Competitive Advantage & Moat

Summary: Marketplace that connects hosts and travelers for off-the-beaten-path long-term vacations and experiences. The Moat is Trust.

AirBnb was zagging when competitors were zigging. They focused on things that the traditional tourism industry didn’t address:

1. Look for local and even hyperlocal stays and experiences while the rest of the industry focused on things like proximity to “city center” and “top tourist destinations”.
2. Make it easy and affordable for families and groups of friends to travel and stay together.
3. Provide affordable options for longer stays – weekly and monthly prices/discounts and the ability to cook and do laundry for free. A 15-day hotel bill for a group of 4 can run into thousands of dollars.
4. Make it easy to get information – undigested information – from local hosts about what to do and where to eat in a new city or village.

AirBnB made this possible via great user-interface and user-experience for both hosts and travelers. While the tech part of the offering is impressive, it’s amazing how they got through the initial phase of getting a critical mass of hosts to actually sign up to have random strangers rent their homes for short-term leases. You’ve probably heard the stories of Founder and CEO Chesky actually knocking on doors in New York City to get hosts to sign up and agree to rent out spare rooms. Somehow, by doing things that are not scalable, they’ve scaled it up to millions of hosts around the world. And somehow, they got random people to actually agree to go and stay in someone else’s home instead of a sterile hotel where they do your sheets every day. The latter happened because of the 4 factors we listed above. AirBnB found and niche and built a business around it with patience.

A schoolteacher from, say, Chicago, takes a flight to Barcelona to spend her vacation in a beautiful 19^th century flat in the Eixample district owned by a Catalan restauranteur – this is insane, right? AirBnB makes this insanity possible because they’ve created a system that both parties trust.

The mobile-friendly, easy UI and UX has helped. But they had blueprints for that from competitors like Hotels.com. The feedback system, where guests rate the property was also put in place. AirBnB, however, also added a reverse feedback facility – where hosts can rate guests as well. This contributes to the main asset that AirBnB has built – TRUST.

They have an easy-to-use feedback loop that incentivizes both the host and the traveler to put their best foot forward. This is, again, a tech issue. But they also have easily accessible ways to contact AirBnB staff members to resolve conflicts. This part takes money, time, and patience to build. A traveler books with the comfort of knowing that she has power to criticize a host and his flat, and to call AirBnB in case something goes wrong. The host knows he has the power to leave a consequential, bad review for the traveler, and that he can call AirBnB in case something goes wrong.

Essentially, AirBnB sells Trust. This is the point most investors seem to miss when they’re modeling the business on a spreadsheet. AirBnB used technology – easy host onboarding and traveler user experience – to draw people in. But these people stay on the platform because they trust it.

AirBnB has spent a long-time building trust – and that’s the Operations & Support part of the business. That time has resulted in a certain level of scale. That scale has resulted in a certain level of word-of-mouth marketing. That has resulted in more scale, and on and on the virtuous cycle goes. The product part of it – user experience – is an important competitive advantage. But the durability of the business relies on Trust.

Competitors will find it hard to break into AirBnB’s niche because there is a massive first-mover advantage to this business. People are looking for reliability. That comes with making sure Operations & Support is top-notch, over many years. This is the key difference between AirBnB and competitors like Booking.com – AirBnB has bult a system around Trust. Competitors have built a system around choice. Both are important. But AirBnB, either by accident or design, focused on Trust first. We suppose they had to. They were already zigging while others were zagging – they were selling “off the beaten path”, inconsistent, unique experiences. The others were selling consistency and familiarity – like a Starbucks or a TGI Fridays. It took AirBnB 12 years to build this Trust. It’s very hard for a competitor to step in, especially one that’s built an infrastructure around short-stay hotels in touristy places.

The very real safety-net that AirBnB has built to promote Trust – it’s Operations & Support division for customer support and dispute resolution – is a massive differentiator. AirBnB’s relationship with both customers – hosts and travelers – continues throughout the stay. Both parties have the comfort of knowing that AirBnB will step in to resolve any disputes at any point during the stay. In this C2C (consumer-to-consumer) transaction, all available trust-promoting measures and incentives are needed. AirBnB has built up a reputation of trust but it will need to keep building on this, forever.

But the thing is: To keep building on their Trust asset, they must also build scale.

Next, we'll go over: 

• Management Strategy
• Growth Drivers
• Competition
• Strategy Risk
• Key Risk
• Valuation
• Thesis Summary

Management Strategy

Summary: The main job is to keep adding to that irreplicable asset called Trust. That starts with Scale. Scale begets scale, which begets Trust.

The 360 degree feedback loop works only if there is a critical mass. Travelers wouldn’t hesitate to book something with a 4.2 rating on that obscure villa in the Pyrenees if the rating is average of a hundred ratings. Hosts would feel a lot more comfortable opening up their homes to travelers who have, say, 5 or more five-star ratings. Then both parties sleep well at night and tell their friends about it. AirBnb already has a decent amount of scale. In 2019, they had 327 million nights booked on their platform.

Management knows that they have two main avenues to increase scale:

1. Product – user interface, user experience and so on…
2. Customer Retention.

This is obvious. But the challenge is to decide how to allocate their operating budget. CEO Chesky and team are now spending to be ready for the big reopen. That’s what he declared in the Q1 2021 earnings call. What does that mean? They’re now spending money on the product – on technology. Check out the comparison of operating expenses in Q1 2021 with Q1 2020:

On May 24^th, AirBnB will unveil some new product features. We were told that one of them may be the ability for a traveler to have more flexible plans. Let’s say there’s a particular villa in the French Countryside that he likes. It should be easy for him to find the dates when its available, based on which he can alter his holiday or “work from anywhere” schedule. Currently, a traveler is asked to first enter travel dates, based on which AirBnB gives options. It’s a subtle change but CEO Chesky believes that many travelers are looking for unique experiences for which they’re willing to adjust their dates.

Essentially, AirBnB is currently investing to match supply and demand more precisely. That’s the non-tech problem it’s trying to solve with tech. There are other changes in the menu, we’re sure, but we’re not privy to them. You can see, however, from the chart above that this is where they’ve been spending their money.

We must admit that we’ve been a bit disappointed with the dip in “Operations & Support” spending. This is the Customer Retention part of the spending plan. This is the part that we think is the Economic Moat. Going forward, we would like to see more spent on this. But this dip may be related to an overall dip in travel spending in 2020-21

2020-21 is such a bad sample of data for a company like AirBnB. So, we must look ahead if we’re to invest in this company. The last 1.5 years have been a washout. What will the next 5 years look like.

Growth Drivers

Summary: The pandemic is a hiccup, after which travel may come back with a vengeance. 2 main underlying tailwinds are “a local experience” and (now), “work from anywhere”.

CEO Chesky believes in 2 pandemic-induced trends:

1. Traveling will make a comeback in a massive way – the likes of which we’ve never seen.
2. The lines between working and living will keep blurring.

We think that he’s almost obligated to shout out the first point. But he’s on to something with the second point. The most interesting factoid in the Q1 2021 earnings call was:

“Nearly a quarter (24%) of our nights booked (prior to cancellations and alterations) in Q1 were not for traditional travel, but for long-term stays (defined as stays of 28 days or more).”

It seems that with the newfound, pandemic-induced freedom of working-from-home (WFH), many people are looking for a WFA (work from anywhere) facility. AirBnB helps them do just that. This is a completely new tailwind for the company.

That WFA tailwind can now be stacked right on top of the “local experience” tailwind. Over the last 5 years, AirBnB has only had the local experience tailwind, and look how well that did:

This puts some context around the revenue growth scenario we’re entertaining for evaluating AirBnB. We’re willing to believe that over the next 5 years, AirBnB can increase nights booked by 200% off its 2019 levels. Considering the growth level you see above, it’s not so outlandish.

But there is another way to do a sanity check on this crazy growth scenario. We did some snooping around for a measure of “Total Addressable Market” for AirBnB, and we found 2 reliable numbers:

1. Total number of hotel nights booked in 2019 in Europe.
2. Total number of hotel nights booked in 2019 in US.

For the US data point, we had to back into the number from the “number of unbooked rooms” and the stated “occupancy rate” in 2020. Effectively, we’re assuming a 100% occupancy rate in the US, which seems ridiculously optimistic until we tell you that we’re skipping the entire continent of Asia for this analysis. We just don’t have good data for Asia. So, we’ll just assume that Europe + 100% US is our TAM. Well, TAM is not exactly right because AirBnB has created its own market; maybe Potential Market Upside is a better term. Here’s how our AirBnB scenario stacks up against this Potential Market Upside:

So, based on AirBnB’s past record and on our estimate that it can conceivably corner 19% of the “traditional” vacation market, we think our 200% revenue growth scenario is believable. Put another way – about 19% or 20% of what could be hotel bookings can shift to AirBnB in the next few years. In this scenario, hotels would remain the dominant portion of the pie. AirBnB would cut into their business, which would drive many unremarkable hotels out of business. Most of them would be just fine.

The main caveat or argument against this is: everyone expects business travel to decrease. Again, we don’t have good data for this. So, let’s call it a wash since we have not included the fast-growing Asia sector.

Competition

Summary: Not much competition. Traditional travel websites for traditional hotels like Booking.com do compete for short-term stays in tourist hotspots.  

In the Competitive Advantage & Moat section, we had listed the market “shortfalls” that AirBnB addressed – it’s rasion d’etre, if you will:

1. Local/Hyperlocal stays and experiences as opposed to things like proximity to “city center” and “top tourist destinations”.
2. Easy and affordable for families and groups of friends to travel and stay together.
3. Affordable options for longer stays – weekly and monthly prices/discounts and the ability to cook and do laundry for free. A 15-day hotel bill for a group of 4 can run into thousands of dollars.
4. Easy to get information – undigested information – from local hosts about what to do and where to eat in a new city or village.

What’s stopping booking.com or Expedia from going all-in on the “off the beaten path” business model. They’d need to build an infrastructure around TRUST – around the safety net of dispute resolution between two individuals. Currently, they’re set up as B2C transactions – between a business (usually a big hotel chain) and a consumer. And their involvement in the transaction ends the moment the consumer checks in. From that point on, it’s between the hotel and the individual. Of course, the individual can leave a bad review on booking.com, and the hotel can respond. But the risk profile of having a “bad tenant” is very different for a hotel vs. someone renting out their home. AirBnB must have all available risk mitigation tools and services to avoid bad experiences – both for the host and traveler. AirBnB’s relationship with both parties lasts until the traveler finally checks out and the host has finally inspected the place for damages. In that sense, AirBnB is so much more than a “marketplace”.

We believe that AirBnB has the first-move advantage and 12 years of experience on their side, which will not be easy for Expedia or Hotels.com to replicate. Direct competition is still limited to some regional upstarts. There is no other serious global player competing with AirBnB.

Other Risks

Strategy Risk: Scale begets scale, which begets trust – but scale is also the anti-thesis to AirBnb’s image of “off the beaten” path.

Let us make an analogy here. At some point in history, Starbucks was cool. Then it got so big that it became a joke amongst serious coffee lovers. It went through some tough times in terms of brand equity, but its financial results haven’t disappointed. From 2010 to 2019, its revenue grew by 128%, cumulatively. Not bad. But from 2001 to 2010, revenue had grown by 394%! What happened? We suspect it was a case of market saturation in some key market (like New York and London) AND a steady migration to little, off-the-beaten-path artisanal coffee shops. Many people crave uniqueness over consistency.

The risk for AirBnB is that they become the big, bad wolf of tourism at some point. Defections would follow because the whole reason for Airbnb’s existence is to be anti-corporate, anti-establishment, or anti-blasé. We believe there is a limit to scale. But there is no limit to Trust – more the better. AirBnB should strive to not be the next Starbucks, that is – somehow becoming THE beaten path. We do believe that as long as Brian Chesky – the founder – is at the helm, he’ll do everything he can to not let scale reach the tipping point where it becomes the antithesis of what he set out to achieve in the first place.

Key Risk: Stringent legislations across Europe that restrict apartment-owners from “AirBnB-ing” their flat because of shortages in affordable rentals in cities.

This is a fluid situation that we can’t predict. In fact, it’s the only reason that we aren’t diving straight into the AirBnB story without first comparing it to DoorDash and Etsy for a place in our portfolio. Otherwise, for us, the AirBnB story is a slam dunk. Articles like these keep popping up every now and then, basically suggesting that European city governments will get strict if housing prices increase dramatically.

CEO Chesky was asked about this issue in the Q1 2021 earnings call. He retorted back with his view of an emerging, long-lasting trend AND a hard data point:

1. According to Chesky, this risk is mitigated by something he’s seeing in his dashboard – that travel is moving from big, famous cities to smaller, lesser-known places. It’s that “uniqueness” factor again.
2. A lot of cities have been hit hard economically due to the pandemic – so it’s no surprise that over 100 cities have struck “tourism deals” with AirBnB. Apparently, more cities, especially in Europe, are reaching out.

The Catch-22 for city governments is that AirBnB brings in a lot of money into their city, but it could also create distortions in housing supply that would probably increase housing prices. In a continent like Europe, where unemployment rates often veer into double-digits, cost-control is a big priority for governments.

We have no risk-mitigation or calibration tools for this particular risk. It’s political in nature. For now, we’ll need to buy into Brian Chesky’s optimism and keep watching this space for more developments.

Valuation: What is Sustainable?

Our ABNB valuation assumes a massive 5-year revenue growth number: 200%, cumulatively, from 2019 levels. As we’ve explained in the sections above, given AirBnB’s history, competitive advantages and the TAM ahead, we don’t think it’s a hard pill to swallow. Let’s go through our assumptions line by line in our Sustainable Free Cash Flow waterfall:

1. Revenue – There are 3 variables to consider:
   1. Number of nights booked in a year
      • We assumed that this variable will increase by 200% in the next 5 years.
2. Average price per night
   • We’ve assumed that it remains stable at 2019 levels of about $116.
3. Airbnb’s take rate or percent (a times b) charged by Airbnb
   • Assumed this will remain stable at 13% because of lack of credible competition.
4. Cost of Goods Sold:
   • We assume Gross Margin remains stable at around 75% - same as 2019 levels.
5. Operations, Support & Product Development
   • We believe this budget will increase modestly over the next few years – by about 20%.
6. Sales & Marketing
   • We believe this budget will increase modestly over the next few years – by about 10%.
7. Depreciation & Amortization
   • We believe this will remain stable at 2019 levels.
8. Maintenance Capital Expenditure:
   • Remains at long-term average of about $100 million.
9. Increase in Working Capital
   • We’ve assumed that this will neutralize to $0 over the next 5 years.
10. Cash Interest
    • We assume that as Airbnb’s revenue increases, they will pay down debt.
    • Currently, Airbnb’s debt load is about $2 billion. Even at an interest rate of 5%, the cash outlay would be $100 million per year. This does not materially alter our valuation estimate of ABNB.
11. Cash Taxes
    • We’ve assumed a cash tax rate of about 15% - assuming that it will be a combination of a slightly higher tax rate than the current rate (21%) and the benefit of net operating losses over the previous years, including 2021.
12. Growth Capital Expenditure: $0
    • Assume as growth initiatives are expensed at the Operations, Support and Product Development line item.

Here's how it all shakes out - from our estimate of Sustainable Revenue to Target Price:

And here’s the key assumption – the revenue matrix which is at the heart of our valuation:

All this amounts to a Sustainable Free Cash Flow estimate of $5.2 billion. That translates to a valuation estimate of about $174 per share – using our standard 20X multiple on Sustainable Free Cash Flow. That implies just about enough margin of safety between our valuation and the current price of about $136/share.

Please see Airbnb Thesis Presentation for Valuation Details.

Final Thesis Summary

AirBnb has become a verb, like Google. And yet, after a decade of existence, it doesn't have any credible competition. AirBnB has harnessed technology to sell something that's not easily replicable - Trust. We believe this core advantage and moat will not diminish over the next few years. Reasonable growth assumptions about the number of nights booked per year, imply a valuation estimate of about $174 per share.