Why network effects matter

Are network effects really all they're cracked up to be? There was certainly scepticism in the comments below the recent review of online classifieds company Carsales, titled Carsales: the canary in the car yard?.

It's right to question 'sacred cows'. As investors we must be aware that businesses can be disrupted by new competitors or emerging technologies. It's something we keep a close eye on, although by definition anyone can be blindsided by unknown unknowns.

So what exactly are 'network effects'?

When it comes to online classified businesses, the term means that a platform ('network') increases in value to its users the more of them there are. The platforms operated by Carsales.com (ASX: CAR), Seek (ASX: SEK) and REA Group (ASX: REA) are more useful to users precisely because they are the market leaders.

Rusted on

It might seem a little incongruous; these companies just operate websites after all. But their platforms have become valuable because their audiences are large and 'rusted on'. Carsales.com.au, seek.com.au and realestate.com.au are the sites many Australians automatically search when they're looking for a car, job or house.

Take Carsales. Car dealers know that many Australians visit carsales.com.au when looking for a used car, so that's where they must display their inventory. Prospective buyers also know there are plenty of cars for sale on Carsales' site. The numbers of users - and sellers' preparedness to pay a relatively small sum for access to this large audience - is the very metric that gives these companies their value.

When you consider how these businesses emerged, their strong market positions make sense. Classified listings were previously hosted by newspapers, which were usually monopolies or duopolies in their markets.

The newspapers made so much money from classifieds - remember Fairfax's 'rivers of gold'? - because everyone read them. The classifieds business model isn't that much different to 25 years ago - except now the listings are online rather than in printed form.

Different niches

What is different is that the cost of displaying a listing has fallen significantly thanks to technology. This has allowed free (or 'freemium') sites such as Gumtree to compete with premium players who offer associated services. Carsales and Gumtree occupy slightly different market niches, allowing them to coexist.

So why can't another vehicle classifieds company enter Australia, set up a website, do some advertising, and attract Carsales' user base away?

To have a hope of competing with Carsales, you need either listings or an audience. Then you would need to spend time and money building out what you don't have. It's not impossible - in fact Domain Holdings (ASX:DHG) has built listings so that they're almost at parity with REA - but it is difficult to dislodge the market leader once it's entrenched.

Carsales and Gumtree are already free for buyers to browse, so there's little incentive to switch to a new provider of listings. And if dealers were enticed away from Carsales' system, they would lose access to its technology as well as an important source of leads. Attracting listings, developing a compelling offer and then changing consumer behaviour is trickier than it seems.

The power of Facebook, which has recently announced it will allow car dealers to upload their inventory onto Facebook Marketplace, is that it already has a large audience. Presumably it will charge dealers who wish to advertise using the Facebook platform. Our view is that Facebook can coexist with Carsales, just as Gumtree does, but it will need to be watched.

Triumphant

Carsales has already seen off numerous competitors, including Drive, Carsguide, eBay Motors and the Trading Post (as have Seek and REA Group). The vehicle classifieds market now consists of two main players - Carsales and Gumtree - with a few others hovering around the edges.

While new competitors shouldn't be underestimated, Carsales' attractive financial metrics - including an operating margin of 43% - arise because of the strength of its business model. Much of this comes down to network effects. Dealers must list their inventory on carsales.com.au because they know the site's large audience delivers them sales.

Online classifieds companies are wonderful businesses. They may not be impregnable, especially in the face of global technology behemoths, but competing with them is more difficult than it looks.

New competitors will undoubtedly emerge. The speed of change means online classifieds companies are not 'set-and-forget' investments. But just as the newspapers of 25 years ago made enormous profits from classified listings, so can their online replacements today.

Disclosure: The author owns shares in Domain Holdings and Seek.