What do Afterpay, Google and Facebook – some of the most in-vogue listed companies – have in common?
It’s not the tech, origins, backers or industry. Arguably, it’s that their core products are free to consumers, in a monetary sense at least. Extending the concept a bit, some of the biggest brands to emerge in the past decade, such as Uber and Airbnb, have clearly grown rapidly by undercutting incumbents on price. Even established companies across industries like banking and telecommunications have recently sliced a range of fees and charges, and are having to offer more and more digital services at zero cost.
Forgetting for a second any data customers are transferring to tech platforms in the background, it seems what has been dubbed the business model of “free” is thriving.
But it’s also showing signs of fatigue among investors in the frothy world of tech and start-up “unicorns”, where profits can be harder to deliver than customers and revenue.
Hot on the heels of underwhelming listings by ride sharing players Uber and Lyft, loss-making US shared office business WeWork recently aborted its high profile initial public offering after investors gave the deal the cold shoulder. Locally, credit provider and aspiring tech player Latitude Financial also pulled its planned float, while the high growth “WAAAX” tech stocks – Wisetech, Appen, Altium, Afterpay and Xero – have lost some of their shine as investors question whether the small, or in some cases zero, profits justify the heady valuations.
Amid toppy markets (US stocks are trading around record highs), a divisive issue has come to the fore: are “free” and super cheap business models the key to returns in today’s digitised world? Or is it unsustainable, bar the few outliers, at a time when near-zero interest rates are lowering the cost of capital for competitors and technology advancements?
“‘Loss-leading’ and losing billions has proven to be one way to achieve household name status and investors, allergic to low-yielding term deposits, have been more than willing to fund the dream,” prominent Sydney-based funds manager Roger Montgomery wrote on his website this month, claiming WeWork “exemplified the euphoria surrounding start-ups” after its pulled float and suffered an 85 per cent fall in valuation via a subsequent buyout.
“But for the dream to become a reality, these enterprises need to convert revenue to profits and positive margins require the ability to reduce costs, raises prices or both. And that’s where competition becomes an issue.”
According to Deloitte, free strategies take many forms – “freemium” (whereby more advanced offerings are paid for), cross subsidises, advertising or deferred free – and tech companies had proven they drive adoption, market share and loyalty.
In 2011 as tech euphoria was stepping up, Deloitte opined that “free is well on its way to becoming a sustainable, meat-and-potatoes business model for companies that make money by giving something away”, citing the likes of Flickr, Skype and Facebook, but also noting “more traditional companies” were “jumping on the bandwagon”.
It said that while some had brushed free off as a “business fad” in the wake of Chris Anderson’s 2009 book Free: The Past and Future of a Radical Price, it was risky for businesses to do so given the spreading psychology of free, growing competition, technological disruption, demographic shifts and the potential from partnerships.
More recently shifting customer expectations and heightened scrutiny has also played a part with banks erasing or reducing a swathe of fees, such as for using a competitor’s ATM, as telcos dump excess data charges and retailers ramp up online and delivery capabilities.
For societies, free and falling prices are often welcomed by consumers and politicians. But it also has broader implications.
For years, economists have been wrestling with what the rise of the digital economy means for inflation and productivity, and whether living standards have improved more than GDP figures suggest. Reserve Bank Governor Philip Lowe has repeatedly said technology was a key driver of low inflation globally, while his counterpart at Chile’s central bank this month called out the rise of free products and services as a reason for “a revision of a number of assumptions behind GDP as a measure of the population’s well-being”.
“Central banks around the world, despite multi-decade low unemployment rates, are having trouble hitting their inflation targets,” Governor Lowe told an event this month at the International Monetary Fund in Washington, D.C. “In my view there’s really something structural going on and that relates to the combined effects of globalisation and advances in technology. Together these factors have increased competition and they’ve increased uncertainty.”
Falling interest rates and slower growth since the GFC has seen private investors and venture capital pour billions of dollars into loss-making but high growth, high potential companies in the hope they’ll become the market leader and deliver profits and returns. As tech enthusiasm spread, many investors have been able to revalue and on-sell businesses to others willing to pay an even higher price.
And it’s often worked.
In the US, venture capital exits have exceeded $US200bn this year for the first time in a decade, according to researcher PitchBook, “despite some high-profile hiccups in the exit market”. Prior high-profile tech floats like China’s Alibaba and Facebook – one of the highly-valued “FAANGs” alongside Apple, Amazon, Netflix and Google that often don’t charge consumers anything or very much – have since become some of the largest companies in the world.
Hamish Douglass, chief investment officer of Magellan Asset Management, a high profile backer of global tech stocks, this month put Alibaba alongside Google’s parent Alphabet, Amazon and Microsoft as one of the “four most powerful businesses in the world today with enormous growth prospects” driven by their massive amounts of data, intellectual property, technology and market shares.
VC firms have also cautioned against suggesting WeWork’s troubles were representative of the entire start-up space, warning that it’s normal for some new concepts to fall over, and the likes of Google and Amazon were considered overvalued for years. Writing for tech website VentureBeat this week, entrepreneur David Friedman says the issue with WeWork was that top line growth can’t overshadow the “sound unit economics” that investors increasingly demand the older start-ups get when they’re asked to provide funding.
“All technology investing is characterised by a power law. That means some business that win keep on winning and some don’t quite get there and gravity kicks in. It takes time to know which is which,” says Reinventure co-founder Danny Gilligan.
In Australia, established disruptors REA Group, Seek and Carsales have been bid up due to their high profitability and optimism for their platforms that provide consumers free listings of properties, jobs and cars while charging advertisers. More recently, Afterpay and Zip have become some of the key poster children of the expanding fintech and start-up scene in Australia, quickly attracting multi-billion dollar valuations and loyal users who relish being able to pay for products in instalments for free, assuming they pay on time.
But they’ve also drawn widespread debate among bulls and bears about their valuations.
Initiating coverage of Afterpay and rival Zip Co this month, UBS analyst Tom Beadle cited potential regulation risks, such as what would happen to growth if consumers had to start paying for the service or if merchants, such as retailers, started surcharging to recover the costs charged by providers, similar to other options like credit cards. A day later, the RBA then said the prevention of surcharging by buy-now-pay-later (BNPL) providers “can be problematic” for merchants and it “will be considering if there are any policy issues associated with the growth of BNPL services” in its 2020 review of card payments regulation.
“In our view, somewhat paradoxically, the more successful BNPL services are, the more likely they are to attract regulatory scrutiny,” Beadle said, adding the space also had low barriers to entry.
Looking ahead, Montgomery, a “value” investor in contrast to “growth”-focused money managers, said increasing competition was a key issue for start-ups, arguing it makes it hard to lift prices and cutting costs isn’t easy when needing to retain market share. The long-time Uber sceptic points to how it under-prices its car rides, generating a good outcome for consumers but a “lousy” one for investors after posting billions of dollars in losses since kicking off operations in 2009 in contrast to Facebook and Amazon, which were cash flow positive after five years.
Also, they’ve managed to see off competitors, helped in Facebook’s case through acquisitions such as Instagram and Whatsapp.
Naturally, success stories continue to abound – Sydney-based graphic design software start-up Canva was reportedly just valued at $4.7bn.
But at the end of the day, factors like sustainable cashflows will remain “eternal”, says Schroders’ deputy head of Australian equities Andrew Fleming, who used the Beatles’ track You Never Give Me Your Money from Abbey Road -- which just re-topped the British charts – to describe the WeWork drama: “…You never give me your money, you only give me your funny paper, and in the middle of negotiations, you break down….”
Or perhaps Deloitte put it best eight years ago: “Nothing is really free. Companies that employ free strategies are simply transferring cost and value to different parts of the value chain – or to a different time in the revenue cycle.”
The views expressed are those of the author and do not necessarily reflect those of the Westpac Group.
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