What went wrong with Snap, Netflix and Uber?

Despite their superficial differences, the business models of leading technology companies rest on the same shaky foundations.

When Evan Spiegel, Snap's chief executive, wrote in a leaked memo that the social media company has "taken a major hit from the new economic reality of 2022," he could very well have been talking about America's big-name tech companies in general. After years of growth, the sector is experiencing a sharp correction. The NASDAQ index, which includes many consumer internet companies, has fallen nearly 30% over the past 12 months; The Dow Jones Industrial Average, which represents less technology-heavy companies, fell less than 10%. US tech companies have already cut more than 45,000 jobs this year, according to data firm Crunchbase.

Macroeconomics is partly to blame, of course. Soaring inflation is forcing consumers to cut back on non-essential spending, which includes most tech giants' products and services. Even Alphabet, Amazon, Apple and Microsoft, which have collectively lost $2 trillion in market value over the past 12 months, have not been spared.

If you think big companies are doing poorly, imagine how the not-so-big ones are doing. In particular, three business models that companies built after the dot-com crash of 2001 are falling out of favor. These are the transportation model, the video streaming model, and social networks that make money by monitoring their users and selling advertising. Over the past year, companies embodying these business models include Uber and DoorDash; Netflix and Spotify; Snap and Meta lost an average of two-thirds of their market capitalization (see chart).

And things could get even worse. Despite being the global leader in private transportation services, Uber is expected to continue to experience declines in its free cash balances (cash after capital expenditures). Over the course of its 13-year existence, Uber has burned through a total of $25 billion in cash, equivalent to about half its current market value. DoorDash, a leader in food delivery, also remains unprofitable. So are Spotify and Snap. Netflix—a child of the 1990s and a video streaming provider only since 2007—has been profitable, but its third-quarter revenue growth fell to 6% year-over-year, compared with a historical average of over 20%. Meta's revenues have declined for two straight quarters.

At first glance, the business of all these companies is very different, which means their problems should be different. However, upon closer inspection, all of their businesses are faced with the same basic misconceptions: over-reliance on network effects, low barriers to entry into the business segment, and dependence on other people's distribution platforms.

Let's start with network effects, expressed in the idea that the value of a product to the user increases with the number of users. It is assumed that once the number of consumers of a company's products or services crosses a certain threshold, the network effect sets in motion a self-perpetuating cycle of growth. This is why so many startups strive to expand their consumer base at any cost, spending millions to attract new customers.

Network effects are real. But they also have their limits. Uber believed that its early entry into the segment provided it with a guarantee of success—more riders and drivers would mean less downtime for both, drawing more users into an unstoppable growth spiral. Instead, he faced the problem of diminishing returns to scale: reducing average wait times from two minutes to one would require twice as many drivers, although most would barely notice the difference.

Likewise, hungry consumers of DoorDash delivery services only need and can use a certain number of alternative Indian restaurants. And the network effects that drive the business of delivery service providers are local in nature: a user in New York has little interest in food from restaurants in Los Angeles.

Spotify and Netflix also tried to capitalize on network effects, as the wealth of data on user habits promised the potential to create a superior product. The belief that Netflix's trove of user data would give it an edge in content creation has been undermined by flops like True Memoirs of an International Assassin, which earned a rare 0% audience rating on the website Rotten Tomatoes.

For social media owners whose businesses rely heavily on network effects, it's worth worrying about what happens if the flywheel starts spinning in the opposite direction. So Meta lost 1 million users in the fourth quarter of 2021. Fortunately, this loss did not turn into a stampede and the company has since managed to increase the number of users again. But next time you may not be so lucky.

The second problem is low barriers to entry. This is a blessing that can easily turn into a disaster. Advances in technology, from smartphones to cloud services, have allowed startups of all kinds to quickly and cheaply create software for their applications. But it also means a rapid emergence of copycats who thus have relatively low costs and can offer generous discounts in pursuit of expanding their consumer base.

While Uber faces only one real ride-hailing competitor in its domestic U.S. market: Lyft, its global expansion has almost immediately encountered local rivals such as Yandex in Russia, Didi in China, or Grab and Gojek in Southeast Asia. It turns out that the combination of relatively simple products and free access for users makes it possible for a new startup to achieve success simply through a marketing twist: just enough to lure teenagers away from TikTok.

The barriers to entry for the streaming business are higher—Netflix and Spotify spend a lot of money creating or licensing content. But these barriers are not insurmountable, especially for rivals with larger budgets. To counter the challenge from Disney, which spends a total of $30 billion a year on content, Netflix has to spend about $17 billion a year. Advertising and content creation costs eat up most of the profits. Disney's streaming services lost $1.1 billion in the second quarter of this year, and the company said its Disney+ platform will remain unprofitable until 2024. High costs explain why Netflix's free cash flow is only 6% of revenue.

The third drawback common to all three business models is their dependence on distribution platforms that do not belong to them. Uber and DoorDash pay hefty sums to advertise in Alphabet's iPhone and Android app stores. Spotify pays a commission of 15% on subscriptions purchased through an iPhone - a fee so ruinous that the company filed a complaint against Apple over it. Netflix avoids paying fees to distribution platforms by forcing users to sign up for its services through a web browser, passing the frustration on to the customer and potentially losing some subscriptions in the process.

Social network owners suffer the most from the lack of their own distribution platforms. Their dependence on the iPhone-Android duopoly poses an existential threat. Apple's new requirement that users give iPhone apps permission to track their activity across other apps and websites - a move that Alphabet later replicated - could cost Meta an estimated $10 billion in lost revenue this year. Parler, a social network popular with the far right for its liberal stance on speech norms, was temporarily blocked by both Apple and Android. If US national security hawks concerned about Chinese ownership of TikTok get their way and force Apple and Alphabet to remove it from their app stores, the rising social media star could face a similar blow.

Different business models do not face the same set of challenges. Companies providing transportation services would be in a much better position if their segment had significant barriers to entry. Streaming platforms might be able to push aside new entrants if their network effects were stronger. And social networks would feel great if Apple and Alphabet did not encroach on their profits. If one of the listed problems is present, the business already faces a difficult situation. And all three together mean a disaster just waiting to happen.

Prepared from materials The Econimist