Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 135

Great businesses where customers do the work

What business would you like to own? For some, the dream might be McDonalds, Subway or even the local Laundromat, all potentially good businesses. But some new companies have more compelling operating models. Uber owns no cars, Facebook doesn’t pay for its media content and Alibaba, the world’s largest e-commerce site, has no stock to store. They’re all great businesses because they require little inventory and have low capital costs. They also become better businesses as they get bigger because of the network effect (see Facebook below). Some businesses like Tripadvisor have customers that do their work for them. That’s a fantastic business model - customers make the business better for free.

You are the content

Facebook doesn’t buy TV shows. It’s a reality show that is you. Your posts are the content. Unlike other media businesses, Facebook doesn’t pay money to produce shows or write off shows you don’t like. It makes money from your content by placing advertising within your newsfeed. On average, 1 in 20 posts have an advert. In the past 12 months, their global average revenue per user was $10.47. Australia is not broken out but the average US user brings in $34.

All those likes you click add up. Facebook needs 70 likes to understand your personality better than your friends. With 250 Facebook likes, a computer can know you better than your spouse. Facebook has a Superbowl-like audience every day where advertisers can target specific customers with a compelling alternative to television advertising. Facebook doesn’t need to market to sign up new users. Current users help Facebook grow for free as they send out links to sign up friends. The network effects are strong with one billion daily active users. A past example of the network effect is the telephone. The more people who own telephones the more valuable the telephone is to each user. Facebook is the same.

The average gross margin (sales minus costs of goods sold) for S&P500 companies is 33%. A large gross margin means greater potential profitability. Facebook’s unique business model delivers its 83% margin. The majority of expenses are employees researching and developing new services such as Instagram, instant messaging with WhatsApp and virtual reality with Occulus Rift. According to Nielsen, the average Australian spends 1.7 hours a day on Facebook. It’s easy to admire a new age media company that doesn’t pay for the content that drives the business.

Customers working for you

Tripadvisor is a similar user-generated model. It is the world’s largest travel site allowing travellers to plan and book their perfect trip. Tripadvisor doesn’t employ staff to write hotel reviews, their customers do it for them. Every day, the CEO wakes up and customers have added thousands of more reviews every night. I personally like the sound of this business.

Tripadvisor has 250 million reviews on 5.2 million places to stay, eat and things to do. You couldn’t hire enough staff to build it. Frequent reviewers receive virtual badges and you can guess how much that costs. Users are even willing to write reviews on small mobile screens. Like Facebook, it has a virtuous circle where more reviews lead to more traffic which leads to more reviews. Tripadvisor employs only 3,000 staff compared with 18,000 staff at Expedia and 12,700 at Priceline. Gross margins are even larger than Facebook’s at 96% (that’s not a typo). The majority of expenses are sales and marketing, such as television advertising. As the diagram below shows, customers (free employees) add 160 contributions a minute.

Source: Tripadvisor 2Q Investor Presentation

Can the business scale?

Apart from user-generated content, other good businesses involve companies that can grow and scale with little additional staff. As an ex-accountant and fund manager, I appreciate the benefits of scalability. Good people are hard to find. As accounting or law firms grow, they need to add more staff as they win new business. However, as a fund manager grows they don’t have to increase staff numbers commensurately. Look at the success of Magellan and Platinum. Magellan manages $39 billion with only 90 staff.

Another great business model is one that involves large-scale exchange traded funds (ETFs). There is none of the key man risk associated with star portfolio managers, and it’s hard to underperform a benchmark when you create it. In most sectors, ETFs are highly scalable with few of the limits to capacity evident for specialist managers such as hedge funds or small caps. In fact, as an ETF attracts more money it becomes more valuable to customers as liquidity and trading increases. For example, the US ETF provider, WisdomTree (represented in Australia by BetaShares), employs 124 people to manage $60 billion.

High gross margins and scalability

There are many great businesses out there but technology tends to top the list. The reason why the NASDAQ is one of the best performing indexes is because their companies tend to have high gross margins and scalable business models. Anyone in an operating business would love to have these characteristics. It’s hard finding good staff and attracting customers. Let your customers do the work and scale your business!

 

Jason Sedawie is a Portfolio Manager at Decisive Asset Management, a global growth-focused fund. Disclosure: Decisive holds Facebook in its fund. This article is for general purposes only and does not consider the specific needs of any individual.

 


 

Leave a Comment:

RELATED ARTICLES

Network effects: when big gets very big very quickly

Facebook, Google need new business model

Why the tech giants still impress

banner

Most viewed in recent weeks

Are term deposits attractive right now?

If you’re like me, you may have put money into term deposits over the past year and it’s time to decide whether to roll them over or look elsewhere. Here are the pros and cons of cash versus other assets right now.

Uncomfortable truths: The real cost of living in retirement

How useful are the retirement savings and spending targets put out by various groups such as ASFA? Not very, and it's reducing the ability of ordinary retirees to fully understand their retirement income options.

How retiree spending plummets as we age

There's been little debate on how spending changes as people progress through retirement. Yet, it's a critical issue as it can have a significant impact on the level of savings required at the point of retirement.

Where Baby Boomer wealth will end up

By 2028, all Baby Boomers will be eligible for retirement and the Baby Boomer bubble will have all but deflated. Where will this generation's money end up, and what are the implications for the wealth management industry?

Is Australia ready for its population growth over the next decade?

Australia will have 3.7 million more people in a decade's time, though the growth won't be evenly distributed. Over 85s will see the fastest growth, while the number of younger people will barely rise. 

20 US stocks to buy and hold forever

Recently, I compiled a list of ASX stocks that you could buy and hold forever. Here’s a follow-up list of US stocks that you could own indefinitely, including well-known names like Microsoft, as well as lesser-known gems.

Latest Updates

Property

Financial pathways to buying a home require planning

In the six months of my battle with brain cancer, one part of financial markets has fascinated me, and it’s probably not what you think. What's led the pages of my reading is real estate, especially residential.

Meg on SMSFs: $3 million super tax coming whether we’re ready or not

A Senate Committee reported back last week with a majority recommendation to pass the $3 million super tax unaltered. It seems that the tax is coming, and this is what those affected should be doing now to prepare for it.

Economy

Household spending falls as higher costs bite

Shoppers are cutting back spending at supermarkets, gyms, and bakeries to cope with soaring insurance and education costs as household spending continues to slump. Renters especially are feeling the pinch.

Shares

Who gets the gold stars this bank reporting season?

The recent bank reporting season saw all the major banks report solid results, large share buybacks, and very low bad debts. Here's a look at the main themes from the results, and the winners and losers.

Shares

Small caps v large caps: Don’t be penny wise but pound foolish

What is the catalyst for smalls caps to start outperforming their larger counterparts? Cheap relative valuation is bullish though it isn't a catalyst, so what else could drive a long-awaited turnaround?

Financial planning

Estate planning made simple, Part II

'Putting your affairs in order' is a term that is commonly used when people are approaching the end of their life. It is not as easy as it sounds, though it should not overwhelming, or consume all of your spare time.

Financial planning

Where Baby Boomer wealth will end up

By 2028, all Baby Boomers will be eligible for retirement and the Baby Boomer bubble will have all but deflated. Where will this generation's money end up, and what are the implications for the wealth management industry?

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.