The European Equities team, explores the power of platform businesses and explains why the trajectory of their corporate models is often misunderstood.
- Platform businesses facilitate the exchange of value between producers and consumers for something that is not produced by the platform itself. Rather than creating value by making and selling things, platforms provide a mechanism for exchange that is much less capital and labor intensive than linear businesses.
- These types of businesses often experience network effects, which could make them more valuable as more people use the product.
- Most investors continue to apply linear business prospects to platform businesses, which does not consider the flywheel effect that is often present. The market can sometimes struggle to digest this concept, which can lead to inefficient pricing.
Since the industrial revolution, when the invention of machine tools and the development of steam power marked the transition from hand production to mechanized manufacturing processes, the industrial landscape has been characterized by “linear” business models. Linear businesses take inputs such as physical production assets and labor to make goods and services that are sold to customers through a linear, unidirectional value chain (think car manufacturers, steel makers and consumer goods companies). In many cases, technological advancement has not changed the linear aspect of these companies’ value chains.
In several industries, the Internet has dramatically lowered distribution costs, permanently impairing capital in those industries that previously enjoyed economies of scale in physical distribution. Examples include travel agents, newspapers, bookstores, video rental services and shopping malls. Businesses with high fixed costs of incremental production have faced competition from companies enjoying the negligible marginal costs of Internet distribution. The transition that many software companies have made to recurring revenue models has been driven by the desire to lower the marginal cost of distribution and increase incremental returns on capital. But these software companies still operate a linear supply chain: they create products and services using their internal resources and means of production.
We tend to find platform businesses far more interesting from an investment perspective. A platform business facilitates interactions and the exchange of value between producers and consumers of something that is not produced by the platform itself. Rather than creating value by making and selling things, platforms provide a mechanism for exchange. As such, platforms are much less capital and labor intensive than linear businesses. Platforms generate revenues by capturing a share of the transaction value their network enables. Producers that use a platform accept an additional cost of unit production in return for the larger volume opportunity that the platform affords.
Building a successful platform is not straightforward and necessitates solving the “chicken or the egg” problem of needing to have enough producers to attract consumers while simultaneously needing enough consumers to attract producers. Without adequate scale and liquidity, the value to users will be lower than the cost of participation. It is this dynamic that makes platform businesses more difficult to build from a standing start when compared to their linear counterparts. However, once you are past the tipping point at which user value is greater than the cost to participate, powerful network effects take hold that can rapidly increase the per-user value of the network. Therein lies the real beauty of this type of business model.
Platform Business Models Reap Other Benefits
In addition to network effects, successful platforms also benefit from the impacts of producer switching costs. On a platform, consumers often provide non-monetary benefits to producers in the form of reviews, ratings and other feedback such as “likes” and “shares” on social media platforms. This is an important mechanism that encourages good behavior and preserves required levels of customer service. As producers build up these goodwill assets, the costs of leaving the network and establishing a reputation from scratch increase.
The platform business model is also less susceptible to antitrust than linear business models. The objective of antitrust is to promote fair competition for the benefit of consumers. Traditional monopolists control the means of production – they earn supernormal profits by restricting output, charging anticompetitive prices and minimizing consumer surplus. Platform businesses do not own the means of production, but simply the means of connection. Platforms do not control the prices and outputs of producers. But by facilitating more touchpoints between consumers and producers, they can increase competition, to the ultimate benefit of the consumer. Platforms are therefore characterized by an alignment of interest between shareholders and customers that is not found with traditional linear monopolists. As such, a regulatory intention to curb a platform’s dominance could have the undesirable effect of harming consumers’ interests.
Platforms make fragmented supply available to consumers in one place. Consider consumers looking to find the best price for a house or a car. There is an opportunity cost associated with the time spent manually finding the owners of that inventory and comparing availability and pricing. Conducting that price comparison exercise for your property on a website is a much more efficient process.
In addition, price transparency leads to a more competitive outcome for the consumer. The platform increases choice and saves the consumer time and money. And the more scale the platform has, the greater the choice and the more competitive the price. In this way, platforms grow by delivering more value to their users rather than by controlling the supply chain. However, while these considerations may be logical, until the regulatory regime evolves to be suitable for 21st century business models, regulatory bodies are likely to use arguably unfit-for-purpose antitrust frameworks to make life difficult for some of the dominant platforms (such as Airbnb and Uber).
Platforms Create New Markets and Foster Innovation
One of the main challenges for regulators as well as investors in analyzing such businesses is identifying the total addressable market (TAM), especially at the beginning of a platform’s life. For example, the valuation exercises for Uber’s equity value at its origins started with the global taxi industry as the addressable market. With the benefit of hindsight, we can say that was plainly wrong because the potential market was much greater than the taxi market due to the superior customer experience when compared with traditional taxis (e.g., cheaper, shorter pick up times, more convenient payment methods, tracking technology, etc.). As such, the relevant addressable market was not just the taxi industry, but also public transport, walking, rental cars and driving owned vehicles.
The outsized return on investment for Uber’s early investors was made available in part because of the equity market’s failure to look beyond the incumbent industry in determining the prospects of those disrupting it. Platform business can thus be underappreciated when there exists the potential to leverage the strength of the network to invest into adjacencies.
In his 2011 annual letter, Amazon’s Jeff Bezos explained at length how a platform nourishes creativity, fosters innovations and as a result, creates new TAMs:
Invention comes in many forms and at many scales. The most radical and transformative of inventions are often those that empower others to unleash their creativity – to pursue their dreams. That’s a big part of what’s going on within Amazon. We are creating powerful self-service platforms that allow thousands of people to boldly experiment and accomplish things that would otherwise be impossible or impractical. These innovative, large-scale platforms are not zero-sum – they create win-win situations and create significant new value for developers, entrepreneurs, customers, authors, and readers.”
-Jeff Bezos, 2011 annual letter to Amazon shareholders
Even today, the market has a tough time digesting this concept and remains quite inefficient in pricing in this flywheel effect. Most investors continue to apply linear business prospects to a set of outcomes that could include exponential value growth.
Growth Potential of Platforms Is Underappreciated
Linear businesses’ customer acquisition efforts result in singular relationships per customer added. Recurring revenue business models may lower the cost of customer acquisition and retention, but they could still result in a singular profit stream associated with each customer.
In contrast, when platforms acquire users – whether they are customers or producers – those users form relationships and transact with the existing users in the platform. As the number of users grows arithmetically, the number of potential relationships and interactions may grow exponentially. And due to the very low marginal costs of distribution and production, profit margins can expand materially.
The application of linear growth expectations to platform businesses therefore could imply a failure of the platform to facilitate, nurture and monetize these potential interactions. Once we understand the dramatically lower cost of growth for these businesses, we should question the relevance of previously accepted valuation methods based on outdated accounting metrics.
In our view, the availability of this opportunity to public equity investors could imply a dramatic underappreciation of the exponential growth properties of successful platform companies. We believe investors should remain vigilant and seek to identify these mispriced opportunities.
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