Social Networking: The Millennial Application Moves Out of its Parents’ Basement

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Artur Pylak


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August 21, 2012

Social Networking: The Millennial Application Moves Out of its Parents’ Basement

  • Born into the PC era of neutral browsers and open web opportunity, companies like Facebook now grope for revenues in a new era dominated by harsh platform masters with an “app” access model that forces social networkers into a box. Desktop users keep social network tabs open all day as a bases for value creating activities ranging from games to media streaming, but mobile users open social apps with a purpose and close them when they move on. This puts broad social networks at risk, as circles of more narrow interest emerge and grow as distinct apps, and as Apple, Google and Microsoft co-opt monetization opportunities for themselves. The platform owners carry extraordinary advantage as the inherent conflicts with social networks play out, but now, they struggle as mightily to establish their own social communities as the newcomers do with revenue streams. This momentary stasis opens the door for focused social apps, like Pinterest, Yelp, LinkedIn and others, to establish critical mass as acquisition bait rather than cannon fodder for platform players. Ultimately, broad social networks might be better served on mobile platforms as portfolios of focused apps leveraging a common user data base.
  • The first successful social networks, like Facebook, were built for the PC era of neutral browsers with tabs that stayed open. In a 2001 consent decree with the DoJ, Microsoft was forced to separate Internet Explorer from Windows, leaving the browser as a neutral window that favored no particular web site. Social networking was born into this government mandated equal playing field, with Facebook, in particular, designed as an always open platform for its user base to communicate and share with one another, and in the process, provide valuable user profile data, receive well targeted ads and engage in revenue generating auxiliary applications.
  • In the portable platform era, social networks are apps, called by users for a specific reason and closed after each use – favoring best-of-breed over jack-of-all-trades. Portable device apps are rapidly becoming the primary mode of consumer internet access. Unlike PC browsers, apps do not remain open between uses, limiting their effectiveness as platforms in their own right. Rather than launch one app to get to another app, users may prefer to access auxiliary applications – e.g. photo sharing, media streaming, news feeds, social games, etc. – directly, diluting the value of broad social networking sites in favor of focused ones.
  • The platform owners – Apple, Google, and Microsoft – have significant advantage in pursuing revenue opportunities vs. social networkers. Apple and Google have been aggressive in integrating emerging high-value functions directly into their platforms with each release, squeezing out 3rd party apps in the process. The platform owners also choose default apps that are pre-installed, forcing the choice on their users for a hefty fee from the app provider. Finally, both top platforms ask for a 30% cut of all app revenue and Apple prohibits apps from linking directly to standard web sites. This tightly controlled environment severely limits the revenue opportunities for apps, including social networkers.
  • Platform owners are moving to integrate their own social networking solutions, but struggle just as social networkers struggle with monetization. Social networking could be a powerful integrated function for portable platforms, but the owners have had little success, with only Google+ gaining any traction at all. Meanwhile, most social networkers, and notably Facebook, have failed to articulate viable models for growing their revenue streams from their mobile apps. One answer may be cooperation, and Apple and Microsoft have been receptive, thus far, toward integrating both Facebook and Twitter more tightly into their platforms. Nonetheless, these relationships are not free and could prove transient as these companies also continue to explore ways to build social awareness into their own applications.
  • Best-of-breed social networks, establishing critical mass for valuable markets and barriers to competition, will be acquisition targets and could thrive across platforms. Platform owners may look to loosen their reliance on 3rd party social networking through acquisitions, most likely looking at smaller, more focused, social apps. These best-of-breed sites, having established sustainable advantage in functionally defined markets, could also play across platforms, provided that they establish clear sources of revenue. The salient example is LinkedIn, with its professional demographic and recruiting/job search revenue model.
  • The best strategy for Jack-of-all-trades social networks might be as portfolios of narrowly defined social apps linked by a common user base and service infrastructure. Facebook could launch targeted apps that address specific activities, such as game playing, photo sharing, reviews and recommendations, topical discussion, media distribution, etc., all leveraged against its massive user base and extensive social graph. Doing so would resolve the unwieldy user experience of its mobile app, potentially improving its delivery mechanism for advertising, emphasizing revenue generating services and extending the Facebook brand in the process. It could also establish a better context for licensing its API to 3rd parties. However, such an approach would not countermand the power of platform owners to integrate similar functionality, favor alternatives or to extract a share of revenues.
  • This scenario is good for Apple, Google and Microsoft, and bad for Facebook. Well differentiated, focused social apps may also benefit. We have written extensively of the advantages that the platform owners wield in the new era. While Apple, Google and Microsoft have struggled to build relevant social networks, the ability to integrate social functionality directly into platform software and with other high value cloud applications is a substantial boost to these efforts as the penetration of portable devices expands. Meanwhile, the paradigm shift to the app model is unequivocally bad for Facebook, which is already struggling with the restraints of the platform owner controlled environment. We do see opportunity for focused, revenue friendly social apps with critical mass and barriers to completion to generate value and to attract M&A interest. Examples include LinkedIn, OpenTable, Twitter, and Pinterest.

Summarizing Social

Facebook’s abrupt post-IPO nose dive has obliterated any notion of a social bubble, as investors now question the ability to monetize social connections in an increasingly mobile context. While this is the right question to ask, the answer is not universal, as the relative sales growth success of more focused social apps like LinkedIn and Twitter appears to confirm. Facebook’s troubles, and the related difficulties faced by others, like Zynga, Groupon, and Pandora, are the result of a paradigm shift from the neutral browsers of the PC era to the platform controlled app model introduced by Apple and mimicked by Google and Microsoft.

By its consent decree with the DoJ, Microsoft was required to separate Internet Explorer from Windows, and in doing so, renounce influence over what websites its users might visit. The browser was established as neutral – type in a URL and go – and the lack of platform control allowed the proverbial thousand flowers to bloom. If Microsoft had been able to exercise its market power, Google wouldn’t have been Google, Amazon might not have become Amazon and Facebook certainly couldn’t have become Facebook.

In contrast, iOS and Android rivalry keeps the DoJ out of the portable market. Consumers have embraced the convenience of apps over the neutrality of browsers, and in doing so have granted Apple and Google carte blanche to shape the web to their own interests. Apple exerts strict control over the apps that it allows in its store, extracting a healthy chunk of revenues and restricting apps from bridging to sites outside of Apple’s purview. Google is less restrictive, but also asks a 30% cut and unapologetically favors its own apps, installing them as defaults that are rarely changed by users, and integrating the most promising functions directly into their operating software with each subsequent update. Of course, Apple and Microsoft do exactly the same, leaving 3rd party apps at the mercy of the platform masters.

The big three have already played for social networking, with little to show for it. Apple’s iTunes-linked Ping died of neglect and the marginal success of Google+ comes only after a string of abject failures. However, the pace of adoption gives the iOS and Android ecosystems the substantial benefit of critical mass, added to the freehand to force internally derived social technologies on users by integrating them directly into the platform. The value of this power is not to be underestimated, particularly should social networkers discover the secret sauce to monetization.

Moreover, Facebook is designed to be open all the time, to be visited in the gaps of the day or as a platform in its own right, bridging to a variety of activities related to the social network. The app model stymies this approach. Mobile use is specific – users open an app for a reason and close it as soon as they are finished – discouraging the use of the app as a bridge to other activities. Why use Facebook to play a game, read an article, manage your photos, stream music, or shop when you can select a specialized app directly.

We think the answer to the mobile social question lies in focus and differentiation. Best-of-breed social apps, like Twitter, LinkedIn or Pinterest, draw users for specific purposes that map well to the in-and-out nature of the app model, have defined vehicles for monetization, while establishing scale and community advantages that will make them difficult to replicate. These businesses can be successful on their own terms, but may be even more valuable as deal bait for the big three, who continue to cast about for social success.

We are doubtful that Facebook’s aspiration to platform status is achievable in the app model. However, it is intriguing to think of an archipelago of apps, each specific to a purpose with its own monetization strategy but leveraged to Facebook’s brand, its massive user base and its extraordinary social graph. Separate apps for photo sharing, messaging, social reading, media streaming, event driven chat, on-line gaming, reviews and recommendations, etc. would declutter the Facebook experience and sharpen revenue opportunities. Perhaps the Instagram deal will spur a move in the right direction.

Exh 1: U.S. Web Browser Market Share Trends 1996-2011

PC World

Early in the life of the World Wide Web, Microsoft made a play to claim it all. Netscape had gained success and notice with its Navigator browser, making Jim Clark a Silicon Valley rockstar and leaving Bill Gates both envious and nervous. Microsoft’s response was Internet Explorer, a functional mimic of Navigator that was integrated directly into Windows. You could run Navigator on your PC, but IE was the default and you couldn’t get rid of it. Knowing that users would take the path of least resistance, this was Microsoft’s coup de grace on Netscape. Internet Explorer soon became the dominant browser, drawing the attention of the U.S. Department of Justice, which won the subsequent anti-trust case (Exhibit 1). The original penalty would have forced the company to split itself in two, but an alternative solution was negotiated and Microsoft agreed to disintegrate IE from Windows, to make it easy for users to designate alternative browsers as their default, and to give no favor to specific web sites over others. The browser would be neutral and all Internet-based businesses would be on equal footing. Let the thousand flowers bloom.

Exh 2: Global Facebook User Growth, 2004-2012

This is the world into which Facebook was born. MySpace and Friendster were first, but Facebook was better and in a stunningly short span of time, hundreds of millions of global members were using it to find friends and share their lives. The usage numbers were staggering, and despite an apparent indifference to generating revenue, private investors assumed that monetization would follow, as it had for Google before it (Exhibit 2). In the PC world, this was a reasonable assumption. Facebook expanded on its original premise of users posting status updates to their wall and commenting on others, adding in auxiliary applications, like on-line social games, company pages, social readers and sponsored stories, local business check-ins, etc., all tied into users “news feeds”. Facebook users stayed logged in, keeping a browser tab open to return over and over again as a primary indulgence between the drudgery of work and other useful pursuits. In this, Facebook began to post outrageous user engagement numbers – the average user now spends nearly 2 hours each week on the site – blowing past every other web site and accounting for 18% of the total time spent online by Americans (Exhibit 3). This is the business that had investors champing at the bit for the eventual IPO and that fueled the mini-bubble in social networking companies that weren’t Facebook, but at least you could buy the stock.

Exh 3: Monthly time spent on social networking

Downward Mobility

Mobile platforms have gone from 1% of global internet traffic at the end of 2009 to more than 10% in less than three years (Exhibit 4). E-Commerce has kept pace, with roughly 10% of US transactions executed from mobile devices, while online advertising has not, with just 5% of Internet ad revenue on mobile platforms (Exhibit 5). Little wonder, then, that many social networking apps have struggled to monetize their mobile businesses. Many observers blame this on the screen – smartphone displays haven’t the real estate for big splashy banner adds or an extra column of ads running aside the content. We think the importance of this obstacle is somewhat overstated, as ingenuity ought to remove it over time, location-aware mobile platforms have unique benefits to advertisers, and if it were the only issue, tablets shouldn’t be affected. We also note that advertising is not the only proposed vehicle for monetizing mobile apps. Direct fees, sponsored media, games, and other non-ad monetization schemes have been disappointing on mobile as well. It may be that the struggle to monetize mobile platforms is merely a function of its relative youth – advertisers are conservative and their comfort with browser-based advertising platforms comes with a decade of familiarity.

Exh 4: Mobile as Percent of Global Internet Traffic

Exh 5: Internet Advertising Revenue Components

We think there is another bogeyman. The 2007 introduction of the iPhone brought with it a radical new concept for accessing web-based resources. Apps, those now universally understood mini-applications that conveniently tap users into their preferred internet sites, superseded the neutral window browser mode of web access. At first blush, this was viewed as a big positive for web-based businesses, as they could engage the customer directly, without slavish adherence to the basic browser interface. Android jumped on the app bandwagon, along with Windows Phone and, for that matter, a slew of walking dead platforms like Nokia’s Symbian, RIMs QNX and HPs WebOS. Social networkers rushed to establish their own apps, beating back would-be 3rd party launchers looking to front end established web sites with their own interface programs. Five years later, the vast majority of access to leading web-based businesses from mobile platforms comes via apps rather than the rarely used browser that is still shipped on every mobile device (Exhibit 6).

Exh 6: Top Smartphone Properties and User Engagement (Browser versus App), March 2012

Therein lies the rub. Unlike the PC and its government mandated Internet neutrality, iPhones and Androids are not bound to maintain a level playing field, and they don’t. Apple and Google favor their own apps and those of partners who pay them for the favor, shipping them as defaults with every product that ships. Few users ever bother to even try to change default apps, but if a user prefers to use a 3rd party alternative, the process ranges from mildly annoying to nearly impossible. If a particular category of app proves itself to be unusually useful, the platform owners typically move to integrate their own favored version directly into the platform software, as Apple has done with iTunes, Siri, and its new maps functionality, and as Google has done with its search, places and navigation. Doing so enables a smoother, more integrated user experience, but essentially eliminates 3rd party opportunity altogether.

Exh 7: Comparative App Store Terms by Platform

Even if an app covers ground that does not overlap with an integrated function or a default app, the 3rd party is bound by the rules of the App store. Apple and Google open negotiations by asking a 30% share of all revenues associated with apps sold through their stores (Exhibit 7). That is 30% of the price of any paid app, 30% of any advertising revenues associated with the app, 30% of subscription fees, 30% of in app purchases, 30% of everything. Microsoft starts at the same list prices, but gifts an automatic discount to 20% for any app that can cross the $25K total revenue threshold. Apple takes the further step of prohibiting apps from linking directly through to revenue generating web sites out of Apple’s purview. Of course, web businesses that have established legitimate consumer pull through their browser based sites, like Facebook, Twitter, or Amazon may negotiate better, and always undisclosed, terms, the power in those negotiations is squarely with the platform owner. So, as portable platforms become the predominant consumer Internet access vehicle, the power of Apple, Google and, maybe, Microsoft to influence the web sites their users visit and the cloud-based services that they employ while collecting more than a tithe along the way is by far the biggest impediment to social networkers monetizing their mobile presence.

It Gets Worse

The app model is particularly vexing for a service like Facebook, which has aspirations to establish itself as a social networking platform, hosting its own range of social apps such as games, photo sharing, media streaming, social reading, product ratings, reviews, and others, many carrying interesting revenue opportunities with them. The problem is that the app model is designed for hit and run – you can’t keep Facebook open as a tab to return to, you have to open it each time you visit and close it when you’re done. This eliminates browser snooping to fill in the social graph with web surfing activity and it makes the path to the auxiliary applications that much more trouble for the user. Why click open Facebook, and then open Farmville, when you can waste time with a game that is a single click away?

The social apps that have gained traction in the portable era are generally more focused (Exhibit 8). Pinterest users comment on shared links categorized by subject matter. Instagram users process digital photos and share them. Tumblr hosts microblogs. Such focus likely draws more purposeful visitors in a context better suited to advertising, while Facebook’s jumble of activity centers on communications with a roster of friends, a core activity where commercial intervention may be less welcome.

Exh 8: New Social App Usage Growth

Acquisition Bait or Cannon Fodder?

Even focused social apps are subject to the whims of the platform masters, but Apple, Google, and Microsoft have proven clumsy social networkers. Apple’s idea of community begins with everyone owning Apple gear, a self limiting proposition that largely counts it out of the social networking game, where universal access is generally a defining characteristic. Google has flailed for years, successful with Gmail, but launching duds like Orkut, Google Friend Connect, Lively, Latitude, Wave and Buzz. Google+, launched about a year ago, has had ambiguous results, introducing a number of well received social concepts, such as easily configured social Circles, ad hoc video conference Hangouts, and integration to Google’s many other cloud-based offerings, including Search, Maps, Places and Gmail, but failing thus far to deliver penetration or engagement to challenge Facebook. Microsoft has made a play for social within the workplace, recently snapping up Yammer for $1.2B and has an active gaming community around its Xbox, but has not articulated a broader consumer social strategy around Windows and Windows Phone.

Exh 9: Recent Tech IPO Performance

The circumstances, as the platform wars heat up, suggest that social opportunity for Apple, Google and Microsoft is upon them. Just as Facebook snapped up Instagram, the platform masters could look to fill out the social component of their platforms with acquisitions. To that end, companies like LinkedIn, Pinterest, Twitter, Path, OpenTable, Tumblr, and others could see more value in acquisition than in public markets befouled by the Facebook IPO (Exhibit 9). The key is establishing critical mass and other barriers to competition that would make a deal less expensive and/or more likely to succeed for platform players than simply copying the business concept. Given the power of the platforms, these competitive barriers will need to be very strong, but the lucky few may have sufficient momentum to be successful as independent apps even if they are not acquired. The rest may be the victims of the cold and cruel app model world.

What About Facebook?

Facebook’s plight on mobile platforms has been played out ad nauseam in the wake of the disastrous IPO and subsequent share price freefall. Most of the commentary has focused on the small screen issue with some play toward the receptivity of users to advertising in the midst of interacting with their friends. Our take is a bit different. While small screens and advertising receptivity are obstacles, and tribute payments to Apple and Google for its slot as a default application must be particularly galling, Facebook suffers most from its inability to act as a platform in its own right (Exhibit 10). Ambitions of a Facebook app store for a future wave of 3rd party services levering those 950 million users and their hours of engagement, all generating their own tribute to Facebook will be hard to accomplish on Apple or Google’s watch. Meanwhile, the real platform masters will calmly sift through Facebook’s best laid plans and copy them into their own operating system as well integrated defaults.

We think the right strategy for Facebook is to break out the activities inherent in their web site into separate, targeted apps, all tied from below to the Facebook user community and its awesome social graph. In this model, an acquisition like Instagram would remain distinct on mobile platforms and not automatically integrated to the broader online site. Users would be tied to their Facebook IDs; “friend” lists would be coordinated across apps, although not necessarily identical; and social data would be collected as usual. In this, Facebook could become an archipelago of mobile apps, each defining a social function – Instagram by Facebook, Facebook reviews and recommendations, Facebook video, Facebook social reader, Facebook messaging, Facebook chat, Facebook newsfeed, Facebook social TV, etc.. The multi-app approach would remove monetization pressure from the overcrowded mother site, would raise functionally specific monetization strategies for each app, would dramatically improve usability, and would take up a lot of real estate on a device’s main pages.

Exh 10: Facebook Mobile Monthly Active Users, Q2 2010 – Q2 2012

Of course, each of the individual apps would still be subject to platform tribute payments and the risk of an integrated alternative, but Facebook’s cross platform presence and huge user base offers a real advantage on inherently social applications. If Facebook can build real value from social networking into a wider array of portable apps, the leverage of scale will be all the more important and the benefit of cross-platform ubiquity will be a powerful differentiator, even against integrated alternatives.

Exh 11: Winners and Losers

Winners and Losers

Given our perspective, we obviously see Apple, Google and Microsoft as long term strategic winners in social networking (Exhibit 11). As it stands now, Facebook has to be considered the big loser as social networking transitions to the portable era and the app model. In contrast, LinkedIn, OpenTable, and a handful of private companies like Pinterest, Twitter, and Tumblr, appear to have built sufficient critical mass and sustainable differentiation in narrowly defined and attractive slices of the social market to remain successful and possibly attract M&A interest. Other publicly traded companies with a social networking component, such as Zynga, Yelp, Pandora, and Groupon appear to be vulnerable to competitive inroads as Apple, Google and Microsoft integrate similar functionality into their own ecosystems.

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