DIGITAL MOATS (August 2007)

Internet companies investing in their competitive positions can afford to

ignore short-term profitability
Eight years ago, when it looked as though the future belonged to Internet companies, it was
possible to double your money in a matter of months by investing in any company with
dotcom attached to its name. At the time, we were unable to justify the valuations of any of
these companies, nor identify any which we could safely say would still be going strong in
years to come. Consequently, Marathons global portfolios avoided any exposure to
Internet companies at that time. Yet some of the best recent performers in our global
portfolios are companies which execute all of their business online. Two of them are even
former highflyers from the dotcom bubble, Amazon.com and Priceline.com. Given that
these firms have little in the way of current profitability, why do we own them?

For a start, each of these companies are building sustainable competitive advantages. Their
strategy is to use the low cost and scalability of Internet technology to provide savings for
their customers. They recognize the importance of securing a dominant position in their
respective markets by operating their businesses with low margins, in the short-term, so as
to maximize their earnings potential in the long-term.

Amazon.com is the best known and most established of the businesses, having expanded
well beyond its origins as an online discount book retailer. A lot of scepticism surrounds the
stock, partly because of its high profile at the time of the Internet bubble, and more recently
because of the volatile progression of the companys margins. The variation in the margin
stems from Amazons desire to continue to expand its offer, and the fact that a number of
the new services including Amazon Web Services, which provides computing services for
clients, and Fulfilment by Amazon, which enables other retailers to use Amazons expertise
in processing inventory and orders have required large upfront investments and will take
some time to develop into profitable businesses. This investment, most of which is written
off as an expense in the accounts, has made margins rather volatile over recent years.

While Wall Street fretted about the collapse in margins, without thinking of the longer-term
benefits of the investment, the stock declined from $60 to $40. Now there are signs that
Amazons margins are recovering, while sales are growing at 35 per cent year-on-year. The
stock has almost doubled since the start of 2007. Amazon gives frustratingly little long-term
guidance about the potential profitability of its new initiatives, but hints at an ambition for
margins in the high single digits once these businesses have reached maturity. The
companys track record gives us confidence that they can achieve this, and at the current
valuation of 2.3 times current sales, the shares are far from overvalued.1

Priceline.com shares took one of the biggest tumbles when the Internet bubble burst, falling
from a peak of $974 to a low of $7. The company had been operating an undifferentiated
name your own price model, until the acquisition of Booking.com in 2005 shifted the
corporate strategy towards developing its European agency hotels business. Some 32,000
hotels have signed up so far; with over 100,000 hotels to target, along with increasing

1
The positions in Amazon.com and Priceline were eventually sold in February and September 2013, having risen respectively by
231 per cent and 1,055 per cent since the date of this piece. Amazons stock has continued to perform strongly, up 18 per cent
from the date of sale to the end of 2014, yet the company still shows nothing in the way of profit (its net margin in 2014 was -
0.3 per cent.)
Internet use by Europeans, Booking.com is well placed to capture a much larger share of
hotel bookings in Europe. Operating the platform requires minimal cost and the company is
already generating good cash flow which is being used to repurchase stock. It may be that
the management of Priceline.com stumbled on this European opportunity by chance, but
they have been smart enough to recognize the potential to create a business which could be
generating enough cash in three to five years time to make the valuation of the company
look far too conservative.

The basic corporate model of low margins in order to maximize long-term absolute profit is a
well-trodden path, with Wal-Mart the most notable exponent. It is not surprising that some
companies will have the good sense to apply this old model to the new medium of the
Internet. This strategy dramatically reduces business risks (via reduced competition) whilst
simultaneously raising long-term rewards (via likely growth). Internet technology will help
these firms secure competitive advantage and investors should benefit in the long run.