Tencent vs Alibaba on the Quest to Go Global

Finally catching up on some reading: Bloomberg published an excellent profile on Tencent and the co’s strategist, Martin Lau. I highly recommend the article as it not only goes through the history of the company, but reveals the type of thinking and mentality that has helped Tencent become one of the most successful companies in the world.

For the uninitiated, Tencent is one of the “BAT” trinity (Baidu, Alibaba, Tencent) that dominate the Chinese tech space. The Chinese are increasingly living their lives in a “digital-first” manner, and as a result, BAT’s influence extends across nearly all aspects of Chinese life in a way that Google, Facebook, Amazon, Apple can only wish (and try to replicate with limited success thus far). All three players operate across nearly all verticals including social, video/entertainment, e-commerce, search, browsers, app stores, delivery, cloud services, payments, finance, and many more. They have gone beyond being just software/service companies to essentially digital lifestyle companies.

Despite the BAT moniker, investors view the strengths of each company quite differently.

Generally, Baidu (the company with search as its core strength) is viewed as the weakest. Unlike Google’s dominance in the US, Baidu has struggled to find its place in China’s highly digitized mobile world were users largely spend their time in Tencent or Alibaba’s walled gardens. Whereas Google has been able to run its search crawlers through the open internet and through the Android platform (majority global share), Baidu does not have the luxury of a dominant mobile platform nor access to the increasingly large amounts of data that is generated outside of the browser.

Of the remaining two, Alibaba and Tencent are generally neck-and-neck. Alibaba absolutely dominates in e-commerce and payments/finance while Tencent owns the incredibly sticky WeChat messaging super-app with a fast growing payments solution. Nonetheless, investors overwhelmingly consider Tencent to be a much stronger business with a 1yr forward P/E of 45x to Alibaba’s 34x despite similar growth rates according to consensus estimates. The difference in perception largely comes down to the fact that investors consider WeChat to be mostly un-disruptable while Alibaba is currently contending with a sizable #2 player in JD.

However, I believe that perception is misplaced especially when we consider Tencent’s and Alibaba’s prospects for going global.

The Bloomberg article mentioned above highlights the challenges that Tencent faces in trying to export its WeChat model abroad:

Then there’s the matter of Facebook Inc. and WhatsApp, which have a huge market advantage pretty much everywhere outside China. Going overseas, Lau says, “is essentially the challenge of every Chinese company. We tried to make WeChat international. The reality was that there were other products in the market already.”

Tencent faces a much more formidable competitor in Facebook as they try to expand abroad, while the global e-commerce landscape is much more benign for Alibaba. E-commerce is much more fragmented on a global scale, and Amazon is nowhere near as dominant on a global scale as Facebook is for social networking.

The valuation gap between the two companies only make sense in a China-specific context. In a global context, why should that gap exist?

Disclosure: I have no direct beneficial interest in Tencent (700 HK) or Alibaba (BABA) as of publishing date and have no intent to initiate a position within the next 48 hours. 

Temptations to Go Beyond Our Circle of Competence

Summer’s full swing has kept me away from this blog, but luckily it gave me some time to think more deeply about a number of ideas and topics.

One of those is: What tempts us to go beyond our circle of competence?

Buffett constantly warns investors against going outside their circle of competence since doing so would mean treading into industries/areas where one would not have an edge. Yet, despite this constant exhortation and strong evidence that sticking to one’s own domain of expertise is a very good strategy, very few seem to follow that sage advice (including myself on a number of occasions in the past – I certainly hope I won’t ever experience another JCP).

Although I am speaking from an investing context, this advice is clearly useful as a general life strategy. I often chuckle when the average Joe wants to teach their doctor about how to deal with certain ailments…

So I gave this question a good think while on a walk.

And then I realized that it’s not so much that we, humans, are terrible at remembering good advice. It’s that the cards are stacked against us.

The investing market has become far more crowded in recent years, and there are far too many bright people chasing similar ideas. In order to truly make a lot money, two things need to happen: 1) You are right about something that nearly everyone thinks is wrong (contrarian), or 2) You are right about something before anyone has even heard about it. And unfortunately, both of these things naturally push us outside of our circle of competence.

Let’s consider the first case where we find ourselves amongst a small minority view. If the opposition is equally smart (and good looking) and working purely within their circle of competence, it is highly unlikely that we, as a minority, would have the right view and also be within our circle of competence. It is highly unlikely in such a situation that both longs and shorts are within their own circle of competence but then come to different conclusions from the facts at hand. These are battleground stocks (like Ackman short Herbalife vs Icahn long Herbalife) and best avoided…clearly one of them is outside their circle of competence. Where the investor base is generally “smart”, the consensus probably holds the right view, and as a result the opportunity for alpha is low.

Let’s consider the second case where we find a brilliant new opportunity (a fine gem!) before anyone else has heard about it. These situations usually only come about from two pools of stocks: 1) Small caps, and 2) New companies. Assuming we put in the effort to sift through the long tail of small caps and new companies, we should be able to generate alpha. But here we also find that the world constantly conspires against us to push us outside of our circle of competence! These companies are often in new industries or with untested business models. Though we may deem ourselves to be within our circle of competence, the potential for misjudgment is higher.

In some prior time, investing was a much simpler endeavor, and sticking within one’s circle of competence was likely a much easier task to accomplish. Generating alpha is always easier when “investors” do not understand the basic tenets of fundamental investing. Now the market is crowded, and it seems to me that sophisticated investors are increasingly pushed outside their circle of competence in order to achieve alpha.

What a tough cookie.

 

You Know What’s Better than Owning an Airline?

An airport. 

Airports are natural monopolies. Who wouldn’t like owning a natural monopoly?

And unlike other natural monopolies such as local utilities, airports tend to be higher growth assets (air travel is less penetrated than electricity). 

At a high level, airports receive revenues from 2 sources: 1) fees on passenger tickets, and 2) commercial revenues generated in airports (e.g. rents from terminal vendors, parking fees, baggage fees, etc).

Airport business models are generally superior to airline business models in nearly every single way:

  • Usually exempt from competition at the local / micro level – Many cities only have one airport. Only in extremely high-trafficked areas will there be multiple airports serving the same catchment area, but that’s a rich problem to have.
  • Less cyclical than airlines – Airports generally receive a large proportion of revenues as fees from passenger tickets. During recessions or downturns, airlines are incentivized to cut prices to keep planes full. That behavior supports passenger flow, which acts as a countercyclical buffer for airports.
  • Beneficiary of irrational airline competition – Since airports are more levered to passenger flow than ticket prices, irrational competition between airlines (e.g. low ticket prices) could lead to higher passenger flow, while airline income statements bear the cost.
  • Lower sensitivity to commodity prices – No need to worry about direct impact of oil (although there is some indirect impact if oil prices change enough to affect ticket prices and air travel demand).

There are no publicly traded airports in the US, but many well-trafficked airports around the world are privately operated and publicly listed. And a cursory glance at 10-year stock price performance illustrates the lower volatility and range of outcomes for airports vs airlines.

Mexican American Airports (ASUR MM – Cancun, GAPB MM – Guadalajara, OMAB MM – Monterrey) vs Mexican Airlines (Aeromex, Volaris) and Pan-LatAm/Brazilian Airlines (Gol, Copa)

The Mexican airports have seen stock price increase anywhere between 4x to 9x over the last 10 years. The Mexican airlines have only been public for less than 2/3 of the timeframe but have not even doubled. I have also generously left out the Mexicana bankruptcy in 2010. Gol has declined by 93% over the last 10 years. Copa has done decency well, returning 4.7x.

Mexican Airports

Mexican Airlines

European Airports (KBHL DC – Copenhagen, FHZN SW – Swiss, FLU AV – Vienna, FRA GY – Frankfurt) vs European Airlines (IAG LN – British Air/Iberia/Aer Lingus, RYA ID – Ryanair, EZJ LN – Easyjet, NAS NO – Norwegian Air, AB1 GY – Air Berlin)

European airlines have done decently well (excluding Air Berlin, which has lost 96% of value in 10 years), mainly because of the low-cost carriers Ryanair and Easyjet. As a result, airlines have kept up decently well with airports but with higher volatility, nonetheless.

European Airports

European Airlines

Chinese Airports (694 HK – Beijing, 600009 C1- Shanghai, 600004 CH- Guangzhou, 357 HK – Hainan) vs Chinese Airlines (1055 HK – China Southern, 670 HK – China Eastern, 2610 TT – China Air, 600221 CH – Hainan Air, 753 HK – Air China)

Out of the various geographies, China appears to be the most volatile, even for the airports. Airports have done fairly average, returning 56% to 2.9x over the last 10 years. However, similar to the other geographies, airport performance is better clustered than airline performance. Airlines have returned anywhere from -65% to 4.8x.

Asian Airports

Asian Airlines

Seems to me that airports are generally one of those assets that you can buy and tuck away for a very long time. 

Disclosure: I have no direct beneficial interest in any airline or airport mentioned as of publishing date and have no intent to initiate a position within the next 48 hours. 

Pandora – Fast Fashion or Fad Fashion?

What would you pay for a well-regarded, branded business that is expected to grow revenues and net income around 10% CAGR for the next 3-5 years with industry leading margins, high returns on capital, and low capital intensity?

And better yet, given that this business has low capital intensity, the company generates and distributes high free cash flows back to shareholders in the form of dividends and share buybacks, bringing total shareholder returns to 15%+ per year?

That’s Pandora (the jeweler) in a nutshell.

And unusually, Pandora trades at just 12.5x trailing P/E (~10.5x 1yr forward P/E) and 10x trailing EV/EBITDA (~8.5x 1yr forward) based on analyst estimates.

Were the multiple to revert closer to branded peers or the index as a whole, that would potentially add another 40-50% return. Realizing that over a 3-5 year period would add an additional 10-13% return per year, bringing total returns to 25%-30% CAGR.

Of course the natural question to ask is why the market doesn’t see or believe the story? It all comes down to durability of the core product.

A Brief History of Pandora

Pandora is a Danish jeweler that was established in the 1980s. Although it’s been around for quite a long time, the company’s modern formula for success did not come about until the early 2000s when Pandora launched the charm and bracelet product.

Pandora Charms.png

The bracelet forms the core of the product, but the charms is where the magic lies. Through the selection of charms, Pandora customers (almost exclusively female) can personalize their bracelets and switch it up depending on the occasion. Today, Pandora carries a catalogue of more than 700 different charms, covering nearly every occasion and personal taste imaginable.

Through this product, Pandora embarked on a fantastic journey of growth with revenues expanding >12x between 2008 and 2016.

Pandora Revenue Growth.png

Pandora Today

Today, charms makes up ~60% of revenues with another ~20% coming from bracelets. The remaining 20% is composed of rings, earrings, and necklaces – categories that were mostly launched after 2013 in order to expand Pandora’s portfolio.

Pandora sells through 3 formats – concept stores, shop-in-shops, and multi-branded. Concept stores are standalone Pandora stores where the customer experience is designed and tightly-controlled by the company. Over the past few years, Pandora has been shifting the mix from predominantly shop-in-shop and multi-branded towards concept stores.

And layered on top of the channels, Pandora either runs the stores themselves or acts as a franchisor. Currently, 38% of revenues are generated through Pandora owned concept stores while the remainder is generated by franchisees or 3rd party distributors. In owned stores, Pandora captures the full retail price, while in franchise/3rd party stores, Pandora sells into those channels at a wholesale price. The difference is 2.4x (i.e. $100 worth of wholesale goods would fetch $240 if sold within owned stores).

Charmed or Cursed?

So far, the charms business has performed exceptionally well. Not only has it attracted a large customer base, it is also distinctly Pandora, which is an unusual feat of differentiation in the jewelry business. Jewelry tends to be a fairly commoditized industry (the inputs are commodities and final products are usually not distinguishable across brands) so product differentiation is usually non-existent except perhaps in ultra-high-end jewelry.

But that is exactly the paradox here – Pandora is not an ultra-high-end jeweler (Pandora’s price points are $25-$200), and the company sells a product that is quite non-traditional for a jeweler.

The prevailing thinking is that Pandora charms are a fad. One day customers will get over it, and sales will plummet. 

This fear has percolated for a decade, but over the past 12 months, the fear seems to have materialized. Reported like-for-like sales slowed across all regions with the most recent numbers in North America turning negative (this was partially compounded by confusing metric calculations, but I’ll refrain from discussing the nuances to avoid complexity). As a result, the stock has declined approx. 1/3 over the last 12 months.

In essence, the market appears to assume that Pandora is cursed, and one day investors will wake up to find that the charms business has been nothing more than a passing illusion. 

What Makes a Fad?

I challenge that view. Certainly there will come a day in which the charms business will be fully mature, but the performance of the charms business does not carry the usual characteristics of a fad.

For one, Pandora has been selling charms since 2000. If charms were a fad, the customer base would have likely moved on many years ago, yet the charms business still exists 17 years later. If this were a fad, it would certainly be the longest living fad.

Pandora recently conducted a survey of former customers and discovered that many customers remain interested in the brand and would consider buying Pandora products even after 6+ years.

Pandora Customer Consideration.png

In addition, fads usually tend to develop within certain groups (e.g. teens) or geographies. Yet, neither of these are observable within the Pandora customer base. Pandora charms and bracelets are worn across the age spectrum, and Pandora’s products are finding success across the world from the US to Latin America to the UK to continental Europe to Australia and to Asia. The global success of the product suggests broad appeal, and such broad appeal does not suggest a fad. 

A Fast Fashion Business Model

Rather than getting hung-up on whether the product is a fad or not, I think it’s more instructive to think about the business model and how the company operates.

At its core, Pandora is a fast fashion jeweler. Unlike traditional jewelers that have inventory cycles longer than a year and glacial lead times, Pandora’s inventory cycle is less than a year and lead time is only ~100 days. The company is targeting lead times of just several weeks by the end of this decade. Like Zara, the fast fashion retailer, Pandora can respond relatively quickly to customer preferences and adjust the product mix as the data prescribes. No one worries that Zara can’t sell fashion because when they do have a fashion miss on their hands, they can respond and fix the issue within weeks. Pandora is positioned similarly in the jewelry world.

Pandora sells fashion and newness, not “forever”Diamonds are forever. Pandora doesn’t do diamonds. What Pandora does do is drop 7 collections a year. Every season and holiday brings a new collection, a new reason for customers to pop in and see what else they can add to their collection, in effect creating a recurring customer/revenue streams. Given the low prices, charms are priced to be impulse purchases.

In addition, Pandora is a branded affordable jeweler. Investors and pundits seem to have a tendency to compare Pandora to other branded jewelers, which tend to be higher end. Pandora is no Tiffany. Pandora’s true competitors are mom & pop jewelers. Pandora offers customers a good brand, attractive products at an affordable price, and fashion – everything that mom & pops do not have the scale to offer.

If we consider the business model, it seems more than likely that if charms truly were declining, Pandora has the right business model to quickly adjust and adapt to whatever is next. 

What If I’m Wrong

Pandora is already priced as if the business will cease to exist in 10 years. That’s a fairly large margin of safety given that analysts expect the business to continue to grow at 10% CAGR for the next few years, but a couple of other things offer additional comfort:

  • Jewelry as a category is growing ~5% per year. If Pandora’s above-average growth simply normalized to industry growth, you would still have an okay business for the share price available today.
  • Pandora’s newer categories are growing >50% per year. In just about 3 years, Pandora has launched and grown non-charms/bracelet categories that now represent 20% of total revenues. Within a few years, these categories could represent 40-50% of total revenues, significantly reducing the dependence and fear of charms.
  • If worst comes to worst, Pandora’s continued conversion of franchise stores to owned stores would keep revenues unchanged even if the entire charms business goes away since owned stores generated 2.4x more revenues on an apples-to-apples basis compared to the wholesale channel. 

So the risk/reward looks pretty good to me.

Disclosure: I have no direct beneficial interest in PNDORA DC as of publishing date but I may initiate a position within the next 48 hours. 

Value Creation in the Investment Management Business

Do investment managers add any value?

This question is clearly of interest to clients of asset managers, but it is also an increasingly important question for industry professionals as well. It’s hard for industry professionals to do good work if they do not believe in the work they do, and for clients, it is dangerous to be invested alongside managers that are distracted.

Part of the challenge of answering that question is that the general dialogue usually conflates two separate questions into one: 

  • Do asset managers add any value when they do not outperform the benchmark? 
  • Does the industry add any value when it moves money around trading listed equities/bonds and not directly funding new ventures (e.g. venture capital or IPOs)? 

These are very different questions that could lead to very different answers.

Performance as the Primary Value-Add

The argument is seemingly quite simple – most managers don’t beat the index. So asset managers, on average, don’t create value.

The long-term statistics are quite depressing. Depending on the study and timeframe, the proportion of active managers that beat their benchmark can be as high as 1/3 (and that’s on the high end) to as low as 15%. Whatever the actual number, it’s not good…especially when you throw in the exorbitant fees that the public is paying for that underperformance.

However, I don’t think the argument is that simple.

I don’t think it’s that simple because this argument assumes that the alternative for the average investor is to buy and hold the benchmark through thick and thin when there is strong, consistent evidence that the average investor buys high (following strong market performance) and sells low (after painful breaks). 

Although indexing is indeed a very sound strategy for most people, the average investor generally does not hang on through thick and thin.

And this is precisely an area where asset managers will increasingly need to focus on in order to make up for the collective shortfall on the performance side: How to impart confidence in clients so that clients will invest through the cycle, or better yet, invest when markets are down. 

After all, if an asset manager is able to do just that, clients would likely achieve a better outcome investing through the cycle even if performance is marginally subpar compared with the alternative of indexing but buying high and selling low. This becomes even more apparent when considering the number of studies that show that many clients underperform when invested with managers that outperform because clients invest high and sell low.

Managers that are able to engender confidence and encourage countercyclical investments, create value that is not captured in pure performance comparisons.

It’s also important to consider that an investment manager’s value-add is more than just returns. How that return is generated is also an important consideration: How much risk was required to generate that return? And, how volatile are those returns? Historically, hedge funds also added value by mitigating volatility (hence hedging). Hedge funds have strayed from that orientation, but the argument remains true today.

Value of Trading in the Secondary Markets

The second question is a trickier one: if the secondary markets purely involve exchanging stock/bonds between different investors where one investor’s gain is another’s loss, is there any value creation at all?

It’s tempting to say no, but that ignores the interdependence of the primary markets with the secondary markets. Without strong liquid trading of stocks and bonds in the secondary market, the primary market would also be much weaker. And we know this because when the secondary markets are poor, companies tend to hold off on IPOs leading to a drying-up of the IPO market. Without a strong IPO market, venture funding would likely also be impacted.

At the extreme, you also have many tech companies that pay a significant portion of employee compensation in the form of stock options. For example, Facebook recognized $3.2bn of share-based compensation expense in 2016. Secondary market trading is needed to create the value associated with those shares for employees. And for a (albeit controversial) company like Tesla, which is largely unprofitable at the moment, the ability to divert compensation costs into stock options/grants (>$300mm in 2016 vs net loss of >$200mm) gives the company additional room to continue to operate.

————–

Lately, it’s become quite unfashionable to believe that asset managers create any value (and for good reasons). However, it’s not an untenable situation. Remediating the problem simply requires being more thoughtful about what clients need and how the asset management industry operates within the broader financial sphere.

A Publicly-Traded Airline “Float” Company

The last post, How Airlines Generate Float, compared the similarities between airline mile programs and insurance companies. I argued that airlines are now essentially generating float through their miles programs. Turns out it’s not that original of an idea (as much as I wish it was!) as there are at least two publicly-traded mile program managers in Brazil.

Smiles

One of these mile program managers is Smiles (SMLE3 BZ). Smiles actually directly calls out the “float” element of their revenue stream.

Smiles Revenue Streams

In essence, Smiles derives its revenues via the following ways:

  • Mile Sales – Smiles sells miles to program partners (e.g. airlines and banks). Partners give these miles to customers as a way to reward loyalty such as through airline frequent flyer programs and credit card points. From Smiles’ perspective, mile sales generate revenues as well as a future obligation to honor mile redemptions.
  • Float – Since mile redemptions occur months or perhaps years after customers earn/purchase miles, Smiles’ business model generates float. Like Berkshire’s insurance businesses, this float is carried as a liability but can be used/reinvested by Smiles to generate further revenues.
  • Breakage – And lastly, breakage, which refers to the revenues that is recognized from miles that expire/are never redeemed. Note this is primarily an accounting concern (earned when miles expire), while from a cash flow perspective, there is no  additional cash inflow associated with this revenue.

Smooth Sailing Through Stormy Skies

So how does this type of business model perform? Quite well actually.

Below are recent performance figures pulled from the latest Institutional Investor Presentation (March 2017). Despite the deep recession in Brazil and challenged airline industry, Smiles has been able to grow EBITDA margins over the last 2 years. 3Q14 – 1Q15 appear to have been the most challenging periods over the last two years (which saw earnings pressure), but the company appears to have been able to adjust fairly quickly and return to 40-60% YoY earnings growth by mid-2015. That is remarkable.

Smiles Performance.png

One other thing I’d point out is the growth rate differential between miles accrual and miles redemption (both ex-Gol, more on this in the next section). Except for the last 3 reported quarters, miles accrual growth rates far exceeded miles redemption growth rates. However, even though miles redeemed has been out-growing miles accrued, miles accrued is still growing faster on an absolute basis because it is a much larger number. Smiles references a “burn/earn” ratio, which came in at ~80% in the last Q. The faster growth in miles accrued vs miles redeemed is something that I argued would likely be the case in my previous post, and it is an important factor in driving the growth of float.

Finding the Pocket of Turbulence

As wonderful as this business appears to be, there are reasons why this company trades at only 14x LTM P/E despite a 6.7% dividend yield, HSD-to-teens revenue growth, and MSD-to-HSD EPS growth…

The largest concern is around Smiles’ ability to control its own destiny since it is closely linked to Gol, one of the largest Brazilian airlines. In fact, Smiles was created from within Gol to operate the miles program. A very significant proportion of Smiles miles is redeemed for Gol flights, and thus the value of Smiles miles is highly dependent on Gol’s operations. Unfortunately, Gol is highly levered and not particularly profitable. To make it more complicated, Gol remains a 54% owner of Smiles.

Although Smiles has operated admirably well during the recent recession in Brazil, Smiles’ equity hit major pockets of turbulence as Gol’s fortunes rose and fell.

But there is always a price. What price is appropriate for this kind of a business model if the company is not fully in control of its own destiny?

Concluding Thoughts

Smiles has a fascinating business model and validates a number of arguments in my prior post.

But I do wonder about two things:

  1. What is this type of business mode capable of if the float is used for investments similar to how Berkshire reinvests insurance float (or excess cash flows generated from his operating businesses)?
  2. Although airlines have attractive miles programs that generate float, they are used to finance cyclical operating businesses that have been prone to irrational competition. Although Smiles is a publicly-listed miles program pure-play, it is not free from the influence of an associated operating airline business. Would it be possible to isolate the advantages of the miles program and limit the exposure to the pure operating business?

Disclosure: I have no direct beneficial interest in SMLE3 BZ as of publishing date and have no intent to initiate a position within the next 48 hours. 

 

How Airlines Generate “Float”

Recently, I’ve been spending quite a bit of time pondering airlines. Perhaps out of concern that someone could violently drag me down United’s tiny aisles! Good thing I don’t fly United…but I kid, of course.

What has caught my attention is Buffett. He now owns approximately $10 billion of airline stocks. And for anyone that has followed Buffett over the years, this is unusual not least because he’s never minced words with respect to airline industry economics:

“The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, then earns little or no money. Think airlines. Here, a durable competitive advantage has proven elusive since the days of the Wright brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.” -Buffett

Following the disclosure of his airline investments at the end of 2016, here’s what Buffett had to say:

“It’s true that the airlines had a bad 20th century. They’re like the Chicago Cubs. And they got that bad century out of the way, I hope…The hope is they will keep orders in reasonable relationship to potential demand.” –Buffett on CNBC

Buffett’s thesis appears to be industry rationality (finally!) now that the industry has consolidated down to 4 major airlines.

Although that could very well be the thesis, it just didn’t feel like the full story to me. After all, memory chips is a consolidating industry, why not own memory chips? Oil and gas services is a consolidating industry, why not own oil and gas service providers? This last comparison is even more compelling when you consider that a company like Schlumberger has much more differentiated technology than peers, whereas every airline offers essentially the same product.

I believe the critical insight is in recognizing that the airline industry now generates a significant amount of “float” and evolution of the airline business model has made it much more similar to an insurance operation. 

Modern Airline Business Model

To understand why, we need to understand how airlines make money today. By chance, I came across the excellent Bloomberg article, Airlines Now Make More Money Selling Miles Than Seatswhich makes the following points:

  • Airlines now make more money selling miles than seats.
  • Many customers carry airline branded cards that earn miles. Banks are responsible for rewarding those miles and buy those miles from airlines at 1.5-2.5 cents each.
  • Revenue from mile sales is estimated to be up to 3x the final cost to an airline (e.g. margins of 66%).
  • Miles are earned and paid for far in advance before redemption. 

“Float”-ing Miles in the Air – Similarities to Insurance

The last point in the list above is key – by virtue of earning the vast majority of income from selling miles that won’t be redeemed for months or even years, airlines have essentially created float.

In insurance, an insurance company receives payment upfront with the promise to pay in the future upon a contingency. In the airline industry, airlines now receive the vast majority of income upfront with the promise to dispense seats/services in the future. That is the essence of float.

In insurance, an insurance company can generate an underwriting profit if premiums received exceed payouts. Similarly, airlines can generate an “underwriting profit” if miles expire, if customers forget to redeem miles, or even if customers develop the habit of accruing miles far faster than they redeem (which is very likely the case).

Airline Float Better than Insurance Float?

Risking the potential that I’ve taken this idea to far, I do wonder if airline float could even better than insurance float:

  • Insurance float is not costless on average since the industry tends to generate underwriting losses with the intention of making it up via investments. Airlines do not appear to suffer from this underwriting tragedy.
  • Insurance contingent liabilities are fairly fixed (e.g. you know the value of the house insured or car insured or life insured), but the value of a mile can change over time (e.g. if necessary, an airline can significantly devalue miles).
  • Monoline insurance leads to exposure to a very specific sector/area (e.g. housing, healthcare, autos), while airline miles are generated via card spending, which is diversified across a number of industries (but most likely concentrated on high frequency, day-to-day spend).

The points above are likely oversimplified, but I believe there are merits to the argument. Taking the miles business model into mind and similarities to insurance “float”, airlines as an investment would appear to be much more Buffett-like.