Can relationships be the foundation of business?
Back on March 10 here at my Insights blog I pieced together a little jigsaw puzzle that served as a warning to Value.able Graduates researching Carsales.com.au:
“…Relationships it seems, matter. And so they should.
“In the end, it is not cars, boats and planes that bring joy, but the quality of the relationships you develop.
“This week (commencing 7 March 2011) I read that Carsales.com.au had been sold out of Nine Entertainment Co, the rebadged PBL Media (which is owned by CVC Asia Pacific).
“Reading Terry [McCrann’s] article caused a rumour I heard last year to become louder in my mind.
“The rumour was that a group of customers of Carsales.com.au (ASX:CRZ, MQR:A1, Value.able Margin of Safety; -24%) were thinking of leaving to start a rival that would be funded by News. You could understand News’ interest, given it is losing the online automotive classifieds race to Drive (Fairfax) and Carsales.
“If this is true, and if Terry is also on the mark with the intimacy of the relationships amongst Australia’s media barons, both individual and corporate (excluding Fairfax), then it would be reasonable to assume that the status quo should be maintained until after Carsales had been spun out of the former PBL, finding itself completely owned by institutions and private investors.
“Now that hurdle is out of the way, let’s see if Carsales does lose any major customers.”
That was the crux of my 10 March blog post – that Carsales’ biggest customers were about to leave to start a rival with Newscorp.
Just 2 months have passed and if you didn’t already know, guess what? Splitsville.
The Carsguide brand, owned by News Limited and a consortium of foundation dealers that includes Automotive Holdings Group Limited, A.P Eagers Group and Trivett, plus a few other dealerships representing a quarter of Australia’s car dealers, will hop into bed together in a joint venture and share Carsguide’s revenue.
Chairman and chief executive of News Limited John Hartigan told one journo, “We will be investing in the new company, doubling the number of staff and throwing our combined resources and expertise behind the joint venture, with the intent of aggressively growing the business.”
Please refrain from posting any banter as comments, just your highest quality thoughts and experiences investing in online businesses. How have you faired investing in online businesses?
Posted by Roger Montgomery, author and fund manager, 13 May 2011.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Christopher
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OTH Onthehouse IPO
I have only looked into this briefly, as the closing date is nearly upon us.
Issuing 55m shares is likely to result in around $1.1 of equity per share, and the offer price is $1. However, total shareholder’s equity is 60.306m, and the company counts among its assets 62.578m of intangibles. 39.4m of this is goodwill, which they state will not need writing down (page 50 of the prospectus). Intangibles also include 13.3m of customer contacts and relationships, which they plan on writing down by a couple of million over the next few years (also on page 50).
42m of the 55m raised is going towards the purchase of Console, while another 7.5m is going towards the acquisiton of PortPlus. The ‘goodwill’ on each is 28m and 11.3m respectively.
Onthehouse itself is not turning a profit, but predicts an NPAT of around 2m in 2012, after the acquisitions of Console and PortPlus.
If we ignore the goodwill, we are left with 20.1m of shareholder’s equity, or 38c of equity per share. An NPAT of 2m would come close to a return on equity of 10%. So their intrinsic value would be somewhere near their equity per share value of 38c. Return on equity would be closer to 3% on the actual pro forma numbers, thanks to carrying all that goodwill.
I might give this one a miss.
AndrewM
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Some responses to comments on this post;
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Hi Ben:
While being popular does create a virtuous cycle of creating more word of mouth and therefore more customers, etc, it is not the “network effect”.
The network effect is something very different and very powerful. It creates natural monopolies and pricing power. So what is it? It arises in rare situations where the more people who become customers, the greater the functional value generated to all customers.
If there is a big beer promotion for brand x and lots of people buy brand X beer and therefore I keep hearing about brand X, and then buy it – that’s all good. But me buying the beer doesn’t add value to all the other beer X drinkers. It might be good for the company and it might be a virtuous cycle, but it is not a long term moat and it is not the “network effect”.
The network effect, or “network externality” was first proposed by Lytkins in a paper written for Bell telephone in 1917. Look up Metcalf’s Law or Network Economics for more reading.
A good example is imagine two competing telephone companies in a small US town in 1915. Importantly, assume there is no interconnection between the two phone systems. (Like Bell telephone’s market place 100 years ago).
Company A has 100 customers. Co. B has 110 customers. Which would you join? Telephone company A has 100 x 100, ie 10,000 potential links for you to use and enjoy. Company B has 110 x 110 = 12,100 connections. 10% more customers has generated 20% more possible interconnections. The network externality according to Metcalf’s Law is the square of the users of the system.
So you will rationally sign up to Company B.
Crucially – by you joining Company B you create another 110 possible connections available to ALL customers within Company B. You joining adds value to every other customer. That’s the “network externality”.
It’s a natural monopoly. Good luck to Company A, its days are numbered. And God help crazy Company C who wants to enter this towns telephone market. Just ask the guys who built VHS video platform. Or Mark Zuckerberg – Facebook is a perfect network externality example. Businesses that “sell” connections between people often enjoy the network effect.
Carsales sells connections between car buyers and sellers. It has very little to worry about. Think like a consumer… if CRZ has 90% of all cars listed, and the competitor has, say even 50% of the market – which site are you going to use?
The network effect creates a natural monopoly and pricing power. That’s why car dealers are upset. CRZ is using its pricing power.
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Brad:
“Certainly we’re about to see the first test of the durability of the “lists” franchise with newscorp backed cars guide taking crz on”.
I don’t believe so. James Packer tried the exact same thing in 2006 with his Myhome.com.au website up against realestate.com.au, using a group of the biggest real estate agent franchises in Australia. Big relationships, bug bucks spent. Dead in 12 months.
Or ask REA in the time of Simon Baker when he tried to use a better website, improved usability and better management decisions to take on big but very dumb Rightmove.co.uk with propertyfinder.co.uk. REA wasted a mountain of money before the new CEO stopped the insanity.
Or even ask REA why a global realestate giant like them fails completely against tiny tiny competitor, Allhomes.com.au, that dominates the Canberra real estate market -with a really substandard site. Why? Allhomes have the most ACT buyers and ACT sellers – so they own that market. Thats the power of the network economics. It’s bullet proof.
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Andrew:
“I think people get too caught up on the network effect even though their are many many examples of it not being an enduring asset to have.”
I can’t think of many examples. The only examples I can think of is the once in 150 year paradigm shift from print to online. In the 150 years of the primacy of newspaper technology, the network effect held strong, as it is again proving in the new paradigm, online world.
A personal example – I own a little site that is the biggest secondhand textbook market in Australia; http://www.textbookexchange.com.au. Ebay in Australia decided to take us on a few years ago. Ebay! I spent nothing and they still lost. Every year some uni student somewhere launches a competative site with innovative technology and… they all fail. I love the network effect.
—-
Rob S:
“Take a look at http://www.suburbview.com. It’s a one stop shop for searching for Australian properties… it’s innovative and you could easily imagine significant numbers of people using it. The bottom line: for me, the space is too fast moving and I’m not convinced about the barriers to entry.”
Don’t “imagine” – look at the published traffic data (try Fairfax annual report or the latest rea annual report, or search alexa.com). REA has only one competitor in Australia and that is domain.com.au. Nothing else is even vaguely close. Suburbview doesnt make it even into the top 20 sites.
This is a decade old duopoly. And the traffic gap between Domain and REA has been consistently growing for years and years, with REA pulling ahead more and more every year as a result of its network externalities.
REA didnt raise a sweat when James Packer attacked them and failed in 2006. Even I had my doubts about REA vs Google Realestate in 2009. But that was a walk in the park too. Rob, how many companies are that solid that packer and Google aren’t even speed bumps?
I don’t know the oil or coal price next year or how many contracts some mining services company in WA will win next year. I do know that REA will dominate the Australian realestate advertising market in 2021.
Long post. Sorry. The conclusion: Understand what exactly the network effect really is, and where it arises, then back it every time for predictable earnings for many many years to come.
No one will be surprised to hear I am buying CRZ right now, along with the Chairman of CRZ and a string of fund managers who have all just clocked their 5% notices. CRZ has a huge moat that luckily, to many -including even News Limited’s John Hartigan, seems invisible.
Roger Montgomery
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Thanks Andrew,
Well said and thanks for a very thought provoking addition to the discussion. I am sure everyone reading this will think carefully about it now. Not sure we’re in bargain territory yet, but that is what makes a market.
Andrew
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Nice counterpoints Andrew, I do agree with you, at least, in regards to the current and past of CRZ but stand by my comments on the durability of the “network effect”. But differences of opinion are great and i love hearing a difference to my opinion so that i can analyse my thoughts, so thankyou.
One thing i would like to add though is in regards to your comment:
“if CRZ has 90% of all cars listed, and the competitor has, say even 50% of the market – which site are you going to use?”
That might be the case now and in the past but how many of those 90% of cars were due to the sellers which have now just gone over to be part of Carsguide? I don’t know the answer but i would expect it to be a lot from what i have heard.
If CRZ no longer has the most cars listed, will it still have in the long term its huge moat that it currently has? Especially if a high profile push of carsguide gains traction.
Brian
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Well said, Andrew. When I try to explain the true meaning of the network effect, I sometimes use the real-world example of Brambles and their CHEP pallets. Each pallet storage-and-distribution centre represents a node in a network. Having a multitude of nodes worldwide gives them a genuine competitive advantage, since they can more cheaply provide pallets to (and collect pallets from) their customers. Meanwhile their competitors, with fewer nodes, have to transport their empty pallets over longer distances. It requires a big investment to replicate CHEPs network, and although it represents a sizable barrier to entry, it certainly is NOT an unbridgeable moat. (In fact, iGPS already has a grappling hook yanking on the drawbridge.)
Roger Montgomery
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Thanks Brian,
The question now is whether the competitive advantage is a valuable one, producing high rates of return on equity / the ability to charge more in the face of inflation / etc…
Brad
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and
“The key to this business is personal relationships”
Dicky Fox
Jerry Maguire
Brad
:
“Business is people”
Warren Buffett
Brad
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CCP looking cheap – I have have value 2011 > 6.50 and 2012 > 9.00
any thoughts?
PS I know this is not an internet stock but errrr, sorry Roger
Roger Montgomery
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Apology noted but patience is a virtue. I am about to publish a post that you can go crazy with.
Allan
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Very new to this but I have lots of patience!
David C
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A quick comment on REA vs CRZ – News ltd owns 61% of REA.
Roger Montgomery
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Maybe not for long?
ben
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Also I’d like to add my thoughts on internet businesses- The weird thing about the net is that your product (the site) actually has to be of quality to do well. This is reflected in the ‘network effect’, people flock to your site and there are gains in business value from the expansion of its consumer base and in many ways it creates a self perpetuating cycle of high RoEs and cashflow ie people see its popular, they tell their friends, they go on and tell others etc etc (ala facebook)
HOWEVER, once a new BETTER product comes and plonks along- its gone. This is so different than any other business take for example shoes. You can argue there is no material difference in functionality and usability in any of them. In fact, Nike, has consistently ranked badly in sports science testing yet, it still permeates as a market leader. The intangibles associated with a brand are simply non existent in the website space. Its weird.
Roger Montgomery
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Very very interesting. I think you might be saying, the network effect is less value.able as a competitive advantage than brand/association. Perhaps the less ‘tangible’ the intangible is, the harder it is to replicate…
ben
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Thats right, to put it more bluntly and direct, the internet businesses are ‘no bulldust’ zones. Theres no hiding behind marketing and brand perception.
Andrew
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I have been thinking more about the network effect, I don’t consider ‘the netowrk effect’ to be a competitive advantage. Rather, it is a result or symptom of one, and I question the sustainability of that effect. There for I believe it is something that needs to be defended rather than exploit.
I think it all comes down to the site usability, management, innovation and other valuable differentiating factors that are the cause of the competitive advantage and if they can do a better job on these factors than competitors and stay that one step ahead than they can keep it but as soon as they are not on their toes a new site will pop up and take that effect away.
The net is full of tech savvy early adopters who are on the look out for the next big net sensation, there are low barriers to entry and also very low to zero switching costs to the ‘eyeballs’ which means they can come and go as they wish.
I just wonder whether we would be citing the network effect for a non net based business, I think people get too caught up on the network effect even though their are many many examples of it not being an enduring asset to have.
Roger Montgomery
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Agree and have often suggested its permanence is lower.
ben
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An example of a network effect outside of a net business would be say.. a foreign exchange institution whereby the liquidity in turn brings in more liquidity ala the network effect. In the specific instance, it’d be very hard to topple it because you’d have to come in with more liquidity.
ben
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A bit off topic but I attended an investor conference whereby a smart fund manager (the few that actually out performed the index) said he’d rather invest in a bad company that was progressing towards a mediocre state rather than a great business that has the potential to fall down to a mediocre. I believe the correct term for this is ‘smoking the last cigar butts’.
Roger, you should track the progress of the CX’s/BX’s and see if they actually move up in ranking over time.. it would be a really interesting thing to see the results.
Roger Montgomery
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Hi Ben,
I have those results. Soon, you can have them too.
Brad
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The car sales, rea, seek franchises are quite different to say the SMH / Age classifieds monopoly pre Internet,
For one thing, SMH / Age had (has!) content being news which drove readers to the properties.
The seek, rea etc are lists and buyers go there for only one reason, to buy a car, house or look for a new job
Certainly we’re about to see the first test of the durability of the “lists” franchise with newscorp backed cars guide taking crz on.
I’ll be watching that space but won’t be placing any bets unless the odds get irresistible
Ron shamgar
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I have to disagree brad. REA has been tested with ninemsn backed homehound. They threw big money at it and failed miserably.
REA is not the same lists business as crz. You must look at who is selling and paying for the ads.
In REA case it’s the agents who list on it, but their customers r paying. You could say the customers r unsophisticated and therefore follow the agents advice. The agents will list on as many sites he can access.
Crz case it’s got two types of customers. The private sellers who will go where the content is. Price is a factor but u must have content/traffic.
The second type of customer are the car dealers. They r the ones who pay per lead for each car they display. Therefore if u offer them a better deal elsewhere they will switch.
As u can see these businesses operate in different market forces. Crz is a riskier proposition, but, in my opinion what will happen is the car dealers will give the new website a go while at the same time they will keep their ads with crz. Over time if the new website gains awareness and traffic, crz will be forced to compete on price to keep these guys on board.
Ron shamgar
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One more thing I would like to add:
When u sell a $500,000 to a million dollar property paying several hundred dollars for a listing is irrelevant.
When u sell a $10,000 – $20,000 car, every $50 – $100 is substantial!
ron shamgar
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i have spoken to several real estate agents in my area in regards to REA, domain and onthehouse.
they claim that it doesn’t matter who comes along with a new site to advertise properties, they will just use all of them as a package for their clients.
one of them claimed that lately he has achieved better results through domain rather than REA.
we have to remember that the agents pay annual fees for these sites and charge their clients for the ad costs so they have no cost.
carsales is a different story and maybe a new competitor can capture some of their dealer listings.
if i had a gun to my head i would choose REA any day.
Ash Little
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Yes Ron
But as you say “say gun to the head”
I like you just have this all on watch
fred
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Hi Roger,
I have never been interested in carsales.com ( crz ) but seeing there sticker on every other car makes you think that carsales are not to bad. I would not pay a billion dollars for carsales.com!
Thank’s Roger
Rob S
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Not entirely on this topic, but on a related note, Allhomes.com (and allclassifieds) have the local monopoly on online real estate listings here in the ACT. It is the first place anyone looks here for rentals and purchases. REA is active, but it’s the secondary resource.
Allhomes recently won a government grant to help them expand outside the ACT and develop the business with the aim of a public listing. We are yet to see how this expansion goes, or if they will indeed list but I suspect Bruce Greenwald will once again be shown correct in that “All competitive advantages are local”.
I think this statement is always worth keeping in the back of the mind when looking at companies looking to expand their market.
Ann
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Relationships are the foundation, BUT not family relationships
Kim jordan
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My thoughts on the online businesses e.g. Carsales and wotif etc is that these first cabs off the rank, by being a bit too greedy have killed the golden goose.They could have kept the rivers of gold if they had done it a bit different. But maybe carsales has left it a bit late to modify their behaviour.
Peter A
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As a member of the IT Industry, my comment / inside knowledge is that it doesn’t necessarily take a great deal of cost to establish a new site (depending on the complexity, hundreds of thousands or low millions could get you started), so if there are big profits or margins out there in one particular domain (eg carsales or rea), someone with a bit of cash to spare could certainly have a crack and try to eat the established players lunch, and there are always people looking to create the newest fad or trend.
As a result, any online business needs to be constantly prepared to repel boarders.
Take a look at http://www.suburbview.com. It’s a one stop shop for searching for Australian properties that aggregates results from REA, Homehound, local real estate agents, etc. Incidentally, it does give a good sense of what proportion of the market REA has.
It has been stated that REA’s competitive advantage is that it has 90% (say) of the listings. However, this site has REA’s 90% plus the other 10% as well. I don’t know who owns this site, but it’s innovative and you could easily imagine significant numbers of people using it.
The bottom line: for me, the space is too fast moving and I’m not convinced about the barriers to entry. On that basis, I don’t know that I can predict the earnings in 5 to 10 years with any certainty. I’m happy to look elsewhere.
Peter A
Roger Montgomery
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Great thoughts Peter. This is precisely the logic that has kept Buffett from investing in technology and other ‘fast moving’ sectors.
The Mac DailyNews, quoting Bloomberg, reported the following:
“Warren Buffett said he’ll probably prolong his aversion to electronics makers such as Apple Inc. because their business prospects are harder to predict than companies such as Coca-Cola Co.,” Jun Yang-Mar reports for Bloomberg.
“‘We held very few in the past and we’re likely to hold very few in the future,” the billionaire chairman of Berkshire Hathaway Inc. said in Daegu, South Korea, today, referring to electronics makers,” Yang-Mar reports. “Coca-Cola, based in Atlanta, is ‘very easy for me to come to a conclusion as to what it will look like economically in five or 10 years, and it’s not easy for me to come to a conclusion about Apple,’ he said. Buffett, 80, arrived in Daegu yesterday to attend a ceremony for a new factory being built by TaeguTec Ltd., a South Korean company partly owned by his Iscar Metalworking Cos. unit that makes cutting tools. He canceled his scheduled trip to Japan this week after the earthquake.”
“Apple, the Cupertino, California-based maker of the iPhone and iPad, last year overtook Microsoft Corp. as the largest technology company by market value. The 8.6 percent stake in Coca-Cola is Omaha, Nebraska-based Berkshire Hathaway’s biggest equity holding, followed by Wells Fargo & Co. (WFC) and American Express Co. (AXP), according to regulatory data compiled by Bloomberg,” Yang-Mar reports.
“MacDailyNews Note: On March 21, 2001, ten years ago today, AAPL closed at $10.06 per share (split adjusted). KO closed at $35.37 (adjusted for dividends and splits). AAPL is currently trading at $338.60. KO is trading at $63.65.”
The final point shows Buffett would rather be certain of a good profit than uncertain of a great one…
Andrew
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I agree Peter, online businesses have a very low barrier to entry, one reason that i think it is so appealing to a lot of entrepreneurs who want to start a business up (another being the global nature of the opportuity). The management of these companies will need to be continually on their toes and try to innovate at every opportunity.
The internet i feel is all about staying relevant, this means your systems, website functionability and other value adds are essential and need to be continually improved. The company which does this the best will be or stay king.
A lot has been said about the network effect, however to me, the network effect is just fashion. As soon as something shinier and sparklier comes along and becomes the new cool thing than that network effect can go, which is what i mean when i say that internet businesses are about staying relevant. This extends more than just social media websites as well.
This can happen to a company like Carsales as well. If this new venture creates something that surpasses carsales than in the long term they could do great damage to CRZ.
(Warning: some comments below are my speculated opinions)
If the new company has locked up 25% or more of car retailing exclusivley (and as they are part owners why wouldn’t they) in Australia than this is a real form of competitive advantage over CRZ and could turn CRZ into an irrelevant small company that only deals with personal sales. CRZ will then need to turn this into some type of niche or try and compete with the new site in the mass market. Both of these approaches will in my mind take a hit from the CRZ financial reports and in the long term damage its “network effect” and competitive advantage.
Investing in online companys can be a bit of a rollercoaster, and as i mentioned management need to be on their toes as if they relax and take it easy than they will be overtaken by a newer company.
Steven
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I think a great recent example of the Network Effect not being entirely relevant to continued dominance is Apple’s gains against Microsoft. Microsoft had a massive share of the PC market place and it’s dominance was assured thanks to its customers, particularly businesses being heavily invested in it’s technologies. However, Apple came out with an iPod and began to win customers because of it’s ease of use and consumer appeal, then progressively over the last 5 years they have eaten away at Microsoft’s traditional dominance (although they still have a long, long way to go) because of these ancillary consumer devices, i.e the iPhone, iPad have arguably swayed more businesses and governments into the Apple market due to their ease of use, popularity and less virus issues. Slowly we see Apple’s Mac sales growing as a result of this ‘Halo effect’, that is iPhones, iPods and iPad sales leading to Mac sales.
A classic example of this was at my old workplace 3 years ago, where the CEO bought an iPhone, loved it, and almost the next day had ordered 1000 phones for the company. He didn’t ask if we had the infrastructure to accommodate it, he just bought it and we then had to go about fitting the phones into our company’s infrastructure. Soon Macs began infiltrating the organisation that was heavily Microsoft based and will continue to do so as long as Apple don’t make any mistakes. I must say part of the loss of sales can also probably be attributed to Vista being a much maligned OS for businesses and consumers alike.
As an interesting footnote, I find Apple have their own network effect, in that their products all seemlessly integrate with each other with minimal user input. For example, if I have an iPhone 4 and I encourage my wife to get one too, then we can FaceTime with each other which means that we both benefit from the other owning the same product, whereas we cant do this if she owned a different brand. Plus, I only recently bought my first Mac because I needed it to be able to develop Apps easily so I am yet another convert from PC to Mac even though I have owned PCs since the early 80s.
Paul
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It will be interesting to see what model the revised Cars Guide comes up with . As i have said before dealers highly dis-like the pay per lead model of car sales .I know of one large operator spending $20 to $30k a month with car sales – obviously they continue to do this as they are selling vehicles off it . But like the internet itself drives prices down , so it will to operators on the net when new sites can get that momentum going via cheaper prices to advertisers .
Dealers can also have a toe in each camp by using both sites and will do so , particularly if Cars guide charges a flat fee for unlimted leads .Ulitmately going to the cheaper one once they feel it is working.
This is going to take some time to work out – all i can say is keep an eye on Car sales revenue and if it starts to slip that may be the indicator that the shift is on . Yes Car sales is effective , yes they have a great site – but they have a lot of clients itching for something cheaper ( at least a quarter of the nations dealers who are involved in the takeover of Cars Guide ). Watch this space !
Roger Montgomery
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Thanks Paul,
…and coming from an industry ‘insider’ that is really insightful.
ron shamgar
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in an earlier post i mentioned that the only risk to the networking effect of these businesses is the risk of a bunch of their main customers (car dealers) switching to a competitor in tandem.
now we need to ask two questions:
– will they keep their listings on carsales or remove it completely?
– will private car sellers have a need to switch to a new website? or at what point do they switch? (cheaper listing maybe?)
interesting test coming up for carsales and maybe an opportunity for us investors in the longer term.