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Is culture a dead-end business model?

Glenn Freeman  |  05 Jul 2017Text size  Decrease  Increase  |  

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While network effect is widely viewed as a driver of competitive advantage--see Facebook, Uber, Amazon and home-grown operations Domain and realestate.com.au--cultural networks may be a dead-end road.


There can only be so many companies like Google, Facebook, Uber and Amazon: the eponymous search / social media / online retail / app-based disruptors, which are in some instances hybrids of all four categories. They derive much of their competitive advantage--in Morningstar parlance, moats--from their network effects. This creates both barriers to success for potential new competitors, as well as barriers to exit for existing users.

In the case of News Corporation-owned REA Group's (ASX: REA) property classified website realestate.com.au, this network effect means that as more people access the site, its value increases, making it harder for competitors to lure users away.

Another example is Domain, a competing online property classified site owned by troubled media company Fairfax (ASX: FXJ). Domain was widely viewed as a "diamond in the rough" by private equity bidders circling the company recently, before ultimately abandoning their approaches after five weeks of due diligence. While such businesses can, in effect, ring-fence their users while also keeping competitors at bay--not all network effects are created equal.

In the US, another global tech firm, Verizon, is set to complete its acquisition of struggling internet group, Yahoo. The US$5 billion transaction will see the US telecom company acquire Yahoo's internet business--including blogging website product, Tumblr.

This is part of Verizon's push into mobile online advertising, as it attempts to take market share from the giants of the space Google and Facebook. However, while Tumblr and its better-known competitor, Twitter, are "enormously popular among the coveted youth crowd" they "never quite figured out how to make money at the level Facebook has led managers and shareholders to expect," writes Brian Feldman in New York Magazine.

Trump and other risks

While Twitter "steers a huge portion of online culture"--in addition to an inglorious resurgence at the finger-tips (or thumbs) of President Donald Trump--it still struggles to turn a profit, writes Feldman.

Reddit is another otherwise successful network-based business unable to fully capitalise on a huge audience and strong online influence--it had more than 235 million users in September 2016, according to Reddit's own figures.

Advertisers are both a key part of what these companies need to survive, and an intrinsic problem they face.

"With a handful of exceptions, the advertising riches never really materialised," writes Feldman. In short, running a platform that facilitates the creation and sharing of cultural content--photos, videos, text comments--is difficult to monetise. Making money from culture is tough, though not impossible.

Key reasons for this are the complexities of explaining to board members of potential advertisers exactly what such platforms do; and the reputational risks they create, with "reams of porn, hate speech, copyright infringement…floating around on these platforms, easily accidentally placed adjacent to a company’s studiously inoffensive ad".

In Australia, powerful brands Vodafone Hutchison, Nestle, Holden and Kia last month began removing their advertising from Google around concerns their ads couple appear near "harmful online content". Global brands Walmart, Pepsi, Renault and others have taken similar steps in recent months.

What to look for in technology

Morningstar equity analyst covering technology stocks, Gareth James, emphasises the importance of qualitative research over balance sheet analysis: "step back from the financials and look at the qualitative factors".

He also says investors shouldn't be deterred by the higher price-to-earnings ratios often seen in technology stocks. "Often people will see them as too expensive, for example, they'll look at a company whose share price is trading on a 50-times multiple as overpriced," James says.

"But looking to a company like REA Group as an example, whose revenues grew from $6 million in 2006 to more than $200 million by 2015, you're going to see that growth potential."

He says that, in looking for a sustainable, profitable network effect in potential businesses, investors should consider tech companies with a "lack of economic sensitivity" as appealing characteristics. For example, Xero (ASX: XRO) is driving cost reductions for businesses by replacing desktop software with a cloud-based solution. "And each of our most successful technology companies--REA Group, Seek (ASX: SEK), Trade Me Group (ASX: TME)--they all have that network effect."

Beyond using direct equities, with access to global stocks more complicated and expensive for share investors, exchange-traded funds--such as the ETFS Morningstar Global Technology ETF--are options worth considering. This tracks the performance of the Morningstar Markets Technology Moat Focus Index, with Oracle, Adobe, Facebook, Microsoft and Workday among its top 10 holdings.

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Glenn Freeman is a Morningstar senior editor.

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