Netflix: a proven come-from-ahead strategy

Now that it seemingly has the DVD-by-mail and download markets locked up, Netflix has decided to gouge its customers for every penny that they’re worth. When the news hit, I tweeted

@openITstrat
Joel West
Aren't monopolies grand? Netflix jacks up prices. http://lat.ms/n8NkcJ Suggests they no longer worry about competitors.
12 Jul via Tweetie for Mac

A lot has been written about this decision. For example, the Merc wrote Thursday:

After the Los Gatos-based DVD and streaming video company announced Tuesday that it was raising rates as much as 60 percent, tens of thousands of disgruntled subscribers flooded social networking sites with complaints and threats.

"Sorry Netflix, but you're losing another customer of many years," read one of the more civil posts.

Because of a growing chorus of sentiments like that, the price hike is beginning to look like the company's first major misstep -- and one that could damage its business as consumers consider alternatives.

Indeed, the official Netflix blog entry announcing the decision attracted a flurry of comments — until the 5000 comment limit was reached.

While the AP speculated that the price increase was to get consumers to drop physical DVDs and go with streaming-only plans, this seems at best a contributing factor, for two reasons.

First — as the Netflix customers complained — everything is available on DVD but Netflix offers a much smaller range of content via streaming. Thus, a streaming-only account gets a much smaller library and the streaming — while convenient — is not yet a complete substitute.

Secondly, while Netflix has the DVD model wired, the streaming model has less barriers to entry and imitation. There are scale economies for digital download but not the network effects of physical DVDs. Netflix also has two established competitors — Amazon and Apple — who may not have the market share for movie downloads but certainly have the technology. By dropping a bundling discount for the combined DVD-download business, Netflix is shifting its download business into more direct (and less differentiated) competition with A&A.

Since Netflix has not backed down, I must conclude there’s something more than sheer greed at stake. One possibility is that Netflix is passing along a price increase from its main suppliers — Hollywood — who are facing declining DVD sales after relying on these for year to support the bottom line. Mike Masnick of Techdirt also wondered along these lines.

Still, it makes me glad I haven’t signed up with Netflix. With my relocation to a new city and a new job, I was about ready to sign up for a streaming-only service. Now I’m going to sit back and see what competitors emerge and how they try to exploit the opportunity that Netflix has handed them.

Opener than thou

Like many analysts, I thought one of the most striking things about Apple’s earnings call Monday was how much time Steve Jobs spent criticizing Google, particularly on openness. The frenemy of a year ago now seems to have become a rivalry every bit as bitter as Microsoft was during the early 90s. (Perhaps this is a side effect of vying for Total World Domination, much like the European Great Power rivalries from 1588-1918).

(I wasn’t able to capture the money quotes in realtime, but fortunately — as it does every quarter — Seeking Alpha has posted a complete transcript within a few hours. This is a great increase in financial openness over the way things were done 5-10 years ago.)

Here’s are some of the key points that Jobs (clearly) read from his prepared remarks:

Google loves to characterize Android as open, and iOS and iPhone as closed. We find this a bit disingenuous and clouding the real difference between our two approaches. …

In addition to Google's own app marketplace, Amazon, Verizon and Vodafone have all announced that they are creating their own app stores for Android. So there will be at least four app stores on Android, which customers must search among to find the app they want and developers will need to work with to distribute their apps and get paid. …

In reality, we think the open versus closed argument is just a smokescreen to try and hide the real issue, which is, what's best for the customer, fragmented versus integrated. We think Android is very, very fragmented and becoming more fragmented by the day. And as you know, Apple's strives for the integrated model so that the user isn't forced to be the systems integrator.

Some people called this a “rant,” but Jobs was far more factually accurate than the average political ad (admittedly a low bar) or even a typical comparative product TV ad (say from a cellphone carrier.)

Of course, there are important ways that Android is more open than the iPhone. It’s available from multiple hardware vendors and multiple carriers, not just from vertically integrated Apple. And the software is available royalty-free to other potential handset makers from the Open Handset Alliance, facilitating entry by even more vendors.

Other measures of openness are less important. Android founder (now Google mobile exec) Andy Rubin replied to Jobs with his first tweet about “the definition of open” being the ability to modify the source code. Like other Google execs, Rubin has a habit of using openness as a weapon against rivals and has been peddling the Android openness angle for some time.

While I haven’t met him, I’m guessing even a former geek like Rubin is too smart to drink too much of his own Kool-Aid.® Providing source code is only a small part of open source openness: as CNET’s Steven Shankland points out, being able to modify Android source code has little practical value to customers. In reality, Google determines the direction of the Android code base, and because letting go is hard to do, will likely to do so indefinitely.

Google’s openness glass is half-full, too. (Or, more charitably, it’s 2/3 full while Apple’s is only 3/8 full.) As Matt Asay so famously noted:

Google is a self-interested, profit-maximizing, semi-proprietary co that embraces openness when it suits its purposes

In fact, in one way Android is far less open than Apple. To get access to the customers of cellphone carriers, Google and its hardware partners have acceded to the closed demands of those carriers. Exhibit A is MG Siegler’s oft-remarked posting on TechCrunch last month:

Android Is As Open As The Clenched Fist I’d Like To Punch The Carriers With
MG Siegler
…
The thought of a truly open mobile operating system is very appealing. The problem is that in practice, that’s just simply not the reality of the situation. Maybe if Google had their way, the system would be truly open. But they don’t. Sadly, they have to deal with a very big roadblock: the carriers.

The result of this unfortunate situation is that the so-called open system is quickly revealing itself to be anything but. Further, we’re starting to see that in some cases the carriers may actually be able to exploit this “openness” to create a closed system that may leave you crying for Apple’s closed system — at least theirs looks good and behaves as expected.

The proliferation of carrier-controlled app stores (as mentioned by Jobs) is just one of the problems that ceding control to the carriers has created.

The reality was that breaking the control of the carriers with the iPhone was one of the greatest contributions Steve Jobs (or anyone) has made to ICT openness in the 21st century. Now perhaps someday we’ll get a choice of iPhone carriers here in the US, as other countries have had for years.

Len Lauer’s brave bet on open innovation

Well, everyone was telling the truth when Len Lauer stepped down as COO of Qualcomm last month to become CEO of a “non-competing” company.

He’s surfaced as the CEO of Memjet, an inkjet printer company also based in San Diego. Don Clark of the Wall Street Journal has the story.

Like Qualcomm, Memjet likes to patent things, in this case behind its lead technologist Kia Silverbrook, formerly CTO of Canon.

Something about this just doesn’t make sense. While I’m a big advocate of open innovation, Memjet is trying to crack a very vertically integrated industry.

I actually worked in inkjet printers for more than a decade — sitting there in my Oceanside software company, supervising (and sometimes actually writing) software for a wide range of color printers, including (for a time) most of HP’s inkjets.

The problem I see with Len’s career move is the part about Memjet licensing its inkjet heads to others to make the actual printers. HP, Canon and Epson have a cozy patent cartel, cross licensing and making their own printers and disposable cartridges. I don’t see any of them licensing technology, no matter how cool it is. (Attempting to invent patents — or suing for a cross-license ala Broadcom — around seems much more likely).

So maybe some of the 3rd tier players — Brother, Samsung — might be interested. Maybe even the 2nd tier players such as Lexmark and Xerox. But how are you going to get market share with these players — no matter how cool your technology — given their distribution and brand recognition are so far behind the Big Three?

Even if you did, get some of them, would the royalties ($1 per printer? $5 for a printer and a lifetime of cartridges?) be enough to pay back “hundreds and hundreds of millions” of VC investment?

Yes, I certainly see the analogy to Qualcomm’s QCT chip business, but Qualcomm got into the chip business when no one knew how to make CDMA chips and few merchant chip vendors existed for handsets (Motorola, Nokia, Ericsson, Matsushita made their own.)

Maybe I’m missing something, but to me printers are a 20-year-old mature industry, without a lot of opportunity for entry.

So my hat’s off to Len, a braver man than I. We’ll see in a few years whether he’s a smart man too.

High margins, high entry barriers

Microsoft reported earnings on Thursday. Its gross margin was 80.3% (i.e. the cost of goods sold was 19.7%), down from 81.9% a year earlier. (Actual revenues were down 17.3%). Revenue from desktop OS licenses were down 29%, due both to cheaper netbooks and deferral of purchases awaiting Windows 7.

On the same day, the Federal government revealed the margins of one Levy Izhak Rosenbaum as it unsealed a sweeping indictment (and conducted arrests) of more than 40 corrupt New Jersey politicians and other community members. Mr. Rosenbaum is accused of buying kidneys for $10,000 and selling them for $160,000. His cost of sales were not revealed, but that implies a gross margin of 93.7%.

High margins are usually an indication of high barriers to entry or imitation: in this case, the government forbids a market in kidneys so there is a black market with high risk and high margins. Writing in the Atlantic two weeks ago, columnist Virginia Postrel notes that — absent markets or any other incentives, there is a huge imbalance of supply and demand for kidney donations. Or, as Harvard economist Greg Makiw summarizes the article:

What market has 80,000 potential consumers each demanding one unit, 300,000,000 potential producers each capable of supplying one unit, and a shortage nonetheless?

There’s no question that stimulating and allocating a supply of kidneys could be done more effectively. Today 11 patients die every day waiting for the donor kidney that never arrives, and all of the 80,000 are undergoing some form of dialysis that many patients view as only slightly better than death.

Postrel talks about donor chains as one short-term solution within the limits of the current rules that forbid kidney sales. In the meantime, she has done her part to solve the problem by donating one of her own kidneys to someone who otherwise had little hope for a donation.

App stores: early or not at all?

In the past 10 months, the Apple app store has been a tremendous success, helping to fuel the success of the iPhone. Now all the other platforms owners (Google, Microsoft, RIM) and operators are planning their own app stores.

There are some dubious assumptions that both app store owners and app developers are making about app stores.

• Early apps were successful so we can be too.
• Early apps were successful but it’s too late for us.
• App stores made Apple a success and will make our platform a success too
• All we need is the “killer app” to make our platform a smash hit.

The answer is: Your mileage will vary.

All this is a preface to a discussion Wednesday in San Mateo by two Symbian Foundation executives — “catalyst” David Wood and interim marketing VP Ted Shelton — on their own planned app store.

The app store plan for Apple is pretty simple: Apple makes the phone, Apple makes the platform, and Apple strong-armed the carriers into providing (on-deck) access to App Store apps on any iPhone. For firms that license their OS (Google, Microsoft, Symbian) the story is quite a bit messier, since both the phone maker and the operator may want to get involved.

At the Nokia Developer Conference last month, Symbian Foundation head Lee Williams announced Symbian will be developing its own app store. It appears most analysts in the US missed the story, to the point that some (like my friend Matt Asay) are growing impatient.

Shelton and Wood talked about the app store Wednesday night to a small grouping of developers and analysts. The name is not settled, but the name I thought fit best was “Symbian App Warehouse.” Rather than sell to end users, they will certify applications and distribute them to all manner of application stores (e.g. Nokia Ovi) run by handset vendors, operators. The claim was that it would be without a fee, but I (like others) suspect in the long run they will need a minimal fee to cover operating costs; Mike Mace suggested 5-6%.

Symbian is shopping for lead ISVs: 5 developers in July, 100 in October for the 2009 Symbian Exchange and Exposition (“Come and SEE the future of mobile.”) The idea is to scale slowly to work out some of the kinks — not to impose some sort of limit as to the number of applications.

So the offer from Symbian was simple: do you want to be app # 45,678 at the Apple store or one of the first five at the Symbian store? As Shelton said, “the first movers have a greater opportunity to make money because there is a lower signal to noise ratio.” Palm has been making similar claims to prospective Pre developers (but with 0% share for its new platform vs. nearly 50% for Symbian).

Shelton had a point: ceteris paribus, later is worse. When I launched my Mac software company in July 1987 I had a far harder time getting carried by the channel and getting noticed than had Silicon Beach Software 3 years earlier. (I also had less money and less compelling applications). Of course, big companies with big budgets are better equipped to enter late than small self-funded (perhaps garage-dwelling) startups.

The iPhone App Store with its high visibility (and high download rate) would be very attractive if I had a narrow niche program, such as a virtual bass guitar. Unfortunately, PocketGuitar (99¢) already does that, and there are also other electronic guitars, several pianos, drum sets and even simulated sax, flute and bugle (blow on the mike). This is among more than 1300 applications listed under the “music” category.

So the Apple app market is heavily fragmented, and with a free online course being viewed by 100,000 developers, it will only get worse. Expectations for the Android Market mean that it is likely to head in the same direction. What should a developer do?

In the long run, developers will enter with one platform and then (if their app is hot) port to everything in sight; as with videogames, a platform will have only a temporary exclusive. The web-based apps (Facebook, MySpace, Google maps etc.) are already heading in this direction. A handful of companies (like Pangea Software on the iPhone) will figure out a way to come up with a string of hits.

In the short run, young developers need an open field market entry strategy: go where the competitors ain’t. Videogame developers have done this for more than a decade, just as companies choose geographic markets that are most promising. Once all the app stores have their initial launch ISVs, it will be up to developers to figure out a way to stand out of the clutter.

Patent cartel formed to fight "trolls"

The Wall Street Journal this morning spins the PR of some big companies tired of paying patent royalties

Tech Giants Join Together
To Head Off Patent Suits

Several tech-industry heavyweights are banding together to defend themselves against patent-infringement lawsuits. Their plan: to buy up key intellectual property before it falls into the hands of parties that could use it against them, say people familiar with the matter.

Verizon Communications Inc., Google Inc., Cisco Systems Inc., Telefon AB L.M. Ericsson and Hewlett-Packard Co. are among the companies that have joined a group calling itself the Allied Security Trust, these people say.

The article goes on to cite horror stories of how those evil patent trolls that have been shaking down big companies. The big business alliance has as its CEO Brian Hinman, a big business licensing executive:

Previously he was Vice President, Intellectual Property and Licensing for IBM Corporation. While at IBM, Brian held various positions including Business Development Executive for IBM Research at the Thomas J Watson Research Laboratory. Prior to IBM, Brian was Corporate Director of Business Development and Licensing at Westinghouse Corporation.

The website Q&A says

What is Allied Security Trust?

AST is a Delaware statutory trust that was originally formed by several high technology companies to obtain cost-effective patent licenses. The Trust provides opportunities to enhance companies’ freedom to sell products by sharing the cost of patent licenses. At the same time, the Trust creates new opportunities for patent holders of all sizes to generate a return on their rights.

AST is not an investment vehicle. Its purpose is freedom of operation and cost reduction. It generates no profits and does not engage in patent assertions against other companies. AST maintains a “catch-and-release” commitment that returns to the market in a timely manner patents acquired on behalf of Trust members after licenses are secured. The Trust also addresses the increasing need for innovative companies to defend against costly patent law suits.

Why was the trust formed?

The Trust was formed in reaction to a marked increase in patent assertions and litigation involving high tech companies by patent holding companies, also known as NPEs (non-practicing entities) also known as “patent trolls.” These organizations produce no products or services of their own, and acquire patents, sometimes hundreds of them, with the sole intention of asserting them against operating companies and conducting patent litigation to extract settlements or licensing fees.

How many members are in the trust and who are they?

Currently, there are eleven members in AST. AST anticipates reaching a goal of between 30-40 members.

While some are hailing this cartel as (for example) bringing “some sanity to the patent-litigation racket,” there are at least four reasons why this is effort is suspect.

First, there’s the eligibility. The WSJ article says that any company can pay $250K to join and deposition $5m for the patent buying pool ($1.5-$2 billion). But the website imposes the additional requirement “Any company in the high tech field with annual revenues of a defined minimum level is eligible and encouraged to join.” If someone wants to put in $5.3 million, why does it matter how big they are? (Qualcomm makes $10b/year — are they eligible?)

So we have a group of big companies (no more than 40), working to their own common interest against the interest of nonmembers. Sounds like a cartel to me. The business model is that AST buys patents, grants nonexclusive royalty-free licenses to members, and then sells them.

Mr. Hinman said the group doesn't face any antitrust issues because it isn't a profit-making venture and its members don't actually own patents -- they just grant themselves a license to them.

This cooperation for the benefit of members against nonmembers has potentially collusive and anti-competitive implications. I’m no fan of big government, but I hope the DoJ will give this the same scrutiny as any other big business combination.

Third, we have the hypocrisy (conflict of interest) of the big firms suing others to put them out of business or merely to extract rents. Rich Tehrani lists the example of (member company) Verizon suing to crush Vonage — i.e., to use patents as an entry barrier to little companies that would increase competition. I would also list Alcatel’s efforts to squeeze Microsoft for a half-billion dollars.

So all we can say for sure is that this is a bunch of big companies that pay royalties who don’t want to pay royalties — whether to small companies, big companies or even universities. They intend to reduce the attractiveness of all IP licensing business models (a centerpiece of open innovation) in the name of fighting the dreaded “patent troll.”

That brings me to the fourth and final point. I have been studying IP licensing issues in the telecom industry for almost a decade, first with the Qualcomm teaching case and then for the past two and a half years with Rudi Bekkers studying all the W-CDMA patents. And the problem is, there is no viable definition of a patent troll — from a economic, legal or policy standpoint.

The claimed test (as implied in the WSJ article) that any company that “never produced a (product)” is a troll is just poppycock: that isn’t why patents exists. The patent system exists to reward inventors. For every horror story of a post hoc shakedown artist or silly story of claimed invention, we have a Bob Kearns, who invented the intermittent windshield wipers but the Big 3 auto makers decided to ship their own products without paying a license. Kearns sued for decades to get what was owed to him, ending up divorced, broke and dying without the recognition that he deserved.

And while yes, my perspective is biased because I’m writing a book that has a chapter about Qualcomm, what about Qualcomm? They brought CDMA to the cell phone industry when people said it couldn’t be made to work, designed systems to show it would work, built handsets, infrastructure and chips to jump start the industry. Is this a patent troll? (Let’s leave aside the knotty question of what the fair price is for their IP).

Or what about Dolby — Dolby Noise Reduction, Dolby Surround and Dolby Pro Logic? Again, they don’t make any products, just sell IP licenses.

My hunch (which I cannot yet prove) is that the best solution will be to reform the patent system to eliminate obvious patents, those that reflect prior art, and perhaps some of the incremental patents that are implied by prior art. I think Osapa — Open Source as Prior Art — is a great solution, and I hope there will be more. Less patents = less transaction costs = less uncertainty, and the role of patents would shift towards protecting major innovations like those that invent an entire new product category.

Nothing beats a good monopoly (2)

As I’ve said before, nothing beats a good monopoly. Eventually, the monopoly may come to an end due to substitutes, or the monopolist may squander his billions, or the would-be monopolist could even help his enemy get ahead.

If you can’t get a monopoly, then a duopoly or oligopoly can be nearly as lucrative. In fact, if there are high entry barriers and orderly competition (i.e. no price wards), the oligopoly may be preferable because it invites less antitrust scrutiny from the government.

This week saw the biggest IPO in US history, when the bank-owned Visa Inc. (NYSE: V) raised $18 billion in its offering Tuesday. In the first two days of trading the stock was up 17%.The markets were closed today for Good Friday, but at Thursday’s closing price of $64, counting the Class B shares Visa has a market cap of more than $62 billion, more than twice that of rival MasterCard (with a higher multiple).

Most people forget that Visa began life as BankAmericard in the 1950s, IIRC a decade or more ahead of MasterCard. At the time, it seems like BofA competed with AmEx and Diner’s Club by being slightly less exorbitant in merchant fees. BofA also pushed beyond the standard T&E (travel & entertainment) business to merchandise, and (IIRC) was less elitist in who it targeted. The network effects made the BankAmericard (later Visa) and MasterCard more widely usable, more widely adopted, and so on in a virtuous cycle that swamped the first movers in T&E cards, Diner’s, Carte Blanche and AMEX.

Both consortia leveraged their credit card oligopoly to win comparable merchant fees for debit cards — where they bore lower costs and lower risks — crowding out attempts to build a rival (competing) debit card fulfillment system. With two main credit card networks, not surprisingly there is little competition and high prices (hence the lucrative IPO this week).

The banks have even managed to delay (if not defeat) the world’s most powerful retailer. To avoid paying high bank fees, Wal-Mart tried to open its own bank but the banks were able to exploit Walmartophobia* and round up the usual suspects in their (thus far) successful lobbying to have the government block Wal-Mart from such vertical integration. (Although Wal-Mart is offering its own VISA debit card for undocumented workers and others in extreme poverty).

Of course, when someone sells an asset, you wonder why. Selling shares is improving balance sheets for banks at a time when they desperately need it. But, with the debit card shift nearly compete, are Visa’s best days behind them — or will their share of the oligopoly deliver high margins and high growth for decades to come.

* Walmartophobia. n. 1. An irrational fear of large chain store retailers; 2. political demagoguery that seeks to increase and exploit such fears.

All good monopolies come to an end

Anyone who teaches strategy ends up teaching some aspects on industrial economics, specifically Michael Porter’s Five Forces. Generally instructors need illustrative examples of the two extremes: a highly competitive, low-profit industry and an oligopoly (or monopoly) with high profits.

As I’ve said before, if you want to make money, nothing beats a good monopoly. But a good oligopoly comes close: a favorite industry for illustrating this point is the pre-Napster recording industry, ca. 1995. (Obviously a lot has changed in the last decade).

With undergraduates, I need something to illustrate the concept of formal entry barriers, such as a government-controlled monopolies. Cable TV — one franchise per city — is pretty easy for most to understand. And, in fact, it’s been a very lucrative business for the past few decades to own.

This month’s (Jan. 28) Forbes looks at the recent decline in the market power of Comcast, one of the top 4 cable operators (a national oligopoly, each with a local monopoly). It focuses on the ability of the Internet to deliver content while bypassing the last mile monopoly for TV.

An interesting commonality between record labels and cable TV operators is that they didn’t face increased competition — the entry barriers to their traditional business remain as before. Instead, the threat comes from substitutes enabled by technological change — either things that weren’t possible to do before, or things that were possible but now have become more attractive substitutes.

Are substitutes the most likely cause of ending monopoly power? Another example is the world’s richest man (no not Bill Gates) who bought CompUSA — the biggest US computer store, pinched between general electronics retailers on one side and online retailers on the other.

Normally in teaching business we teach that profits are good and competition is bad. (Sorta the opposite of economics, where competition and consumer welfare are good). But in this case, substitutes can provide market entry for those blocked by the old entry barriers — openness that is bad for one part of the value chain is good for another part. It hasn’t changed the lot of independent record labels (yet), but clearly video producers have a way to bring content to market that they never had in the days of the big three TV networks and the subsequent cable oligopoly. (Not counting new business models like JibJab, which wouldn’t exist without the Internet).