SINGAPORE (Oct 14): Investors on Wall Street are clearly losing appetite for overhyped loss-making technology companies with uncertain business models and unclear paths to profitability. The disaster surrounding WeWork’s planned and now-aborted IPO is the latest sign of disconnect between the private equity and capital markets.
At the start of the year, investors were snapping up shares of tech darlings such as Uber Technologies and Lyft, overlooking their massive losses and debt. The hope was that these companies would be big game changers, and the next Amazon.com of their industry. That has not quite panned out. As noted in my article two weeks ago, most recently listed technology stocks are trading well below their IPO prices. On the other hand, the early batch of players, such as Amazon, Facebook and Alphabet (parent company of Google), continue to fare well.
As sensibility starts returning to the market, it is good to take a step back from the hype, and go back to the key basics of investing — understanding business models.
What defines a successful technology company? The traditional SWOT (strengths, weaknesses, opportunities and threats) analysis still applies for any business, but we believe technology companies in particular must have four key ingredients:
• Network effect;
• Marginal cost approaching zero;
• Significant moat; and
• Behavioural change.
Network effect (NE)
This is where the value of a product or service increases with a rising number of people participating, interacting, interconnecting or exposed to it. NE is strong in companies such as eBay, Facebook, Alphabet and Amazon, which encourage active participation by users, buyers, sellers and content creators, among others.
Social media platforms grow by the number of users and interactive experience, while online retail sites grow by market base, product offerings and competitive pricing. NE also affects the acquisition cost of new customers; companies with strong network effect can add customers with lower cost.
The biggest challenge for any new product or service is gaining traction, or attracting enough users initially so that NE takes hold to achieve critical mass.
Marginal costs approaching zero (MC-O)
All businesses have fixed and variable costs. Traditional companies prefer low fixed costs and high variable costs, so that fixed overheads are low and margins stable. Technology companies, on the other hand, invest heavily in technology, software, distribution channels and platforms from the beginning. Helped by NE, these costs do not necessarily grow in tandem with the increase in customers. The marginal costs — for adding customers, services or revenue — should ideally approach zero.
What differentiates them from traditional companies is the ability to scale without physical constraints. Coca-Cola Co needs additional factories and logistics to sell its product in a new country or region, but Facebook or Alphabet can acquire new or potential monetisable user bases using existing platforms, without much marginal cost. Amazon and Alibaba Group Holding use their platforms and customer base to progressively roll out new services and product offerings.
Significant moat (SM)
A moat is a company’s distinct or competitive advantage that allows it to protect its market share and profitability. An SM is difficult to duplicate and includes branding, size and scale, patents, technology, a sizeable customer or user base, and a large NE. When technology businesses scale up, they gain a competitive advantage and NE, which become effective barriers to entry. Companies with SMs include Facebook, Alphabet, Amazon, Alibaba and Tencent Holdings.
Behavioural change (BC)
Great companies have the ability to cause disruption in the competitive landscape of an industry. Great technology companies can go beyond that and change how consumers react, by creating a need or prompting an action that did not previously exist, such as creating online communities, hailing cabs through phones, making e-payments to street vendors and shopping online.
These companies establish a new factor in the hierarchy of needs, or simply revolutionise behaviour in carrying out tasks. They ultimately open up a blue ocean strategy with new uncontested market space and enjoy being the market pioneer, making competition irrelevant. If their products are unprecedented, or disrupt how things were conventionally done, they will enjoy high profitability — until the next disruptor comes in.
In the accompanying table, we have outlined our views as to the key positioning of the major technology companies in respect of these four key factors.
There are also other factors that the business models need to take into account, notably “market size”. Is the market size big enough for the business to be economically viable? Where is the revenue source — are sales one-off or recurring? If there is a subscription model, is it sustainable? Is there a “product market” that serves users? Are there regulatory framework challenges, like what Airbnb and Uber are facing?
Looking at the above, it is quite clear why WeWork did not work as a technology play. It had a low score in NE and MC-O, and a medium score in SM and BC. The business had no technology or scaling effect. It is basically a real estate play, leasing large office space on a long-term basis and carving it up into smaller, shorter-term spaces. In that sense, it did serve a “product market”, but not at technology valuations.
A look at the players
In our view, three companies score highly in all four attributes — Alphabet, Facebook and Tencent. Amazon and Alibaba score highly in three attributes.
Facebook probably has the best effect of all four attributes. It boasts strong revenue growth and margins, with minimal new customer acquisition costs. It revolutionalised social media with a platform of more than 2.3 billion users that cannot be duplicated. Facebook derives more than 98% of revenue through advertising, although its wide reach has also raised privacy issues. Its WhatsApp and Instagram services offer additional growth and monetisation opportunities.
Alphabet derives most of its revenue and earnings from advertising, primarily from Google. Although Google was a relatively late-starter to the search engine game, it has since gone on to displace all other earlier competitors. Alphabet has numerous platforms with a huge user base and opportunities for growth and monetisation, including YouTube, Gmail, Google Maps, Chrome and Android, as well as side bets on artificial intelligence and autonomous cars.
Tencent operates a deeply entrenched ecosystem connecting more than one billion people in China and worldwide via social media platforms, digital games, mobile payments, search engines and entertainment content, among others. One of China’s most technologically innovative players, Tencent develops proprietary products, content and technology with enormous monetisable potential through advertising, gaming and content streaming. It is also venturing into developing technology for automated cars.
Amazon is the largest e-commerce player in the US. The company is also investing big in physical stores, warehouses and distribution logistics, and has severely disrupted the brick-and-mortar retail industry.
Amazon already accounts for about half of all online sales and is adding even more products and services to its pipeline, including food and groceries. In a similar vein, Alibaba is the equivalent of Amazon in China, with the added attraction of AliPay, its payments system.
What about Apple? It is a great and innovative brand. We believe it ticks off highly in two of four attributes: NE and SM. It scores low in terms of MC-O and BC, however, as its business model is based primarily on sales of products, rather than services, with more than 60% of revenue from the iPhone. Nonetheless, it is now aggressively developing subscription revenue.
Let us take a look at some of the other players, and their positioning in relation to NE, MC-O, SM and BC:
Zoom Video (High NE, Medium MC-O, Medium SM, Low BC): The video communications platform has a growing customer and revenue base, with earnings before interest, taxes, depreciation and amortisation (Ebitda) margins growing from negative in the April 2018 quarter to 4.27% in the July 2019 quarter. Its customer net expansion rate is at 130%, while 39% of revenue growth came from existing customers, suggesting clear demand for its products from both existing and new customers.
Pinterest (High NE, High MC-O, Medium SM, High BC): Pinterest’s unique social network platform allows users to visually share and “pin” images and discover products, with the company deriving revenue from advertising. It has more than 300 million active users, having added 45 million to 65 million users a year in the past three years. Average revenue per user (ARPU) in the US increased from 74 US cents in 1QFY2016 to US$3.16 in 4QFY2018.
Spotify (High NE, Medium MC-O, Medium SM, Low BC): The audio streaming provider’s costs remain sensitive to the demands and negotiation whims of music rights owners. Nonetheless, gross margin expanded to 22% from 12% a decade ago. Competition is increasing from the likes of Amazon Echo and Apple Music.
Teladoc (Medium NE, Medium MC-O, High SM, Medium BC): The telemedicine company’s service coverage and medical professionals in service and scale are unmatched, but half of sales is still generated from call centres, which provides a physical constraint.
ServiceNow (Medium NE, Medium MC-O, High SM, Low BC): The enterprise cloud computing and IT service management player is the biggest of its kind in a burgeoning industry. Technology is hard to imitate because of scale and complexities. It offers a host of modules, plenty of up-sell opportunities and different entry avenues.
Netflix (Low NE, Low MC-O, Medium SM, Low BC): The company enjoyed first-mover advantage in the streaming segment but is now facing increasing competition from the likes of The Walt Disney Co, AT&T and Comcast Corp, which are entering the market. Netflix’s customer addition rate has missed expectations and 60% of current content is from third parties, which will incur significantly more production cost to create content.
Snap (Medium NE, High MC-O, Low SM, High BC): Snap’s key Snapchat social media platform is facing heightened competition, with fewer competitive advantages after Facebook replicated Snap‘s main features on both Facebook and Instagram. Active users are declining in North America, and the company is still operating on negative free cash flows.
Uber (Medium NE, Medium MC-O, Medium SM, High BC): Uber fulfilled a key BC need with its universal app and the ability to connect passengers with a large pool of cars and ordinary drivers as opposed to taxis. Marginal cost is still considerable, though not from its technology platform, but from the high cost of acquiring new customers and drivers, owing to competitive pressure in the ridesharing industry.
Fitbit (Low NE, Low MC-O, Low SM, High BC): It was the pioneer in the wearable fitness tracking device market, creating a BC for consumers. Its first-mover advantage did not last long, however, as Apple and Samsung ventured into this fast-growing space, with their much stronger brand presence, financial and technical clout and NE. Fitbit did not have SM and lost out to others. The stock has fallen more than 80% since its IPO in 2015.
Beyond Meat (Low NE, Low MC-O, Low SM, High BC): It fuelled a behavioural change in the West towards healthy, vegan meat-substitute food products. At the heart of it, Beyond Meat is still essentially a food manufacturing company with limited scalability in terms of production cost. It may have promoted vegetarian meat-substitute food in the West, but these have long existed in the East and the technology is hardly proprietary. Entry barriers are low and many food players and restaurant chains are already developing their own meat-substitute versions.
Our portfolio gained 1.6% last week, outpacing the increase in the MSCI World Net Return Index of 0.8%. This brought total portfolio returns to 8.9% last week. We continue to outperform the benchmark index, which increased 5.3% over the same period.
Tong Kooi Ong is chairman of The Edge Media Group, which owns The Edge Singapore
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
This story first appeared in The Edge Singapore (Issue 903, week of Oct 14) which is on sale now