Facebook’s embedded option

The best way to think of Facebook’s stock is as the sum of two businesses: the existing display ad businesses, and a probability-weighted option on a new line of business. This is how Wall Street views it. For example, here is a section of a recent Goldman Sachs analyst report on Facebook:

Optionality not in the model: further potential upside

While not in our model, as [Facebook] has not publicly expressed pursuit of these areas, we believe there are three obvious opportunities that the company could leverage its platform to capitalize on:

– Developing an external ad network

– Monetizing paid search

– Entering China

Of the three options, search is clearly the most interesting. An external ad network is inevitable. Google proved this model with Adsense. With an already huge base of advertisers bidding on CPCs, it is impossible for most other ad networks to compete on publisher payouts. But Facebook’s traffic is so great now that an external ad network might increase their revenues by 2x or so. The same goes for entering China. They might get another half a billion users who monetize at lower ad rates than US users. Neither move would put them in Google’s revenue range. They need a better business model for that. The only (known) models that deliver RPMs high enough to compete with Google are search, payments, and e-commerce.

At TechCrunch Disrupt last week, Mark Zuckerberg talked about possibly entering the search business. Investors had been concerned that maybe Zuckerberg really meant what he said in his IPO letter – that he just didn’t care that much about making money. By expressing an interest in search, Zuckerberg signaled that he understood Facebook’s immensely valuable embedded option and was thinking about ways to exercise it.

 

Incumbents die due to irrelevance or ineptitude

Judging from the tech press, you’d think the biggest risk to successful companies is competition. But when you examine the history of technology, incumbents usually decline because the world changes and they lose relevance, or because they lose visionary founders and the organization decays. Some examples:

– Dell thrived when PCs dominated the computer market and Dell was the low cost provider of commodity hardware products. The shift to mobile and tablet computing meant that hardware quality (not price) was once again the primary basis of competition. As a result, Dell’s laser-like focus on cost reduction became a liability.

– The New York Times was, for many decades, one of the few premium channels through which brand and classified advertisers could reach mass consumers. Thus car companies and real estate brokers subsidized foreign reporting and investigative business journalism. The internet provided a vast alternative channel, and the Times became far less relevant. At the same time, the internet provided many new sources for breaking news, editorials etc, hurting the Times on the subscriber side.

– Yahoo didn’t lose because Google out-competed them on search. They lost because they didn’t really care about search – indeed, they outsourced algorithmic search to Alta Vista, Inktomi and then Google itself. The leading portals back in circa 2000 (Yahoo, Excite, Lycos etc) desperately wanted to keep keep users on their site – the buzzword was “stickiness” – but Google knew better and focused on getting users off of Google to other places on the web. Yahoo became just another place to read celebrity gossip and use generic web services.

– Netflix thrived when they could simply ignore the movie companies and rely on the first-sale doctrine to get DVDs. The market shift to streaming video created a new and brutal dependency. They had to go make deals with content companies. Now they are even trying to create their own content to lessen this dependency. They have a brilliant and visionary management team but this is a tough transition to make.

– Sony relied on its Steve-Jobs-like founder, Akio Morita, to repeatedly develop incredibly innovative products (among them: the first transistor radio, the first transistor television, the Walkman, the first video cassette recorder, the compact disc) that seemed to come out of nowhere and create massive new markets. Since he left, the company has floundered and the stock has fallen dramatically.

– Google’s biggest risk isn’t a direct competitor. Startups and incumbents who’ve tried to create better search engines have barely cut into Google’s market share. Google’s primary risk – and they seem to know this – is that they are no longer relevant when people find content through social sites, and where an ever increasing portion of the web is uncrawlable.

Google released their “Dropbox-killer” a few days ago. I don’t know if Dropbox has yet achieved incumbent status, but they certainly seem to be the market leader. They also seem to have a very competent management team. So if history is a guide, Dropbox’s biggest risk isn’t a competitor but irrelevance – if, for example, files become less and less important in a web services world and Dropbox doesn’t adapt accordingly.

Facebook’s response to Yahoo’s patent lawsuit

Like many in tech, I believe all software patents should be abolished. That said, I think Facebook made the right move by filing a lawsuit against Yahoo’s patent attack.

As I see it, Facebook had 4 choices:

– Settle. Given their pending IPO, this would have been the easiest route. But, by rewarding Yahoo, settling would have encouraged more frivolous patent lawsuits.

– Defend without countersuing. On the surface this would have been the “principled” stance, but it would have severely weakened their legal position, and therefore would have made it more likely that Yahoo profited from the lawsuit.

– Countersue without signaling any aversion to patent lawsuits.

– Countersue and signal that they are averse to patent lawsuits, which in turn signals that they will drop the lawsuit if Yahoo does. This seems to be what Facebook has done:

“From the outset, we said we would defend ourselves vigorously against Yahoo’s lawsuit,” Ted Ullyot, Facebook’s general counsel, said in a statement. “While we are asserting patent claims of our own, we do so in response to Yahoo’s short-sighted decision to attack one of its partners and prioritize litigation over innovation.” [emphasis added] – NYTimes

Countersuing gives Facebook the best chance of fending off Yahoo’s lawsuit – and therefore not rewarding patent lawsuits. And signaling they are only doing so in response to Yahoo (hence might drop the suit if Yahoo does) keeps them on the right side of innovation.

The internet is reshaping our economy from one of huge corporations with lots of jobs to huge platforms with lots of income streams

From Innovation and the Bell Labs Miracle in today NYTimes:

Innovation is an important new product or process, deployed on a large scale and having a significant impact on society and the economy, that can do a job “better, or cheaper, or both.” Regrettably, we now use the term to describe almost anything. It can describe a smartphone app or a social media tool; or it can describe the transistor or the blueprint for a cellphone system. The differences are immense. One type of innovation creates a handful of jobs and modest revenues; another, the type Mr. Kelly and his colleagues at Bell Labs repeatedly sought, creates millions of jobs and a long-lasting platform for society’s wealth and well-being.

The conflation of these different kinds of innovations seems to be leading us toward a belief that small groups of profit-seeking entrepreneurs turning out innovative consumer products are as effective as our innovative forebears. History does not support this belief. The teams at Bell Labs that invented the laser, transistor and solar cell were not seeking profits. They were seeking understanding. Yet in the process they created not only new products but entirely new — and lucrative — industries.

Putting aside the obvious rebuttal that large companies like Intel, Microsoft, Apple and even AT&T were once startups, the author seems to confuse “jobs” with “income streams”. For example, it would be easy to dismiss a website like Craigslist as a “social media tool” that has only created a few dozen jobs for its employees. But in fact it has created billions of dollars of income streams for people buying and selling things on its platform. The internet is increasingly reshaping our economy from one of huge corporations with lots of jobs to huge platforms with lots of income streams.

eBay vs Amazon: decentralized vs centralized e-commerce

Note: The company I cofounded, Hunch, was acquired by eBay in November 2011. I am now an eBay employee. But all the opinions expressed below are my own, and were developed prior to the Hunch acquisition, through my own research on e-commerce.

Amazon and eBay are the two largest e-commerce companies. As of this writing, Amazon has a market cap of about $87B, trading at a trailing twelve-month P/E of about 139. eBay has a market cap of about $42B, trading at a trailing P/E of about 13. Each company competes with many other companies in many different areas. For example, Amazon competes with Apple on tablets (Kindle vs iPad) and digital media (Amazon’s media store vs iTunes). Ebay’s Paypal unit competes with multiple payment companies, and its marketplaces division competes with other “peer-to-peer” e-commerce sites like Craigslist. But given the potential size of the e-commerce market (not to mention the online-to-offline commerce market), Amazon and eBay’s main competitors are each other. And to understand their large strategic moves (e.g. large acquisitions like GSI and Zappos), it is important to understand their fundamentally opposing strategic outlooks: eBay wants commerce to be more decentralized (around its GSI/Magento partners and eBay marketplaces sellers) and Amazon wants it to be more centralized (around itself).

First, some background. During the dot-com boom, many largest offline brands debated how to best move their businesses online. Some tried to build their own websites from scratch. Others partnered with commerce technology providers. Toys ‘R’ Us took a novel approach and signed a “strategic alliance” to outsource all of their e-commerce operations to Amazon. Over the next few years this relationship soured – apparently Toys ‘R’ Us felt Amazon was competing too directly with them and successfully sued to end the relationship.

The end of the Toys ‘R’ Us – Amazon relationship marked a turning point for a company called GSI Commerce. GSI took an aggressively neutral approach to providing technology and marketing solutions to retailers. Their main appeal over Amazon is that they didn’t compete with their partners (but of course their partners competed with each other). This approach paid off: GSI now powers over 500 large commerce sites, including Toys ‘R’ Us, Adidas, Ralph Lauren, and the commerce sites of all the large sports leagues like the NFL, MLB and NBA.

Last year, eBay paid $2.4B to acquire GSI Commerce. They also acquired a smaller company called Magento that provides e-commerce technologies to smaller retailers. You can think of GSI as the leading commerce platform for the “fat head” of retailers, and Magento as the leader for the long tail.

The key difference between eBay and Amazon isn’t auctions vs. fixed price sales (the majority of eBay sales aren’t auctions anymore). It is that eBay doesn’t take inventory, and prefers to be an intermediary that facilitates peer-to-peer commerce. This strategy wins if e-commerce becomes more decentralized, with the majority of commerce continuing flow through small to medium retailers. In this world, eBay makes money by sending traffic from eBay.com, from fees collected by GSI and Magento, and Paypal transaction fees. In a centralized world, Amazon grows its current 9% e-commerce market share to a much larger percentage, taking advantage of its scale, efficiency, advanced technology, and the convenience of shopping in one place.

One way to view this battle is to think of eBay as a platform a la Windows or Android and Amazon as an end-to-end solution a la Apple computers in the 90s or iOS devices today. Platforms tend to provide greater diversity. In the case of e-commerce, the platform approach could also have a price advantage. As the CEO of TrialPay, Alex Rampell, argues: “Who can beat Amazon on price? The companies whose products are sold on Amazon”. End-to-end solutions like Amazon’s tend to provide greater convenience and a better user experience.

I’m not arguing that one approach is superior to the other. My point is simply that when you understand that the battle is between centralized and decentralized commerce, the strategic moves of the two companies make a lot more sense.