Samsung’s predicament

In the past year, Samsung went from being a moderately successful electronics manufacturer to the leading non-iOS mobile device maker. Together, Apple and Samsung earn 98% of the profits in the smartphone market. MG Siegler echoed a common sentiment when he wrote that Samsung is now the “fifth horseman” of tech, alongside Apple, Google, Amazon, and Facebook.

The mobile device industry is still in its infancy. Samsung’s fate depends largely on how the industry evolves. If the computer-in-your-pocket (smartphone/tablet) business ends up being like the computer-on-your-desk (personal computer) business, Samsung is on track to be the modern Dell. Dell had a good run as the low-cost provider in a highly commoditized business, but the vast majority of the industry profits went to Microsoft.

So the big questions for Samsung are:

1. Will the smartphone/tablet industry stratify the way the PC business did? 

The dominant view is that technology markets inevitably stratify. Clay Christensen is the most sophisticated proponent of this view. In his theory (more here and here), every tech market eventually “overshoots” the needs of its customers, at which point the benefits of horizontal specialization outweigh the benefits of vertical integration.

A minority view, held mostly by Apple faithful, is that Christensen et al are guilty of over-theorizing. Apple lost the PC business simply because, when Steve Jobs was fired, they stopped innovating. When Jobs returned, Apple started gaining PC market share again. In this view, the future mobile industry structure mostly depends on whether Apple management is innovative enough to keep making superior vertically-integrated products.

2. If the industry stratifies, will the lion’s share of the profits go to the OS and application layers as it did for PCs?

Generally, technology businesses that are defensible have network effects, and network effects usually arise from products with significant software components. Samsung’s competitors like HTC are just one hit product line away from stealing Samsung’s position. Eventually, handset designs will converge and, as happened in the PC market, consumers will stop paying premiums for performance improvements (arguably, this has already started happening). The OS and apps layer, on the other hand, are very hard to replicate. If you invest enough money you can usually build or acquire decent software, but it takes more than just capital to build a vibrant developer ecosystem (just look at Microsoft).

Samsung’s predicament is: their current strategy succeeds only in the scenario where both (a) the industry stratifies, and (b) significant profits flow to hardware. Samsung seems to understand the improbability of (b), which is why they’ve been hinting at throwing serious support behind a new OS. Getting traction with a new OS will be difficult, to put it mildly. Google and Apple have vastly more experience making software and a huge head start with developers. Moreover, Google’s strategic position is even stronger today than Microsoft’s was in their heyday. Google makes so much money from web services (mostly search, for now) that they can afford to lose money on handsets and OSs indefinitely – a very scary fact for Samsung and everyone else in the mobile hardware business.

Regulatory hacks

A common way to think of business regulations is by analogy to sports: the rules are specified up front, and the players follow the rules. But real regulations don’t work that way. Regulations follow business as much as business follows regulations.

Sometimes the businesses that change regulations are startups. Startups don’t have the resources to change regulations through lobbying. Instead, they need to start with regulatory hacks: “back door” experiments that demonstrate the benefits of their ideas. With luck, regulators are forced to follow.

Nextel was one of the all-time great regulatory hacks. In the late 80s and early 90s, the FCC’s rules banned more than two cellular operators per city. As Nextel’s cofounder said, “the FCC thought a wireless duopoly was the perfect market structure”. Nextel (called Fleet Call at the time) circumvented these rules by acquiring local (e.g. taxi, pizza truck) dispatch radio companies, which they then connected to create a nationwide (non-dispatch) cell phone service.

Predictably, the cellular incumbents tried to regulate Nextel out of existence. From a 1991 New York Times article:

In a move that could threaten cellular telephone companies, the Federal Communications Commission may decide on Wednesday to grant a small radio company’s request to provide a new form of mobile telephone service in six major cities, including New York. If the request is approved, the action could inject new competition into the industry. At the moment, Federal rules permit only two cellular systems to operate in any city. But the new proposal could open up a regulatory back door, allowing companies that provide private radio service for taxi fleets and delivery services to offer mobile telephone services to individuals…. The proposal has alarmed the industry, which has heatedly opposed it and enlisted support in Congress late last year to delay the F.C.C.’s decision.

The incumbents argued that Nextel’s service would interfere with public safety frequencies and therefore endanger the public. They also argued that Nextel’s service would be too expensive:

Some analysts contend that the radio handsets for Fleet Call and its imitators will be more expensive than cellular units. The technical features of cellular equipment are now standardized nationwide, making it possible to bring down costs through higher selling volumes. Specialized mobile services are currently different in each city.

And their call quality would be inferior:

Some analysts contend that Fleet Call’s local service is likely to be inferior as well. “It is highly unlikely to be as good as cellular service,” said Denise Jevne, telecommunications analyst with T. Rowe Price Associates in Baltimore.

The FCC eventually decided not to block Nextel. Nextel grew to become a top five US cellular operators before it was acquired by Sprint in 2004 for $35B. Their service turned out to be cost-competitive, high quality, and safe. The only thing endangered were the incumbents’ profits.

What Nextel faced in 1991 is very similar to what many startups face today. Uber is being threatened by the taxi industry, Aereo by the TV broadcasting industry, and Airbnb by the hotel industry. Some industries, like finance, are so heavily regulated that almost any new idea runs into regulatory objections.

Of course regulations that truly protect the public interest are necessary. But many regulations are created by incumbents to protect their market position. To try new things, entrepreneurs need to find a back door. And when they succeed, it will all look obvious in retrospect. Today’s regulatory hack is tomorrow’s mainstream industry.

 

E-commerce startups

Very few successful e-commerce companies were started in the 2000s. Since then, e-commerce startups have enjoyed a revival. Dozens of companies have gotten traction and venture dollars have followed. Phrases like flash sales, social commerce, and subscription commerce have entered the startup lexicon.

As Josh Kopelman points out, the list of the top 15 e-commerce companies has barely changed over the past decade, in sharp contrast to the list of overall top internet companies. This can be interpreted in one of two ways.

The bull case is that startups neglected e-commerce and are now waking up to the opportunity. The key equation driving e-commerce is: profit = lifetime customer value minus customer acquisition costs. New marketing strategies (“content plus commerce”, social commerce, etc) lower acquisition costs enough to make startups competitive with incumbents.

The bear case is that scale and brand effects make e-commerce incumbents nearly unbeatable. As one entrepreneur said, “If it has a UPC code, Amazon will beat you.” A lower price is just one search away. The only way to compete is to sell used stuff or make your own products (or provide a marketplace for those things). The fat head (large incumbents) and the long tail (artisanal shops) will thrive, but the middle of the distribution will suffer. (The public markets seem to agree with this assessment, e.g. Overstock trades at 0.2x revenues.)

What most people agree on is that e-commerce as a whole will continue to grow rapidly and eat into offline commerce. In the steady state, offline commerce will serve only two purposes: immediacy (stuff you need right away), and experiences (showroom, fun venues). All other commerce will happen online.

The default state of a startup is failure

If you are starting a company and wondering why nothing good seems to happen unless you force it to happen, that’s because the world wants to stay the way it is. Customers, partners, and most of all incumbents don’t want to think hard, try new things, or change in any way. The world is lazy and just wants to keep doing what it’s doing.

A friend of mine got a job at a big company and was shocked to see his colleagues worked just a few productive hours a day. They didn’t seem to care about their work or have relevant expertise. My friend said: “Wow, this company is going under.” Then the company released its quarterly reports and profits rose to an all-time high. The momentum of the company’s brand and relationships was sufficient to propel it forward.

On the flip side, first-time entrepreneurs often fail to realize that when you build something new, no one will care. People won’t use your product, won’t tell people about it, and almost certainly won’t pay for it. (There are exceptions – but these are as rare as winning the lottery). This doesn’t mean you’ll fail. It means you need to be smarter and harder working, and surround yourself with extraordinary people.

The default state of the world is to stay the way it is, which means the default state of a startup is failure.

Incumbents die due to irrelevance or ineptitude

Judging from the tech press, you’d think the biggest risk to successful companies is competition. But when you examine the history of technology, incumbents usually decline because the world changes and they lose relevance, or because they lose visionary founders and the organization decays. Some examples:

– Dell thrived when PCs dominated the computer market and Dell was the low cost provider of commodity hardware products. The shift to mobile and tablet computing meant that hardware quality (not price) was once again the primary basis of competition. As a result, Dell’s laser-like focus on cost reduction became a liability.

– The New York Times was, for many decades, one of the few premium channels through which brand and classified advertisers could reach mass consumers. Thus car companies and real estate brokers subsidized foreign reporting and investigative business journalism. The internet provided a vast alternative channel, and the Times became far less relevant. At the same time, the internet provided many new sources for breaking news, editorials etc, hurting the Times on the subscriber side.

– Yahoo didn’t lose because Google out-competed them on search. They lost because they didn’t really care about search – indeed, they outsourced algorithmic search to Alta Vista, Inktomi and then Google itself. The leading portals back in circa 2000 (Yahoo, Excite, Lycos etc) desperately wanted to keep keep users on their site – the buzzword was “stickiness” – but Google knew better and focused on getting users off of Google to other places on the web. Yahoo became just another place to read celebrity gossip and use generic web services.

– Netflix thrived when they could simply ignore the movie companies and rely on the first-sale doctrine to get DVDs. The market shift to streaming video created a new and brutal dependency. They had to go make deals with content companies. Now they are even trying to create their own content to lessen this dependency. They have a brilliant and visionary management team but this is a tough transition to make.

– Sony relied on its Steve-Jobs-like founder, Akio Morita, to repeatedly develop incredibly innovative products (among them: the first transistor radio, the first transistor television, the Walkman, the first video cassette recorder, the compact disc) that seemed to come out of nowhere and create massive new markets. Since he left, the company has floundered and the stock has fallen dramatically.

– Google’s biggest risk isn’t a direct competitor. Startups and incumbents who’ve tried to create better search engines have barely cut into Google’s market share. Google’s primary risk – and they seem to know this – is that they are no longer relevant when people find content through social sites, and where an ever increasing portion of the web is uncrawlable.

Google released their “Dropbox-killer” a few days ago. I don’t know if Dropbox has yet achieved incumbent status, but they certainly seem to be the market leader. They also seem to have a very competent management team. So if history is a guide, Dropbox’s biggest risk isn’t a competitor but irrelevance – if, for example, files become less and less important in a web services world and Dropbox doesn’t adapt accordingly.