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The Dangerous Seduction of the Lifetime Value (LTV) Formula

Posted on September 4, 2012. Filed under: advertising, Internet, Uncategorized, Venture Capital, Web/Tech | Tags: , , , , , , , |

Many consumer Internet business executives are loyalists of the Lifetime Value model, often referred to as the LTV model or formula. Lifetime value is the net present value of the profit stream of a customer. This concept, which appears on the surface to be quite benign, is typically used to compare the costs of acquiring a customer (often referred to as SAC, which stands for Subscriber Acquisition Costs) with the discounted positive cash flows that will come from that customer over time. As long as the sum of the discounted future cash flows are significantly higher than the SAC, then people will argue it is warranted to “push the accelerator,” which typically means burning capital by aggressively spending on marketing.

This is a simplified version of the formula:

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The key statistics are as follows:

  • ARPU (average revenue per user)
  • Avg. Cust. Lifetime, n (This is the inverse of the churn, n=1/[annual churn])
  • WACC (weighted average cost of capital)
  • Costs (annual costs to support the user in a given period)
  • SAC (subscriber acquisition costs, sometimes refereed to as CAC = customer acquisition costs)

The LTV formula, when used correctly, can be a good tactical tool for monitoring and comparing like-minded variable market programs, especially across channels. But like any model, its proper use is entirely dependent on the assumptions used in that model. Also, people who have a hidden agenda or who confuse a model with reality can misuse it. For many companies that subscribe to its wisdom, the formula slowly takes on more importance than it should. Seduced by the model, its practitioners often lose sight of the more important elements of corporate strategy, and become narrowly fixated on the dogmatic execution of the formula. In these cases, the formula can be confused, misused, and abused, much to the detriment of the business, and in many cases the customer as well.

Here are ten reasons to avoid worshiping at the LTV altar:

  1. It’s a Tool, Not a Strategy.  Heavy LTV companies forget that the LTV model does not create sustainable competitive advantage. You shouldn’t’ confuse output with input. The LTV formula is a measurement tool to be used by marketing to test the effectiveness of their marketing spend – nothing more and nothing less. If one asserts that buying customers below what they charge them is a corporate strategy, this is in essence an arbitrage game, and arbitrage games rarely last. Too many of the variables (specifically ARPU and SAC) are outside of your control, and nothing would prevent another player from executing the exact same strategy. It’s not rocket science; it’s a formula that any business school graduate can calculate. Do not fool yourself into believing it creates a proprietary advantage.
  2. The LTV Model Is Used To Rationalize Marketing Spending.  Marketing executives like big budgets, as big budgets make it easier to grow the top line.  The LTV formula “relaxes” the need for near term profitability and “justifies” the ability to play it forward – to spend today for benefits that are postponed into the future. It is no coincidence that companies that put a heavy emphasis on LTV are also the ones that have massive losses as they scale, frequently even through an IPO. Consider that most companies limit any “affiliate fee” they would be willing to spend to 5-10% of sales. Yet when they are marketing, they use different math. They use LTV math, and all the sudden it’s acceptable to spend 30-50% of revenue on customer acquisition. Find the most boisterous executive recommending excessive spending, and you will usually find a loyal servant of the LTV religion.
  3. The Model is Confused and Misused. Frequently the same group that is arguing for more spending is the same one that “owns” the LTV calculation. (This is a mistake – finance should monitor LTV).  As a result, it is not uncommon for one to see shortcuts taken that allow for greater freedom. As an example, marketers often divide spend by total customers to calculate SAC rather than just those customers that were “purchased.” If you have organic customers, they shouldn’t be included in the spend calculus. They would have arrived regardless of spend. Also, many people discount “revenues” rather than marginal cash contribution. It is critical to bundle all future variable costs of supporting the customer in order to fairly estimate the future contribution. As an example of the sloppiness that exists around the formula, consider this blog post (http://blog.kissmetrics.com/how-to-calculate-lifetime-value/) from KISS metrics, a company whose aim is to “help you make smarter business decisions.” Not only do they include a version of the model that specifically ignores future costs, but also they recommend taking an average of three different results, two of which are clearly flawed. This voodoo-math has no place as part of a multi-million dollar marketing exercise.
  4. Business Isn’t Physics – The Formula Is Not Absolute. LTV zealots often hold an overly confident view of the predictive nature of the formula. It’s not “hard science” like say predicting gravity. It’s at best a “good guess” about how the future will unfold. Businesses are complex adaptive systems that cannot be modeled with certainty. The future LTV results are simply predictions based on many assumptions that may or may not hold. Yet the LTV practitioner often moves forward with a brazen naiveté, evocative of the first time stock buyer who just found out about the price/earnings ratio, or the newcomer to Vegas who has just been taught the basics of twenty-one. LTV models win arguments because executives perceive them to be grounded in science. Just because its math, doesn’t mean its good math.
  5. The LTV Variables “Tug” at One Another. This may be the single most important issue and it lies at the heart of why the LTV model eventually breaks down and fails to scale ad infinitum. Tren Griffin, a close friend that has worked for both Craig McCaw and Bill Gates refers to the five variables of the LTV formula as the five horsemen. What he envisions is that a rope connects them all, and they are all facing different directions. When one horse pulls one way, it makes it more difficult for the other horse to go his direction. Tren’s view is that the variables of the LTV formula are interdependent not independent, and are an overly simplified abstraction of reality. If you try to raise ARPU (price) you will naturally increase churn. If you try to grow faster by spending more on marketing, your SAC will rise (assuming a finite amount of opportunities to buy customers, which is true). Churn may rise also, as a more aggressive program will likely capture customers of a lower quality. As another example, if you beef up customer service to improve churn, you directly impact future costs, and therefore deteriorate the potential cash flow contribution. Ironically, many company presentations show all metrics improving as you head into the future. This is unlikely to play out in reality.
  6. Growing Becomes a Grind. Let’s say you have a company that estimates it will do $100mm in revenue this year, $200mm the next, and $400mm the year after that. In order to accomplish those goals it is going to invest heavily in marketing – say 50% of revenues. So the budget for the next three years is $50mm, $100mm, and $200mm. How realistic is it to assume that your SAC will drop as you 4X your spend? Supply and demand analysis suggests the exact opposite outcome. As you try to buy more and more of a limited good, the price will inherently increase. The number one place on the planet for marketing spend is Google Adwords, and make no mistake about it, this is an increasingly finite resource. Click-outs are not growing at a meaningful pace, and key word purchases are highly contested. Assuming you will “get better” at buying while trying to buy more is a daunting assumption. The game will likely get tougher not easier.
  7. Purchased Customers Underperform Organic on Almost Every Metric. Organic users typically have a higher NPV, a higher conversion rate, a lower churn, and more satisfied than customers acquired through marketing spend. LTV heavy companies are in denial about this point. In fact, many of them will argue until they are blue in the face that the customer dynamics are the same while this is rarely the case. A customer that “chooses” your firm’s services will be much more staisfied than one that is persuaded to buy your product through spend. Find any high-marketing spend consumer subscription company, and I will show you a company with numerous complaints at the Better Business Bureau. These are companies that make it almost impossible to terminate your subscription. When you are scheming on how to trap the customer from finding the exit you are not building a long-term brand.
  8. The Money Could Go to the Customer.Think about this. If you are a company that spends millions and millions of dollars on marketing, wouldn’t you be better off handing that money to the customer versus handing it to a third-party who has nothing to do with the future life-time value of the customer? Providing a better value-proposition to the customer is much more likely to endure goodwill than spending on marketing. A heavy marketing spend necessitates a higher margin (to cover the spend), and therefore a higher end user price to the customer! So the customer is negatively impacted by the presence or “need” of the marketing program. Plus, a margin umbrella now exists for competition that chooses to undercut your margin model with a more efficient customer acquisition strategy (such as giving the customer the money).“More and more money will go into making a great customer experience, and less will go into shouting about the service. Word of mouth is becoming more powerful. If you offer a great service, people find out.” – Jeff Bezos
  9. LTV Obsession Creates Blinders. Many companies that obsess over LTV, become overwhelmed by LTV. In essence, the formula becomes a blinder that restricts creativity and open-mindedness. Some of the most efficient forms of marketing are viral, social, and effective PR (public relations). Most companies that obsess about LTV are less skilled at these more leveraged techniques. Ironically, it’s the scrappy and capital starved startup with absolutely no marketing budget that typically finds a clever way to scale growth organically.  I love this historic slide from Skype comparing their SAC with that of Vonage, an iconic disciple of LTV analysis.

Image

10. Tomorrow Never Arrives.  The Utopian destination imagined by the LTV formula is a mirage. It almost never works out as planned in the long run. Either growth begins to slow, or you run out of capital to continue to fund losses, or Wall Street cries uncle and asks to see profitability. When this happens the frailty of the model begins to appear. SAC is a little higher than expected. You met your growth target, but the projected loss was bigger than expected. Wall Street is hounding you for churn numbers, but you are reluctant to give them out. The lack of transparency then leads to cynicism, and everyone assumes the worse. It turns out that the excessive marketing spend was also propping up repeat purchase, and pulling back to achieve profitability is increasing churn. Moreover, a negative PR cycle has ensued as a result of your stock decline, and the press’ new doubts about your model. This also impacts results, and customer perception of your brand. The bottom line is that “one day we can stop spending and be remarkably profitable” rarely comes to fruition.

It is not impossible to create permanent equity value with the LTV approach, but it’s a dangerous game of timing – you don’t want to be the peak investor. Let’s say a new business starts with an early market capitalization of A (see graph below). Through aggressive marketing techniques, and aggressive fund raising, the company is able to achieve amazing revenue growth (and corresponding losses), but nonetheless creates a rather sizable organization. At this point, the company is value at point B. Eventually, however, gravity ensues and the constraints outlined herein raise their head, resulting in a collapse to point C.  For early founders and investors at point A, they may do OK (as long as C>A), but it will be accomplished on the backs of later stage investors that helped fund the unsustainable push to point B. This is the story of many a telecom and cable provider expansion history, as well as a few recent Internet companies.

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This should not be misconstrued as a eulogy for the LTV formula. It has a very important place in business as a way to contrast and compare alternative marketing programs and channels. It is a tactical marketing tool that requires candor and thoroughness in its implementation. The fundamental reason that it is so amazingly dangerous and seductive is its simplicity and certainty. Generic marketing is conceptual. LTV marketing is specific. Building a plan to grow to a million users organically is an order of magnitude more difficult than doing it with the aid of the LTV formula. There is comfort in its determinism, and it is simply easier to do.

Some people wield the LTV model as if they were Yoda with a light saber; “Look at this amazing weapon I know how to use!” Unfortunately, it is not that amazing, it’s not that unique to understand, and it is not a weapon, it’s a tool. Companies need a sustainable competitive advantage that is independent of their variable marketing campaigns. You can’t win a fight with a measuring tape.

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Intuit to Acquire Demandforce for $424MM

Posted on April 27, 2012. Filed under: advertising, Internet, Uncategorized, Venture Capital, Web/Tech | Tags: , , |

This morning, Intuit announced its agreement to acquire one of Benchmark’s portfolio companies, Demandforce, for $424mm. As with Instagram, Benchmark Capital is the largest institutional investor in Demandforce. Unlike Instagram, which is a consumer application and is extremely well known, Demandforce focuses on local professional businesses and has chosen to keep an intentionally low profile – a strategy that has served them well.

Great entrepreneurs often blaze their own trails, and the founder and CEO of Demandforce, Rick Berry, is no different. In a day and age of social media, where many companies project a persona much larger than reality, Demandforce chose instead to focus on its customers and its products. We never even announced Benchmark’s funding of the company, which I believe is unprecedented. The Demandforce team always felt that the attention should be focused on the customer rather than the company.

Demandforce’s customer mission has always been the same – to help small businesses thrive in an evolving and increasingly complex connected world. Today, they are the leading provider of interactive “front office” SAAS services to thousands and thousands of professional small business owners. The Demandforce product is a powerful web-based application that seamlessly integrates with existing workflow systems, works automatically, and delivers guaranteed results. Through this, Demandforce provides local businesses – like salons, auto shops, chiropractors, dentists, and veterinarians – with affordable and easy access to the tools and platforms that large enterprises use to communicate with customers, build a strong online reputation and leverage network marketing. It you have ever received an automated communication from your dentist, it was likely sent through Demandforce.

Demandforce’s success puts it at the forefront of the burgeoning “Local Internet” wave. The combination of Internet pervasiveness and smartphone penetration has led to a complete reconfiguration with regard to how local businesses interact with their customers. These local businesses have traditionally spent over $125B/year on traditional media, and this is only in the U.S. But the channels they have historically used, such as the newspaper and the yellow pages, are increasingly compromised. These business owners know they need new solutions, and these dollars will be reallocated to these exciting new platforms. Benchmark believes this “Local Internet” wave is many times larger than the “social” and “mobile” themes with which it is often contrasted. In addition to DemandForce, Benchmark is fortunate to have backed such “Local Internet” market leaders as OpenTable (OPEN), Zillow (Z), Yelp (YELP), Peixe Urbano, GrubHub, Uber, and Nextdoor.

It has been an honor and a pleasure to work with Rick Berry, Patrick Barry, Hoang Vuong, Mark Hale, Sam Osman and Annie Tsai at Demandforce. This is truly one of the best teams ever assembled. It was also a pleasure to work with Steve Kostyshen as well as Mike Maples of Floodgate and Peter Ziebelman of Palo Alto Venture Partners, all of whom preceded us in their investment, and all of whom are passionate fans of the company.

It is certainly thrilling to see a team of entrepreneurs reach a significant milestone such as this.  That said, it is equally bittersweet as it means we will no longer be working directly with them on this incredibly compelling mission. Our loss is unquestionably Brad Smith and Intuit’s gain. Combining the leading “front office” small business SAAS vendor with the iconic Silicon Valley small business company is an incredibly compelling combination.

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You Don’t Have to Tweet to Twitter

Posted on November 15, 2011. Filed under: advertising, Facebook, Internet, IPO, social networking, Twitter, Uncategorized, Venture Capital, Web/Tech | Tags: , , , , |

Frequent comparisons to Facebook leave many confused about the true value of Twitter.

[Follow Me on Twitter]

“In a brand new direction
A change of perception
On a brand new trajection”
UB40

[Disclosure: Benchmark Capital is a major investor in Twitter, and my partner Peter Fenton sits on the Twitter BOD.]

Twitter is having a remarkable year. Active users have soared to over 100 million per month, with daily actives now above 50 million. Tweets per day are over 250 million. Most top actors, athletes, and artists are all active on Twitter. Every news and sports program proudly advertises its Twitter account handle. No one would consider running for public office without a strong Twitter presence. Global news in any region breaks first and spreads fast on Twitter. Even uber-socialist Hugo Chavez of Venezuela has 2.24 million followers (which puts him slightly behind Mandy Moore, but just ahead of Queen Latifah).

So, Twitter’s traffic has been growing in leaps and bounds. It has become an indispensable tool for managing personal and corporate brands. And Twitter, along with its verb form “tweet”, have become words in everyday usage all over the world. Yet despite these impressive strides, Twitter’s upside is far, far greater and its user base will expand by an order of magnitude – as soon as the service can overcome a major perception problem.

Twitter suffers from two key misperceptions that need to be resolved before the business can reach its true potential. The first misperception is that Twitter is simply another social network, like Facebook. People commonly think of Twitter as a variant of Facebook. The press frequently positions the two together as “leaders in social networking.” This pairing erroneously implies that the two services are used for the exact same thing, even though the two platforms are very different. Facebook is a few-to-few communication network designed for sharing information and life events with friends. Twitter, on the other hand, is a one-to-many information broadcast network. The only way magic happens on Facebook is through reciprocity: I friend you and you friend me back – then information flows. But on Twitter, I can get something out of following Shaquile O’Neil who has no social obligation to follow me back.

As its roots are in communication, a key part of the Facebook value proposition is sharing information. Any potential anxiety with regards to Facebook sharing is reduced by the fact that these communications are generally seen only by one’s friends. In fact, users react quite negatively when this information is unknowingly shared more broadly. For the people who view Twitter as a Facebook variant, they immediately assume the platform’s core purpose is for the user to broadcast his or her own thoughts and personal information (like Facebook), but to a much broader public audience. For those with this perception, the notion of potentially exposing their own private thoughts to the broad public Internet is overwhelming and uninteresting.

The second, and more critical, Twitter misperception is that you need to tweet, to have something to say and broadcast, for the service to be meaningful to you. For many non-Twitter users, Twitter is an intimidating proposition. “Why would I tweet?,” and “…but I don’t want to tweet” are two common refrains from the non-adopter that highlight this key misperception. But this completely misses the point as to why Twitter has become such an amazingly powerful Internet destination for 100 million others. For the vast majority of Twitter’s next 900 million users, the core usage modality will have very little to do with “tweeting,” and everything to do with “listening” or “hearing.”

Twitter is an innovative and remarkable information service. While it is amazingly democratic and allows literally anyone to broadcast publicly as a “tweeter,” the core value in today’s Twitter is the amazing flow of curated and customized information that emanates from its crowd-sourced user feeds. Other Internet networks like to keep the user “inside.” Much like Google, Twitter points out to the world. It’s a “discovery engine” and an “information utility” rolled into one. With Twitter, you get news faster, you see updates from your favorite artists, you hear directly from key politicians, and gain insights from influencers in a wide variety of specializations. Just as Facebook is symmetric in terms of its poster-reader relationship, Twitter is highly asymmetric. The majority of the tweets on Twitter are posted by a small sub-set of the users. And the majority of the users get value from “reading” or “listening” to the tweets from these core influencers. Once again, for most users it’s more about what you hear, learn, and find than the fact that you can tweet.

In many ways, Twitter is much more of a competitor to other “discovery tools” and “information sources” than it is to Facebook. Facebook is unquestionably the number one resource for “sharing with the people in your life.” From this perspective, Facebook competes (extremely well) with email, instant messengers, and certainly other symmetric social networks like MySpace. Twitter, on the other hand, competes most directly with other tools that help you find important links, news, and information. It is in this broad, non-friend based crowd-sourcing and speed of discovery where Twitter truly shines. A recent Tweet by famed sci-fi author William Gibson highlights this point. Having become accustomed to the non-linear speed of information flow on Twitter, Gibson grew frustrated watching news of the Osama bin Laden killing on TV: “Network news feels like trying to suck cold tar through a milkshake straw.

Some who understand this point have suggested that Twitter is merely a “Better RSS reader.” While this analogy is directionally more accurate than the Facebook comparison, it greatly underestimates the power and value of Twitter. RSS feeds are simply computerized information “routers” that require complex setup, initialization, and maintenance. Twitter has three breakthroughs that make it dramatically more powerful than simple RSS. First and foremost, your personalized Twitter feed is human-curated by a potential universe of millions of curators. When you “check Twitter” you are looking at the specific articles and links purposefully chosen by people you have chosen to follow. That is powerful leverage. Second, it is easily extensible. Due primarily to the concept of “retweeting,” the simple act of using Twitter exposes you to new and interesting sources to follow. It evolves into a richer and more customized offering over time. You discover new people as well as new information. Lastly, Twitter’s unique handles and follower networks create a strong-form network effect that has high lock-in and high switching costs. Twitter and its top tweeters have a deeply symbiotic relationship.

So what can Twitter do to solve this misperception problem? The first thing they can fix is the new user registration flow, a process that has already begun. Earlier this year, a new user would be encouraged to “tweet” very early in the registration process, basically reinforcing the perception problem. Today’s “first 60-second” Twitter experience is quite different and revolves around choosing the influencers you will follow. You should expect even more evolution in this direction in the future. Next, Twitter must make it crystal clear to the press and prospective user that there is an amazingly powerful value proposition for non-broadcasting users. This will not be easy, as it requires a reprogramming of perception across a broad audience. Not only will this aid in incremental adoption, but it will also help subdue the confusion with respect to Facebook.

Twitter is on an amazing trajectory and will continue to increase in usage and influence.  However, the power of this discovery platform is much more about the tweets themselves, and not simply about every single user having the ability to tweet.

[Follow Me on Twitter]

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Understanding Why Netflix Changed Pricing

Posted on September 18, 2011. Filed under: Internet, online video, Uncategorized, video, Web/Tech |

Many journalists have offered their opinion on Netflix’s recent changes, its stock price decline, and their even more recent branding changes (Qwikster). Yet in each article, it appears as if the journalist all agree that the price move (creating separate prices for streaming and DVDs) was a bad strategic move. As an example, Techcrunch notes:

“Raising prices for those of us who opt for both streaming and DVDs would have been fine if Netflix had a deeper streaming catalog. But the gap is still too big, and the price hike seemed premature. Your customers are extremely loyal. Don’t piss them off.”

The problem with this perspective is, in my opinion, the price move was not a “decision,” so much as a “reality” presented to Netflix from the content owners in Hollywood.

Hollywood is a unique place, and understanding “business” in Silicon Valley leaves you ill-prepared to understand what makes Hollywood tick (for more on this see: When It Comes To Television Content, Affiliate Fees Make The World Go ‘Round). Very few people understand the key underpinning of the Netflix “original” business model — a 1908 Supreme Court Ruling known as “first sale doctrine.” From Wikipedia:

“The doctrine allows the purchaser to transfer (i.e., sell, lend or give away) a particular lawfully made copy of the copyrighted work without permission once it has been obtained.”

Because of the first-sale doctrine, any DVD reseller, including Netflix, can basically buy a DVD at WalMart, and turn around and rent it to someone else the very same day. The content owners have absolutely no control over whether the copy can be resold or rented. Period. As such, Netflix has the ability to rent (via DVD) any movie which has ever been sold on DVD, and its costs are relatively fixed as a result of the retail price of the actual DVD. In some ways, it is a perfect storm.

Fast forward to digital streaming and all bets are off.  More specifically, the first-sale doctrine does not apply. That’s right. For DVDs, Netflix’s rights are unlimited and its costs are constrained. For digital, its rights are constrained and its costs are unlimited. In the absence of the first-sale doctrine, Netflix must negotiate each and every title, and the price of the right to stream that digital title is up to the whim of the content owner. For many titiles, you cannot even obtain digital rights, because they can’t find all the people the need to release the rights to do so.

So here is what I think happened with Netflix’s recent price change (for the record, I have no inside data here, this is just an educated guess). Netflix has for the past several years been negotiating with Hollywood for the digital rights to stream movies and TV series as a single price subscription to users. Their first few deals were simply $X million dollars for one year of rights to stream this particular library of films. As the years passed, the deals became more elaborate, and the studios began to ask for a % of the revenues. This likely started with a “percentage-rake” type discussion, but then evolved into a simple $/user discussion (just like the cable business). Hollywood wanted a price/month/user.

This is the point where Netflix tried to argue that you should only count users that actually connect digitally and actually watch a film. While they originally offered digital streaming bundled with DVD rental, many of the rural customers likely never actually “connect” to the digital product. This argument may have worked for a while, but eventually Hollywood said, “No way. Here is how it is going to work. You will pay us a $/user/month for anyone that has the ‘right’ to connect to our content – regardless of whether they view it or not.” This was the term that changed Netflix pricing.

With this new term, Netflix could not afford to pay for digital content for someone who wasn’t watching it. This forced the separation, so that the digital business model would exist on it’s own free and clear. Could Netflix have simply paid the digital fee for all its customers (those that watched and not)? One has to believe they modeled this scenario, and it looked worse financially (implied severe gross margin erosion) than the model they chose. It is what it is.

Netflix is an amazing company, and Reed Hastings is one of the best CEO’s Silicon Valley has ever seen. That said, at age fourteen, the digital world is forcing Netflix to execute a pivot. And the world they are entering is radically different from the world they are leaving. There is no longer a first-sale doctrine to keep things neat and tidy.

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Google’s Acquires ITA: Will Deeper Vertical Integration Lead to Higher Revenues?

Posted on July 8, 2010. Filed under: advertising, Internet, Uncategorized, Web/Tech | Tags: , , , , , |

“It’s funny how fallin feels like flyin,
for a little while…”

– Jeff Bridges, Crazy Heart Soundtrack

On July 1st, Google announced its intention to acquire ITA Software. ITA owns a primarily B2B airfare search and pricing system called QPX. Several of the leading online travel sites, like Orbitz, Kayak, and Bing Travel, use information from QPX to power their airfare search. Many in the industry view this move as a seminal event in Google’s history, as the company makes a decisive step from being a general search engine, into more structured vertical search. Certainly, Google already offers vertical search in Images, Videos, Maps, News, and several other categories. Despite that, ITA feels different. Perhaps the difference is that this is a step into a vertical where many independent incumbents, like Priceline and Expedia, who are material customers of Google, have large established businesses.

There are two reasons mentioned for why Google feels compelled to dive deeper into verticals. The most straightforward explanation is competitive pressure. Following its own acquisition of Farecast, Microsoft has subsequently launched Bing Travel, a much richer travel search product than offered on Google today. The second argument given for the move is that by moving deeper into verticals, and closer to the actual transaction that Google can actual make more money per visit. This argument suggests that CPA (cost-per-action) is a fundamental improvement over Google’s current business model, CPC (cost-per-click). The competition argument seems obvious and accurate. However, it is not at all clear that going deeper in verticals will raise Google’s revenues. In fact, there are several scenarios where they could actually go down.

Let’s first address the easy part – competition. Bing buys Farecast and Google needs to respond. This make sense, but it is not the whole story. If you are searching for a book or an author you go to Amazon, or at the very least you do a search like “Man in Full Amazon” so that you go directly to the page you want on Amazon. The same is true for hotels with TripAdvisor and for restaurants with OpenTable. These sites offer deeper and richer experiences for a vertical searcher precisely because they incorporate deep meta-data, faceted search, transaction connectivity, and typically a form of community or UGC (user generated content). These things simply do not exist in the simple but limited Google user interface that Om Malik affectionately refers to as “10 blue links.”  So Google has competition in verticals not just from Microsoft, but also from best of breed vertical sites offering users a richer, deeper experience.

Some have suggested that Google’s move into a deeper vertical experience is more about greed (more money) than fear (competitive) response. The argument voiced by Barclay’s analyst Douglas Anuth and others, is that by moving closer to the transaction, Google can ask for CPA fees, which naturally carry higher margin. Clearly, a single CPA fee will be much higher than a single CPC fee, but you will also have much fewer of them. The variable that links the two is conversion. One can certainly argue that Google can drive higher conversion if they can help drive the customer closer to the actual result they need. This will require a materially better product. Even then, however, there are two key reasons Google may not see higher revenue with deeper vertical integration.

Reason #1: Irrational CPC Pricing on Google Today, “Uber-Optimization”

Some might argue that Google’s current bid-based CPC model results in “optimal” pricing. The argument would be that the market-clearing price settles out at the precisely rational price for each and every keyword pair. A market-place model naturally results in efficient pricing. While this makes logical sense, we all know that there are companies participating in the CPC purchasing game who simply are less sophisticated than others. Moreover, many of these buyers win bids and have huge CPC budgets. The point is that there are plenty of startups, arbitragists, and even large companies “experimenting” with CPC purchasing in an attempt to gain an edge. The winner in this bidding game isn’t the most rational, but simply the one with the highest price. Certainly, over the long run if a company irrationally pays too much for CPC ads, they will eventually go out of business. But the key word here is eventually. For a long period of time, they are paying an “uber-optimized” price for their keywords.

If there are enough of these players in the market, then Google’s CPC prices aren’t economically rational. Rather, they live slightly above that level driven by irrationality and experimentation in the market. If you have a hard time with this theory try typing a search term like “laser treatments” in Google and look through the list of CPC purchasers on the right side of the screen. Would you put money in these companies?  Do you have confidence they will be around in ten years?  Have you ever heard of them? It gets even better. Many believe that Google uses a low quality rating score on these “middle-men” to force them to pay a higher fee for a single CPC, thus getting an even higher price than previously discussed. That’s right, for certain CPC buyers, Google has a mechanism for extracting an even higher price, even if the buyer is already the high bidder!

As Google moves past its “10 blue links” model and connects directly to airlines, hoteliers, etc, it will be removing the irrational and arguably temporary middle-man from the system. This fleeting but determined participant, very likely has a negative long term ROIC, and Google, riding the brilliance of the CPC model, stands as the beneficiary. With this player out of the system, and with the connections directly to the service provider, the model will naturally trend to a more efficient pricing.  You will have fewer larger players, who are all more rational, and all more experienced. As such, you would have to expect more rational, and therefore lower, pricing. Building a better product could actually result in less lead-generation revenue.

Reason #2:  Moving from a Marketing Channel to a Transaction Channel

If you have ever sold anything on the Internet, ask yourself the following question. What is the maximum amount you would want to pay for a transaction fee?  5%?  10%? There is data in looking at typical affiliate fee percentages, which can range from say 4-15%. Amazon charges 6-15%. Ebay charges about 11% (with Paypal).  Comparison shopping engines make even less. When an etailer assumes they are “always going to pay” for something on every single transaction, they are very sensitive to the % of revenues, as this payment will always reduce their margin. One could assume the general average for all affiliate fees or similar distribution type arrangements is around 10%.

Now, ask someone in your marketing department how much they are willing to pay to “acquire a customer.” While I don’t pretend to support this logic, the Lifetime Value of the Customer (LTV) model depicted herein mesmerizes many marketing managers. Using this simplistic but highly regarded model, many marketers justify “acquiring a customer” not as a percentage of revenue, but as a percentage of life-time value. The key to reaching this Zen state of marketing awareness is to believe that Google is sending you this customer only this one time, but for here ever after this customer is going to come directly to your own site, bypassing Google. This logic supports a much larger denominator, known as LTV. With LTV, ad buyers are easily willing to spend 25-50% of a first purchase in order to “acquire a customer.”

We could talk forever about the LTV formula, and we could argue back and forth about its efficacy, but that would miss the point. Consider the following assertion. People that are buying CPC ads are frequently marketers, and marketers are much more likely to think in terms of LTV. When you enter into a CPA deal it feels very transactional. When you do deep integration it feels very transactional. And, if Google is building a deep vertical site in travel that will pass leads to companies like American Airlines it will feel very transactional. It will be harder and harder to assume that you are “acquiring a customer,” and it will feel more and more like you are paying a distribution fee to a channel. As such, it may turn out that moving deeper into a vertical will puncture the illusion that marketers are “acquiring a customer” from Google, and get them in touch with the fact that they have a permanent CPA “transaction fee” they need to “pay” to Google. The end result is a lower overall rake for Google with the per transaction model.

Could this be wrong? Absolutely. Perhaps conversion rates will triple due to the incredible design, implementation, and ease of use of the Google’s new product, more than offsetting the two points we just mentioned. Or perhaps, Google will have such a powerful place in the travel ecosystem that travel companies will simply be “price-takers.” If this is the case then Google will once again find the exact right way to optimize their business model. It is equally likely, however, that Google’s current business model is highly, highly optimized and tweaking it may have as much risk as upside.

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When It Comes to Television Content, Affiliate Fees Make the World Go ‘Round

Posted on April 28, 2010. Filed under: Internet, online video, Uncategorized, video, Web/Tech | Tags: , , , , |

“The clock on the wall’s moving slower
My heart it sinks to the ground
And the storm that I thought would blow over
Clouds the light of the love that I found”

Fool in the Rain, Led Zeppelin

More often than not, we here in Silicon Valley are prone to idealism. We see a scenario the way we want to see it, and make predictions that fit our view of how we think the world should work, or perhaps even how we would like the world to be. This is especially true when it comes to technology. Outsider “luddites” who do not immediately grok the remarkable disruptive power of our latest and greatest technologies are doomed to the business trash heap – driven there by obsolescence and an obstinate refusal to accept their fate. Often times, our version of them “accepting their fate” would require them to abandon everything they know, walk away from the majority of their revenue, and terminate 80% of their employees. But hey, that’s their problem, not ours. We love disruption. It serves our purpose.

One often discussed target of such criticism is the media industry. There is a widespread belief that Hollywood now faces the same digital threat that has plagued the music industry over the past ten years. The argument goes something like this: There is nothing Hollywood can do to stop this train. The problem, you see, is that technology is merciless, impersonal, and unforgiving. Video can be turned into bits; Moore’s Law will make a pile of bits smaller and smaller over time; and efforts to erect pay walls will prove fruitless and even Quixotic. Studio heads should simply throw in the towel now and take what’s coming to them. Denial equals delay, and delay costs you time away from learning how to execute within your new constraints. All content will be free, and you simply have to live with that fact. The sooner you get in touch with it the sooner you will learn to execute in the new reality.

There are three key reasons why Hollywood is under less duress than Silicon Valley wants to believe. For starters, the leaders are wide-awake. Ever since Boxee offered Hulu (and were told to stop), the executive ranks at the major cable companies have been alert and engaged. Second, Hollywood has a solid track record of enforcement. They understand the stakes are high, and they are willing to invest in lobbying, regulation, litigation, and enforcement. They are also unafraid to throw around their weight (witness Viacom vs. Google). The final and most significant reason is that this is a massive, massive business, and it is critically important to understand where the money flows (most people don’t). You can spend plenty of time talking about other issues, but when it comes to understanding the key factor at play in nearly every major business decision in television, you will find affiliate fees – all $32 billion of them.

For those who do not know, affiliate fees are the primary revenue stream that funds today’s mainstream television content development. These are basically a “share” of the subscription fee you pay to your cable or satellite operator that is then shared back to the content owner/distributor (typically on a per subscriber basis). As an example, you will hear that some less notable cable-only channel was able to negotiate $0.25/sub/month, or that ESPN can negotiate $2.00/sub/month, because any aggregator would be afraid to market a television package without ESPN. Over the past 30 years, these fees have become the lifeblood of the TV content business – affecting how the major aggregators think and operate, and also affecting how content is produced, financed, and packaged.

Here are some specifics to help frame the issue. According to Matthew Harrigan at Wunderlich Securites, in 2009 DirecTV paid approximately $37/sub out of an ARPU of $85/sub to content owners for programming costs (i.e. affiliate fees). In this case, affiliate fees represent roughly 43% of total revenue for DirecTV. Similarly for Comcast, Matthew estimates programming costs at 37% of video revenue (Comcast has high-speed data and voice revenue that are separate). These are just two examples, but to give you a sense of scale these numbers represent around $7-8 billion/year each for Comcast and DirecTV. The recent, and very well written Business Week cover story on this same topic pegs the aggregate fees of all content providers at $32B per year. These are big, big numbers. To put things in perspective this is about 33% higher than Google’s annual global revenues including revenues for its advertising network.

These affiliate dollars flow through to the content producers. Estimates suggest that the annual affiliate fee revenue at companies like Viacom and Disney is around $1.5B and $2.0B respectively. On their own, numbers this large would obviously be motivational to corporate executives. But the reaction is even more intense because affiliate fees “feel like” 100% gross margin revenue. From a cost accounting perspective, a studio should allocate these fees across the content development costs, and therefore, they are not explicitly 100% GM. But as there are no significant variable costs related to the deployment of these programs to the carrier, most content owners cannot help but think about affiliate fees as 100% gross margin and therefore the key contributor to overall profitability.

Affiliate fee optimization is the key objective behind many of the industry’s most high profile strategic moves.  Here are a few examples.

  1. Cablevision vs WABC. Recently, there was a high profile stand-off between WABC in New York City and Cablevision. As is often the case, the content owner here was threatening to cut-off access to their content precisely before a very high profile and high demand piece of content was set to air. This particular piece of content was the Oscars. A cable channel owner holds up a cable company to extract a higher per-sub affiliate fee for the next contract. They always put the customer in the middle, and both sides try to argue that they are virtuous and that the other is greedy. There have been numerous examples like this over the years, and it is common to see one of these showdowns each and every year.
  2. Modern Day Cable Channel Strategy. Today’s most typical cable strategy is built entirely around profit maximization utilizing affiliate fees. If you own a cable channel, your goal is to develop one or two key, hit programs, and fill the rest of the linear lineup with very inexpensive content. The “hits” make you a “must have” for any cable or satellite carrier – granting you the right to ask for fees. Too many hits drive up costs. This is why you will see more and more hit shows on the less well-known cable channels. Mad Men on AMC is a perfect example. How can a cable company not offer Mad Men? Once you nail the single channel game, you immediately try to proliferate that into multiple channels a la MTV and ESPN.
  3. Comcast Acquires NBC. Why would a cable distribution network want to own content?  First, it’s a hedge against rising content costs (affiliate fees).  Second, it offers leverage vis-à-vis their competition.  DirecTV needs NBC.  DirecTV will have to negotiate affiliate fees for NBC with Comcast (Comcast also owns other channels like E! Entertainment, The Golf Channel and Versus).  This helps keep Comcast’s business model in check.  It’s also why Comcast made a huge play for Disney in 2004. Affiliate fees have been rising for some time.
  4. Networks Ask for Fees. For the longest time, the major networks were not part of the affiliate fee gravy train. In fact, due to “must carry” laws, most networks never considered intentionally restricting their own distribution. They were simply pleased to get redistributed over cable and satellite. As these fees have grown in size and importance, the networks have changed their position and have come to the table asking for affiliate fees also. The WABC case above is one such example.
  5. Oprah Asks for Fees. Many people seem confused by Oprah’s decision to abandon her network television show after 25+ years of unquestionable success and relaunch it within her own cable network. Why would she do such a thing? Because she can. When Oprah launches her own network (with the help of Discovery), she will get per sub affiliate fees. Which cable company is not going to carry Oprah?  What programs will be on during the other 23 hours? As stated in #2, it really doesn’t matter. They still need to carry the Oprah channel. That said, Oprah has proven she can launch other personalities (Dr. Phil), and one would suspect that any new celebrity she “launches” will be tied to the Oprah network, increasing her leverage and her affiliate fees.
  6. Sports Networks Ask for Fees. Affiliate fees are driving an endless supply of channels for anyone that has “must see” content. The NFL has a channel, and had some high profile disagreements with the carriers over the “need” for its affiliate fee. You also see an NBA channel, an MLB channel, and pro wrestling is vying for one as well. If you own exclusive content, you might as well build a channel around it. This endless proliferation of channels will one day reach a limit, but for now it’s the game on the field.
  7. Hulu/Boxee. Many people blamed Hulu for its decision to block access on the Boxee platform. These users simply didn’t understand the power of affiliate fees. Comcast told NBC/Fox that if Hulu could distribute their content for free, then they would like to take their own affiliate fees (the newly negotiated ones in #4) to $0.00. This caused NBC/Fox to tell Hulu that maybe Boxee isn’t such a good idea.

In addition to not appreciating these money flows, most of the digerati in Silicon Valley have huge misperceptions about the content owner’s preferences. They assume that content owners would like to distribute directly to consumers precisely because the Internet allows them to do so. They would no longer  be in the “death grip” of the content packager (cable and satellite companies) who take an unreasonable fee for their services. This is simply not how these content owners view the world.

Content owners absolutely prefer to be aggregated in a bundle of channels and, as a result, to receive affiliate fees. They also have little interest in “a la carte” packaging, a concept dreamed up by regulators in Washington but not desired by the heads of the content studios. Simply put, there is adequate value provided in distribution and revenue collection. To launch a direct channel (and forgo these fees), and then attempt to regain your customers one by one is a harrowing experience. Why earn your customers one by one when you can get to mass volumes, and a fixed amount of recurring revenue, through a distribution partner? If you create a new piece of camping equipment would you sell it online or try to obtain distribution through REI?

ESPN360 is a solid example of content owner’s preference for the affiliate fee driven/ distribution partner model. As the Internet became fast and pervasive, ESPN (owned by ABC/Disney) saw a clear opportunity to deliver more programming to their users and launched an online-only product called ESPN360 (recently renamed ESPN3). This on-demand, “over the top” offering is a killer product for the true sports fan, offering access to significantly more live games that was ever possible on a traditional linear cable channel. Despite the fact that ESPN has the brand, the reach, the market power, and the technology to charge users directly for this new product, they chose a different path. ESPN sought out distribution partners to bundle ESPN360 in with their standard video television packages, even though this was confusing and even baffling to most Internet users.

So against this backdrop, the cable companies have developed a remarkably shrewd strategy to simultaneously leverage their broadband infrastructure and affiliate-fee money flows. This concept, known as TV Everywhere, has two main components (once again, this move by the cable companies is extremely well articulated in the recent Business Week cover story on the same subject). First, you tell your customers that you want to provide them with a killer new service. They are already paying for all the content they receive through the linear channel stack. What if that same content could be viewed at any time “on-demand” and also through multiple devices (TV, PC, and mobile)? Sounds great so far. Who wouldn’t want this? And “everything” on a service like Comcast is more than any digital aggregator has yet even dreamed of aggregating. Ignore for a moment that this is not completely working just yet and focus on what they will “eventually” deliver. It’s also helpful to show the FCC you are being innovative, and not resting on your laurels the way a true monopolist would. Check.

Next comes the clever part.  The cable companies go to the content owners and make the following argument. With Internet-connected TVs on the horizon, you can no longer separate the Internet from the TV or the office from the living room. We pay you an affiliate fee to distribute your content to the homes we serve. We understand you have multiple distribution partners. What we don’t understand is why you would give content to some of them for free, and still expect us to pay our feesCheck-mate. This is the move that forced Hulu to a subscription model. The content owners, struggling with depressed advertising rates as a result of the global recession, quickly acquiesced to Rupert Murdoch’s assertion that maybe all their content should have a price.  Disruption disrupted.

Some have even suggested that Comcast has approached the large networks and offered an “extra” affiliate fee of around $0.50/sub to pay for over-the-top rights. Proactively increasing your own costs is a fairly unique business strategy. But this move also increases the costs for the disrupters, who are far less likely to be able to afford it.

As a result of these maneuvers, the current trend in the market is for less rather than more prime-time content to be openly available for free on the Internet.  Do you remember when South Park boldy made all episodes available for free on the Internet? Check out where things are today.  Try to watch the recent Facebook parody “You Have 0 Friends,” and you will receive the official message “DUE TO PRE-EXISTING CONTRACTUAL OBLIGATIONS, WE CANNOT STREAM THIS EPISODE UNTIL 05.08.10.” They may have wanted it to be free, until someone threatened to take their affiliate fees away. Viacom also recently removed shows like “The Daily Show” and “The Colbert report” from Hulu noting that “we could not agree on a price.” Suggesting there is a “price” at all would indicated they were discussing affiliate fees, as opposed to ad splits.

While this likely enrages the disruption enthusiasts, expect this trend to continue over the next year. More and more content owners will rip their shows “over the paid wall” as they get reacquainted with their own affection for affiliate fees. There is much speculation about Hulu’s forthcoming subscription launch with many journalists hopefully optimistic that Hulu as we know it will remain free and that all sorts of new features (TV support, iPhone support) and content (movies, back catalog) will be behind the paid wall. They may be surprised to find that “paying” may be necessary just to obtain what users see today. Affiliate fee parity may demand it.

So does this imply the end of all digital packagers? Not at all. Most clearly, NetFlix has successfully built a hybrid physical/digital strategy while maintaining its “all you can eat” model. It is also going toe-to-toe with other packagers by striking deals to lock up digital content (including TV programming). Furthermore, Hulu has executed well beyond anyone’s original expectation, and there is no reason to expect that to change as they move to a new model. One would expect them to continue to lead in terms of ease-of-use and simplicity even within a new model. Also keep in mind that Amazon has a strong VOD offering integrated into its overall purchasing experience, and many suspect both Apple and Google will enter the game as well. Despite this level of competition, all of theses vendors will need to find unique ways to compete against TV Everywhere. And with “free” off the table, the dimensions of competition will be inherently less disruptive.

There are two other potential challenges for non-facilities based content aggregators. First, as was the case with Satellite radio, we may see a “no holds barred” price war break out in an attempt to grab “exclusive” content to distinguish one’s package. As we all know, exclusive deals with the likes of Howard Stern nearly killed XM and Sirrus. DirecTV already pays $700 million per year to the NFL to have an exclusive offering of every NFL game on every weekend (NFL Sunday Ticket), and they recently coughed up over $4 billion to extend this deal. Wow. What if other digital “packagers” look for unique differentiation by leveraging the cash on their balance sheet? If this happens, any digital aggregator without deep pockets will be holding a knife at a gun fight.

The second externality that could cause trouble is “bandwidth limits” or “metered usage” on the Internet. While some people assume this will never happen (especially the idealist in Silicon Valley), the quiet momentum is building. There are continuing tests at AT&T and Time Warner, and AT&T’s president Randall Stephenson spoke openly about metered Internet pricing as recently as a month ago. Also, the Supreme Court recently put the kibosh on the FCC’s deliberate effort to make net neutrality one of its defining policies. This is perhaps an entirely separate post, but one should be confident that the rate charged the consumer by the owner of the transport for one hour of Internet video would be quite a bit higher than that for one hour of the same video over their own “optimized” TV infrastructure (backed up with an ample helping of technical analysis and white papers).  The fox isn’t just guarding the henhouse, he designed it.

There are still two legitimate arguments that trump all these discussions of affiliate fees and deft corporate strategy – piracy and content democratization.  Let’s start with piracy.

What if “BitTorrent 2.0” in whatever form it takes is just blatantly unstoppable?  No matter what you do, content has become too small relative to the big broad pipes and storage devices.  Technology trumps determination, and the minute something has been shown once, it will be free for all takers.  Isn’t this true in China today? It’s a big leap from expecting this to happen “someday” to expecting a content creator/owner to throw caution to the wind and immediately adopt a strategy that is congruent with unlimited free distribution (what is this strategy by the way?  can’t ads be removed also?). Technology is inevitably a tough competitor, but so is regulation and enforcement, and you should expect that a mighty effort on the part of a multi-billion dollar industry would mute any expectation of an overnight transformation. In her latest post at All Things Digital, Kara Swisher suggests that a recent increase in the number of intellectual property enforcement officers at the DOJ may be a direct response to the immediate needs of the entertainment industry.

Other cheerleaders of the disruption bandwagon point to the undeniable future where the availability of low-cost, high-feature camcorders at BestBuy will lead to a mass democratization of content creation. In this brave new world, the bloated and lavish infrastructure of Hollywood will give way to thousands of mini-Tarantinos who produce hit after hit on shockingly low new-world budgets that redefine the content creation business. This is the video equivalent of the infinite monkey theorem.  While this may be true when it comes to low-budget formats like game shows, talk shows, and reality television, today’s fussy television viewer has come to expect a product that is much more equivalent to feature films than home movies. Each episode of Lost costs well over $1mm to produce. Cheap cameras do not disrupt “production quality”. And let’s not forget that The Blair Witch Project was over ten years ago, and desperately stands alone as an exception and not a rule.

In the long run, the disruption zealots may be right. It may all come undone in the unstoppable Armageddon of unlimited “all you can eat” content enabled by the undeniable liberation of all bits big and small. But with $32 billion on the line, don’t expect it to happen overnight. You will be sorely disappointed.

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Want To Know More About the Future of Internet TV?: Let’s Look to Korea

Posted on September 29, 2009. Filed under: Internet, online video, Uncategorized, video, Web/Tech | Tags: , , , , |

megatv

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We are clearly at a very important point in time when it comes to Internet video, especially video that is served to your television, but over the Internet (also known as “over-the-top” Internet video). Christmas of 2009 and Christmas of 2010 will mark the point in time that Internet menus began to show up in-mass on televisions, DVD players, and game machines. That said, one would be hard pressed to predict exactly how this market will evolve.  There are simply way more questions than answers. For example:

  • Who will own the operating system layer?
  • Who will own the menu “stack” which dictates discovery?
  • What will be the key features of this menu system, and which applications will be most useful and successful?
  • What type of programs are most popular in this format?
  • What are the typical pricing/product offerings?
  • Will this product live inside the carrier set-top box or outside?
  • Will the carriers that control the pipe also control this interface (either directly or indirectly)?
  • Are these systems selling at rates that are above or below expectation?  Why or why not?
  • Is it considered a viable alternative to cable or satellite?

One way to have an advantage in “predicting” what will happen is to look at other countries that are further evolved in terms of broadband. The most obvious of these, with over 90% broadband penetration, is South Korea. Three providers in Korea offer an over-the-top Internet set-top box, and recent press suggests that there are now just over 800,000 subscribers of these services (out of roughly 16-17mm South Korean HHs).  The leader is KT with their Mega TV offering, followed by  LG Dacom, and then SK Broadband.  While these numbers are certainly impressive, if memory serves, the estimates from a few years back were for multiple-millions at this point, so for some reason the roll out has not gone exactly as planned.

According to this article from January, MegaTV has 38 live channels and 85,000 episodes in VOD format.  Also, the video included immediately after this paragraph shows an integration of the Mega TV service on the Playstation 3 (unfortunately its not in English).  This highlights the complexity of the “who owns the menu” question. Mega TV is a set-top box as well as service offering on other boxes.

Unfortunately, outside of what is shared here, I do not have much detail on exactly how this market is evolving. If any readers have more data, or have perspectives or answers to any of the questions listed above, add them to the comments or send them to me at bgurley@benchmark.com with “Korea IPTV” in the subject, and I will incorporate the responses into this post. In other words, I will try to make it a living blog post with the latest and greatest on the Korean “over-the-top” video market.  Thanks a ton – I look forward to hearing from you!

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Bill Gurley on the “Free” Business Model

Posted on July 15, 2009. Filed under: advertising, Internet, online video, Uncategorized, Venture Capital, video, Web/Tech | Tags: |

get_free_wiredI have been intrigued by the back and forth between Chris Anderson, Malcolm Gladwell, and Mark Cuban on the topic of “Free” as a strategy and business model. For those that haven’t read the articles and posts, I highly reccomend them all. Here they are in a list:

1) Back in February of 2008, Chris Anderson wrote the original cover story for Wired Magazine, title “Free! Why $0.00 Is the Future of Business.” Recently he has expanded this into an entire book. I have felt for the  past year or so, that Chris’ first article is quintessential reading for the entrepreneurial set.  More on why later.

2) In the July 6, 2009 edition of the New Yorker, one of my favorite authors, Malcolm Gladwell, took issue with Chris’s book in an article titled “PRICED TO SELL“. In this article, Malcolm does a good job of disputing some of the core pillars of Anderson’s thesis. Basically, there is always a cost to delivery, even if its really low on a marginal basis, and in volume it can get quite expensive on the cost side. He also, appropriately highlights that “Free” is not a panacea of a business model. It doesn’t always work.

3) Mark Cuban then chimed in with not one but four posts: “Free vs Freely Distributed,” “When You Succeed with Free, You are Going to Die By Free,” “Google Is Learning the Reality of Free,” and “A Quick Ditty on Free.” Mark, like Malcolm highlights many of the dark elements of the Free model. Namely, it is risky, it can be costly, and that the “freemium upgrade model” may be create a lead that is temporary.

guillotine

Here is where I come down on all of this. First and foremost, Free is a disruptive force. This does not mean that if you deploy a free business model you will be successful. In many (perhaps even most) cases you will not. However, if a disruptive competitor can offer a product or service similar to yours for “free,” and if they can make enough money to keep the lights on, then you likely have a problem. To me this is the essence of Free and why no one can ignore it. It’s less about offense and more about defense. Plain and simple, Craig’s List is a massive problem for the newspapers. When Photobucket offered unlimited photo-hosting, and survived by showing ads in the admin console, the management teams at other photo hosting sites must have been at least slightly concerned. Prior to Zillow, Realtor.com charged anyone that wanted to post a house for sale on their web site. Zillow offers this for free, and as a result, the executives at Realtor.com have something to ponder. I would argue the same issue exists for Webex (there are about five free Webex competitors), and SlideRocket certainly must be on the mind of the GM at Microsoft that is responsible for PowerPoint revenue. So basically, Free is an incumbent competitive threat.

Because Free is a disruptive way to compete, it is a great choice for an entrepreneur to use to break into a new industry. Coming in with a disruptive price (in this case Free), is simply a form of the  Innovator’s Dilemma innovator strategy. It’s not guaranteed to succeed, and depending on the category, the number of page views needed to generate substantial advertising revenue is amazingly high.  However, it is a great way to quickly steal share in a category, and it has the added benefit that most incumbents have no legitimate way to react. In some cases, like the one outlined in the famous New York Times article on PlentyofFish.com, the incumbents become the key revenue partner for the new entrant – all at once acquiescing, legitimizing, and ensuring the long-term success of the Free player.  Such was also true of TripAdvisor.

Lastly, agreeing with Mark and Malcolm, I do not believe that free is a universal truth. I don’t think that content has some kind of destiny to be offered for free. Even though the marginal cost may be zero, if you have highly differentiated content, there is no reason to adopt a free business model (assuming the government will stand behind your intellectual property protection). HBO’s hit shows should not be free. The NFL has no need to offer free access to all games. The Wall Street Journal is doing the exact right thing, and I find it peculiar that the New York Times is not executing the same strategy. I would also suggest that over the next two years you will see the majority of high-quality video content move behind a subscription wall, even at sites like Hulu.

The key question for anyone in business is, “Can someone do what you do for free?”.  If the answer is “yes” you have a problem.

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Bill Gurley’s Online Video Market Snapshot

Posted on May 10, 2009. Filed under: Internet, online video, Uncategorized, Venture Capital, video | Tags: , , , , |

I recently spoke at AlwaysOn’s OnHollywood conference on the subject of today’s extremely dynamic online/Internet video world. Things are moving so amazingly fast that its extremely hard to predict specific outcomes. That said, I believe there are a number of critical issues to understand as we watch this market unfold over the next  few years. 

Here is the video of the event:  

And here are the slides:

I wish they were synchronized, but alas after well over an hour of work, I gave up.  I believe that Google bought a company that will allow this, but they haven’t released the functionality yet on YouTube.  And they still limit personal videos to 10 minutes.

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How To Monetize a Social Network: MySpace and Facebook Should Follow TenCent

Posted on March 9, 2009. Filed under: advertising, casual games, Internet, social networking, Uncategorized, video, Virtual Goods | Tags: , , , , , , , , |

“Little Joe never once gave it away
Everybody had to pay and pay”

                  — Lou Reed, Walk on the Wild Side

The consensus seems to be that social networks have a monetization problem.  On this topic, both the leading technology industry blogs and the world’s top news organizations agree.  The problem is not that these sites have no revenue.   I “guesstimate” that MySpace and Facebook have annual revenue run-rates of approximately $650mm and $450mm respectively – highly reputable numbers.  The perceived problem relates directly to revenue per user or page view, as these are two of the most heavily trafficked sites on the Internet.  As a comparison, other companies with similar usage, like Yahoo, are doing $7.2B in annual revenues.  When reporting earnings from Q4 of 2007, Google also opined on the difficulty in monetizing social networking sites.  Sergey Brin noted, “I don’t think we have the killer best way to monetize social networks yet.”

There is ample historical data that proves web sites like these are inherently difficult to monetize.  Most other online communication products have had similar struggles.  Two great examples of this: the many leading players in the Instant Messaging (IM) space (AIM, ICQ, Yahoo Messenger) and the leading free email sites (Hotmail, Yahoo Mail).  These products/sites have always had some of the lowest eCPMs on the Internet.  Many speculate that this is because the user is so heavily engaged in using the product (i.e. communicating) that they are unlikely to be distracted by or engaged in an advertising message.  Another corollary to this point is that other Internet properties offer more direct purchasing intent based on the way they aggregate users.  Example here include TheKnot for brides, TripAdvisor for travelers, and even Google, where the search query highly delineates the direct intent of the user, allowing the advertiser to find users already in the purchasing funnel.  All of these properties have incredibly high eCPMs.

0700hk

Despite this conundrum, there is a solution.  Luckily for these U.S. based companies, a Chinese company named TenCent has already paved the way by identifying the optimal way to monetize this type of product.  For those that don’t know, TenCent is the owner of the leading IM franchise in China – a product known affectionately as “QQ”.  TenCent was founded in 1998, has 355 million users,  US$1.2B in annual revenues, and a US$11.2B market capitalization.  The stock chart for the past 5 years is included in the adjacent graphic.  The two primary drivers of revenue for TenCent are digital items and casual game packages and upgrades.  Advertising, which doesn’t work well on U.S. products like IM, doesn’t work well in China either.  Advertising revenues for TenCent represent only 12% of total revenues.  Recently, I asked a leading Internet analyst which company in China is best positioned above all others?  He quickly replied “TenCent”.

The spreadsheet below tries to highlight the monetization differences between TenCent, Facebook, and MySpace.  For each we have taken our best guess at monthly unique users, monthly page views, monthly revenues, and advertising as a percentage of revenue.  For TenCent, these numbers are published.  For MySpace and Facebook we used the best information we could find and/or infer.  We then calculated effective CPM (eCPM), revenue/user, and advertising revenue per user.  Lastly, we show these same numbers for TenCent with a cost of living adjustment.  In China the cell-phone ARPU (average revenue per user) is about 1/5th of that here in the U.S., so adjusting these numbers up by 5X gives you a much better number for comparing directly with the U.S. properties. 

social-spreadsheet2

The takeaways are quite straightforward.  The amount of advertising revenue on an adjusted basis at TenCent ($2.08) is quite similar to Facebook ($2.44) and MySpace ($5.85) (some may wonder why MySpace ad revenue per user is higher than Facebook – many believe they are more aggressive with ad placement and insertion).  The key difference in this comparison is obviously the revenue TenCent generates with business models that are largely absent on both Facebook and MySpace — digital items and casual game revenue.  For every $2 of adjusted advertising revenue TenCent has per user per year, they generate $17 in other revenue streams.  Benchmark Capital has invested in two private companies in the social/virtual world space – SecondLife and Gaia Online.  In both cases, the company revenues are significant, and in both cases advertising is not the leading business model.

More supportive data comes from the three leading social network players in Japan.  Believe or not, all three companies are already public and trade on different segments of the Tokyo Stock Exchange.  You will see in the same spreadsheet that Mixi, DENA (Mobage-town), and GREE have market capitalizations of US$511MM, US$1.5B, and US$1.1B respectively, and are all very profitable.   DENA and GREE, which interestingly are more popular on mobile than on the PC, have invested heavily in these two magic business models (casual games and digital items) and have revenues per user that dwarf that of Facebook or Myspace (DENA is 10X Facebook on this metric!).  As a result, these companies sport market capitalizations per user of over $100.  Here is the big punch line: Mixi is the actual leader in the market in terms of users, is the clear leader on the PC, is the company that most resembles U.S.-based social networks, and has remained focused on advertising as its core revenue steam.  Not surprisingly, their revenues per user are a fraction of DENA and GREE, as is their market capitalization.  

At a recent public investor conference in San Francisco, Alexander Tamas, an executive associated with the leading free email service in Russia (Mail.ru), noted that his company felt that the U.S. companies have little understanding on how to monetize a product like Mail.ru, and that they were taking their clues from TenCent in China.  Most of the public market investors in the audience, who have witnessed TenCent, DENA, and GREE’s remarkable success, nodded in agreement.  Gaia also presented at this conference and the crowd was standing-room only.  The questions from the audience made it even more apparent that the buy-side investors have a strong appreciation for the digital item business model. 

It is peculiar to have a situation where the NY-centric public market investors are more open minded to a new business model prior to the entrepreneurial executives on the west coast, but that is clearly the case here.  It is not hard to see why investors like this model.  When Pony Ma, the founder of TenCent, first described the digital item model to me five years ago I was blown away.  He was selling virtual clothes and accessories for digital avatars that represented his users online.  Think about it; this is a beautifully high gross margin business with very low marginal costs.  He even told me he thought digital shirts should deteriorate over time like real ones.  Pure genius. 

sunglassesIt is my perception that most U.S. executives have trouble conceiving and believing in the digital item model.  For starters, they simply think it’s strange.  “Why would someone buy clothes for their virtual avatar?  That’s weird.”  What they fail to realize is that U.S. consumers pay for “virtual” things all the time.  In the attached picture you see a pair of expensive Chanel sunglasses that retail for $329.  If you removed the Chanel logo from them, and offered them for $50 cheaper, you could not sell a pair.  Not one.  Why?  People are buying an image that they want to project about themselves.  Without the logo, they fail to make that statement.  The same is true for watches, clothes, cars, sodas, beers, cell phones, and many more items.  People care greatly about how they are perceived, and are willing to part with big bucks to achieve it.  Digital items are merely the same phenomenon online.

Another reason that digital items are a great monetization model for a social network is congruence of fit with the core activity of the site.  We already discussed how for TheKnot, the decision to come to the site is very consistent with identifying exactly “who” the advertiser is trying to reach and at “what time”.  For social networking sites, one of the key “experiences” of users is self-expression.  Think about it: is the Facebook news feed more about the reader or the poster?  Isn’t someone’s MySpace page all about self-expression?  If people are there to represent and express themselves, shouldn’t you build a business model that charges for the ability to better differentiate oneself?  Shouldn’t you also charge for ego-gratification on a sliding scale (the bigger the ego, the more the charge)?

These same executives like to believe that digital items are distinctly an Asian phenomenon – a convenient theory will prove to be a dangerous rationalization over time.  Here are some numbers from a U.S. corporation.  As I mentioned we are investors in LindenLab and their leading vitual world, SecondLife.  In SecondLife, the users are the ones that get to sell digital goods (rather than the company as in TenCent’s case).  Linden makes its money providing the platform services underneath this powerful economy.  At this moment in time, the economy inside of SecondLife – the amount of digital goods and services – sold each year between SecondLife users, is over a US$450mm annual run rate.  Of this, developers are realizing over $100MM in real profits extracted from Linden’s in-world to real-world currency exchange.  And keep in mind that SecondLife has much fewer users than either Facebook or MySpace.

Another interesting data point exists in the Facebook and MySpace application developer programs.  Best I can tell, the startups that are generating the most revenue on top of either platform are either selling digital items/avatars, or providing casual game packages — the exact two business models that are the drivers at TenCent, DENA, and GREE.  This is hardly a coincidence.

Despite these arguments and the fact that others have also been arguing this same point, it would be surprising if either MySpace or Facebook move in this direction.  First, they would need to have executive buy-in, which is not obvious at this point.  Second, they would need to hire people with experience in executing against this model.  Like any other endeavor in life, there are right ways and wrong ways to exploit these models, and there are already many experts in the field of digital items and casual games.  Lastly, they would need to prioritize this direction over other programs.  Currently, MySpace seems extremely focused on music, and Facebook on user-based communications.

The good news is that if they ever get around to deploying these models, they will not have trouble convincing Wall Street it’s a good idea – Wall Street is already there.

(follow me on twitter)

More Information:

Wikipedia on TenCent
TenCent IR About Page
TenCent IR Investor Intro
Stock Information and Company Financials on Mixi
Stock Information and Company Financials on DENA
Stock Information and Company Financials on GREE

In addition to these, most of the large US investment banks are covering TenCent, DENA, and GREE with English based research.  If you have a relationship with one of these banks, you can likely ask for their reports.

 

 

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    …focusing on the evolution and economics of high technology business and strategy. By day, I am a venture capitalist at Benchmark Capital.

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