Last week we examined how execution should trump ideas when making investing decisions. But how do we quantify execution? Companies that are executing well should be able to grow earnings in a sustainable way. This means they should not have to perpetually spend an arm and a leg in order to fuel growth. The main expenses incurred by growing technology firms are research and development (R&D) and selling, general and administration (SGA) expenses. Keeping R&D and SGA expenditures at reasonable levels is the most critical part of technology company execution.
This article will evaluate the expenditure levels of Pandora (P), LinkedIn (LNKD), Groupon (GRPN), Yelp (YELP), Zynga (ZNGA), and Facebook (FB). It will address why these companies are failing to execute at a level that justifies the multi-billion dollar valuations. What will it actually cost for these companies to grow market share, develop new products or better monetize existing ones? Ultimately, the proof will be in the execution. Companies executing well will eventually show strong earnings growth. Those earnings will never come if expenses cannot be managed at reasonable levels.
As we touched upon last week, ideas in technology are hardly a scarce resource. They can be copied at little cost, and can be made more valuable through brilliant execution. Steve Jobs has echoed Pablo Picasso in clearly stating that "good artists copy. Great artists steal." He similarly revealed that Apple (AAPL) has "always been shameless about stealing great ideas." However, merely delivering an idea to market will not lead to execution. As a rule, companies that are executing well will be able to generate sales without consistently having to incur large expenditures as a percentage of revenue. They do this by employing strategies that allow for sustainable growth as opposed to growth that is reliant upon ever-higher levels of spending.
Apple was articulated as an example of a company that executes brilliantly. Apple's percentage of revenue in the most recent quarter in terms of R&D was only 2.5%. Apple is the epitome of efficiency in terms of R&D execution. Apple's percentage of revenue in terms of SGA was 7.3%. Apple is able to spend less per sale because its record of brilliant execution has allowed the company to employ a strategy that promotes organic growth.
Apple was not the first company to introduce a portable MP3 player, tablet computer or touch-screen smartphone. But Apple brought them all together in a way that its competitors could not. The ecosystem that Apple created incentivized developers to produce applications and content for the App Store and iTunes. This development greatly increased the value of Apple's devices as consumption platforms (and essentially serves as 'free' R&D for the company). Apple's relatively low expenditures as a percentage of revenue goes a long way in explaining its strong profit margins and ability to execute. It had a clear and well-thought out plan and it executed on it.
How does the performance of the online companies in question compare with Apple's record of execution? Surely this is a case of comparing apples to oranges. There are few companies that can measure up to Apple's performance. However, it is useful to have an example of what brilliant execution actually means as a yardstick. At the end of the day, an investor should be focused on buying future earnings performance. Below is a table outlining R&D/SGA expenditures and recent growth metrics for the following companies:
Y-o-Y Revenue Growth
Quarterly Revenue Growth
Despite the continued high levels of spending on the behalf of social media companies, revenue growth is largely decelerating across the board. While the main selling point of these companies has often been the explosive growth potential, it appears that the fastest days of growth for these companies are in the past. This slowdown in revenue growth has also occurred without the commensurate decrease in expenses. Therefore, future earnings growth will rely on R&D and SGA execution. The social media companies in question do not appear to have the sort of strategies in place that promote sustainable growth without high levels of expenditure. Moreover, the best ideas they have can and will be copied in the marketplace. Low barriers to entry. Plenty of competition.
We will now examine the conditions of each company and why it will be difficult for it to maintain growth rates while also improving R&D and SGA execution. Earnings will be hurt as these companies labour to meet top-line growth expectations.
In the most recent quarter, Facebook's percentage of total revenue in terms of R&D spending was 59.5%. Despite the continued high levels of spending, revenue growth is slowing down. This of course could change if Facebook proves better able at monetizing its existing products or if it develops new ones (like sponsored stories). But what will further growth truly cost? Acquiring competitor Instagram has already cost the company a billion dollars. Facebook won't be able to acquire every company that threatens the Facebook ecosystem and siphons a revenue source. There are many other questions concerning Facebook's growth potential. Facebook will need to continue to spend heavily on new products and selling expenses in order to maintain its market lead. These concerns put Facebook's ability to consistently generate earnings and live up to its valuation in question.
LinkedIn's percentage of total revenue in terms of R&D spending was 26.3%. In terms of SGA expenses it was 46.8%. While LinkedIn is the de-facto leader in professional social networking, neither of these expenditure levels is appropriate for an $11 billion dollar company. Competitors such as Facebook app "BranchOut" (25 million members), Europe's "Videao" (45 million members) and German company "Xing" (10 million members) will all test LinkedIn's market share and attempt to provide superior professional networking solutions. LinkedIn will need to continue to spend at a high level in order to develop new products and expand or maintain market-share. As a result of this necessity, LinkedIn's sky-high P/E will eventually come down to earth in the form of price depreciation as opposed to earnings growth.
Groupon's percentage of total revenue in terms of SGA and marketing* expenses was 77%. It is facing enormous competition from numerous copycat daily deal services, most notably LivingSocial. There is little to no barrier to entry from entering the daily deals space and Groupon will need to continue to spend heavily on selling expenses to grow the company. The company did not post the top-line growth investors expected recently and it has been hammered as a result. This type of market reaction just increases the tendency of management to focus on short-term growth goals as opposed to sustainable strategies. Additionally, larger companies such as Google (GOOG) and Amazon (AMZN) are reportedly trying to establish themselves in the space. Moreover, consumers have less loyalty toward any particular deal service than they do with other online services. Consumers treat purchasing decisions on a transaction by transaction basis and seek out the best deal available. They do not care if the discount comes from Groupon or another local competitor. Aggregator sites such as Yipit allow consumers to easily compare deals across services. With SGA spending already high and these concerns in mind, it is difficult to see how Groupon will be able to maintain its market lead and generate the earnings that will be needed to justify its valuation.
Pandora's percentage of total revenue in terms of R&D was 4.9%. More relevant for Pandora's growth is SGA costs as a percentage of revenue. In the most recent quarter, SGA expenses alone represented 111.3% of total revenue. Management is spending wildly in an attempt to grow market share and displace alternatives such as Sirius Satellite Radio and traditional in-car radio. They know that competition from similar online streaming services such as Spotify and Slacker Radio is looming. Pandora is not the only game in town in online streaming, yet the market is pricing it as though it is. High licensing costs are also proving to be a constant headache. Increasing the amount of advertisements served will weaken the quality of Pandora's product when compared with its competition. The current levels of spending are not a sustainable way to grow the company.
SGA expenses as a percentage of revenue came in at 80.6%.The high costs of expanding the review site coupled with an unsustainable revenue model have resulted in years of negative earnings. Yelp is a company that at its core has an unsustainable business model. The quality of Yelp's reviews has come into question for many. The company also sells advertising packages to businesses at high rates when compared with other online advertising options. Rocky Agrawl at Venture Beat has observed that Yelp sells advertisement packages to small businesses at over 1,000x the standard online CPM rates they can find elsewhere on the web. Competition in the small-business review area is also heating up. Google's recent purchase of travel service Frommer's indicates an aggressive move toward Google realizing its goal of "providing a review for every relevant place in the world." How long are small business owners going to be willing to pay more for visibility on Yelp's site as strong competition enters the fray? Aggressive hiring and investments in marketing will allow Yelp to continue to grow revenue and acquire users in the short term. It is unclear where the earnings will come from in the long term.
Zynga's percentage of total revenue in terms of R&D spending was 58.8%. SGA came in at an unfavourable 35.9%. Zynga has a relatively meager pipeline of products and has essentially no economic moat. It is simply a game developer that relies on producing hit game after hit game in order to stay afloat. What's more, it is losing fickle consumer attention to competition such as "Angry Birds" producer Rovio. It will require extensive R&D spending in order for Zynga to keep pumping out strong titles. But how many "Farmvilles" does Zynga really have left? The market has rightly devalued this company because it does not have a sustainable growth strategy.
R&D and SGA execution can be quantified and represent two of the most critical components of technology company execution. Publicly traded social media companies all spend wildly on R&D and/or SGA in order to meet the optimistic top-line growth expectations that the market has set out for them. The key is not greater levels of spending, but more efficient strategies for spending. Social media companies should focus on growing ecosystems and increasing economic moats and not just rapid growth. This will obviously be a difficult task and value will be destroyed if it cannot be accomplished successfully. Earnings will be fleeting when the firm's main sources of growth rely on sustained levels of excessive spending. For these social media companies to execute to the levels inherent in current valuations, they will need to lower SGA and R&D expenses as a percentage of sales eventually. Management will be tasked with achieving this deed amidst a constantly changing competitive environment. Due to these concerns, these social media companies still appear overvalued.