November 2009 – Andreas Goeldi's Blog

Google’s Attempt at OS Disruption: Doing It Wrong?

Chrome Yesterday, Google finally showed off some of the details of its new Chrome operating system. The new OS should be available by Q4 2010. Google most likely didn’t show everything that will be in the final product, but it’s safe to assume that the basic concepts will stay the same.
Some things turned out as previously expected: Google’s OS fully revolves around its Chrome browser, is extremely web-centric and will be based on Linux and other open source packages. But there were also some surprises: Chrome OS will only be available on special hardware that is compliant with Google’s specifications. It will not support traditional hard disks and not run any locally installed applications outside of the browser. Chrome OS devices will not do everything that a PC does, but they will be cheap and easy to use.

This sounds like a fairly typical disruptive strategy (see Clayton Christensen’s books). A new entrant (Google) tries to disrupt the incumbents’ (Microsoft, Apple) business by offering a significantly cheaper and simpler product that will only appeal to the very low end of the market. Over time, as the new product category gets better, the incumbents’ products retreat more and more into the very high-end of the market, increasingly losing relevance.

The big question is of course if Google’s approach has a serious chance to disrupt the OS market. There’s more than enough reason for skepticism.

First of all, the OS is not a major cost point anymore at the low end of the PC spectrum. According to some sources, A Windows license only adds $15 to $20 to the price of a netbook. It’s unlikely that people will go with a very limited OS just to save a few bucks on a $300-$400 purchase. Disruptive price points have to make a 5x-10x difference to really move a market. Witness the fate of Linux-based netbooks. After a few months, the whole netbook market moved to Windows XP, because most buyers were willing to pay the difference for a more familiar OS.

Secondly, Google’s vision of a purely cloud-based computer (everything in Chrome OS is stored in the cloud, the local storage just serves as a cache) could turn out to be too cutting-edge for the low end of the market. In order for this to work, you need a pretty fast broadband connection and you have to understand and trust the concept of storing your digital stuff on somebody else’s servers. I’m not sure that most consumers are really comfortable with that just yet.

Finally, there’s little reason to believe that the incumbents couldn’t offer a stripped-down version of their OSes for low-end machines in order to defend their market. Microsoft has already been toying with the idea of a limited Windows 7 version for netbooks, but did not release it after complaints from its OEM partners. Apple is rumored to work on a tablet device that probably would run a stripped-down version of Mac OS X and could compete with web-centric netbooks.

It seems fair to say that Chrome OS will likely not succeed as a traditional, straightforward disruptive product in the PC OS space. But Google probably hopes for a much bigger, much more fundamental shift. Most people today have a primary computer that they spend most of their computing time on. The massive shift from desktops to laptops in the consumer market over the last few years shows that people want to take their primary machine everywhere, and that makes a lot of sense in the traditional model of personal computing. However, the increasing availability of cheap web-capable devices (like netbooks, smartphones, tablets, even game consoles) could potentially break this 1:1 relationship between user and PC. The more people get used to accessing the Internet from a variety of devices, the more they will want to seamlessly access their data from any of these channels. The consequence is that people will move more of their data into the cloud, and local storage and applications will lose much of their importance.

Chrome OS is probably a bet that prices for web-enabled devices will drop far beyond today’s $300-$400 netbook price point and that people will have not one, but several of these devices that they can use interchangeably for most (though not all) of their computing needs. Google is not trying to win Microsoft’s game. There will be no new PC OS war. Google is trying to start an entirely new game, where it could easily turn out to be the dominant player from the outset. Or to put it another way: Google is probably not interested in a short-term disruption of Microsoft’s dominance, but in winning the next game — which it hopes to be a fundamental shift in how people use computers.

The only problem is that nobody knows yet if and when this game will take place. Dominant designs in technology, like today’s PC, can be pretty hard to displace. Remember the Segway? Looked like a great idea, a fundamentally new way to provide transportation, much more efficient than the tired old car. But it didn’t go anywhere because people tend to be happy with a “good enough” solution that they already know, even if it’s more expensive and complicated. And that’s why Chrome OS could turn out to be the Segway of computing in the end. Maybe today’s PCs are just not flawed enough to open an opportunity for an entirely new approach. Time will tell, but Google is certainly not fighting an easy battle here.

Virtual Goods: Scam, Fad, or The Next Big Thing?

The idea seems strange at first: Do people actually pay real money to buy virtual “stuff” that only exists in an online game or on a social networking site? Virtual goods, the latest hype in the world of digital business, can take on many forms: digital flowers that you can send to your Facebook friends, better weapons and equipment for online games, or a new outfit for your Second Life avatar.

According to some estimates, Facebook could make about $75M in revenue this year from virtual goods. Social game maker Zynga is even bigger in this space, with most of its estimated $250M in sales coming from the game add-ons it sells to its users. The total U.S. market for virtual goods could reach $1 billion this year. But that’s almost chump change compared to the Asian market, where one Chinese social network alone apparently sold $1B in virtual goods last year. Chinese authorities now even have to regulate this exploding sector.

So why would anybody in their right mind pay hard-earned money for something that is basically just a pile of pixels? Well, most probably for the same reason that makes people pay $450 for a regular pair of jeans just because it says “Gucci” on the label: To impress other people.

It’s no secret that people spend more and more time online, be it on social networking sites, playing online games or even in virtual worlds like Second Life (which is doing better than most people think) or teenage girl hangout IMVU. Online interactions with other people (under real names or nicknames) are an increasingly significant part of many people’s lives. And obviously, the natural need to define your social status carries over into the online world.

Most of these online platforms have managed to establish something like a social hierarchy that strongly depends on virtual status symbols. If you want to be cool in Second Life, you need to own a fancy island and have a nicely equipped avatar, which will cost you a bunch of “Linden dollars” (you can get that virtual currency for real U.S. dollars, of course). If you want to avoid being humiliated by a monster in an online role playing game in front of your virtual friends, you’ll need good weapons, which are available for cash. Oh, and all these annoying “Mafia Wars” and “Farmville” updates that you get on Facebook? Just shows you how many of your friends are already trapped in one of these games. And yes, they’re probably spending money on that stuff.

It’s easy to see why platform owners like virtual goods: Margins on this stuff are amazing. Once the software is written, the costs are minimal. And for that reason, the idea of virtual goods spreads to more and more platforms. For instance, Apple now allows iPhone developers to sell virtual “things” right inside an app.

Probably nobody will claim that virtual goods will make the world a better place, but people get what they want, and sellers make a killing. So everybody should be happy about this rapidly growing new market, right?

Well, there is a dark side to the virtual goods market. First of all, some game vendors don’t make their users pay directly for all goods. Instead, people can sign up for “offers” (e.g. a Netflix trial subscription) and get some in-game currency in return. The problem is that many of these offers are scams or at least use unscrupulous business practices like hidden subscription sign-ups. After getting a wrist slap from TechCrunch, Zynga and other game makers just announced that they will police their vendors more strictly and weed out questionable offers.

The other problem is that almost all virtual goods just work inside a particular game or platform. That’s a restriction that is even more extreme than the hated DRM of digital music which allows you to only play your (legally purchased) music on compatible devices. What happens if you get fed up with a game? In some cases, you can sell you virtual goods, but that’s not always possible. Even worse, if the game company goes bankrupt, you probably lose your “investment”. But the most significant problem is that platform owners can suddenly change the rules. Second Life maker Linden Labs for instance banned virtual banks in its system a while ago, costing several people very significant amounts of money. It’s therefore not surprising that some governments are already considering to regulate virtual currencies and virtual goods markets.

We will probably see quite a bit of growth in virtual goods over the next few years. But the real danger for this market is probably none of the issues mentioned above, but the possibility that people simply could lose interest after a while. To some extent, most forms of virtual goods have the typical characteristics of a fad. It’s a frequent cultural phenomenon that large groups of people spend a lot of money on a seemingly pointless (or at least not particularly remarkable) product or activity, just to lose interest after a few months. Not surprisingly, virtual goods are most popular with very young people, a target group that is particularly susceptible to fads of all kinds. Remember Tamagotchis? Virtual pets looked like THE next big thing at the time. Now they’re just embarrassing.

The economic problem with a fad-driven business is of course that fads are entirely unpredictable. There are entire industries (like the toy industry) that try to produce fad after fad, but it’s very difficult to consistently come up with something that will take off in the mass market. It’s therefore really hard to build a sustainable business on this foundation. That’s bad news for investors and startups in this sector.

So there are good reasons not to believe the hype, even if some industry analysts already provide the usual hockey-stick growth curves. For instance, Piper Jaffray predicts that the global market for virtual goods will grow from $2.2B this year to $6B in 2013. Maybe so, but almost all analysts overestimated the growth of social networking revenues a few years ago. And just to put things in perspective: $6 billion is a big number, but for Google, this would just be a nice single quarter of ad sales. And for Microsoft, it’s less than half a year of net profits.

(Picture: Ivan Walsh, CC license)

Google enters the GPS market: Internet-based disruption on steroids

One of the greatest — or, depending on you perspective, nastiest — effects of the Internet is that it tends to drive prices to zero in almost every market it touches. This effect has been extensively described in books and countless blog posts, so there’s little need to reiterate all the many well-known industry cases (in news, music, movies, software, etc.).
However, almost every week brings a new example of dramatic price erosion through the power of the Internet. The latest case: Google now offers a free turn-by-turn GPS navigation application on Android smartphones (and, subject to negotiations, probably soon on other platforms). Until now, the established vendors charged more than $100 for applications with the same functionality. Poof, there goes another profit pool.

Why can Google do this? It now owns all the necessary map data thanks to its Street View project, and reusing this wealth of data for another application is very cheap. Giving away the navigation software probably won’t cost Google much in incremental costs, since it’s already giving away the entire smartphone OS anyway. Of course Google hopes to make money in the only way it really excels at: Through advertising, in this case built-in ads in the GPS application.

Tough luck for TomTom, Garmin, Navigon and all the other vendors of GPS products, right? They will just need to adapt and match Google’s business model. Well, unfortunately, they will have a hard time doing that. Only TomTom owns a maker of map data, but probably can’t easily afford to just give this data away, because it doesn’t have an unrelated source of profits the way Google does. Things look really bad for the other vendors, because they have to buy their map data from external providers. The only company that could match Google’s free offer is Nokia, which bought map data provider Navteq a couple of years ago. But Nokia has no experience selling advertising, and it’s increasingly losing momentum in the smartphone market.

This case shows very nicely how whole industries can be turned upside down without warning by a new player who leverages the Internet to completely change the economics of a market.

Let’s recap: Google takes advantage of

free distribution of its software (the app will simply come pre-installed on smartphones or can be downloaded)
free marketing (no need to convince people to use a free, pre-installed app)
free support and maintenance infrastructure (software and data updates will be distributed through the wireless data plans that smartphone users already pay for — at no cost to Google)

The missing link that prevented anybody from offering a free GPS app so far was the map data. And Google is in the unique position to have collected the necessary data (at least for the United States) for its Google Maps service. This huge effort has probably already been paid for by the local ads that Google shows in Maps.

Of course there are still years of life left in the traditional GPS device market, since not everybody owns a smartphone and Google still has to overcome obstacles with data availability. But the writing is on the wall: Another fundamentally disrupted market, with incumbent players that soon will fight for survival.

History shows that no business is ever really safe from disruption. But the Internet with its particular economic characteristics speeds up disruptive processes and makes them much more dramatic. The classic case studies of disruption show how disruptive competitors enter a market with products that are less sophisticated than the “state of the art”, at much lower price points. This over time forces the incumbents to offer simpler, cheaper products (if it’s not too late by then). But having somebody come into your market who simply gives away a sophisticated, in some aspects even superior product for free is an entirely different matter.

Sure, Google cross-subsidizes its new GPS service heavily from its traditional business. It will probably not make money from this product for years, if ever. It’s a long-term bet and an investment into a whole ecosystem. The fundamentally important point is that this kind of extreme strategic move is only possible in the digital world, and only thanks to the ubiquity of the Internet, which provides nearly free distribution. The marginal costs of digital goods are very close to zero, and this enables an entirely new set of deeply disruptive strategies that most managers (and academics) have probably not even begun to understand.

If you sell a product or service that can be replaced by an entirely digital product or service, all that is needed for a fundamental disruption is somebody who is willing to invest some money into the initial development of such a product. The money can come from an existing profit pool (as in the case of Google) or from investors who believe that there could be profits in the future. The barriers to entry are extremely low in almost all digital markets, and the speed of disruption can be breathtaking. Just ask a newspaper executive.

The characteristics of digital markets attract competitors who behave irrationally in the short term (by putting money into a free, profitless product) in the hope of somehow winning control of a market in the long run. The low barriers to entry (thanks largely to free digital distribution) make many digital markets look very disruptible and hence attractive to potential disruptors.

Unfortunately, once a player gains significant market share and starts to make profits, it will attract other competitors with similarly aggressive strategies. The result is almost constant disruption, which makes it hard to ever build a consistently profitable business. Commoditization is of course nothing new and happens in the physical world too. But the clock-speed of Internet-based disruption is much, much higher. Remember, just two years ago, MySpace looked like the unassailable king of social networks. Then it got replaced by Facebook, which burned through $716 million in capital to build its current position and is still not profitable. It’s safe to assume that somebody with even deeper pockets and/or better ideas could eat Facebook’s lunch in the near future.

This increasingly frequent pattern will have pretty profound consequences. For instance, the traditional venture capital model is built on the assumption that a tech startup can achieve a strong market position and profitability within 4-7 years and is then ready for a major exit, preferably an IPO. The attractive past returns of venture funds were fully based on this model, not the profitless “Please, Google, buy us” model of most Web 2.0 startups. But when even very well capitalized, market-leading startups have trouble reaching profitability before yet another disruptor attacks them, the whole system of tech investments as we know it breaks down.

Are there any strategies that protect a company against this kind of disruption? There are probably only two: One is to have extremely strong platform-based lock-in effects, as in the case of Microsoft Windows. For most businesses, switching from Windows to even a free OS like Linux would be so costly that it’s almost impossible to justify. However, this is not the same as having just some superficial network effects, which are often weaker than expected. Facebook is not safe from disruption just because a lot of people have built their friend lists on it. Yes, that is a network effect, but the decline of MySpace shows that it’s not a very strong protection against a better competitor. Building a deep lock-in is very difficult. Apple and Amazon are trying to do this for digital media, but their lock-in doesn’t look nearly as strong as Microsoft’s.

The other strategy is to consistently be at least as good as all competitors and invest heavily into a protective ecosystem. Google is of course the poster child for this strategy. No company so far has come up with a search engine that is really significantly better than Google’s. And through services like Maps, Gmail, Google Docs, Wave etc., Google is slowly building a network of small lock-in effects that collectively can build a pretty strong wall against attackers. The free GPS app is of course part of this plan, because Google wants to play in most parts of the mobile Internet market in order to defend its core business against competitors.

But it is clear from many recent examples that the Internet will change how we think about competition, strategy and business plans. And this change will probably be more fundamental than we think.

(Picture: Erik Charlton, CC license)