Microsoft: Apostasy Or Head Fake?

My appetite whetted by three days of rumors, I went online last Monday and watched Microsoft introduce its Surface tablets. After the previous false starts — the moribund Tablet PC and the still-born Courier — Microsoft finally took matters into its own hands. Ballmer & Co. could no longer wait for OEMs to create vehicles worthy of Windows 8’s “reimagined” beauty and function, not while the A-team ran away with the tablet market.

It was a terrific performance that hit all the right notes:

• World-class industrial design by Microsoft’s guru, Panos Panay.
• An ARM-based consumer tablet running Windows RT, and an x86 enterprise version on Windows 8, both with the innovative Metro UI.
A “digital ink” stylus for handwriting and drawing, faithful to Gates’ famous dictum: “I’ve been predicting a tablet with a stylus for many years, I will eventually turn out to be right or be dead.
• Creative, thoughtful touches: the integrated kick-stand, a novel smart cover with an integrated keyboard, the magnetic stylus that sticks to the side of the device.
• MicroSD, USB 2.0, and Micro HD video connectors.
• 10.6” displays: ClearType HD for the ARM-based tablet, ClearType Full HD for the x86 device.
• Both tablets are slim and light: 9.3 mm/676 grams for the consumer model, 13.5 mm/903 grams for enterprise. (That’s .37”/1.5 lbs, .53”/2 lbs, imperial.)

47 minutes later, Microsoft has jumped to the head of the tablet race. Yesterday’s laggard is now the Big Dog. Thrilling. I want one — probably the lighter Windows RT model.

The live demo wasn’t fumble-free, as a number of critics have pointlessly pointed out. Yes, Windows Chef Steven Sinofsky had to swap out a busted tablet, but this (probably) means nothing, it happens all the time, trust me — I gave my first computer demo 44 years ago and have fumbled through a few more since then.

I smile when I imagine Ballmer on the phone to Tim Cook, letting Apple’s CEO know that a complimentary toaster/fridge – the “convergence” of his nightmares – is on its way to Cupertino’s One Infinite Loop. (Perhaps I should explain: In a recent D10 Conference interview, Cook dismissed the notion of a hybrid tablet + laptop with a quip: “You can converge a toaster and a refrigerator, but those aren’t going to be pleasing to the user.”)

Fantasy phone call aside, this is an historic event. Microsoft decides to make its own hardware and, straight out of the gate, unveils two attractive products that combine the best features of tablets and laptops, both supported by the huge Windows ecosystem.

Unsurprisingly, the momentous happening unleashed an orgiastic excess of premature evaluation. Reactions were fast and predictably polarized. It was, in the repurposed words of one witty blogger: Choo, choo, all aboard the Pundit Express to PageHitsVille! (He was referring to a different event, but I can’t resist repeating the epigram.)

After a few hours, a pattern started to emerge:

- Reviewers who weren’t in attendance, unencumbered by direct experience, were more inclined to view the new products through pre-existing biases and to issue clear-cut predictions.

- The privileged few who were invited to the press event in Los Angeles were more nuanced in their analyses, but with a recurring complaint: They didn’t have an opportunity to use the product for themselves, they were hurried along in small groups to look at non-functioning machines. A couple examples:

I was only permitted to touch the device while the machine was powered off. Microsoft representatives were happy to show off the device, but they didn’t let me actually use the new tablet (Slate’s Farhad Manjoo).
As for performance, we’ll be honest: tech press were treated to about two minutes at each of several stations, some of which demoed design, and not so much the power that lies inside that thin frame.

Unfortunately, we didn’t get to see a working demo of the keyboards. As in, we weren’t permitted to type sample sentences and feel what it’s like to hammer out characters on a flat keyboard, or on keys that have just 1.5mm of travel (Endgadget’s Dana Wollman).

With these observations in mind, I took another look at the video and realized how many other important details were omitted from the well-oiled presentation: Price, delivery dates, battery life, wireless connectivity, display resolution (could we have an unequivocal definition of the ClearType HD and ClearType Full HD?).

The missing data, the evasions, the lack of hands-on examination, even the circumstantial evidence of a stage struck device…it all smacks of products that aren’t ready — or even almost ready — for customers’ mitts and credit cards.

This leaves us with a list of questions.

First: Why now? Microsoft’s agitprop specialists aren’t new to the game. They know what happens when you show up with less than fully-baked devices and refuse to answer simple, important questions. Why not announce on, say, October 15th – the beginning of the Holiday shopping season — when they would have a better chance of running a FUD (Fear Uncertainty and Doubt) campaign against the opposition? Why the rush?

Maybe it’s the expectation that Google will announce its own Android tablet at Google I/O later this week…but I find the argument unconvincing. Microsoft would have been better off letting Google speak first so they could analyze the product and come up with a sharply targeted counter, especially if Google ships much sooner than Microsoft.

Second, the Apostasy question. For decades, the Redmond company has preached the Righteous Way of its OEM ecosystem, the wide range of hardware configurations and prices for its Windows platform. Now Microsoft pulls a 180º, they design and contract/manufacture Surface tablets by themselves, with distribution through the Microsoft Stores and online. That’s a whole different religion.

Why?

Is it because, as one supporter put it, “greedy” OEMs have become “obstacles of innovation”, that “the software giant has bled too much for OEMs far too long”? That’s one way to look at it. (Another reading of history sees that under the Windows thumb, Microsoft’s vassals have had little choice but to engage in a price war, in a race to the bottom. For PC makers, this undercut the margins they needed to design and manufacture the “innovative” products that their overlord now chides them for not having in their arsenals.)

There must be a more sensible explanation, and our friend Horace Dediu doesn’t disappoint. In his Who will be Microsoft’s Tim Cook? Dediu comes up with an eye-opening analysis that focuses on the “business model inversion” that has taken place in the last two years.

For decades, software generated much higher margins than hardware. Microsoft was admired for its extremely high margins, while Apple was criticized for stubbornly sticking to hardware and its lower profitability — to say nothing of lower volumes as a marginal PC player. But now, as Dediu points out, Apple is the company with both the higher revenue and operating margin [emphasis mine]:

If we simply divide revenues by PCs sold we get about $55 Windows revenues per PC and $68 of Office revenues per PC sold [1]. The total income for Microsoft per PC sold is therefore about $123. If we divide operating income by PCs as well we get $35 per Windows license and $43 per Office license. That’s a total of $78 of operating profit per PC.
Now let’s think about a post-PC future exemplified by the iPad. Apple sells the iPad with a nearly 33% margin but at a higher average price than Microsoft’s software bundle. Apple gives away the software (and apps are very cheap) but it still gains $195 in operating profit per iPad sold.
Fine, you say, but Microsoft make up for it in volume. Well, that’s a problem. The tablet volumes are expanding very quickly and are on track to overtake traditional PCs while traditional PCs are likely to be disrupted and decline.
So Microsoft faces a dilemma. Their business model of expensive software on cheap hardware is not sustainable. The future is nearly free software integrated into moderately priced hardware.

Which leads Horace to his killer conclusion:

For Microsoft to maintain their profitability, they have to find a way of obtaining $80 of profit per device. Under the current structure, device makers will not pay $55 per Windows license per device and users will not spend $68 per Office bundle per tablet. Price competition with Android tablets which have no software licensing costs and with iPad which has very cheap software means that a $300 tablet with a $68 software bill will not be competitive or profitable.
However, if Microsoft can sell a $400 (on average) device bundled with its software, and is able to get 20% margins then Microsoft is back to its $80 profit per device sold. This, I believe, is a large part of the practical motivation behind the Surface product.
The challenge for Microsoft therefore becomes to build hundreds of millions of these devices. Every year. Sounds like they need a Tim Cook to run it.

It’s difficult to argue with Horace’s logic, but there’s another way to look at Microsoft’s new posture: It’s just that, a posture, a way to wake up PC OEMs and force them to react. “If you do the right thing and come up with the world-class product Windows 8 deserves, we’ll back off and let you enjoy the just deserts of your efforts.” It’s a devious thought, but it could be more realistic than the notion that Microsoft will produce something in the order of 100 million Surface tablets in 2013 in order to keep their dog in the fight. (For reference, the lead PC maker, HP, currently ships about 16M devices per quarter.)

I’m also curious about Microsoft’s rigid insistence on calling these devices PCs. See their official site announcing a “New Family of PCs for Windows”:

Try as they might, Microsoft won’t be able to convince folks to refer to the Surface as anything other than a “tablet”. The Redmond team seems fixated on a best-of-both-worlds product: Everything a PC does plus the best features of a tablet. This is what John Gruber calls being caught Between a Rock and a Hardware Place. (Gruber’s post, which quotes Dediu’s, is itself quoted and felicitously expanded upon by Philip Elmer-DeWitt.)

Peter Yared offers his help with a witty clarification:

In the end, I can’t see how Microsoft can suddenly morph into a tablet, er, PC maker capable of pumping hundreds of millions of devices per year. The fuller Surface story is yet to unfold.

JLG@mondaynote.com

Off The eBook Shelf

Readers are voting with their wallets: The eBook is winning. In the US, eBooks sales are now topping hardcovers for the first time (story in TechCrunch). Not everywhere of course. According to the Bowker Global eBook Research, the global market for eBooks is driven — in that order — by India, Australia, the UK and the United States. The laggards are Japan and (no surprise) France. The chart below shows the percentage of internet population reporting the purchase of a digital book over the last six months prior to the survey.

Interestingly, for most population samples, the level of purchases is not correlated with awareness. France enjoys the highest level of awareness but its internet population buys five times less eBooks than India’s. Once an Indian internet user finds an attractive digital book offer, he/she will most likely jump on it. This could lead to the following: in emerging countries, the cellular phone has become the main communication tool, leapfrogging the deployment of land lines; similarly, we could see eBooks bypassing print in countries like India where a large segment of the population is getting both literate and connected at a fast pace. (Actually, Bowker also reports that over 50% of respondents in India and Brazil are likely to buy an eBook in the next six months, ten times more than in France.)

If the rise of the eBook happily provides access to knowledge in emerging countries, the picture is more contrasted in countries with a long history and high penetration of printed books.

For instance, let’s have look at the ISBN registrations data for the United States. The chart below, drawn again from Bowkers (full PDF table here) shows a steady progression:

Between 2002 and 2011, in the US market, ISBN registration grew by 61% and reached 347,178 new titles. (A technical note: I’m only taking into account books that fall in an identified category, such as Arts, Biography, Business, etc. I’m excluding the huge segment labeled as nontraditional, which includes reprints, public domain, and titles printed on demand; this segment grew by over 3500% to 1.2 million registrations, which would distort the picture.)

We clearly see the impact of mainstream e-readers such as the Kindle and the iPad. Without any doubt, they contributed to the growth of registrations. (Unfortunately, ISBN counts does not provide a breakdown between print and digital.) Over the last nine years, some book publishing segments fared better than others. See the chart below:

Fiction is doing twice better than all other categories together. The Digital Book is the medium of choice for fiction: a) eBooks are set to be cheaper that print and price elasticity is now a proven fact, the cheaper a book is, the more likely a reader is to try it; b) e-commerce breeds impulse buying (cf the famous “One-Click® feature); c) readers can test the product more efficiently than in the printed world as Amazon and the iBooks Store make larges sample available for free. No surprise, then, to see the Fiction category holding well.

No surprise either in seeing the three worst performers also as prime victims of the digital era. History books have to compete with the vast trove of material available on the web; that’s the Encyclopaedia Britannica syndrome, going out of print after 244 years of duty, demoted by the 11-year-old Wikipedia. Like it or not, most history books publishers will follow the same fate.

Similarly,Travel and Computer books are in direct competition with mostly free online services. Who will buy a “how-to” computer book today? There are plenty of video tutorials explaining how to replace a hard drive or how to struggle with Photoshop? And let’s not even mention the Travel segment with tons of guides, reviews, price comparators and transactions services. As for the language sections of the bookstore, again, a simple query in Google can help with spelling, translation and grammar… Even the precious Roget’s Thesaurus is online, and rather efficiently so. I’ll just venture French Canadians did Roget one better: A company called Druide publishes a suite of applications for PCs, tablets and smartphones called Antidote. It’s an unusually clever combination of dictionary, thesaurus, quotations, etymology and more. I wondered for a while about the name Antidote — until I realized Quebecois saw the product as an antidote to… English. An old struggle.

The main eBooks casualty is likely to be bookstores. In a city like New York, in the Fifties, about 330 bookstores were in business. Now they are down to 30 or even less, laments André Schiffrin, former head of Pantheon Books, in his recent book Words & Money. Countries like France or Germany have laws that protect independent bookstores: From Bordeaux to Berlin, citizens are thankful for finding warmer and more relevant recommendations than the algorithm-based suggestions provided by Amazon. But how long will it last?

frederic.filloux@mondaynote.com

The Nokia Torture

How would you like to be a Nokia employee? Last week the bosses came up with more bad news: In order to cut 3B€ (about $3.8B) in expenses by the end of 2013, another 10,000 employees will be shown the door — this after earlier cutting payroll by 4,000 people. The news came couched in corporate doublespeak: Nokia sharpens strategy and provides updates to its targets and outlook, with a shamefully misleading first subtitle:

Company announces targeted investments in key growth areas, operational changes and significantly increased cost reduction target

Followed by a second one, finally hinting at the bad news:

Company lowers Devices & Services outlook for the second quarter 2012

In the opaque 2900-word release, management concedes business is worse than expected, with no immediate hope of improvement:

During the second quarter 2012, competitive industry dynamics are negatively affecting the Smart Devices business unit to a somewhat greater extent than previously expected. Furthermore, while visibility remains limited, Nokia expects competitive industry dynamics to continue to negatively impact Devices & Services in the third quarter 2012. Nokia now expects its non-IFRS Devices & Services operating margin in the second quarter 2012 to be below the first quarter 2012 level of negative 3.0%. This compares to the previous outlook of similar to or below the first quarter level of negative 3.0%.

In English: ‘Our smartphone business sucks, it lost money last quarter, it will lose even more money for the current quarter ending in June, probably in the 5% operating loss range, and we’ll experience similar bleeding for the foreseeable future.’

Bond-rating agencies took note and promptly downgraded Nokia’s debt to junk status, another worrisome development. Reading Nokia’s Q1 2012 numbers, we see Net Cash at 4.8B€ (approx. $6B), 24% less than a year ago, 13% less than the immediately preceding quarter. With accelerating losses, the cash drain is likely to do the same. This puts Nokia in a dangerous squeeze: It could have to borrow money at unfavorable rates, or be prevented from doing so, or be forced into liquidation.

This is how: We know Nokia has already borrowed money, about 4.9B€ (approx. $6.3B), but we don’t know what the small print on those bonds say. Creditors often put conditions (covenants) giving them the option to demand immediate repayment if the debtor’s business deteriorates too much.

Nokia’s management is worried, it shows in little signs such as the length of precautions taken in what is known as Forward-Looking Statements. These consist in lawyerly language telling us everything we have heard or read could be nullified by a number of changes in the weather, the price of pork bellies or crop failures. The practice, as often, stared with the best of intentions: Management should be free to share their views of the future without being held too strictly to their description of inherently fragile circumstances.

In February 2011, Nokia’s cautious language about 255 words. Last week, attorneys in charge of covering the backs of Nokia execs needed more than 1,400 words, listing precautions from A to K, and from 1 to 39.

Put simply, this betrays is a growing fear of lawsuits.

In the meantime, Nokia’s CEO, Stephen Elop, is “opening the second envelope”, that is firing members of his exec team, including one who imprudently followed him from Microsoft. Next time, it’ll be his turn — and too late to save the company.

Many blame Elop, but what about the Board of Directors? In 2010, when the fact Nokia was on the way down became too obscenely obvious for the Board to ignore, they fired the CEO, OPK (Olli-Pekka Kallasvuo), an accountant cum lawyer, and doubled down by hiring Elop, a Microsoft exec with zero smartphone experience and a record of job-hopping. The new CEO soon said one very true thing, ‘This is a battle of ecosystems’ and did a terrible one: He osborned Nokia’s existing Symbian-based products as he committed to a distant collaboration with Microsoft and its unproven Windows Phone system software. What did the Board do? Directors approved the move. Willfully or stupidly, it doesn’t matter, they supported Elop’s imprudent move.

Nokia, once the emperor of mobile phones, shipping more than 100 million devices per quarter, is now in a tailspin, probably irrecoverable, taking its employees into the ground.

And there is Nokia’s chosen partner, Microsoft. What will Nokia’s failure do to its future? Ballmer knows Microsoft can’t be relegated to a inconsequential role in the smartphone wars. Will this lead to Microsoft going “vertical”, that is buying Nokia’s smartphone business and become an vertically player, as it already is in its Xbox business?

JLG@mondaynote.com

Pro (Advertising) Choice

A couple of weeks ago, I came to a realization: I was becoming more and more reluctant to click on advertising banners because I feared I being digitally tailed for the next few months. When I mentioned this to friends, I noted that I was not alone. Everyone had their example of ads that, once clicked, become as sticky as the proverbial band aid. This could be the result of exploring a product (read my own experience testing an app), or occasional research on a subject… Your online behavior — queries you send, ads you click on — draws your marketing profile, enabling brands to deluge you with “targeted” ads. A shoe freak will be swamped by shoemakers ads, someone who intends to buy a car will be targeted by automakers and dealers. (I always wonder how the web page of someone afflicted with an embarrassing disease looked like…)

Once you’re caught in the behavioral targeting net, you’ll have a hard time cleaning up your surfing. I recently tested a utility for my computer — a poor quality product I quickly dumped — and ended up having to spend time removing the offending cookies with metaphorical tweezers. Now, I sacrifice a “polluted” browser (and a specific email account) which I use to click on ads, download products or marketing information, and do my best to keep my other browsers clean.

Why not flush the hundreds of cookies piled up inside my browsers, you might ask? Good question. In a file on my two computers, I keep almost 200 encrypted passwords, ranging from subscriptions to various publications, accounts to e-commerce sites or business online services. I don’t want to re-enter these codes each time I get rid of unwanted cookies. Hence the “dirty” browser.

The conclusion is obvious: behavioral advertising is backfiring. The more experienced users become, the more cautious they get in order to avoid aggressive tracking. For advertisers, this is the exact opposite of what they meant to achieve. And I take the trend will accelerate. Marketers have more sense of efficiency than of measure; they were quick to embrace these clever technologies without considering they might end up killing the golden goose. It is happening much earlier than anyone has anticipated.

The debate around the Do Not Track (DNT) system epitomizes this trend. The idea originated at the US Federal Trade Commission (FTC): it devised a piece of software embedded in a browser or an application, able to send a signal instructing a web site not to inject a tracking cookie in the user’s computer. After that, it is up to the website to comply or not. Mozilla quickly included the feature in its version 9.0 of Firefox, and Twitter followed.

Early june, Microsoft added fuel to the fire by announcing the DNT feature will be turned “on” as a default on its new Internet Explorer 10 browser set to work with Windows 8. This is by no means unimportant: the vast majority of users do not change default settings in their software. As a result, a sizable percentage of web surfers could end up automatically asking web sites to forgo any tracking. A potential catastrophe for the advertising industry: while most ads are purchases in bulk, at heavy discounts, the industry relies on behavioral targeting to increase the efficiency of ads — and of their resulting margins.

Intense lobbying on behalf the ad community ensued.

First, the definition issue, As viewed by the FTC :

An effective Do Not Track system should go beyond simply opting consumers out of receiving targeted advertisements; it should opt them out of collection of behavioral data for all purposes other than those that would be consistent with the context of the interaction.

Naturally, marketers are in favor of a much narrower definition, excluding the data collection process. In other words, OK for not targeting users, but their personal data must be ours.

In this story, Atlantic’s senior editor Alexis Madrigal makes the following point:

No one understands the industry’s definition because it deviates so far from the standard english definition of the word ‘track.’
Stanford’s Aleecia McDonald found that 61 percent of people expect that clicking a Do Not Track button should shut off *all* data collection. Only 7 percent of people expected that websites could collect the same data before and after clicking a ‘Do Not Track’ button. That is to say, 93 percent of people do not understand the industry’s definition of DNT.

Eventually, Microsoft had to backtrack under pressure from the Digital Advertising Alliance. The DAA is a one-year old body that defines itself as the “Self-regulatory program for online behavioral advertising”; it lines up all the major players in the business, including Google, Apple and Microsoft. The DAA fired a first shot by saying that the “on” default setting envisioned by Microsoft was going way beyond FTC’s definition as well as the W3C (World Wide Web Consortium)’s DNT recommendation. The DAA suggested DNT activation ought to be left to users — for instance, when they launch their browser for the first time. As a consequence, Microsoft’s IE10 featuring a DNT set to “on” as a ‘‘factory default’’ would be seen as “non-compliant” and the no-tracking signal sent to websites could be legally ignored.

The battle is just starting. It is unclear if Microsoft will fight the non-compliance issue and what kind of compromise will be reached. (The DAA’s final position will be disclosed in a few months.) In the meantime, digital kremlinologists will keep dissecting Microsoft true motives. After all, according to eMarketer, this year, in the US alone, the Redmond giant will make $700 million in advertising revenue:

This chart also clearly shows what’s at stake here. With DNT-as-a-default, Microsoft is obviously aiming Google and Facebook — and their higher advertising income. Both rely heavily on data-collection to serve relevant ads. It is even a crucial part of Facebook’s business model (see this previous Monday Note: Facebook’s Bet on Privacy) based on people giving up personal data in exchange for its service. A bet increasingly at risk.

frederic.filloux@mondaynote.com

Mobile Advertising:
The $20B Opportunity Mirage

There are a lot of questions left to be answered about Facebook’s IPO fiasco, but one thing we know is this: As consumers shift their use of Facebook from PCs to smartphones, investors worry about lower mobile advertising revenues. Is this a temporary situation that will be remedied when usage patterns settle, or do investors have a right to be concerned? Must the advertising industry learn to adapt to a permanently leaner income stream from smartphones?

Let’s start by taking another look at Mary Meeker’s latest Internet Trends presentation from last week’s All Things Digital conference. On slide 17, she projects a $20B opportunity for Mobile Advertising in the US:

When Meeker uses the word “opportunity”, she means “unfulfilled potential”: Mobile Ad Spend in the US alone should be $20B larger than it is. For reference, Google’s latest quarterly revenue was about $10B worldwide.

$20B is a big number, and it got me thinking. How is it possible that the industry’s richest and most sophisticated players are unable to grab such a big pile of money? They have the brains and the computers, they’re aware of the situation…Is there a deeper problem?

A too-easy answer is the market’s age: Mobile advertising is still in its infancy. But that’s an indefensible excuse: The first iPhones shipped in late June 2007, the Smartphone 2.0 era is now five years old. Both Android and iOS are prosperous platforms with bulging App Stores, they sell tens of millions of devices every month, close to half a billion this calendar year. Brand managers, advertising agencies, search engines, social networks, a myriad of vibrant startups keep trying, but mobile advertising barely moves the needle.

We get closer to the heart of the matter when we look at a common thought pattern, an age-old and dangerously misleading algorithm:

The [new thing] is like the [old thing] only [smaller | bigger]

We’ve seen this formula, and its abuse, before. Decades ago, incumbents had to finally admit that minicomputers weren’t simply small mainframes. Manufacturers, vendors, software makers had to adapt to the constraints and benefits of a new, different environment. A semi-generation later, we saw it again: Microcomputers weren’t diminutive minicomputers but truly personal machines that consumers could lift with their arms, minds, and credit cards.

The “Tech-savvy We” should know better by now; We should have learned, but the temptation — and the lazy easiness — of the “X=Y but for the form factor” algorithm continues to derail even Our most “different thinkers”. When the iPad was introduced, a former Apple Director described the offering thus: “It’s just a big iPod Touch” (which proves nothing more than that Steve Jobs didn’t burden his Board of Directors with loads of information).

At the D8 conference in 2010, in front of an iPad-toting audience, a bellowing CEO dismissed Apple’s tablet as just a PC, minus the keyboard and mouse. (And I’ll share the shame: On April 3rd 2010, I looked at my new iPad through PC goggles and lamented the Mac features that were “missing” from my new tablet.)

Now we have advertising on smartphones, and we’ve fallen into a comfortable, predictable rut: “It’s just like Web advertising on the PC, shrunk to fit.” We see the same methods, the same designs, the same business models, wedged onto a smaller screen.

PC advertising has successfully navigated different screen sizes. On a large screen you might see something like this:

Plenty of space for both advertising and content. Even on a smaller screen, the ads are unobtrusive:

But on a smartphone, this is the advertising that’s supposed to entice us:

…and this is the NY Times, one of the better mobile apps.

Mobile ads aren’t merely smaller, they have less expressive power, they don’t seduce…and they’re annoying.

Of course, there’s more to the smartphone misunderstanding than the fairly obvious screen size problem. There’s also a matter of how we use our computing devices.

When we sit down in front of a laptop or desktop screen, our attention is (somewhat) focused and our time is (reasonably) committed. We know where we are and what we’re doing.

With smartphones, we’re on the move, we’re surrounded by people, activities, real-world attractions and diversions. As yet another Mary Meeker presentation suggests, time spent on mobile devices is fragmented:

We’re not paying (a loaded word) the same type of attention as we do on a PC.

Business Insider features an InMobi report on mobile ads, with the following comment [emphasis mine]:

Those ads were served across 6 billion mobile devices. That’s less than $1 per device, per year—a tiny sum. That tells you how far mobile advertising has to go, and how massive it will become in the next five years.

The dollar-per-device statement is a fact, the assumption of “massive” growth is wishful thinking.

When I hear that there’s a mother lode of advertising revenue in location-based ads that are pushed to my mobile phone as I stroll down Main Street (with my permission…I hope), ads that offer succulent deals in the stores and restaurants I’m about to pass, I wonder: Do we want barkers on our devices? Is this the game changer for mobile advertising, yet another kind of spam? LBA may be a hot topic among marketers but the public is dubious, as this MobileMarketer article soberly explains:

The reality is that this scares consumers, rather than excites them. Mobile marketers need to realize that what gets them and their peers fired up does not necessarily move consumers in the same way.

And this…

According to [Rip Gerber, CEO of Locaid Technologies, San Francisco], marketers create their own privacy obstacles when they forget relationship, relevance and preferences in favor of short-sighted metrics.

If the industry hasn’t cracked the mobile advertising code after five years of energetic and skillful work it’s because there is no code to crack. Together, the small screen, the different attention modes, the growing concerns about privacy create an insurmountable obstacle.

The “$20B Opportunity” is a mirage.

JLG@mondaynote.com

Apps Features: Social vs. “Related”

Mobile application design is hard. For websites, we have well-established graphic rules. For PC screens, the tolerance for interface mishaps is fairly broad. Mobile apps are the  opposite: space is much scarcer, every pixel counts. Try shrinking a tablet app screen down an to a smartphone size: homothecy (linear reduction) rarely works. This is the reason why we often see fine iPad applications turn into flunked smartphone ones. It sometimes takes a while for a successful iPad app turn in to a well-adapted iPhone one: Flipboard, Zite and Bloomberg BusinessWeek were wise enough to take as much time as needed to roll-out great apps for the small screen.

When designers (and marketeers) perform user tests for a small screen app, they realize their design will have to adjust to many new circumstances and constraints. Reading time and general use conditions change substantially from a tablet to a smartphone: while the former is definitely a lean-back device, the latter will be used in many different ways, often including uncomfortable settings — I glance at my phone in a lobby, a waiting line, in the subway, etc. All this deserves thoughtful consideration when designing an application. The same applies to advertisers: they can’t expect to capture the same level of attention when moving from tablets to the smartphones.

With this in mind, I made a quick list of mandatory features for mobile applications.

Social vs. “Related”. Today’s hype leaves no other option but making an application as “social” as possible. This being the certitude du jour, allow me to think differently.

True, some apps are inherently social: when it comes to rating a product or a service, the “crowd factor” is critical. Beyond that, it should be a matter of personal choice — an antinomic notion to today’s the “Social” diktat. When you enroll into Spotify, the default setting is to share your musical taste with your Facebook friends and to suffer theirs in return. I personally can’t stand such obligation: I quickly dumped the application and cancelled my account.

The social idea’s biggest mistake is the belief in a universal and monolithic concept everyone is supposed to be willing to embrace with a similar degree of scope and enthusiasm. That’s a geeky, super-cartesian, Zuckerberg-esque view of society. Among my friends, some like opera (the singing, not the browser), others prefer heavy metal and I’m more into jazz tunes; some are tech-minded like me, others are more inclined towards literature. When it comes to sharing news, I tend to be naturally selective about the people I send a link to: I don’t want to swamp everyone with stuff they don’t care about. I might be wrong, but this is the way I see the social cyberspace: segmented and respectful of each other.

Where am I getting with this: When I read news online, I care about what is related (i.e. recommended by editors) as much as what is social (recommended by the crowd). Of course, Trending, is a good indicator of what’s hot. Here is a good example on TechCrunch iPad app, by any measure a thoughtfully designed one. Its Trending sidebar cleverly displays what’s hot and how it evolves:

Even better: when you dive into a story, the app will give you a better-focused “Trending” indicator on a particular company, in this example Buddy Media….

… will send you to the Crunch Base repository of people and companies:

TechCrunch’s social treatment is mostly Twitter-based. Subjects are connected to relevant tweets with the underlying story shown in a web view:

Related contents come in different flavors. Take the Bloomberg way shown in its remarkable BusinessWeek application. Companies mentioned in a stories can pop-up in a black sidebar drawn from the Bloomberg financial app.

Similarly, ProPublica’s application uses a lateral “drawer” to display related contents in an efficient way:

These features are by no means secondary. Providing related contents or a supplement of data, such as financial of biographical information, is the best proven way to retain users.

Finally, a word about graphics. Apple and the iPad have set the bar pretty high and very few apps takes fully advantage of their graphics power. One company rises way above the crowd: Roambi, in a class in itself when it comes to visualizing information. My take is, someday, most business sites will borrow from Roambi’s spectacular way of displaying graphics (part explanation of its design sophistication: the core of Roambi’s designers comes from the video game industry).

One last world about the ongoing debate between open web-apps and proprietary ones such as iOS or Android: The gap is narrowing. The FT.com, which pioneered the genre two years ago, made tremendous progress in its app. Periodically, a new release comes up with slight improvements in fluidity and ease of use. The iOS system and its software development kit remain a must for games and 3D intensive applications, but for news and data apps, HTML5 is getting closer.

One feature, though, is missing in most of these apps: the ability to use them offline. 3G coverage and cellular data transfers are more unstable than developers tend to believe; users should have more leeway in configuring their apps to download content in the background, ready for later offline use.

frederic.filloux@mondaynote.com

Monday Note Exclusive: The Walmart Garden Smartphone

Last week was the 10th anniversary of the Wall Street Journal’s All Things Digital Conference, D10 for short. For the past three years it’s been held at the Terranea Resort in Rancho Palos Verdes, South of Los Angeles.
If I leave in the wee hours and take an North and East detour around the Evil 405, it’s a “short” 6-hour drive from Palo Alto. This is a welcome opportunity to avoid airport hassles, to bring all my toys, to listen to Glenn Gould and to catch up on phone calls. For a long I5 Central Valley stretch, I also get to work on my Spanish, the only language spoken on local FM stations. The fare varies widely: plagent Mexican love songs; garrulous commercials spoken at ultra-high speed with the rolling rrrrs that bring up smiles and childhood memories; the obligatory preachers and the occasional public interest program — the latter with a distinctly more educated Castellano enunciation.

I like the conference formula: Interviews of ‘‘heads of state’’, high-tech and media CEOs, by Walt Mossberg and Kara Swisher, two highly regarded tech journalists. No talking heads, no mind-numbing PowerPoint presentations — we gave at the office. I once complained to Uncle Walt his questions looked a little soft, without much of an attempt to follow-up on obvious evasions or outright fabrications. ‘Think again’, Walt said, ‘you used the word obvious; don’t think you’re the only BS expert in the audience, I let everyone draw their own conclusion.’ He’s right, I recall moments when a telco executive made such impudent statements audience members looked at each other wondering wether the guest was lying or incompetent.

The D10 site is supplemented by iPhone and Android apps, all giving access to videos, transcripts and commentary. High-quality, mostly, but the abundance can be overwhelming. If you’re short on time, look for the following:

Ed Catmull, the Pixar co-founder. For me, his interview was the highlight of the conference. Quietly brilliant and wise. A short video here.
Larry Ellison, founded Oracle in 1977 and still running it. He never disappoints, mercilessly ridiculing SAP and HP and the former CEO of both. Larry is a dangerous adversary, wittier and more knowledgeable than most CEOs.
Mary Meeker broke the No PowerPoint rule, she took us through a 125-slide deck.
I’m a fan of hers and often refer to her legendary Sate of The Industry presentations, but she could have done an even more effective job by concentrating on one or two slides, by commenting on their origin and significance. See for example this one:

It summarizes Facebook’s biggest problem, what she diplomatically calls a $20B opportunity: mobile ads fail to produce any kind of significant revenue, and we’re not sure why.
Ari Emmanuel, the assoholic Hollywood super-agent was equal to his reputation, he shouted down The Verge’s Joshua Topolsky for having the nerve to question his view of Google’s role in filtering content. For all the entertainment value, the verbal violence and bad faith were uncalled for and do nothing to improve the agent’s clients image. Topolsky’s measured reply is here.
Tim Cook, long-time Steve Jobs’ second-in-command and now Apple CEO. He gave a quiet, competent performance, masterfully deflecting questions about future products and reminding us imitating Steve Jobs definitely isn’t the way forward.

But we shouldn’t lose sight of the real formula for this gathering: Great interviews and demos on stage + even greater schmoozing in the hallways.

There, I got really lucky.

In the line for the coffee urns, I overheard two Walmart execs animatedly pitching their upcoming smartphone to the CEO of an app development company — in Spanish. They must have felt safe in the belief the catering staff might understand the language, but definitely not the topic. Using a simple, striking one-liner…

“Walmart wants to become the Walmart of smartphones.”

… they told the gent he could help their company achieve this goal and, in the process, profit immensely.

Later that evening, I introduced myself to the developer — in his native language. After a couple of drinks and cross-cultural pleasantries, I asked about his interest in Walmart’s smartphone. He was relaxed and practical: ‘They have a big business (and big problems) in Mexico, I can help them get good apps for their launch there later this year, but you know their reputation, they squeeze their suppliers, I’ll want money upfront…’
I nodded and asked what he liked most about the product: the design, the platform, the business model? Little by little, I learned Walmart’s smartphone program came from Walmart Labs, a Silicon Valley outpost of the Arkansas giant. The project was born out of frustration with Google’s conversion of Google’s free Product Search to Google Shopping’s pay-to-play model where inclusion in search results (as opposed to ads on the side) now requires a payment. There is also a reaction to Amazon’s rumored smartphone, a complement to its Kindle Fire. Actually, my drinking companion said, Walmart’s smartphone takes more than a leaf off Amazon’s playbook: like the Kindle Fire, it relies on an Android fork, that is grabbing the Open Source code and retargeting to its own business purpose — without the onus of included Google apps that come with the sanctioned Android version. The hardware is from HTC, with a NFC chip for fast and easy contact-less checkouts; the software platform is designed to help product discovery and content sales and, like Amazon, Walmart will launch its own App Store in the US, Canada and Mexico.
To sell its “Walmart Garden” smartphone, the company will use its more than 5,000 North-American stores and set itself up as an MVNO, reselling Sprint in the US, Rogers in Canada and Telmex in Mexico. The Walmart smartphones will come with both conventional (also called post-paid) contracts and pre-paid plans for customers will lower credit scores.
I couldn’t get an idea of projected prices or sales volumes, but the developer said evangelizing Walmart execs were dangling a future installed base numbering in the tens of millions, may be 100 million after a few years.

This is fiction.

Mostly but not all: Walmart Labs do exist, but the rest is invented. I’m sure Walmart watches Google’s every move and worries about the Search giant becoming an unavoidable — and therefore increasingly expensive — toll gate. But designing, selling and supporting one’s smartphone is no easy task, even for a competent giant like Walmart.
Put another way, does it make sense for every major corporation to develop its own branded smartphone as a way to keep their customer relationship “pure”, protected from search engine and social network predators?

Smartphones aren’t merely handsets with bigger screens and more functions, they’re app phones, they’re part of an ecosystem. They’re a separate, highly specialized, often risky trade, not just another line of business easily added to a large corporation’s portfolio.

Which bring us to the recurring Facebook phone rumors. Some are so asinine I’ll just quote without a link:

Facebook has quietly assembled all the important bits of a mobile phone [emphasis mine]. It just released its new camera application that uploads directly to Facebook, its own messenger service, and it’s reported that Facebook is courting mobile web browser developer Opera.

Right. Kick any trash can around the Valley and all the unimportant bits, hardware, operating system, retail distribution, service and support crawl out. Unsurprisingly, the general reaction to the latest Facebook phone rumor, summarized here, has been overwhelmingly negative. It’s one thing for Apple to defy conventional wisdom (infelicitously spewed by Palm’s Ed Colligan), they had never made a telephone before, but Jobs & Co. had validated experience in the entire hardware food chain, from design to retail stores. It’s another for Facebook to learn and quickly become competitive in a trade now dominated by giant slayers of Apple and Google stature.

I greatly admire Zuckerberg, I think he’s a cagey strategist playing the long ball, and I don’t believe he’s this naive. He might worry about Google becoming too much of a toll gate for his company’s good, but building a Facebook smartphone in order to contain the Android invasion isn’t the right answer. Google has enough adversaries, some with business models that differ enough from Facebook’s, to offer a choice of viable allies. Stay tuned, as Apple’s CEO said at D10.

JLG@mondaynote.com

Facebook: The Collective Hallucination

Facebook’s bumpy IPO debut could signal the end of a collective hallucination. Most of it pertains to the company’s ability to deliver an effective advertising machine.

Pre-IPO numbers looked nice, especially when compared to Google at this critical stage of their respective business lives:

Based on such numbers, and on the prospect for a billion users by the end of 2012, everyone began to extrapolate and predict Facebook’s dominance of the global advertising market.

Until some cracks began to appear.

The first one was General Motors’ decision to pull its ads off Facebook. This was due to poor click-through performance compared to other ads vectors such as Google. No big deal in terms of revenue: according to Advertising Age, GM had spent a mere $10 million in FB ads and a total $30 million maintaining its presence on the social network. But Facebook watchers saw it a major red flag.

The next bad signal came during the roadshow, when Facebook issued a rather stern warning about its advertising performance among mobile users.

“We believe this increased usage of Facebook on mobile devices has contributed to the recent trend of our daily active users (DAUs) increasing more rapidly than the increase in the number of ads delivered.”

If Facebook can’t effectively monetize its mobile users, it is in serious trouble. Numbers compiled by ComScore are staggering: last March, the average American user spent 7hrs 21 minutes on mobile versions of Facebook (80% on applications, 20% on the mobile site). This represents a reach of more than 80% of mobile users and three times that of the next social media competitor (Twitter), see below:

(source : ComScore)

More broadly, Facebook experiences the unlimited supply of the internet in which users create inventory much faster than advertising can fill it. This trend is known to push ads prices further down as scarcity no longer contains them. The reason why the TV ad market is holding pretty well is its lasting ability to create a tension on prices thanks to the fixed numbers of ad slots available over a given period of time.

Unfortunately for its investors, in many ways, Facebook is not Google. First of all, it has no advertising “killer format ” comparable to Google’s AdWords. The search engine text ads check all the boxes that make a success: they are ultra-simple, efficient, supported by a scalable technology that makes them well-suited for the smallest advertisers as well as for the biggest ones; the system is almost friction-free thanks to an automated market place; and its efficiency doesn’t depend on the quality of creation (there is no room for that). One cent a time, Google churns its enormous revenue stream, without any competition in its field.

By contrast, Facebook’s ad system looks more traditional. For instance, it relies more on creativity than Google does. Although the term sounds a bit overstated considering the level of tactics Facebook uses to collect fans and raise “engagement” of any kind. For example, Tums, the anti-acid drug, developed a game encouraging users to throw virtual tomatoes at pictures of their friends. On a similar level of sophistication, while doing research for this column, I landed on the Facebook Studio Awards site showcasing the best ads and promotional campaigns. My vote goes to the French chicken producer Saint Sever, whose agency devised this elegantly uncomplicated concept: “1 ami = 1poulet” (one friend, one chicken):

If this is the kind of concept Facebook is proud to promote, it becomes a matter of concern for the company’s ARPU.

Speaking of Average Revenue Per User, last year, Facebook made $4.34 per user in overall advertising revenue. A closer look shows differences from one market to another: North America, the most valuable market, yielded $9.51 per user vs. $4.86 for the European market, $1.79 in Asia and only $1.42 for the rest of the world. Facebook’s problem lies exactly there: the most profitable markets are the most saturated ones while the potential for growth resides mostly in the low-yield tier. In the meantime, infrastructure costs are roughly identical: it costs the same to serve a page, or to synchronize a photo album located in Pennsylvania or in Kazakhstan (it could even cost more per user in remote countries, and some say that FB’s infrastructure running costs are likely to grow exponentially as more users generate more interactions between themselves).

Facebook might be tempted to mimic a rather questionable Google trait, that is “The Theory Of Everything”. Over the last years, we’ve seen Google jumping on almost everything (including Motorola’s mobile business), trying a large, confusing array of products and services in order to see what sticks on the wall. The end result is an impressive list of services that became very valuable to users (mail, maps, docs). But more than 90% of Google revenue still come from a single stream of business, search ads.

As for Facebook, we had a glimpse already with the Instagram acquisition (see a recent Monday Note), which looked more like a decision triggered by short-term agitation than by long-term strategic thought. We might see other moves like this as Mark Zuckerberg retains 57% of the voting shares and as the company sits on a big (more than $6 billion) pile of cash. Each month brings up a new business Facebook might be tempted to enter, from mobile phones, to search.

All ideas that fit Facebook’s vital need for growth.

frederic.filloux@mondaynote.com

Decoding Share Prices: Amazon, Apple and Facebook

There are many religions when it comes to calculating the “right” price for the shares of a publicly traded company. At a basic level, buying a share is an act of faith in the company’s future earnings. The strength of this belief manifests itself in the company’s P/E (Price/Earnings) ratio. The stronger the faith, the higher the P/E, an expectation of increased profit.

Sometimes, an extreme P/E number beggars belief, it invites a deeper look into the thoughts and emotions that drive prices.

One such example is Amazon. On the Nasdaq stock market, AMZN trades at more than 174 times its most recent earnings. By comparison, Google’s P/E hovers around 17, Apple and Walmart are a mere 14, Microsoft is a measly 11.

This is so spectacular that many think it doesn’t make sense, especially when looking at Amazon’s falling profit margin (from this Seeking Alpha post):

Why do traders bid AMZN so high in the face of a declining .5% profit margin?

In his May 5th PandoDaily piece, “Nobody Seems to Understand What Jeff Bezos is Doing. Does He?”, Farhad Manjoo questions Jeff Bezos’s strategy and Amazon’s taste for obfuscating statements:

“Amazon is not merely “willing” to be misunderstood, it often tries to actively sow widespread misunderstanding. This works [to] its advantage; if competitors don’t know what Amazon is up to, if they can’t even figure out where and how it aims to make money, they’ll have a harder time beating it.”

…and he concludes:

“Is Bezos crazy like a fox? Or is he just plain crazy? We have no idea.”

He’s not alone: Year after year, critics have challenged Bezos’ business acumen, criticizing his grandiose views and worrying about the company’s bottom line. But the top line, revenue, keeps rising. See this chart from a Seeking Alpha article by Richard Bloch:

The answer to Farhad’s question, the cold logic behind the seemingly irrational share price is clear: Amazon sacrifices profits in order to gain size and, in the process, kill competitors.

That’s step one.

Step two: After having cleared the field, Amazon will take advantage of what is delicately called “pricing power”. As the Last Man Standing, they will raise prices at will and regain profitability. This isn’t Amazon’s only game. The breadth of their offering, their superior customer service and awesome logistics, make life difficult for poorly managed competitors such as Best Buy, or the undead Circuit City, to name but a few companies whose weaknesses where exposed by Amazon’s superbly efficient machine.

But traders recognize the wink and the nod behind today’s numbers, they are willing to pay a high price for a share of Amazon’s future dominant position.

Apple’s share price sits at the other end of the P/E spectrum. Revenue and profits grow rapidly: + 58% profit year-to-year, + 94% net income. “Normal” companies in their league are supposed to fall to the Law of Large Numbers: High percentage growth becomes well-nigh impossible when a company achieves Apple’s gigantic size. A $100B business needs to dig up $25B in new business to grow 25%. $25B is roughly half the size of Dell. When Apple’s revenue grows 58%, that’s more than one Dell on top of last year’s business.

Apple is the nonpareil of fast-growing, prosperous companies. They’re in a young market: smartphones and tablets. They can easily break the Law. With only 8% of the mobile phone market, the iPhone enjoys considerable headroom. And the iPad’s +151% year/year unit growth shows even greater potential.

So why isn’t Wall Street buying? Why do they think Apple has so much less room to grow than Amazon?

First, a big difference: Apple’s founder is no longer with us while Bezos is very much in command. This is no criticism of Tim Cook, Apple’s new CEO. A long-time Jobs lieutenant, the architect of Apple’s supremely effective Supply Chain, a soberly determined man, well liked, respected and healthily feared inside the company, Tim Cook is eminently credible. But traders are cautious; they want to see if the Cook regime will be as innovative, as uncompromisingly focused on style and substance as before.

Second, the much talked-about iPhone subsidy “problem”. The accepted notion is that Apple has strong-armed carriers into paying “excessive” subsidies for the iPhone, some say as much as $200 more than carriers pay other handset makers. (See “Carriers Whine: We Wuz Robbed!” of March 11, 2012.) Carriers rattle their sabers, they let everyone know they’re looking forward to the day when they will no longer be fleeced by the Cupertino boys.

The numbers are impressive. Take about 150 million iPhones this calendar year (37M units in the last quarter of 2011); assume that 80% of these iPhones are subsidized by carriers…that’s $24B in subsidies. For people who are betting on Apple’s future profits, these are big numbers that could go either way: Straight to Apple’s bottom line as they do today, or back to the carriers’ coffers “where they belong”. For Apple, with today’s P/E of 14, a swing of $24B in profits would result in a change of $336B in market cap. (Today Wall Street pegs AAPL at $525B.)

I’m not saying such a shift is likely, or that it would happen in one fell swoop. I use this admittedly caricatural computation to make a point: Carrier subsidies have a huge impact on Apple’s bottom line, and the perceived uncertainty over their future gives traders pause.

I’ll now take the opposite tack with this Horace Dediu tweet:

In my venture investing experience, it sometimes happens that the top salesperson makes more money than the CEO. In most instances the exec is happy to see big revenue come in and doesn’t begrudge the correspondingly large commissions. But, in the rare case of the CEO turning purple because a lowly peddler makes more money than him (it’s a male problem), we take the gent aside and gently let him know what will happen to him if he does it again.

Carriers sound like the bad CEO complaining about excessive sales commissions racked up by their star revenue maker. Carriers are contractually obligated to keep iPhone figures confidential so we can’t make a direct ARPU comparison — but we have anonymous leaks and research-for-hire firms, they’re curiously silent on the question of actual ARPU by handset. In the absence of a clear case made to the contrary, we’ll have to assume that the iPhone is the carriers’ top revenue generator, and that the subsidies will continue.

This said, if Apple comes out with a mediocre iPhone, or if Samsung produces a distinctly more attractive handset, the salesman’s commission will disappear, Apple’s revenue per iPhone (about $650 in Q1 2012) will drop precipitously, and so will profits.

That’s the scenario that makes traders cautious: Large amounts of profit are at risk, tied to carrier subsidies. They wonder if Apple’s lofty premium is sustainable and, as a result, they assign AAPL a lower P/E.

But “caution” may be too weak a word. In a May 7th 2012 Asymco post, Horace Dediu plots Apple’s share price as a function of cash:

This is troubling. It implies that cash is the only determinant of Apple’s share price.

Put another way, and recalling that share prices are supposed to reflect earnings expectations, it appears Wall Street puts little faith in the future of Apple’s earnings [emphasis mine]:

“Given this disconnect from the income statement, the pricing by balance sheet multiple seems to be a symptom of something deeper. Reasons vary with the seasons, but the company is not perceived to have sustainable growth.

Fascinating. The collective wisdom of Wall Street is that one of the most successful high-tech companies of all times, with three healthy product lines, strong management, generally happy customers and employees is not perceived to have sustainable growth.

We’ll see.

(In the interest of full disclosure, I’ll repeat something I’ve stated here before: I don’t own publicly-traded stocks, Google, Microsoft, Apple or any other. I consider the stock market a dangerous place where, across the table, I see people with bigger brains, bigger computers, and bigger wallets than mine. I can’t win. The casino always does…unless you don’t trade but, instead, invest–that is buy shares and keep them for years, the way Warren Buffet does.)

And Facebook?

I’ll wait for the dust of this botched IPO to settle before I try to figure out what Facebook’s share price reflects. I agree with Ronal Barusch in his WSJ blog piece: I’m not convinced that Facebook or its bankers will suffer irreparable damage.

Still, rumors and accusations are flying. Following Nasdaq’s disastrous handling of Facebook’s opening trades, we hear that the New York Stock Exchange is discreetly suggesting that the company move to a more sophisticated trading platform. This is a great opportunity for Facebook to change its FB stock trading symbol and adopt one that more accurately reflects its opinion of Wall Street.

I have a suggestion: FU.

JLG@mondaynote.com

California’s Financial and Cultural Deficits

I think I found a cure for both. First, the symptoms. Financially, California is close to being bankrupt, it spends more than it makes and runs a huge $361B debt, as illustrated by the online, live Debt Clock:

Unemployment is high; infrastructure is neglected; the pride of California, its UC Colleges, must raise tuition beyond the reach of the very people it was supposed to lift into higher education; California’s State Parks, another treasure, are neglected and being closed.

Fortunately, there’s a solution — and it’s right in our neighborhood. We’ve seen the wealth created by a flurry of recent Valley IPOs, and we’ve watched the rise in share price of more established companies. From Apple to Zynga, Facebook, and LinkedIn, we have a fresh crop of McBillionaires ready to help.

So, here’s what we’re going to do.

First, let’s all agree: $100K in monthly compensation is plenty. Beyond that, a 75% tax rate will help replenish the Golden State’s coffers.

Second, millionaires and billionaires won’t suffer much from a small yearly tax on their assets: 0.25% from $1.5M to $5M, half a penny on every asset dollar from $5M and up. Simplifying a bit, if you have $10M in assets you’ll pay about $50K in asset taxes every year, $100M yields $500K, $1B (think Facebook IPO) brings in $5M, and so on. A pittance for the great feeling of helping one’s fellow Californians.

Then there’s culture. Californians are perceived as a bunch of materialists obsessed with bling, cars, tans, IPOs, wineries, private jets, and various types of cosmetic augmentation and reduction. Outsiders deride our materialism, they call us nekulturny, they joke that the difference between yogurt and California is that yogurt has a living culture.

We can change all this by adding a simple clause to our asset tax code: Works of art are non-taxable. This would result in an explosion of art purchases and patronage. Sculptures, paintings, installations would grace every home and office of substance; artists from all over the world would flock to California, a Villa Medici for the 21st century.

Finally, we have to take care of our abused high-tech workers. Regard the poor Facebook programmers who had to spend yet another night in front of their computers before the IPO. Management profiteers attempt to ennoble this abuse by calling it a hackathon and parading the participants before the media, but we’re not buying it.

Let’s put an end to these destructive and demoralizing practices. Instead of a single 70-hour work week, we’ll create two jobs, hire two employees, each working 35 hours per week. And to promote a serene atmosphere, let’s agree that companies with 50 employees or more will have a “worker council” to oversee decisions such as staffing changes, compensation levels, group activities, layoffs, and the like.

Of course, as with any bold reform, some unintended, counter-productive side-effects may need to be considered.

Let’s start with the asset tax scenario. You work at a successful Valley company, you make good money and decide to help younger entrepreneurs by recycling your gains into their creations. You invest $1M in a startup and get 20% of its shares. As expected, you have to pay the asset tax on that investment, every year. The company attracts new investors at a higher valuation. Great, your initial $1M is now worth, say, $10M…on paper. You will now pay 10 times as much asset tax as before, $50K every year. Unfortunately, after years of valiant struggle, the company shuts down. You lose your investment — and the cumulated asset tax. You would have been better off buying art instead. Less angst, more civic pride (although, admittedly, less investment and innovation, fewer jobs).

You’ve long figured out I’m not serious. A 75% tax bracket, an asset tax, a 35-hour work week and worker councils — such naive measures would create a massive flight of money and talent out of California and into neighboring states that would be delighted to benefit from our boneheaded reforms.

And you’ve also figured out that the measures I’ve outlined, in a slightly oversimplified form, are or will shortly be in force in France. The asset tax is almost 30 years old and its current rate is likely to increase; the 75% income tax bracket is an election campaign promise and, believe it or not, the works-of-art exception is real.

This has resulted in a number of unfortunate countermeasures: High-tech execs pull up stakes and head to London or Brussels; European headquarters move out of Paris and Lyon or are created elsewhere. All because, to paraphrase François de Closets, French demagogues see no difference between Steve Jobs’ fortune and traders’ loot.

The 35-hour work week experiment failed to stanch French unemployment.  The code that complicates the management of companies employing 50 or more people, as Frédéric noted two weeks ago, has resulted in an abnormally high number of companies with 49 workers or less.

From the outside, this is puzzling: Instead of attracting talent and capital, France creates a combination of fact and perception working against the very interests it purports to protect. In addition to the flight of taxable assets, this will accelerate the Brain Drain French officials often rail against. In the US—and particularly in California—we welcome French entrepreneurs, engineers, business people—and money. Do French politicians understand the real world, or will they continue to closet themselves in the French Exception’s virtual reality?

JLG@mondaynote.com