Introduction

Patrick: [00:00:49] My guest today is Ben Thompson. Ben is the author of my favorite business strategy newsletter called . He's also the host of the Exponent podcast and now, The Dithering, a podcast he recently launched with John Gruber. I think Ben is among the most interesting business analyst in the world, and I've learned from and directly applied many of his ideas. We cover many of the major concepts he's introduced over the years, including his well-known aggregation theory. I think that to understand how the internet has changed the business world for good, you must read Ben and follow his thinking. I'm excited to finally have him as a guest on the show. Please enjoy our conversation.

Companies Built for Disruption

So Ben, I thought a fun place to start would be with a recent post that you called the end of the beginning, and we're going to back way up after we talk about this concept to talk about aggregators and platforms and ecosystems and all these cool things you've written about, but I'd love to start at the end there. Tell us a little bit about what you were thinking through in that post and why it might be important for this big incoming technology companies.

Ben: [00:01:48] Well first off, thanks for having me on, even though I'm not your typical investor. Good to be here. I've been a big fan of the podcast. So that post, it's interesting because there is an aspect to the post where it's obvious but also it's very heretical in some corners of Silicon Valley in particular. The idea there is that maybe tech isn't so special after all, meaning that tech likes to think of itself, "Oh, we're constantly disrupting ourselves." Back in the day, IBM was powerful and then Microsoft came along. And then, Microsoft was powerful and then Google came along, and then Google is powerful and then Facebook came along, et cetera, et cetera. And, Apple came along, et cetera, et cetera.

The idea being that there's always a new power around the corner and the position of the largest companies is very fragile, even though they look totally dominant today, in the future, they're going to be disrupted. Disruption certainly fits very much into this framework. The question that I have is it looks at technology as the discreet series of events where you went from the mainframe to the desktop, for example. I'm obviously compressing significantly. There was many computers and a whole host of things in the middle there, but then you went from desktop to mobile, and you went from the desktop to the internet. All these are presented as discrete events.

It's like we're in one era, and then that era goes on and then suddenly the era is disrupted by a new era. You can actually look back, and all these eras from another point of view are actually all on one continuum where you have two dynamics going on. On one side you have the shift of how you interact with computing going from being a batch process where that's destination-oriented, where you literally had to go into the compute room. You went into the compute room with your stack of punch cards, or whatever that might be, and you went in, you ran your job and then you came out and then you had your job finished and you went back and you checked it. And then, you made a new job and you went in and did it, and then you shifted to being on your desktop.

Wow, the personal computer because you have your own computer. You had to go to the company batch center or whatever it might be, and you can sit there and you can do a job mobile while your phone's with you. And people have talked about the phone is actually the personal computer. We wasted a perfectly good name for the phone on the desktop computer, but you think about it, we said personal computer because it was my computer but it was still a destination device. You had to go to your desk to use it. The phone, what made it different is the phone is always with you.

I would say that's actually one broad process of going from destination, batch-oriented computing to continuous, always with you computing. Instead of those being discreet steps, it's a progression and where we've ended up in a pretty ideal spot as far as that paradigm is concerned, which is you have this device with you that has a large enough screen to do work done. It's small enough to be pocket-able. It's always connected. You can always be connected with it. You think about it, what's after that? Well, there's the watch is almost too small. It's better for a few specific use cases but it's not better as a general-purpose computer. You see the same thing with AR glasses, for example. You can see them being better for certain use cases, but at some point, you're going to cross the line where you've maximized the general-purpose usefulness and now you're going into specialized bits.

You saw that with chips, for example, where chips all came into a central processing unit and what's been characterizing the industry over the last decade has been an explosion of specialized chips. And, I think as devices, you'll see that explosion of devices and sensors, but the core piece, the hub of it, that general-purpose device that can scale in lots of directions is the smart phone and we've reached a logical endpoint of that revolution. So, if you think about it in that perspective, that suggests that IOS and Android are actually far stronger and in a better much position than even Windows was, and Windows was thought to be the most dominant monopoly ever. Why? Because there was a natural step, hardware-enabled step beyond the PC that did everything the PC did but better. It was more continuous. It was more usable in more places.

Whereas what's after the smartphone, you're starting to get into specialized devices which may be better. Again, for some use cases, but generally speaking may not replace the general-purpose nature. So, that's one side. One side is the interactive part of computers.

On the other side is where data lives, and broad computing generally. And what's interesting is we started out with an all-in-one room. When you went to that batch room to run your stack of cards, that was where the mainframe was. There was a big computer that took up the whole room, or multiple rooms, and it ran all the computations and it spit out. So, we started out with it being actually being one big piece, and then when you went into the desktop, yes, you had some compute locally but that connected to the internet and you had the on premise's server room, and things would be handled there and there'd be data storage there, et cetera, et cetera.

Now, you back up into the mobile era, at the same time, you're shifting to the Cloud as far as the backend storage goes. What has happened to the Cloud? Well, it's gone from being in one room to being on one campus, or with VPNs, maybe one entire company, to spanning the entire globe. These companies brag about how many data center researchers they have all over the world. What's next after that? Are we talking interstellar? You think about it, again, there are more specialized applications. CloudFlare's take down Amazon's work on the edge. But that's maybe a more specific use case than just general widespread, everywhere available compute.

You've had the compute and data storage layer expanding from one room to being omnipresent in the Cloud. You've had the interaction layer expanding from being a batch processing in one room to in your pocket everywhere, and its natural endpoint. Anything passed this is getting super-specialized and is not necessarily general-purpose. So, it follows then. The companies that are dominant at this specific moment in time, at this endpoint, are by far the best place for anything going forward. So, I already mentioned IOS and Android on the handheld. In the Cloud, it's Amazon and Microsoft, and Google to an extent. Those are the companies that are best placed, not just because their current paradigm is probably going to last longer than people think, but also they're best placed for these specialized applications because those specialized applications are not as large of an opportunity.

The companies that are dominant at this specific moment in time, at this endpoint, are by far the best place for anything going forward.

It's not going to have the disruptive potential that Cloud relative to on premise's server had, or mobile relative to the PC had. In this view, the companies that we're at, this is the foundation going forward. Whatever happens, is going to build on top of these companies. In that article, I gave an analogy to the car industry where we had this explosion, hundreds and hundreds of car companies per decade in the first decades of the 20th Century, and then by 1930, it was over. The top three car producers were established. They were established basically all over the world and there's barely any new car companies formed until Tesla 60, 70 years later because once things were in place, once the economies of scale were in place, one the paradigm was set, it was set.

So, that's my point about it being obvious. This is what happens to most industries, but tech has always thought it was special and that's the heretical part to say, "Well, maybe you're not so special after all." That was a very long answer to your question.

Patrick: [00:08:50] No, I love it. I mean, it's such important history and so far, the stock market agrees with you. If you take price action in this most recent period as an indication of whether or not that will be true, it seems as though the market thinks it will be. It's continued to assign really, really not crazy rich, but rich valuations to these companies and they're near their all-time highs.

Ben: [00:09:09] It makes sense because I think the way to think about the pandemic generally and it's impact on the world is not that it's going to provoke a sudden shift in direction, but rather … because, we were already in this period of transition because of the internet, and the internet impacting all sorts of businesses and the way people work, et cetera, et cetera. What the pandemic, I think, did was accelerate trends that were happening anyways, and if this thesis is correct that the trend is these companies become even more foundational and critical to everyday life, then the pandemic ought to help their valuations because it's accelerating that shift or completing that shift, as it were. So from that perspective, it definitely makes sense.

Aggregation Theory

Patrick: [00:09:49] We'll come back around to some of the interesting issues around whether or not these companies should be regulated, some aspects of them should be considered utilities and so on, but I want to back up to some of the root level ideas that you've introduced into the world around technology strategy over the years starting with the big one, which is aggregation theory. I thought a neat entry point into aggregation theory would be this concept of the Smile Curve. Could you describe what the Smile Curve is and then we'll use that as a jump-off point to go a couple layers down on aggregation theory.

Ben: [00:10:19] The Smiling Curve is actually from here in Taiwan where I live. The former CEO of Acer, Stan Shih, the founder of Acer actually. What he observed a long time ago was that with the PC industry, on one side there is the brand and service and marketing side of things. And on the other side, there are the RND things that are secured by patents and excellence in marketing, et cetera. Then, fabrication is in the middle. The value of those components looks like a smiling curve where it's high on the ends, the brand, and marketing, and all of those sorts of things are high. The specialized technology secured by patents or foundries, superior manufacturing technology is very high, but fabrication, actually putting stuff together, is very low.

A company like Acer, ironically enough, tended to sit in that fabrication space where you win in the fabrication space by having a superior cost structure, but you're not going to capture a lot of the value at the value chain. You see this, for example, in the iPhone. A company like Foxconn relative to their perceived importance has actually a relatively low market gap, whereas when I originally introduced this, I compared them to Largan Precision, which creates the lens assembly for the iPhone. A tiny part of the phone, but a much higher relative market cap to their sales because it's a highly differentiated piece that is a sustainable, protect-able position.

And obviously, TSMC is a good example of this. Intel traditionally was on this side, that's why they charged so much for their processors, and then the other side, when Stan was writing about this, he was thinking about, "Oh yeah, Dell basically" Or Compaq, when they shifted away all their fabrication to Asia, and they were trying to capture that high end and using Acer to move up the chain here, particularly Windows and stuff being on that higher end side of the PC value chain. And so, this is this idea where value flows to either highly differentiated inputs on the one side or the end part where you capture a lot of consumer attention on the other end. To be in the middle putting pieces together is not a particularly great place to be.

Source: Wikipedia

I actually first introduced this concept, I talked about the Acer example and Largan Precision, but I was actually writing about publishing where the idea in publishing was increasingly that the value is going to flow to either side, either the side that captures consumer attention, which was Facebook and Google and these companies where users go to them first and then follow links to publishers. Or, it was going to go individual content producers like myself where you could actually be highly differentiated and you could be able to capture value in that way.

The publishers were the fabricators, where they were in the middle trying to use the differentiated inputs to sell to the users at the end, but actually, all of the power and value was accrued to the ends and they were losing their position in the value chain, which is different than the old days where the local publisher had a local monopoly and their power was predicated on controlling the distribution, but when there's worldwide distribution, then that goes away.

Patrick: [00:13:18] This might be a ridiculous question, but I'll ask it anyway. Partly ridiculous because the major aggregators may already be created in the internet era, back to our opening discussion, but the question would be how would one go about creating an aggregator? What are the steps to building something like this, and I guess of course, we need at the beginning of a simple definition of your three rules for what an aggregator is. The one that I've seen you write before are direct relationship with the customer, zero marginal costs and lowering customer acquisition cost as it scales.

Ben: [00:13:47] Yeah, the idea of an aggregator is something I've just been developing for a long time, but the most important thing is first and foremost is that it's different than a platform. This is a big frustration I have. We can get into perhaps later, or too when it comes to the question of regulation, is that people think about big internet companies and they're frozen with this picture of Microsoft where you have a platform with an API and drivers, so the OEMs plug in at the bottom and applications sit on top, and it's a facilitator for the entire ecosystem.

Platforms have tremendous value because, again, they're a facilitator of the ecosystem. They're also dangerous because they have direct controls or components in that value chain, so you can squeeze the OEMs on one side, you can squeeze developers on the other … I think an example today would be Apple and their control of the App Store is a great example of leveraging the power of a platform in perhaps problematic ways.

An aggregator on the other hand is very different in that they leverage abundance because there's so much stuff out there, consumers are overwhelmed and they need a way to sort through it. Classic example is Google, where there's so much stuff on the internet, how do you find stuff on the internet? Well, you go to Google and Google helps you find it. When you go to Google and you find something, well then, that's great. You go there and everyone benefits. You benefit, Google benefits and the site they directed you to benefits. And now, all those sites are motivated, work better on Google. They want to work harder and show up better behind Google's search results.

And what's funny, the SEO industry is in many respects an industry where people pay money to be better Google suppliers. You think of a Google's perspective, they're not spending a dime. They're just putting specifications out there and people are jumping saying, "Oh, can I serve you better, Google?" They serve Google better and users get better results, et cetera, et cetera and you get a virtuous cycle and then boom, Google can drop ads in front of you. So, what enables this to get to Google's three characteristics you mentioned, one is a direct relationship with users. Google is directly connected to users. They go to Google to search for something, or they go to the search bar in their browser.

Facebook, same thing. You go to Facebook first. It's a place that you go to directly, and that's what is the core at capturing value. You do that because you provide something users like. This is what regulators have to get through their heads is no one's forcing people to go to Google. No one is forcing people to go to Facebook. They're going there by choice. They could not go there. They could go to Bing, or a better example, they could type in the URL. This is where complaints from companies like Yelp for example fall very flat for me. At the end of the day, it wasn't that long ago when people were saying, "Oh, Google is doomed" and I wrote something similar this is a problem for Google because people can get apps and do search directly. They're going to lose local because people are just going to go straight to Yelp.

Well, it turns out that Google responded very aggressively to that and is that a bad thing? Because they didn't stop users from going to Yelp. It's not like Yelp was banned from Android. That's a platform issue. If Androids only made it so the Yelp app didn't work on Androids, that's an obvious abuse of platform power. People using Google instead of using Yelp is a problem of you not liking what customers choose to do, but there's nothing you can really do about that. So, Sony's regulations ended up being like pushing on a string. We saw this with Europe and Google shopping where they're like, "Oh, Google disadvantaged these shopping comparison sites."

Well, you know what? If you go to Google and you search for shopping comparison sites, they give you a list of shopping comparison sites. If you search for shoes, they give you shoes and somehow this bothers regulators that by giving customers what they wanted, which were shoes, they didn't serve up shopping comparison sites. Well, your problem is that customers are not searching out other shopping comparison sites, which is a marketing problem for those companies. It's hard to see how that's Google's responsibility.

And again, that's not to say Google hasn't committed abuses. It's just to say that if you don't understand the nature of their power, which is customer choice driven, your regulations aren't going to work. We've seen that again and again. So, number one is regulation with users. Number two is zero marginal cost of serving users and what this means, because Google when they get good, they can scale infinitely. There's no natural geographic limitation or production-based limitation on how many people they can serve. This matters for both a marginal cost effectiveness and a transactional cost. It's a lot of accounting. Stratechery, for example. Could I scale infinitely given that I'm doing a credit card check for everyone? There's probably some sort of gating factor.

With Google, it's all so frictionless that they can scale infinitely. Facebook is the same sort of thing. Number three is this idea where you get decreasing acquisition costs over time. So, you think about Google. The more people use Google, the more data there is the system, the more feedback loops there are that makes the search results are better and that attracts more users. So even the marginal user, the products getting better over time. I actually think a better example of this that I like to use is Netflix. Netflix is a little interesting because they're dealing with money is involved in a much more direct extent, so the scalability factors are much more limited relative to say Google or Facebook, where it's all frictionless.

But, you have this concept where the marginal user for Netflix at the beginning was having to sign up for a service with a few thousand shows, and now the marginal user is going to Netflix and signing up for a service with tens of thousands or hundreds. Who knows how much content is on Netflix. Why? Because the content they seek out is evergreen. It's always available. I can go watch Orange is the New Black, one of their original shows and it's valuable to me today. So the marginal value of Netflix is increasing as their customer base increases, as opposed to a lot of services where the more customers there are, it degrades in quality and becomes even harder to acquire them, and then they have to spend marketing costs to acquire them and that's just where companies fall apart.

So many companies base their projections and calculations on the cost of acquiring a customer at the beginning. The problem is at the beginning, you're serving your ideal customers, the ones that really want your product so they're going to look over the problem with your product, et cetera, et cetera. They're going to be easy to acquire, and usually, your marginal customer gets more and more difficult to acquire. You have to spend more money and what happens is Facebook and Google actually end up taking all your profit over time.

Patrick: [00:19:46] How much of the aggregators that we have, or we can point to, do you think strategically thought about this concept early in their lives, whether it was the founder or the CEO? I'd be curious to hear your thoughts on how these things tend to get going, if there is a common pattern between say Facebook or Google or some of the other aggregators that you've written about, Airbnb being a level two aggregator. I'm just curious if you think there's some sort of magic spark that makes it possible for a company to potentially grow into one of these things?

Ben: [00:20:14] Yeah, I think that is giving me and this concept too much credit. There's certainly a bit of a descriptive nature to this. I think someone who has written about these concepts a lot is Bill Gurley, particularly this idea of owning demand is way more important than owning supply. Hopefully what I've contributed is noting that this concept is more generalized than maybe it first seemed, and is actually pretty descriptive. And the other thing that I think I've really focused on is why this is different than a platform. This is actually something I've talked to Bill about a fair bit is pointing out why this distinction is actually really, really important, so I think that's probably my biggest contribution is teasing out why those are different and why that matters for how to think about these companies.

But to actually think about this, and probably the best example of, I think, a company that's thinking about this explicitly is Spotify and their shift into podcasts. The recent news about them taking Joe Rogan and there's going to be exclusive Spotify, a lot of people assume, "Oh, that's just Spotify trying to get more subscriptions." And I think they'll be happy with subscriptions they get, but this is pretty clearly an advertising play. That's why, for example, Spotify recently shifted their accounting of costs for content completely to the advertising division. People keep pushing back on this like, "Well, you don't change your accounting if you're not pretty clear about where this is going," but most people are not the ins and outs of accounting, to say the least, although your audience, I'm sure, loves it.

What I see Spotify trying to do is trying to get a critical mass of listeners to podcasts. And meanwhile, their technology is much better suited for monetizing and to me, that's very under-monetized. How do you monetize a podcast? Well, one you could have a host read an ad, which is very hard to manage and scale, so you see the companies doing it are ones with very large lifetime values because it's worth the time, domain registers and stuff like that. Or, you have something where you use the dumbest dynamic insertion, which is you insert a download. So, you see the IP address, "This person is in the Los Angeles area so we'll put something somewhat related to Los Angeles in the download."

You know nothing else about the customer. It's the dumbest targeting possible. And I've seen people trying to say this is similar to Spotify. Not at all. Spotify is trying to deliver a Facebook type of advertising experience. They have a relationship with you. They already have a few hundred million people with Spotify in general. A lot of them are paying customers, so they have zip codes, demographic information. They have your name. They have your email address because you had to register with them. The email is the key to unlocking identity broadly, and they have a much more finely tuned understanding of their customers, number one, and then number two, because Spotify streams everything, they don't need to worry about this download issue because as you're listening to a podcast, they'll be able to put in an ad specific to you in the time and place that you are, and it will be different for everyone.

Again, we'll see if it works but you can see a world in which this monetizes way better than other podcast ads. Just like Facebook ads monetize way better than your general banner ad on the internet that's not applicable to anyone. If that happens, then suddenly their CPMs are so much higher than everyone else that future podcasters, Spotify won't need to pay them. They'll be saying, "Look, we have all these customers. We monetize better because we understand these customers better. You need to come on to our platform and use our superior 'We will monetize you better'." And then suddenly, they become the center of this where they have a critical mass of users who they understand better and they pull podcasters on and they start getting this virtuous cycle and become the center of podcasting.

We'll see how that works out. It's interesting because in one respect, podcasting it super fragmented and that's a great place for an aggregator to come in, because an aggregator cleans up the mess. Google came into a world of all these websites everywhere that was just hard to manage, and they just organized it and made it approachable. I think a challenge for Spotify is because the ecosystem relatively has been around for a while, there's a lot of people that are set in their ways, and you see that even Spotify to date, their growth in the area has mostly been converting new podcast listeners, making people who didn't listen to podcasts before start listening to them.

The big question is can they get people to actually shift their habits to use Spotify, and it's going to be a little tougher because that's where they have to do exclusive content. If you do exclusive content, then your value starts being captured to the smiling curve idea by the differentiated creator themselves. So, it's going to be a little more difficult than the path that Google or Facebook went but it's certainly what they're trying to do.

Aggregation Theory in Media

Patrick: [00:24:34] You've raised such an interesting example with Spotify and think about sometimes Netflix in a similar vein where it lets us explore this concept of the suppliers in the marketplace. You've already talked about these concepts and a few different company examples. You've also written about how there's three different levels of aggregator depending on the type of supply. The magic, of course, is the Google and the Facebook where people, like you said, paying money to make themselves better suppliers, let alone not having to pay them anything. But things like Netflix and Spotify obviously, they're paying suppliers to come on the platform, and I guess I'd be curious what you call Netflix's originals. I guess, first-party suppliers, or something like that.

But how do you think about the role of supply from a competitive standpoint how aggregators interact with providers or suppliers?

Ben: [00:25:20] The idea that on the Internet controlling demand is more important than controlling supply is the big picture takeaway, but to your point, the relative power of suppliers determines how big and profitable the company that controls demand can be. Take Spotify's other business, music, as an example. In this case, because the supplier have a monopoly on music for all intents and purposes, what's so brilliant about the music industry model is because they're doing almost a venture idea where they give you money up front to do your recording, but then they own it. They'll take a lot of losses and a lot of bands that don't break through, or singers that don't break through, but because the ones that do, the moment that song is recorded, it is now part of the back catalog.

[O]n the Internet controlling demand is more important than controlling supply

And the power of music companies comes from the back catalog. You're like, "Oh, why don't new artists just go to Spotify?" It's like, "Well, they still need help getting off the ground, and if Spotify "Spotify is certainly working in the long run, I think, to make that something they can help new artists with but as long as new artists are going somewhere else, the back catalog of these companies are getting more valuable over time and the more valuable that back catalog is, the more negotiating power they have relative to Spotify. Thus, they can take a percentage of subscriptions as opposed to. That's the other thing why the podcast bought subscriptions doesn't make sense. Spotify pays based on the money they make, not necessarily the share.

And yes, they're trying to change those parameters over time, but the hold that the industry has on Spotify because Apple can step up and offer the exact same songs is a very strong one. So, Spotify is a very weak aggregator in the case of music. Whereas podcasts, because the supply is much more disparate, everyone's independent. There's not that unifying force tying a bunch of them together. That's actually a place where Spotify can absorb much more potential control and power in the space. If Apple actually cared, or had any interest in doing this, they could have rolled up the podcast space ages ago but they had the central directory.

iTunes doesn't post podcasts. A lot of people don't realize this, but it's the directory where everything is, and the more important thing is the Apple podcast player is the biggest podcast player. Had Apple chosen to leverage that, particularly a couple years ago, they could have built this whole thing, built an ad network, built all these sorts of things. It's just not what Apple does, so they just let it be but that's where the power would have been because they controlled the math. They controlled the end user.

Netflix is interesting here because Netflix has shifted over time to integrate down the value chain and assert more and more control over suppliers. People don't realize that the Netflix Originals strategy has actually also shifted over time, where originally, they were just buying shows. House of Cards, I believe it was Sony. It was also sold internationally. I remember it being on global TV here. It was only on Netflix, I believe, in the US. Sony took out all the costs. They produced the show and they sold it to Netflix. What Netflix has shifted to over the last several years, and this is why Netflix has had such crazy cash burn is they are producing shows from the get-go, which means they own the entire thing. They own all the worldwide rights. They own all the residuals, and this is something that creators have grumbled about. A lot of them don't get residuals on Netflix.

So, when Netflix keeps all the upside, they pay more upfront for that right but in the long run, remember the Orange is the New Black concept, it lives on Netflix forever. It provides customer acquisition benefits to Netflix forever, so Netflix wants to keep all that forever upside on their own books. Well, if you're putting in all the money upfront for a show, taking all the risks, you're going to spend a lot of cash, and that's why for about three years, Netflix's free cashflow was massively negative because they were pulling forward all these costs, whereas House of Cards, they paid Sony over time as it was delivered. They're putting in all those costs upfront so that in the long run, they only have revenue upside. They don't have costs in the future.

Obviously, from an accounting perspective, they're going to deal with the costs then but from a cashflow perspective, the cashflow is all pulled forward. The idea there, though, is they're actually asserting more control over supply so they can garnish more upside from controlling demand. People really fundamentally, I think, don't get that specific point. There's such a focus on their free cashflow without understanding why is it that there's free cashflow for these few years was unusually high in a way it wasn't before, in a way they project it won't be going forward.

Because if you're shifting your business model from cash flowing out over X number of years to all the cash flowing out in one year, and then you garnish it in the long run, if you're shifting your working capital model, you're going to have a huge cashflow but once you adjust, then it will look more normal over time. I think that's what you're seeing with Netflix forecasting that their cashflow is going to improve. It's because they've now shifted their model, flipped it on its head and will be able to capture that upside without these extreme outflows in the meantime. And meanwhile, they're doing it at a time where interest rates are minuscule so it was a good taking advantage of the moment and now they're, I think, a much better place going forward.

And by the way, you see this in the pandemic. A lot of the networks and a lot of the traditional folks are trying to stretch out their content because they don't have enough content. They only have content three to six months ahead of time. It's just in time content, whereas Netflix, because they've shifted to this working way ahead of time model, they have content for the next year. So, they're not shifting their timing at all. Obviously, they might have to make adjustments to their production going forward, but they've ended up being better placed because they shifted to a higher inventory model, if that makes sense.

Patrick: [00:30:49] You've talked about two really fascinating examples where the categories are video for Netflix, and as Daniel has talked about with Spotify, not music but audio for Spotify, how do you think it's possible to compete against one of these aggregators when scale economies tip in their favor? The Netflix example, the amount of cash that is being spent and burned to produce this stuff is staggering, and it's growth rate is staggering and obviously, they've got enormous scale economies advantage. Do you think that it's possible to attack them in that category of video?

Ben: [00:31:22] I think it's very stupid to attack them head-on. The problem is that just think about that scale advantage. If Netflix spends X amount on a show, they can spread it out over way more subscribers than you can, which means that your cost per subscriber for a new show is going to be massively higher than Netflix is, and that's just going to be a fact of life for all these folks going forward. That's a tough place to be in. The answer, though, is you don't necessarily have to take the same business model and approach as Netflix. Disney, the reason what is compelling about their streaming model and the low price that they've done it is they have other ways to monetize customers. They can monetize through theme parks or cruise ships. This is all pre-pandemic thinking but one suspects that'll it be the case in the long run. We shall see.

But the idea is that Disney actually establishing a direct connection with customers really for the first time, beyond maybe their cruise ships and stuff like that, to understand their customers, to have their email addresses, to have their credit cards, to be able to communicate with them directly is so valuable given the other ways Disney can monetize those customers that you have to think about Disney Plus not just as being a potential moneymaker but as a phenomenal top of the funnel tool. A lead generator for their entire business. So, in that case, they can compete with Netflix because their payoff for buying content, or not selling it to Netflix as it were, is monetized not just by their streaming prices where they compete with Netflix head-on, but also by all the other parts of their business.

So, it's a much more rational approach. Another company where they're just trying to also build a subscriber business and compete with Netflix, you're trying to compete on Netflix's grounds in a manner where Netflix has a massive advantage and it's going to be a very difficult position to beat. Now, you could brute force it. I mean, if Apple really wants to spend several billion dollars a year, that could be a problem for Netflix, but it entails Apple accepting pretty significant massive losses for quite a long time by definition because they are going to spend less efficiently just because they have a smaller user base.

That's just why Netflix is difficult to compete with in this regard. Again, the scale matters. You need a different business model, a different way to monetize, or just limitless cash and a willingness to spend it. I think the outcome here is the next couple of years are going to be a little tricky for Netflix because there's all these competitors popping up, but I think in some respects it's setting Netflix up for the next stage, which is all these companies realizing this is a terrible business for them and they're actually better at being suppliers, and then they go back to selling to Netflix, and then Netflix ends up being the future cable bundle for basically anything that's not live and everyone just sells to Netflix.

I think that actually is the logical place where this ends up, so maybe a rough few years as Netflix competes, but I think they'll win that competition and then they'll be very well placed.

Platform vs Aggregator: Amazon and Shopify

Patrick: [00:34:10] Leaving media now to talk about two other fascinating companies as it pertains to this lens of platform and aggregator, which are Amazon and Shopify. The famous example of Shopify is called arming the rebels against maybe the empire that is Amazon. I'm curious how you think these concepts of platform and aggregator apply to those two companies and whether or not Shopify specifically will trend towards becoming an aggregator when thus far, it really has been about arming merchants with better and better platform tools?

Ben: [00:34:42] It is a good example, and the third company I would discuss here is Walmart and their particular Jet focus, sort of eCommerce ambitions. What Walmart has figured out is, it's a great example, to the extent they can do things differently than Amazon, they can succeed. Grocery, for example, Walmart is doing much better than Amazon because they already have existing grocery infrastructure and it turns out a big problem with groceries is perishables where you need a regular supply chain that's different than an eCommerce supply chain, and Amazon has really struggled to figure these aspects out because they're totally optimized for a different use case whereas Walmart has done well.

Walmart, meanwhile, has done terribly at traditional eCommerce because they're not optimized for that and Amazon is. So, Walmart then tried to build up their capabilities to take on Amazon, and it was a total disaster because they're trying to beat Amazon at Amazon's own game, and Amazon is already at scale, they already have all the capabilities and all the customers go to Amazon already. So, how do they actually compete? They offer lower prices, they try marketing. Now you're killing yourself with customer acquisition costs and you're getting hit from both sides. You have a worst cost structure and you're handing money to Facebook or Google to acquire customers. So, it was a very tough go of it.

Meanwhile, Shopify is very different. If you're a merchant and you to Amazon, you're giving everything to Amazon. It's Amazon labeling, it's Amazon's website, it's Amazon's boxes. You're literally paying Amazon to hold your inventory for you. It's a pretty tough gig. Why do you do it? Because the customers are on Amazon. People go to Amazon, they search for something. If you want access to customers, you need to be there. It's a great example of the aggregator concept where controlling demand lets you control supply.

Shopify goes in the opposite direction in that it enables suppliers to have their own direct relationship with customers. They can set up their own store. They can get customers to come in and acquire things without having to have the middle man there. This is a concept. This is how you compete. I am online, I'm publishing things online, how do I succeed in a world of Google and Facebook? I go around Google and Facebook. I establish a direct connection with my customers. I send them emails, email's an open standard just like the web is an open standard, that lets me send my content to them directly and that lets me build a nice little business that goes around the aggregators as it were.

That's what Shopify enables as well. This is the way to compete with Amazon because you're competing with Amazon in a way that Amazon can't respond to. It's an orthogonal competition because your entire point is to support and feature suppliers to the left side of the smiling curve, to go back to our initial idea, that are differentiated on their own. Now, there's lots of challenges on that side of the supply chain, particularly because of customer acquisition issue. Facebook ends up eating up a lot of the profit there. If you're actually not differentiated and you don't get customers via word of mouth or spreading and you have to go through Facebook advertising, Facebook is going to end up eating a lot of that up.

But, just the fact that the internet, because competition is so high, a lack of differentiation is going to kill you either on one side or the other. That's not necessarily an indictment of Facebook or Shopify. It's just a reality that the competition with the entire world as your addressable market is higher than it has ever been.

So, will Shopify become like Amazon? Well, I think that'd be a mistake. I think people don't associate.The entire reason why people use Shopify is because people don't know it's Shopify. They know it's, "Oh, this shop with cool shoes that I like." Or, this shop with cool knickknacks or whatever it might be, whatever thing is on Shopify. And the brilliance of the Shopify model is people like to point out the churn rate, "Oh, we don't know what the churn rate is. How many people start shops on Shopify and flame out?" It doesn't matter for Shopify. Their platform is scalable because of technology in a way that a million people can start a Shopify shop and 950,000 can go out of business and Shopify now has 50,000 new customers who are generating them money. That's a great place to be.

Why? Because the cost of scaling to serve people because of technology, the marginal cost is zero. So, it's actually high churn on Shopify is a positive signal, not a negative signal. This is something I think a lot of people that I think aren't familiar with the internet have a hard time wrapping their heads around. Wait, you want high churn? Absolutely that means you're getting way more customers in at the top of the funnel. Now, it's going to be challenging for Shopify and I'm actually writing today I think it'll probably post before you post this about the Facebook shopping thing where they're partnering with Shopify.

Well, the problem is that the gravity on the internet always flows to whoever owns consumer attention. So, I actually think this is a natural place for the value chain to go, but it does show the weakness of Shopify, which is I actually don't write about valuations. Shopify is an Amazon competitor. It doesn't follow that they're going to in the long run have Amazon valuation. It's a different model that can be a very, very profitable, very successful one. One that arguably has a better and greater impact on the world than the aggregator model, but you're not going to have the same big picture scalability.

[T]he problem is that the gravity on the internet always flows to whoever owns consumer attention

If you think about where Shopify could really make a difference and cement their position, it's getting into things like logistics. Announced this last year trying to get a 3PL network. It's like Windows. Windows had the OEMs in the bottom and the applications was always on top. Well, Shopify should have merchants on the top, all the infrastructure to support eCommerce on the bottom. Any one 3PL provider, logistics provider, can't interface with a tiny mom-and-pop shop selling cookies on the internet. But Shopify can intermediate that so they can provide scale in both directions such that you can make those connections in a way that's very, very useful to both sides and also a very, very deep moat because you have that connection that you can't form one-on-one.

An aggregator, I can always go around and form a one-on-one connection. It's an aggregator type of moat, and this goes back to the regulation question. An aggregator type of moat is very different than a platform type of moat. A platform type of moat is all about APIs and drivers in a literal sense for an operating system. But in a broader sense, it's about making these connections that can't be made without the platform. An aggregator, I can always go around and connect to my consumers directly because of scale and use of ease and it's the obvious thing to do. To beat that, you have to have something that's easier and better, or so highly differentiated that customers will go through the effort to go around it.

Patrick: [00:40:56] There's an adjacent concept to all of this, which you call the moat map. We've talked about parts of this and we've started really picking apart suppliers as differentiated versus commoditized but there's a second element here around network effects, which is a concept that's nice that it's taken you this long to get there. Usually it's the central point of a conversation in technology discussions. Describe what you mean by the moat map and where some of these companies might sit, and also what some examples are like Uber that may not sit in the right spot on the conceptual map.

Ben: [00:41:24] I actually thought this was an interesting concept. It's a hard one to communicate, which probably means I haven't thought it through sufficiently, but there's this idea of basically what I just referred to where a platform, their network effects are externalized. Microsoft built a network between developers on side and users on the other. Basically, OEM is on a third side, so it's a three sided network. You can argue system integrators and all those sorts of things on the fourth side. It's a four sided network. It was a brilliant business. It continues to a brilliant system.

Microsoft has leveraged it into what they're doing today and they're trying to build an OS in the cloud. A lot of this build last week was about this, and the things that they opensource and the tools they made are all about making it possible for people to build on business applications that connect to users, that work on Microsoft services, et cetera, et cetera.

And in the future, IOS and Android are the OEMs of the future and Microsoft services sit on top of them. It's what Microsoft does. They're very good at that. Apple's Apple Store is a similar thing. Network effect between developers on one side and users on the other. So in this case, the network effect is externalized. You go the opposite direction where the network effect of having more users becomes more internalized to the product. Facebook's an extreme example. The suppliers are the users. The users go on, they write content on Facebook, the put photos, they look at content and photos from other users and they're all locked into the network and Facebook owns that entire thing.

To the extent that others come in, it's still defined by Facebook owning that network there. Same thing with Google. I talked about the feedback, the data feedback loop that Google gets from people on the internet or on Google services that makes the service better and learning and they talk about machine learning and AI. All this is about Google harvesting the usage and users to enhance their services in a feedback loop. Those are network effects. It's a type of network effect, but it's much more internal to the product. It's not about tying together different pieces on the outside.

And, I think that you get this idea where in that world where everything's internal, the suppliers are totally commoditized. The websites on Google, Google doesn't care which website it is. All they want is the particular information or fact. Total commoditization of websites. Facebook does the same thing. A story from The New York Times is given the exact same prominence as a picture of my nephew. They're just all in the same feed. Total commoditization of content, and I think that's a characteristic of companies that have internalized network effects where it's all self-contained and they're just diminishing what a supplier is. It's a differentiation. They're squashing that left side of the curve to go back to what we talked about before.

Source: Stratechery

It's the opposite in the case of a platform. If you have external network effects where people come to your platform because they want a particular application, then it's in your interest that application be highly differentiated. Having Photoshop on your platform, you want Photoshop to be more differentiated, not less because you want people to want to use that application and thus use your platform. The motivation and the way that the moat works for an externalized network effects, they want highly differentiated suppliers because those suppliers are dependent on the platform, so the more differentiated suppliers are, the stronger their own platform becomes.

Again, this gets at why a platform, their motivations, the way they work, the way they're defensible, the way they need to be regulated are just fundamentally different than aggregators on the other side. It just works totally different and we try to do it the same way.

You mentioned Uber. I think a challenge with Uber is their network effects are externalized because they have drivers and then they have passengers, but there's no differentiation. They're trying to commoditize the drivers, so they're in this weird spot where it's misaligned with the way these platforms typically work. They don't keep people completely internalized but also, there's no differentiation so that's why they're oppositional to everyone. Uber is very, very user friendly. But they have a very oppositional relationship with drivers, and the drivers, they're always multihoming. They want to be a lift or maybe they'll do delivery with other services, et cetera, et cetera.

When you get out of that alignment, it gets much more challenging. And I think you've seen this when Airbnb was really humming, they had a much more I think positive relationship with their hosts, where the hosts were commoditized to an extent where you went on Airbnb and you saw who's out there, but it was totally an internalized Airbnb. Again, it's all gradient as it were, a spectrum, but I think the more that you're highly tuned to one side or the other, the better your business is going to be, and the less you need to, for example, Uber, at least in theory, they should spend all their money on acquiring users and that should bring suppliers onto Uber to serve those users. It ends up that Uber actually spends a ton of money trying to recruit drivers. That's a signal that they're not quite an aggregator. There's something that's not quite right here, so part of this article is trying to figure out what is it that's off about this business model.

Patrick: [00:46:16] One thing we haven't talked about, we talked a lot about how the lack of friction on the internet just changes the entire dynamic of the world. We haven't talked a ton about just pure constraints. There are lots of business strategy books written about wanting to control a choke point in a value chain. I'd be curious to hear your thinking related to everything else that we've talked about value chain thinking and this difference between modularity and integration that you've written so much about and how that relates to good profitable business models.

Ben: [00:46:50] Well, the big problem is you're right. People talked about controlling a point in the value chain, but it turns out in the analog world, that point was almost always physical distribution. You think about you had the people watching football on TV. Well, there's a limited number of broadcast licenses. There's a limited number of professional football teams, so you have scarcity there. You have scarcity in the licenses, the distribution of them, or the football game. You have commercials. There is a constraint on the number of commercials that can be shown based on how many pauses in the game there are.

Yes, football has a lot of stoppages but there still has to be a game at some point. Or, your sitcom show is 22 minutes long. There's eight minutes of commercials. That's it. There's no more commercials after that. There's 24 hours in a day. That's a constraint. You had to go to the store. Well, there's a constraint on land. How many big stores can there be in your area. You go to the store, there's a constraint on the amount of shelf space that there is. How many things can go on the shelves? There's a constraint of the stuff you can actually physical carry in your cart or in your car to take home. And then, of course, there's a constraint on money. How much can you afford to spend?

Constraints up and down that entire value chain, and that value chain that I just described was basically all the dominant US western companies in the area. You had the media companies, sports is a big linchpin for that. You had the car companies. You had the big retailers. You had CPG companies. All of them were defined by physical constraints. All of those constraints are going away on the internet. So, you can watch content on Netflix and Netflix goes on and on and on. There's no constraint of content. Everyone can watch different content because you're not constrained by time. There's not, "Oh, we have a limited block." There's no constraint on broadcast channels.

There's an infinite number of things you can watch at any one time so you don't have to fit in three channels, or on cable, 100 channels or 500 channels. It's infinite channels. You can start and stop at any one time. Oh yeah, we have 500 channels but the movie is going to start at 8:00 pm. No, the movie can start at 8:00 pm for you, and 8:30 pm for me, and 8:25 pm for the other person. It's just the loss of constraint of time. You have no more constraint when it comes to shelf space. Amazon has infinite shelf space. It can hold as many products as possible. That's why they have the merchant program because the merchants let them expand their inventory massively at zero cost to Amazon. It's an incredible model.

[T]he entire thing that undergirded all parts of our economy were based on scarcity. In almost every case, that scarcity has disappeared. The way you win on the internet is you be the starting place where people go to start

You have no more constraint on how much you can buy because you can bring something ... There's no more advertising. Facebook and Google, the internet generally, there's an infinite amount of space to advertise. Now realistically, Facebook has chosen to limit how much advertising is in a feed but then stories comes along. Suddenly Facebook inventory explodes. Remember people when Google first IPO'ed in their early years, but all these folks said, "Oh, the cost per click is decreasing or cost per ad is decreasing. This is such a bad sign." It was totally analog thinking.

No, the cost decreasing is a positive signal because it shows they're increasing inventory faster than it's being consumed, which means they're actually increasing their long term upside. And, the same thing with Facebook. Facebook Stories come along. They had that earnings call a couple of summers ago and it was like, "Oh, our cost is going to go way down. These won't monetize as well." And their stock plummeted. It was like this is actually the best news about Facebook in quite a while because they were previously talking about we're going to have a constraint on the number of inventory we have because with don't want to be saturated or give users too many ads.

They suddenly created tons and tons of new inventory. That's a great signal for them. That's a very positive indicator for them. The price dropping per ad is good news, not bad news. Again, this requires the shift to thinking about abundance, not thinking about scarcity. So, users, users, now everything's ad-supported, it turns out the constrain on spending is actually lowered, too, because users can consume basically an infinite amount of media whereas they had to pay for all their media previously.

In all these cases, the entire thing that undergirded all parts of our economy were based on scarcity. In almost every case, that scarcity has disappeared. The way you win on the internet is you be the starting place where people go to start, Google, Facebook, these aggregators, or you're highly differentiated and you leverage the fact that you have zero distribution to reach anyone. Also, the internet allows drastically lower cost structures. You see this in publishing. It blew my mind last week where the Atlantic laid off a bunch of people and they have 80 writers on their masthead, and they had a staff of 350. Well, it made sense in the previous world where you had all these support functions that actually made the money, because what actually made money in publishing previously was not writing.

It was delivery trucks and distribution deals, printing presses. That's what actually made the money. On the internet, though, you actually make the money through Atlantic is shifting to subscriptions. It turns out those writers, they're no longer a cost center. They're a profit center and they're the only profit center that you have, and they need to dominate your roster of what's on there, and you have to get way more efficient on the backend in how you support them because everything else is a cost center. It's a shift in mindset about what is profitable and what drives meaningful profits in the long run, sustainable profits in the long run, and has to get away from distribution and into how do you deliver sustainable differentiation.

Future of Media Business Model

Patrick: [00:51:58] Obviously, you're doing a version of this but I'd be curious to hear your thoughts on the future of the media business model more generally speaking. You started to hint at it there, that differentiated talent, that people to get around the aggregator will seek out the absolute best writer or podcaster or video producer, whatever, on a given topic. Do you think then that that's the model, that its individual creators that go direct to consumer? Does it start to re-bundle again, as things always seem to do? What do you think about the future of media on the internet?

Ben: [00:52:30] There has to be a lot of experimentation and trying, for sure, is what I do. It's basically I write analysis about tech and media to try to win on that regard. That's honestly a really hard model. I'm not sure it's actually the best way to think about things. Differentiation does not necessarily have to be just analysis. Differentiation could be I'm going to write about this specific topic that no one else is covering ... You have to think about it being a horizontal opportunity, which lets you go very deep in a specific area. Whereas the previous publications were more broad based, future publications will be very, very narrow and they'll take advantage of the fact that their addressable market is not just New York, or it's not just the United States.

The addressable market is the entire world, and I just need to get X number of subscribers, wherever they might be, and I will succeed. One example I'm pretty bullish on and I'm waiting for someone to crack this code ... I don't know that that's been deeply tried yet, but is this idea of local journalism. I'm from Madison, Wisconsin. If I wanted to find out what's going on in Madison, I could go to the Wisconsin State Journal and it is an atrocious experience. There's ads everywhere, it's hard to find out what's going on. It's just wire stories of the national news stories, et cetera, et cetera. And, why? Why is it like that?

Because they are a newspaper that's been around for a long time. Their assumption is we need to publish something every day and we need to get content out there that we put ads next to, and the motivations on the version one media companies of the internet were the same thing. More content so we can get more ads. It turns out thought what I actually want, I just want to know what's going on. I usually go back there every summer. I want to know the news that's going on, they're building a new convention center, a new hotel is going up. What I would actually really like is someone on the ground to send me out an email every day saying, "Here's what happened today. City council did this, et cetera, et cetera."

And, if nothing happened, then send an email that said, "Nothing happened." That's actually way more valuable to me to get something that says nothing happened because I'm not looking for content to read. There's so much content to read on the internet. I don't need more content. What I'm looking for is to feel informed, and you deliver the experience of feeling informed often times by telling someone nothing here, go spend your time somewhere else, and you've actually checked that mental box. It's a total shift in mindset about what you're delivering.

Trying to sell content on the internet is a loser's game. It's bits on a screen. Zero marginal cost. What you need to deliver is a service, a service of continually making someone feel informed about something, or continually delivering analysis they find valuable. Service is something that, in the consumer's mind, is an ongoing thing. In that case, the emails that I send four days a week are artifacts of the service I'm providing of "My service to you is I'm going to think about the internet and the media and the way things are changing, and current news, and I'm going to figure out, continually shift my thinking. And oh, I'm going to deliver to you a summary of my thought process four days a week."

That's the service that I provide. If you think that's valuable, you can pay me directly. You don't need to go through Apple. You don't need to go through Facebook. You don't need to go to Google. We have a one-to-one relationship that by the way, thanks to the internet, does scale very, very, very well. I do the same amount of work that I did a few years ago but I make more money because I have more subscribers. That's me leveraging the internet, leveraging technology to make a model that was not possible previously possible.

And, oh by the way, I have subscribers in 85 countries because the whole world is my market. So many media companies view the internet as killing their business, and it did. The ones that succeed in the future, though, will figure out how the internet makes their business possible in the first place.

Patrick: [00:56:07] Seems like there's room in media for ... I'm thinking about writing here. I pay your annual fee and then I bought another one on Substack, which is an interesting platform that enables writers as creators to create these subscription business models. But then I very quickly got fatigued at constantly paying ... because the subscription rates are pretty high for Substack writers. $50, $100, $200 a year. After four or five of these things, I'm like, "Geez, I'm paying more for this than ... This is rising my list of costs pretty quickly." It seems like a great place for there to be a recollection of different writers that I could peruse. What are your thoughts there? Do you think that there are, for writing as an example, room for someone to go try to build all of the demand, which doesn't seem to have happened thus far?

Ben: [00:56:53] For sure. There's an aspect of this model that's a bit consumer unfriendly to the exact point that you said. You have to manage them all separately. You have to pay for them all separately. It doesn't scale very much with one customer. So first off, I would say the answer to that is there's a lot of people in the world and the answer to publications is to find their specific niche, such that the customers that are willing to go through the hassle and pay, and there's something that it was your second, third, fourth subscription. Then, you weren't their target customer anyway.

I think this is an aspect where people underestimate how big the internet is because I hear this subscription fatigue thing a lot. There's this assumption that there are only about 10,000 potential subscribers in the world and how much are they going to pay again and again. No, there are actually billions of potential subscribers in the world and a lot of them have different interests and care about different things. I'm a little skeptical about the big picture subscription fatigue issue as far as this model being a problem, because I think it underestimates how big the internet is.

That said, on an individual basis, for sure it's a thing. It would be better if there was a bundle. You could pay X amount and get all these great independent writers. I'm a big believer in bundles. The economics makes sense for everyone involved. The probably is how do you get from here to there? If you wanted to make a bundle of say tech analysis, I would hope to think you would want Stratechery to be involved in that. Well, for a bundle to make sense for me, the person that would not subscribe to Stratechery directly but would subscribe to the bundle, the number of those customers and their incremental value has to outweigh the value I'm giving up from my current subscribers by contributing to the bundle.

Given that I'm in a strong position, I was fortunate to be early to this space, that's going to be a very difficult proposition, which means you're probably going to have to pay me a bunch of money. And then your economics start to fall apart. You see this with Spotify. They're paying Joe Rogan a lot of money because they want him to bring his customers into what is their bundle for podcasting for all intents and purposes. So, that's just a real challenge.

What you see with bundles is despite the fact that they make sense because they're so hard to form, they usually end up forming for infrastructure reasons. A classic example here is the cable bundle, which did not form because people thought it would be a great way to make money. It formed because there were people West Virginia or something that wanted to watch broadcast TV and their homes couldn't get a signal because they're hollow in a mountain. So, they got together and they put up a big antenna and ran cable from that antenna to their homes so they could watch the Big 3 broadcast networks.

As more and more communities did this, at some point someone was like, "Wait, we have cable in everyone's home. We could put extra stuff on this cable and we could actually show things that aren't on the broadcast networks." And thus, you had community access television which came along. CATV into that transition to cable and then HBO came along and was like, "Well, what if we put satellite dishes at all these antennas such that we can broadcast one signal that is not over the air, but is actually something different. It goes to these satellites and then it plugs into the cables and goes to everyone's house."

Boom, the cable industry was born. Actually, I think TNT did it first. That's where the cable industry came from. You ended up with a bundle, but the bundle came from the fact that you needed the cable.

On the internet, where everyone has distribution, it's a lot harder to figure out what is the cable. What's the thing that holds everyone together? Maybe Substack, given the fact that everyone's on Substack, they're probably better placed to maybe make a Substack bundle. I think that's something that they hinted at and certainly would make sense in the long run. But, that goes to the point that you need a way to already have everyone in place before any one of those providers gains too much economic power such that you have to buy them off to get them in and your economics fall apart.

The Infrastructure Layer

Patrick: [01:00:37] We haven't talked at all about what I would call a layer below platforms. I think infrastructure is probably the right word, a company like Stripe or Plaid that is providing tools to all sorts of different companies. Any thoughts here from a strategic standpoint. I've seen you write less about these companies, but I'd love to hear your thought on this infrastructure layer of technology.

Ben: [01:00:59] Well, I think that that's more of a platform layer is the way to think about it, and platforms don't need to interact with the end-user. AWS, most people are using programs that run on AWS and they have no idea that they're using AWS. There was this story a couple years ago, someone going, "Oh, I'm going to try to not use Amazon and they IP blocked all the Amazon's addresses and none of their applications worked." That's a great example of AWS is a platform and that a platform does not need to interact with customers at all. It can just be the layer that stuffs just on top of.

I think there's an aspect where that's a way to think about Stripe. Stripe is a platform. Another way to think about it is it is just infrastructure and infrastructure requires massive amounts of investments to build, which provides its own natural moat, because if you want to build a competitor, Stripe has such a huge cost advantage relative to you trying to catch up that it's going to be very hard to deal with. Obviously, Stripe is taking that and trying to layer up into merchant services, into financial services, et cetera, et cetera, and I'm pretty bullish on that opportunity to do so.

It's an approach that is less about ... It's not actually at all about acquiring demand. It's about having that superior cost structure that comes from scale, and that is what gives you your moat. It's actually living at the bottom of the smiling curve, to go back to the example from before but you're dominant there because you have a superior cost structure and you have scale that lets you provide services at a way that no one can compete with. And, it lets you spend on things like superior developer tools and superior documentation, and all the things that Stripe is so great at because your cost per production of those things is lower than anyone else, because you have such a large customer base.

Patrick: [01:02:36] A company that I haven't seen you write a ton about, which I'd love your opinion on is Epic Games. They seem like both infrastructure and platform components. They've created amazing media, if you consider game to be media, interactive media, and they also seem very intent on behaving strangely and producing their own cashflow in a variety of interesting ways. They recently increased their floor from $50 grand a year before they started charging to a million dollars a year, as one example. Any thoughts on Epic as an infrastructure layer, a platform company or what it might represent in the competitive field that we discussed?

Ben: [01:03:11] I've written on them a bit. I think the gaming industry is fascinating and in many respects, a leading indicator of where things are going. The whole free to play versus free to win concept is fascinating. Free to play is you can use a game and then you'll hit a wall and you need to do in-app purchase to unlock it. That's been a dominant model on mobile and is the reason why these companies make a lot of money, whereas free to win is you can be fully competitive in the game. There's no advantage accrued from paying. The only reason you would pay is because you want a different avatar or you want different clothing, or you want decorative functions ... Fortnite, famously a different dance. A celebratory dance.

Which, have nothing to do with your ability to win, but do have a lot of ability to do with your status and sense in the game. This really taps the idea that a lot of these games are better thought of as different worlds. No one bats an eye at someone buying a luxury bag to signify their status in the real world, and if you're online and in these virtual worlds, why is it any different to buy a special dance to signify the same thing? It's not any different at all. But again, there's an insistence on the real world is different than the virtual world. The world is defined by where we are and where we are mentally, and a lot of people are spending a lot of time in these spaces, and it makes total sense that we'd monetize them in the same way we monetize in the real world.

So just broadly speaking, I think that's one way to think about it. Another way is the benefits that come from being a platform, that come from the broad base availability. From Epic's perspective ... I would imagine it comes with an engine, or those lines ... is if you have it in your game, they make all their money, all their money, a huge amount of money from the huge winners. You think about a VC model. You don't really care about the ones that have a nice outcome. Yeah, it's okay to get your money back but you're not making your reputation or raising your next fund based on someone doubling your money over five years. That's actually would be a worse way to return than just investing in Big 5 tech companies in the market.

You make your money off of the huge return, and this is the case, I think, on the internet generally. There is this returns to scale, these exponential returns, and I think that's probably a similar mindset that Epic is taking, where actually we only really want to collect money from the games that go huge, and the best way to maximize the number of games that go huge with our engine is to get our engine in more games, which means charging less up front, making it more attractive. It's the Shopify thing. The more companies that use Shopify and fail is a positive indicator for Shopify because that means they're getting more rolls of the dice at that one that hits it big.

Same thing with Epic, the more rolls of the dice, the better. Increasing the rolls of the dice is, in a world of abundance, all about increasing the rolls of the dice. It's not about your failure rate, because failing is cheap. It's often zero. It doesn't cost Epic anything. If someone uses an Epic engine and doesn't pay Epic a dime, it doesn't cost Epic anything. It's all virtual. There's no marginal cost. So, in a world of zero marginal costs, you want to increase your rolls of the dice as much as possible.

Increasing the rolls of the dice is, in a world of abundance, all about increasing the rolls of the dice. It's not about your failure rate, because failing is cheap. It's often zero.

Patrick: [01:06:13] You've talked so much about the bits and the rules of bits instead of the world of atoms and the transition between those two things. I'd love to come all the way full circle now to the future and this notion that has become popular of it being a time to build. You wrote about Marc Andreessen's now instantly famous call to action saying that this is a key time for us to make big advances that we haven't, or maybe have failed to in the last couple of decades. But it seems like a lot of that might be much more in the real world than in the internet world. I'm curious how your thinking shifts over into that part of things into the atoms rather than the bits.

Ben: [01:06:51] It's certainly a tough question, and it's striking how the responsibility for this is immediately thrust upon the tech world. The entire point of technology in many respects is this idea of zero marginal costs. The whole idea of Silicon Valley is chips, which are SAM. The idea of a chip is that you spend a ton of money developing a chip, but once you start producing chips, the chips are basically zero marginal costs. All the high price of the chips is either capturing profit or its capturing your R&D dollars and your infrastructure dollars.

In that model, we need a lot of money up front and then infinite upside on the backside. That's what venture capital is. Venture capital was formed around the economics of chip production. It turns out the economics of chip production are very similar to the economics of software production, which is you spend a lot of money building out a product or a service. Then, once people use it, it scales infinitely. For Epic to build a game engine costs tons and tons and tons and tons of money. For an additional to user to use that game engine, it costs zero.

This is the fundamental core economic and principle of technology and it's the reason why so many people get the industry wrong because they don't grasp that issue. Well, it follows though that that is a very poor model for real world infrastructure spending, which often entails ongoing costs, putting things in. Now maybe there's an asset when you build a road once and then over time ... There was a former venture capital around canals and turnpikes and things around those lines. It's not as extreme as the modern venture capital model, so that's one area where there is room for innovation. Is there room for a type of investment model that is less grand slam driven and is more of a guaranteed return, even though that absolute return might be slightly less?

I think there's definitely need for a new kind of investment model to drive that sort of thing, and maybe tech VCs can help drive this but I think VC is a very small part of the overall world. To say that VC has to take this responsibility is weird when your typical fidelity fund manages as much money as the entire US VC industry combined. There's a very weird focus on this specific sector that doesn't actually manage that much money.

Other things tech can do, though, is the work from home, distributed work thing is very, very interesting. And it's interesting not just for the implications of the companies themselves. I think a lot of companies haven't fully thought this through, and there's going to be lots of hiccups and they're projecting the experiences in a pandemic to what's going to be normal all the time, and that might not work out well. But this idea of the more that tech spreads out and is less San Francisco centric and the more there's driving competition between cities and between politicians in spreading the influence, I think we have a very positive impact.

Why can San Francisco be so poorly run while all these tech companies are there? Well, because there's no competition. They're not going anywhere so they're just in a general state of annoyance with each other, and no actual change. Well as it turns out, we see this with an Amazon second headquarters, and it's framed negatively for understandable reasons, given Amazon's wealth that, "Oh, they're seeing this cities against each other."

Well yes, in a very narrow sense. Anything that has good or bad sides, but that's a pretty bad articulation of it. But, this idea that companies should compete for workers by having better infrastructure, by having better capabilities is something that I think is an important one.

The third thing, though, is there absolutely a political aspect on this, and tech probably needs to be more involved in politics. To what extent are a lot of the most innovative people in tech because they're naturally interested in tech, or because to build a service online doesn't encounter any regulation or any challenges? They're not going through five million committees to build a road or whatever it might be. There is certainly a big issue there and just how hard it is to get stuff done in the real world. Why would you spend time doing that if you could just do stuff online and not face any obstacles? And, that's going to be a more challenging one to fix, certainly one that we need to think about broadly.

There's also, I think, more room for industrial policy. I think globalization that was unlocked in part by the internet, in a big part by the internet, but not just the internet. Also, things like 747's that could fly over the ocean and carry a lot of freight, or containers being a standardized shipping things. All those things drove towards this world of extreme efficiency that it turns out that if something hits, or there's an issue, end up one, being a problem as you're seeing currently but also shifts where the power is, and this idea that opening up to China would allow liberalism to flow from the west to China. Well, it turns out it's a two-way street and Chinese authoritarianism can flow out where they are demanding a NBA GM be fired because of something he said on Twitter, which is supposedly banned in China.

What are we doing here? If China wants to ban Twitter, that's fine. Now they're reaching into the US to say what we can or can not do. That requires a collective response, which is a government response which may be industrial policy to encourage production. If not in the US, maybe in the west broadly. It's funny because it's like the Trump administration on one hand, good to stand up to China. On the other hand, it'd be much more cogent to meanwhile be forming deals with your allies, with Mexico, for example. We should be trying to make Mexico into the next China. There is clearly not a holistic thought about this, but it is certainly I think good generally that we're taking steps in that direction. But, there should be lots of pieces and it's not just tech's responsibility but tech can probably do more as well.

Patrick: [01:12:18] Over the years covering so many different companies, what company have you learned the most by investigating?

Ben: [01:12:24] It's a tough question to answer, so I'll go with the one that popped in my head right away, which is Netflix and the way that they shifted their strategy over time. In every step, they have made shifts that increased their embrace of internet assumptions, if that's a way I can put it. Starting out with DVDs and no more late fees, well that is an idea of unhooking from infinite inventory and also time is no longer a constraint. Then, shifting to buying the catalogs from other folks. Well, when they bought that catalog from Starz famously, what was interesting is there was I think 11,000 movies in that catalog. The effective number of movies on Starz was what? Which is whatever was showing on the Starz channel.

Whereas the effective catalog size on Netflix was 11,000. They actually immediately had a superior product on a new dimension that never even occurred to Starz because they're thinking internet assumptions and you could actually stream things. Then, the shift to acquiring first buying shows that they owned, but then producing their own shows. All of these are predicated on this idea of zero marginal cost, the power of scale, being able to stream to the whole world with no increased cost. In every step, they've been ahead of their competitors and their suppliers and have gotten superior deals because they understand how the internet works in the way that's fundamentally flipped so many assumptions on their head.

Patrick: [01:13:48] My closing question for everybody is to ask you for the kindest thing that anyone's ever done for you.

Ben: [01:13:53] The one that pops in the head, I think I've told this story on another podcast before, was when I first started Stratechery, I had been doing it for a month or two before I reached out broadly because I wanted to have a bit of a catalog there. I'm a big believer that for a publication, the most important story you write is the second story someone clicks on. People can write one good article, but if they go to your site and say, "Oh, this is a good article," and they start clicking around, if the second article they click is also really good, they're like, "Oh, wow. Maybe there's actually some degree of consistency here where I should be connected to this."

I had this in mind. I didn't want to send my site off to someone with one article on it like, "Oh, please read my book." Well, there's one article here. Is this actually worth my time? So anyhow, a few months in, I emailed a guy named John Gruber, who does Daring Fireball, mostly folks on Apple, and someone I had respected a lot. He had been independent since the mid-2000s and I always looked at as that's what I want to do. I want to be an independent writer on the internet. It'd be great.

I reached out to him and said, "Hey, I read a new site. You should check it out." Listed a few articles. Didn't hear anything back. Maybe a month later, I got an email from him pointing out how I misused a word. He gave me the etymology of the word, "Oh, I used to make the same mistake. I actually made a shortcut so it would auto correct itself." Et cetera, et cetera. And, that was the end of the email.

But, people who know who John Gruber is, this is a very unsurprising email to get from him but I figured, "Oh, he's probably going to link to a piece to it. It's going to be very exciting." Well, he didn't just link to a piece. He actually wrote a full article. In the beginning, he's like, "Oh, this is the best new blog I've seen in years. Read this article. Read this article." Glowing praise. And then at the end, he says, "But for the first time, I disagree with Thompson." Then, he spends 1000 words saying why I was wrong about something.

That endorsement, at the time I had about 500 Twitter followers just to use as a metric. I went from 500 to 1500 overnight. Since then, I have 140,000 more but it's been just a slow and steady progression. As far as a step change goes, that was by far the biggest and that is really what kick started the site. I've always been deeply appreciative and grateful for that. Funny now, six, seven years on, we actually just started a new podcast ... I do Stratechery, obviously, which you're aware of, four days a week. You can consume it either via email, which is the way it's always been, or via podcast which is a new offering.

Me and John are actually doing a new podcast three days a week, 15 minutes per episode, just to explore what does it mean to monetize a podcast, so it's subscription only, which is a new idea. But it's cool that he did this great favor for me and now seven years later, we get to do something as equals. It's very gratifying in that regard.

Patrick: [01:16:25] I love the bookends of the stories. Such a neat concept, and so many of these answers are about helping somebody early on in their career or their project, or whatever it is, and I love that example. Thank you so much for your time today, Ben. I learned a huge amount from your writing over the years. I've been trying to get you to do this for years. I'm glad that we waited because there's so much more to talk about. I really appreciate your time, 12 hours ahead on the other side of the world. I've loved the conversation and I love your writing. Thank you.

Ben: [01:16:51] Well, thank you. I appreciate it and I'm a big fan of the podcast, and it's a real honor to be here.

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