Flywheels vs. Hamster Wheels

 | Jun 30, 2014 | 2:32 PM EDT  | Comments
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tsla

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pcln

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goog

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aapl

Recently, David Sacks, who was the first chief operating officer of PayPal and more recently the founder of Yammer, which sold to Microsoft for over $1 billion, tweeted that he prefers businesses that are flywheels and not hamster wheels. 

What he meant is that as an angel investor or stock market investor, you want to find businesses that become more powerful over time.

As these businesses grow, more people know about them and buy from them. Therefore, they can spend less in the future to get the same or more business. And ideally, as these companies get more users or customers, their service improves or the price drops, and that further attracts more users or customers. Those are flywheels, otherwise known as businesses where the rich get richer.

Hamster-wheel businesses are the ones which have to put in the same amount of effort (or maybe more effort) to attract the next incremental dollar of sales. They don't get stronger over time. Their margins don't improve. They get more sales, but they're spending more to get those sales.

One way to measure a company's efficiency is to look at its sales and marketing expenses as a percentage of sales. A flywheel business should see these expenses drop as a percentage of sales. A hamster-wheel business should see the percentage stay the same or even increase over time.

It's not a perfect measure, and it should be used only in combination with others. However, it's interesting to look at various companies on this measure over time.

At the moment, SolarCity (SCTY) has a pretty high percentage of sales expenses as a percentage of its revenue. It was at 70% in 2011. It dropped down to 55% in 2012 but then increased to 60% by 2013. Perhaps this is partly why SolarCity has a very high short float at the moment.

But another Elon Musk company, Tesla Motors (TSLA), also had a pretty high sales and marketing expense as a percentage of revenue. Back in 2010, it clocked in for Tesla at 73%. Recall that this was when the company started to build out its stores internationally. But this percentage dropped to 51% in 2011, 36% in 2012 and 14% last year. What happened? More Model S sales and the increased store presence, which started as an investment in 2010, paid off.

On the other hand, current market darling Priceline (PCLN), which has been seeing a steady climb in its stock price over the past few years, has also seen an increase in its sales and marketing expense as a percentage of overall sales. Back in 2009, Priceline's percentage was 20%. That percentage has risen consecutively every year since, and it was 37% last year.

Google (GOOG) has also seen its sales and marketing expense as a percentage of sales increase over time, from 8.3% in 2009 to 13.1% in 2013. Yet its percentage spend is about a third of Priceline's, showing the inherent strength of Google's search business. Also, its recent climb in the last few years is in part due to the Motorola acquisition. In its most recent quarter, when Motorola was removed, it started to tick back down to 11%.

Apple (AAPL), whose stock has been unloved in the last couple of years, has seen its sales and marketing expense as a percentage of sales steadily drop even below Google's. It started at 10% in 2009 and was 6.3% last year. Clearly, Apple's iOS ecosystem continues to accrue large benefits to its business.

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