The network effect is present where a service becomes more valuable as a result of attracting more users, and it often results in the company with the largest network dominating the market for as long as it maintains the network.
Perhaps the most successful Australian company that fits this description is jobs website Seek (ASX: SEK). However, nothing is guaranteed and network effects can unravel very quickly if the service is superceded.
Seek runs jobs websites, as well as selling internet-based educational services in conjunction with tertiary institutions. The company owns or partially owns websites in Africa, Southeast Asia, China, Brazil, Mexico, New Zealand and Australia. Its various brands are the key to its business, because although the actual platform could be replicated by a competitor, the brand awareness is what keeps job seekers visiting the various sites, and in turn this makes the websites more useful to employers.
Seek has grown by acquisition in recent years. The pattern is for Seek to buy a part of an emerging jobs website in an emerging market, and then increase its holding if and when there is an opportunity to do so. It has recently increased its holding of companies operating in China and Southeast Asia. As a result of fairly aggressive international expansion, Seek has about $300 million in debt.
As Seek has transitioned from an organically growing domestically focused company to an acquisitive company with websites around the world, the return on investment that the company achieves from capital expenditure has decreased. However, the company is still able to benefit from organic growth, as it has focussed its acquisitions in growing markets with lower levels of internet use than in Australia.
Whereas Seek has pursued international expansion rather aggressively, accommodation website Wotif (ASX: WTF) has taken a slightly different approach. Wotif has made some (not particularly successful) acquisitions. However, its focus is to expand the number of hotels available through its main website, and it is currently adding hotels from around the world to its Australian website.
It has also expanded its Wotif brand to include flight bookings and has developed, in house, a reasonably successful iPhone application that can be used to easily book a room on the go. However, mobile phones account for only 9% of bookings at this stage.
Wotif has recently begun increasing the commission it charges hotels, and this is a true test of whether the website has pricing power. The website is undoubtedly an important source of revenue for some hotels, but if it were to lose accommodation providers in sufficient numbers, we could witness the unravelling of the network effect.
If prices on the website start to noticeably exceed prices offered by the hotels on their private sites, Wotif could increasingly be used for selection, but not for booking, thereby cutting the company out of the transactions all together.
It has also been noted by some that Wotif has $150 million in cash, and very little debt (unlike Seek). While this is true, it misses an important point, because Wotif had about $170 million of payables on its balance sheet at December 2012. This is because Wotif takes cash from the website users, and then pays the hotel once it has provided the room. Wotif does not have a debt burden to worry about, but its balance sheet is not as strong as the cash figure would suggest.
Foolish takeaway
Seek and Wotif have superficially similar businesses, but the companies are following different strategies. Wotif is more focussed on maintaining the profitability of its core website and at $4.90 pays a dividend of about 5.1% fully franked.
In contrast, Seek is expanding into new services and new markets and has much stronger growth prospects as a result. At $9.25 it yields about 2%, also fully franked. Both companies deserve a spot on your watchlist.
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Motley Fool contributor Claude Walker does not own shares in any of the companies mentioned in this article. Find him on Twitter @claudedwalker.
