India Equity Research Internet April 19, 2021 TechWeiss SECTOR UPDATE Decoding the platform economy Internet evolution has propelled network effect-led business models, dubbed platforms. These businesses enjoy near monopolistic positions and entail high pricing power as well as switching costs. Facebook, Google, Uber, Zomato, Naukri and IndiaMART are a few examples. They are characterised by initial cash burn phase to establish network effect to get consumers on board, followed by monetisation phase. Since they require minimal hard assets and unit economics evolve with business maturity, they need to be evaluated differently from traditional capacity businesses. Steady-state unit economics and addressable markets are key parameters for platform businesses. Network effect underpins platform business The value of network effect-led platform increases as more people use the product or service, creating natural monopolies with high entry barriers. However, in initial stages, these businesses are compelled to spend money to attract consumers to reach a critical threshold to exploit the network effect. This naturally translates into high cash burn and minuscule revenue. After establishing a strong network, companies invariably focus on monetisation of the platform and then cost optimisation. As this focus shifts, the unit economics can materially change. Platform versus capacity businesses: The valuation divergence The public market investor community is habituated to analysing capacity businesses where companies create capacities for certain products. Their success typically depends on economies of scale, efficiency of operations, distribution etc. and unit economics are fairly straightforward compared to already established peers. On the other hand, platform companies require significant initial investments to drive network effect, but focusing on cash burn is futile considering that unit economics evolve. Hence, while market share, capacity utilisation and ROIC are key parameters determining valuation of capacity businesses, in the platform business total addressable market (TAM) and long-term margins are key parameters. Get ready for the changing paradigm We see a divergence in the way public and private market investors evaluate platform businesses. We attribute this to relatively longer history of platforms in India’s private versus public markets. Not all platform businesses succeed and there can be various reasons for their failure–poor customer experience, paucity of capital, small addressable market, etc. However, we expect such platforms to capture many spheres of life going forward; the disruption is already underway in many industries–moving gradually from information-based industries to asset- heavy industries. Platforms of different size and shapes are emerging at global, national and local levels. Having said that, monopolistic nature of these businesses is bound to invite more scrutiny and we expect regulations to evolve accordingly. Pranav Kshatriya Sandip Agarwal Pulkit Chawla +91 (22) 4040 7495 +91 (22) 6623 3474 [email protected] [email protected] [email protected] Edelweiss Research is also available on www.edelweissresearch.com, Bloomberg - EDEL, Thomson Reuters, and Factset Edelweiss Securities Limited TechWeiss Rise of the platform economy “Companies in every industry need to The internet evolution has propelled many network effect-led assume that a software revolution is business models, dubbed platforms. These are characterised by near coming.” Marc Andreessen in his famous monopolistic positions in respective markets and entail high pricing essay, Why Software Is Eating the World power as well as switching costs. While Google, Facebook, Uber, AirBnB are a few global examples, Zomato, Naukri and IndiaMART are local examples. Success of these companies has attracted a lot of money and interest from investors in their quest to discover the next big bang platform. In the initial stage, such companies need to invest to reach critical mass of the network. Hence, they are characterised by cash burn phase, followed by monetisation phase. We also note that platform businesses are different–minimal hard asset requirement, unit economics can significantly change as the company enters monetisation phase–from traditional businesses and they are evaluated differently than typical capacity businesses. Their eventual unit economics and addressable market are key valuation parameters. Network effect underpins platform business The internet evolution has led to emergence of many businesses, characterised by network effect, creating near monopoly in their respective verticals. Facebook & Twitter in social media, Google in search, Uber in cab aggregation and AirBnB in vacation rental are a few examples of such businesses. Unique feature of network effect-led businesses is that the value of the platform increases as more people use the product or service. This creates natural monopolies with high entry barriers. Network effects can either be same sided or cross sided. Social networks are examples of same-sided network where a higher number of friends on a platform will render that platform more valuable for users and will, in turn, attract more users. Uber is an example of cross-sided network effect where a higher number of riders will attract higher number of cars, which in turn will increase cab availability, which will further attract more riders. High cash burn in initial stage, followed by monetisation phase In initial stages, network effect-led companies have to focus on on-boarding consumers to reach a critical threshold to exploit the network effect. Hence, companies tend to have high customer acquisition costs with minuscule revenues. Customer experience also tends to be key focus area as engagement on platforms is of paramount importance at this juncture. This naturally translates into high cash burn in the initial stage. At times, as companies expand geographically, cash burn tends to increase, but that also brings scale to the network. Therefore, companies earn minuscule revenues in initial stages with high cash burn. After establishing a strong network, companies invariably focus on monetisation of the platform and then cost optimisation. Platform companies can have multiple ways of monetising the platform with advertising, virtual goods, membership fees, etc., being some of the options. For scaling the platform, we have seen companies expanding into new geographies or into adjacent areas to replicate their business models and backward integrating to capture higher value of the supply chain. 2 Edelweiss Research is also available on www.edelweissresearch.com, Bloomberg - EDEL, Thomson Reuters, and Factset Edelweiss Securities Limited TechWeiss Fault-lines for platform businesses Not all platform businesses succeed and there can be various reasons for their failure–poor customer experience versus competition (Orkut versus Facebook), lack of capital versus competition (Shopclues and Snapdeal versus Amazon and Flipkart), small addressable market, etc. However, we do expect many network effect-led businesses to emerge in various verticals as the market matures. What initially started as information-based networks are incrementally disrupting hard asset- based industries as well. Initial players, such as search engines, messaging platforms and social networks were pure information-based networks. However, next generation businesses such as ride hailing, hotel room aggregators and food delivery are multi-faced networks and are impacting industries which have underlying hard assets. Some of these networks are local, national as well as global. Platform versus capacity business: The valuation divergence The investor community is used to analysing capacity businesses where companies create capacities for certain products or services and there are multiple players offering similar products. Success of such companies typically depends on economies of scale, efficiency of operations, distribution reach, etc. and unit economics are fairly straightforward compared to already established peers. In the platform economy, however, successful companies typically have dominant market share, significant pricing power, strong unit economics and high direct or indirect switching costs for users. Platform companies do require significant initial investments to drive network effect, but focusing on cash burn is futile considering the unit economics evolve and can be significantly different in a mature stage. Hence, while for capacity businesses market share, capacity utilisation and ROIC are key parameters determining valuation, in the platform business total addressable market (TAM) and long-term margins are key parameters. What to track in platform business? Platform business metrics can be classified In capacity businesses, investors track parameters like revenue, fixed & variable into four--acquisition related, engagement costs, capital employed, margins, etc. For a platform business, measurement related, economic related and marketplace parameters can be broadly classified into four categories--acquisition related, and competitor metrics engagement related, economic related and marketplace & competitor metrics. In acquisition-related metrics, total traffic and composition of free versus paid traffic are important parameters to track. Engagement metric typically tracks how users are engaging with the platform which determines strength of the network as well. Daily/Monthly Active Users