The Power of the Platform: The Promise and Peril of Technology Investing
Without question, technology’s rapid development during the past 20 years has played an incredibly powerful and largely positive role in furthering the progress and productivity of modern economies throughout the world. Technology’s track record as a profitable investment theme, however, is a bit cloudier.
Fortunes have clearly been won in the arena – just ask anyone who bought Microsoft in 1994 or Apple in 2004. Unfortunately, people who invested in Excite@Home in 1998 or Research in Motion in 2008 have an unhappier story to tell. Many losses within the technology sector occur when capital is poorly allocated to old technologies that eventually become obsolete or to emerging ones that never quite live up to their promise. Throw in the volatility inherent in most technology stocks, and you’ve got a recipe that many investors are not able to stomach.
The unfortunate reality is that numerous challenges – with a capital C – face the technology investor. Among them:
- Cyclicality – During an economic downturn, investment in the sector declines considerably as companies and consumers alike tighten their budgets and try to squeeze one more year out of last-generation equipment.
- Competitive – Relatively few barriers to entry within most industries in the sector mean that existing companies find their profit margins under constant pressure as new entrants offer attractive alternatives.
- Commoditized – Without rock-solid intellectual property and patent protection, most companies find that their innovations are easily replicated, if not actually surpassed, which also serves to put significant pressure on margins.
- Constantly changing – Obsolescence and creative destruction is the rule – not the exception – within the sector. Today’s winners are often tomorrow’s has-beens.
Indeed, the very qualities that have allowed technology to have such a dynamic, outsized impact on modern societies and economies are also what make investing in the sector such a perilous endeavor; so perilous, in fact, that many investors – even those as smart and successful as Warren Buffett – have chosen to largely stay on the sidelines.
However, the fact that the barriers to successful, long-term investing in the technology sector are significant provides experienced managers with a disciplined, distinctive investment process a meaningful opportunity. These managers may have the ability to add real value for investors who want exposure to this important sector but who can’t keep up with its constant changes and emerging trends.
Disciplined, distinctive approach offers merit
We believe all investors should have some exposure to the technology sector. The key is to invest as wisely and discriminately as is possible. Technology companies that operate in extremely large markets, are supported by capable management teams that possess strong competitive positions with significant protective moats may have the potential to add value to an investment portfolio. In general, companies with these characteristics can potentially:
- Boast impressive revenue growth
- Enjoy industry-leading profit margins
- Operate large platforms on which to expand their businesses
And because stock performance can follow in the wake of consistently strong revenue, earnings and profit margin growth, the stocks of these companies are potentially more likely to demonstrate significant potential for capital appreciation over time. Discovering these types of technology companies is no easy task.
The Power of the Platform Defined
In technology, a platform frequently refers to the underlying hardware or software of a computer system, which enables the creation of products and processes for future development. Another way to think about it is to imagine the New York Yankees organization. The Yankees, in their own right, are a successful enterprise generating hundreds of millions of dollars in revenue through a variety of business lines. Yet at the same time, the organization acts as a platform allowing other businesses to grow and thrive on top of it, whether they are television network providers, parking/real estate developers or merchandise salesman in the stadium.
A successful platform possesses the following characteristics, which work together to create a virtuous loop that enhances the platform’s power and functionality:
- Ease of use
- A high degree of utility for developers and consumers
- Large user bases and active developer communities
- Flexibility to adapt to evolutions in technology
For equity investors looking for potential compelling long-term values in the technology space, successful platform plays offer a number of very important advantages, including the high margins and strong revenue growth potential derived from impressive scale and limited competition. Specifically, an effective, broadly accepted platform lends itself to margin-enhancing phenomenon as seen in Figure 1.
Figure 1: Powerful Platforms & Margin-Enhancing Phenomenon
The idea and promise of a technology-based platform that helps lock in customers and fend off competitors is hardly new; in the pre-Internet world, of course, Microsoft and Intel benefitted from owning one of the greatest of all early platforms with their powerful Wintel alliance. During the heyday of the desktop PC market, both of these companies enjoyed tremendous success on both their top- and bottom-lines, and their stocks performed accordingly, as seen in Figures 2 and 3.
Figure 2: Wintel & Competitors Total Returns 1987-1997
Figure 3: Wintel & Competitors EBITDA Margin
Not surprisingly, other earlier technology companies for years tried to mimic the Wintel platform to varying degrees of success. But it was the coming of age of the Internet – surely the biggest, most comprehensive technology platform known to man – that truly accelerated the proliferation of platforms. Platforms of almost every size and scope, and in almost every vertical and horizontal market, have exploded on to the scene during the last five years.
Just take a look at Figure 4 for some of the newer broad platforms made possible only because of the Internet. Frankly, we believe we’re at the point where virtually every technology company in existence will continue to attempt to position themselves as a platform play (nary an investor presentation or an earnings conference call goes by where we don’t hear the term at least once!). The trick then as investors is to discover the companies with genuine platforms in ascendance and truly using their power to achieve transformative changes in their respective markets.
Powerful Platforms in action
Of the numerous potential examples of what we consider existing powerful platforms, two in particular illustrate the potential of this type of advantage in different ways. These two companies are, in our opinion, the best illustration of the virtuous loop that platform plays can demonstrate as seen in Figure 5.
Figure 4: Platform Proliferation Since 2008
Apple
Google, Amazon, Facebook and Salesforce.com may argue otherwise, but Apple is probably the company that has benefitted the most from their platforms. And we believe most investors, myopically focused on why a new product was delayed a quarter or why gross margins fell 50 basis points, continue to underestimate the long-term value of these assets.
Remember, it was only about a decade ago that Apple was a niche computer hardware company with very modest market share. That all changed for the company with the introduction of the iPod music player. The incredible success of the iPod – ironically, spurred by its expansion to Wintel computer compatibility – led to what many analysts deemed the halo effect.
The halo effect is a phenomenon often associated with successful platforms, where customers committed to a particular technology decide to explore the company’s other products and services. In this case, iPod users storing their songs on Apple’s iTunes software became a lot more interested in also owning a Mac computer. And while Apple’s market share in computers kept creeping up, the company proceeded to use its positioning as consumers’ preferred mobile entertainment platform by launching the transformative iPhone and iPad tablet.
Today, hundreds of millions of consumers rely on Apple as the platform on which to store all of their songs, photos, documents, books, TV shows, movies, mobile apps, contacts, etc. It’s easily one of the largest, most dynamic ecosystems in existence. Importantly, Apple – and its partner and developer communities – earns a great deal more money than do any of the other large platforms within the same markets. In its 2013 fiscal third quarter, Apple says it generated over $4 billion in billings in its iTunes store, while developers earned more than $5 billion during the last year from the App Store.
And it’s easy to envision how Apple will continue to offer more and more products and services to a user base that has already invested a lot of time, money and energy in the Apple ecosystem. In June, for example, the company launched a streaming radio service to compete with folks like Pandora and Spotify. During the next 12 to 18 months, we believe it is likely that Apple will continue to productively expand its business lines. If Apple is successful and sufficiently creative, its platform-based, non-hardware-generated revenue has the potential within the next five years to equal at least a third of the company’s total business.
Figure 5
The Platform’s Virtuous Loop
Ellie Mae
Not all successful platforms have to be as large or as broad as Apple’s. Ellie Mae offers an intriguing, comprehensive platform for mortgage brokers, consolidating all of the necessary documentation in a single cloud-based application. This loan-origination software, called Encompass360, automates the mortgage process, enhancing access and communication between all of the respective parties in a transaction. At the same time, the software also reduces the complexity, inefficiency, and cost of completing a mortgage, from the credit application to the post-closing process.
The powerful network effects of Encompass are what truly drives the success of the Ellie Mae platform. When a new mortgage broker customer starts using Encompass, they will often bring in their own trusted partners – appraisers, lenders, investors, insurers, etc. – whose products dramatically increase the scope and functionality of the platform. Those service providers, in turn, have relationships with other mortgage brokers who are often compelled to sign onto the platform as well, reinforcing the virtuous loop.
As testament to this, the number of Ellie Mae users subscribing to the company’s SAAS offering grew by 178 percent in 2012, equaling more than half of the customer base. And even with this exploding user base, the platform is so effective that it has captured an even higher level of customer use. That’s because service providers on the platform conducted six related transactions for every individual loan processed on the platform during the second quarter of this year, up about 20 percent, year-over-year. That is the potential network effect of a platform product geared to truly improving the efficiency of an industry.
Platform caveats
While powerful platforms have numerous advantages, they are not impenetrable, of course. In fact, the very benefits a successful platform provides can sew the seeds for its eventual undoing by encouraging complacency and a failure to evolve to changing circumstances. We have seen this fatal flaw time and time again in the technology space, and the resulting slow motion train wreck can be painful to watch, as platforms tend to limp around and linger even while in their death throes. After all, people still use AOL email, for heaven’s sake.
Indeed, if there’s a major concern about Apple, it’s that we have seen a bit of this arrogance and inflexibility in their strategy of late. While the company’s tight control over the ecosystem and user experience, along with its very measured pace of expansion, likely helped Apple achieve its early successes – particularly with monetization – that control now seems to be putting Apple at a disadvantage versus the more wide-open, freer mobile platform that Google provides with its Android platform.
The danger is that once a platform begins to decline and users start abandoning the ecosystem, it becomes an extremely difficult task to reverse, or even stem, the tide. And for equity investors in companies with faltering platforms, the pain is especially excruciating. Just take a look at the performance of some companies as they began to see their once powerful and influential platforms overtaken by newer upstarts: Microsoft in web browsing, Monster in jobs, MySpace in social and Research in Motion in messaging.
The other concern we have regarding platform companies revolves around valuation. No matter how powerful a platform is, we believe a company must still be valued on future cash flows. This is of course always a subjective, tricky and imprecise calculation but it is especially so with emerging platform investment given that much of the potential monetization opportunities remain embryonic at best. Financials are, after all, only a snapshot of the current situation of an investment and do not tell the story of the potential long –term economics for a company. These valuations become dangerous when the market already factors in overly optimistic projection for future growth and margin expansion, limiting an investment’s upside or setting it up for collapse.
Conclusion
Investing in technology can be a highly profitable enterprise but is also one rife with challenges. Companies in this sector are often subject to margin pressures spurred by fierce competition and rapid commoditization. Some of the more interesting technologies may be too far ahead of their time, while many of the most established face the constant threat of obsolescence.
But technology remains a vital component of the global economy and many investors are willing to accept the sector’s greater short-term volatility in exchange for its potentially substantial long-term returns. It is, however, vital that investors participating within the technology space find the companies with meaningful scale, significant barriers to entry, loyal users, deep partnerships, and the inherent ability to rapidly pursue future growth opportunities in adjacent or complementary markets. We believe technology companies exploiting the Power of the Platform are most likely to sport these kinds of characteristics, and thus their stocks should offer the greatest potential to post significant long-term returns.
© Jacob Asset Management
