Beyond The Headlines

The True Cost of Things

April 28, 2022 | Diandra Ramsammy
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I was on a video call last week. We were using someone’s else link, and 40 minutes into our conversation, we were cut off. My host realized that his free video calling plan only allows limited use per call. I know he upgraded to a paid plan since, but that experience reminded me of a more significant phenomenon. We are quickly learning the true cost of many services we use, and it has important consequences for how we invest. Let me explain.

As investors, we have an opportunity to get to know many businesses all around us, especially if they are already publicly traded. I’m often positively surprised by the extent of disclosure of public companies. I imagine few people have the time, the interest, or the need to read it, but if you are serious about your investments, there is plenty to learn.

One phenomenon that we observed over the last ten or maybe even twenty years is the birth of freebies in the internet world. We all know well the free samples we can get at a local supermarket, anything from gourmet cheese to a slice of fresh fruit. The internet changed a lot how we can access a variety of services. The cost to add an incremental user dropped substantially.

The funding coming from venture capital firms allowed many companies to enjoy a large audience without charging a dollar for the service provided. It was all done in the name of fast growth and with the hopes of reaching scale, adoption rate, or stickiness that will allow the company to start charging something down the road. With expanding services and user base, the costs usually run up, while insufficient revenue makes turning a substantial profit difficult.

With the proliferation of smartphones, we saw an even bigger growth in the number of services we use. There are apps for almost anything from cooking to dating, banking, communication, and more. We have seen many specialized professional apps helping doctors, engineers, lawyers, investment professionals, etc.

As consumers, we got used to getting almost everything for free. We don’t feel like paying for our email, messenger, online searches, weather reports, news, entertainment and more. In some cases, companies discovered a workaround. They reinvented an old solution used by media companies before, from newspapers to radio and television. The service might seem free, but it’s the consumers’ attention that’s auctioned off to the highest bidder and sold as advertising space. This path proved highly profitable for a handful of tech giants.

Not everyone successfully followed, and many others try to charge for premium services and introduce many levels of service, enticing users to pay up. Researching many companies in that space as potential investment targets, we noticed how difficult it could be to introduce a paid service. It’s even a more significant challenge to pass through price increases to existing paying customers.

The other troubled model we observed included offering proverbial $100 bills for $50. With flawed unit economics, no matter how big and how fast a business grows, there is no path to profitability. We saw challenges at some meal kit companies that shipped ready-to-use ingredients to our homes. As consumers, we took advantage of those offerings; as investors, we stood away. There was also a real estate company disguised as a tech unicorn locking in overpriced long-term leases only to turn around and rent back office space with no commitment and at a usually much lower price.

With billions of VC funding, a lot of magic is possible for a brief period of time. The start-up founders have been praised for growth at any cost, and consumers were enticed to believe that we can get not only free lunch but also a free ride, free office, free music, and more. Some investors might lose sight of what’s real with all the smoke and mirrors.

Something has changed recently, though. It might have overlapped with the pandemic shifts in consumer behavior. We think it probably accelerated a change that was bound to happen eventually anyway.

Among the winning companies, we witnessed big leaps in the adoption rates of a variety of online services, from streaming to video calling and more. The importance and relevance of those offerings in the eyes of consumers must have changed as well. How do we know? We saw several service price increases in the last two years.

Some might argue that this renewed pricing power comes under the guise of general inflation. Everything is more expensive, so it’s easier to accept price increases for our favorite streaming service or work essential video calling app.

Maybe it’s the inflationary environment; maybe it’s the scale, the importance, the adoption rate. Perhaps it’s all of the above. In the end, it’s the result that matters, and we are seeing how customers are starting to embrace what we like to call the true cost of things. They might be reluctant to pay or pay up – old habits die hard. Still, with this new phenomenon, some companies finally have a chance to enjoy higher revenues and improved profitability.

Others might have failed the test and will fade away or need to change course dramatically. Venture capital firms grew again a bit more reluctant to fund growth at any cost — as they do every so often.

From an investment perspective, we see the potential for improved earnings and real, sustainable upside in many current and future businesses that offer valued services and discover a lasting pricing power. We are keeping an eye on them, and we intend to seize all opportunities that may arise as consumers reluctantly discover the true cost of things.


Happy Investing!

Bogumil Baranowski

Published: 4/28/2022


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