Over last two decades or so, we have seen the advent of Tech platforms. And these Tech platforms have resulted in a major shift in the way we do things; be it how we buy goods (E-Commerce), how we consume content (Netflix, Spotify), how we interact (Social Media) and various other things like Travel (Uber, Airbnb, OYO) & Ordering Food (Zomato, DoorDash).
But not all these Tech platforms are successful in terms of core driver of a business and a stock, ie. earnings & profitability. On one hand you have highly profitable platforms like Google & Facebook and then you have slightly profitable ones like Netflix and then you have a whole long list of loss makers like Uber, Spotify, Oyo and E-commerce firms. And this is despite the fact that all these tech platforms are monopoly or duopoly in their respective businesses & markets.
So, what determines this key aspect of Profitability across these Tech Platforms?
Well at its core these platforms are either providing some kind of content (Music, Videos, Search Results, Social Content) or some kind of service (delivery, accommodation).
The key factor that determines the profitability is the costs attached to this core factor of Content or Delivery of Service. And there are three broad categories for these costs-
Think about what Google & Facebook are doing, they are basically monetizing the content (Search Results, Images, Videos etc) through advertisements. But they are not paying anything for this content & data. We as consumers are freely providing all these content to these platforms by posting content on say Facebook/Instagram or indexing our website on Google search. This model is more commonly referred to as UGC (User Generated Content).
And tech platforms that have this characteristic of User Generated Content are the most profitable and scalable. Scalability comes from the fact that the companies don’t have invest their time & effort into increasing the size of this content pool, it is the collective result of a huge & growing consumer base that does it for them. So, their network effect becomes stronger on its own without costs attached to it.
The likes of Facebook, Instagram and Tik-Toks are said to have >85% gross margins, primarily because the cost for content is Zero, the only cost attached is one that goes into keeping the platform running.
The second category is where the tech platform has to pay some cost for content, but the cost is fixed. An example here is that of Netflix. Netflix provides users with Video content and monetizes the same through subscription plans. But Netflix has to buy or produce itself this Video content and that has a cost attached to it. But the good part is that the cost attached to this is fixed, so there is no proportionate increase in costs for each new customer. And thus, if Netflix is able to monetize its content across an increasingly larger share of customer/revenue base, it will turn out profits and also the profitability would expand.
The 3rd category is where the Tech platform has to pay cost for the content and that cost is variable. Tech platforms that deliver services like Uber, Zomato etc also falls into this category. The real problem in this category of platforms is that the cost attached to the content or delivery of service is relatively high, plus since it is variable, increasing scale of platform does not provide much improvement in profitability.
Spotify is a good example here. The content for Spotify is the Music IP it acquires from Music Lables and this cost is actually variable. So, Spotify typically shares 66% of its revenues with Music Lables and thus its gross margins are low at just ~33%. And these margins never improve as the business scales up.
The worst of the bunch are the platforms that deliver service like Zomato, Uber and E-commerce. Here not only is the cost variable and high, but the scalability is a big challenge as well with highs costs attached. Since these platforms have a tangible aspect to delivery of service, scalability becomes a big challenge as every transaction on the platform has to result in an equal increase in transaction in the physical world.
If Zomato has to deliver more orders, it needs more delivery boys and attracting more & more delivery boys takes it own time and costs. Same with Uber, for its network effect to grow & strengthen, it needs to add more & more drivers and that will require time, efforts and also cost.
In some cases, we might also have a hybrid among categories. So, consider YouTube for example. On one hand, YouTube has the characteristics of 1st Category- UGC. YouTube does not have to put efforts in securing & increasing the content that it will monetize. But YouTube does have to pay variable costs for this content. So, YouTube actually shares 55% of its revenues with the Content creator and thus its gross margins are relatively lower compared to something like an Instagram or Facebook. However due to UGC, it is highly scalable and thus does ends up being decently profitable.
So, in summary, for us as investors, if we have to invest in a platform business, it is very important to look for two characteristics. First that the content should be User Generated and that either the cost should be Zero or if there is some cost attached, it should be fixed. Only when we have these two characteristics is when we get profitability & scalability.
If we look in the listed India context also, there are only two tech platforms that have really been able to scale profitably yet- first is obviously InfoEdge (Naukri) and 2nd one we cannot name it given that it is one of our most recent initiations. Both these platforms have the same two characteristic; the content that they monetize is generated by end user and they do not pay anything for that content.
That’s it for this week, new insight coming up next week. So stayed tuned!
Surge Capital is a trade/brand name used by Ankush Agrawal (Individual SEBI Registered Research Analyst INH000008941) to provide equity research services in the Indian Equity Markets.
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Stock specific investment disclosure:
Naukri- Not Invested. Not Traded in last 30 days. Not an active recommendation in Research Service
Zomato- Not Invested. Not Traded in last 30 days. Not an active recommendation in Research Service