Thursday, 19 July 2012

The business of technology (1)

In my first post I talked about why technological change makes tech companies different. Now I look at what's so special about their business models.

Technology companies are often extraordinarily good at making money. As an analyst of Software, tech Hardware and IT Services companies over the last ten years I've noticed a number of features of their business models which set them apart from most other companies.

Four habits of highly successful companies

1) Structural pricing power. I've already discussed the structural pricing power for much of tech in the previous post. Faster silicon = newer products = people want to pay up. One qualifier - sometimes this enables price to stay constant rather than going up (e.g. the New iPad costs as much as last year's iPad 2). That's also not a bad thing, so long as a lot more people want to buy this year's model than last year's i.e. volumes are going up.

2) High volume growth markets. This leads us onto volume, the second driver of revenue growth. Again this comes back to the the product innovation point mentioned before - technology companies often operate in markets which see extremely high (>20% annual) volume growth. Now this isn't normal - for more mature markets like cars, microwaves or groceries you're lucky if you see volumes up low single digits. But for cutting edge products like smartphone, cloud computing services or tablet computers its an entirely different ball game.

3) Scalable. Conventional business models often find it hard to ramp up growth to meet demand - to produce twice as many widgets you need to build twice as many factories; this all takes time. For technology companies however models are often extraordinarily scalable. There are a number of reasons for this. Firstly technology companies are often selling intangible goods such as software or services. These are easy to duplicate - want to sell more software? Just print off another CD or email out another copy of the program - marginal cost = close to zero.

Secondly for those companies which do manufacture physical product, many have adapted to globalisation and outsourced manufacturing - again someone else (normally a far Eastern manufacturing giant such as Foxconn) has already built the factory - Apple just tells them how many iPhones they want to build this month. A similar analogy applies to cloud computing services - Microsoft or Amazon do the leg-work of building the data-centres and providing the cloud computing platform. Cloud services providers simply build their products on top of that and can add as much capacity as they need at the flick of a switch.

4) Asset light models. As an adjunct to this, it means technology companies often don't need many assets to get of the ground (equipment required to launch this blog - 1 computer and 1 internet connection). This is a beautiful scenario from a business point of view, because how a business makes money is paying out more cash than you put in (not always the same as turning a profit on your P&L account!). The heart of value creation is producing a positive return on invested capital. Guess what? The less assets you have the less invested capital you require.

That's not saying other companies don't have all or some of these attributes, but from my experience technology companies are often lucky enough to have a number of them at once which gives them a great platform for doing business.


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