It's Hard to Beat "Network Effects"
By Amrit Tewary
Although many companies whose success depends on the Internet or other networking technologies continue to suffer in the weak economy, something called "network effects" has played a big part in the survival of others. Companies with strong network effects are those that have locked in a large customer base -- one that remains loyal because of the effort and expense involved in switching platforms. This also discourages potential rivals, who know they will face a difficult time winning worthwhile market share.
Before we name a few companies benefiting from strong network effects, it's worth explaining the difference between physical and virtual networks. A physical network, such as a telephone network or the actual backbone of the Internet, is one linked by components such as phones or servers through some type of wireline or wireless infrastructure.
A virtual network, on the other hand, is comprised of compatible products that are linked because they share a technical or software platform. Examples include all the PCs using Microsoft's (MSFT ) Windows 2000 operating system or the network of Sony (SNE ) PlayStation 2 video game consoles. Computers running Windows 2000 are linked because they can share word-processing and spreadsheet programs, as well as other applications. Similarly, two different PlayStation 2 consoles can share video games made for the platform.
IN THE LOOP.
Size and scale of a company's physical or virtual network determines how much it will benefit from network effects. For example, the value of a telecommunications network increases with each new customer, since every fresh user creates more possible linkages for calls. At the same time, existing customers benefit from being able to access more people. That's the network effect.
In the case of virtual networks, the value of the network rises when more software applications are created to work with the technology. The best example for this "positive feedback" loop is the Windows operating system and its complementary software applications. In the past two decades, the increase in the installed base of computers using Windows resulted in more applications from third-party software developers designed exclusively for that operating system, which in turn increased the value of owning a Windows PC.
Strong network effects like these result in "customer lock-in." This occurs when users become comfortable working with a particular technology, such as Windows 2000 or PlayStation 2, and using applications and software that go with it. Once a user latches on to a particular technology platform, it becomes very costly to switch, since this would demand significant time, money, and effort to purchase and learn about it and all the associated applications. It often takes a large technological shift to overcome this customer lock-in. (Click here for an in-depth look at network effects and the economics of networks.)
A few technology companies besides Microsoft (which S&P ranks 5 STARS, or buy) benefit from network effects that have helped them lock in a large number of customers. Take financial-data provider FactSet (FDS , ranked 5 STARS by S&P). Its clients, typically financial analysts or asset managers, share a common technology platform that gives them access to info from more than 200 financial databases (mostly through third-party vendors such as Thompson Financial (TOC ) and Multex.com, which is planning to be acquired by Reuters (RTRSY )). As the number of clients on FactSet's network has grown, third-party database vendors have been making their database or application products compatible with FactSet's platform to reach its many users (see BW Online, 1/21/03, "FactSet's Numbers Add Up").
Typically, FactSet's clients are heavy number-crunchers, building spreadsheets and financial models with the outfit's data and software tools. These tend to become embedded in the customer's daily work routine, and, in this instance, it would be expensive for clients to switch to a different data source.
Online auctioneer eBay (EBAY , ranked 3 STARS, or hold, by S&P), along with other e-commerce sites, benefits from strong network effects because it gives a way for buyers and sellers to congregate online and transact. As the installed base of potential buyers using the site increases, a potential seller will likely generate more bids for a product on sale, and hence get a higher price for the item. Similarly, potential buyers will benefit from a large number of sellers because they can pick and choose from a wide variety of items to bid on. Plus, eBay generates transaction fees from each item sold. Overall, as people get more comfortable buying and selling on eBay, they become increasingly locked in.
LOCKING 'EM IN.
As these companies have shown, strong network effects can give them a competitive edge. In many industries, there can be only one dominant network company capable of capturing significant market share. On the other hand, companies that can't create a large enough following and make money from their networks usually fail -- as we've seen when the Internet bubble deflated.
Investors can measure a company's network effect in a variety of ways. Some important indicators are the number of users on a network and market share. Combined with an assessment of how much it would cost for a company's customers to switch to a competing technology, market share gives investors a sense of the barriers to entry, or an outfit's competitive advantages. If switching costs are high, there's a good chance companies will successfully lock in a large number of customers.
Another item to track is recurring revenue -- the amount that repeats over a certain time period due to existing contracts. Also, keep an eye on customer churn, which is how telecom and cable industries measure how many customers leave their networks.
These measures of network effects can certainly be a good screen when looking for technology companies that are poised to succeed. It shouldn't be the only evaluator of whether a stock is worth buying, however. We at S&P believe that a more comprehensive analysis of a company and its industry is needed before making an investment decision.
Analyst Tewary follows diversified technology and consumer discretionary stocks for Standard & Poor's
Edited by Karyn McCormack