Growing Users Without Growing Profits

A number of popular companies with great products or services don't seem to make much money or are losing money; some of these are closely held, making it hard to determine the extent of losses. These companies include: Uber, Tesla, Amazon, Twitter, and Evernote.

I use Uber, Twitter, and Evernote regularly -- they're invaluable to me. Yet these companies apparently lack the pricing power needed to acquire users, grow sales, and generate/grow profits.

Investors satisfied with profitless sales growth seem to be banking on speculative, undemonstrated pricing power. Many investors believe these companies can turn a profit -- and generate healthy sales and sales growth -- once they stop focusing on the "land grab" effort of acquiring new users. When this kind of speculation doesn't pan out -- either user growth slows and/or profits never materialize -- the stock can really take a beating (a la Twitter). 

Absent aggressive, successful equity fundraising, a company that grows users without growing profits is going to have a hard time investing in its business and improving its product. Uber and Tesla have been very successful fundraisers, allowing them to continue releasing new, improved products/services. At some point though, investors want profits -- they want a return on their investment. Aggressive fundraising won't work forever. If the fundraising music stops and the profits aren't there, an unprofitable company faces major problems like paying its bills and improving its product/service at a rate sufficient to compete. Companies with profitable business models can invest in product/service improvements that unprofitable companies cannot.

If a stand-alone service can't increase its user base without losing money, what alternative business model could work? How could the service still drive profits? Possibly through tight integration with a product that does make money, like an iPhone or iPad or Apple Watch. Tight hardware/service integration creates a more unique, "magical" user experience by making things faster, simpler, and more convenient. As Michael Porter notes, companies should compete to be unique rather than competing to be the best.

It's worth noting that Apple doesn't try to compete within traditional, well-defined hardware or service categories -- they compete by trying to provide the best integrated hardware/software/service experience. This point was recently emphasized in John Gruber's podcast interview of Craig Federighi and Eddy Cue (on Gruber's "The Talk Show" podcast). When questioned about whether the quality of Apple's services was slipping, Federighi and Cue both emphasized that Apple focuses on the integrated, holistic user experience, not on the specific hardware or service component (consistent with Apple's functional organizational structure, its single P&L, and Steve Jobs's advice to focus on the user experience and work backward to the technology).

Apple's in a great position to cherry pick useful services and integrate them into their products, making their products more unique and "sticky." Apple can see how Evernote has become more and more valuable and can use this knowledge to make a more attractive, useful version of Notes. Apple can look at Uber's unprofitable transportation service and find ways to provide a more unique, magical user experience through an integrated hardware/service offering driven by profitable device sales (i.e., iPhone, Apple Watch, and Apple car). Apple can use the unprofitable stand-alone service to complement/strengthen its ecosystem and its profitable hardware.

This article has been amended since it was first posted. 

The author owns stock shares of Apple.

Ability to Partner as Competitive Advantage

When it comes to services, Apple is in a better position to partner than any other tech company. It's difficult for Facebook or Google to closely partner with other service providers because other providers steal user attention and hurt ad sales. Horizontal service companies trying to be on all devices depend on the user's choice of their services over other services. 

A vertically integrated player like Apple doesn't care if its services dominate. Apple wants its services to be attractive and promote ecosystem stickiness, but Apple doesn't need its services to dominate to drive profits. That's because Apple's profitability is driven not by services, but by a three part mix of hardware, OS, and ecosystem. No single element of this mix dominates, and Apple can have a great ecosystem with in-house services/apps like contacts, calendar, notes, maps, and iWork, and third party services/apps provided by IBM, Microsoft, Twitter, Google, Facebook, and thousands of independent developers.

If you don't need your services to dominate or even be profitable to prosper, then you're free to partner with any service company you want. And that's what Apple does, partnering with IBM for enterprise software, Microsoft for its Office suite, and even Google for maps. These kinds of partnerships are difficult if you have a horizontal business model and you need your services to dominate to drive subscriptions or ad sales (e.g., Google search, Facebook, Evernote, etc.).

In a 2007, D5 interview Steve Jobs said he admired Microsoft's ability to partner with other companies. Apple now seems to address this issue by partnering as convenient on services while still owning the key hardware, manufacturing, and OS technologies and IP. See post titled Why Apple "Outsources" Applications and Services.

The author owns stock shares of Apple.

Why Apple "Outsources" Applications and Services

I believe Apple's business model is based on hardware profits, rather than profits from apps and services, because expensive hardware creation and the accompanying creation of Apple's OS and iOS are uniquely suited to the resources and capabilities of a large, well-funded company. 

Unlike hardware, the creation of apps and services doesn't normally require large capital outlays. And the best apps don't come from just one company or person -- they come from thousands of highly creative developers working alone or for small developer companies. Rather than compete against a large mass of highly creative developers -- by hypothetically trying to sell profitable, proprietary apps -- Apple instead offers its own apps/services at breakeven and allows developers to capture the profits from apps and services (with the possible exception of Beats Music, which Apple just purchased). This approach allows Apple to embrace and benefit from the creative efforts of thousands of developers -- creative efforts which Apple could not match in-house. It also allows Apple to embrace large, best-in-class service providers like Facebook, Twitter, and Google (to the mutual benefit of the service providers and Apple). When Apple feels it needs more control over an important service to enhance integration, ease of use, and the end user's experience, it takes steps to make the service proprietary (e.g., Apple Maps and Beats Music).

This may ultimately be the problem with Xiaomi's business model -- by relying on profitable apps and services rather than profitable hardware, Xiaomi makes the development of proprietary in-house apps/services the priority, when this kind of work should logically be outsourced to thousands of creative developers. Rather than embracing independent developers so that it can offer end users creative, best-in-class apps and services, Xiaomi puts itself in direct competition with developers.

The author owns stock shares of Apple. 

How Successful Strategies Develop and When Subsidies Make Sense

Deliberate and Emergent Strategies

Christensen talks about how the best strategies develop through a mix of deliberate, intended creation and emergent, opportunistic, iterative adjustments. A strategy is initially deliberate and explicitly stated (at least normally). It then goes through an emergent fine-tuning process as a company discovers what does and doesn’t work, and as it discovers new opportunities it didn't initially think of. See Concepts page and discussion of Clayton Christensen and list of sources. 

In How Will You Measure Your Life?, Christensen notes that 93% of successful companies have had to abandon their original strategy. Companies need to be opportunistic and change strategies when appropriate. Once a strategic approach starts clicking, a company can shift from an emergent strategic approach to a deliberate approach, where the focus is on execution. See Concepts page and discussion of Clayton Christensen and list of sources.

Christensen says the best way to test a strategy's viability is to make a list of the assumptions which must prove true for the strategy to work. If key assumptions are unrealistic or unlikely to prove true, then the strategy probably isn't the right one.

Serendipity can also play a part. In How Will You Measure Your Life?, Christensen notes that in the 1970's Honda abandoned its original, unsuccessful strategy of selling large motorcycles (competing directly with companies like Harley-Davidson), and started selling smaller Honda Cub motorcycles when customers showed an unexpected interest in the Cub. 

When a strategy changes, resources should be reallocated as necessary. A company shouldn’t keep pouring resources into an initial deliberate strategy that isn’t working. It should look for mistakes and opportunities to adjust and improve the original strategy through an emergent, iterative process, and should adjust its resource allocation appropriately (as Honda finally did with the Honda Cub motorcycle). 

If the original strategy, and emergent adjustments to the strategy, don't have the necessary resources supporting them, then they'll never actually happen. Christensen notes that strategic actions are what's relevant, not strategic intent.

The end result of cycling back and forth between deliberate and emergent strategic approaches is a set of activities/processes that’s been fine-tuned over time, and that’s often difficult for competitors to duplicate. 

Resource scarcity and the need for early profits facilitate the development of a successful, unique strategy, because companies with limited resources are forced to promptly adjust their original strategy, as necessary, to generate the profits needed to continue funding the new product. That's why Christensen counsels new companies to be impatient for profit and patient for sales growth. 

Once a company develops a successful strategy, and achieves profitability sufficient to fund upmarket product improvements, it can shift its focus to growing sales and increasing the scale of manufacturing/distribution, all of which leads to growing bottom line profits.

Companies that don't face resource scarcity can pursue and fund an unprofitable deliberate strategy indefinitely, often growing sales but not profits. These companies aren't forced to cycle between deliberate and emergent strategies in search of life-blood profits. As a result they never develop a profitable, unique set of activities with great fit (although they may fully develop -- and find themselves mired in -- an unprofitable set of unique activities, making future strategic changes more difficult). See Concepts page and discussion of Michael Porter; also see post titled "Acquisitions, Rivalry, and Strategic Trade-Offs.

Product-specific strategies can be emergent until an attractive offering is developed/created, at which point product strategy should become deliberate and execution focused. Once a company hits on a successful product strategy through an emergent process, it should shift to a deliberate approach that aggressively executes the strategy. Successful product strategies are targeted on a job that customers need done. Products that don't accomplish a job well -- for a meaningful segment of the market -- struggle to succeed.

Blending the ideas of Porter and Christensen, Porter seems focused on the strategic target, which is a unique strategy that’s hard to duplicate. Christensen seems focused on how companies reach this strategic target, which is through deliberate and emergent strategic approaches.

Real World Applications and When Product Subsidies Make Sense

Apple seems to pursue product-specific, emergent strategies in-house, through its own employees. Apple keeps working on a product until it's something its own employees want, and then shifts to a deliberate strategy that brings the product to market. The one exception seems to be the Apple TV: in this case Apple seems to be following a very public emergent product strategy, slowly adding content and features and letting the product gradually gain market traction (in the classic, unthreatening style of a new market or low end disruptor). 

The concept of emergent strategy is helpful in examining how Apple might handle the slow-selling iPhone 5c. If sales of the 5c are profitable but small, then Apple can afford to be patient for sales growth (so long as sales are slowly trending up). If sales are not profitable, or if sales are profitable but remain flat over time, then Apple can adjust its product strategy by questioning the underlying assumptions that led to the 5c’s release. If any of these assumptions appear untrue or unrealistic, then Apple can modify its “low end” iPhone strategy accordingly. The overall goal is a product that does an important job for a significant/meaningful customer segment.

Christensen and Porter’s strategy concepts also impact when a company should subsidize unprofitable or break-even products or services. Apple runs iTunes, the App Store, iWork, iLife, and Apple TV hardware at anywhere from a loss to slightly above break-even. But these products also enhance and protect Apple's hardware margins and whole company profits, in addition to raising switching costs for anyone who wants to leave Apple’s ecosystem. So in total, Apple’s approach seems to make sense. 

Amazon subsidizes break-even — or close to break-even — Kindle Fire hardware to generate profitable e-commerce sales for Amazon.com. But Amazon’s margins have stayed razor thin, suggesting the Kindle Fire hasn't enhanced Amazon's pricing power, while whole company, bottom line profits have stayed small (both before and after introduction of the Kindle Fire). Given this kind of limited financial impact, do Kindle Fire subsidies make sense?

Product subsidies are more logical when they’re part of a unique, well-integrated set of carefully chosen activities that produce healthy margins and strong profits. Without this profitability test, product subsidies can burn through a company’s resources indefinitely, in addition to preventing the company from really working to develop a profitable product strategy.  

It's interesting how so many companies today -- Amazon and Twitter come to mind — have been rewarded by investors for being patient for profit and impatient for sales, which is exactly the opposite of what Christensen recommends. 

The author owns stock shares of Apple.