Tech boom or bust
Software and technology companies currently trade at or close to all time highs despite the world being on the brink of a global recession or even depression. It therefore is right to ask whether we are facing an imminent collapse in the value of those companies? The short answer is that no-one knows how they will perform in the short-term… However, we maintain a significant exposure to selective software and technology companies because we believe that the long term value creation potential is significant even from these levels.
According to Ben Thompson there are two types of companies. The first type and the one that many Australian investors are familiar with are aggregators. Companies like REA Group, Seek and Carsales are examples that are listed on the ASX, and Google and Facebook are examples in the U.S. The three Australian companies were probably the first and most prominent publicly listed technology companies that succeeded domestically. Their business models were based on users listing property, job and car classifieds online as an alternative to posting them in print newspapers decades ago. The three companies above capitalised on the cost of distribution falling to zero thanks to the Internet, giving them a permanent competitive advantage over their print counterparts. Both the classifieds in print newspapers before the Internet and the online classifieds companies after the Internet enjoyed/enjoy excellent financial returns. They were/are the dominant destination for demand (property buyers, job seekers and car buyers), which attracted more supply (property sellers, employers and car sellers). More supply attracted more demand and it became a positive feedback loop making it difficult for other players to compete. Back in the day the cash-flows from the leading print classifieds were considered to be ‘rivers of gold’ for its growth and reliability, and it was the Internet which changed the cost structure and the economics of the industry giving REA Group, Seek and Carsales the opportunity to thrive. Now, when online advertising is the norm, all three companies have clear dominance, pricing power and have consistently fended off new entrants. It is unlikely that dominance will change in the foreseeable future unless we see a major technological change without those companies adapting to the new environment. It could be argued that we recently saw that major technological change when mobile usage started overtaking desktop usage. All three companies successfully adapted their business models, and continued their dominance on mobile devices.
The second type of software and technology companies are platforms. Users will use the software for a specific purpose, but are also able to integrate with other products and features. Apple’s operating system, iOS and Google’s Android are examples. The sheer volume of apps that are available on those systems makes it impossible for even companies like Microsoft to compete in this space. Although Microsoft lost to Google in mobile phone operating systems, Microsoft also has a platform in Windows and Office. Teams is offered as part of Office, and the success of Teams shows the strength of the platform. Teams doesn’t have to be the best collaboration product on the market, but as long as it is offered as a package with other embedded applications, it is likely to do well.
So what are some of the Australian listed companies that understand the platform concepts? Adrian DiMarco, the founder and Chairman of Brisbane based Technology One gets it. Their strategy is to offer a software solution and a platform with multiple applications to universities and local governments. Each application offered by the company may not be the best-in-class but when you consider the total offering across the platform, it becomes a very compelling proposition for their customers.
Another company is Xero, the cloud accounting software company. The original reason for business owners to use Xero was for basic accounting and bookkeeping purposes. The functionality on offer slowly expanded to include features such as payroll, invoicing, finance, integration with government agencies and more. They then created an app market place where third party developers could create apps which could easily integrate into Xero for their users. For example, there are third party apps for inventory management, HR, CRM and the list goes on. As the number of Xero users increases, more apps are likely to be developed making Xero a much better alternative for business owners. Furthermore, as more apps and features are taken up by business owners, Xero becomes further embedded into the businesses they serve, lowering churn and increasing the value of Xero. This positive feedback loop leads to a ‘winner take all’ industry structure, where the company leading the industry ends up with most of the market share. We think that Xero and Intuit will likely dominate this market globally. This is unlike the traditional industry structure predicated on competition. Steve Vamos, the CEO of Xero was a Microsoft executive, and is most likely aware of the power of platforms.
Bill Gates once said 'A platform is when the economic value of everybody that uses it exceeds the value of the company that creates it.’ It therefore has the potential to unlock significant economic benefits to users, and although the platform is only extracting a small slice of the entire value chain, it still is a significant amount that accrues to the platform owner.
This note has been prepared by ELM Responsible Investments (‘ELMRI’) ABN 70 607 177 711 AFSL 520428, for Australian wholesale clients for the purposes of section 761G of the Corporations Act 2001 (Cth).
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Past performance is for illustrative purposes only and is not indicative of future performance.