I have an inherent distrust of dot-coms. I just don't trust that their competitive advantages are durable. Cases like Google (NASDAQ:GOOG) and Amazon.com (NASDAQ:AMZN) clearly prove that they can be, but still, my suspicion lingers. (Perhaps I need therapy.)

My doubts flared anew when I  recently looked at LoopNet (NASDAQ:LOOP), a stock worth just 25% of its 2007 high. Is LoopNet's competitive advantage fleeting or durable? Is it at risk? Let's look under the hood.

Showcasing the competition
LoopNet operates the largest online commercial real estate listing service. Essentially, it functions as a market, providing the information for commercial real estate buyers to connect with sellers, and vice versa.

And it is a huge player in this market. In fact, just the pure size of LoopNet has been incredibly daunting for competitors.

That is, until recently. Last year, CoStar Group (NASDAQ:CSGP), sometimes referred to as the Bloomberg of commercial real estate, announced the christening of its own online marketplace, Showcase.

CoStar seems to be pursuing LoopNet's turf, with its brand and client base behind it -- an unwelcome development for LoopNet investors, to say the least. As of last September, CoStar had a subscriber base of 92,000, compared to LoopNet's premium subscriber base of 83,808. If anyone can challenge LoopNet's pure scale, it appears to be CoStar.

CoStar's Showcase launch in May seemed to go well. By June, CoStar got more than $2 million in subscription orders from over 300 firms, but since the company has released only one quarter's worth of results, it's too early to say if Showcase will truly gain traction. 

Nonetheless, there are plenty of valid reasons to believe it will. In looking at LoopNet's and CoStar's offerings:

  • LoopNet charges for full search capability, but CoStar allows its listings to be viewed without even registering. CoStar only charges for listing.
  • A subscription with Showcase allows an unlimited number of listings. Meanwhile, LoopNet charges tiered pricing for additional listings.
  • CoStar's larger subscriber base will likely all use Showcase.

CoStar is giving away some of the services for which LoopNet charges. CoStar appears to be competing mostly on price, while leveraging its large and growing client base and brand. It's clearly taking square aim at LoopNet.

Size matters
As new and significant competition enters the space, LoopNet's past competitive advantages -- size and network effects -- have weakened, thanks to a combination of market forces and management missteps.

One of the key components of LoopNet's durable competitive advantage has always been that it benefits from positive network effects. In other words, as more people use LoopNet's marketplace, its value increases to others, causing more people to join -- and this process continues in an ever-increasing virtuous cycle. Network effects can be powerful, as businesses like MasterCard (NYSE:MA), eBay (NASDAQ:EBAY), and Liquidity Services (NASDAQ:LQDT) have discovered.

Since the first quarter of 2007, LoopNet has raised its average monthly premium membership price from $49.75 to $64.51 in the most recent quarter, and management expects that average price to continue to rise. Increasing these prices was a serious strategic mistake, made more with an eye toward boosting profits than maintaining the company's long-term competitive advantage.

If LoopNet had kept prices stable, the value proposition of membership would have increased naturally through network effects, making membership more and more irresistible. Memberships would have burgeoned, the marketplace's size would have become dauntingly large, and once LoopNet was in a position of unassailable dominance, it would have been free to set its own terms.

Instead, LoopNet undermined the natural workings of network effects by increasing prices, thereby artificially limiting the size of its marketplace. The result: Its main competitor now has more customers.

Network effects … in reverse
Those price hikes are now coming back to haunt LoopNet. As of Sept. 30, premium subscribers had declined 7% year over year. Even back in the fourth quarter of 2007, when premium memberships first began to decline, management recognized that price hikes were actively driving customers away.

Unfortunately, that means the network effect has started working in reverse. As people defect from a marketplace, the value of that marketplace decreases to everyone else, leading to an ever-increasing defection of subscribers. LoopNet's subscriber numbers show that subscriber declines are accelerating, from 0.1% in the first quarter of 2008, to 1.8% in the second, and finally to 3.4% in the third. The death of LoopNet's positive network effect is now eating away at its former size advantage.

You opened the door
The combined effects of CoStar dramatically undercutting LoopNet on price, and the ever-declining value proposition of LoopNet because of reverse network effects, increases the likelihood that LoopNet subscribers will defect to alternate services, particularly Showcase. By raising prices, LoopNet opened the door to competition, and now its competitive edge is more at risk than ever. 

In the short term, possible Showcase cannibalization, coupled with an almost assured continuing deterioration in the number LoopNet's premium subscribers, would provide a disastrous double-whammy for LoopNet, whose margins are already quickly deteriorating:

Margins

12/07

3/08

6/08

9/08

Operating

40.4%

35.4%

32.7%

32.5%

Net

29.1%

23.6%

20.6%

21.5%

Source: Capital IQ, a division of Standard and Poor's.

As for the company's long-term prospects, investors should question whether LoopNet's management is really up to the task of building the company's competitive advantage in the face of determined competition. So far, it seems to have undermined its competitive advantages simply to shore up short-term results, which is a recipe for disappointment in the long run.

More on LoopNet:

Devon Rackle does not own shares of any of the companies listed in this article. LoopNet is both a Motley Fool Hidden Gems pick and a Motley Fool Rule Breakers pick. eBay and Amazon are Motley Fool Stock Advisor selections. Google is a Rule Breakers pick. Try any of our Foolish newsletters, free for 30 days. The Fool has a disclosure policy.