This article originally appeared at Russia Direct
Yandex, the flagship company of Russian innovation, as well as the country’s most valuable Internet company, has recently attracted a lot of media attention by appealing for the first time for a market intervention by the Russian government. Yandex has filed a claim against the international heavyweight Google stating that the latter abuses its capabilities as a provider of the popular mobile operating system, Android, to promote its online services.
The situation is largely reminiscent of the battles waged back in the 1990s by the independent providers of Internet browsers (Netscape) and word processing software (WordPerfect) against the actions of Microsoft, which was using the omnipresence of its Windows operating system to promote Internet Explorer and MS Word.
Some observers have endorsed Yandex’s appeal for help to the Russian government as the only possible strategic move, given the current difficult economic situation. But is this true – that no other route is left for the company’s development, other than a fierce shootout with its international archrival?
Investors’ expectations are hard to sustain
Let’s review the issue with the help of the recently released Yandex financial results for the fourth quarter and full year 2014. According to the reports, the general outlook for the company is quite positive. Revenue and net income are up 29 percent and 26 percent, respectively, compared to 2013. This is a slowdown compared to the annual growth rates of revenue (37 percent) and net income (64 percent) in 2013, but it still represents over-performance in the Russian market for online advertising, which grew by 20 percent in 2014.
The problem for the company is that it is judged by the investment community, not against the performance of the Russian market, but against the international benchmarks. What investors were seeking in previous years – and receiving in full – was growth in high double digits. If the company does not manage to sustain this, it is likely to receive strong pressure from its shareholders – or to start quickly losing market capitalization.
But what can Yandex promise to investors in 2015, when its core segment of the text-based search-related advertisements in Russia is expected to grow at maximum by 10 percent in ruble terms, which means a significant drop in dollars in view of the recent devaluation?
Even holding its leadership position in Russia in search-related ads (two-thirds of the market) becomes increasingly expensive for Yandex. The financial report indicates that the “traffic acquisition costs” have increased by 41 percent, strongly outpacing the growth of revenue. In short, to get advertising money, Yandex needs to attract an audience, and the associated expenses are growing quicker than revenues.
With the current net income margin of 33.5 percent, these costs are not yet a major threat, yet combined with other factors, the trend may turn out to be a disturbing one. The company is losing its market position in “display ads” (i.e. the types of graphic banners that are usually bought by bigger advertisers for the goal of promoting the brand image). Those grew by just 4 percent, indicating that Yandex was not effective enough in pitching to the major brands and their advertising agencies. In contrast, Google was gaining ground here, offering on its YouTube site the new and highly popular format of online video ads – much favored by brand marketers that are not seeking immediate “clicks” by their customers.
Innovating faster than Google is becoming more expensive
Simply boosting product research and development (RD) efforts may present a strategic challenge for Yandex. To stay competitive against Google in the core market of search-related advertising, the company employs more and more sophisticated techniques of data processing on two ends – generating the personalized search results for the users and developing the algorithms that link those results to the ads placed by the clients so that more users will click on the ads.
This RD activity is seen as essential to defend the company’s market share, but like any defense, it tends to become increasingly costly while bringing diminishing marginal returns. The current economic situation, however, offers one bright spot: the product development process is highly labor intensive and the economic recession will therefore put a check on the growth of salaries.
On the other hand, technological development demands ever-increasing computational power – which is in the end imported (even the Russian-made servers and network equipment are built on foreign processor and memory chips) and, thus, prone to the ruble devaluation and the stated currency risks that affect Yandex severely.
After all, the company depends enough on the constant imports of hardware for its operations and these become materially more expensive when the ruble loses its purchasing power. In the fourth quarter, the company posted a foreign exchange loss of 4 billion rubles – over half of the quarter’s income. In 2015 the negative impact could be even more material.
Another risk comes if the company’s major RD projects are currently in midstream. Monetization will happen only later and only if the cash will be continuously pumped into these RD efforts. The development of highly sophisticated technologies is notorious for the ability of being behind the schedules, but time is of the essence now.
Diversification remains a pressing issue
The company was well aware of the challenges of its core market some time ago and took substantial measures for diversification. Even before the current economic turbulence came, its David vs. Goliath battle with Google was struggling to find new revenue streams. As the report of 2014 shows, the company has boosted its efforts in this direction with product development expenditures up 52 percent (from under 15 percent to over 17 percent of the total costs), and the non-advertising revenues growing by 138 percent!
However impressive the figures are in relative terms, advertising still accounts for almost 99 percent of the company’s revenues. This means that a breakthrough is needed in the alternative approaches to monetization. This is always easier said than done and the challenge is hugely increased by the economic context: the stated breakthrough should be achieved in a relatively quick and cheap way.
Yandex should seek out the “low hanging fruits” in diversification
What could be the company’s strategy be in the middle of an economic storm? On the one hand, any management textbook will say that, in these circumstances, a focus of efforts and resources is the key word. On the other hand, Yandex does really need diversification for sustainable revenue growth, without which it may fall out of favor with international investors.
The only chance to solve the dilemma is to understand the company’s core assets and see if some alternative monetization can be built for them in a relatively quick and cheap way.
A year ago it was all about world-class data capabilities. Those opportunities remain, but the attempts to promptly find an alternative monetization for them were somewhat below expectations. Despite the remarkable growth of non-advertising activities, they constitute just about 1.2 percent of revenues. Will they be able to turn into a material stream within a year or two? This is highly doubtful. It becomes increasingly costly to the company.
What else if not the data? What about the client base? The company has access to small and medium business in Russia that is second to none. Well, 1C, the leading accounting software, probably sells licenses to more clients, but in their case, the actual client relations are held by the reselling partners, while Yandex holds the direct line to its customers. How can this be monetized? A range of ideas spring to mind, from loans to cloud accounting to online business education.
All of those are not within Yandex’s current domain of competencies, yet they are relatively cheap in implementation compared to the less cost-effective initiatives that the company is engaged in right now. There may be stronger potential in more down-to-earth offers to the existing customer base, rather than in continuing the highly theoretical improvement of data processing, the impact of which on customer-perceived performance start to be less visible.
It is extremely important for the Russian innovation ecosystem that Yandex survives the current storm as a strong, independent and innovative player, the flagship of the industry. The company stands for the successful commercialization of Russia’s talent pool and the strong faith of international investors in the country’s digital industry.
Yandex is also at the core of the unique school of data science that has enough potential to achieve global leadership for the coming decades. Yandex can do it, though it will require certain rethinking of core business concepts in order to turn its current service offerings based around generic advertising into a multi-functional business platform for Russia’s small and medium businesses.
Regarding the Android dispute between Google and Yandex, the sad part of the history is that the similar legal battles did not work for smaller sides of the disputes in the past. Despite certain regulatory setbacks for Microsoft neither Netscape nor WordPerfect are on the market now. Though Russia may be somewhat different it is still too risky for Yandex to count on legal protection as a strategic measure. Building a stronger grip on its customer base seems to be a surer route through the economic storms to the bright future which the company truly deserves.