No. 330: Gen Z Arbitrage

For those with Android-based smartphones in 2010, you may recall a fear of missing out. For iPhone owners who had access to a fledgling startup called Instagram, they made sure to remind you that your phone was incapable of using the software. Nothing matched the aesthetic or network effects of the photo-sharing platform for the rich kids. The fear of missing out moved many to leave Android for iOS. For those who couldn’t, Apple’s products lived – rent free – in their minds until they too had the opportunity to own their very own iPhone. This was Apple’s strategy and there’s a chance that it wouldn’t have been executed without John Doerr’s vision for Steve Jobs and his app store.

In 2008, Kleiner Perkins Chairman and partner John Doerr recognized the transformative influence that the iPhone’s launch would provide for the mobile software industry. As the story would go, Steve Jobs privately discussed the prospects of the iPhone’s fledgling app store with Doerr. Jobs originally viewed the marketplace as a private entity, one that would remain under the complete control of Apple’s management. Doerr had different plans. He believed that by outsourcing the development and marketing of apps to third party teams of software engineers, Apple would build an effective moat around their mobile operating system.

Eventually, Jobs obliged. He agreed with the ecosystem lock-in potential of tens of thousands of software engineers building products for Apple’s new mobile operating system. Managed by Kleiner’s Matt Murphy (now with Menlo ventures), the $100 million iFund launched in 2008 and was later doubled to $200 million. Kleiner’s commitment to the burgeoning mobile software industry directly and indirectly impacted consumerism forever. Numerous venture firms identified the massive opportunities that mobile applications would provide and billions in venture capital followed suit.

Leading iPhone apps in the Apple App Store in the United States | Source: Priori Data

Just as Kleiner’s pioneering iFund once inspired an arbitrage that even Steve Jobs couldn’t have anticipated, the iPhone is once again at the center of an equally critical opportunity. As of March of 2019, the iPhone had an installed base of around 193 million in America. An astounding number given that the United States population is estimated to be around 372 million. By 2021, 45.4% all Americans are projected iPhone users.

China already is outpacing the U.S. and much of the developed world in mobile payments, and a new digital currency that authorities say would be like cash and accepted everywhere would put China miles ahead in the currency space. [1]

Apple’s app store helped to solidify the iPhone as perhaps the most pivotal consumer product of the early 21st century. One that powered transportation, communication, advertising, and global commerce. But nearly 12 years later, America’s commerce adoption still lags behind other global powers. Consider China, a country that achieved 73.6% digital shopper penetration in 2018. Mobile payments continue to drive the vast majority of online retail activity in the Asian country.

The rise of mobile payments in China

As a result, over 35% of all retail sales in China are done through online retail channels. In the United States, online retail adoption hovers at 12%. Mobile payments are commonplace throughout China across age, geography, and economic status. The ability to buy and sell goods online is so commonplace that Generation Z is the leading market for online luxury shopping in China. This has been bolstered by explosive growth in mobile payments over the past five years, a transaction volume that reached $45.1 trillion in 2018. According to the People’s Bank of China, this figure grew 28x in five years. It was largely driven by a cultural shift that saw China’s youth (Generation Z) empowered to transact for goods and services across China’s online retail and media ecosystem. According to Chinese media, proximity payment platforms Alipay and WeChat account for nearly 90% of the transactions. In America, there are 61.9 million proximity payment users, transacting just 113.79 billion in retail sales according to Statista’s 2019 data.

The Retail Arbitrage Ahead

Generation Z is the largest, youngest, most ethnically-diverse generation in American history. With over 82 million members, this cohort comprises over 27% of the US population.

While China’s Generation Z is more active in the purchase of consumer goods than their American counterparts, a snapshot of Gen Z’s current buying power would likely surprise you. TransUnion studied the credit market for buyers between the ages of 18 and 23 between Q2 2018 – Q2 2019. In that year, this consumer cohort accounted for 319,000 mortgages, 746,000 personal loans, 7.75 million credit cards, and 4.37 million auto loans.

Penetration rate of online luxury shopping in China | OC&C

Nearly 27% of Americans (and growing) fall within the birth years of Generation Z, a demographic that is of critical importance to legacy retailers and DTC brands, alike. In China, a country often measured as a leading indicator for American commerce trends, Generation Z leads in luxury retail adoption. In America, Generation Z is awaiting the opportunity to buy with the frequency of Millennials and Generation X. The data suggests that their consumer activity will trump that of previous generations. While Millennials prefer DTC brands by a margin of just 4% over traditional retailers, Generation Z prefers these online-born brands to their legacy counterparts by over 40-45%.

Gen Z, the group born between the mid-1990s and 2010, is already known for its financial literacy. More mature and pragmatic than its older millennial forbearers, the cohort is savvy with both finances and technology, survival skills that members gained after watching siblings and parents suffer through the 2008 recession. [2]

These are the brands that they’ve grown up with on social channels used over their iPhones: Snapchat, TikTok, WhatsApp, Instagram and others. The DTC arbitrage in 2020 and beyond will be closely tied to mobile payments. The growing adoption of CashApp, Venmo, and teenage banking programs like Current may begin to help Americans close the gap between the US v. China mobile payment adoption rates. At the center of this activity is Apple Pay, the tool with the most potential to influence Gen Z’s retail habits.

Web Smith on Twitter

Online retail / DTC arbitrage: 2008: Shopify over custom builds 2012: Warby’s PR playbook 2014: Facebook advertising 2016: Key affiliate partnerships 2018: Selling the first $3-5M w/o ads

Generation Z is as technologically independent as Generation X was physically independent. Whereas all day bicycle excursions and unannounced sleepovers were a fixture in the 70’s and 80’s, that is much less so today. The meeting places and opportunities are increasingly presented in the form of digital layers. In that way, millennial parents have had to come to terms with moderating a new era of independence. Fewer drivers licenses and cars, more subscriptions and teen banking accounts.

Alexis is a middle school-aged girl in the American Midwest. An A student, athlete, and all-around great kid, she tends to earn extra privileges from time to time. Equipped with her Apple Pay-enabled iPhone, her love of TikTok and Instagram, her fascination with Glossier and Athleta, and a bit of granted independence – she’s transacted $113.41 with Glossier and Athleta’s cart in the first three quarters of 2019. The limiting factor has been her access to funds, a constraint that Apple will likely account for by offering a peer-to-peer subscription product. Apple Pay provides an independence that Americans are still dueling with. But that’s evolving. Parents are trusting of their children maintaining cash balances on their mobile phones, especially if they can easily monitor spend and availability.

If you ask the founders of Warby Parker how the team scaled so quickly, they may mention the low costs of Facebook and Instagram ads at the time. They may cite the savvy public relations work that led to that magnanimous GQ article. This moment was responsible for the  initial sell-through of their first run of prescription glasses.

70% of Gen Z has made in-app mobile payments in the last year. More than any other generation. [3]

From time to time, there are technological and economic advantages that lift the brands that are prepared for the moment. For direct to consumer brands, a category of brands that Gen Z prefers over traditional retail, there is an opportunity to shorten the marketing funnel by appealing to a generation of consumers that have been written off by the incumbents in retail. Traditional brands are marketing to the parents of America’s youth rather than directly communicating to a demographic that could benefit them. The data suggests that as Apple Pay’s adoption rates continue to improve, Gen Z will become the primary consumers of the goods that have, so far, been marketed to Millennials and Gen X members.

Year 2020

We underestimate the significance of the Apple card being used as a function of the Family Share, a program that allows Apple users to share access to digital products and assets with their families. The moment that ‘Gen Z’ is capable of spending (while accountable to their parents) is the moment that 27% of American consumers, with a preference for DTC brands, floods the market. This is the potential arbitrage that awaits for this era of retail.

And in this way, this small shift in corporate strategy resembles the magnitude of moment that John Doerr was responsible for. Either Apple will build a native function that allows guardians to ‘subscribe’ and account for potential monthly allotments to their dependents. Or a third-party solution will be engineered by an outside developer. Of all the mobile payment solutions available to consumers, it is Apple that sits at the trusted intersection of family and finance.

The Apple card is a platform that few have recognized. It’s also another lock-in opportunity, perhaps the first of the Tim Cook era. With few exits, low multiples, and increasing customer acquisition costs – the weakening viability of the DTC ecosystem has been difficult for operators and investors alike. By accelerating Gen Z’s path to becoming independent consumers, Apple stands to benefit during a time where the Cupertino-designed hardware is as commoditized as ever.

And like Silicon Valley benefited from Apple’s democratization of the app store in 2008, this era of consumer brands will stand to benefit from democratization of consumerism within the home. Our Gen Z daughters want Balm Dotcom.

Read the No. 330 curation here.

Research and Report by Web Smith | Edited by Tracey Wallace | About 2PM 

No. 325: Consolidation and Cable 2.0

The center of the home is still the room with the television. In that room, there is an arms race happening before our eyes. Streaming properties are adopting an end-to-end format that reflects the very nature of digitally native brands: own the product, own the channel, and you’ll own the consumer. But it wasn’t always that way and it may not always be.

This past weekend, my wife wanted to watch our favorite show. But in my parents’ market of Northwest Florida, that Sunday evening was disrupted. Their home was in a sort of in between, half traditional cable and half streaming services. But without HBO Now, we couldn’t watch the one show that we agreed upon. This situation was not without its irony.

Now-retired, Cleon Smith spent 30+ years as an executive in the cable industry. First for Time Warner, then Comcast, and finally – Cox Communications. It was within the walls of Time Warner that I interned with his upstart broadband internet department: code named “Road Runner.” As GM of the service, his market (the dense triangle of Houston, Dallas, and Austin) launched shortly after the test in Elmira, New York. At 14 years old, I watched his group tweak, market, and launch a product that would shape Texas’ future and then the nation’s. That broadband service, the first of its kind for the general public, would disrupt his company’s core business forever. Or so I thought.

I understood why the streaming industry took off but in the end, those consumers will yearn for simplicity of the good ole’ cable days. We sold a good product.

With the advent and widespread adoption of broadband internet, services like Youtube launched in 2005. And then, like a hurricane hitting an unsuspecting island of plywood homes, Netflix pivoted to streaming service in 2007. That did change everything.

Companies like Comcast, Time Warner, and Cox Communications began to innovate by introducing on-demand options and, eventually, the ability to login to Netflix or Hulu accounts to their OTT devices. But it didn’t end there. Each of the aforementioned properties were disrupted. First, by the Netflix approach to marketplace growth – an innovation that provided millions of cable, Dish, and DirecTV subscribers the incentive to “cut the cord.”

This is an example of a consumer household in 1995:

  • broadcast television: cable or satellite provider
  • basic: cable or satellite provider
  • premium services: cable or satellite provider

This is an example of a consumer household in 2012: 

  • broadcast television: cable or satellite provider
  • basic: cable or satellite provider
  • premium services: Netflix, iTunes

This is an example of a consumer household in 2020:

  • broadcast television: antenna, Hulu+, Sling, DirecTV Now, CBS All Access
  • basic: Philo, Sling, YouTubeTV, Playstation VUE, Netflix, Roku, iTunes
  • premium services: Netflix, Showtime (streaming), HBO Now, Prime Video, Vudu, Disney+

Between 2007 and 2018, Netflix worked to build a proverbial “mall” of properties by purchasing, licensing, or manufacturing intellectual property. It resembled elements of traditional cable but it emphasized the program, not the channel. Netflix Originals were purchased from independent filmmakers and marketed as Netflix’s own. Broadcast television properties like “Friends” and “The Office” were licensed for tens of millions of dollars per year. Hollywood A-listers and top directors were granted $300 million budgets for films meant to rival big studio releases. Yet, Netflix is currently trading at six month lows after news of: historic subscription losses, a small revolt after a $2 price increase, and the loss of two major properties. Industry analyst Andy Meek [1] on the matter:

Netflix lost 126,000 subscribers during the quarter, the first time that’s happened since the streamer actually started producing original content. Yikes. And then when you couple that fact, plus the quarter’s lack of new hit content and the imminent loss of shows like “Friends” and “The Office” with the forthcoming launch of rival streamers from Apple, Disney, and HBO’s parent company, among others — it’s a recipe for disaster and whatever the Streaming War’s version of hand-to-hand combat is, with everyone taking a piece out of Netflix, right?

As Netflix’s value erupted, an inverse relationship manifested: Netflix’s success and the commodification of the studios. The streaming industry increased their leverage by providing more consumer optionality and negotiation-by-wallet power to end users. In the process, cord cutting began to hurt studios as well. Not only are their cable contracts diminishing in value, their streaming payouts aren’t making up for the lost revenue.

Coupled with changes in consumer behavior, contract fallouts between studios and streaming channels, and the continued proliferation of speedier data services – you have the basis for the continued fracturing of the industry.

2PM Data: The Macroeconomics of Streaming

Subscriber losses for selected cable companies in the U.S. 2018 | Source: Leichtman Research Group
Pay TV penetration rate in the United States from 2010 to 2018 | Source: Leichtman Research Group
TV services used as substitute by cord-cutters in the U.S. 2017, by viewer type | Source: Nielsen
Monthly time spent watching OTT services in the U.S. | Source: comScore

The final graph is, perhaps, the most interesting. Disney-owned Hulu has begun to close the gap between their offering and Netflix. With Disney’s properties growing in popularity, analysts anticipate Hulu will continue narrowing Netflix’s lead.

Netflix planned to be the modern consumer’s iteration of cable television – a model that depended on a critical mass of content and viewership. That critical mass had to remain greater than the sum of all potential streaming competitors. For a time, the Reed Hastings-run media company had enough of what America needed: great classics, go-to films, syndicated sitcoms, game-changing originals. And then the ecosystem began to fracture. Properties like “Friends” left for WarnerMedia’s streaming service while “The Office” prepared to depart Netflix’s content menus for NBC’s streaming equivalent. Becca Blaznek on why “The Office” has left Netflix [2]:

Among them is NBCUniversal, which owns the rights to The Office. On June 25, 2019, the company released a statement that they will not be renewing their deal with Netflix, instead bringing the “rare gem” to their platform beginning in 2021. According to the Hollywood Reporter, this will not affect international viewers for the time being.

Like the consumer categories that went vertical to compete in a new economy, so have the studio brands competing for the mindshare of cord-cutting consumers. This had an unintended effect however. While modern consumers prefered streaming over traditional broadcast or service providers, the traditional consumer still prefers their traditional television over other devices for streaming media.

The DTC Evolution

Sales of OTT devices | Source: Strategy Analytics

As media fracturing continues, contract negotiations between studios and existing streaming services will only intensify. This will result in added subscription costs for consumers. The promise of the cord-cutting age was two-fold: (1) improved household economics and (2) accountability. Consumers wanted to avoid the pages of unused television programming that went neglected. Today, it’s typical for a cord-cutter to maintain subscriptions to 5-10 monthly media services to accomplish the same consumer tendency: availability irregardless of usage rate.

Today’s consumer is submitting to this dizzying dance of “subscription / login / password recall / and idle subscription” but without the convenience that consumers found with traditional cable providers.

As such, the disruptor is due for disruption. And in this way, an earlier inference may have been mistaken and my dad could end up right. With cable and data providers like Comcast, Cox, and AT&T controlling the pipeline and studios increasingly at odds with new-age streaming services, the momentum is tipping in the favor of tradition. While OTT boxes like Roku and Apple TV have made subscriptions and programming search infinitely easier, the 1:1 connections between consumers and streaming agents continues to subvert the innovation’s original intent: ease, consistency, and value.

It’s likely that the traditional media consumer has reached their limit. Cord cutting was an economically-driven phenomenon. Foregoing the streaming economy in exchange for returning to traditional cable is a question of programming availability and ease of access (try logging into Netflix on a relative’s cable box).

Streaming services will be bundled. It’s likely that we’re near the point of OTT carriers marketing the opportunity for consumers to purchase pre-negotiated, economically-friendly bundles of streaming services packaged. With no-login, one collective price, and less of a fear of missing out – the past has become the present. Disney’s streaming offering may be the sole victor here; their value and reach may outlast a shift back consolidation. For all others, the fracturing market of streaming video on demand (SVOD) has begun to cannibalize the direct to consumer opportunity that was the initial appeal.

In this manner, there is similarity between retail’s DTC cost-elasticity and SVOD’s elasticity. For online retailers, CAC has risen as digitally native brands flooded the market (performance advertising inventory remained constant). For streaming media companies like Netflix, CAC has risen as studios flooded the streaming market and costs to feature their properties became prohibitive. While Facebook and Google’s ad inventory’s limitations have resulted in price elasticity, the SVOD parallel is slightly different. The streaming consumer’s spend is nearing its point of elasticity. And the end game may be consolidation, a result of the yearning for good old cable days.

Read the No. 325 curation here.

Research and Report by Web Smith | About 2PM

Additional reading: (1) Member Brief: The Netflix Report (2) Monday Letter: The Hundred Year Titan (3) This wonderful thread by Nate Poulin that further contextualizes this report.

Member Brief: 2007 – 2019

As the direct-to-consumer industry evolves, so will the inferences and analyses that we can make. In Asymmetrical Warfare, I wrote: “As media buying becomes more difficult for challenger brands, more direct-to-consumer brands will shutter. And competition will become more symmetrical and predictable as the hundreds of new brands narrow down to the sturdier dozen.” In hindsight, this is only partially correct.

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