In the digital economy, the consumer remains king

Capturing the new value created in the digital space over the next several years will depend on the ability of companies--even those currently furthest from consumers--to develop strategies that bring them closer.
(Financial Times ‘The Connected Business’ guest column)

Show transcript

WEDNESDAY NOVEMBER 23 2011

FT.COM | The Connected Business

In the digital economy, the consumer remains king
By David Standridge and Christopher Pencavel

W

e all know how greatly the rise of the digital economy has transformed how we work and play. Just how that process has happened is less clear, especially from a business perspective. So in hopes of gaining some insight into the changes wrought by the move to digitisation, we set out to analyse how the distribution of revenues and profits within the digital economy has changed over the last decade. The results are instructive. The value chain that makes up the digital economy includes all the sectors that benefit from the production and sale of digital goods and services. It starts with the content providers, such as media and entertainment companies that create content, and the services providers, including telecom and cable companies that send it out over their networks. The equipment providers produce the servers, routers, and other equipment that enables the distribution of content, while the software makers create the information technology and network intelligence that underlies the Internet itself. The Internet software and services companies broadly aggregate and distribute the content to consumers, who consume that content over the PCs, laptops, smartphones, and tablets built by the device makers. We began our analysis in 2002, the year the digital economy began to rebound after the bursting of the dotcom bubble. That year, the

digital economy’s profits totaled $498bn on $3,700bn in total revenues. Service providers captured fully 58 per cent of the revenues and 76 per cent of the profits. At the other end of the value chain, the Internet software and services segment took in just 1 per cent of the revenues while losing $658m. Exhibit 1 (below) shows the relative share of both revenues and profits by sector; the width of each box along the x-axis indicates the segment’s total revenues, while the height along the yaxis indicates the segment’s average profit margin. Thus, the area of each box represents the total dollar profits earned by that segment. All figures are adjusted for inflation. By 2010, total revenues in the digital economy had risen 17 per cent, to $4,300bn, and total profits had grown 46 per cent, to $726bn, a compound annual growth rate of five percent. But the relative value of the six segments in the value chain had shifted considerably, making the picture look very different (see Exhibit 2). The key insight: over the eight years between 2002 and 2010, the digital economy experienced a sustained shift in profits and revenues toward the consumer end of the value chain. Revenues and profits at the content providers, the segment furthest from the customer, actually fell. And while the service providers continued to earn by far the most profits, $482bn, their share of total profits fell 10 percentage points, to 66 per cent. All of the other segments

grew their shares, collectively capturing 14.7 perc entage points from the declining segments. Much of the profit gained at the consumer end of the value chain came in the form of growth in the devices segment, whose share of the profits grew by 5.7 percentage points. Apple alone accounted for 47 percent of the profit growth in this segment. But the biggest gainer in terms of both revenue and profits was Internet software and services, which went from a loss in 2002 to record $25bn in revenues in 2010. Again, much of this is attributable to one company, Google, which accounted for 28 per cent of the segment’s profit growth. Despite the large gains made by a few large companies, however, those organisations alone do not account for the shifts in profit pools. Why are these shifts taking place? Several technological developments have occurred that are transferring power from the forces of production to the forces of consumption, which are, in turn, leveraging powerful positive network effects. First of all, back in 2002, the core asset of the digital economy was the content itself -“Content was king.” Since then, however, the onslaught of information, news, media, and entertainment available on the Internet has become relentless, to the point where companies in the Internet software and services - those companies that can successfully filter and

categorise all that information - have gained tremendously in power and value. Second, technological advances in data storage, digitisation of content, and communications have made it far easier to copy, share, and transfer content. As a result, content providers have struggled to control the dissemination of all sorts of content, including music, movies, news, and the like. Both service and equipment providers have also suffered as new technologies have whittled away at their pricing power and business models. Thanks to services such as Netflix, Hulu and Apple TV, for instance, many consumers are opting to drop their cable TV subscriptions. Third, the means of consumption on the Internet are becoming the means of production. In the bricks-andmortar economy, consumers do not have the ability or resources to produce the goods they consume. In today’s digital economy, however, anyone with an Internet connection and a computer, or even a smartphone, can create and write blogs, editorials, and user reviews, or post pictures, music, and videos. Social networks such as Facebook and services such as YouTube organise and screen the content for users, thus replacing the role of traditional content providers. The result: increased competition and lower profits among traditional content providers in the early stages of the value chain.

© THE FINANCIAL TIMES LIMITED 2012

Finally, companies such as eBay, Amazon, Google, Apple, and more recently Facebook and Twitter have benefited enormously over the past decade from the positive network effects of their vast customer bases. Apple’s network of thousands of apps programmers and Facebook’s

enormous user base, for example, afford these companies greater bargaining power, engender user loyalty, and create significant switching costs for users. Such companies, all of which are in the software, Internet software and services, and devices segments, and thus closest to

the consumer, have enjoyed stronger pricing power and influence as their networks have grown. Clearly, capturing the new value created in the digital space over the next several years will depend on the ability of companies - even those currently furthest from

consumers - to develop strategies that bring them closer. David Standridge is a Partner and Christopher Pencavel is an Associate at Booz & Company.

Exhibit 1. Profit Pools in the Digital Value Chain, 2002
Profit margin
35%

Software
30%

$22 bn 4% Service Providers Content Providers $66 bn 13% Devices $25 bn 5% Revenue ($tril.) $380 bn 76%

25%

20%

15%

10%

5%

0% $0.0 -5% Source: Capital IQ and Booz & Company analysis. $0.5 $1.0 $1.5 $2.0 $2.5 $3.0 $3.5 $4.0 $4.5

Equipment Providers $6 bn 1%

Internet software & Services $(1) bn (1)%

Exhibit 2. Profit Pools in the Digital Value Chain, 2010.
Profit margin
35%

Software $52 bn 7%

30%

25%

Service Providers Content Providers $61 bn 8% $482 bn 66%

Equipment Providers $28 bn 4%

Internet Software & Services $25 bn 4% Devices $78 bn 11%

20%

15%

10%

5%

0% $0.0 -5%

$0.5

$1.0

$1.5

$2.0

$2.5

$3.0

$3.5

$4.0

$4.5

Revenue ($tril.)

Source: Capital IQ and Booz & Company analysis.

© THE FINANCIAL TIMES LIMITED 2012