Key Metrics to Track: How to Assess the Strength of the Network

In our previous blog posts as part of the Discovering the Power of Platform Businesses series, we explored the journey of multi-sided platforms, dissecting their stages of network creation, consumer behaviour influence, and the resultant superlative profits and value generation with examples from the US.

In today’s rapidly evolving digital landscape, understanding the metrics that signify the strength of a network is crucial for public market investors. This blog series delves into the key indicators that can help assess a platform’s value, starting with metrics like customer interaction frequency and customer acquisition cost. By examining real-world examples and analyzing the cost structures of mature digital platforms, we aim to provide a comprehensive framework for evaluating the potential profitability and growth trajectories of these businesses.

To simplify matters for public market investors, who may not always have access to all the company’s data, we believe there are two major indicators to consider when evaluating the value of a network.

Firstly, frequency: How often do customers return to the platform to interact or transact? Has this frequency increased over time? Has the average order value also increased over time? These questions are crucial for understanding the network’s value to its users.

Consider this example: A customer who joined the Zomato app six years ago is likely to spend five times more than they did in their first year of interaction with the network. What does this indicate? It suggests that customer behaviour has become more consistent over time (resulting in higher order frequency). Sticky customer behaviour leads to predictable, recurring, high-quality profitable revenue. 

To delve deeper, let’s assume Zomato spent an average of 250 INR to acquire a customer. If, on average, a customer ordered 10 times in the first year, they would likely place ~150 orders over six years. With an average order value of 300 INR and a 20% take rate, approximately 9000 INR in revenue is generated. Considering a direct delivery cost of 30 INR paid by Zomato to its riders, it costs around 4500 INR to serve a customer on average. With most costs outside of delivery being fairly fixed, this cost structure offers significant operating leverage as long as the platform continues to grow.

The second crucial metric is the customer acquisition cost (CAC). This metric is critical as it determines the company’s ability to achieve profitability. A simple rule of thumb is that the CAC should decrease over time as the platform organically attracts new customers and early customer discounts decrease with increasing frequency of interactions.

If these two metrics are trending in the right direction, the platform is likely to achieve profitability. Understanding the cost structure of a mature platform business is essential for evaluating its potential profitability profile, whether high or low ROEs.

India Thesis: Growth + Path to profitability

We’ve extensively discussed India’s digital journey in our previous writings (accessible here – The Roots and Enabling Commerce). In essence, the widespread adoption of the internet and smartphones, facilitated by affordable data and devices, has brought a significant portion of India’s population online. Concurrently, the government’s steadfast focus on bolstering Digital Public Infrastructure, exemplified by initiatives such as Aadhar and UPI, has fostered a robust and seamless digital ecosystem. Moreover, the onset of the COVID-19 pandemic served as a catalyst, further propelling the adoption of various digital services.

Beyond the surge in digital consumers and the frictionless payment capabilities facilitated by UPI, we’d like to emphasize two key aspects of our thesis.

Firstly, the escalation in per capita spending. Indian discretionary consumption is poised for substantial growth, propelled by various factors including favourable demographics, escalating income levels, expansion of retail credit, and evolving consumer aspirations. Notably, most digital platforms (listed thus far) are intricately linked to the upsurge in discretionary spending.

The surge in consumption demand underscores a multi-year theme, underpinned by robust demographic trends, burgeoning incomes, aspirational shifts, and evolving consumer preferences. With India’s GDP per capita recently surpassing the $2000 threshold, a significant uptick in discretionary consumer spending is anticipated over the next decade (as evidenced by the consumer S-curve phenomenon observed globally post reaching the $2000 per capita mark). Consequently, we view consumer aspirational spending as a compelling micro-trend that we actively invest in.

Secondly, consumers are progressively embracing digital-native behaviours. Notably, with over 50% of India’s population currently under 30 years of age, the future primary consumer cohort is poised to be inherently digital-native, contrasting with today’s consumers who have had to adapt their purchasing habits to accommodate new-age digital platforms. As the current generation assumes a leading role in consumption patterns in the years ahead, their inclination towards online spending or share of overall digital expenditure is expected to significantly outweigh that of the current consumption cohort.

Digital platforms stand to benefit from both the upsurge in consumerism and the shift towards digital channels and apps.

Quick Digital Disruption Thesis Summary

While the potential for robust business growth (exceeding 30%) in this sector is widely recognized, we believe that markets may be underestimating the extent of growth opportunities available to these businesses.

Of paramount importance, however, is the undervaluation of the true profitability potential of these enterprises. Our analysis unequivocally demonstrates that the substantial losses incurred by most of these platforms presently stem primarily from investments aimed at hyper-growth (necessitated in the initial two stages of developing a digital platform). As these companies transition into the monetisation phase (the third stage of digital platform business evolution), a combination of a significant reduction in hyper-growth investments (no longer necessary), enhanced monetisation strategies, and operating leverage can precipitate a notable upswing in profitability. The inherent profitability of these businesses at a mature stage is exceedingly appealing.

The confluence of sustained high growth, coupled with a shift towards profitability, is poised to catalyze robust value creation and outperformance among listed digital platforms in the ensuing decade. We anticipate that the forthcoming decade could witness growth outpacing for Indian listed digital platforms, akin to the trajectory observed for US technology companies over the past decade.

Across the board, digital companies have consistently surpassed profitability expectations over recent quarters. This trend seamlessly aligns with our thesis, suggesting that the transition to profitability in digital platforms will likely catch most market participants off guard once they pivot towards monetization. We firmly believe that the expansive growth trajectory and nascent profitability will lead to substantial value creation over the medium-to-long term.

Portfolio Approach

IME Digital Disruption stands as India’s sole listed equity strategy exclusively dedicated to investing in platform businesses. Adhering to stringent selection criteria aimed at identifying dominant franchises with robust moats, we maintain a highly selective approach and adopt a concentrated private equity-style (PE) strategy while investing exclusively in listed digital platforms.

Our pursuit involves identifying companies that:

  1. Hold a dominant market presence within their respective sectors,
  2. Operate in large markets, facilitating scalability and optionality potential,
  3. Demonstrate a visible path to profitability (in the case of loss-making entities),
  4. Are led by competent and astute management, and
  5. Are reasonably valued based on conservative future profitability projections.

We maintain highly concentrated positions in these selected companies (ranging from 7 to 15 stocks). Our objective is to identify and invest in digital platforms poised to emerge as market leaders within their focus areas. We eschew diversification for the sake of diversification, as we prioritize investing in companies that exhibit clear leadership or dominance. 

We aim to capitalize on the compounding benefits inherent in investing in companies capable of consistently delivering growth outperformance, margin expansion, and super-normal profitability over the long term. Consequently, we adopt a long-term investment horizon (exceeding 5 years) in our investee companies, provided the long-term value creation thesis remains intact. However, we remain vigilant and ready to exit positions should we detect any signs of deterioration in the network’s value or the platform’s ability to enhance economics over the long term.

Noteworthy aspects of our portfolio positioning include a predominant focus on large and mid-cap companies, coupled with prudent diversification across various segments in which digital platforms operate. This diversification strategy mitigates the risk of capital erosion stemming from changes in competition or business dynamics within any particular vertical.

As we conclude this series on evaluating the strength of digital platforms, it becomes clear that metrics such as customer interaction frequency and acquisition costs are pivotal in determining a platform’s long-term success. By focusing on dominant market players with scalable operations and strong management, investors can capitalize on the evolving digital landscape.

As our IME Digital Disruption Strategy recently marked its one-year milestone, we invite you to reach out to us for further insights.

Note: The examples/companies mentioned above are purely for informational purposes. Please note, they are not to be deemed as investment advice/recommendation.