CAC is the new rent
Rent is one of the largest costs for retailers that exist in the offline world. However, the internet has forged a new set of dynamics in an online world for consumer-oriented firms, with customer acquisition cost (CAC) usurping rent in importance. As Gavin Baker argues in an insightful article, “CAC is the new rent” and scale and loyalty are more important in an online world than has been the case in the past with offline businesses.
Customer acquisition cost refers to outlays made by firms for advertising and other costs related to attracting new customers to the business. It is typically the largest cost for most online consumer-facing businesses and is the lifeblood for many of these businesses. Cut off spending to acquire customers, and you will likely see a corresponding fall in revenue as a result. This is of similar import to the rent an offline retailer pays: without paying rent the lease will be forfeited and there will no longer be a location from which the company can sell its goods or services.
The nature of how auctions are run on Facebook and Google – and where many firms spend heavily to acquire customers (i.e., where they pay their CAC) – favours firms that are scaled and have customer loyalty. These advertising giants typically are paid on a cost per click (CPC) basis, whereby they are only paid if a user clicks on the ad. As such, Facebook and Google assign a “quality score” to different advertisers (i.e., the companies paying the CAC) which seeks to predict the likelihood of a user clicking on that ad. Firms that have a product or offering that resonates with customers grow in size as more customers buy their goods. During this process, the quality score of these firms when they place ads on Facebook and Google increases.
Why is this quality score important? With a higher quality score, companies are able to increase their chances of winning an ad inventory auction while bidding lower CPCs. Put it this way, if a company is adored by consumers and sells products in hot demand, it might bid $1 for an ad placement. Facebook and Google run self-service ad models that auction off ad inventory via a second price auction mechanism (i.e., you bid the highest CPC you’re willing to pay and if you win the auction you pay $0.01 higher than the second highest CPC bid). Knowing this, let’s say that there is another firm that is disliked by consumers and sells faulty products that have minimal demand. They might bid a CPC of $2 for the same ad slot but still lose the auction if their quality score is low. This makes sense, given that they could bid an astronomically high CPC but Facebook and Google only get paid if someone actually clicks on the ad.
These dynamics favour scale players that already have built some level of market recognition and demand for their products, and can also stifle new entrants that are seeking to muscle into any given industry if they begin with a low ad quality score.
If these scale players are also able to build customer loyalty, then they also carve out another neat advantage for themselves: they don’t need to pay away as much to Facebook, Google and other advertising platforms in the form of CAC. This is totally different for an offline business that scales – it might be able to negotiate lower rent if it gains leverage over landlords but it can never completely stop paying rent and expect to operate as normal. Repeat customers in an online world essentially allow for rent avoidance and this helps cement the advantage of the incumbent relative to firms that must keep paying CAC in order to continuing generating revenues.
It is clear that the internet has created strong winner takes most dynamics for firms that are able to achieve scale. These are the sorts of businesses you want to identify and buy at sensible prices.
Montaka owns shares in Alphabet and Facebook. This article was prepared 29 October with the information we have today, and our view may change. It does not constitute formal advice or professional investment advice. If you wish to trade Alphabet or Facebook you should seek financial advice.