Comparing Facebook and Google Business Models

In our previous blog posts, we represented the business models of Facebook and Google over the Business Model Canvas. The Canvas diagrams are reproduced below for your convenience. Please click the link to the blog post, if you want to read the details.

Understanding Facebook Business Model

Understanding Google Business Model

In this post, we will attempt to compare the two business models using Gurley’s Test. Please refer to the post ‘Assessing a Business Model Attractiveness’, if you want to understand the 10-point criteria that we will be using to compare Facebook and Google business models.

We will take each of the 10 criteria one-by-one. We will try to give scores to both the companies based on the information available in the public domain and our knowledge/understanding of the companies. In case you think that we are missing some key aspect, please feel free to bring it out in the comments section. We will give 1 point if the criterion is fully satisfied, 0.5 points if it is partially satisfied, and 0 points if it is not satisfied at all.

1. Sustainable Competitive Advantage.

Google is a dominant web search provider with over 66% of search market share. As per Analyst estimates, Google has over a million servers that process over a billion search requests every day. Google has invested billions of dollars in building huge data centers across the globe. The resulting economies of scale and economies of scope provide a sustainable competitive advantage to Google over new market entrants and existing players.

Facebook is a dominant social networking site with over 845 million users at the end of 2011. Facebook aspirations are even high. They aim to connect all global Internet users – more than 2 billion in number. Facebook strategy is to design social products and enter into partnerships that drive engagement levels of these users even further. Facebook has built a multi-sided platform (MSP) with strong network effects. These network effects and Winner-Takes-All (WTA) dynamics of MSPs provide sustainable competitive advantage to Facebook.

Both the companies have very strong Research and Development capabilities and lead the market through Innovative products. It is very difficult for a new company to enter into web search or social networking services market and beat Google or Facebook in these markets. So, we can give 1 point to both the companies on this criterion.

2. Presence of Network Effects.

Though Google search product serves multi-sided markets, it doesn’t induce network effects because it doesn’t enable interactions between the users on the two sides. Online advertisers benefit from having a large base of search users, but it doesn’t lead to network effects. However, with the Android product, Google has been able to create cross-side network effects between mobile users and mobile developers. Google is also betting big on Google+, its social networking service. Google+ claims to have over 100 million users in less than a year. It is yet to be seen how Winner-Take-All (WTA) dynamics will pan out between Google+ and Facebook.

Facebook is benefiting from very strong network effects since its inception. Facebook benefits from the same-side network effects between the Facebook users. Facebook also benefits from the cross-side network effects between the developers and the users.

We can give 1 point to both the companies on this criterion.

3. Visibility/Predictability are highly valued.

Both the companies are dependent upon online advertisements for their revenues. Google earns over 96% of its revenue from advertising, whereas Facebook earned 85% of revenue from advertising in 2011. Both the companies have self-serve auction-based Ad products and a “long tail” of customers. This makes modeling or predicting the future revenues of these companies little difficult, as compared to that of product companies.

While both the companies don’t disclose and won’t disclose the following statistics, they can help with some visibility/predictability of their future revenues: How many customers (advertisers) they have? How the number of customers has increased over time? What is the average revenue per customer? What are the revenues from mobile advertising? How they are increasing over time?

As we move more and more from an offline to an online world, both the companies are going to benefit in a big way. We can give 1 point to both the companies on this criterion because their revenues are not going to go down anytime soon.

4. Customer lock-in/High Switching costs.

Both the companies are focused on Lifetime Value (LTV) of the customers. Both the companies are trying to lock-in users with their data in form of emails, photos, videos, documents, and blogs. Google has over 350 million users using Gmail. Over 250 million photos get uploaded on Facebook everyday. Over 4 million businesses use Google Apps for Business. Over 4 billion videos are streamed on Youtube everyday. Facebook has over 100 billion friendships. Both the companies have achieved data lock-in with their users. We can give 1 point to both the companies on this criterion.

5. Gross Margin Levels.

Facebook has higher gross margins than Google. In fact, they are amongst the highest in the Technology Industry. Google gross margins have been improving over years. They also provide enough room for high operating and net margins. We can give 1 point to both the companies on this criterion.

6. Marginal Profitability calculation.

To check whether higher revenues are translating into higher profit margins, we can compare the revenue growth with the operating profit growth. Higher operating profit growth would mean higher marginal profitability.

Over last 5 years, Google operating margins have remained between 30-35% range. For Facebook, operating margins were negative during 2007-08, reached a peak of 52% in 2010, and then declined to 47% in 2011. Google’s revenues and operating income grew at same pace at 23% CAGR from 2007 to 2011. For Facebook, it is not possible to calculate CAGR number because its operating income was negative during 2007-08. However, Facebook operating margins are very healthy and are higher than Google. We can give 0.5 points to both the companies on this criterion.

7. Customer concentration.

Both Facebook and Google have a “long tail” of customers. Both of them are not dependent upon any single customer for their revenues. Both of them have implemented self-serve auction-based Ad products. This makes customers “price accepters” than “price demanders”.

Though Zynga accounted for 12% of Facebook revenues in 2011, Facebook revenues are not highly dependent on Zynga. Moreover, Zynga also needs Facebook for its revenues. Both of them are into a long-term relationship. For Google, no single customer or group of affiliated customers contributed more than 10% of revenue during last 3 years.

We can give 1 point to both the companies on this criterion.

8. Major partner dependencies.

To increase the engagement levels of its users, Facebook has partnered with content companies such as Netflix, Hulu, Spotify, and Washington Post providing online movies, TV shows, music, and news respectively. However, Facebook is not dependent on any single partner.

Google has partnered with content companies that are referred to as Google Network members. Google helps Advertisers extend their Ad campaigns to these Network member websites through its Adsense product. Google shares Ad revenues with these websites in turn. Google gets nearly 30% of its Advertising revenues from the member websites. In addition to the Adsense arrangements, Google has product distribution partners to bring traffic to Google websites. The traffic acquisition costs from distribution partners represent 10-12% of the total cost of revenues. However, Google is not dependent on any single partner for its revenues or traffic acquisition.

We can give 1 point to both the companies on this criterion.

9. Organic vs Heavy Marketing spend.

Both the companies are very well known Global Brands. Both the companies serve multiple audiences: Users, Advertisers, and Developers. So, both companies run different marketing programs for different audiences to achieve different marketing objectives. Both the companies spent nearly 12% of the total revenues on Marketing and Sales in the year 2011. We can give 1 point to both the companies on this criterion.

10. Growth.

Facebook revenues grew from $153 million in 2007 to $3.7 billion in 2011 at a 4-year CAGR of 122%. Google revenues grew from $16.5 billion in 2007 to $37.9 billion in 2011 at a 4-year CAGR of 23%. During 2007, Facebook revenues were 1% of Google revenues. During 2011, Facebook revenues were 10% of Google revenues.

Clearly, Facebook has grown much faster than Google over last 5 years. However, if we take a look back into Google’s early years, its numbers were better than Facebook numbers today. Google was founded in September 1998. Facebook was founded in February 2004. In its 4th year of operations, in 2001, Google revenues were $86 million. By 2005, Google revenue reached $6.1 billion at a 4-year CAGR of 190%.

Whether we consider the base effect or not, Google’s current CAGR of 23% is also a pretty good number as compared to the Industry. So, we can give 1 point to both the companies on this criterion as well.

Summing up,

If we sum all the points up, we will see that both the companies scored 9.5 of 10. The scores are represented over the Canvas as follows:

We believe that both the companies are very promising. Both of them have a big mission that they are after. Google’s mission is to organize the world’s information and make it universally accessible and useful. Facebook’s mission is to make the world more open and connected. These missions are driving scale and innovation in these two companies. The global online advertising market is big and will expand further. These two players are in a good position to capitalize on the global opportunities.

What is your opinion of using this approach to compare the business models of two companies? Does the reasoning help you in judging which company has a superior business model? It is not meant to be an investment guide. But, using the 10-point criteria, you can achieve a better understanding of a company’s business model.

Additional Reading

 

Assessing a Business Model Attractiveness

In our previous posts, we learnt how to visually represent the business models of different companies using the Business Model Canvas. Our first post, Understanding Business Model Fundamentals, answered why we should study Business Models and how Business Model Canvas helps with the visual representation of a Business Model. Then, we attempted to represent the business models of Google, VISA, and Twitter over the Canvas. In this post, we will learn how to assess the attractiveness of a Business Model from an Investor perspective.

Bill Gurley (Venture Capitalist at Benchmark Capital) wrote an interesting article titled, ‘All Revenue is not create equal – The keys to the 10x Revenue Club’ on 24th May 2011 over his blog at www.abovethecrowd.com. In this article, Bill talked about 10 distinguishing traits that warrant high price/revenue multiples and thus higher valuations. These traits are described as follows:

1. Sustainable Competitive Advantage – Here, an Investor is looking for answers to the following questions: Do you know your competition well? What kind of advantage do you have over your competition? Can you sustain it over time? How difficult is it for your competition to provide the same product or service that you provide? Does your business have high barriers to entry?

2. The presence of Network Effects – As per Wikipedia, a network effect is the effect that one user of a good or service has on the value of that product to other people. When network effect is present, the value of a product or service is dependent on the number of others using it. Network effects are present in two-sided markets. Example markets include credit cards, composed of cardholders and merchants; operating systems (end-users and developers); video game consoles (gamers and game developers).

There are two types of network effects: A same-side effect, in which increasing the number of users on one side of the network makes it more valuable to users on the same side; and a cross-side effect, in which increasing the number of users on one side of the network makes it more valuable to the users on the other side. The question to ask is whether your products create Network effects. What kind of Network effects do they create?

3. Visibility/Predictability are highly valued – Investors favor pricing models that provide a high level of predictability & consistency in the future. They would ask you whether your business is vulnerable to the “hit” risk. Do you have follow-on products to your great initial hit?

4. Customer lock-in/High Switching Costs – Investors favor companies with low churn rates of customers and High switching costs. The switching costs can take many forms like Hardware lock-in, Data lock-in etc. How are you creating Customer lock-in with your products or services?

5. Gross Margin Levels – It tells how much leverage exists in the business. Companies with lower gross margins will trade at highly discounted price/revenue multiples because lower gross margins translate into lower net profit margins. You need to answer how your Gross margins compare to that of your competition? If they are high, how will you protect them over time? If they are low, what is your strategy for increasing them?

6. Marginal Profitability Calculation – As per Bill, Investors love companies with scale. Investors will value a company more if higher revenues create higher profit margins, all other things being equal. Marginal Incremental Profitability calculations help Investors understand how well your business is scaling. Investors would ask whether higher revenues translate into higher profit margins for you.

7. Customer concentration – Investors prefer a highly fragmented customer base versus a highly concentrated one. This is because concentrated customers have “market power” whereas small customers are “price takers” in the market. Do you have few big customers or many small customers? Do you have a “long tail” of customers?

8. Major Partner Dependencies – As per Bill, Investors will discount price/revenue valuations of any company that is highly dependent on another partner in some way or another. How much dependent are you on your partners for your value proposition development or for Go-to-Market (GTM) channels?

9. Organic vs Heavy Marketing Spend – Investors love companies where the products/service sales are achieved through “word of mouth” process and the cost of new customer acquisition is low. Lower the marketing spend, the better it is. Does the visibility of your business increases through word of mouth? How your marketing spends compare to that of your competition? What are your Customer Acquisition Costs for new customers? How do they compare to that of competition?

10. Growth – The faster you are growing, the larger your future revenues and cash flows will be. As per Bill, High growth also implies a company has tapped into a powerful new market opportunity, where customer demand is seemingly insatiable. How your business growth compares to that of your competition or your Industry? Are you growing faster than or slower than your Industry?

Different Investors can add more criteria to the list above. But, we would restrict ourselves to these 10 criteria to test the attractiveness of different business models. These criteria force us not only to analyze the financials of a company but also to look at a firm’s position in the context of an industry. These criteria will also help us gain a better understanding of different businesses and industries.

We would be using these criteria to test the attractiveness of different business models. So, let us give a name to these criteria. Since, Bill Gurley first outlined these in his article, we will refer to these as ‘Gurley’s Test’.

These 10 criteria can be visually represented over the Business Model Canvas as follows. The visual representation will help us easily remember these 10 criteria. In the upcoming posts, we will apply Gurley’s Test to different businesses and see how they score.

Please click the image below to see it on full screen.