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. However my employer does own Shanghai Airport.

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.

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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.

Disclosure: I am employed by an investment manager. 

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. 

 

Amazon’s Capital Market Dependence

Lately, there’s been no shortage of positive coverage on Amazon – and for good reasons. The vast majority of retail is struggling with declining same-store-sales, yet, Amazon continues to post a torrid pace of growth despite its size. In FY16, Amazon grew North America segment sales by 25%, and that growth came at the expense of the rest of the retail industry.

From a business model perspective and from a consumer perspective, Amazon appears to have built an incredible flywheel that is gathering momentum. As the rest of the retail industry is forced to retrench and cut costs (e.g. reduce stores, reduce staff, reduce inventory / SKUs…), it serves to further widen the gap in consumer experience as Amazon continues to invest. Amazon’s product assortment advantage, delivery speed advantage, data advantage all continue to grow. And the wider the gap, the more inevitable Amazon’s dominance.

It’s not hard to see why sentiment has swung so strongly in Amazon’s favor.

However, as an investor, it is almost always prudent to revisit assumptions when the market believes so overwhelmingly in a single narrative.

Amazon’s Overlooked Advantage

Recently, I had the opportunity to catch up with the CFO / Chief Strategist of an Amazon competitor (which will go unnamed). Although this company is doing quite well and holding its own within the retail space, it’s clear that a full-scale showdown with Amazon could be looming. And such a showdown will be painful.

During this conversation, the company asked me an unusual question and offered an interesting remark: How would I feel if the company significantly ramped up investments to fend off competition (i.e. Amazon)? And, perhaps the more interesting part, the CFO remarked that it is unfair that Amazon has the advantage of an investor base that does not care whether they produce any earnings at all, only that they have the ability to do so. He wished he had a similar investor base because it would allow him to compete on a more level playing field.

Those words stuck with me because it’s true. A large part of Amazon’s competitive advantage in pricing and consumer experience (driven by Amazon’s large investment programs) would be far harder if investors required Amazon to produce stronger earnings. After all, the rest of the retail industry is unable to respond precisely because they are forced to defend earnings and unable to invest aggressively to ensure that they exist in the future.

In essence, Amazon’s continued success perhaps does depend in part on capital markets cooperation.

The Dangers of Capital Market Dependence

Reliance on capital markets usually don’t lead to good places. Although it is efficient to utilize capital markets to support operations and growth, a dependence on capital markets has led to the downfall of many companies.

For example, levered companies that suddenly discover that maturing debt can no longer be rolled over.

Or roll-ups / M&A-driven companies that suddenly discover that the market is no longer going to allow them to issue high-valuation stock to purchase low-valuation targets.

Or REITs and MLPs that generally have high payout ratios and therefore require capital markets to grow.

The moment the doors to the capital markets close, companies that depend on capital markets find themselves with few friends and tough choices.

How it Could Hit Amazon

I should reiterate that all of this is purely conjectural, and I remain a fairly firm believer in Amazon’s business model, but investors shouldn’t overlook the small points of weaknesses especially when consensus is overwhelmingly bullish.

If capital markets suddenly stop giving Amazon a pass (which wouldn’t be particularly outrageous since investors did become skittish just a few years ago), Amazon would likely have to pull back on fulfillment and content, which represent two of the largest costs. And these are likely the two strongest differentiators of Amazon’s customer experience vs. traditional retailers.Amazon IS 2016

And on the cash flow side, perhaps stock-based compensation would need to be swapped for cash compensation if equity investors stop believing. In FY16, Amazon recognized $3bn of stock-based compensation, which is quite sizable compared to the $3.9bn of FCF less finance lease repayments and assets acquire under capital leases.Amazon SBC.png

Concluding Thoughts

Jeff Bezos has built an incredible business in Amazon that is gathering strength. However, Amazon’s strength (and momentum) relies at least in part on investor trust. Like a flywheel, speed will beget speed. But if investor sentiment flags even if momentarily, the flywheel’s momentum could slow considerably.

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

What Apple, Google, and Facebook’s Business Models Tell Us About Their Ability to Adapt to the Coming AI-Future

 

Judging from market multiples, it’s clear the market is skeptical of Apple’s ability to continue to succeed and has been for many years (currently, 1-yr forward P/E of ~15x despite recent re-rating), while holding limited concern for Google and Facebook (both 1-yr forward at ~26x).

This concern is understandable given the ever-changing tech environment and the long list of tech companies that have been buried over time (e.g. Nokia, Blackberry, Motorola). Even industry stalwarts of the bygone PC-era such as HP, Dell, and even Intel/Microsoft now stand on far weaker ground. And this concern for Apple is not new as Horace Dediu points out at Asymco

However, I contend that Apple’s business model is far more robust than Google’s in the coming artificial intelligence (AI)-revolution. 

Leaving aside potential differences in technical competency, AI is likely more complementary to Apple’s business model, but potentially highly disruptive to Google’s.

And to understand why, it requires understanding the job-to-be-done for search users and how Google’s ad-centric business model fits in.

The Assumptions Behind Search

Let’s start with the user – why do Google users search? What is the job-to-be-done?Seemingly simple question with a straight-forward answer: We are curious about many things and don’t have perfect knowledge. Google can help us answer what we don’t know. For most of Google Search’s existence, the service has approached this job-to-be-done by returning a curated list of search results that are most likely to match what the user is looking for. These are organic results that are designed to improve over time as the algorithm takes into account the answers/results users found most useful in the aggregate. Fairly simple and straight-forward.

So now turning to the business model – Google Search makes money on the ads that appear alongside search results. Every click on an ad (as opposed to an organic result) generates a small bit of revenue for Google.

Under what circumstances would a user prefer an ad over an organic result? 

Philosophically, Ben Evans (A16Z partner and almost always more than a few steps ahead of the curve) hits the nail on the spot:

In essence, the existence of ads on Google Search is the most egregious effigy to the failure of the underlying search algorithm. Every time a user clicks on an ad, it is an implicit acknowledgement that Google Search did not accomplish its job-to-be-done, that the desired answer would not have been provided had the advertiser not paid for that placement.

Given a long enough time horizon, if Google Search is truly improving, barreling towards a future where Google can answer any question without doubt and with perfect context, Google’s business model would have to evolve because ads do not have an obvious place in that future. 

And that future is coming closer with the advancements in AI. 

Search and AI

What could search look like in an AI-driven world?

It might not look all that different – perhaps Google’s I’m Feeling Lucky option or the knowledge graph cards.

But, it could also be radically different such as the search results provided by assistants such as Apple’s Siri or Amazon’s Alexa.

Regardless of the ultimate direction, it’s clear that ads have a far less obvious place in this future. If AI can be used to surface the right answer the user needs, the user would have less of a need to click on an ad.

I think we’ve seen the first instance of this issue with Google’s recent Beauty and the Beast ad on Google Home. The Google Home assistant (like Alexa) does not offer a natural channel for ads, and as a result, Google will have to find increasingly creative ways to adapt their business model for the changing environment. But history is filled with examples of failed business model surgeries.

It also makes Google’s persistent pursuit of a hardware/software business model a la Apple much more understandable. Perhaps selling hardware isn’t just about protecting access to market (after all, it’s unlikely that Android will be unseated now that it is so entrenched, so why continue with the direct hardware efforts?), it could be a deliberate attempt to evolve their business model to ensure financial relevancy in the AI-driven future.

Why Investors Seem Complacent

I contend that investors (or analysts) are confusing two separate concepts to be the same thing – the universal desire to know (hence search) and the need for ads to provide that information.

There is no doubt that search queries will only grow. It’s not farfetched to imagine a future where there are 7 billion search users instead of the less than 2 billion today. But that’s a far different conclusion from assuming Google’s financial future and business model are robust as long as search queries grow.

Search is robust, but are ads robust relative to our AI-future?

Apple’s Business Model is Far More Complementary to AI

Apple’s business model, on the other hand, is much more aligned. Sell the best products available for customers’ job-to-be-done.

AI is not orthogonal to this pursuit and business model. The only question is whether Apple has the technological capabilities to do so. However, even under the assumption that Apple is not the leader in AI-technology, it is not clear that it matters. After all, Apple was not the original leader in GUIs (Xerox PARC was). Apple was not the original leader in phones (Microsoft, Palm, Blackberry, Nokia, etc. were). Despite not being the original leader, Apple had the business model and insight to ensure that they could ride the underlying technological trend, and if I were to take a bet today, I believe Apple’s business model makes them more prepared to usher in an AI-world than Google is. AI is a feature to Apple. AI is a potential danger to Google’s business model.

From a business model standpoint, Apple is far more robust in an AI-world.

What About Facebook?

Facebook’s an ad-driven business model. What about them? Surely, Facebook is potentially in danger as well.

Facebook’s situation is less clear cut because the job-to-be-done for users is different vs search. Search has a “right” set of answers. Facebook’s feeds do not. Users are not necessarily searching for anything specific but rather using the services as an outlet for time. The “wrong” answer in a search query is far more obvious than a “wrong” answer in a Facebook feed.

And if AI can be used effectively to ensure that organic content on News Feed, Instagram, etc. are more relevant and engaging, then perhaps that can even offset any deterioration in experience from an increase in ad load. AI can never make Google’s organic results more engaging to the point where a user will tolerate a less user-friendly ad environment.

Facebook’s job-to-be-done is to, cynically, offer a time sink. Google’s job-to-be-done is to get you your answer as fast as possible. One of these is more complementary for an ad-driven business model. 

Concluding Thought

Is Google as robust as investors think? Borrowing from Peter Thiel – is this something that could be true that no one believes? Is Apple in as much danger as the average person believes?

Disclosure: I have no direct beneficial interest in AAPL, GOOGL, or FB as of publishing date and have no intent to initiate a position within the next 48 hours.