Southwest Airlines (NYSE: LUV) has a bunch of infrastructure. It has airplanes, and contracts with airports, and a staff, and an advertising budget, and everything. But, it's not a company where inventory really matters. Sure it has some stockpiles of fuel, and spare parts for the planes, and of course peanuts. (Unless it contracts all that out to maintenance organizations that keep its inventory.) But, what it's really selling is service capacity.

Southwest is a service company. It flies planes full of empty seats from point A to point B, and charges people money for the opportunity to sit in those seats during a flight. It advertises to let people know when those seats will be available, where they fly to, how much it costs to get there, and of course to build brand awareness so people pay to sit in Southwest seats instead of Delta Air Lines (NYSE: DAL), or Northwest Airlines (Nasdaq: NWAC), or somebody else.

The job of a service company like Southwest or Delta is to sell all of its capacity every month. This turns out to be really tricky, because it's selling to people who have a nasty habit of behaving unpredictably. If, on average, 10% of the people who buy tickets don't show up for the actual flight, then Southwest isn't selling its full capacity unless it sells 10% more tickets than it has seats. But, sometimes everybody DOES show up for the flight and, if there are more tickets than seats, somebody has to be bumped. (At which point the airline usually first asks for volunteers, and gives them a free bonus ticket on a future ride to make up for the inconvenience.) Sometimes there aren't enough customers for every seat, in which case more advertising or perhaps a rearrangement of the flight schedule is in order.

A more elegant solution is to offer the extra 10% (or more) as "standby" tickets. Customers don't pay for them unless they get them, but they don't know until the last minute (standing at the airport, with their luggage) whether they'll make it on the plane. These tickets are worth far less than normal tickets due to the inconvenience. But hey: to the airline it's free money for an otherwise wasted seat, and a manageable way to sell unpredictable extra capacity without violating customers' expectations of receiving the service they bought.

As you can see, selling all the service capacity isn't always an exact science. More often, it's an exercise in statistical optimization. Companies that sell capacity to other businesses prefer predictable, long-term contracts that allow them to predict future earnings and demand for their services -- from the airline maintenance company mentioned above, to a pest control service, day care center, or shopping mall full of store spaces. (Mall management sells the spaces. Making enough money off of random passing customers to pay the rent is the individual stores' problem.)

Selling to individual customers is almost never predictable. A movie theater shows a movie to row after row of empty seats. Sometimes NOBODY shows up, sometimes they're sold out, and it can vary from theater to theater, from night to night, even showing the same movie. An Internet service provider sells bandwidth, but how much bandwidth a customer uses is an open question.

Phone companies are an interesting case. One of the taped lectures I bought at February's Linux World Expo includes a speaker who used to work for telephone companies, who claims that with the new fiber-optic technology now in use, the cost of placing a call from one phone to another is dwarfed by the cost of tracking calls so that they can be billed by the minute. That is, if phone companies went to flat-rate international long distance (all calls in the U.S. treated like local calls), their costs would go down substantially (and they could pass that savings on to the customer, or beef up their profit margins).

Phone companies insist on seeing long distance as a product (minutes) rather than as a service. Yet, what they're really selling is fiber-optic data transmission capacity (bandwidth), plus a little electricity to run your phone. The way I'm charged for my cell phone makes a lot more sense. I pay a flat rate for a thousand minutes a month and free domestic long distance. The company knows how much money it's getting, and places an upper limit on my bandwidth usage (rather than trusting statistical norms to average out over a wide enough population). I've found this convenient enough that I haven't bothered to get a land line since the last time I moved. It's cheaper to use my cell phone for everything.

So, I have no trouble with adding another $500 to Yahoo! (Nasdaq: YHOO). It's a service company that knows it's a service company, selling computer server and bandwidth capacity. It started by attaching advertising to page views as a search engine, and expanded with more types of page views like stock quotes, telephone number listings, and driving directions.

It has diversified its revenue stream by acting as a broker (or auctioneer) between buyers and sellers in their auctions, which is still server capacity but paid for in a different way. They provide websites and e-commerce infrastructure to businesses that sell products, with a business model closer to the shopping mall management that charges for physical square footage.

Since increasing server capacity and bandwidth is trivial, Yahoo! can grow at an amazing clip with very little investment, limited more by hiring people than installing new infrastructure. Yahoo!'s task going forward is to find more ways to get customers to pay for the service it can provide. Its growth is limited only by how creative it can get.

I like that business model.

-- Oak

Related Link:
Evolution at Yahoo!, Rule Maker Portfolio, 7/6/00

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