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Even though the Internet stock bubble eventually burst, one thing should be kept in mind. The Internet created the possibility of very scalable business models. Despite what happened to Internet stocks in general, the right investment in a good scalable business model could still prove to be a great investment going forward. What are scalable business models?
The term business model refers to a very simple concept: how a company receives revenues in exchange for value delivered. If you have a good understanding of a company's business model, you can understand how the earnings of a business respond to growth of the business.
To understand any company's business model, you need to ask the following questions:
There are many business models where the person receiving the value is not the one paying the revenues. Broadcast television is perhaps the best example. TV is free, but advertising pays for delivery.
Although it seems like a simple concept there were, and still are, companies that became public in the Internet boom without well thought-out business models, scalable or not.
Many Internet business models didn't pass basic tests of credibility. For example, sites with pure advertising models are usually unable to answer the most basic question about growth: how big can you get? The reason is that growth is entirely dependent upon increased page views, either by more users, or more pages, offset by declining ad rates.
Both have upper limits and most companies with advertising models have fixed costs exceeding current revenues. When you try to compute how many page views a pure advertising model needs to generate just to cover fixed costs, it is usually baffling.
A scalable business model is also a simple concept. A scalable model is one where:
In other words, the operating margin increases as the company's revenues grow.
Technology's greatest achievements have all been associated with scalable business models. The reason Ma Bell (American Telephone and Telegraph, now AT&T) grew so powerfully in the last 100 years was that it had a very scalable business model in an era where scalable models were scarce.
Another way to think about scalable models is to look at a company's fixed costs versus variable costs.
Fixed costs are costs that a company incurs whether it sells or not.
Variable costs are costs that a company can control, or which it incurs as it makes sales.
A company with a scalable business model will have variable costs that are small, per unit, or discretionary, as in R&D. The fixed costs should be ignored so long as you believe that revenue will be large enough to exceed the fixed costs.
A scalable model is not the same as economy of scale. The phrase economy of scale means that a company's variable costs become lower as the company gets bigger. In addition, fixed costs can be spread over a greater number of units sold. This helps earnings, but economy of scale does not ensure that operating margins increase as revenues increase.
Another way of understanding a scalable business model is to examine the relationship between cost-of-goods-sold and revenue. Companies that have a very low cost-of-goods-sold percentage generally have an opportunity for a scalable model.
Gross margin is the difference between revenue and cost-of-goods-sold. If the cost of sales and marketing, per unit or per customer, is less than the gross margin, then the company's model is scalable. For every dollar spent on marketing more than a dollar is generated in gross margin, provided there is demand.
Revenue, cost-of-goods-sold, sales and marketing, can all be read from a company's earnings report.
Scalable business models have the potential for earning high profits. That potential is only fulfilled when demand actually drives revenues up. Finding a scalable model is one thing. Finding a scalable model with evidence of booming demand is the ideal situation for an investor.
The most common example of an established scalable business model is software. Developing software costs a tremendous amount, but delivering a copy of that effort costs next to nothing.
Microsoft takes the concept of scalability further than any other software company, because it provides only a single image of the Windows operating system to hardware vendors. The hardware vendors absorb all the charges for developing documentation and CD-ROM copies of software. In essence, Microsoft receives revenues with zero cost-of-goods sold.
The Internet is unique in that it is creating software delivered electronically which is the best of both worlds. The application software world, where software was delivered in a shrink-wrap box, had costs associated with each unit sold.
The Application Service Provider (ASP) model delivers software at no additional cost per user. Provided that ASPs can actually charge for services on a per user basis, the ASP model is very scalable.
There are two ways to search for possible investments in scalable business models:
Note that companies that both sell and deliver their service over the Internet are the most scalable business models of all. Delivery of services over the Net costs nothing.
There are still opportunities coming in Internet companies. Most will probably be new companies. Many existing companies, such as Amazon.com, just didn't turn out to be scalable, despite their great growth.
If you can uncover an existing company that has a scalable business model, and the market has depressed the price, it may be a great investment.
Robert V. Green