Beyond The Hype: Platform Business Model And Dangers Of Overvaluation

In the world of business and investing, the word ‘platform’ has acquired an almost magical significance. The drastic rise in the valuations of technology companies over the past few years, world-over, has created a strong investor demand for platform companies.

Several famous Indian investors have taken to Twitter and espoused the greatness of platform businesses. But, not all platform businesses have performed well and the mere existence of a platform does not guarantee high returns.

As usual, the market’s narrative has followed the price — after companies like Indian Energy Exchange (IEX), Multi-Commodity Exchange (MCX) performed well, every investor began talking about the advantages of platform-based businesses. Both of these businesses are certainly well-run, high-quality business with good managements.

However, their outperformance has more to do with the nature of the market, rather than the presence of the platform itself. Building a tech platform for an exchange is actually quite easy; it is getting a critical mass of trading volumes on the exchange that is difficult.

Both of these companies had a first-mover advantage in their business which virtually guaranteed high returns. Traders are unlikely to move to another exchange with less liquidity as it increases trading costs and time.

In contrast, streaming platforms have been struggling continuously. Originally, these platforms were focused on streaming content produced by third parties. However, with intense competition they were forced to create their own content. The large number of streaming platforms on the market clearly indicates that the barriers to entry in the business are low.

Zee5 was among the first few Indian streaming platforms. For financial year 2021 (FY21), the streaming platform’s revenue stood at Rs 419 crore and its operating loss stood at Rs 672 crore. Alt Digital Media, which owns AltBalaji, has steadily burnt cash for years.

Now, while some might claim that creating original content can help these companies drive their viewership base and differentiate them, the real question is whether these investments in differentiation actually yield any results for shareholders.

So far, streaming platforms operating in mature markets too haven’t shown consistent profits. Netflix finally generated positive operating cash flows for the first time because the pandemic forced people to stay at home. Whether, the trend will continue, remains to be seen.

The food aggregation market in India currently has two players — Zomato and Swiggy, but the current duopoly rose from years of discount wars, mergers, acquisitions and cash-burn. These two are the last platforms standing in the market.

The companies can easily be attacked by well-funded rivals. Despite their chest-thumping, “food aggregation platforms” have not yet developed a sustainable business model in almost any part of the world.

Those who point to the Chinese tech-giant Meituan as an example of profitable food aggregation should remember that Meituan became profitable quite recently. In addition, Meituan derived 57 per cent of its revenues from food aggregation, while the remaining came from the other businesses on its super app.

Despite its large revenue share, food aggregation contributes to only 20 per cent of its profits while 75 per cent of its profits came from its in-store business, hotels and travel. Meituan and other tech giants until recently enjoyed government support and protectionism, a luxury not available to Indian companies.

Recent initial public offering (IPO) prospectuses by Indian tech startups have mentioned “fly-wheels” wherein their immense data capabilities can help them drive more user engagement and increase their user acquisition, becoming a reinforcing loop.

However, the actual utility of such data is questionable. More often than not, the basic data available with banks is enough to determine credit quality of the entity. If anything, some of these digital lending startups have shown much higher rates of delinquencies compared to normal loan portfolios, further exacerbated by the pandemic.

Marketplace platforms are often touted as great businesses due to their strong network effects. Buyers on a marketplace attract more sellers and vice versa, resulting in a positive feedback loop. But, not all market places are created equal. The structure of the market in which a company operates dictates how well the marketplace does.The emergence of niche marketplaces often results in customers migrating to these niche platforms from generic platforms.

IEX, MCX and National Stock Exchange (NSE) have emerged as dominant marketplaces because of the traders’ need for liquidity, speed and low impact costs.

PolicyBazaar has built a brand around its product which has helped it become the largest marketplace of online insurance, though its status is being challenged by well-funded rivals. But other online marketplaces like car markets, excess inventory markets or invoice discounting markets are yet to see a single platform emerge as a profitable dominant player.

Recently, people have been classifying every business with a dependence on technology and a fixed cost structure as a platform business. Case in point — Central Depository Services Limited (CDSL) —CDSL is, by definition, a simple depository and not a platform.

It has benefitted immensely from regulatory protection, the stock market boom and its cost structure. Classifying it as a platform helps justify its high valuations while simultaneously driving the ‘platform’ narrative.

CDSL operates in a highly-regulated industry and can certainly not expand beyond its core business. The management has so far been reluctant to distribute the huge cash pile to investors through large dividends or buybacks as it will lower the other income and the accounting profits for the business. With these constraints in place, the current high valuations do not seem to be justified.

The main takeaway from these facts is that not all platforms are created equal. The value of some platforms increases at a rapid pace with the addition of each new user — telephones, gas pipelines, social media networks and certain marketplaces.

But the increase in value might not hold true for platforms operating in other industries. The structure of an industry makes a huge difference to how various factors interact and help a platform scale further.

Investors should realise that narratives always follow the price. Rather than simply buying into a ‘platform business’ at any valuation, an investor should spend time understanding the market structure.

Though platform businesses superficially look the same, on deeper analysis, one finds that each business has a different dynamic. The low-cost nature of these technology-based businesses with low barriers to entry continues attracting new competitors. For instance, Udaan is challenging IndiaMart’s B2B marketplace.

Companies like IEX are valued at almost 60 times their earnings, while larger platform companies like Facebook and Amazon, which have multiple growth drivers, are priced at around 30 times earnings.

The lack of opportunities in India has pushed the valuations of these companies sky-high. Investors are better off focusing on valuations and analysing each company on a case-by-case basis, rather than focusing exclusively on the platform aspect.