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<\/p>\nThe disproportionate value creation by the FAANG stocks over the last decade has made \u2018Platform\u2019 a buzzword among investors and start-ups. Every business wants to call itself a Platform to attract investors, and dissuade competitors. The most unlikely businesses have called themselves platforms \u2013 WeWork (Co-working), Beyond Meat (Synthetic Meat), Casper (Mattress e-commerce) and Peloton (Exercise bikes). In India too, Platform is a highly coveted tag. Almost all tech companies that got listed in the last 3 years call themselves Platforms. The below table outlines the number of times the word \u2018Platform\u2019 was used in the Red Herring Prospectus (RHP) of some of the recent tech IPOs:<\/p>\n
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We have previously written about the Platform business model more than three years back in our Q4FY19 investor letter. At that time there were only a few Platforms listed in the Indian markets. In that letter, we had discussed the investing implications of the rise of platforms (with particular focus on the disruptive threat to incumbent brick and mortar\/non-platform businesses). Since then, several so-called Platform businesses have listed in India.<\/p>\n
In our Q4FY19 letter, we had said –<\/p>\n
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To be fair, all the companies that we mentioned in the Table above fit the definition of a Platform (they connect and facilitate exchange of value between two user groups, and they all have network effects). But are all platform companies invincible? Do all of them have \u2018winner-take-all\u2019 characteristics? Should investors avoid all businesses that compete with these companies? The recently published book \u2018The Platform Delusion\u2019 by Jonathan Knee provides good answers to many of these questions. We discuss the key takeaways below..<\/span><\/p>\n Platform-dom is not a Panacea<\/strong><\/p>\n The invincibility of \u2018Platforms\u2019 as a business model is more a myth than a reality. The author debunks the four pillars of the \u2018Platform Delusion\u2019:<\/p>\n In short, just because a business is a platform business, doesn\u2019t say anything about how good or bad it is. Network effects alone are neither sufficient nor necessary to build durable competitive moats. The business must be accompanied by age old durable competitive advantages to survive and make money.<\/p>\n Platforms too require Sustainable Competitive Advantages<\/strong><\/p>\n In his seminal piece \u2018Competition Demystified\u2019, Bruce Greenwald said that there are really only three sources of competitive advantages (or \u2018moats\u2019) for a company:<\/p>\n How relevant are these age-old moats in the age of digital platforms? The answer is \u201cvery relevant\u201d. But there is an added source of competitive advantage that Greenwald did not discuss in detail but is uniquely facilitated by the internet. This is the ubiquitous Network effects or the Flywheel effect that everyone talks about. We discuss below these sources of competitive advantages in context of digital businesses \/ platforms.<\/p>\n Offline businesses benefit from supply side scale advantages as the fixed costs are spread over a larger base reducing the per unit cost of operations. The internet, however, has reduced the relevance of this supply side scale advantage because of significant reduction in the fixed cost of operations, particularly marketing and distribution. Jonathan Knee says, \u201cThe internet facilitates the establishment of an entirely different breed of scale advantage that does not owe its existence to high fixed costs\u201d. This is what we call network effects or the flywheel effect. \u201cRather than representing a supply advantage, network effects yield a benefit on the demand side of the equation: the bigger you are, the easier it is to attract new customers and incremental revenue\u201d, says Jonathan Knee.<\/p>\n In essence, the internet makes it harder to secure supply side (fixed cost) scale advantage but easier to develop demand side scale advantage through \u201cnetwork effects\u201d. However, it has not totally eliminated the supply side scale advantage.<\/p>\n Scale advantages by themselves, whether manifested through demand or supply-side benefits, are fragile without reinforcing entry barriers. If the only advantage is supply-side scale (fixed cost advantages), then the business is vulnerable to anyone with deep pockets willing to share the spoils. Some degree of customer captivity can however prevent competitors from capturing meaningful market share. Demand side scale (network effects) advantages are similarly fragile. Beyond simple habit, the most typical forms of customer captivity are switching and searching costs. Internet reduces the frictional cost of switching\/searching thereby reducing barriers to entry for new players..<\/span><\/p>\n Evaluating two consumer-tech companies<\/strong><\/p>\n We evaluate the strength of Zomato\u2019s and Nykaa\u2019s business using the framework we discussed above. While Zomato and Nykaa have a host of competitive advantages, the nature of these advantages is very different.<\/p>\n Zomato is one of the two platforms that have a combined 90%+ market share of the online food delivery market in India. It is a two-sided platform that connects restaurants with users. Zomato\u2019s main source of competitive advantage is the network effects inherent in its business model. Every additional restaurant or user on its platform increase the value of the platform. Restaurants want to be listed where the maximum users are and users want to use the platform that has the maximum number of restaurants. Zomato also has some traditional supply side economies of scale. For a pan India food delivery platform, a physical presence of delivery partners is required in all locations. This requires significant fixed cost investments for any new player to enter this market. However, Zomato has limited customer captivity because of limited search\/switching cost. Customers mainly care about the lowest price and the fastest delivery. A user may easily shift to a Swiggy if it has better offers than Zomato.<\/p>\n Nykaa, on the other hand, has more traditional sources of competitive advantages such as supply side economies of scale, and customer captivity. In fact, Nykaa does not even fit the definition of a platform because it stocks and retails all the products itself (in its beauty business) and is not a marketplace like other e-commerce businesses. This has been a source of customer captivity for Nykaa as it has built a name for itself in authenticity and quality control because of the control it exerts on its inventory. Nykaa also benefits from supply side economies of scale. Nykaa has invested in creating a network of 100+ offline stores to create an omnichannel presence. It has created physical warehouses for stocking inventory and quickly delivering to its users. It incurs significant cost on advertising on national television or on hiring a celebrity brand ambassador. It also derives advantage from better gross margins due to a much larger scale.<\/p>\n While Nykaa does not have strong network effects (new users or new cosmetic brands do not really increase the value proposition of the platform) but that doesn\u2019t take away from the fact that Nykaa is a superior business than Zomato (at least as of now). Its core business is highly profitable and it is at least 4x larger than its next competitor (2Point2 Estimates). This is despite the fact that Zomato has all characteristics of a Platform business.<\/p>\n Summarising, platforms are successful not because they are platforms but because they have the same sources of competitive advantages that traditional businesses have enjoyed for decades. In fact, it is more difficult for digital platforms to sustain some of these competitive advantages as discussed above. Although the key categories of competitive advantage have not changed, digital models undermine the ability to sustain certain entry barriers (such as customer captivity) but potentially facilitate network effects and other supply side advantages from some combination of data, technology and learning and sometimes from significant fixed costs as well..<\/span><\/p>\n .<\/span><\/p>\n Disclaimer: All information provided is for information only and should not be considered as investment advice or a recommendation to purchase or sell any specific security. 2Point2 Capital may or may not have a position in any of the securities mentioned above.<\/em><\/p>\n\n
\nThe author compares Shopping Malls and their digital counterparts E-commerce companies (both are two sided platforms connecting buyers and sellers) to demonstrate this point. Malls have two structural advantages \u2013 their vendors are committed to long term leases and their shoppers need to travel many miles to find the next alternative. This results in customer captivity and enables them to generate superior returns for their investors. An e-commerce platform\u2019s relationship with its buyers and sellers exhibits none of this durability. A buyer is free to shop anywhere and a seller will optimize by selling on all platforms. Estimates of e-commerce\u2019s failure rates are as high as 97%. Some advantages of digital platforms (network effects, zero marginal cost) are often completely negated by other disadvantages (low entry barriers, low switching costs).<\/li>\n
\nZoom is a communication platform that enables users to connect by simply clicking on a browser link. During the pandemic, the stock zoomed ~8x because of the sudden demand for such a service. However, soon a number of competing products (MS Teams, Google Meet) were able to gain market share. Zoom\u2019s initial success which was driven by its network effects was easily overcome due to the low switching costs of the service. The stock has crashed more than 80% from its peak since then.<\/li>\n\n