Amazon
Amazon was founded by an entrepreneurial individual who recognised the potential power of a new distribution medium. Following this recognition, a prototype was created with the assistance of external funding and translated into a working model. The company experienced rapid growth in top-line revenues in its early years and also burned capital as the infrastructure necessary to sustain future growth was put in place. Amazon got through cash at a rapid rate and faced a constant battle to retain the confidence of capital markets (and hence the future supply of capital) at a time when its balance sheet was deteriorating rapidly. This placed it firmly in the tradition of previous technology pioneers that needed at all costs to maintain a convincing evangelist stance in order to survive. Bezos and his colleagues produced a steady stream of bullish statements on future prospects for the Internet and e-commerce.
The big question for Amazon shareholders at the time the first edition of this book appeared in 2001, was whether the company could translate continued growth in gross revenues into a positive profits stream. Gross revenues were compounding nicely, but the expansion had largely been funded through debt or debt-related instruments. The company was approaching a cash flow crunch as its balance sheet was stretched. If holders of its debt had demanded greater security at that point, it could have been forced to slash its variable costs, including the marketing spend it needed to sustain its future growth. Operational losses at that point exceeded $0.5bn, while shareholder equity was less than half that figure. In the aftermath of the stock market crash, shareholders were fearful of having their already much reduced equity diluted further at the behest of the debtholders.
10.23 – Amazon: growing like a weed, still waiting for profits
Source: Thomson Reuters Datastream. Amazon annual reports.
As it turned out, while Amazon was unable to deliver meaningful profits, it did continue to grow its revenues at a rapid rate and this was sufficient to maintain confidence. The combination of positive cash flow and balance sheet debt allowed it to avoid further dilutive equity issuance, other than in the form of staff compensation. The share price fell by more than 90% from the peak, but the company survived and the shareholders avoided dilution. Despite a fragile balance sheet the management successfully managed to maintain the confidence of its suppliers and lenders against a backdrop of criticism in financial markets and the media.
Since the lows of 2001 the company has continued its relentless top-line growth, with sales revenues compounding at around 25% per annum. The business has both broadened and deepened with the addition of cloud services and ever-improving content. The efficiency of its inventory and distribution systems has produced an economy-wide revolution in online retailing. By 2015 annual sales, remarkably, passed $100bn for the first time. Profitability has lagged, however, and operating margins remain low. The fact that the company’s valuation has remained so persistently high is a testament to the focus of investors on the company’s relentless pursuit of scale. By its nature Amazon’s online offering means that the company has only a limited ability to raise pricing if it is to maintain the ‘lowest-price’ offering. Any expansion of profitability will therefore have to come from added services such as new content, product extension and cloud services to third parties. Notwithstanding the growth in top-line revenues, there is now a danger that investors have become too enthusiastic about Amazon’s profit potential, just as they were overly pessimistic during the TMT collapse.
Facebook: the rise of social media
Developing a dominant social media presence on the Web has long been a holy grail for new Internet businesses and by 2006 one company seemed to have it nailed. MySpace was the most visited website in the US and a hot property for media businesses such as News Corp and Viacom. Rupert Murdoch successfully purchased the business in 2005 for a price in excess of $0.5bn, much to the chagrin of Viacom chairman Sumner Redstone, who allegedly fired his CEO for failing to make the acquisition. The ambition to merge content and distribution has a long but distinctly mixed history. News Corp’s attempt at this with the acquisition of MySpace proved another spectacular failure, fit to sit alongside AOL Time Warner. The rise and fall of MySpace has been chronicled in many books and articles. It was not unique in its fate – other social media businesses such as Friendster, Bebo and Google’s Orkut suffered a similar end. Flaws in one or more of simplicity, speed or safety were the most common criticisms of social media sites that fell by the wayside. Although each site had these flaws in different combinations, and the flaws are clear in hindsight, scepticism was far from widely shared at the time the MySpace deal was announced. As one author noted then, “Murdoch remains focused on the Internet as the future of News Corp. He has called MySpace the ‘digital centerpiece’ of his company and has predicted that MySpace could fetch more than $6 billion if it were sold. ‘This will be the single biggest mass platform for advertising in the world,’ he predicts.”¹⁰⁵
The interesting aspect is that Rupert Murdoch was well aware of the trend away from offline to online advertising and the need for his organisation to protect its position as a leading player in the media industry. As an astute investor he paid a premium to capture what, at the time, was the most valuable Internet real estate around. Yet his purchase was to fall in value by over 90% in just a few years. Was this a failure of analysis or a mistakenly bullish judgement? Most likely it is simply another reflection of the difficulty in picking and maintaining long-term winners in technology, where mortality rates are high and the decline of an uncompetitive business can be remarkably rapid.
Conventional wisdom now claims to understand why Facebook’s competitors failed – but it also failed to predict with any confidence that Facebook would emerge as the industry goliath. When Facebook began, it did so in the rarefied environment of one of America’s most prestigious universities. Harvard conferred a veneer of exclusivity and sparked curiosity. Indeed initially access was restricted to Harvard students – and later to members of other Ivy League universities. Whether or not this was a deliberate ploy, selling exclusivity is one of the oldest marketing tricks in the book. For a business that was in time to exceed 1 billion users, it now seems rather ironic. Facebook has since run its business in model fashion. Google deliberately settled on a minimalist home page, and Facebook, to its credit, was smart enough to do the same. Whereas other social media entrants suffered from a range of problems relating to privacy and the potential for bullying or sexual exploitation of users, Facebook has spent substantial time and resources on minimising the potential impact of those issues.
In a commercial sense Facebook is the largest competitor to Google, despite the fact that the service is completely different. In principle its model is similar to that of a traditional market research company. Consumers are incentivised to provide details about themselves which can then be used to inform advertisers/producers on how best to reach this self-defined target audience. Whereas consumers of mainstream media are paid to reveal their preferences, either directly through compensation, or through some form of media content, Google and Facebook profit from users defining their interests, likes and dislikes through their use of the product. In the case of Facebook, users reveal information about themselves, including likes and their location, in their social media interactions with other users. The majority of Facebook revenues stem from the information advertisers can derive from this database. The challenge for the company, just as it is for Google, is to continue providing a service that generates revenue without becoming too intrusive in terms of personal data or advertising.
Like Google, Facebook is well aware that the core advertising franchise has to be protected and like Google it has made acquisitions to protect it from the potential drift of traffic. For example, in 2012 it acquired Instagram for approximately $1bn in cash and stock. At the time Instagram had no revenues and Facebook was pre-IPO. Similarly, WhatsApp was purchased for $19bn in 2014. This again highlights the importance of ensuring that any poten
tial weaknesses in a product line-up are quickly addressed, before either customers move to freestanding applications outside your stable, or before a competitor begins to encroach on your territory. This is a sign of both weakness and strength in the Internet advertising space. The weakness is that the major players need to be continually alert not just to the threats of existing competitors but of new entrants. The strength is that while new entrants can emerge very quickly, the capital base of the incumbents is such that they can acquire and embed these potential threats quickly, even if the standalone cost of acquisition does not always look earnings-enhancing.
Facebook
With its roots in Harvard, it would be hard to describe Facebook as having been of humble origins, but in a corporate sense it did fall into the dormroom/garage category of start-ups. The social network concept behind Facebook was not new and it was an area not short of both existing and nascent competitors. Nevertheless, even from its early days, the user growth figures suggested that the company had arrived at a formula that worked. The rapidity of user growth helped underpin the funding rounds that supplied the company with ample capital and deferred the need for revenue generation until scale had been built. As functionality was built and data gathered, so the attractiveness to advertisers grew. Buoyed by global user growth and the continued shift of advertising to online, Facebook’s revenues grew dramatically. Not being capital-intensive, profits also expanded despite the investment needed to fund that growth.
For the same reason as Google, historic growth levels will not be sustainable indefinitely. As the two drivers of user growth and advertising revenue shift slow, so too will growth in revenues and profits. Despite this, Facebook’s business model remains very strong. Given that the ability to interact is a product of the number of users, there are inherent barriers to entry for newcomers. The strength of a ‘network’ that enables hundreds of millions of users to connect and interact with each other tends to create a natural monopoly. However, unlike the telephone – the barrier to entry of which rested on the scale and strength of a physical network and a monopoly of connection (which allowed poor service levels and anti-competitive practices to persist) – the fact that Facebook does not directly charge for its service will make it hard for antitrust measures to be applied to break up its dominant market position. The challenges Facebook faces will flow more from potential boredom and a lack of engagement from its user base. Maintaining freshness and additional services will be the constant challenge for the company.
The key financial decision for the company will probably come when its growth rate starts to flatten and it has to decide whether or not to accept that this is a natural result of the laws of proportionality – meaning it has to devote its excess cash to reduce the equity base – or whether instead to diversify into other areas of activity in which, most likely, it will have a much lower natural competitive advantage. It has made two important acquisitions in recent years, in the shape of WhatsApp (messaging) and Instagram (photo sharing), both designed to broaden its user base and protect itself against the risk of a potential new functional network threatening its own growth. Future growth rates of the core business will depend on the overall growth in the advertising market and the extent to which dollar spend continues to shift from offline to online media.
10.24 – Facebook: from the dorm to global leadership
Source: Thomson Reuters Datastream. Facebook annual reports.
As is the case with Google, the capital-light nature of the business means that even when growth does slow, the substantial cash the business generates could be returned to shareholders either through equity repurchases or dividends, as Microsoft has done since its business model and market dominance started to mature. One persistent danger for the company will be conflicts with regulators engendered by its monopolistic position in terms of the power that its network bestows on it, which is not dissimilar to that which once accrued to the press barons of yesteryear. Historically, companies with the political power of Facebook have posed a threat to the political establishment irrespective of whether the power has been abused deliberately or inadvertently. The row over the role that social media might have played in the election of Donald Trump as president of the United States in 2016 is just one portent of the legislative scrutiny that is likely to intensify over time.
Snapchat
Snapchat is another example of a by-product company. It is an app beloved of younger generations, in which users are able to interact with messaging, photos and videos. Unless captured by a screenshot, the messages disappear after being read, which makes the interaction feel more human and current. User growth has been rapid and the Wall Street Journal reported in November 2013 that Snapchat had spurned a $3bn acquisition offer from Facebook. By the time of its near-$25bn IPO in 2017 the number of daily users exceeded 150m and at the time of writing this has risen closer to 180m. Conceptually the business model mirrors that of Facebook and Google, in the sense that the product/service is given away in exchange for access to user information which in turn is monetised through advertising.
User acquisition has been rapid, thereby fulfilling the first objective of the business model. The second part requires the user audience to translate into revenues from advertisers. This puts Snapchat in direct competition with the dominant players in online advertising, and also with other new entrants seeking to tap into this market. Snapchat’s messaging app, not being data-rich, is at a disadvantage to those whose applications collect greater and more relevant information. Moreover, its competitors are attempting to create similar functionality to that of Snapchat within their own product line-up in an effort to forestall users migrating to the newcomer. The most obvious example of this is Facebook’s acquisition of Instagram to rival Snapchat, a classic case of imitation being the sincerest form of flattery!
One cannot say with certainty that shares in Snapchat were listed at an exorbitantly high price, but one can be clear even on the most favourable assumptions the price was full, leaving little room for disappointment. Needless to say, this did not prevent the brokers underwriting the issue from coming up with attractive but optimistic price targets. The IPO also raised some serious questions of corporate governance. There were three classes of share issued – class-A stock which carried no votes, class-B stock which had one vote per share, and class-C stock, the one owned by the founders, which carried ten votes per share and so gave them overwhelming control of the company. Prior to the issue, leading staff members were given loans on favourable terms, enabling them to buy additional shares which they subsequently sold back to the company at premium prices. There was nothing untoward in these related-party transactions, in the sense that they were all appropriately approved. The overall impression given, however, was that this was a very fully priced IPO in which shareholders were completely disenfranchised even though the company faced serious competition. Perhaps it should not be a surprise that before the year was out the ‘price targets’ had dropped by an average of over 50%.
10.25 – Snapchat: a high price and no votes
Source: Thomson Reuters Datastream. Research reports from Deutsche Bank, Goldman Sachs, J.P. Morgan, Morgan Stanley.
Part 3: The Internet bubble in perspective
A new Industrial Revolution…
The Internet and the World Wide Web have together created a new technology that clearly mirrors many of the characteristics of previous advances. Like the railroads, it has generated significant improvements in carrying capacity, engines and signalling. Like the telephone, it has become a new revolutionary method of linking different parties. Just as the railroads took traffic from other means of transport to increase usage, so too the Internet has replaced and expanded on the back of other forms of communication. Like the telephone it has achieved extremely high penetration rates. Access to the Internet is now ubiquitous in both fixed-line and mobile communications.
The comparisons with the railroad and the telephone are not entirely exact, however. In b
oth those cases the owners of the networks had control over access. The financial benefits of control over a monopolistic industry eventually produced an antitrust backlash, resulting in the breakup of Standard Oil and the Bell Companies. This history has contributed to the regulation of modern telecoms and the application of the principle of ‘net neutrality’. In general, telecom operators are allowed to charge for access to their network but typically within a framework of regulated returns based on invested capital, with some form of pricing discipline created by allowing others access to the network. Loosely defined, net neutrality is designed to prevent discriminatory charging and service levels between different forms of traffic on the Internet. What this means in practice is that providers of digital content effectively have access to a free distribution channel. This in turn places a premium value on content ownership. Whether this survives indefinitely is another question.
Engines That Move Markets (2nd Ed) Page 56