Early Indications - July 2007

From Programming to Programming

In the past ten to fifteen years, many barriers between traditional industries have broken down. We're in the early stages of another big, blurry brawl, but to set some context, here are a few examples and data points:

-Entertainment and computing now overlap in many significant ways. According to Neilsen, Americans between eight and thirty-four spend more time gaming than watching television. Globally, computer gaming has become about a $30 billion industry, compared to worldwide box office receipts of about $26 million in 2006, which was an all-time record.

-Telecommunications and media are battling into each other's territory. Cable television and voice providers, as of 1990, were separate and distinct. By 2000, cable providers led telecoms, in North America anyway, in Internet access. Starting early in the decade, the cable providers have gathered significant share (approaching thirty percent in some markets) of the wireline voice market, but as gained back some share in Internet access. In the next five years, look for telecoms to provide television content; Verizon has announced Fios1, a "hyper local" channel in the Washington, D.C. area. A recent study by Motorola found that forty-five percent of Europeans, led by fifty-nine of the French, watch some TV over the Internet. Cellular telephony is shaping up as the next media platform: Japanese phones routinely include television tuners already, and growth is expected to be rapid in many areas of Asia.

-Retail has been redefined along several dimensions. The U.K. grocery chain Tesco punches far above its weight in petrol sales: with only four percent of the retail locations, it has captured over twelve percent of the market, lagging only BP, which controls nearly seventeen percent of the market, but has three times as many locations. Here in the U.S., it's hard to believe that Wal-Mart expanded from general merchandise into the grocery business less than ten years ago, but it controls at least twenty percent of a highly fragmented market. eBay, which began as a secondary market, now also includes many new, branded goods from established sellers. Our focus today, however, is on a different "invasion" of an adjoining market. Ten years ago, when investors were looking for "the next Microsoft," they held certain assumptions about what a highly successful software company looked like:

-Winners choose the right platform, picking well according to the market size and share of the hardware on which the software, of whatever sort, runs. IBM's OS2 operating system in the early 1990s had some technical advantages over Windows, but IBM never established the application layer which would make its OS competitive.

-Winners develop mechanisms for user lock-in and network effects. Word processing programs stand as an obvious example, where switching is hard and expensive, and it makes sense to be on the same product as all of your co-workers.

-Winners manage upgrade cycles efficiently: that locked-in user base will eventually have to buy the new, improved version, delivering a major revenue infusion to the software seller and perhaps the wider ecosystem.

-Winners sell software to large customer bases one consumer or one business at a time. This reality of the market implies effective management of brand, retail channels, and enterprise sales forces.

-Winners care about software functionality and performance; data as it is generated or managed by the application falls out of scope.

-Winners hire strong technical teams because functionality is specified early in the new product development cycle and must be hard-coded into the package.

-Winners think of the world in rows and columns. Whether in calendaring, spreadsheets, databases, project management (swim lanes), presentation graphics, or customer contact management, most programs of the 1985-2000 period deeply embedded a grid metaphor and/or architecture.

Times have changed. Whether one looks at Google, a clear challenger to Microsoft's dominance, or at the new crop of companies all seeking to ride the "web 2.0" bandwagon, many of these assumptions about software no longer hold true. For example, in a survey of twenty-five startups to watch compiled by Business 2.0, fully twenty had revenue models at least partly based on advertising. Greatness in software now requires a lot of the old world skills and positioning, plus a healthy dose of some new elements as well.

To set some context, look at some familiar companies listed by market capitalization and price/earnings ratio as of 19 July:

Company Cap P/E

Microsoft 301B 23
Oracle 105B 25
SAP 67B 26
Disney 68B 16
Time Warner 78B 13
Google 171B 48
Yahoo 35B 51

Ten years ago, anyone looking for "the next Microsoft" probably would not have looked to Viacom or Disney as models. And for good reason:  the role of "pushed" content is itself in transition. Yet the core of the media model -- the packaging of audiences for sale to advertisers -- is fueling growth at Google, presenting both technical and cultural challenges at Yahoo, and the source of deep concern among Microsoft's top leadership. The changing of the guard is further emphasized by Microsoft's experience with the most recent exemplar of old-school software, its Vista operating system. The product shipped three years late, with a stripped-down feature set, and effectively cost several senior executives their jobs: Brian Valentine, Jim Allchin, and, to a degree, Bill Gates. It also has yet to sell in large numbers, in part because enterprise buyers are waiting for the first updated release, when many of the first-run glitches will be addressed.

What are the emerging dynamics for software dominance? Compared to the standards for success circa 1997, a few factors have been inverted while most still hold true, with a twist.

Platforms

Rather than developing for Unix, Windows, Mac OS, Symbian, set-top boxes, and a variety of other operating systems, Google and Amazon have led the way toward development of services for the Internet as a platform. Among other things, this stance greatly simplifies product distribution: the differences between Google Maps and my 1998 version of Rand McNally's Windows package are striking. Every time a new road is built, or interstate exits renamed, or a pedestrian mall built, millions of CDs become obsolete. Google (or NavTeq or whoever) makes one change to the base map and every subsequent query will be addressed with accurate information. Getting the platform right still matters, but the definition of the term is changing from local to virtual, solitary to distributed, and product to environment.

Lock-in

This aspect still concerns financial analysts, particularly because switching costs can be so low. If I change from Yahoo Finance to, say, Fidelity's investor workbench, apart from my investment in the old interface, there's very little to restrain me from leaving. Tim O'Reilly, who helped formulate the very notion of Web 2.0, asserts that users own their data in these sorts of scenarios, but the exceptions to his assertion prove that Web 2.0 is hardly the last word. My eBay reputational currency, iTunes preferences, and Hotmail account are neither open nor portable -- by design.

Network Effects

There's no question that successful software still exploits network effects. The more developers who code to a given platform -- Facebook, Salesforce, or Google maps -- the more that standard gains authority: note that none of those aforementioned businesses counts as a Web site. One of the platform pioneers powerfully illustrates the point perfectly: Amazon just noted in its earnings conference call that it has 265,000 developers signed up to use its Web services. There are also powerful network effects among users, whether at eBay, MySpace, or BitTorrent: the more people who use the service, the more valuable it becomes. Compare that one fact to consumer products, banking, automobiles, or pharmaceuticals, and we are reminded how significantly online dynamics depart from those of widget business or even most of the service sector.

Upgrade (and therefore revenue) Cycles

No longer is the objective to leverage a large installed base onto a new version of the product. Google makes money every hour of every day, and apart from acquisitions, we don't expect spikes in its revenues. Indeed, the escape from the cyclicality of product upgrade cycles may not yet be fully appreciated as analysts assess the new breed of software companies. The dependence of shrinkwrap software companies on secondary revenue streams may become problematic: Larry Ellison noted in an interview with FT last year that Oracle was getting ninety percent margins on maintenance. Customers can't be, and aren't, happy with those economics, so it is likely only a matter of time until competition and/or customer resistance change the model. To what, nobody can say.

Selling Software as a Product, One at a Time

On July 19, Google reported quarterly revenues of $3.87 billion, a year-over-year improvement of fifty-eight percent. Did its sales force grow by sixty percent in a year? I highly doubt it. Although the company offers a few software products a customer can purchase, they amount to mere drops in that $15 billion annual bucket: enterprise search hardware and software, hosted applications, GIS tools. An important facet of the (lowercase) software as a service trend is that in an increasing number of cases, users don't have the software on their own devices, but access a server, its location irrelevant, to get something done. As a result, the customer base (of advertisers) is dramatically smaller than the user base, delivering favorable sales force performance metrics.

Accordingly, software distribution channels are being completely reinvented: the old goal used to be to get your product onto a shelf and/or catalog page at Computer City, Egghead, or Micro Warehouse. Note that all of those businesses are defunct, another indication of deeper change in the industry. In a related development that sheds further light on a complicated situation, PC Magazine subscriptions have dropped from 6.1 million in 2003 to 4.8 million.

People Buy Features and Performance

There's a wonderful video that embodies this thinking perfectly: enter "microsoft ipod" into the YouTube search bar. Microsoft apparently produced this spoof internally, illustrating the trend toward "speeds and feeds" in stark contrast to Apple's aura and powerful design sense. Just run down the standard old-school software questions in regard to Hotmail or Mapquest:

-What is the recommended processor?
-How much free disk space is required?
-What is the minimum memory required?
-How many transactions per second can the application handle?
-How fast can the application render/calculate/save/etc.?

The very mention of these former performance criteria in regard to the most successful "applications" of our time highlights the discontinuity between where we are and where we were. It's critically important to note that the path from Lotus Organizer or the original Encarta to Basecamp or Wikipedia involved a step-function change rather than evolutionary progression.

Hire the Best Technical Team

There's no question that high-caliber architects and developers matter. Look at the arms race among Microsoft, Amazon, Google, and Yahoo to hire the giants of the industry: Gordon Bell, Brian Valentine (see above), Adam Bosworth, and Larry Tesler, respectively, only begin a very long list. But the outside-in dynamic of user-generated content also allows such sites as del.icio.us or Grouper (now Crackle) to thrive. In these kinds of businesses it's certainly imperative to get top-flight operations and data-center professionals, no question, but these folks are of a different breed compared to the breakthrough innovators of the caliber mentioned above.

Quality is Built from the Inside Out

This area is tricky. Certainly the core application functionality and engineering need to be built into the base architecture, as eBay discovered a few years back. But no longer is the internal team the only resource: many of the best businesses balance internal and external talent, Amazon being exhibit A. In contrast, efforts built on pure volunteer collaboration, such as the Chandler PIM and Mozilla browser, have been outpaced by commercial ventures. It's also worth reiterating that Apple runs a very closed shop very successfully: the iPod and iPhone feel antithetical to the Web 2.0 mantra. It would appear that in this regard, as in many others, several successful paths remain available.

Rows and Columns

While I don't want to oversimplify and assert that value has migrated from nodes to links, the fact remains that the structure of business, personal connections, and information is looking much more like a spider web than a library card catalog. As scholarship from Rob Cross at Virginia and others has illustrated, informal networks of personal contacts, once exposed, often explain a corporation better than the explicit titles and responsibilities. More recently, Mark Anderson at Strategic News Service has connected some of the dots around Google and Apple, at both the board level and elsewhere, contending that an ecosystem is taking shape to challenge Microsoft. At the engineering level, the very concept of social networking behind Twitter, flickr, and the Dodgeball startup scooped up by Google represents a departure from a conventional relational database mentality.

Calling this a trend would be premature, but the corporate architectures at Microsoft, Google, and Apple mirror their varying approaches to the market. Apple's share price includes a healthy dose of respect for the management ability of Steve Jobs, in that particular context, to both envision and execute. Conversely, the achievement of Google, with the jury out on the model's staying power, may lie in leadership's balancing of individual brilliance at different layers of the hierarchy with financially realistic corporate objectives. Finally, Microsoft appears to be working hard to define an emerging management model as the founding generation hands off to new COO Kevin Turner (from Wal-Mart) and CTO Ray Ozzie, long ago at Lotus.

While it certainly includes a substantial element of buzzword-mania, the shift from rows and columns to graphs -- whether in software architecture (cf. Metaweb), business model (Facebook), or management structure (Linux still matters here) -- merits watching for several reasons. First, the combination of cheap and (remotely available) processing, effectively infinite online storage, and functionality tuned to these realities means that graphs are required to handle the sheer scale of available data. Second, the ability to map and model networks allows their structures to be better understood and utilized.

Finally, social groups get larger than could be managed in an unconnected world -- according to a recent survey of 18,000 people conducted by Nickelodeon, MTV, and Microsoft, "Globally, the average young person connected to digital technology has ninety-four phone numbers in his or her mobile phone, seventy-eight people on a messenger buddy list and eighty-six people in his or her social networking community." This requires both new ways to understand social connections and tools with which to manage them. To underscore this shift, the North Carolina Attorney General announced earlier this week that MySpace just ceased hosting pages for 29,000 known sex offenders.

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Taken together, these tendencies are reshaping the software business: programming (as in putting content together) has joined programming (as in coding) as a core competency for many kinds of businesses that fall in the gaps between computing and media. The fusion also shakes up conventional media, as we have noted earlier. The purely push-based media model, used to advertise things primarily for largely unmeasurable brand impact (unmeasurable at the level of the ad, particularly), is being challenged by viewers and readers who want more participation in both the experience (what used to be called consumption) and the process (formerly known as publishing or content creation). The YouTube-CNN debates feel to some extent like a gimmick, but they appear to be a harbinger. As blogs, social networks, and professional content get further jumbled, as Rupert Murdoch seems to be intent on doing, the business models of media, software, gaming, and transport will continue to feel the effects.