How to profit from platform risk

Platforms and sinkholes

A rather literal example of Platform Risk...

I wrote a brief post Wednesday on platform risk (in a nushell, when you building a gigantic mansion and then discover the land you've stuck it on is a giant sinkhole). There were two big takeaways.

The first is that platform risk  is more prevalent and you think, and doesn't just affect small software devs. The day Microsoft rolls out its own-label Windows Phone, is the day Nokia finds it suddenly has an awful lot of platform risk.

The second is that that platform risk isn't the real problem. It is merely a symptom which arises when you have an unstable relationship between the platform owner (e.g. Facebook, Apple, Google) and the "platform rider" which works on top of the platform (e.g. Zynga).

I want to expand on the second point, and show how looking at different types of platforms can guide your investment decisions.

Understanding platform risk

As a rule of thumb, in earlier stage and/or higher growth platforms, the balance of power sits more with the platform owner (think Facebook's pretty much arbitary power over its platform), while in more mature platforms (where the legacy ecosystem matters more) the platform riders have more say (think the lower growth Windows desktop market). In essence there is a trade-off between growth prospects and stability. Ideally there is a tension here, where the platform is growing handsomely, but the platform owner isn't being too greedy. However its when this tension falls out of balance that platform risk arises.

I believe there are four types of platform, which demonstrate this various degrees of this tension:

The four evolutions of the Platform

1. Closed Platforms (Facebook, iOS, Windows Phone): These are owner-dominated platforms where there is significant platform risk. The trade-off for the platform rider is that these are also high growth platforms. The bottom line is that there is often nice growth that lifts all boats, but a small but material chance of platform risk.
2. Open But Bominated Platforms (Android, Force.com): These are growing platforms where the platform owner doesn't quite has as much dictatorial power. This can be for structural reasons (e.g. Android's open-source nature which means that platform-riders retain the nuclear option of forking, something we are seeing with the Kindle Fire or Baidu Yi), or because the platform owners are not big enough to drive growth on their own (e.g. Salesforce is relying on its ecosystem on Force.com to fill in some of the gaps in its application portfolio).
3. Mature Platforms (Windows, Linux, OSX): These are older platforms which offer a large market opportunity, but one that isn't growing as fast. Because a lot of the attraction of the platform comes from the existing ecosystem, the platform vendor is unlikely to break backwards compatibility with the platform riders in a major way (e.g. Microsoft ensure Windows 8 includes a kludgy legacy desktop mode).
4. Burning Platforms (Symbian, RIM): These are dying platforms which present massive risk of platform decline. Thankfully by this point any platform rider with two brain cells has already left the building by the nearest fire exit.

The economics of platform risk

So what does this mean for the vendor and, more importantly, the investor? (this is a blog about finance, as well as tech after all). Here are a few thoughts on who profits:

Closed platforms

• Platform owner: Excellent for the platform owner, as they have both control. They benefit from growth and their control gives them either the ability to extract excess rents, or a competitive moat to defend them if the market starts to change. The one downside is that in the early-stages closed platforms are less profitable due to start-up costs (Windows Phone, I'm looking at you...)
• Platform rider: This is a satisfactory place for the platform rider to be, as they benefit from the rising tide of growth. However there are two big caveats - 1) the coolest platforms attract the most competition (as thousands of failed iOS devs have found out), 2) there is occasional, but massive, PLATFORM RISK.
• Investor: Buy into the platform owner, but avoid investing in platform riders. If the platform is successful, the majority of profits accrue to the platform owner anyhow. If the platform rider is big enough to be worth investing in, there is a greater chance they would have drawn the attention of the platform owner and be vulnerable to platform risk.

Open but dominated platforms

• Platform owner: The economics are good for the platform owner. Although they don't have the optionality they get from being a dominant position, they benefit from good growth. More importantly, platform riders are more likely to want to play in their garden because of the lower platform risk, and thus do more of the legwork in terms of driving growth for the ecosystem (translation: Platform owner might get a higher ROIC).
• Platform rider: This is the ideal platform to work on as they benefit from growth but have only limited platform risk.
• Investors: Buy into both the platform owner and any investable platform riders. Both should benefit from rising volumes and favourable pricing, which will help defend profitability.

Mature Platforms

• Platform owner: Economically speaking, this is the best position. While you don't have the explosive growth, a mature platform generates incredibly high cashflows (viz Warren Buffet's comments on Microsoft back in 1997) for minimal new investment. That is pretty much the ideal business model under any economic conditions.
• Platform rider: This is a good place to be in if you already have an established position and franchise, given the minimal platform risk. However the one caveat is that competitive pressures are likely to be higher, particularly if you lack a killer USP. In the absence of growth and differentiation, your competitors will find the only tool they have to compete with is price.
• Investors: It makes sense to hold shares in the platform owners as a long-term holding/dividend play. Over the course of time you will make an enormous cash return. One safety warning though - such stocks are often under-valued by the market (particularly in tech which has the strange obsession that more expensive growth stocks are more valuable. In reality they are more expensive, but not always more valuable!), so don't expect to make a quick profit.

Burning Platforms

• Platform owner: Bad for the platform owner. Doubly bad as the temptation for them will be to double down in an attempt to turn things round (translation: burn a few more barrowloads of cash) rather than admit defeat.
• Platform rider: Has already left the building.
• Investor: Short the hell out of the platform owner. And stay short (give or take dumb-acquirer M&A risk).

... And shifting platforms

Of course the juiciest investment opportunities come when platforms change - that's when you have the cataclysmic shifts in industry economics which are one of the most fascinating features of tech (something I've touched on before here and here).

By far the most common example is of platform decline. A good one going on at the moment is the shift from PCs towards tablet. This imperils the whole Windows 8 ecosystem (at least on the consumer side - enterprises are much more resilient). This puts a lot of platform riders in a very uncomfortable situation, both on the software and the hardware side. Normally they should be running for the exits but sometimes they weight of their legacy business means they can't (two words: Innovator's Dilemma).

AMD/ATI (which had a cute warning last night) is a good example of this - first the shift from desktop to notebook brutalised ATI's market for discrete CPUs, then as the world shifts towards low-power and tablet they have again been caught short. Logitech's keyboard/mouse business may also be caught in the same trap.

Apple (and Google's) moves towards the world of a connected TV (which I wrote a series on earlier in the year) is another example of a potential platform shift.

That's all. Enjoy the weekend!

An entirely unrelated form of Platform Risk