The Amazing Amazon

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Some companies are simple to analyze. Their business models are straightforward, customers are easy to identify, and products clearly distinguishable. To the deep chagrin of analysts, Amazon is not this type of company. 

Amazon went from having Sales of $511k in 1995 to $2.76b in 2000. Fast forward to 2014, Amazon's Sales were roughly $90b. I have no doubt Sales will continue to grow in the future, but the question is just how fast? In percentage terms, Sales growth seems to have slowed since 2011, and has been declining since. This is a normal trend as a company matures, so it's nothing to get preoccupied about, but is nonetheless worth noting. Wall Street adores Amazon because of its unrelenting growth, and any significant slowdown may hurt Amazon's stock price. 

Not much to add here except that Gross Profit continues to grow as a result of Sales growth. 

This next chart is where things get a little more interesting. The Gross Margin percentage restates Gross Profit on a percentage of sales basis to give us a little clue how profitable Amazon is as a business. After a period of plateau from 2003 - 2011 where Gross Margin hovered around 22-24%, it started to lift off in 2012 reaching 25%. Since 2012, it continued to grow to 27% and 29% in 2013 and 2014, respectively. 

I wanted do some more digging on why Gross Margin increased, so I took a deeper look into Amazon's financial statements. In Accounting-speak, here is Amazon's statement on the increase in margins (emphasis mine):

Gross margin increased in 2014, compared to the comparable prior year periods, primarily due to service sales increasing as a percentage of total sales. Service sales represent third-party seller fees earned (including commissions) and related shipping fees, digital content subscriptions, and non-retail activities such as AWS, advertising services, and our co-branded credit card agreements.

There is a lot to take in there, so let's break it down one by one. The first statement I bolded was that margins grew primarily due to service sales increasing. Amazon makes money from two primary sources: 1) product sales and 2) service sales. Products are the physical goods Amazon delivers (clothes, diapers, granola bars) as well as their digital media (video). Services include Amazon Prime (Amazon takes the $99/year subscription and allocates it between products and services such as video/music), Amazon Web Services (AWS), seller fees (Amazon charges you for selling on Amazon just like eBay), advertising (Amazon.com has ads), co-branded credit cards (you can purchase credit cards on Amazon, for which they take a cut). Since Amazon stated margins grew primarily due to services sales, we know where growth may come from in the future. To narrow it down even further, I suspect growth will come from Amazon Web Services (AWS) at an increasing rate (Apple, for example, uses AWS to host many of its iCloud services).

Percentage of Sales

Operating expenses are growing in real-terms, but decreasing on a percentage basis. Around 70% of these expenses are Cost of Sales, which is as expected. 12% are Fulfillment, which is basically delivery of goods. 10% have to do with Technology and Content, which encompasses the licensing deals Amazon has to pay for the TV, movies, and music it provides with Amazon Prime. 5% of the expenses are Marketing (have you seen their Kindle commercials? They are terrible). Finally, the remaining 3% include General and Administrative and Other expenses, which is nothing in the grand scheme of things. 

There are two types of people in this world: those that think Amazon will never be profitable, and those who think Amazon can turn profitable as soon as Jeff Bezos flips a switch. I think we need a third type of person in this binary world who will say Amazon can turn more profitable, but not necessarily be extremely profitable. Amazon is not exactly a high margin company (perhaps AWS will be as it becomes an increasing part of Amazon's business), so quickly scaling it profitability will be tough. I did a quick calculation that may interest you: since 1995, Amazon made $2,441,872,000 in profits. In other words, after 20 years of being in business, Amazon made roughly $2.5 billion in clean, unadulterated income. Of course, this is because Amazon reinvests most of the money it makes back in the business, but the statistic is nonetheless fascinating. 

Coda

If you saw me walking on the street, ran up to me, and said "Larry, what do you think about Amazon", I would tell you I don't know. Amazon is difficult to form an opinion on because it's like trying to predict the behavior of a human being, which in this case is Jeff Bezos. On the whole, people act entirely rationally, and a smart person makes mostly good business decisions (expanding from selling books to products to services and now AWS is what a smart person would do). But even the best of us make strategic blunders sometimes, which can either set us back a little or totally ruin the company (the Amazon Fire devices are just setbacks - why do they exist again?) The best person to ask about the future of Amazon would probably be Bezoz's psychiatrist rather than an analyst. 

The Future is the Present, and the Present is the Past

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Over the long-run, technology moves at a lightning pace. But at times, it can feel downright dilatory. If you asked me in 1998 if I would still be using paper textbooks in school, I would say there is no way. We’re about midway through 2015, and textbooks are still the norm (in university, at least). If you told me in 2005 that scrolling through an 800-page PDF would be slow on a relatively new laptop (late 2013 rMBP), I would have politely called you a cynic who needs to look up Moore’s Law. And yet, these are the realities we have to deal with. Sometimes moonshot products are revolutionary and change the world. Most of the time though, they are early arrivals and short guests. There are, however, some technologies that arrive right on time and make it to dinner. Here is a short list of technologies I believe will succeed in the next 20 years. 

1: Usable Voice-Input

Dictation technology is not new. As far as tech goes, it’s ancient. For voice-input to be truly useful, it needs to do 90% of the job a secretary would otherwise do. Take nearly flawless notes. Schedule and re-schedule meetings with contextual awareness (“John called in sick today, we will need to reschedule to 5pm tomorrow”). We’re still far away from an AI with human empathy, but not so far away from great voice-to-text+a little more input. 

2: (Semi)-Self Driving Cars

They already make cars that will alert you from switching into lanes with another car nearby, or breaking for you. It’s still a luxury feature, and it still doesn’t do enough. I can see a future where cars will park themselves, but not drive themselves. Hence, (semi)-self driving cars. What we really want is cars that are totally self-driving, but that is farther than 20 years away. Why, you might ask? Well, it isn’t a technology issue, it’s a trust and safety issue. 

For self-driving cars to become a thing, they not only have to be safer than human-driven cars (being as safe isn’t enough), but they have to be viewed as safer. There’s a subtle difference: how safe a car actually is versus how safe we perceive it to be. Air travel is a safer method of travel than automobile, and yet the perception it is more dangerous. This perception of danger is based both on reality and fiction. In reality you’re thousands of miles in the air and not in control (the pilot is, hopefully). In a car, you’re on the ground and totally in control (in reality, you’re texting or listening to music). Self-driving cars need to tackle both reality and fiction to become the mainstream, which is why they will be (semi)-self driving for the next few decades. 

3: Stream Everything

Without being too much of a curmudgeon, I’ll say that I grew up in the golden era of Blockbuster and local mom and pop video shops. Sometimes you had to wait a week or two until the movie you wanted to see was back in the store and available for rent. It was glorious and it was miserable, all at once. As a result, there were a lot of movies I wanted to watch but ended up skipping just because of the friction of getting it on VHS.

A bit later, we were introduced to downloadable movies and music, which were mostly available through iTunes and torrent software like LimeWire. This was an improvement over VHS and DVD, but you still had to download the content to watch it (and it could take anywhere from 30 minutes to 3 days to download). Once again, the friction was tugging. 

Now we’re at the point where streaming is king. Netflix, Hulu, Spotify, Beats, HBO…every content producer already offers streaming, or is planning to at some near point in the future. Still, there are some holdouts. AM/FM Radio is still popular among certain demographics. Podcasts are becoming increasingly more popular, but still not popular enough to be labeled mainstream. What’s more is that podcasts are still mostly downloaded through iTunes or your favorite podcast app (I shuffle between Pocket Casts, Overcast, and Castro at least twice a year). This will change soon. Podcasts will become radio, and radio will be streamed. Some radio stations already offer podcast versions of their shows (NPR, Bloomberg Radio, and many more), but I’m sure most people still listen through traditional means. Cars will be equipped or be more easily parable with smartphones in order to stream shows and music in 5–10 years (I’m talking about mainstream here, not luxury $40,000+ cars). 

4: Virtual Economy

The fiat dollar was one innovation that spread like wildfire. The next natural step is a wholly virtual economy. Apple Pay, Google Wallet, Square Cash, Venmo, and the hundreds of other payment apps already make physical currency irrelevant. But again, they’re all technologies used by technocrats, and not the mainstream public. Most stores still don’t accept mobile payments, although this is changing rapidly. I expect to see mobile payments for shopping to become totally mainstream (75%+ adoption) within five years. We’ll be going to supermarkets without our wallets and only with our phones/smartwatches/future wearables. Paying at the pump will be a similar ordeal. I can already go into Walgreens with only my Apple Watch to buy a bar of soap and some Colgate toothpaste, but not all companies are as forward looking. That’s why I’m giving them five years to catch up. 

I wrote about the state of financial technology (fintech) a few months ago, which includes the aforementioned payment apps in the previous paragraph. In this next one I’ll talk about the virtualization of investing. There’s a huge amount of startups that will take your money and invest it for you in diversified portfolios. In the old days, you had to schedule a lunch meeting with your broker to discuss the performance of your stock portfolio. A little more recently, you would have had to at least pick up the phone and give them a call. Now we’ve got apps like Wealthfront, Betterment, and Robinhood that promise to provide you with the same performance through well-designed mobile apps that are powered by complex algorithms. The metric used to gauge the popularity of these companies is Assets Under Management (AUM), which in English means how much client money they’re actually holding. Thus far, these robo-advisors are still a small percentage of the total investment base, but it will undoubtedly increase in the future as traditional investing companies make robo-advisor services of their own (Charles Schwab and Vanguard already started offering their robo-advisors services). 

Unlike mobile payments, however, robo-advisors and other investment vehicle (investment vehicle - doesn’t that sound great and important?) services will take longer to propagate. Most people are extremely conservative with their investments. After all, these are your life savings that we’re talking about. These robo-advisor startups will need to tackle the psychology of investing before they make any other breakthroughs. For this reason, I’m guessing it will take five-ten years for them to truly become mainstream. 

5: Educational Shakeup

This one bothers me a lot. I would be more willing to accept the theory of survival of the fittest as it applies in business if not for the for-profit education industry. I was sure that by the time I entered college, all textbooks would be all in digital form. But here we are, four years later, and printed textbooks are still in final, dominant form. Some publishers offer digital versions of their books, but the interface is such an atrocity that I would rather buy a printed copy of the book. Of course, some students are mischievous cheapskates and find older PDF versions of the book from undisclosed sources in unidentified locations - sources familiar with the matter tell me this is the case anyway.

Online classes are popular now, but you’ll be hard-pressed to find a student to tell you (honestly) that they’re actually academically helpful. The material may mirror that of a regular class, but watching pixelated low resolution videos of PowerPoints narrated by monotonous voices makes me think we can do better. Interactivity is key. You should be able to click items on the video to see annotations, practice problems with clear step-by-step explanations, and be able to contact the teacher at any point during the lesson as you would in a normal classroom. Some online learning websites got this right, but they’re not degree-bearing institutions so how much do they really matter at the moment? Most people I know use and love Khan Academy, but until you can get a valid bachelors degree from these institutions, their value is capped to a minimal amount. 

Academia moves notoriously slow, so I will have to place an educational revolution farther on the timeline: 15–20 years. That’s when colleges will offer fully featured online classes that replicate the in-class experience. Alternate/Virtual Reality technology may help with this, but at the end of the day it’s time that does the innovation in the educational milieu.

6: Drones

Full disclosure: I’m not very qualified to talk about drones because I follow the topic only lightly, but I have a hunch that it will be meaningful sometime soonish in the future…five-ten years max. My reasoning is simple. You look at drone technology and you can just tell how much can be done with it. Construction, photography, travel, military, espionage, delivery…these are all applications that immediately come to mind. The major obstacle for drones will be government regulation. The drone companies that traverse regulation well will succeed. Those that don’t will fail. 

Coda 

This isn’t a comprehensive list. It’s a list of bigger items that I think will be breakthroughs in the coming two decades. There will undoubtedly be disruptive technologies that I have missed, but that’s because they’re impossible to predict with any certainty (see a technology palm reader for that). Hopefully this site will be around in 20 years for us to grade my scorecard.

Goodwill and Innovation

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How can you gauge how innovate a company truly is? Is there a metric that comprehensively measures the innovative capacity of a company? It’s a loaded question, I know. 

There are many ways analysts look at the innovation that comes from within a company using their spreadsheets as lorgnettes, but none of the metrics alone answer the question. You can look at cash flows from investing activities to see what assets a company is purchasing to develop future products. You can look at revenue and income growth, which encompass the affects of innovative products and services. Or you can take the holistic view and see how the actual products and services compare to those of competitors (is the Apple Watch innovative compared to the Pebble, Galaxy Gear?). There are probably hundreds of other metrics you can look at, but watch out, don’t get bit by analysis paralysis. 

I decided to take a different approach to gauge the innovation index of a company - one you will not find in textbooks. My approach is simple (Excel bravura seems to be a major trend among analysts. I’m a strong believer the less complexity your financial models contain, the more accurate they are). I’m looking at goodwill on the companies balance sheets and the age of the company. Divide goodwill by age (in days), and you get goodwill acquired per day. The higher the goodwill per day, the more acquisitions a company engaged in over the years. Usually, acquisitions mean external innovation rather than internal innovation, since by definition you are hiring people from outside your company.

If you’re not aware of what goodwill is, don’t worry, we will cover that now. When a company buys another company, they will often pay a premium for the other company. In short, that premium is goodwill. The accounting behind goodwill is rather complex, but I think an example will greatly simplify the idea for you. When Apple acquired Beats, they paid $2.6B for the company. Of this, $2.2B was goodwill. Try to imagine the assets of Beats. They might of had some cash on hand, maybe some accounts receivable, some office space, a few company cars, and a bunch of headphone inventory. They probably also had a good amount of debts in the form of accounts and notes payable. If you add all of the assets, and subtract the liabilities, do you think Beats would be worth $2.6B? Of course not! In other words, Apple paid $2.6B for something that is worth around $400M (net of liabilities). In accounting, everything has to balance. The difference between the price you paid ($2.6B) and the net price Beats is worth ($400M) is goodwill. In this case, Apple added $2.2B ($2.6B - $400M) of goodwill to its books. For the accountants reading, I know this is a gross simplification of goodwill calculations, but work with me here! 

So why does goodwill matter? Well, because it’s essentially external innovation. You purchase innovative, external companies to generate income for you in the future instead of generating it internally with your own employees. There’s nothing wrong with that. In fact, acquisitions are a way of life in some industries. But it’s always better to innovate from within when you can. Normally, older companies tend to start amassing goodwill as they become more bureaucratic, larger, and as a result much slower to innovate. In contrast, younger companies are less bureaucratic, much smaller, and can move fast and break things more easily. They also tend to have much less cash on hand to make the acquisitions in the first place. With all that out of the way, let’s take a look at a few goodwill charts using my simple method. 

For the chart above, I picked a few well-known companies to see how much goodwill they carry on their books. As you can see, IBM and Microsoft lead the way. IBM has been around in some way or another for over a hundred years, so it’s no wonder their goodwill is almost $30B (goodwill can be “impaired” and written off the books, so this $30B is everything that wasn’t written off over the years). Similarly, Microsoft and Intel also accumulated high amounts of goodwill over the years as a result of many acquisitions. Unlike the ancient tech giants, however, Facebook has not been around for decades, and yet it leads the pack in goodwill. This is mostly due to the WhatsApp acquisition, which contained $15.3B of goodwill. It’s also worth pointing out that neither Tesla nor Netflix have any goodwill, which is because they haven’t purchased any companies. In other words, all of their innovation comes from within the company. Finally, look how low the goodwill of Apple is, despite it being older than Microsoft (more on that later). 

This chart is where the interesting stuff begins to appear. The simple goodwill metric I was talking about it evidenced here. While it’s by no means a perfect metric (all metrics have flaws), it attempts to show how much innovation is developed internally versus externally. Goodwill is displayed by the light blue line, while Days Since IPO is shown on the navy bar chart. As you can tell, IBM has been around the longest, and also has the highest amount of goodwill. Next on the list is Microsoft, which is relatively old, but has goodwill that is disproportionately higher to its age (look how much higher goodwill is compared to the age of the company). Intel developed most of its technology internally, since the light blue goodwill line is inside the Days Since IPO bar. I won’t detail every company on the chart, but here are some the caught my eye.

Amazon develops most of its stuff in-house. Relative to the age of the company, Amazon’s goodwill isn’t too high, which means that Amazon hasn’t made many acquisitions. Google has goodwill that is higher than the age of the company, which tells us a lot innovations made by Google were purchased from external companies. For a large and old company, Apple has a remarkably low amount of goodwill. Crazy low, in fact (it would be even lower before the Beats acquisition, which was one of the largest goodwill acquisitions Apple has ever made). In English, we know this means that almost all of Apple’s products and services are developed internally without the help of external purchases. Since its IPO in 1980, Apple has been able to innovate incredibly well. Facebook, by stark contrast, has a goodwill that is literally off the charts, compared to its age. Of course, this is mostly because of one major purchase (two if you count Instagram). Since Facebook is such a young company, it is too early to tell how innovative it is internally, but the data so far suggests it is not. 

There isn’t much to say about this chart other than it’s interesting, but not as insightful as the previous two charts. I divided the total goodwill of each company by its age to get Goodwill Acquired Per Day. Again, look how small Apple’s goodwill compares to the other tech giants (IBM, Microsoft, Intel, and Google).

Finally, I took the goodwill and divided it by the total assets of each company. While this is a deeply flawed metric, it does attempt to communicate a powerful point: the percentage is how much a company relies on external innovation (see the caveat emptor below for more disclosures before relying too heavily on these metrics). 43% of Facebook’s assets are goodwill - crazy! In contrast, only 2% of Apple’s assets are goodwill. 

Coda

What I like about these goodwill charts is that they confirmed what I always suspected. It’s best to compare the companies as a cohort. IBM is in its own cohort because it’s by far the oldest company. Intel, Microsoft, and Apple are the next oldest cohort. All of the other companies are the third, and youngest cohort. Feel free to make as many cohorts as you like - my only advice is to make a cohort in the first place because it would be foolish to compare IBM to Facebook (IBM has over 100 years on Facebook!). Just to provide an example of how this could be done, let’s take the second cohort of Intel, Microsoft, and Apple. Their goodwill as a percentage of total assets is as follows: Intel 12%, Microsoft 12%, Apple 2%. Judging by the much lower percentage Apple holds, you can draw the conclusion that Apple makes less acquisitions and thus develops more innovations internally. Intel and Microsoft, on the other hand, are just about equal in their reliance on external acquisitions. If you want to beef this metric up, I would even recommend you make a historical comparison of goodwill for these companies just to see how write-downs have impacted goodwill over the years. 

Caveat Emptor

Before any critics start commenting on this post, allow me to point out the major flaws of this goodwill metric. First, it uses goodwill as of the most recent balance sheet date. This means that if any goodwill was written off in prior periods, the charts above will not factor that in. Next, there is no weighting for the age of the companies. It would be most interesting to compare all of the companies as if they were the same age (Apple at 2 years old, Microsoft at 2 years old, Facebook at 2 years old, etc) so that we see how goodwill compares relative to the age of each company. I wasn’t able to find financial records dating that far back for the older companies, granted I only checked EDGAR archives and could probably find them with more time (perhaps in a future post). More caveats still - goodwill can be the result of overpayment. Finally, it’s a valid argument that goodwill does not imply a company is not able to innovate internally. Perhaps a company with a large amount of goodwill acquired many companies, but nothing innovative came out of them, and instead, the innovation came internally. This is entirely possible, but I cannot measure that in a spreadsheet. There are many more flaws to this metric, but it still gives us an interesting look into goodwill. I recommend adding it to your arsenal of metrics to gauge a company by.

Chart Dump

Apple Watch and the Hierarchy of Needs

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You will agree, my voracious reader, I am not a product reviewer. For this very reason, I mostly refrain from publishing any reviews of products I have purchased. That isn’t to say I don’t have strong opinions about those products (ask my friends, they will attest), but simply that I do not publish them on this site. Let us leave the reviews to our more adventurous writers. Instead, we aim here to understand the hidden complexities that are not often talked about in the contemporary technology and business press. On today’s agenda - the Apple Watch. 

As you so astutely recall, I have written about a few scenarios the Apple Watch can take upon its entering the market. For your convenience, I have summarized those scenario below:

1) It can flop, and Apple will abandon efforts.
2) It can be a semi-successful product like the iPad.
3) It can be extremely successful like the iPhone. 

Well, as of last week, the Watch became available for preorder, as well as up for display at your nearest Apple Retail locations. Of course it is still too early to tell which scenario the Watch will take, but as of most recently, I have thought of some additional complexities that will undoubtedly affect the success of the Apple Watch. 

The Watch, and the Hierarchy of Needs 

In a 1943 paper titled A Theory of Human Motivation, Abraham Maslow proposed a psychological theory called the Hierarchy of Needs (HoN), which aimed to describe the patterns of motivation us humans go through. Like any psychological theory, the HoN is imperfect and met with heavy criticism. Despite this, it is still commonly taught in most psychology classes and remains as well regarded as a theory may be. For your double-fold convenience, I have reproduced Maslow’s hierarchy below.

With this hierarchy in our retinas, let us begin to answer some questions. First, where do we think smartphones belong (note: there is no wrong answer, only more correct answers). If you asked your writer, he would answer that smartphones started at the peak of the pyramid (“Self-Actualization”), but have descended one level down to “Esteem”. As you descend down the pyramid, the importance of each step grows until you reach “Physiological” needs such as food and water. We cannot live without those items, making them of the utmost importance. Smartphones started at the top of the hierarchy because their utility went from little to great; their impact on our lives followed the same trajectory. 

It is still possible to live without a smartphone, but increasingly, that life is not worth living. I jest, of course, but the importance and value of the smartphone in the life of the average human continues to grow with each new iteration. Deviation from the “Esteem” step, on which I currently place smartphones, leads to helplessness, a lack of respect, and to weakness. Imagine traveling to a new country without a smartphone. Most likely, you would get lost - Helplessness. Alternatively, what if someone told you they don’t have or cannot afford a smartphone? Would that person be given the same respect as a smartphone owner? Lack of respect. Finally, picture yourself doing a group project for which you need to Google something. Without a smartphone, you are helpless. Weakness. 

If you are thinking these examples are cruel and not perfectly symmetrical to the real world, you would make a solid argument. But it is impossible to deny the rise of the smartphone in our daily lives, and its downward descent on the hierarchy of needs. 

Are you hungry on the day the Dow Jones Industrial Average hits its peak for the year? Probably. What about on the day it falls eight percentage points? Still, you’re probably hungry. And if the market totally plummets, leading to a full-fledged depression. Still, you have to eat. Maslow’s HoN shows that the physiological and safety needs must always be met; the alternative is death. For this reason, companies in the business of selling food, water, and shelter are not as hard hit by the impacts of the economy. This is in stark contrast to companies in the business of selling luxury items such as cars, clothing, and perfume. The hierarchy of needs allows us to gauge the relative importance of these products in our lives, and how the economy and human tastes will affect them. The lower the product is on the hierarchy, the less affected it will be. 

Let us circle back to the iPhone for a minute, which sits on the second to last step. In the case of a market downturn, do you think consumers would still purchase smartphones? Well, you might say, it depends who the consumer is and how bad is the market crash. Your answer would be precisely right. The rich and less affected would still upgrade their phones every year, as would the working middle class, since they would probably require the smartphone for work. It is entirely plausible, however, that the less fortunate, poorer demographic would eschew upgrading their phone this year. If things get really bad, they might even cancel their contract and go without a smartphone. And since the smartphone is on the second step, esteem, it would be hit less hard than the products at the top of the pyramid, self actualization. It isn’t too hard to imagine a future where smartphones will descend further down the pyramid, into love and belonging, and thus be further insulated from any market movements. 

Finally, we have arrived to the point of discussing the Apple Watch, and where we think it fits within this hierarchy. We can quickly dismiss the Apple Watch from the physiological, safety, and love/belonging steps, since it is not necessary for survival, safety, or belonging. That leaves us with esteem, and self-actualization - the least fundamental needs a human being requires. As you recall, I placed the iPhone on “Esteem”, which is the second to last step. I now ask you to pause and think for your own, omnivorous reader: where do you think the Apple Watch belongs? Once you’re done, return your gaze here and let us continue.

If you placed the Watch in the “Esteem” tier, you expect to be provided with the same value, utility, and prestige as the iPhone. Otherwise, you chose “Self-Actualization”, placing the Watch on the top tier of the hierarchy - a tier which supposedly results in the realization of a person’s full potential (who knows what that means, exactly?).

Despite the cryptic definition of “Self-Actualization”, your dear writer believes the Watch fits in this tier. The utility and cultural value of the smartphone reaches far wider than the smartwatch (at this time); in most developed nations, you will not find many people without a smartphone. The Watch, as it exists today, is a luxury item assembled for prestigious wrists. It is a fashion statement just as much as it is a fashion accessory. The value it provides is ancillary to the value of the iPhone. Alone it does little. If you’ve got food in your fridge, a house and a spouse, respectful co-workers, and a smartphone, the Watch is the last remaining step to your actualization. It does not come before those items, however.

If you feel philosophically enlightened from our discussion of the hierarchy, I hope too you will also feel logically and realistically liberated soon. Given our placement of the Watch in “Self-Actualization”, it is the least critical element to our existence. As such, it is a product that is least insulated from market movements. If an economic disaster were to strike, the Watch would be the first product to have its sales hurt. Therefore, the future success of the Watch is heavily correlated with the movements of the economy; when the economy slows, Watch sales will slow. When the economy speeds up, Watch sales will follow. 

The Watch, more than any other product in Apple’s portfolio, sits highest on the hierarchy of needs. It is simultaneously the least fundamental and the most desirable product a person can dream of. Consequently, Apple Watch sales will be predicated upon the buying power of consumers - which itself is derived from the economy - more than any other product Apple has recently released. And that, my friends, is as close to a product review as I will come to.

Strategies for Beats

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It has been quite some time since I wrote about Spotify and Beats, so let’s briefly step aside from the automotive and tech posts and into music. Some fairly important news got lost in the Apple Watch shuffle last week — music labels aren’t willing to go below $9.99 per month for music streaming. The most interesting information is tucked away in the last paragraph of the Billboard article (emphasis mine):

There’s also an element of geopolitics at play. A weakened Spotify could help create a more powerful Apple subscription service. That would remove the comfortable, valuable counterweight to Apple that labels don’t have in the digital download space. There’s even some doubt that Apple is out to beat Spotify rather than grow the music subscription marketplace. “If they’re out to kill Spotify, it’s news to us,” says an industry source. "And it’s the last thing we want. We want Spotify to be a strong competitor.

Spotify is king when it comes to music streaming — it has around 15M paying subscribers, and 60M free users. Probably the most important variable to Spotify’s growth is that it allows you to use the desktop apps for free, which is always the preferred option. Spotify is available in most countries and practically on every platform. It was also one of the first entrants in the play-on-demand business (Pandora doesn’t allow for this), which undoubtedly gave it a first-mover advantage in terms of total users. 

Unlike what smartphones have become today, music streaming is a luxury that not every person needs. Therefore, the total market size for paid-for music streaming is quite limited. Although Spotify + Rdio + Deezer + Rhapsody have much more room to grow their paying subscribers, that growth is slowing down. The best way for Beats to grow is either to convert existing iTunes users into paying subscribers (a challenge made even harder if that user is already paying for a competing service), or to steal market share away from Spotify/Rdio/Deezer/Rhapsody. The best way to steal market share would be to offer Beats at a lower monthly price ($7.99), which reports suggest Apple has tried to do and failed. The music industry doesn’t want to make the same mistake as it did with iTunes, which allowed Apple to become a monopoly on music sales. The more competition exists, the more bargaining power the music labels have over steaming services. Since it is unlikely Apple will convince the labels to a lower price tier, Apple must find a different way to grow the Beats brand into the next iTunes. Here are some strategies I would advise Apple to partake with Beats (preferably more than one):

#1 Take the hit

Just because the music labels won’t go lower than $9.99 doesn’t mean Apple can’t. There is always the option of taking the difference ($9.99 - $7.99 = $2) as an expense, thereby subsidizing users. It’s doubtful that existing users of Spotify/Rdio/etc will be enticed purely by the features of Beats, which might be less expansive (compared to the competition) when Apple’s redesign of Beats goes live. A user of Spotify myself, I’ve been extremely impressed with the latest updates to their apps (ample gesture support, song lyrics, and the overall design aesthetic), and I can’t imagine the first version of Beats to be as fully fleshed out. Although features themselves won’t entice users to switch to Beats, a slightly lower price of $7.99 surely will. Finally, it’s worth pointing out that most of the existing streaming services offer a 50% student discount, effectively making the monthly price $4.99. I use this discount, and I know many other friends who do the same. Beats doesn’t currently offer any student discount, but they will have to if they want to reach the price-conscious college age audience. 

#2 Exclusives

There is a new Kanye West album coming out later this year. What if Beats were able to snag it as an exclusive for the first month, thus having it before all of the other streaming services get it. That would be a very powerful value proposition, and one only Apple can negotiate. Of course Kanye wouldn’t be the only artist Beats would have exclusive rights to — they should negotiate similar exclusivity rights for as many artists as possible. If you knew that your favorite artists new album will only be available on Beats for the first month, you sure as hell would consider switching to Beats. It should be noted that these type of deals are expensive and difficult to negotiate, but Apple has money, and money talks. 

#3 Preinstalled with hardware

Apple has complete control over the hardware and software of its products. Just as the the music app is bundled with all devices, so should Beats. The Beats app should come preinstalled on the iPhone, iPad, Mac, and the Apple Watch. This will serve two main purposes. First, it will cement the brand name. Most people aren’t as familiar with Beats music streaming as the Beats headphones, mostly because the service has done very little promoting of itself. Coming preinstalled with Apple hardware would certainly fix that. 

Deriving from this first benefit of being preinstalled on hardware is the second benefit — increased usage of Beats. If more people are aware of the Beats music service, it is logical to assume more people will use it. Where these users come from doesn’t matter; it may be those uninitiated to any music streaming service, or those switching from Spotify/Rdio/etc. 

#4 First-party advantages

As the software chieftain of its products, Apple can use API’s not available to 3rd party streaming services. You don’t need to search too hard to find miffed developers complaining online about their apps not being able to using the same API’s Apple uses in its apps. These API’s are locked from 3rd parties for safety and privacy reasons, but they allow for many functions regular apps simply cannot do. It’s still not clear how Spotify will work with the Apple Watch, but I imagine the limitations will be plentiful. For one, the Apple Watch comes with 8GB of storage, but only 2GB are available for storing photo’s and music, with the remaining 6GB used to store the OS. Perhaps the Spotify app will be limited to offline storing of only 2GB of music on the Watch. Meanwhile, the Beats app will allow for more, since it will be graced with Apple’s first-party stamp of approval. This is all conjecture, of couse, but you can bet that Apple will use 1st-party API’s to allow for more features that 3rd party apps can only dream of. 

Précis

I have many more ideas for what Apple should do with Beats to make it overtake the other streaming services, but we can leave that novella for a later time. The four strategies I have listed above are the most vital to the success of Beats. So vital, in fact, that I don’t think Beats will succeed unless at least two of the four options will be chosen. Realistically, options 3 and 4 will be implemented by Apple, mostly because they come with no additional costs. I do not think, however, they will be enough to convince people to switch to Beats. To steal market share from the other music streaming services, options 1 and/or 2 should be chosen. They will likely cost an additional few hundred million per year, but I think those costs will be indemnified by the goodwill they generate, and the influx of new, paying users. 

For next week, we will continue our automotive industry discussion by comparing the unit sales of the major automotive manufactures.

If you have anything to add, or just want to share your meandering thoughts about what we covered, please comment below! I’m also very active on Twitter, so don’t hesitate to @lsukernik me!