldn’t pursue on its own, because it has its own profits to protect. Most importantly, though, it’s a business model that is anathema to Sony: making titles broadly available to consumers on a subscription basis is the exact opposite of the company’s exclusive strategy, which is all about locking consumers into Sony’s platform.

Here’s the thing: isn’t this a textbook example of competition? The FTC is seeking to preserve a model of competition that was last relevant in the PS2/Xbox generation, but that plane of competition has long since disappeared. The console market as it is today is one that is increasingly boring for consumers, precisely because Sony has won. What is compelling about Microsoft’s approach is that they are making a bet that offering consumers a better deal is the best way to break up Sony’s dominance, and this is somehow a bad thing?

What makes this determination to outlaw future business models particularly frustrating is that the real threat to gaming today is the dominance of storefronts that exact their own tax while contributing nothing to the development of the industry. The App Store and Google Play leverage software to extract 30% from mobile games just because they can — and sure, go ahead and make the same case about Microsoft and Sony. If the FTC can’t be bothered to check the blatant self-favoring inherent in these models, at the minimum it seems reasonable to give a chance to a new kind of model that could actual push consumers to explore alternative ways to game on their devices.

For the record, I do believe this acquisition demands careful overview, and it’s completely appropriate to insist that Microsoft continue to deliver Activision titles to other platforms, even if it wouldn’t make economic sense to do anything but. It’s increasingly difficult, though, to grasp any sort of coherent theory to the FTC’s antitrust decisions beyond ‘big tech bad’. There are real antitrust issues in the industry, but that requires actually understanding the industry to tease them out; that sort of understanding applied to this case would highlight Sony’s actual dominance and that having multiple compelling platforms with different business models is the essence of competition.

1. Ten years later, as a hand-me-down from a relative ↩

2. The Fairchild Channel F, which was released in 1976, was the actual first console-based video game system, but the 2600 was by far the most popular. ↩

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To what extent are new companies, particularly those in new spaces, pushed versus pulled into existence? Last week I wrote about how Tesla is a Meme Company:

It turned out, though, that TSLA was itself a meme, one about a car company, but also sustainability, and most of all, about Elon Musk himself. Issuing more stock was not diluting existing shareholders; it was extending the opportunity to propagate the TSLA meme to that many more people, and while Musk’s haters multiplied, so did his fans. The Internet, after all, is about abundance, not scarcity. The end result is that instead of infrastructure leading to a movement, a movement, via the stock market, funded the building out of infrastructure.

Electrification of personal vehicles would have happened at some point; it seems fair to argue that Musk accelerated the timeline significantly. Clubhouse, meanwhile, Silicon Valley’s hottest consumer startup, feels like the opposite case: in retrospect its emergence feels like it was inevitable — if anything, the question is what took so long for audio to follow the same path as text, images, and video.

Step 1: Democratization

The grandaddy of independent publishing on the Internet was the blog: suddenly anyone could publish their thoughts to the entire world! This was representative of the Internet’s most obvious impact on media of all types: democratization.

• Distributing text no longer required a printing press, but simply blogging software:
  
• Distributing images no longer required screen-printing, but simply a website:
  
• Distributing video no longer required a broadcast license, but simply a server:
  
• Distributing audio no longer required a radio tower, but simply an MP3:
  

Businesses soon sprang up to make this process easier: Blogger for blogging, Flickr for photo-sharing, YouTube for video, and iTunes for podcasting (although, in a quirk of history, Apple never actually provided centralized hosting for podcasts, only a directory). Now you didn’t even need to have your own website or any particular expertise: simply pick a username and password and you were a publisher.

Step 2: Aggregation

Making anyone into a publisher resulted in an explosion of content; this shifted value to entities able to help consumers find what they were interested in. In text the big winner was Google, which indexed pre-existing publications, independent blogs, and everything in-between. The big winner in photos, meanwhile, ended up being Instagram: users “came for the tool and stayed for the network”, as Chris Dixon memorably put it:

Instagram’s initial hook was the innovative photo filters. At the time some other apps like Hipstamatic had filters but you had to pay for them. Instagram also made it easy to share your photos on other networks like Facebook and Twitter. But you could also share on Instagram’s network, which of course became the preferred way to use Instagram over time.

The Internet creates a far tighter feedback loop between content creation and consumption than analog media; Instagram leveraged this loop to become the dominant photo network. YouTube accomplished a similar feat, although the relative difficulty in creating video meant that the ratio of viewers to creators was much more extreme than in the case of photo-sharing. That, though, is exactly what made YouTube so dominant: creators knew that that was where all of their would-be viewers were.

Spotify is trying to do something similar for audio, particularly podcasts. I wrote in a Daily Update after the streaming service signed Joe Rogan to an exclusive contract:

Spotify, meanwhile, has its eyes on an absolute maxima — a podcast industry that monetizes at a rate befitting its share of attention — but as I have explained, that will only be possible with a Facebook-like model that dynamically matches advertisers and listeners in real-time, as they are streaming a podcast…This, by extension, means that Spotify needs a much larger share of the market, so that they can start generating advertising payouts that are better than the current stunted model, thus convincing podcasters to give up their current ads and use Spotify’s platform to monetize instead.

In this view the motivation for the Rogan deal is obvious: Spotify doesn’t just want to capture new listeners, it wants to actively take them from Apple and other podcast players. And, if it can take a sufficient number, the company surely believes it can create a superior monetization mechanism such that the rest of the podcast creator market shifts to Spotify out of self interest.

Capture enough of the audience and the creators will follow.

Step 3: Transformation

Still, even with the explosion of content resulting from democratizing publishing, what was actually published was roughly analogous to what might have been published in the pre-Internet world. A blog post was just an article; an Instagram post was just a photo; a YouTube video was just a TV episode; a podcast was just radio show. The final step was transformation: creating something entirely new that was simply not possible previously.

Start with text: Twitter is not discrete articles but a stream of thoughts, 280 characters long. It was the stream that was uniquely enabled by the Internet: there is no real world analogy to being able to ingest the thoughts of hundreds or thousands of people from all over the world in real-time, and to have the diet be different for every person.

What is interesting is the effect this transformation had on blogging; Twitter all but killed it, for three reasons:

• First, Twitter was even more accessible than blogging ever was. Just type out your thoughts, no matter how half-formed they may be, and hit tweet.
• Second, because blogging was so distributed and imperfectly aggregated it was hard to build an audience; Twitter, on the other hand, combined creation and consumption like any other social network, which dramatically increased the reward and motivation for posting your thoughts there instead of on your blog.
• Third, Twitter, thanks to the way it combined a wide variety of creators in an easily-consumable stream, was just a lot more interesting than most blogs; this completed a virtuous cycle, as more consumers led to more creators which led to more consumers.

Instagram, meanwhile, had always had that transformational feed, which carried the service to its first 500 million users; it was Stories, though, that re-ignited growth:

Stories — which Instagram audaciously copied from Snapchat — combined the customized nature of the feed with the ephemerality inherent in digital’s abundance; the problem with posting what you had for lunch was not that it was boring, but that no one wanted it to stick around forever.

This too appears to have reduced usage of what came before; while Facebook has never disclosed Stories usage relative to feed viewing, that chart above is from this August 2018 Article about Facebook’s Story Problem — and Opportunity, where I observed:

While more people may use Instagram because of Stories, some significant number of people view Stories instead of the Instagram News Feed, or both in place of the Facebook News Feed. In the long run that is fine by Facebook — better to have users on your properties than not — but the very same user not viewing the News Feed, particularly the Facebook News Feed, may simply not be as valuable, at least for now.

The opportunity came from the fact that dramatically increasing inventory would surely lead to significant growth in the long run, which is exactly what has happened. It didn’t matter that Stories were not nearly as well-composed as pictures in the Instagram feed; in fact, that made them even more valuable, because Stories were easier to both produce and consume.

TikTok is doing the same thing with video; in this case the transformative technology is its algorithm. I explained in The TikTok War:

All of this explains what makes TikTok such a breakthrough product. First, humans like video. Second, TikTok’s video creation tools were far more accessible and inspiring for non-professional videographers. The crucial missing piece, though, is that TikTok isn’t really a social network…

ByteDance’s 2016 launch of Douyin — the Chinese version of TikTok — revealed another, even more important benefit to relying purely on the algorithm: by expanding the library of available video from those made by your network to any video made by anyone on the service, Douyin/TikTok leverages the sheer scale of user-generated content to generate far more compelling content than professionals could ever generate, and relies on its algorithms to ensure that users are only seeing the cream of the crop.

YouTube has invested heavily in its own algorithm to keep you on the site, but its level of immersion is still gated by its history of serving discrete videos from individual creators; TikTok, on the other hand, drops you into a stream of videos that quickly blur together into a haze of engagement and virality.

There is nothing like it in the real world.

Podcasts and Blogs

What is striking about audio is how stunted its development is relative to other mediums. Yes, podcasts are popular, but the infrastructure and business model surrounding podcasts is stuck somewhere in the mid-2000’s, a point I made in 2019 in Spotify’s Podcast Aggregation Play:

The current state of podcast advertising is a situation not so different from the early web: how many people remember this?

These ads were elaborate affiliate marketing schemes; you really could get a free iPod if you signed up for several credit cards, a Netflix account, subscription video courses, you get the idea. What all of these marketers had in common was an anticipation that new customers would have large lifetime values, justifying large payouts to whatever dodgy companies managed to sign them up.

The parallels to podcasting should be obvious: why is Squarespace on seemingly every podcast? Because customers paying monthly for a website have huge lifetime values. Sure, they may only set up the website once, but they are likely to maintain it for a very long time, particularly if they grabbed a “free” domain along the way. This makes the hassle of coordinating ad reads and sponsorship codes across a plethora of podcasts worth the trouble; it’s the same story with other prominent podcast sponsors like ZipRecruiter or SimpliSafe.

The problem is that the affiliated marketing for large lifetime-value purchases segment is not a particularly large one

One of the takeaways of that piece was that monetization was holding podcasts back, and that Spotify appeared to be positioning itself to expand the podcast advertising market via centralization. Looking back, though, I should have realized that but for a few exceptions, advertising never ended up working out for blogs; the premise behind 2015’s Blogging’s Bright Future was that subscriptions made far more sense as a business model:

Forgive me if this article read a bit too much like an advertisement for Stratechery; the honest truth is my fervent belief in the individual blog not only as a product but also as a business is what led to my founding this site, not the other way around. And, after this past weekend’s “blogging-is-dead” overdose, I almost feel compelled to note that my conclusion — and experience — is the exact opposite of Klein’s and all the others’: I believe that Sullivan’s The Daily Dish will in the long run be remembered not as the last of a dying breed but as the pioneer of a new, sustainable journalism that strikes an essential balance to the corporate-backed advertising-based “scale” businesses that Klein (and the afore-linked Smith) is pursuing.

Interestingly enough, of the three authors cited in that paragraph, both Ezra Klein — formerly of Vox — and Ben Smith — formerly of BuzzFeed — are now at the New York Times, which is thriving with a subscription model. Sullivan, meanwhile, is at Substack — itself modeled after Stratechery — where within a month of launch he had reached a $500,000 run rate.

When you think about the Twitter-driven shake-out of blogging this evolution makes sense: Twitter captured the long-tail of blogs, in the process dramatically expanding the market for publishing text, but that by definition meant that the blogs that remained popular had readers that would jump through hoops — or at least click a link — to consume their content. It makes sense that the most sustainable way for those bloggers to pay the bills was by directly charging their readers, who already had demonstrated an above-average interest in their content.

My personal bet is that podcasts will follow a similar path. Podcasts, even more than blogs, require a commitment on the part of the listener, but that commitment is rewarded by a connection to the podcast host that feels even more authentic; host-read podcast advertising leverages this authenticity, but for most medium-sized podcasts charging listeners directly will make more sense in the long run.

Implicit in this prediction, though, is that podcasts actually fade in relative importance and popularity to an alternative that doesn’t simply further democratize audio publishing, but also transforms it. Enter Clubhouse.

Clubhouse’s Opening

The most obvious difference between Clubhouse and podcasts is how much dramatically easier it is to both create a conversation and to listen to one. This step change is very much inline with the shift from blogging to Twitter, from website publishing to Instagram, or from YouTube to TikTok.

Secondly, like those successful networks, Clubhouse centralizes creation and consumption into a tight feedback loop. In fact, conversation consumers can, by raising their hand and being recognized by the moderator, become creators in a matter of seconds.

This capability is enabled by the “only on the Internet” feature that makes Clubhouse transformational: the fact that it is live. In many mediums this feature would be fatal: one isn’t always free to watch a live video, and believe me, it is not very exciting to watch me type. However, the fact that audio can be consumed while you are doing something else allows the immediacy and vibrancy of live conversation to shine.

Being live also feeds back into the first quality: Clubhouse is far better suited than podcasts to discuss events as they are happening, or immediately afterwards. For example, both Clubhouse and Locker Room, its sports-focused competitor, have become go-to destinations for sports reaction conversations, both during and after games; it’s only a matter of time before secondary market of play-by-play announcers develops, and not only for sports: anything that is happening can be narrated and discussed.

Make no mistake, most of these conversations will be terrible. That, though, is the case for all user-generated content. The key for Clubhouse will be in honing its algorithms so that every time a listener opens the app they are presented with a conversation that is interesting to them. This is the other area where podcasts miss the mark: it is amazing to have so much choice, but all too often that choice is paralyzing; sometimes — a lot of times! — users just want to scroll their Twitter feed instead of reading a long blog post, or click through Stories or swipe TikToks, and Clubhouse is poised to provide the same mindless escapism for background audio.

COVID, China, and Controversy

Much of what I’ve written is perhaps obvious; to me that lends credence to the idea that Clubhouse is onto something substantial. To that end, though, why now?

One reason is hardware:

The fact that Clubhouse makes it so easy to drop in and out of conversation is matched by how easy AirPods make it to drop into and out of audio-listening mode.

An even more important reason, though, is probably COVID. Clubhouse launched last April in the midst of a worldwide lockdown, and despite its very rough state it provided a place for people to socialize when there were few other options. This was likely crucial in helping Clubhouse achieve its initial breakthrough. At the same time, just because COVID helped Clubhouse get off the ground does not mean its end will herald the end of the audio service, any more than improved iPhone cameras heralded the end of Instagram simply because its filters were no longer necessary; the question is if the crisis was sufficient to bootstrap the network.

I suspect so. For one there is the brazenness with which Clubhouse is leveraging the iPhone’s address book to build out its network; getting on the app requires an invitation, or signing up for the waiting list and hoping someone in your address book is already on the service, which lets you “jump the line”. This incentivizes both existing and prospective members to allow Clubhouse to ingest their contacts and get their friends on as quickly as possible.

Secondly, any suggestion that Clubhouse is limited to Silicon Valley is very much off the mark. I almost fell out of my chair while playing board games when my not-at-all-technical sister-in-law started listening to a Clubhouse while we were playing board games over the weekend, and by all accounts Taiwan is one of a whole host of markets where the app has taken off. Locker Room, as noted, appears to be the app of choice for NBA Twitter, but I suspect that is a function of Clubhouse being both gated and iPhone-only; I expect both to be rectified sooner-rather-than-later. And, of course, there is the fact the service has been banned in China.

Unfortunately, that is not the only China angle when it comes to Clubhouse; the service is powered by Agora, a Shanghai-based company. The Stanford Internet Observatory investigated:

The Stanford Internet Observatory has confirmed that Agora, a Shanghai-based provider of real-time engagement software, supplies back-end infrastructure to the Clubhouse App. This relationship had previously been widely suspected but not publicly confirmed. Further, SIO has determined that a user’s unique Clubhouse ID number and chatroom ID are transmitted in plaintext, and Agora would likely have access to users’ raw audio, potentially providing access to the Chinese government. In at least one instance, SIO observed room metadata being relayed to servers we believe to be hosted in the PRC, and audio to servers managed by Chinese entities and distributed around the world via Anycast. It is also likely possible to connect Clubhouse IDs with user profiles.

That certainly puts Clubhouse’s aggressive contact collection in a more sinister light; it also very much fits the stereotype of a new social network scrambling to capture the market first, and worrying about potential downsides later. Given the importance of network effects, I’m not surprised, but the choice of a Chinese infrastructure provider in particular is disappointing for a service launching in 2020.

The perhaps sad reality, though, is that most users probably won’t care: the payoff from uploading contacts is clear, and even if you don’t, you still need a phone number to register, which means that Clubhouse is probably reconstructing your contact list from your friends who did. The company has been far more aggressive in implementing blocking and user-reported content violations mechanism; I suspect this reflects the reality that content controversies are, in the current environment, more damaging than China connections, despite the fact that the former are an inescapable reality of user-generated content, while the latter is a choice.

Whither Facebook?

The one social network that I have barely mentioned in this Article is the social network that the FTC has sued for being a monopoly. That sentence, on close examination, certainly seems to raise some rather obvious questions about the strength of the FTC’s case.

Still, the discussion of all of these different networks really does highlight how Facebook is unique: while Twitter, Instagram, YouTube, and TikTok are all first and foremost about the medium, and only then the network, Facebook is about the network first. That is how the service has evolved from text to images to video and, I wouldn’t be surprised, to audio. This also explains why Facebook managed the shift to mobile so well; for these other networks, meanwhile, it was mobile that was the foundation for their transformative breakthroughs.

That is why I would actually give Facebook’s upcoming Clubhouse competitor a better chance than Twitter’s already-launched offering. Facebook takes innovations developed in different apps for interest-based networks and adds them to its relationship-based network; at the same time, this also means that Facebook is never going to be a real competitor for Clubhouse, which seems more likely to recreate Twitter’s interest-based network than Twitter is likely to recreate the vibrancy of Clubhouse.

The other way that Facebook looms large in the social networking discussion is monetization: it is obvious that there is an endless human appetite for social networks, but advertisers would much rather focus on Facebook’s integrated suite of properties. It is not clear that Clubhouse will even pursue advertising, though; the company has announced its intention to help creators monetize via mechanisms like tipping. This has already been proven out on platforms like Twitch in the West, and is a massive success in China (there is a reason, I should note, why the best available live streaming technology was offered by a Chinese company). It’s a smart move for Clubhouse to move in this direction early, both as a means of locking in creators, and also going where Facebook is less likely to follow.

One potential loser, meanwhile, is Spotify; the company has bet heavily on podcasts, which could be similar to betting on blogs in 2007. Still, the fact the company’s most important means of monetization is subscriptions may be its saving grace; it may turn out that Spotify is the obvious home for highly produced content, available in a more consumer-friendly bundle than the a la carte pricing that followed from blogging’s decentralized nature.

For now I don’t expect Clubhouse to be too concerned about the competition; the company said on its website when it reportedly became a unicorn:

We’ve grown faster than expected over the past few months, causing too many people to see red error messages when our servers are struggling. A large portion of the new funding round will go to technology and infrastructure to scale the Clubhouse experience for everyone, so that it’s always fast and performant, regardless of how many people are joining.

That is, obviously, the best sort of problem to have, and one that evinces product-market fit (the only thing missing is a fail whale); the fact it all seems so obvious is simply because we have seen this story before.

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

May 6, 2021: It looks like this analysis may have missed this mark; I wrote another follow-up in this Daily Update — which you can read for free — examining what I got wrong.

The UK ad authority has put the kibosh on a certain format of ads used by Playrix, arguing that the ads for each wildly misrepresent the gameplay of each title. ...

Nintendo has just announced Mario Kart Live: Home Circuit, a mixed reality Switch title that lets players build and race around real-world circuits using remote control karts. ...

In a scathing CNN interview Tuesday, Anderson Cooper absolutely eviscerated MyPillow creator Mike Lindell for pushing the compound oleandrin as a cure for COVID-19 — even though it’s not backed by any sort of scientific evidence.

Cooper begins the interview guns blazing, immediately questioning the credentials and motivations of Lindell, who is on President Trump’s coronavirus task force and serves as a chair of his re-election campaign. Needless to say, you need to watch it.

“You have no medical background, you’re not a scientist,” Cooper began. “Yet you’re claiming this substance, which has not been studied in any meaningful way, can cure COVID. And you have a financial stake in the company. You would profit from it if this is being sold widely. Morally, is that right?”

Lindell, who reportedly has a financial stake in Phoenix Biotechnology, the company manufacturing oleandrin, repeatedly insisted that the drug had been thoroughly tested. But when he was pressed by Cooper, Lindell failed to name a single fact about the clinical trials and research — even basic details like where the research had taken place.

Facing that pressure, Lindell accused Cooper and the media of misconstruing the facts and trying to withhold a miracle cure that he claimed, despite having zero evidence, “works for everybody.”

The entire interview is a thorough debunking of Lindell’s oleandrin push as well as the sort of delusional thinking that tries to assert that the American government has a better grasp on the COVID-19 pandemic that it does.

But it also raises important questions about the media’s role in presenting misinformation: Yes, Cooper pushed back on Lindell every time he lies on the air, but as The Washington Post reports, the interview drew criticism for how much air time Lindell got to share his distorted, dishonest perspective.

The post Watch a Guy Selling a Fake COVID-19 Cure Get Absolutely Destroyed appeared first on Futurism.

Ian Sherr, reporting for CNet:

Ahead of an antitrust hearing on Capitol Hill next week, Apple is fighting back against the perception that its App Store charges onerous commission rates to developers. It hired economists from the firm Analysis Group, who said the tech giant’s fees were similar to competitors.

The research, published Wednesday, collected commission rates reported on or disclosed by app stores from Amazon, Google, Microsoft, Samsung and others. The company’s economists also studied ticket resale marketplaces, game stores and ride-hailing apps. Overall, the economists said the commissions charged were similar, though stores generally offered different features for consumers and developers.

Here is the Analysis Group’s PDF report.

You know you’re in trouble when part of your argument is “Hey, at least we’re better than Ticketmaster.”

Jackbox Games CEO Mike Bilder joined us on the GDC Podcast to explain how his company is dealing with dramatic increases in traffic amid continuing stay at home orders in the time of COVID-19. ...

Nintendo has a habit of launching fitness-focused games paired with new peripherals for its motion-control savvy systems, and the Nintendo Switch is no exception. ...

Face Swap

A mysterious robotics company has an unusual proposition: it wants to pay someone $125,000 in exchange for the rights to use their face on its new line of humanoid robotics.

Working on behalf of the company is London-based machining startup called Geomiq, which Popular Mechanics reports will select one person and plaster their face on thousands of humanoid robots meant to serve as virtual companions for the elderly. Details are scarce, but the result is likely to be a bizarre journey deep into the uncanny valley.

Secret Lab

Geomiq wrote in a blog post that it was approached by the robotics company to find a new face, but that it signed a non-disclosure agreement that prevents it from sharing too many details about who, exactly, will be buying the rights to someone’s face.

PopMech speculates that the company is likely in the medical space. Geomiq’s blog post says that the robots are nearly ready to hit the market — all they need is a “kind and friendly” mug — and that all will be revealed soon.

Sold Off

If someone who sends their headshot to faces@geomiq.com is chosen, they’ll be briefed with the details on exactly what it is they’re signing away. Odds are they’d be selling the commercial rights to their own face.

“We know that this is an extremely unique request, and signing over the licenses to your face is potentially an extremely big decision,” Geomiq wrote.

READ MORE: Want $125k? Just Donate Your Face to Some Humanoid Robots [Popular Mechanics]

More on robots: New Roundup Ranks the World’s Robots by Creepiness

The post Startup: We’ll Pay You $125,000 to Turn Your Face Into Robot Skin appeared first on Futurism.

Sitting in front of a screen is bad for you. Then it’s good for you. Then it’s bad for you again. But, like, only a bit. Allow me to explain.

Shortly after my book on the psychology of video games came out, I was invited to the Annapolis Book Festival to sit on a panel entitled “Video Games: Helpful Tool or Harmful Distraction?” My co-panelist and I planned to tackle the debate about video games and other screen time by discussing the benefits of video games and how they could help kids if parents were involved and informed. I even had notes. On little index cards. They were color coded. 

But things didn’t go as planned. Within seconds, audience members had passed around a box of pearls and people were clutching for dear life. One man stood up and complained loudly that ever since his son had discovered Minecraft, he had not been able to get him interested in going outdoors for activities like flyfishing or furniture building. Others also lamented that their kids spent too much time in front of a screen. 

We tried to take a more balanced approach based on research findings, but the audience wasn’t having it. At the end, the bearded flyfishing father expressed his disappointment over the misleading title of the panel. “I thought you were going to be on our side here and tell us how to fix this problem.”

He’s not alone in his concerns.  One 2015 study of children in the UK showed that the amount of time kids spent online more than doubled from an average of 8 hours per week to almost 19 hours per week in just 10 years. It’s not unreasonable to wonder how that much screen time might affect kids’ well-being.

One of the dominant ideas in the screen time literature is “the displacement hypothesis.” This is just the idea that if kids are spending time in front of screens, it means other activities are being displaced from their day. If that audience member’s kid is playing Minecraft, he can’t be out in the woodshop learning to make mahogany fishing lures with his dad. Or whatever. I don’t know anything about fishing.

But what the displacement hypothesis doesn’t take into account is that people use screens to do many different things in many different ways. My older daughter, for example, may spend five hours a day in front of a screen, but in that time she’s probably…

• Chatting with friends in Discord
• Using a drawing tablet to create digital fan art for her current anime obsession
• Using Google to do research for her History homework
• Sitting in front of the TV with her mother to watch and discuss American Idol
• Listening to a podcast
• Playing the online competitive shooter Overwatch
• Using her cell phone to scroll through the Instagram feeds of artists she likes

Most studies and a lot of other parents would treat her screen time the same as another kid who just played Fortnite for five hours.

The point is that given how central digital devices are to the way we work, play, socialize, and communicate, there isn’t a monolithic thing called “screen time” that displaces other, more beneficial activities. In fact, we might expect that kids would be at a disadvantage in several ways if they didn’t get to engage in a certain amount of screen time. So as an alternative to the displacement hypothesis, we might take up the “Goldilocks hypothesis” that the relationship between mental well being is actually curvilinear. Too little screen is bad and too much is bad. But just the right amount of screen time should benefit mental well being.

This is exactly the hypothesis that two researchers from the University of Oxford tested in a paper called “A Large-Scale Test of the Goldilocks Hypothesis: Quantifying the Relations Between Digital-Screen Use and the Mental Well Being of Adolescents.” (Przybylski and Weinstein, 2017). The authors collected information from a frankly ridiculous number of adolescents in the UK, resulting in screen time and mental well being data on over 120,000 young people.

And they indeed found evidence for the Golilocks hypothesis, where mental well being went down with little screen use, rose some with a certain amount, then started to drop. They looked at different kinds of screen use, including watching TV or videos, playing video games, general computer use, and using smartphones. The same pattern of “Goldilocks” results in every case. Graphed out, the results looked something like this:

In fact, the researchers were able to specify empirically derived “inflection points” where screen use was beneficial up to that point, but then resulted in a downturn beyond. For weekdays, those inflection points were:

• 1 hr, 40 minutes per day for video game play
• 1 hr, 57 minutes per day for smartphone use
• 3 hr, 41 minutes per day for watching TV or videos
• 4 hr, 17 minutes per day for general computer use

On weekends, the inflection points were even higher.

One final thing to note about this study was that even beyond those inflection points, the effects of screen use were small: d = -0.18. This means that screen use beyond the inflection point accounted for less than 1% of the variability in a given kid’s mental well being. The authors provide further context by noting that “These analyses indicated that the possible negative effects of excessive screen time were less than a third of the size of the positive associations between well being and eating breakfast regularly (d = 0.54) or getting regular sleep (d = 0.58).” (pg. 210). 

Furthermore, another study by University of Oxford researchers in 2019 also used data on screen time and psychological well-being collected from over 17,000 people in the UK, Ireland, and the United States (Orben and Przybylski, 2019). Their conclusion about the size of the effect of screen time on psychological well-being kind of puts things in perspective:

…Those adolescents who reported technology use would need to report 63 hr and 31 min more of technology use a day in their time-use diaries to decrease their well-being by 0.50 standard deviations, a magnitude often seen as a cutoff for effects that participants would be subjectively aware of. (ibid, pg. 12).

So play some games. Browse the web. Learn the social norms around communicating on the internet. Just be sure to get enough sleep and don’t skip breakfast.

REFERENCES

Ofcom. (2015). Children and parents: Media use and attitudes report 2015. Retrieved from http://stakeholders.ofcom .org.uk/market-data-research/other/research-publications/ childrens/children-parents-nov-15/

Orben, A., & Przybylski, A. K. (2019). Screens, Teens, and Psychological Well-Being: Evidence From Three Time-Use-Diary Studies. Psychological Science, 30(5), 682–696. https://doi.org/10.1177/0956797619830329

Przybylski, A. K., & Weinstein, N. (2017). A Large-Scale Test of the Goldilocks Hypothesis: Quantifying the Relations Between Digital-Screen Use and the Mental Well-Being of Adolescents. Psychological Science, 28(2), 204–215. https://doi.org/10.1177/0956797616678438

U.S. Readies $11 Billion in Tariffs on E.U.

Aramco Sells $12 Billion of Bonds in Unprecedented Debut

Yes, the Economy Is Slowing. But Don’t Hyperventilate.

For First Time In A Decade, U.S. Companies Could Report Lower Profits on Higher Revenue

U.S. Bank CEOs Face Off With Congress for the First Time Since Financial Crisis

Warren Buffett Just Gave Wells Fargo Some Valuable Advice

Uber Seeks About $10 Billion in Year’s Biggest IPO

Wynn Resorts Ends Talks With Crown Resorts After Premature Disclosure

Levi Strauss Swings to Profit, Maintains Outlook

Standard Chartered to Pay $1.1 Billion in Iran Sanctions Settlement

Are Plastic Bag Bans Garbage?

Prosecutors Say Drugmaker Indivior Lied About Popular Opioid Treatment

Nick Maggiulli: The Money We Don’t Talk About

Ben Carlson: Dividends Don’t Matter As Much As They Used To & The Stories We Tell Ourselves to Sell Ourselves

Michael Batnick: Smart People Saying Smart Things & Animal Spirits: Super Savers

Be sure to follow me on Twitter.

It's interesting to see Nintendo and Twitch join forces for the promotion, and shows the Japanese console maker is searching for ways to maintain and stoke interest in its fledgling online service. ...

The study looked at data surrounding British teens and notes that, unlike previous research into the potential link, the hypothesis, methods, and analysis technique were publicly registered ahead of the actual research. ...

Streaming mogul Netflix claims Fortnite is now a bigger competitor than other media companies like Game of Thrones and True Detective producer HBO. ...

Benedict Evans of Andreesen Horowitz seems to be taking over from Mary Meeker as the “thinking person’s guide to the future of the internet”. His annual presentation, delivered at 100 mph, is very good. I was astounded to see that the global middle class has grown by a billion people (not a typo) since 2006. That’s staggering.

The whole video is worth 25 minutes of your time.

The post Benedict Evans’ annual technology presentation appeared first on Gamesbrief.

According to Rockstar, it's a figure that means the game has achieved the "single biggest opening weekend in the history of entertainment."  ...

Sony has revealed the full list of retro games that'll be crammed onto the PlayStation Classic when it launches this December.  ...

While I was mostly unplugged on my vacation last week, with the news of Facebook’s disappointing earnings report and subsequent stock decline — the largest one-day loss by any company in U.S. stock market history — I couldn’t resist chiming in on Twitter:

I do regret the tweet a tad, and not only because “chiming in on Twitter” is always risky. Back when Stratechery started I wrote in the very first post that one of the topics I looked forward to exploring was “Why Wall Street is not completely insane”; I was thinking at the time about Apple, a company that, especially at that time, was regularly posting eye-popping revenue and profit numbers that did not necessarily lead to corresponding increases in the stock price, much to the consternation of Apple shareholders. The underlying point should be an obvious one: a stock price is about future earnings, not already realized ones; that the iPhone maker had just had a great quarter was an important signal about the future, but not a determinant factor, and that those pointing to the past to complain about a price predicated on the future were missing the point.

Of course that is exactly what I did in that tweet.

It’s worth noting, though, that while the explicit reasoning of those Apple stockholders may have been suspect, their sentiment has proven correct: in April 2013 Apple reported quarterly revenue of $43.6 billion and profit of $9.5 billion, and the day I started Stratechery the stock price was $63.25; five years later Apple reported quarterly revenue of $61.1 billion and profit of $13.8 billion, and on Friday the stock price was $190.98.

To be clear, I agreed with the Apple-investor sentiment all along: several of my early articles — Apple the Black Swan, Two Bears, and especially What Clayton Christensen Got Wrong — were about making the case that Apple’s business was far more sustainable with much deeper moats than most people realized, and it was that sustainability and defensibility that mattered more than any one quarter’s results.

The question is if a similar case can be made for Facebook: certainly my tweet taken literally was naive for the exact reasons those Apple investor complaints missed the point five years ago; what about the sentiment, though? Just how good of a business is Facebook?

As with many such things, it all depends on what lens you use to examine the question.

Lens 1: Facebook’s Finances

As is often the case with earnings, the move in Facebook’s stock was only a bit about the results and whole lot about future expectations. On Wednesday, Facebook’s stock closed at $217, but then its earnings showed revenue of $13.2 billion, slightly below Wall Street’s expectations; unsurprisingly, the stock slid about 8% in after-hours trading to around $200. The real drop was spurred by two comments on the earnings call from Facebook CFO Dave Wehner about Facebook’s expectations going forward.

First, with regards to revenue:

Turning now to the revenue outlook; our total revenue growth rate decelerated approximately 7 percentage points in Q2 compared to Q1. Our total revenue growth rates will continue to decelerate in the second half of 2018, and we expect our revenue growth rates to decline by high-single digit percentages from prior quarters sequentially in both Q3 and Q4.

Second, with regards to operating margin:

Turning now to expenses; we continue to expect that full-year 2018 total expenses will grow in the range of 50% to 60% compared to last year…Looking beyond 2018, we anticipate that total expense growth will exceed revenue growth in 2019. Over the next several years, we would anticipate that our operating margins will trend towards the mid-30s on a percentage basis.

From a purely financial perspective, both pieces of news are are less than ideal but at least understandable. In terms of revenue, Facebook’s growth is from a very large base, which means that this quarter’s 42% year-over-year revenue growth to $13.2 billion from $9.3 billion is, in absolute terms, 36% greater than the year ago’s 45% revenue growth (from $6.4 billion). To put it in simpler terms, massive growth rates inevitably decline even as massive absolute growth remains; as a point of comparison, Google in the same relative timeframe (14 years after incorporation) grew 35 percent to $12.21 billion (i.e. Facebook is better on both metrics).

As far as the operating margin decline, in a normal company — i.e. one with marginal costs — a revenue decrease would not necessarily lead to a meaningful decline in margin since selling fewer products would mean lower costs of goods sold. Facebook, of course, is not a normal company: the only marginal costs for the ads they sell are credit card fees; like most tech companies the vast majority of costs are “below the line” (mostly in Research & Development, but also Sales & Marketing and General & Administrative); it follows, then, that a decrease in revenue growth would, absent an explicit effort to decrease unrelated (to revenue) expense growth, lead to lower operating margins.

In fact, Facebook is not only not decreasing expenses, they are going in the opposite direction; expenses are growing faster than ever, even as revenue growth clearly fell off:

I suspect it is this chart, more than anything else, that explains the drop in Facebook’s stock price: it’s not one thing or the other; it is both revenue growth slowing and expenses accelerating at the same time, with all indications from management are that the trends will continue.

Again, relatively speaking Facebook is in great shape financially — I already noted the company had better revenue and growth numbers than Google at a similar point, and their operating margins are substantially better as well — but there’s no question this is a pretty substantial shift in the company’s longterm outlook. The financial lens still provides a pretty positive view, but it is indeed less positive than before.

Lens 2: Facebook’s Products

It is always a bit confusing to write about Facebook, because there is both Facebook the company and Facebook the product, and there is no question the greatest amount of negativity has, for several years now, been centered around the latter. To that end, it is tempting to conflate the two; for example, the New York Times wrote in an article headlined Facebook Starts Paying a Price for Scandals:

For nearly two years, Facebook has appeared bulletproof despite a series of scandals about the misuse of its giant social network. But the Silicon Valley company’s streak ended on Wednesday when it said that the accumulation of issues was starting to hurt its multibillion-dollar business — and that the costs are set to continue playing out for months.

This is true as far as it goes, particular when it comes to expenses: Facebook is on pace to increase its security and content review teams to 20,000 people, a three-fold increase in 18 months; that is why CEO Mark Zuckerberg warned on an earnings call last year:

I’ve directed our teams to invest so much in security on top of the other investments we’re making that it will significantly impact our profitability going forward, and I wanted our investors to hear that directly from me. I believe this will make our society stronger, and in doing so will be good for all of us over the long term. But I want to be clear about what our priority is. Protecting our community is more important than maximizing our profits.

What is much less clear is what effect, if any, Facebook’s controversies have had on the top line. There were three factors that for many years made Facebook a monster when it came to revenue growth:

• The number of users was increasing
• Ad load (the number of ads shown in the News Feed) was increasing
• The price-per-ad was increasing

A year ago, though, Facebook stopped increasing ad load; as I have documented, this did result in an even sharper increase in the price paid per-ad, but it was still a retardant on growth.

Then, over the last year, Facebook’s user growth started to slow, and in the most-profitable North American region, has effectively plateaued. That, though, isn’t because of Facebook’s controversies: it is because the app has run out of people! The company has 241 million monthly active users in the US & Canada, 65% of the total population of 372 million (including children who aren’t supposed to have accounts before the age of 13).

Given that degree of nearly total penetration, what is more important when it comes to evaluating Facebook’s health is that there is no indication the company is losing users. Sure, the numbers in North America decreased by a million in Q4 2017, but now that million is back; I expect something similar when it comes to the million users the company lost in Europe when it required affirmative consent from users to continue using the app because of GDPR.

The fact of the matter is that nothing has happened to diminish Facebook’s moat when it comes to attracting and retaining users: the number one feature of a social network is how many people are on it, and for all intents and purposes everyone is on Facebook — whether they like it or not.

Interestingly, Facebook is working to deepen that moat even further with its focus on Groups. Zuckerberg said on the earnings call:

There are more than 200 million people that are members of meaningful groups on Facebook, and these are communities that, upon joining, they become the most important part of your Facebook experience and a big part of your real world social infrastructure. These are groups for new parents, for people with rare diseases, for volunteering, for military families deployed to a new base and more.

We believe there is a community for every one on Facebook. And these meaningful communities often spend online and offline and bring people together in person. We found that every great community has an engaged leader. But running a group can take a lot of time. So we have a road map to make this easier. That will enable more meaningful groups to get formed, which will help us to find relevant ones to recommend to you, and eventually achieve our five-year goal of helping 1 billion people be a part of meaningful communities.

Zuckerberg is referring to his 2017 manifesto Building a Global Community; it is a particularly attractive goal from Facebook’s perspective because it makes the product stickier than ever.

All that noted, the most important reason to view Facebook through the lens of the company’s products is that the sheer scale of Facebook the app makes it easy to lose site of the still substantial growth potential of those other products. Instagram in particular recently passed 1 billion users, which is an incredible number that is still less than half of Facebook the app’s total users; by definition Instagram has reached less than half of its addressable market.

Moreover, Instagram has not only been untouched by Facebook’s controversies, it is such a compelling product that, anecdotally speaking, most “Facebook-nevers” or “Facebook-quitters” readily admit to using the service daily. The app also hasn’t come close to reaching its monetization potential: while the feed carries the same ad load as Facebook, the SnapChat-inspired Stories format that has exploded in usage has barely been monetized; in fact, Facebook’s executives attributed some of the company’s slowing revenue growth to increased Stories usage (instead of the feed). From a purely financial perspective this is certainly a cause for concern, but from a strategic perspective it means that Instagram is in an even stronger position that it was previously. Remember, revenue and profit are lagging indicators, and the explosion in Instagram Stories is an extreme example of why that is such an important fact to keep in mind.

WhatsApp is increasingly compelling as well: not only does the app remain the dominant communications medium in much of the world, but the addition of WhatsApp Status updates and Stories dramatically increases the monetization potential of the service — a potential that Facebook hasn’t even started to realize.¹

There is some degree of long-term risk when it comes to products: Facebook acquired both Instagram and WhatsApp, but the company should not be allowed to acquire another social network of similar size and velocity to those two, and I doubt they would be. That concern, though, is very far in the future: for now the product lens suggests that Facebook is as strong as ever.

Lens 3: Facebook’s Advertising Infrastructure

This lens takes the exact opposite perspective of Lens 2; looking at the company from a product perspective shows four different apps, but looking at the company from an advertising perspective shows a single integrated machine.

This was a point Facebook executives touched on repeatedly in last week’s earnings call. Here is Wehner (emphasis mine):

In terms of Facebook versus Instagram, they’re obviously both contributing to revenue growth. Instagram is growing more quickly and making an increasing contribution to growth. And we’ve been pleased with how Instagram is growing. Facebook and Instagram are really one ads ecosystem.

Zuckerberg:

We’re also making progress developing Stories into a great format for ads. We’ve made the most progress here on Instagram, but this quarter, we started testing Stories ads on Facebook too…

COO Sheryl Sandberg added:

Since we have so many different places where you have Stories formats in Instagram and WhatsApp and Facebook, as volume increases of the opportunity, advertisers get more interested.

Zuckerberg and Sandberg were obviously talking about the potential for advertising in Stories, but that potential is simply a repeat of what has already happened with Feed ads: Facebook spent years building out News Feed advertising — not simply the display and targeting technology but also the entire back-end apparatus for advertisers, connections with non-Facebook data sources and points-of-sale, relationships with ad buyers, etc. — and then simply plugged Instagram into that infrastructure.

The payoff of this integrated approach cannot be overstated. Instagram got to scale in terms of monetization years faster than they would have on their own, even as the initial product team had the freedom to stay focused on the user experience. Facebook the app benefited as well, because Instagram both increased the surface area for Facebook ad campaigns even as it increased Facebook’s targeting capabilities.

The biggest impact, though is on potential competition. It is tempting to focus on the “R” in “ROI” — the return on investment — and as I just noted Instagram + Facebook makes that even more attractive. Just as important, though, is the “I”; there is tremendous benefit to being a one-stop shop for advertisers, who can save time and money by focusing their spend on Facebook. The tools are familiar, the buys are made across platforms, and as Zuckerberg and Sandberg alluded to with regard to Stories, the ads themselves only need to be made once to be used across multiple platforms. Why even go to the trouble to advertise anywhere else?

This is why the advertising lens is perhaps the most useful when it comes to understanding just how strong Facebook’s business remains, and why the Instagram acquisition in particular was such a big deal. For all the discussion of Facebook the app’s lock-in, it is very reasonable to wonder if engagement is decreasing over time, particularly amongst young people, or if controversies may drive down usage — or worse. Were Instagram a separate company, advertisers might find themselves with no choice but to spread out their advertising to multiple companies, and once their advertising was diversified, it would be a much smaller step to target users on other networks like SnapChat or Twitter. As it stands there is no reason to leave Facebook the advertising platform, no matter what happens with Facebook the app.

Lens 4: Facebook’s Multiplying Moats

Facebook’s advertising moat may be its most important, and its network moat its strongest, but the company has actually added moats, particularly in the last year.

The first is GDPR; this may seem counter-intuitive, given that Facebook said last week the regulation cost them a million users, and that one of the factors that would hurt revenue growth was the increased controls the company was giving users when it comes to controlling their personal information. Keep in mind, though, that GDPR applies to everyone, not just Facebook, and as Sandberg noted on the call (emphasis mine):

Advertisers are still adapting to the changes, so it’s early to know the longer-term impact. And things like GDPR and other privacy changes that may happen from us or may happen with regulation could make ads more relevant. One thing that we know that’s not going to change is that advertisers are always looking for the highest ROI opportunity. And what’s most important in winning budget is our relative performance in the industry, and we believe we’ll continue to do very well on that.

I made this exact point previously:

While GDPR advocates have pointed to the lobbying Google and Facebook have done against the law as evidence that it will be effective, that is to completely miss the point: of course neither company wants to incur the costs entailed in such significant regulation, which will absolutely restrict the amount of information they can collect. What is missed is that the increase in digital advertising is a secular trend driven first-and-foremost by eyeballs: more-and-more time is spent on phones, and the ad dollars will inevitably follow. The calculation that matters, then, is not how much Google or Facebook are hurt in isolation, but how much they are hurt relatively to their competitors, and the obvious answer is “a lot less”, which, in the context of that secular increase, means growth.

Secondly, all of those costs that Facebook are incurring for security and content review that are reducing operating margin? Perhaps the stock market would feel better if they were characterized as moat expansion, because that’s exactly what they are: any would-be Facebook competitor is going to have to make a similar investment, and do it from a dramatically lower revenue base.

Moreover, just as Facebook benefits from scaling its ad infrastructure to all of its products, it can do the same with its security efforts. Zuckerberg stated:

More broadly, our strategy is to use Facebook’s computing infrastructure, business platforms and security systems to serve people across all of our apps…We’re using AI systems in our global community operations team to fight spam, harassment, hate speech, and terrorism across all of our apps to keep people safe. And this is incredibly useful for apps like WhatsApp and Instagram as it helps us manage the challenges of hyper-growth there more effectively.

This is why the lens with which you view Facebook matters so much: the exact same set of facts viewed from a financial perspective are a clear negative; from a moat perspective they are a clear positive.

Lens 5: Facebook’s Raison D’être

Needless to say, once you view Facebook through anything but a financial lens the health of the business is hard to argue with (and frankly, the finances went from phenomenal to fantastic, but it’s all relative). That’s why I can’t help but wonder if there is something more fundamental about both the collapse in Facebook’s stock and the general celebration that followed.

To return to the early years of Stratechery, it was striking how widespread Facebook skepticism was; I first tried to argue otherwise five years ago today, and in 2015 felt compelled to write The Facebook Epoch that begins like this:

I’m fond of saying that few companies are as underrated as Facebook is, especially in Silicon Valley. Admittedly, it seems strange to say such a thing about a $245 billion company with a trailing 12-month P/E ratio of 88, but that is Wall Street sentiment; in the tech bubble many seem to simply assume the company is ever on the brink of teetering “just like MySpace”, never mind the fact that the social network pioneer barely broke 100 million registered users, less than 10% of the number of active users Facebook attracted in a single day late last month. Or, as more sober minds may argue, sure, Facebook looks unstoppable today, but then again, Google looked unstoppable ten years ago when social seemingly came out of nowhere: surely the Facebook killer is imminent!

That sentiment sure seems to be back in full force!

At the risk of veering into broad-based psychoanalysis, I think a lot of the Facebook skepticism is because so much of the content seems so shallow and petty, or in the case of the last few years, actively malicious. How can such a product survive?

In fact, it survives for the very reason it exists: Facebook began in Zuckerberg’s Harvard dorm room by quite literally digitizing offline relationships that already existed, both in real life and in actual physical “facebooks”. Facebook is so powerful because of this direct connection to the real world: it is shallow and petty and sometimes malicious — and yes, often good — because we humans are shallow and petty and sometimes malicious — and yes, often good.

By extension, to insist that Facebook will die any day now is in some respects to suggest that humanity will cease to exist any day now; granted, it is a company and companies fail, but even if Facebook failed it would only be a matter of time before another Facebook rose to replace it.

That seems unlikely: for all of the company’s travails and controversies over the past few years, its moats are deeper than ever, its money-making potential not only huge but growing both internally and secularly; to that end, what is perhaps most distressing of all to would-be competitors is in fact this quarter’s results: at the end of the day Facebook took a massive hit by choice; the company is not maximizing the short-term, it is spending the money and suppressing its revenue potential in favor of becoming more impenetrable than ever.

“Utter disaster” indeed.

1. There is Messenger as well; I am more dubious of its long-term monetization potential because its natural advertising space — status updates and stories — are basically what Facebook is

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“I thought something was going to get done,” lamented a friend, in reference to yesterday’s Senate hearing that featured a single witness: Facebook Founder and CEO Mark Zuckerberg. “This was the moment of reckoning, but it just turned out to be a whimper — it’s just for show.”

The sentiment seemed widespread on tech and media Twitter: there was a lack of specificity in terms of questions about privacy (this allowed Zuckerberg to turn nearly every question about the ownership of data to a discussion about user interface controls that limit where data is shown to other Facebook users), plenty of dodged questions (every time there was a question about the data Facebook generates about users beyond what they themselves enter into the system Zuckerberg needed to “check with his team”), and bad questions that presumed Facebook sells data, letting Zuckerberg run out the clock at least three times by explaining the basics of Facebook’s business model (this is precisely why I have been so outspoken about the problem of perpetrating this falsehood: it lets Facebook off the hook).

In fact, though, I thought the hearing was quite revelatory — a “show”, if you will. First, the fact that Zuckerberg appeared at all is the most meaningful news; the nature of the American political system is that changes happen extremely gradually, and only then in response to fundamental shifts in underlying political opinion. This can certainly be frustrating if one wants faster change — or a relief if one fears those in power — but that is precisely why Zuckerberg’s appearance was noteworthy: there is a current moving against Facebook, and while it is not realistic to expect that current to already be a wave, it was strong enough to sweep him to Washington D.C. for the week.¹

Secondly — and count this as another indication that that current is stronger than it seems — there was a significant amount of agreement amongst the Senators in yesterday’s hearings that something needed to be done about Facebook. Forget the specifics, for a paragraph, because this is a notable development: while these hearings usually devolve into partisan cliches with the same talking points — Democrats want regulations, and Republicans don’t — yesterday Senators from both sides of the aisle expressed unease with Facebook’s handling of private data; obviously Democrats tried to tie the issue to the last election, but that made the Republicans’ shared concern all-the-more striking.

Here is where the partisan divide does matter: the most important takeaway from yesterday’s hearing was the emergence of two distinct viewpoints on what the problem with Facebook actually is, and what to do about it. That these two viewpoints are in opposition is precisely why their emergence is so compelling: a current has to be very strong indeed for there to be two clearly articulable sides.

Viewpoint One: Facebook Needs Regulation

OK, so maybe one of the viewpoints fit the partisan cliche, but the idea that Facebook might need regulation was a frequent talking point, particularly from Democrats pushing already-proposed legislation. After detailing how, in his view, Facebook violated its 2011 Consent Decree with the FTC, Senator Richard Blumenthal distilled this viewpoint to its essence here:

Senator Blumenthal: What happened here was willful blindness. It was heedless and reckless and in fact amounted to a violation of the FTC consent decree. Would you agree?

Mark Zuckerberg: No, Senator. My understanding is not that this was a violation of the consent decree. But as I have said a number of times today, I think we need to take a broader view of our responsibility around privacy than just what is mandated in the current laws.

SB: Well here is my reservation Mr. Zuckerberg…we’ve seen the apology tours before. You have refused to acknowledge even an ethical obligation to have reported this violation of the FTC consent decree, and we have letters, we’ve had contacts with Facebook employees…that indicates not only a lack of resources but lack of attention to privacy. And so, my reservation about your testimony today is that I don’t see how you can change your business model unless there are specific rules of the road. Your business model is to monetize user information, to maximize profit over privacy, and unless there are specific rules and requirements — enforced by an outside agency — I have no assurance that these kinds of vague commitments are going to produce action.

This view is clearly gaining traction in certain political circles. For example, here is Matthew Yglesias in Vox:

Online social networks obviously pose some novel legal and regulatory issues. But broadly speaking, the question of how to ensure that companies discharge their responsibilities is not a brand new one. Companies involved in the provision of health care are responsible — not just morally but legally and financially — to abide by the terms of the Health Insurance Portability and Accountability Act of 1996. That law hasn’t eliminated all privacy violations in the health care space, by any means, but when violations occur, they are punished, and the punishment gives actors in that space real reason to avoid them. Financial institutions, similarly, must comply with the privacy rules set out in the Gramm-Leach-Bliley Act. GLBA compliance has thus become its own somewhat tedious mini industry, with lawyers and specialized GLBA compliance firms you can hire…

Once upon a time, the US government wisely believed that it would be a bad idea to subject promising young internet startups to the bureaucratic morass involved in things like HIPAA or GLBA compliance. But the young internet startups are all grown up now, and can easily afford to hire vast armies of lawyers and compliance experts who will help them avoid breaches that lead to massive fines. There is no longer a need to treat Facebook like a delicate flower whose agility will vaporize if it is held legally accountable for its actions.

That means disclosure rules for advertising, it means financial consequences for privacy violations, it means firm antitrust action to restrain further acquisitions and try to uphold some semblance of competition in this marketplace, and it means taking a close look at whether the development of ever more sophisticated ad targeting algorithms is being done in a way that serves the public’s interest in creating a robust media infrastructure.

What is worth noting was the extent to which Zuckerberg was open to, if not something as specific as Yglesias’ proposal, regulation of some sort. Zuckerberg told Senator Dan Sullivan:

I’m not the type of person who thinks that all regulation is bad, so I think the Internet is becoming increasingly important in people’s lives, and I think we need to have a full conversation about what is the right regulation, not whether it should be or shouldn’t be.

This isn’t a surprise: Zuckerberg said in his opening remarks that Facebook was “going through a broader philosophical shift in how we approach our responsibility as a company”, which he meant as an indication that the company would be taking more responsibility, but which could easily be interpreted as the company locking the doors to its closed garden and throwing away the key. In this regulation is actually helpful, a point made by Senator Sullivan in response to Zuckerberg’s statement:

Senator Sullivan: One of my worries on regulation with a company of your size saying “Hey, we might be interested in being regulated”, but as you know, regulations can also cement the dominant power. So what do I mean by that? You have a lot of lobbyists, I think every lobbyist in town is involved in this hearing in some way or another, a lot of powerful interests. You look at what happened with Dodd-Frank: that was supposed to be aimed at the big banks, the regulations ended up empowering the big banks and keeping the small banks down. Do you think that that’s a risk given your influence that if we regulate, we’re actually going to regulate you into a position of cemented authority, when one of my biggest concerns about what you guys are doing is that the next Facebook, which we all want, the guy in the dorm room, we all want that to be started, that you are becoming so dominant that we’re not able to have that next Facebook? What are your views on that?

MZ: Senator I agree with the point that when you’re thinking through regulation across all industries you need to be careful that it doesn’t cement in the current companies that are winning…I think part of the challenge with regulation in general is that when you add more rules that companies to follow, that’s something that a larger company like ours inherently just have the resources to go do, and that might just be harder for a company getting started to comply with.

That Sullivan, a Republican, would be suspicious of regulation is hardly a surprise — that’s the cliche I referenced above. There’s more context to Sullivan’s comments though: he hinted at an alternative to regulation.

Viewpoint Two: Facebook is Too Big

Here is Sullivan’s lead-up to Zuckerberg’s embrace of regulation quoted above:

Your testimony, you have talked about a lot of power, you’ve been involved in elections, I thought your testimony was very interesting, really all over the world, 2 billion users, over 200 million Americans, $40 billion in revenue, I believe you and Google have almost 75% of the digital advertising in the U.S., one of the key issues here is Facebook too powerful? Are you too powerful?…

When you look at the history of this country, and you look at the history of these kinds of hearings…when companies become big and powerful and accumulate a lot of wealth and power, what typically happens from this body is there’s an instinct to either regulate or break-up. Look at the history of this nation. Do you have any thoughts on those two policy approaches?

No wonder Zuckerberg was so eager to talk about regulation: it’s not simply that it benefits incumbents, it’s that it is a whole lot more attractive than discussing a potential break-up!

Note, though, that Sullivan wasn’t alone in pushing this idea that Facebook might be too big (a sentiment that Senator John Kennedy also raised last fall). The most fascinating Republican line of questioning came from Senator Lindsey Graham:

Senator Graham: Who’s your biggest competitor?

MZ: We have a lot of competitors.

SG: Who’s your biggest?

MZ: Hmm, I think the categories — did you want just one? I’m not I could give one — could I give a bunch?

SG: Uh-huh.

MZ: So there are three categories I would focus on. One are the other tech platforms, so Google, Apple, Amazon, Microsoft. We overlap with them in different ways.

SG: Do they provide the same service you provide?

MZ: Uhm, in different ways, different parts of it, yes.

SG: Let me put it this way. If I buy a Ford and it doesn’t work well and I don’t like it, I can buy a Chevy. If I’m upset with Facebook, what’s the equivalent product that I can go and sign up for?

MZ: Well, the second category that I was going to talk about…

SG: I’m not talking about categories. What I’m talking about is real competition that you face, because car companies face a lot of competition, that if they make a defective car, it gets out in the world, people stop buying that car and buy another one. Is there an alternative to Facebook in the private sector?

MZ: Yes Senator. The average American uses eight different apps to communicate with their friends and stay in touch with people, ranging from texting to email…

SG: That is the same service you provide?

MZ: Well we provide a number of different services.

SG: Is Twitter the same as what you do?

MZ: It overlaps with a portion of what we do.

SG: You don’t think you have a monopoly?

MZ: It certainly doesn’t feel like that to me!

SG: So it doesn’t. So, Instagram, you bought Instagram, why did you buy Instagram?

MZ: Because they were very talented app developers who were making good use of our platform and understood our values.

SG: It was a good business decision. My point is that one way to regulate a company is through competition, through government regulation, here’s the question all of us have to answer. What do we tell our constituents given what’s happened here, why we should let you self-regulate? What would you tell people in South Carolina, that given all the things we just discovered here, is a good idea for us to rely upon you to regulate your own business practices?

Zuckerberg quickly articulated that he would be in favor of regulation, using much the same language he would return to later in his response to Senator Sullivan, but the implication of Graham’s line of questioning was more profound than that: perhaps the real problem is the monopolistic nature of the company, because the normal checks that come from competition were missing.

This is, I would note, quite consistent with the skepticism about regulation voiced by Senator Sullivan: if the concern is that a bunch of rules limit competition, then a better response, if there must be one, would seek to empower competition by undoing the monopoly entirely.

The Shifting Debate

The most likely outcome of Facebook’s current scandal continues to be that nothing will happen, for all of the inherent lethargy in our political system noted above. And, if something does, European-style data regulation seems the more likely outcome, as I noted last month. No wonder Facebook’s stock was up after the hearing!

It’s worth keeping in mind, though, that because Facebook is so dominant, the question of its governance is ultimately a political question, and to that end the shifts in the terms of debate, if not yet its outcome, have been striking. Zuckerberg is in Washington D.C., everyone says something must be done, and critically, both sides have ideas about what that should be; while this certainly may be mostly a Facebook problem, the rest of the industry should take note.

1. Zuckerberg will testify again later today, this time in front of the House of Representatives’ Energy and Commerce Committee

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

Venture Outcomes

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

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

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

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

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

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

Spotify’s Operational Costs

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

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

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

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

This looks like a well-managed SaaS company:

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

Spotify’s Marginal Cost Problem

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

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

Spotify’s Missing Profit Potential

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

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

That leaves two options:

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

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

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

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

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

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

Lessons from Spotify

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

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

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

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

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

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

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