Swiper no Swiping (Dora Fans Unite)

Value investors make lots of mistakes.  I have made lots of these specific “value investor” mistakes, sometimes the same mistakes multiple times.  Hopefully, knowing where we (I) often go wrong will help us not make those mistakes in the future.  

“Unfortunately we don’t think that it’s the right opportunity for [our firm] from an investment perspective . . . the potential market opportunity did not seem large enough for our required model.” Fred Wilson, Union Square Ventures, on his decision not to invest in Airbnb.

Originally Airbnb was meant to allow homeowners to rent a spare room.  In fact, “To qualify for AirBed & Breakfast, the rules required that hosts had to rent out air mattresses, even if they had an actual bed to spare. (Chesky [CEO and co-Founder] remembers suggesting to one user who wanted to rent out a real bed that he blow up an air mattress and put it on top of the bed so it would qualify.)”

Excerpt From: Leigh Gallagher. “The Airbnb Story.”

For early investors looking at the then-current business model, it does seem possible to miss what Airbnb did eventually become.

One mistake I have made in the past is not seeing what companies could become.  Even after seeing how their business models have changed/evolved and were performing well, being unable to change my mind and reevaluate the situation.  I did this with Facebook.  Facebook’s ad monetization was not entirely clear at its IPO, however, it did very quickly become clear about a year after its IPO.  Imagine betting on the horse after the race was ¾ of the way over. That was Facebook at 50% of its current price (or about $200B ago).  I hope not to make this mistake again.  

Match Group is a collection of dating “properties”, both websites and apps.  Plenty of Fish is one of Match’s properties. Keeping the site Plenty of Fish in mind, one of the specific ways I have thought of Match is a group of fishing nets. These nets are designed to capture as many fish involved in the process of “dating” or “making connections.”  These fish/people will come and go into and out of these nets, but the best use of my time if I am wanting to make a connection is to go where all the fish are.  This is a very simple network effect.  The more people who sign up for Match’s sites make these sites even more popular (and valuable) because the incremental user would like to go where the most users are already present.  Match’s most valuable property at the present time is Tinder, however, Match owns 45 brands, Plenty of Fish being another popular property (which Match acquired in 2015 for $575m).  

If you want a 300 page slide deck on Match, you might want to look elsewhere.  We can boil down the investment case for Match into a few paragraphs.  There are two issues, the User Network Problem and the Monetization Problem.

User Network Problem

First, I think Match has succeeded in solving the User Network Problem.  It’s 45 different properties, including both Tinder, Plenty of Fish, OkCupid, and Match.com are some of the most valuable sites/properties/apps, due to the User Network.  Match’s properties have created a network effect where the pool of potential “dating” people are coming into one of Match’s 45 different nets.  There are a few nets outside of their properties, but the majority of fish will come to Match’s sites because that is where the majority of fish are already (network effect).  As long as Match maintains this strong User Network among its 45 properties (or more) Match will have solved one of the first two issues.  Solving this issue assumes that Match is able to make sure those few nets outside of its 45 properties never gain adequate scale, whether through early acquisition or copying the attributes of the most popular non-Match sites (most likely) and stunting their growth before any non-Match site gains adequate scale (eHarmony is the only large site that Match does not own and has no real chance of eliminating since eHarmony already has the necessary scale to solve the User Network Issue).  Let’s discuss the second issue and then I will circle back to the first issue and its potential problems.    

The second issue is monetization.  It does not help if you catch a lot of fish in your net if they all leave before you can sell them (maybe I am stretching the metaphor too far).  

Monetization is always a tough nut to crack with network effect business.  It’s a chicken and egg problem, where you need users to be attracted to the platform.   The easiest way to gain users initially is to make the network freely available to all parties.  This is how Tinder started, also how Plenty of Fish ramped up initially.  The monetization strategies come later, whether the advertising (Facebook, Twitter, Plenty of Fish) or premium services add-ons, Tinder’s current approach (most mobile games follow this path also).  The monetization steps are difficult ones to take because the user experience starts to change and it is the initial wonderful, ad-free or monetization-free user experience that has initially attracted the large user base.  There are a couple of ways to solve this.  One is to make it as non-intrusive as possible, something Plenty of Fish has done with its ad placements.  The second way is to make the ads as valuable as possible, something that Google and Facebook have both done well (I will admit I sometimes go to Facebook specifically to see the ads, don’t tell my family).

Each step towards monetization of a previously free site makes it incrementally more likely that a new, monetization-free site will emerge.  This is especially dangerous with dating sites because the target audience is constantly turning itself over (a dating site either works and you leave or it doesn’t work and you leave, the only question is how long you stick around before one of those outcomes occurs).  Additionally, Tinder’s attraction has created its largest competitive threat.  The utter simplicity of its app, which incidentally makes it sooooo popular could also be its achilles heel because it is so simple to copy.  There are already about 20 copycats of Tinder in the app store, some focusing on specific dating niches.   It’s wickedly simple to create an app where Facebook handles the login, Facebook and Instagram provide security for pictures and location services: well, one popular copycat admits in their FAQs that they didn’t even bother with this: “People interested in you want to know how far away you live.  You are required to answer the ‘Lives In’ question, but it doesn’t matter what you write.”

In thinking philosophically about Match, you have two problems.  Match has solved the first, but the closer they get to solving the second problem, the more likely they are at risk of undoing their solution to the first problem.  Match has not hit on the holy grail of monetization with its newest property, Tinder.  Match is improving the monetization of these fish, and there are potential possibilities (one includes an advertisement partnership with Facebook), however, I wouldn’t call their current strategy the final iteration of their business model.  Match is still in the dart throwing phase.  That’s fine.  

Looking up from my philosophy books, it appears that Match is executing well and I want to follow this one closely.  

The nagging question is best represented by this quote.  

“At the time there was a new programming language called ASP.NET, and I don’t like reading books, so I just went and created the site in two weeks, and then people started signing up, much to my surprise,” he said. “And it blew up from there. It wasn’t like I had a plan to create a dating site. It was just a side project I created that got really big.”

That quote was from the founder of Plenty of Fish (this article is a great read).  He sold Plenty of Fish to Match Group for $575m.  That’s an expensive fishing net for Match to need to buy.  It scares me that someone can start a competitor in a few hours a day without much programming knowledge and eventually be one of your largest competitors.  Which of the 20 copycats in the App Store is going to be the next Plenty of Fish?

Above are the two main questions, with which I am still wrestling.  In the meantime, I wanted to highlight why I am generally attracted to this business.  Even if I don’t end up investing in this company, these are attributes and patterns to note.

Low Capital Expenditure Requirements
The ability to easily distribute your product without large scale capital expenditures can never be underestimated or underappreciated.  If you make cars and want to ramp up production in a new country, it is going to costs you quite a bit of capital, but not much with Match.  This is a huge advantage in a competitive landscape with iterative changes to your product and business model can keep you ahead of your customers needs and wants.  Match can easily copy something it sees in its French market almost immediately in its German or U.S. market with small tests without additional capital.  It can test, change, and continually refine its product to see what works best.  Contrast this with a company like Horsehead Holdings, who built a new zinc processing plant in North Carolina.  It didn’t work, so the company went bankrupt.  There were no second attempts.  In some ways, these capital-light businesses are more competitive because your competitors also have low capital expenditures.  However, I can get much more comfortable with the execution of a management team who has a lot of chances to learn along the way without committing a fatal error on its first try as is the case with large capex projects, like Horsehead.

Willingness to Kill its Own Business
I like Match’s willingness to kill its own business without a clear path to profitability.  This may sound absolutely nuts as an investor, however, stay with me for a few minutes.  Match developed Tinder internally.  If you come up with a new product that is better than your current product, however, you don’t know how to monetize it yet, I think it is imperative that you push it out (also, I think it is imperative that you always be looking and creating the next product that is better than and will kill your current product).  If Match had not pushed Tinder because it believed (rightfully so) that it would cannibalize its legacy products, someone else would have eventually created Tinder.  That other company, The Terminator Inc. (go ahead and think about it, you will laugh) would have had a huge number of users, data, and brand awareness that would have eventually been difficult or impossible to dislodge.  Finding the product that provides the best value to the customer and owning that product is a much better business model than sticking to your legacy products because you can’t figure out how to make money on the next generation of obviously better products.  Great companies are willing to do this.  If the next iteration of the product is going to provide more value to your customers, damn your current margins, you had better be delivering that product before your competitor does.  Think about hotels companies or car rental companies.  Both could have easily beat Uber or Airbnb, but very few companies are willing to sacrifice current profits for speculative profits in the future.  

I tend to focus on understanding the business more than the current valuation.  I have bought into the idea of Mr. Market’s manic-depressive behavior and always assume a better/different future price is possible.  One aspect of this belief is especially strong with Match given the current ownership situation.  Only about 20% of the stock is currently part of the public float.  The rest of still owned by IAC.  With such a small amount of public float, you typically see wild price movements.    

Roughly speaking, Match is valued around $5.5-6B, enterprise value (including debt), fully diluted with stock options, etc.  In 2016 Match did about 300m in operating income.  If we say, 20x operating income, we are in the ballpark.  I honestly don’t think the current valuation matters much.  If Match figures out how to effectively monetize Tinder and keeps all of the potential “dating fish” in one of their 45 nets, Match will work out as an investment.  

I am still mulling these questions and concerns, but there is a lot to like and it is certainly one I am keeping on my watchlist.  

For those of you without kids, the reference in the title is to the “evil” character in the Dora the Explorer books, Swiper, see here.

Matt Brice is the portfolio manager of The Sova Group, LLC. Matt can be reached at matt@thesovagroup.com. 

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