I guess investors are probably wondering why it's so freaking hard for Google (GOOG, GOOGL) and Facebook (NASDAQ:FB) to diversify away from advertising revenue. I think investors have a valid concern as more diversification reduces risk.
Diversifying hasn't been a simple process. Both Google and Facebook are in the process of developing another star business, which may have meaningful impact on top and bottom line, while diversifying both businesses away from ad-revenue.
This isn't an exact science, but I'm going to start the discussion by using acceptable ideas from the school of economics.
Defining the marketplace
What are some good examples of naturally occurring monopolies: your local utility company, Windows OS, and America Movil.
Technically anyone can design and create a social network; therefore in that context the social networking is an open marketplace. In fact it costs $500,000 plus nine months of web development to replicate Facebook's website. However, Facebook's current market capitalization is $174.3 billion, the company is interpreted to be worth way more than what it costs to create the website.
Traffic acquisition costs, scale, and lack of installed user base are limiting factors to competition. In other words, without mass product adoption, the Facebook model doesn't work. But to create mass product adoption it costs a lot of money, patience, time, and in all reality - luck. Snapchat went nowhere for the first five months, and then suddenly kids in High School discovered that they can share test answers with self-destructing messages. From there it blew up into a sexting app, and practically anything else that requires private conversation.
Therefore, competition can be a factor. It has impacted Google and Facebook. But it has only done this to a very limited extent.
In the case of Google, users flock to the website regardless of alternatives. Very few firms can compete, and this is because the efficient number of search engines is one. You don't need multiple search engines, and assuming one search engine does the function of searching well enough, it's unlikely that users will use an alternative. Plus, the pricing for using the service is zero. At a price point of zero, demand is at its highest assuming ceteris paribus.
Firms that attempt to compete with Google cannot compete on price, and cannot offer distinguishing features that are superior. Google by definition has way more market share than its competitors, and while the cost of creating a search engine is small, only a small handful of firms will earn profit from the search business. It's not an open market; it's closer to monopoly, or a duopoly.
Bing and Yahoo! (NASDAQ:YHOO) have 28% market share when combined, whereas Google has 67.5% market share (making Google the clear leader). Again, Bing and Yahoo! can compete, there's nothing restricting them from doing so, but their ability to compete via pricing, or through superior functionality is rather limited. Furthermore, Google operates at much greater scale giving Google enough resources to acquire traffic through placement in alternative web browsers, and furthermore, Google is the default search engine for Android, making Google's monopoly on search almost unbreakable at the present moment.
Let's get back to Facebook. The company landed itself on a naturally occurring monopoly through its social networking website/application. In this case, the most efficient number of firms is one. You don't need multiple social networking services, and it's because of this fact, services that are adjacent like chat, or mini-blogs are taking off, but a service exactly like Facebook has yet to attract significant mass.
Until another social networking website can operate cross-borders, and allow you to interact with anyone from the past, present, or future in the format of a newsfeed; Facebook has no serious competition. The market can only support one or two firms in a geographic location. I have never seen people use multiple social networking websites. Sure, we can say there's some overlap between Twitter, Facebook, and LinkedIn. But Twitter (NYSE:TWTR) is actually a micro blog, and LinkedIn (NYSE:LNKD) is used for professional networking and finding employment. Because the two are not used for socialization with friends, but rather acquaintances, the two alternatives have been able to thrive alongside Facebook, but cannot be seen as direct competition to Facebook.
Also, Facebook seems to have lost some interest from teens. However, outright Facebook account cancellation, or loss of engagement has been minimal at best. Teens now use Instagram more, which is owned by Facebook. So the lost demand is picked up by another web property that's owned by Facebook. Even with this demographic shift, Facebook has the highest penetration into the teenage demographic at 94%, and research has pointed out that most people who claim to quit Facebook, or have shut their Facebook account almost never permanently do (this is based on data from a documentary that interviewed senior management at Facebook directly). Also, only a small minority of people do not have a social media account, and that figure is decreasing, not increasing. This indicates that people who don't use social networking services, are becoming more familiar with them, and those who quit, eventually come back. Therefore, none of the demographic data is indicative of a declining Facebook, and many of the concerns about aggregate account declines were way overblown.
Furthermore Facebook prices the service at zero. Therefore, firms cannot compete with Facebook on pricing, and it cannot compete with Facebook on the basis of delivering a superior product, because to create a superior product, you need a social network that has more than a billion users that also offers similar features. Since you can't fulfill the conditions of competing on the basis of quality, or pricing, it's likely that Facebook operates in a naturally occurring monopoly.
However, growth rates for Google and Facebook may eventually slow. However, determining this point is rather difficult, because the market saturation point for advertising has not been reached yet. On the other hand, user penetration has been high. Monetizing each individual mobile and web users more effectively can sustain growth rates for a while longer, and adding in additional services can continue the growth trajectory of both companies even as some product categories mature into low growth, high margin businesses.
So how in the heck do they diversify?
Currently, Facebook is unbundling the application, in favor of separate services that are more specialized. The userbase transitions, and it comes with added functionality that's pleasant on different form factor devices (mobile, smartwatch, tablet, laptop). Furthermore, it also helps that you can find a vast majority of your friends on all those other services, and if you can't, you can always invite them over.
The unbundling of the big blue app, can be seen as net positive, as it transitions the company to diversify its pre-existing user base into additional services, while reducing the dependency on its core web property. Furthermore, the unbundling process helps to create a better user experience for those who own a tablet, smartphone, or smartwatch device. The separate apps allow for better screen real estate management.
As many of you are well aware, Facebook and Google generate high revenue growth, and have high profit margins. The perfect definition of a star business, paired with a competitive moat that puts them in the position of declaring that they have a naturally occurring monopoly (which can be confirmed by the high market share relative to other firms in the specific space).
However, to replicate the historical pace of growth, both Facebook and Google will have to identify a way to build another naturally occurring monopoly. I think Google is closer to this than Facebook, as Android is now the world's most dominant mobile OS by market share.
However, this isn't to dump water on iOS. I never said Android dominates the high-end, but what it does indicate is that Google is on its way to cornering another massive market on the basis of features and pricing.
The Android OS has an ecosystem of applications that is as large as iOS, Android OS is priced at zero, and the operating system is considered to be the most superior alternative to iOS. Because of this fact, competing based on features, pricing, and installed base is limited to a very narrow number of firms. Again, this puts Google in the position to create a natural monopoly (similar to how Microsoft was able to ship almost every computer on earth with Windows).
Google generates its revenues by charging a fee for app downloads. It's the only store on the phone (excluding Amazon's app store) and because of this fact, Google has a near monopoly on selling apps to anyone who owns an Android smartphone/tablet.
How about Facebook? Well, I think Facebook's acquisition of WhatsApp is going in the right direction. Sure there are some competitors in international markets, but very few can compete with the price and quality of the product. Plus WhatsApp's installed base continues to grow at feverish pace, pushing away concerns of who will have the stickiest messenger app. I guess the biggest competitive advantage to WhatsApp is that it communicates over any form of broadband and baseband, allowing people to message one another through an internet connection whether it is on tablet, smartphone, or PC. This could grow into a massive market, because communication may no longer be limited to a 10-digit phone number. The limitations of a phone number is overcome by a web-based service, and since features and pricing are superior, it's highly unlikely that a large number of firms will co-exist together to offer the same service.
I think that telecoms will continue to thrive, but they won't thrive due to selling plans with higher minutes, or text messaging. Telecoms will thrive due to data plans, and whoever can sell the most data per dollar, will be considered to be the most price competitive.
From the looks of it telecoms have conceded defeat to over the top messaging/voice services. All four telecoms in the United States offer unlimited talk and text. Instead telecoms maximize profitability by pricing the data plans for incremental data usage.
Therefore telecoms are able to protect their moat to a certain extent, but cannot offer a more compelling alternative to OTT messaging services despite owning the entire network infrastructure.
To answer why Facebook and Google have had difficulty with diversification, it's because diversifying for the sake of it, won't add meaningful results to top or bottom line.
Instead Google and Facebook have decided to create their own natural monopolies in other areas of the tech space. In this case, high growth, paired with high margins is almost guaranteed.
Despite how impossible it is to re-create a utility like business, I think Facebook and Google are on their way to striking gold twice, and because of this fact, I have to reiterate my buy recommendation on both companies.
This also means that Google and Facebook are becoming more "diversified."
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.