THE FIGHT FOR SUPREMACY IN THE VAPORIZED WORLD
ROUND 3: APPLE VS THE MOBILE NETWORK OPERATORS
Apple preserved many of the core features that made the earlier mobile content systems work. For instance, the mobile networks maintained a firm grip on their billing system, exiling those who
attempted to introduce alternative payment systems. Apple emulated this policy and deepened it with in-app purchases inside of free apps. However, the most important lesson Apple learned from mobile operators, who learned it from video game console manufacturers, is the agency fee. The game
industry model is sometimes referred to as “razors and razorblades” because the game console (or mobile phone) is typically provided to the consumer at or below cost: profit is made when the end user buys content and other services.
In February 1999 the Japanese mobile operator NTT Mobile Communications Network (now NTT DOCOMO) launched the first truly successful mobile data service, called i-mode. It took a maximum of 9 percent as a share of revenue from the sale of content and apps, leaving 91 percent of the earnings to developers. When I asked about this relatively low fee, Takeshi Natsuno, the executive director of i-mode, told me that his team deliberately chose the business model that most favored content
providers and developers rather than the network operator or handset maker. This humble approach worked: i-mode’s low fee attracted a vast number of creative developers whose ingenuity and apps distinguished it as the most innovative platform in Japan, and, arguably, in the world at that time. And that is precisely what enabled the company to crush rival telecom companies, by signing up huge numbers of new customers. I was working in Tokyo in 2000 and witnessed long lines around the block outside the DOCOMO shops as customers rushed to switch to i-mode-capable mobile phones.
What the launch team at i-mode understood is that this fee, or “rake,” as the house vigorish (or vig)
is known in the casino industry, introduces friction in a transactional marketplace. Lower fees = lower friction. And low friction means greater velocity. If the goal is to grow quickly, low friction is the way to go. But other mobile operators who emulated DOCOMO missed the point.
In 2002 I spoke to the team that was preparing to launch AT&T’s mobile data services in the United States. An executive told me that AT&T had studied i-mode closely but had decided to double the 9 percent fee to 18 percent in order to cover bad debt incurred by American customers. Ultimately,
AT&T rounded up this figure to an even 20 percent and then, later, bumped it even higher.
In 2003 an executive at Sprint Corporation informed me that its rake for mobile apps and services would be 25 percent, which was similar to the path fee charged by Sony PlayStation. When Verizon Wireless launched its mobile content service, it set the rake at 37 percent, and later raised it to 50 percent for some music products. In some European countries, the rake was 50 percent or higher.
That was too much: developers tend to go out of business when the platform siphons off half of the revenue. Greed and a lust for faster return on investment compelled the mobile operators to skim ever-higher fees off content transactions. This was unwise: they were taking money from the wrong end of the platform. In so doing, they generated friction that would ultimately doom their efforts.
By settling on a flat fee of 30 percent of revenue, Apple chose a financial model that split the difference between DOCOMO and the greediest mobile operators. The 30 percent vig made it possible for app developers to remain in precarious existence, but it also ensured that most would never be so profitable that they could grow independently powerful. Most others app stores, like Google Play and Microsoft’s Windows Phone Store, have followed Apple’s precedent of taking 30 percent. There is nothing about the 30 percent rake that is set in stone: Apple—or any rival—could charge 50 percent or 9 percent or nothing at all. Given the fact that Apple has nearly $200 billion in the bank, the high commission on content transactions is puzzling. A 10 percent commission would still generate
$1.4 billion for Apple, which would surely cover the cost of running the store.
Apple further improved upon the game console and mobile operator model by charging full price for its devices. Whereas the mobile operators subsidized the initial purchase price of the smartphone in order to get customers on the hook, Apple double dips, taking its full profit on the sale of the
hardware and also collecting the agency fee on the sale of content and apps.
Apple also tweaked the original mobile operator formula in some very important ways. For
instance, when customers purchase a new iOS device, Apple enables consumers to transfer the content and apps that they have already purchased from the old device to the new one. This encourages
consumers to upgrade their devices more frequently. Most mobile operators were unable to do this because they offered such a wide range of handsets and could not guarantee that all content was available on all devices. So the content was stuck on the old phone. Net result: their most avid
consumers of content were often the slowest to upgrade their phones, reluctant to retire a device that was loaded with $100+ of content.
Apple changed this dynamic by giving consumers accounts in the App Store where all of their purchases were recorded and available for downloading to a second, third, or even a fifth device.
Giving consumers the freedom to manage their content across multiple devices is one way that Apple reduced friction en route to huge scale. Apple’s best customers tend to buy more content and they upgrade devices more frequently. Most important, they remain loyal to Apple devices. Transferrable content is the glue that binds consumers to Apple’s ecosystem. When a user has dozens of apps, hundreds of songs, and thousands of photos shared across an iPod, an iPhone, and an iPad, that
customer is highly unlikely to switch to an Android device.
When Apple opened the iOS developer program to all comers, it broke with the mobile operators’
usual practice of engaging with only a small number of preferred vendors. Paradoxically, by diversifying and expanding the suppliers of apps, Apple grew more powerful. The intense
competition among millions of developers ensures that none will ever become powerful enough to challenge Apple. And though iOS is not exactly an open platform, it is certainly more open than its predecessors. The more open the platform, the cheaper the content. Opening up the App Store to millions of developers actually increased Apple’s control over the ecosystem because it reduced the bargaining leverage of any single app developer. Openness leads to commodity pricing. (Android is even more open than Apple, and the content in the Android ecosystem is more commoditized:
Android monetizes apps at about half the rate of iOS.)
Finally, Apple crushed the mobile operator portals by focusing all effort and ingenuity on a single device, instead of dissipating effort across thirty-five different handsets. This concentration of
marketing power enabled Apple to accomplish what the mobile operators failed to do: create a scalable network effect. More users attracted more apps, which in turn attracted more users. This upward spiral is great for users. But when the network is privately owned, it’s also an immense win for the owner of the platform because massive user adoption lifts every part of the business. In
Apple’s case, the upward spiral led to the surge in sales of iPhones that continues to this day. Surging demand keeps prices high and margins fat. Every platform aspires to achieve the upward spiral of Metcalfe’s law.
THE KNOCKOUT: WINNER TAKES ALL
As we’ve seen, the winner-take-all phenomenon means that, in every digital category, just one
company emerges as the overwhelmingly preferred option for hundreds of millions of users. And the more users who participate, the larger the leader’s market share and the more valuable the service becomes for all of them. With the worldwide adoption of smartphones, Metcalfe’s law now operates at global scale making the big companies even bigger. This phenomenon isn’t exactly common but it does seem to repeat itself each time a new Internet giant rises.
The companies that master this dynamic become so dominant that we can’t even think of a competitor. What’s the #1 search engine? Google, of course. Can you name the #2 search engine?
Most people would guess Bing or Yahoo or Ask.com. They would be wrong. The #2 search engine, in terms of traffic and search volume, is YouTube, which also happens to be owned by Google.
Facebook is a textbook case in the evolution of a winner-take-all company. In the early days, from 2004 to 2006, the fledgling online social networking service was small and tightly focused on a
growing number of college campuses. Later Facebook expanded from students to alumni, and by 2007 it opened up to anyone over the age of thirteen. Opening up the site to more people made Facebook more useful to its existing members. Still, as recently as 2007 there were dozens of rival social networks—and many of them, including Myspace, were much bigger than Facebook.
That year Facebook made a crucial decision: just as Apple did with the iPhone, Facebook made its closed system available to third-party developers by offering a suite of tools to build apps on top of the social network. This move transformed Facebook into a platform that aggregated apps and games and other services. Instead of competing with thousands of little social networks, Facebook absorbed most of these projects and all of the creative energy of their developers, thereby extinguishing a
generation of rival websites.
Seven thousand apps were published by November 2007; just one year later, at the second annual F8 Facebook Developer Conference in San Francisco, Facebook announced that the number had nearly quintupled to 33,000. These apps added value to the platform by giving the members many more ways to connect and share and communicate. They also generated new revenue streams from the sale of goods like virtual gifts and stickers and boosts in games. Most important, they added immense value to Facebook at minimal cost because they increased the level of engagement and the amount of time its members spent on the site.
Facebook’s next move was equally bold and strategically decisive. By 2008 nearly every
publisher on the Web was seeking to build communities on its own site. Vendors sold custom social networking systems that could be integrated with an existing news or entertainment website, but in December 2008 Facebook introduced Facebook Connect, which was free of charge to publishers. By allowing web publishers to add the Facebook login to their own site, Facebook spared them the considerable hassle of developing and maintaining complex social software systems. And with just the click of one button, visitors to those sites could effortlessly log in via Facebook without the hurdle of setting up a profile account and password. This made life easier for the publishers, but it also left them dependent upon Facebook.
By leveraging the creativity of developers and the reach of publishers, Facebook surpassed Yahoo in early 2010 to become the second-most visited site on the Internet (after Google). When Facebook filed for an initial public offering in 2012, it revealed that more than 9 million apps and websites had integrated Facebook Connect. In a few countries, particularly China and Russia where Facebook was banned or discouraged, homegrown local variants managed to take root. But in most parts of the world, rival sites like Bebo, Friendster, Myspace, and Orkut swiftly faded into irrelevance as Facebook emerged as the undisputed champion in social networking.
In the process of growing from 100 million members in 2007 to 1.4 billion in 2015, Facebook made yet another strategic pivot, focusing on smartphones as the key driver to future growth. In 2012, Mark Zuckerberg, Facebook’s chief executive officer, declared a “mobile first” strategy that began to yield results remarkably fast: less than one year later, mobile ad sales were on track to account for half of Facebook’s revenue. By October 2012, Facebook Mobile had surpassed Google Maps as the most popular mobile app.
Most smartphone owners spend 80 percent of their phone time on apps, and more than 20 percent of that time is spent on Facebook. Naturally, mobile game publishers want to reach those users, and they’re spending advertising dollars to do it: from 2013 to 2014 Facebook’s mobile advertising revenue grew a staggering 150 percent. It contributed more than 60 percent of the social network’s total advertising revenue of $2.7 billion in the second quarter of 2014, and that revenue is largely derived from mobile app developers who are trying to gain some visibility for their products in the App Store. The upshot: a big percentage of the money earned by mobile app developers who publish games on iOS and Android ends up in Facebook’s pocket, because the game developers spend
everything they can on advertising in Facebook Mobile in order to acquire more customers.
So who is the winner? In the Vaporized Era, the App Dictators are. Whoever controls the ecosystem can pick winners, crush would-be rivals, and continuously tweak the revenue-sharing formulas and percentages in their favor. However, the benefits of participation in this ecosystem can be enormous for those who comply. Apple, Google, Facebook, and Amazon can help the publishers in
their ecosystems to reach hundreds of millions of customers rapidly, with easy access to built-in monetization. Successful apps routinely attain tens of millions of users within weeks of launch.
Developers can communicate directly with their end users and get feedback and suggestions for improvements, which are seamlessly pushed back down to the end user’s device. This instant
feedback loop makes it possible for companies to iterate rapidly and keep their customers satisfied.
But success in this environment requires absolute compliance to the rules set forth by the owner of the ecosystem. As unappealing as the dynamics of the app economy may be when compared to the business models of the twentieth century, most companies acquiesce without a fight for the simple reason that the alternative is total annihilation. Your choice is to comply or be rendered irrelevant.