The difference between a good product and a good business

Last month, Instagram co-founders Kevin Systrom and Mike Krieger caused a stir in the tech community when they walked away from the app they created due to tensions with parent company Facebook and CEO Mark Zuckerberg. According to various tech publications, the co-founders had become annoyed at the increased meddling by Facebook executives with Instagram’s operations, which until recently had enjoyed a high degree of autonomy. In a clash between entrepreneurial product vision and commercial reality, commercial reality won out and left the visionaries in search of greener pastures.

Reactions to Systrom and Krieger’s departure largely laid the blame on Mark Zuckerberg’s shoulders, for pushing Instagram to “Facebookify” itself and do more for the core Facebook platform. But this kind of denigration entirely misses the point. Systrom and Krieger’s departure was never about the clash between tech visionaries and greedy corporate managers – it was about Instagram the product versus Instagram the business.

It is important for investors to be able to distinguish between a good product and a good business, as pedantic or arbitrary as that may seem. There is no doubt that Instagram is a great product – it has accumulated over 1 billion users globally since its launch just 8 years ago and is arguably the best $1 billion that Facebook has ever spent for its role in suffocating Snapchat’s growth and keeping these billion users firmly within the Facebook ecosystem. But does that make Instagram a good business?

For one, we can safely speculate that at least part of the friction between Facebook management and the Instagram co-founders was around monetisation, or the transition from a good product to a viable business. With user and revenue growth at Facebook’s core properties slowing, it is likely that Facebook’s management began demanding that Instagram “pull its weight”, so to speak, and take the app in a direction that perhaps conflicted with Systrom’s own vision of what Instagram should be. The fact that Instagram has almost half of Facebook’s Monthly Active User count but only generates around 20% of the revenue (depending on which estimate it used) suggests that the Instagram product is inherently less monetizable than the Facebook product.

Facebook admitted as much on its Q2 earnings call, when COO Sheryl Sandberg said that Instagram Stories monetisation was lagging behind the Facebook news feed, and management didn’t know when that gap would be bridged. This is with the benefit of leveraging Facebook’s enormous advertising back-end and existing relationships with advertisers, after having blatantly copied Snapchat’s best and most-monetisable feature (Stories).

Had Instagram remained a standalone company tasked with building out its own viable advertising business from scratch, it is uncertain whether the company could have avoided a similar fate to Snap regardless of how good its product was. Zuckerberg, who is responsible for running the entire Facebook Inc. business, hailed Systrom and Krieger as “extraordinary product leaders”, but nothing more.

The other reason investors need to understand this distinction between product and business is that even founders and CEOs sometimes fail to do so. One example of this would be Snap’s co-founder and CEO Evan Spiegel, who around the time of Systrom and Krieger’s departure from Instagram, penned his own 6,500-word memo in which he candidly lays out Snap’s missteps of the past and aspirations of the future.

Spiegel opens by saying “2018 was the year that Snap evolved from a product into a company”, effectively conceding the point that Snap IPO’d as a popular product rather than a viable business. Central to the future of Snap is becoming “the fastest way to communicate”, the company’s No. 1 OKR for 2019 and a phrase (motto, even) that appeared 25 times in the memo. This statement, which comes after a very challenging year for the company, betrays the fact that Spiegel still conflates Snapchat the product with Snap the business.

Snapchat began life as a messaging app – a disappearingmessages app at that – which allowed users (mainly teens) to communicate privately without worrying about a permanent paper trail. This point of differentiation drove Snapchat’s popularity as a product, but actually hamstrung Snap’s ability to generate advertising revenue. To borrow the phone/phonebook analogy often applied to Facebook, Messenger and WhatsApp (the “phone”) may have hundreds of millions of users, but it is the News Feed (the permanent “phonebook” that aggregates all your friends’ activity) that is ultimately the monetisation platform. Snapchat the product trying to be the fastest phone will not magically make Snap the business more profitable. Stagnant user growth may reaccelerate which could support the share price in the short term, but the inherent challenge of monetising personal communication remains.

Instagram and Snap are just two of many examples in both the public and private markets where a good product does not necessarily make a good business. Investors must be careful to not let their own (or management’s) enthusiasm for a product cloud their assessment of the quality of the underlying business. A great product can fool the market in the short term, but over the long term it is cash flow and returns that ultimately determine whether a business is successful.

Montaka owns shares in Facebook (Nasdaq: FB)

DH5_2155Daniel Wu is a Research Analyst with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.

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Our Montaka Active Extension strategy strives for maximised return over the long-term. Owning the Montaka long portfolio typically scaled up to approximately 130 percent - and the Montaka short portfolio typically scaled down to approximately 30 percent – this strategy results in a net market exposure of approximately 100 percent most of the time.

Our Montaka variable net strategy strives for significant downside protection – but with minimal upside reduction. Focused on owning the world’s great and growing businesses when they are undervalued, while managing a portfolio of short positions in businesses that are deteriorating, misperceived, and overvalued, this strategy is our flagship long-short

Our Montgomery Global strategy strives to act as a core, high conviction, global portfolio holding. Consistent with the long portfolios in our Montaka strategies, this offering is focused on owning the world’s high quality, undervalued businesses – and cash when appropriate – to outperform its benchmark. Branded as “Montgomery Global” in Australia to reflect a key.

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Our Montaka Active Extension strategy strives for maximised return over the long-term. Owning the Montaka long portfolio typically scaled up to approximately 130 percent - and the Montaka short portfolio typically scaled down to approximately 30 percent – this strategy results in a net market exposure of approximately 100 percent most of the time.

Our Montaka variable net strategy strives for significant downside protection – but with minimal upside reduction. Focused on owning the world’s great and growing businesses when they are undervalued, while managing a portfolio of short positions in businesses that are deteriorating, misperceived, and overvalued, this strategy is our flagship long-short

Our Montgomery Global strategy strives to act as a core, high conviction, global portfolio holding. Consistent with the long portfolios in our Montaka strategies, this offering is focused on owning the world’s high quality, undervalued businesses – and cash when appropriate – to outperform its benchmark. Branded as “Montgomery Global” in Australia to reflect a key.