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Grahamites
Grahamites
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Why They Dominate – Part III

A discussion on platform companies

This is the third part of my summary notes of Alex Moazed and Nicholas Johnson’s wonderful book "Modern Monopolies – What It Takes to Dominate the 21st Century Economy." My notes in my last two articles covered big picture ideas, different platform types and the proper design of the platform. Today's notes can help us understand why platform companies can disrupt linear businesses in such a big way and why it almost always makes sense for internet companies to lose money in the early years.

The mobile revolution

While internet became ubiquitous by the mid-2000s, the real driving force behind the internet’s leap into mainstream culture was the mobile internet. Mobile phones put the internet directly into everyone’s pocket. As the mobile internet exploded in the late 2000s, four key changes flipped the world of business strategy on its head: the democratization of processing power, the declining cost of communication, the rise of ubiquitous connectivity and sensors and growing returns to scale on data analysis.

These four changes are important. First, thanks to rapid advances in the computing process, individuals now have access to processing power and technologies that were once available only to large organizations. This change has empowered individuals to become producers of value on a whole new scale. Second, the declining cost of communication has made it much easier to share all of that value with other people. Suddenly, businesses were no longer the sole source of value creation. Consumers were creating value and sharing it with each other. Transactions costs were now low enough that the bonds holding many traditional organizations together started to disintegrate. Economies of scale in many traditional businesses, such as the newspaper and encyclopedia industries, collapsed completely.

Platform companies combine characteristics of traditional organizations and markets. They firm no longer invests in production but rather in building the infrastructure and tools to support and grow a networked marketplace ocommunity. What these platforms are creating are, in essence, centrally planned markets. EBay (NASDAQ:EBAY), Facebook (NASDAQ:FB), Alibaba (NYSE:BABA), Apple (NASDAQ:AAPL) and Google – a subsidiary of Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) all are networks that enable millions of individuals and companies to interact, but they are built and coordinated by a central entity.

Central planners

When looking at traditional companies, we usually measure the hard assets and things that the business can more or less directly control. These factors won't measure the true value of platforms. With Uber, for example, practically all of the value it creates comes from transactions it facilitates between people who exist outside the company. Its network is what makes the company valuable. The same is true for all platforms. By creating and orchestrating these large networks, platforms are unlocking new, untapped economic and social value. These markets and communities wouldn't exist or spring into existence in a vacuum the platform had to build and manage them. In essence, platforms are correcting for market failures. This isn't a new phenomenon. In the financial sector, economic exchanges, such as the New York Stock Exchange, have served in this capacity for centuries. What's new is that platforms are now extending into more and more areas of our existence and at scale that was previously unthinkable.

As a result, today's most valuable businesses have become centralized organizations that can understand and react in real time to what's happening throughout a large, decentralized economy. Local knowledge is local no more. What is Google Search, for instance, but an enormous, centrally planned economy of content and information? In a manner of speaking, Google is now creating the socialist utopia that all the might of Soviet Russia could not. That you don't think of Google in this way is basically just a matter of marketing and ideology. Google makes you feel empowered, even though it's telling you what you want. Uber makes you happy even though its selects your car for you and picks the route your driver should take to your destination.

All of this economic activity is being centrally planned and orchestrated by computers running algorithms and it seems to bother no one. Nor should it. It turns out that people don't have any problem with central planning in principle they just don't like bad central planning. Today's technology enables platform businesses to step in and create these centrally orchestrated markets where the "free market" failed to do so. As a result, they create entirely new markets or greatly expand old ones.

The zero marginal cost company

Thanks to the internet and connected technology, information goods today have a near-zero marginal cost of distribution. The cost to serve one additional customer is basically zero. Still, the cost of creating the initial application may be high, and if the company wants to expand its business, it needs to create additional modules to sell in order to create more inventory. In other words, it has to incur more large, up-front costs.

Platforms take this dynamic one step further. They removed the high fixed cost of creation and extend zero marginal cost to the supply side of the business.

The implications of zero-marginal cost are enormous. In the 20th century, successfully scaling a business depended on finding channels that drastically lowered the cost of creating demand and lowering the cost of supply. The Internet itself alleviated some of the high fixed costs to launch a business as reaching large audiences became much easier and cheaper. But linear business models still face the marginal cost challenge, forcing them to economize on the cost of supply in order to compete. The whole concept of Michael Porter's value chain is built around the idea of combining activities to create the most value for the smallest cost; in other words, reducing the cost of production. This constraint was the inspiration for many of the most important business innovations of the 20th century, including the assembly line, which improved the efficiency of production.

Also included are less-heralded innovations, such as chain stores, which created economies of scale and reduced costs, and franchising, which externalized much of the up-front cost of creating a new store. The more recently created process of just-in-time production also focused on reducing waste and the dead-weight cost of holding inventory. In short, all of these innovations were focused on reducing the cost of production for linear businesses.

Linear businesses generally grow by adding staff or physical assets, or both. Because these tactics create value by controlling production, linear companies have to invest significant resources in expanding capacity in order to sell more inventory. But physical assets and employees don't scale well. Networks do.

Platforms require much less capital expenditure to be successful at scale. They also require far fewer internal resources than linear businesses do. For example, platform companies require relatively few employees to be successful. Uber, Airbnb and LinkedIn (NYSE:LNKD) each run their global operations with fewer than 8,000 employees. Similarly, Alibaba had fewer than 35,000 employees at the beginning of 2015. In contrast, Walmart (NYSE:WMT), which has a total sales volume similar to Alibaba, has more than 2 million employees.

Platforms eliminate the marginal cost of production by just focusing on facilitating connections. The network handles production. Uber doesn't own and operate a fleet of taxis, Alibaba doesn't own factories that produce the goods it makes available online, Google doesn't create the Web pages it indexes, and YouTube doesn't create the millions of videos it hosts. Platforms are the natural business model of the Internet: They are pure zero-marginal-cost information businesses. They use data to facilitate transactions and enable networked production. The low marginal cost of production means that expenses don't grow as fast as revenue does.

These changes have major implications for linear companies. Platforms can scale cheaply and easily and will increasingly leave behind their linear counterparts

Look at Hyatt (NYSE:H), for example. Hyatt can sell room reservations online through its website and online travel sites. But to create more inventory beyond its current capacity, the company needs to build a new hotel no small cost. When Airbnb wants to add more rooms, it just needs someone to create a new listing on its website. This costs the platform next to nothing. Because the platform doesn't own production, it doesn't need all the resources that go into creating inventory. This networked production radically changes the cost structure of a business and alters the amount of internal resources it needs in order to create value. As a result, the marginal cost of supply drops to zero and its potential market size explodes.

This cost structure means that platforms are capital light and provide high return on investment compared to linear businesses. Thus, platforms don't require a large capital base in order to get started, and relative to linear businesses, they require even less to expand once they’ve established their networks. Additionally, the zero marginal cost of supply means platforms can grow to a much larger size than linear businesses can. The costs of a linear business will always continue to rise as it grows while the cost of a platform tends to level off logarithmically.

Why isn’t everyone building a platform if it’s so great?

Networked production creates unique challenges. Network effects can only be achieved when critical mass is reached – when the value of new users of participating in the platform exceeds the cost of participation.

Linear businesses can start generating revenue right away; platforms usually can’t. Since a platform doesn't own production directly, it may generate less profit than a linear business would until the platform scales well beyond the potential reach of its linear competitors. (This is why internet companies don’t make profits in the beginning; they shouldn’t.) This dynamic means that there's often little point in building a small platform business.

In many cases, linear businesses can serve small markets better than platforms can. The real benefits of a platform business are at very large scale.

Not every business will work just because it's a platform. Picking the right market is even more important for platforms than it is for linear businesses. You usually need a large market for the business model to be sustainable. But if you can dominate a large enough market, building a platform business is well worth the risk. At scale, platforms generate far better margins than linear businesses and, as Fred Wilson and Bill Gurley suggested, are much more defensible thanks to their networks and market power.

It's not just that platforms can grow larger than linear busisnesses; they must. Platform businesses have to harness massive scale. Most platform either make it big or don't succeed at all. This growth imperative for platforms is bad news for linear businesses because as a platform reaches maturity and starts to take over the whole market, its profits both eclipse and squeeze the profits of the linear competitors still remaining in the industry.

As platforms become more common and disrupt more and more industries, platform dominance will mean that many nonplatform businesses will be left fighting for a smaller and smaller piece of the market.

A nonplatform business still can succeed by capturing a slice of another platform's ecosystem (think Samsung [XKRX:005930] with Android), but controlling the platform is the most sustainable and most lucrative way to go.

About the author:

Grahamites
A global value investor constantly seeking to acquire worldly wisdom. My investment philosophy has been inspired by Warren Buffett, Charlie Munger, Howard Marks, Chuck Akre, Li Lu, Zhang Lei and Peter Lynch.

Rating: 4.8/5 (5 votes)

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Comments

Thomas Macpherson
Thomas Macpherson premium member - 1 year ago

Thanks for a great set of articles. I'm greatly enjoying the book myself thanks to your recommendation. The idea of platforms - and their ability to generate high ROC over the long term - is just beginning to take hold in the healthcare ecosystem. I presented some of this at last year's GF conference, but it really deserves an entire series of articles like yours. With the adoption of digitized content and automation, there are quite a few small niche platform players which are becoming the industry standard across healthcare. Investors should be thinking about companies that integrate vital business processes with strong data capture, repository, and analytics capabilities. Examples include electronic healthcare/medical record (EHR/EMR) companies that oversee patient clinical care processes integrated with prescribing, formulary, order sets, and imaging as well as diagnostics. A company like Allscripts (MDRX) is a provider of such platforms. Another example is a former holding at Dorfman Value - Simulations Plus (SLP). This is a microcap company that has created a platform used in drug discovery and development. Again, a vital business function for BioPharma utilizing technology and data to speed up research timelines and access trends/findings faster than ever before.

Finding these companies is harder than it might seem. Understanding the strategic imperatives, operations models, players, etc. in healthcare can be a lifelong effort. But rolling up your sleeves and taking a crack at it can be a very profitable endeavor if you find the right platform based investment.

Thanks again Grahamites for a very valuable series of articles. Best. - Tom

Disclosure: I do not hold any company cited in this article either personally or in my individual client accounts.

Grahamites
Grahamites - 1 year ago    Report SPAM

Tom - You are welcome. I'm glad you are enjoying the book. I'm actually starting to apply the platform concepts to the few healthcare IT businesses I follow such as athenahealth and Cerner. The complex adative nature of the current U.S healthcare system certainly makes it harder to put it all together and I've been humbled many times in healthcare. I think both MDRX and SLP are fascinating examples. It would be great If you can write a series of articles on how the platform concepts apply to healthcare:)

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