Business models can take many different shapes depending on the way the products and services are delivered to the market.
Asset-lite and asset-heavy businesses can largely be viewed through a “pipes” (pipelines) vs. “platforms” framework. Recognizing the two and their differences is important as it will ultimately help determine the nature of a stock‘s upside and the nature of its price action.
Pipes refer to physical assets and infrastructure (“asset-heavy”) that help create products and services, which are then “pushed out” to be consumed, analogous to how volume flows through a pipe.
On the other hand, platforms heavily derive value from their network effects. Typically, but not always, they are more “asset-lite” in nature.
A social network is fundamentally a platform business. It does not have much or any value unless other people use it.
Facebook became one of the world’s most valuable companies by connecting people over the internet to the point where it became almost expected to have an account. Both text and photo sharing on a real-name basis became normal by the late-00s, as people opened up more on the internet.
Google also largely functions as a platform model.
The company has network effects where its products and services synergistically reinforce each other. This includes Search and YouTube (the number one and two search engines), Gmail, Maps, Android, Cloud, Chrome, Firebase, Analytics, and more.
Search is inherently a monopolistic market. Google has tried to generate this effect in all its markets. Gmail works in sync with Google Docs, Hangouts, Drive, and more.
Gmail was not the most popular email service at first, starting out as a side project and an invite-only service. But it fostered an ecosystem that brought up its popularity among competing providers.
When you combine monopolies or potential monopolies with large total addressable markets, it makes for great potential.
Any market participant looking to dabble in growth names and trying to hit on outsized gains, whether in early-stage venture or squarely in the public markets, will need to be able to spot such opportunities and try to understand whether they’ll be executed and by whom.
This is why many tech companies inherently command high multiples. It’s a type of “innovation premium”.
Moreover, many of the top venture arms are run by the big companies. Google shareholders often believe they’re not only getting the high-margin quasi-monopolies that give the company a large valuation on its own, but also getting a type of closed-end venture fund as well.
Apple became the world’s most valuable company by essentially reinventing itself. The company, through Mac OS, had very low share in desktop operating systems (less than five percent) mostly because of Microsoft’s command over the market.
And it had no penetration in mobile. So that effectively wasn’t even in the stock’s valuation. Apple was simply valued as a computer company with a low share of the market with a limited number of side products. (The iPod, for example, was introduced in 2001. The iPad came out in 2010.)
The popular players in mobile in the early- to mid-00s were Samsung, Nokia, Motorola, and LG. Pre-iPhone, they controlled the mobile market with scale. They had patents, financial resources, and brand value.
Yet after the release of the iPhone, consumers largely preferred the design of the new product and its ease of use.
Nokia’s business lost more than 95 percent of its value and Apple’s market value continued to grow quickly, with high margins and continued room for growth.
What made the pivot so successful?
Apple viewed the iPhone as more than just another mobile product but as a platform that could derive value through network effects.
Apple didn’t yet have the resources of a Samsung or Nokia. But it was able to leverage iOS as a platform through the use of apps.
The phone became closer to an integrated computer and do-everything device. This was different than its previous function as just something used to make a call or send messages and emails when you were out and about.
The App Store became a marketplace between app users and app developers.
As users and developers grew, so did its overall value.
The iPhone was a platform that helped generate a large ecosystem off which to launch other products and services.
It could also sync across other products, including the iPad, Mac, and iWatch.
Amazon, another younger conglomerate, creates the same network effects through the size of its e-commerce platform, its core business, as it connects merchants/third-party sellers with its large base of buyers.
It’s now taking that same approach toward disrupting traditional “pipe” models.
In theory, anywhere there is a product to be sold, the e-commerce concept could improve on its distribution. This is accomplished by giving the customer what it wants.
The customer wants to receive the product quickly, inexpensively, and conveniently as possible.
Using a rewards-based credit system and payment products helps incentivize customer loyalty, such as its credit card relationship with JPMorgan. (JPMorgan loses money on the card itself, but wanted the relationship.)
Subscription products (e.g., Amazon Prime) create the same effect. People are likely to use it more if they have to pay. Prime affords value across the product and service portfolio (traditional commerce, grocery, video, music, entertainment, home services), which also helps create network effects.
Also, Amazon plays the long-term game. It has the philosophy of getting market share first, with profitability of secondary consideration. Not all companies can do this, especially when it comes to meeting quarterly estimates. This squeezes competitors.
Types of Platforms
Platforms are not just technology companies. So, the idea of identifying “great platforms” doesn’t just have to flow from technology investing.
There are traditional platforms.
Commercial malls connect merchants, businesses, and consumers.
The advertising business has traditionally been newspapers, magazines, radio, and TV. They provide content – e.g., shows, entertainment, news, opinion – and it connects advertisers with subscribers, viewers, and/or listeners.
However, now with the internet and mobile service growing, there’s less need to use physical capital and assets to push products and services to the market.
It’s no longer only large media companies that control the flow of information.
Many people can build a website or app accessible to many parts of the world. This wasn’t the case in the mid-1990s.
With the marginal cost of data being very small, building and scaling a business is increasingly cheap.
When one’s return on invested capital is high, largely due to this effect, relative to the cost of capital (zero interest rates, QE, stimulative central bank policies globally), this can lead to some very high valuations.
And these platforms also have the ability to obtain and analyze large amounts of data to help yield better insights.
Television, radio, newspaper, and other traditional media ads are not anywhere near as pinpointed as the ones Google and Facebook can provide. This helps increase revenue per customer.
And not all technology companies are platform businesses.
Priceline seems like a platform business. But it’s largely about pushing airline, hotel, and car rental services to its customers.
Asset-Lite Platform Businesses: Potential Hazards
Investing in early-stage tech or trading in these types of stocks is hard to do.
With standard pipe business models, there are tangible assets that have value. In some ways, it can make them easier to analyze.
Platforms generally don’t have much in that department, being asset-lite.
Facebook’s asset base is a small portion of an oil conglomerate like BP or ExxonMobil and merely a few percent of JPMorgan’s.
Yet Facebook’s market valuation is a lot larger than those companies.
Platforms will generally have high book value multiples – namely, the value of the business divided by its asset base or tangible asset base – relative to pipe models.
Banks often have book multiples of less than 1. However, platform businesses are commonly at 5-10 or more.
This reflects the different ways each operates in terms of their asset base.
Facebook’s assets are largely in its code, which doesn’t have a traditional book value.
An integrated oil conglomerate has lots of physical infrastructure in order to pump oil, transport it, refine it, and deliver it.
JPMorgan uses its balance sheet to create lending and other financial products. They’re in the business of using money to make money.
Value investors generally want a “margin of safety” with their investing. So platform models may often not be particularly attractive.
Venture capital in general won’t be for value types.
Warren Buffett commonly stayed away from tech. Ben Graham did too. And though Graham is known as the quintessential value investor, he earned more from one investment in one of the mid-20th century’s growth companies (Geico) than he did from all his other investments combined.
When putting your money in platform models, your downside isn’t only limited to losing a small portion of your investment.
It’s the reality that you could potentially lose your entire investment if the company never generates a profit or cash flow.
The asset base for platform businesses is often too small to generate any residual value for stakeholders. This is unlike a company with a large physical asset base.
It can also impact their creditworthiness.
On the flip side, your potential is generally much higher being a less mature and established business.
So, this often expresses itself through structurally higher volatility in sectors like tech (where asset-lite platform models largely exist) relative to more value-oriented sectors with more asset-heavy models.
Improving your chances investing in platform models
Venture capital is something with an inherently low hit rate because you’re betting on businesses with highly uncertain futures in markets where consumers are picky.
Most portfolio companies in early-stage venture investing are probably going to be worth about nothing.
Many find a small niche and may compete for a while. Maybe another company buys them or they operate for a long time with a respectable but low valuation.
A select few become huge successes.
Nonetheless, there are certain criteria you can go through in order to increase your odds of hitting on a good investment, whether private or public markets.
This is mostly relevant toward platform models, but can also be employed toward pipes:
1) Does it solve a problem in some way?
Put another way – is there demand for the company’s products and services?
Some companies are built trying to get a piece of a very large existing market. Some companies are built with trying to find a unique solution to a new problem.
The most common reason startups fail is not because of competition or because of weak marketing, but because there just wasn’t enough demand for the products or services they were providing.
There are many reasons why startups fail, including:
– poor unit economics
– weak business model
– weak marketing
– founder/management burn out or lost passion
– internal discord among team members and/or investors
– poor location
– couldn’t obtain debt/equity funding
– ran out of funding
– lack of quality advice from network or advisors
– low-quality product or service
– poor product timing
– lacked the right talent
– legal difficulties
– didn’t pivot, when necessary
– pivot failed
But 40-50 percent of the time, the primary reason is the lack of a market need for a company’s products or services.
For those looking to invest in startups or advise them, it’s always prudent that the company form a marketing strategy before they officially begin operations.
Market research can include interviewing, focus groups, product testing, and feedback from prospective consumers.
The product or service doesn’t have to be something completely unique.
But for best results, it should be something that makes a tangible improvement over that in which is offered by the competition.
2) Could the business potentially have a deep moat?
Great businesses are fundamentally monopolies over their market. Google is like this with respect to search. Amazon with respect to e-commerce.
Or it should become a large share of a very large market. Apple with respect to smartphones. Microsoft and Amazon with respect to cloud technology.
That is, how can they potentially control an entire market?
If their total addressable market (TAM) is only $1 billion and they’re only looking to get one percent of that market, that limits their valuation and how good of a potential investment it can be.
One percent of $1 billion is $10 million. Even at a respectable net margin of 20 percent, that’s $2 million per year. That’s great for a one-person business or a small team, but it’s not something that’s going to attract high investor interest.
Ideally a company has or will achieve intellectual property and/or proprietary technology that exceeds their next closest competitor.
Facebook’s monetization plan relied on its ability to collect a lot of information about its users.
That way, companies and individuals could provide hyper-targeted ads that were superior to what any entity in the traditional media could realistically provide to its customers.
Amazon’s value-add lies in its ability to sell everything and act as a one-stop shop for consumers.
Even before it became that, its book selection was far beyond what any other retailer was providing. No longer did people have to go to Barnes & Noble or Borders or similar brick-and-mortar retail outlets.
Microsoft Office became the dominant software after improving over existing technology and by successfully marketing it to consumers. Then it moved on to the cloud business.
It all boils down to how the business makes money.
What is the company’s value proposition?
What is it doing differently from everyone else?
And if that value proposition hasn’t yet been put into place – either because it’s in the very early stages or pivoting – is it credible?
And it doesn’t have to be anything too complex.
A business model should be able to be communicated straightforwardly in 1-3 sentences. Nor does a business model necessarily have to exclusively be a platform model.
And it is perfectly fine if its addressable market is more niche-like in nature rather than all-encompassing.
For example, an e-commerce store can compete with anyone if it promises fast and free shipping (if above a certain price), and a price-match guarantee from competing retailers. This is simple, credible, and straight to the point on how it creates value.
3) What are the network effects?
People use Facebook because everybody else is on there. Same with Instagram as it relates to photo sharing. Same with Twitter as a communication avenue.
Few use MySpace much these days because most of the people you know probably don’t have an account there. But they likely have a Facebook account.
The ecosystem effects help make the platform what it is.
As previously mentioned, startups don’t necessarily need to try to penetrate large addressable markets.
However, it is important to be a dominant player in whatever market it happens to be. Smaller markets are often easier to enter.
LinkedIn, which was acquired by Microsoft in 2016, has no chance of ever having a Facebook-like valuation by itself because the market it caters toward is smaller.
But LinkedIn is a company that achieved a virtual monopoly by staking itself as the official social network of working professionals, providing value for recruiters, companies, and job-seekers. It became about networking and matching talent.
Twitter is also a more niche product.
It has gone from basic micro-blogging to a platform for news, broadcasting, and individuals looking to find content with respect to their own interests such as individual accounts or specific topics.
Economies of scale refer to increased cost savings for every additional unit of output. A business that has scale means increased output can lead to a decrease in long-run average costs.
Network effects help platforms achieve the kind of scale they want. A business in an industry with low barriers to entry and high competition will find it difficult to achieve scale.
On the other hand, if a business can dominate in a market – one possibly small enough where there is little competition – it can be very hard to disrupt.
Labor Advantages and Disadvantages to Platform Models
When analyzing businesses, labor is a big component of its cost structure.
Platform models often rely on independent contractors instead of full-time employees to carry out a large portion of its operations. Uber is well-known for this practice.
Like most debates, there are pros and cons.
Independent contractors can often provide a business what it needs at less overall expense. Not only through wages, but also training and benefits, such as pension and healthcare.
– Avoids unionization
Unionization can help some workers earn more money, but it carry some drawbacks for companies. In general, unions are there to protect workers and reach bargaining agreements.
But they can also undermine market forces that can be bad for both high-performing employees and bad for companies who can find it more difficult to let go of underperforming employees (which is bad for not only the company but can stand in the way of the employee’s progress and overall evolution).
Moreover, employers may need to compensate employees in ways that are not in line with how they drive value for the organization and can limit the overall compensation pool.
Companies have labor needs that can vary based on where they are in the calendar or they may have inherently irregular work flows.
Having full-time staff may not be necessary.
Amazon and FedEx need extra help during the holiday season because of the volume of packages, and less help during other parts of the calendar.
– Reduce legal risk
Full-time, salaried employees can generally push lawsuits on companies they’re either employed by or have been employed by in the past with greater ease.
These most commonly have to do with wage disputes, wrongful termination, and discrimination.
– Less control
Independent contractors have greater flexibility in what they contribute. For example, Uber drivers can practically drive as much or as little as they want. There are certain incentives to drive to better match supply and demand, but no set hours or set amount of work or tasks.
In general, independent contracts have less supervision and more limited ability to manage their tasks in comparison with full-time employees.
– Ownership over output
What a full-time employee creates for the company on the job is the ownership of the company. With independent contractors, that’s sometimes not the case automatically.
– Audit risk
Freelancers and independent contractors are often used to lower costs. But sometimes these employees better fit a full-time designation (e.g., Uber’s dispute with driver classification in California and other jurisdictions).
This can open a company up to fines and other legal risks.
Labor is a big part of a company’s cost structure. Understanding it and how it could evolve is something to look at.
Asset-lite and asset-heavy business models largely come in two different forms – “pipes” and “platforms”.
Pipes involve products created with the consumer in mind. Platforms involve producers and consumers who interact and exchange with each other to give it value.
Platforms are generally more toward the “asset-lite” category and can be difficult to invest in because of the lack of physical assets.
If an investor wants to measure their downside, if they’re investing in an oil or gas company either as a common shareholder or creditor, they know that they may have recourse to many physical assets, such as property, plants, machinery, equipment, refineries, and so on.
If the company doesn’t work out, investors may still derive some residual claim based on the liquidation worth of its asset base.
So pipe models may in some ways be safer investments and have a tighter distribution of possible outcomes than platform models, which have less value to derive from tangible assets.
Regardless of the model, it boils down to a few judgments:
i) Is there a need for the products and services the company offers?
ii) Can it be a monopoly or the go-to business for what it offers?
iii) Are there potential network effects?
iv) What kind of scalability is possible?
Moreover, platform model businesses often employ labor differently relative to pipes, of which there are advantages and disadvantages.
Pipes are also more prone to disruption from platforms.
This goes for taxi services (e.g., Uber), hotels (e.g., Airbnb), retail (e.g., Amazon), and media (e.g., Google, Facebook, Netflix).
Those industries traditionally operate on pipe business models. But they were disrupted recently by entirely new types of businesses formed in the recent past who had the vision to see how something could be done better or differently.
As a result, more pipe companies are becoming taking on more platform qualities and strategies into their models. This includes Wal-Mart’s increasing adoption of e-commerce. Sears famously missed it altogether.
As technology moves forward, pipe models have little choice.