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. 

 

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. 

The Importance of Focusing on Business Models

“Investment is most intelligent when it is most businesslike.” – Benjamin Graham

“I am a better investor because I am a businessman and a better businessman because I am an investor.” – Warren Buffett

Most investors define themselves along a couple of axes: Technical vs fundamental, value vs growth, long vs (and/or) short, contrarian vs momentum, large cap vs small cap, etc. These labels are well understood and established conventions.

However, these labels distract from what is most important when it comes to investing – an understanding of the underlying business.

Whether you are a fundamental investor, a value investor, a growth investor, a contrarian investor, all of these labels serve only to illustrate the “how” and not the “what” or “why”. It seems remarkably odd that few investors refer to themselves as a Business Model Investor, which I believe is a much truer expression of the essence of investing.

The Benefits of Focusing on Business Models

Though I bear the risk of promoting myself to Captain Obvious, I think it’s important to call out what’s important – investing is most likely to succeed when we think of ourselves as buying businesses, and buying businesses entail understanding the business model and how it works.

I believe this is distinctly different from just understanding a company’s products, describing Porter’s 5 Forces, and assessing strategic vision / management.

Understanding business models can help us uncover great companies with sustainable businesses that otherwise may not be apparent. 

The Scourge of Retail

Today, most investors understand Amazon’s outsized impact on traditional brick & mortar retailers including the venerable Walmart. But it was not that long ago that many assumed brick & mortar would be able to leverage their larger scale (at the time) to ward off Amazon and other threats. Surely, Walmart with all its might and low prices can take the fight to Amazon if it wanted to. And of course, brick & mortar had the benefit of strong earnings / cash flows, whereas Amazon had none of the 1st and few of the 2nd (still has essentially no earnings today but cash flows are a massively different story). These were prevailing views just 3-4 years ago.

I think this is a perfect example where business model investing has been far more fruitful. All of the traditional retailers did have a scale advantage (not anymore), but scale is not a business model. Scale is merely a competitive advantage, and a disrupt-able one against a well-funded competitor.

Amazon has the benefit of a better business model. It’s a retailer that did not have to carry the significant costs associated with physical stores or sales staff. From a  business model investing perspective, it takes just a few words to understand Amazon’s advantage. These advantages are not as easily understood from just looking at historical financial statements (of which earnings look terrible and earnings-based ROIC looks laughably poor). Understanding these advantages require thinking of the business model holistically.

Finding the “Most Valuable Company in the World” in No Man’s Land

Apple, the most valuable company in the world, is a curious case. It continues to thrive in the metaphorical graveyard of tech. Few companies have survived (and thrived) for long in tech hardware because the fundamental forces at work are overwhelming – commoditized products, persistently declining prices (not least driven by Moore’s Law), fragmented landscape with too many competitors to count…Generally a terrible industry. And all of these elements are likely to remain true for the foreseeable future, leading many investors to make the case that sooner (and perhaps rather than later) Apple will succumb to the same forces that has brought down Nokia, Motorola, HP, etc.

But that view ignores Apple’s different (and unique) business model within the tech hardware industry.

From a consumer perspective, Apple’s business model is simple – sell highly-designed, premium products where every element / component is customized for use.

But from a strategy standpoint, Apple’s business model is secrecy. Whereas Apple’s peers like to run their companies like scientific experiments in broad daylight, Apple’s business model is to play the cards close to their vest. Is it any mystery then why Apple has been and will continue to be a disruptor of the industry? Nearly everything that can potentially disrupt Apple is brandished in broad daylight years before the hero’s blade is finished forging. Apple knows what’s coming from nearly everyone else, but does the rest of the industry know what’s coming from Apple?

And how does this business model address the overwhelming forces of the tech hardware industry? It allows Apple to differentiate their products with non-commoditized hardware, which can be monopolized for a (short, e.g. 1 year) period of time. Apple has to keep fighting these forces, but it’s a perpetual 1 year advantage until ideas run out (and the human race has demonstrated for 10,000 years that there are many more ideas than we can pursue).

Apple’s vertically-integrated product model also has the advantage of getting innovations to customers far faster than peers. Google is a very able peer in the smartphone OS space, but their innovations are taking on average about 3 years to get into customer hands. The majority of their customers are still using an OS that shipped in 2014 or earlier.

One should rightfully assume that tech hardware is a tough space, but from a business model perspective, it’s easier to see that Apple plays a different game and should have been apparent long, long before Apple became a household name or the world’s most valuable company.

Business Model Differentiation Worth More than “Competitive Advantages”?

One idea that I’ve been turning over in my mind is the importance of having a differentiated business model rather than just pure “competitive advantage”. After all, BHP and Rio Tinto have the unbreakable competitive advantage of immense scale in an industry where large mines cannot be willed from thin air through cash alone. But I do not think it is a stretch to say that BHP and Rio Tinto do not have differentiated business models and are bystanders to the same industry forces that buffet their peers.

Are differentiated business models the most important thing?