SINGAPORE (Apr 29): A significant portion of the value we have seen created in technology has been credited to the network effect (or positive feedback loop) associated with digital platforms. Think Facebook, Apple, Amazon.com, Google (owned by Alphabet), Alibaba Group Holding and Tencent Holdings, all of which have cemented near-monopolistic positions in their respective businesses and generated hundreds of billions in value for shareholders.
The textbook definition of a network effect is a scenario where each new user added to the platform enhances the experience for all existing users and gets value back in return. Hence, users beget more users.
This is no different from the network effect of the telephone — if no one else owns a phone, your phone and the system is of little value, but the value will increase exponentially with each additional phone user to the network. Naturally, it leads to monopolies. The long-term consequences were that these entities were dismantled by rules and regulations that promote competition.
In the initial stage, a start-up platform would have to spend heavily — whether through discounts, incentivised referrals or word of mouth and so on — to attract users. But the cost of acquisition would fall as the user base grows since users themselves are increasingly motivated to join, owing to the network effect. Decreasing marginal costs would then translate into rising profitability for the platforms once they start to monetise. This is the playbook for most tech companies operating digital platforms.
It is also the reason venture capitalists are willing to funnel massive amounts of money to start-ups to drive rapid user growth, and investors buy stocks in loss-making companies — in the belief that the network effect will snowball into user critical mass, unassailable moats and the inevitable pot of gold.
Many of today’s technology companies — including Uber, Airbnb, Netflix, Spotify, Meituan Dianping and Didi Chuxing — use the term “network effect” liberally to justify their lofty valuations.
Ride-sharing company Lyft, whose IPO was one of this year’s biggest and most-talked-about, stressed: “Network effects among the drivers and riders on our platform are important to our success.”
But do all tech start-ups deserve such confidence from investors? Most of these companies are capitalising on opportunities arising from the sharing and subscription economy. While this may be the way of the future, investors should evaluate the financial viability of each business model carefully.
Not all tech companies benefit from the network effect and certainly not all to the same extent. It is one thing to spend heavily on initial customer acquisition and another to be able to retain these customers as well as continue to attract new users once the monetisation phase begins.
Facebook and WeChat are the best examples of platforms with strong network effects. Recent privacy issues notwithstanding, their values are derived from high switching costs.
You are on Facebook, WhatsApp and WeChat because all your friends and family are using these same apps to communicate and share updates. To switch to another social media app would require all your friends and family to do the same. One would also have huge amounts of personal data already tied into these platforms.
Such large and loyal user bases, in turn, make it easier to monetise and further expand into other services as well as attract quality content. And, in the process, further strengthen the network effect.
By contrast, companies such as Lyft, Uber, Netflix, Didi and Meituan are all still burning cash and racking up huge losses. Yes, more customer sign-ups will attract more drivers/restaurants and, therefore, more customers to the ecosystem. However, the network effect is far weaker — and switching costs are far lower.
For instance, it is hard to see how my user experience is enhanced if another person uses Uber ride sharing or orders food delivery. The ride would not be more enjoyable nor would the food be tastier. In fact, it could be a negative network effect if congestion results in longer wait times.
Instead, these platforms are spending huge amounts on customer acquisition. They are capturing market share, but only through heavy subsidies. If they cut back on subsidies and raise prices, would they still get the same amount of sales? I think not.
Raising prices will also attract competitors. Barriers to entry are low. New entrants can cherry-pick and focus on localisation, in a single city or state. Most customers and drivers/restaurants use multiple ride sharing and food delivery apps. You choose the one that gives the most competitive price.
I suspect they are partly relying on the old “economies of scale” model. As a larger customer base results in increasing demand, which in turn draws in more suppliers, their size may enable cost per unit supplied to fall. After all, the sharing economy’s value proposition is predicated on increasing assets utilisation.
Clearly, however, there is a limit if physical logistics are involved — unlike pure digital deliveries such as Facebook, Google and WeChat, where marginal cost can literally fall to zero.
To resolve the above dilemma, their longer-term goal must be to drive logistics costs to almost zero or at least much lower from current levels. This is where the technology of autonomous vehicles comes into play.
Another way is to be a universal app, where you bundle a vast array of services, including payments options. While each service may not itself be sticky, the combination or offer of a bundle may be stickier — and could perhaps create the necessary network effect where one service attracts users to another and so on and so forth. It is old-school “horizontal integration” — and the reason conglomerates were formed in the past.
The best example of early success in employing and monetising this strategy is -WeChat, which new-generation tech players such as Meituan and Go-Jek are attempting to emulate. It remains to be seen whether they too can eventually find a path to profitability.
Positively, Amazon and Alibaba have very successfully bridged multiple businesses — from e-commerce to physical retail, financial services, cloud computing, digital media and entertainment, and consumer electronics — and have done so profitably. This may well be down to the timing in being the first disruptors — they were able to grow very quickly, capitalising on digitalisation and economies of scale to disrupt traditional business models.
That said, these companies may, one day, also be disrupted by new entrants. In a future where frictional cost has been whittled to zero, smaller and more nimble players may regain the upper hand. That is, if the tightening noose of government regulations has not already broken up big tech.
Similarly, subscription services such as Netflix and Spotify are powerful disruptors, exploiting changing consumer preference in how entertainment is consumed and delivering it more efficiently through digital distribution. But like ride sharing-food delivery platforms, switching costs are low. It makes little difference to me which subscription service my friends are on. My decision will be based solely on content and price.
With so many traditional media companies now getting into the game — including The Walt Disney Co, AT&T’s WarnerMedia and Comcast’s NBCUniversal — not to mention Amazon Prime Video and Apple TV+ services — first-mover advantage in these cases may be fleeting.
Scale alone provides a weak network effect when there are few reasons for customer loyalty, which makes it an unsustainable competitive advantage. Remember, the media companies are, at the same time, also pulling licensed content from Netflix in favour of their own streaming services.
Defending market share, therefore, depends on continuous evolution in the platform’s value proposition and ways to strengthen the network effect through differentiating features, branding, trust and reputation, value-added services and others.
This is why Netflix is outspending all of its competitors, to the tune of billions of dollars each year to create original content. Instead of reaping the benefits of strong subscriber and revenue growth, its negative free cash flow has been growing larger each year — totalling US$2.9 billion ($3.9 billion) in 2018 and estimated to rise to US$3.5 billion this year.
Many believe that Netflix can maintain its leading position in streaming services. The real question is whether it can reduce content cost and/or raise prices sufficiently to reverse this cash burn and still maintain market share.
It is for this reason we have the old saying, “content is king”. The quality of content is what customers want and will pay for. The way it is delivered will be commoditised.
The Global Portfolio ended higher for the week, led by gains for Ausnutria Dairy as well as a majority of our US stocks. The US market outperformed the rest of the world, with both the Standard & Poor’s 500 and Nasdaq indices now just a hair’s breadth from all-time record highs.
Last week’s gains lifted total portfolio returns to 2.1% since inception. By comparison, the benchmark MSCI World Net Return Index is up 5.8% over the same period.
This story appears in The Edge Singapore (Issue 879, week of Apr 29) which is on sale now. Subscribe here
Tong Kooi Ong is chairman of The Edge Media Group, which owns The Edge Singapore
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