Internet: Destroyer of Profit Margin

I have discussed how Internet disrupted or continuing to destroy software business models. So lets look at one of those Internet application companies and how they are "thriving" in the age of the Internet.

Salesforce.com is the poster child of the new Internet company that offers Software-as-as-Service applications, or Customer Relationship Management as a service. The application is really good, we use it at our company and we are happy with it. But does this model can translate to sustainable competitive advantage or at least a viable business?

I reason, NO.

After using Salesforce for few years and being happy with the value we got, competitive alternatives are being offered less costly. Competition, although may not be mature yet, but getting there quickly, are offering similar solutions. Competition have huge advantage over Salesforce, being able to use cheaper and more advance technologies. In this industry it does not pay to have a first mover advantage. Salesforce will not chug its infrastructure but a new entrant to the industry will pick the most efficient platform to launch its service. Competition is everywhere for someone like Salesforce with less costly operating structures, prices for these offerings will continue to go down overtime and eventually they will become free.

Google applications market place is one platform for companies and start-ups to develop on a free platform and data centre. Sure it is yet to mature to offer business ready solution but it will get there. Others will offer similar solutions. Actually salesforce offers something similar but its drawback is it has to be developed on their platform, limiting flexibility.

In order for Salesforce to keep its growth it spends heavily on sales and marketing. Actually, 50% of Revenue is spent on marketing and sales annually to continue with its growth. But how long can you continue with such spending before investor want to see some returns?

If we look at their margins they are very depressed. Actually, there are no margins after some 10 years of operations. Sales and Marketing expenditure

will continue to eat at their profitability to ensure they compete and sustain market share. They have generated cumulative earnings of $42 Million from cumulative revenue of $3 Billion, since they went public. And I do not think that will change in the future.

Salesforce sports a very high multiple, in fact 102 x earnings. Investors are bidding these shares up for the prospect of growth in earnings. I am afraid the growth will come but Salesforce and many outfits like it will not benefit. The market for Software as a service(Saas) will grow like crazy but, profitability will be scarce. Why? Free is the name of the game on the Internet.

This is a good candidate for a short:

• one product company with the promise of growth.
• extreme valuations.
• no earnings after some 10 years operations.
• tough market dynamic and getting tougher.
• the accounting is open for games as they book of revenue from deferred customer contracts, which can be messy, I have not analyzed it carefully but it is something I would look at very carefully.
• Something does not add up about there subscriber base:
• based on their financials revenue per user should be around $18,733, based on published users of 60,000.
• however the highest revenue per user is $250 per month or $3000 per year. The two figures are vastly different.
• The discrepancy between the two figures tell me that they may have few large customer that skew the average higher, while the majority of their users are small (1 user) customers.

Would I short? No. People can continue to believe in future growth longer than I can remain solvent.

Internet Economics -part III

Computers stripped down:

I do not see hardware companies with exclusive consumer offerings doing very well in the long term. End user computers will be so stripped down of any horse power or might as most of its computing power shift to the Internet, as I have discussed in my earlier post. Look at some of the strategic actions of the following companies:

• IBM divested from all things consumer hardware.
  
• HP have boosted its data centre management with the purchase of EDS.
  
• Dell is struggling to regain market share.
  

Remember Sun's "the network is the computer" tag line; it makes a lot of sense now. Moreover the computing infrastructure is ready for it. I see computer makers designing and selling for utility providers, to the Google and Amazons of the world. Consumers will use Net-books to access their computing power. Those thin terminals have not taken off before because the utility model was not mature. Now I think it is a better environment. Currently I do most of my applications from online providers, whether business or personal. I hardly use any application from my hard drive. Once my laptop kicks the bucket I am in for a net-book that will cost me $200 or so.

So my conclusion here is to stay away from computer makers who are making heavy investment in distribution channels and goods geared to consumers and look for those with good distribution network with utility businesses.

Free Labour:

The Internet has introduced free labour to many industries like media and software. Think of the contribution of bloggers and content on YouTube. Also, think the volume of applications being used thanks to open source code and other free software used on the Internet like Google Docs...etc. Many have created profitable businesses using this model whether by supplying the infrastructure like YouTube and Blogger applications or by providing the content like blog posts. Participants are benefiting mainly by attracting advertising revenue. I am arguing that this model is unsustainable.

The Internet and computing power over the years have lead to two hard trends:

1. globalization: the shifting of manufacturing jobs to low cost producing countries, and
   
2. automation: the replacement of routine task by machines
   

Both trends have resulted and continue to result in jobs displacement. Job displacement will have to reach a limit where it will affect people who supply the free labour to the Internet eco-system. This will have two outcomes:

1. loss of advertising dollars as advertisers do not want to advertise to unemployed people who can't purchase their goods, and
   
2. the labourer will be so occupied about their livelihood that will consume most of their time to prevent them from being a participant in the Internet free labour force.
   

The idea that you can give things away online, and hope that advertising revenue will somehow materialise later on, undoubtedly appeals to users, who enjoy free services as a result. There is business logic to it, too. The nature of the internet means that the barrier to entry for new companies is very low—indeed, thanks to technological improvements, it is even lower in the Web 2.0 era than it was in the dotcom era. The internet also allows companies to exploit network effects to attract and retain users very quickly and cheaply. So it is not surprising that rival search engines, social networks or video-sharing sites give their services away in order to attract users, and put the difficult question of how to make money to one side. If you worry too much about a revenue model early on, you risk being left behind.Ultimately, though, every business needs revenues—and advertising, it transpires, is not going to provide enough.

Free content and services were a beguiling idea. But the lesson of two internet bubbles is that somebody somewhere is going to have to pick up the tab for lunch.
Source: Economist 2009

Today it is a new phenomena that it will take time to play out but the economics of the Internet will impact us and soon it will force us to change our social behaviour yet again.

The Internet Economics- Part II

Software: Not the same game anymore

Software used to be a wonderful business. It did have many of the attributes of strong competitive advantage. It tied users with high switching and search costs therefore enjoying a great pricing power. Software companies were able to up sell users on ongoing maintenance contract in perpetuity as a percentage of the original sale. Those days are over.

The Internet is turning itself to be the computer for all. It does not matter if you are a small business or large organization, your software use will change. Open source and software as a service applications has almost replaced all kinds of software applications. 

Consider our company, we have cut drastically all types of software purchases compared to few years ago. Please consider:

• We began a year ago to use Google Docs as our email server, office tools and as collaboration and knowledge management platform. 
• As for our Customer Relationship Management we use Salesforce.com. 
• Accounting is done through online packages.
• Open source for many development components. 

What is the effect of such transformation:

1. reduction of need for capital expenditure, improving our cash flows
2. reduction of our technical resources to maintain infrastructure to host all these application
3. ability to scale operations easily
4. we can level the playing filed with large organization by using similar technologies to manage our business.

In an opposite dynamic to the unbundling of media on the Internet, software and hardware are getting bundled. Software and hardware have converged and bundled by Saas companies. Saas companies are providing businesses with the application and the hardware along with the technical expertise to manage them. Businesses will only focus and concentrate on their core functions of converting raw material to products that customer wants rather than worry about supporting functions like IT.  

Google, Amazon and Salesforce are becoming a utility companies distributing computing power to users in same fashion power companies are distributing electric power to households and businesses. Companies like Google, Amazon and Salesforce are investing billions to construct data centres with huge computing power to sell and distribute to the masses, similar to constructing power plants. 

If you look at Salesforce.com financials you will see very similar return on sales and investment to utility companies. The reason is Salesforce and Google are not the software company like Microsoft and Oracle in its day, but it is a capital intensive business. It needs large sums of money to build computing capacity and real estate to be able to be successful in the Internet time. 

Microsoft and Oracle who are traditional software companies will face an uphill battle going forward. The culture of software is so entrenched to change easily. I do not see the merit in investing in software companies anymore, but I like utility companies like Google and Amazon.

The Internet Economics - Part 1

You may think this post is few years too late but I believe there is some relevant issues to discuss. The Internet have been quite a force and I think we do not yet understand its full impact. I did not say potential, because its has a positive implication, I'd rather use impact because we really do not know.

Its impact on our social behaviour is still developing, but its impact on some industries is felt deeply by all. I want to share some thoughts on the affects of the Internet on the following industries( I will do so over several posts so I do not bore you to death, or bore you several times):

1. Media, news papers in particular,
2. software,
   
3. computer hardware, and
   
4. Free labour, not an industry but there are many profit from it.
   

Media, the first casualty:
Newspapers are going into bankruptcy and shutting down exponentially these days. Some, to mitigate the impact, are shifting their distribution model to online only model. I think that will fail as well.

Newspapers will be burdened with legacy costs of their traditional operating model. Once they are online only they will discover that news papers on the Internet are unbundled. People read one article at a time independent of the source. And that will lead to their demise yet again.

The economics are totally different and culture is too instilled in traditional news papers to adapt to the Internet economics. Traditional news papers are sold as a bundle making some sections profits subsidizing others, i.e., classified are actually a subsidy for investigative reports, which costs a lot of money but produce no interest from advertisers. I think newspapers, who consider their reporters to be the starts of the system, will overpay those reporters with no benefit to show for their work. As a result, it saddens me to say that the investigative journalist job may disappear and society will be lose the knowledge and content they produce.

This brings me to bloggers and their content as a substitute for traditional news papers. Bloggers have self-proclaimed that their content is as good as traditional news papers. I say that is a total arrogant bullshit. Most blogs out there would have no content to create if it was not for traditional media. The content generated by blogs are mostly reactive to what is written in traditional media by providing opinion and off-the-cuff analysis.

In my next post I will detail my observations on the software industry.

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"Big Switch", Nicholas Carr