Investing in Localization

Published on 02/12/21 | Saurav Sen | 2,098 Words

The BuyGist:

  • This is not an investment thesis or recommendation. Yet.
  • But this sets us up for a full-fledged investment thesis on one of these companies.
  • This Worldview article is about choosing where we should spend our time, and why.

Off the beaten path.

I don’t know whether it’s Nassim Nicolas Taleb or Donald Trump’s campaign that made this word popular: Localization. They, of course, used the word as a counter to what is, in their view, a pejorative term: Globalization. But to us – and probably to DoorDash and AirBnb – Localization is not an economic rebellion about on-shoring manufacturing or castigating free trade. To us, and presumably to the two companies, it’s about Authenticity.

Localization is about discovering the nuances of a small, specific area in our big, wide world. You could zoom into some random corner of the world or your own little town. AirBnB serves the first crowd; DoorDash serves the second. You could do both, in which case both AirBnB and DoorDash’s services should be interesting to you.

In a hyper-globalized world, many of us crave the cultural peculiarities of hyper-local areas. It could be a small wine-producing region in Europe or a little town in Turkey or our own little neighborhood. Many of us are sick of the “standardization” epidemic that started in the 1980s. It wasn’t all bad – it came with convenience and low costs. But somewhere down the line many people got sick of chain-restaurants. They wanted authenticity – some place that was decidedly local with a distinct personality – both at home and abroad. Chipotle is the exception – kidding, sort of…

One could say that there’s a sort of decentralization movement going on in the Entertainment Space. There’s a bigger market for small, independent products – in food, theatre, movies, museums, hotels, and so on. Ironically, however, the platforms that allow us to sample these peculiar products are big, centralized behemoths.

With decentralization of production comes a problem – lack of information and quality control. And that is the problem DoorDash and AirBnb attempt to solve. They are marketplaces and advertising boards with a feedback loop that allow customers to pick the right products or services – off the beaten path.

If I had to distill what these two companies sell, I would say it’s a potent combination of:

  1. Discoverability
  2. Trust

This is not easy to achieve.

Bring on the Buzzwords.

One of the worst side-effects of Business School is that buzzwords get carved into the brain. I tried to resist, but I’ve been infected.

To state the obvious, both DoorDash and AirBnB are Marketplaces. People buy and sell things on their platform. Embedded in these marketplaces is another buzzword: “Network Effects” – the more people use it, the more valuable the platform becomes. This is because of the Feedback Loop (sorry, another buzzword) built into these marketplaces. This is a MOAT (another buzzword) – a barrier that keeps competition from encroaching further.

The thing about Moats is that it’s a dynamic concept. Competitive Advantage is fleeting. A Moat protects a constantly thinning competitive advantage. The concept of Economic Moat was first made famous by Buffett. There’s a Buffett quote for everything, but here’s my favorite one about Moats:

“The key to investing is determining the competitive advantage of any given company and, above all, the durability of the advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors. The most important thing for me is figuring out how big a moat there is around the business. What I love, of course, is a big castle and a big moat with piranhas and crocodiles.”

Companies that stand the test of time are ones that constantly renew their competitive advantage. The idea is to not only keep the Moat intact, but also constantly widen it. This idea was taken to a new level by another Buffett admirer – Jeff Bezos. Legend has it that Bezos drew the famous Amazon Flywheel on a napkin before he started the company. I can’t verify whether this actually happened, but the Amazon Flywheel is now a permanent fixture in Business folklore.

DoorDash founder and CEO Tony Xu was obviously inspired by this. In their S-1 filing, he made sure to include the DoorDash Flywheel:

Scale begets scale. And larger the scale, wider the Moat. That’s the Flywheel Effect. While DoorDash’s flywheel is very convincing, when it comes to scalability, it’s AirBnB that stands out.

Scalability: Where they diverge.

Scalability means higher profit margins as revenue increases. Wall Streets analysts also call it Operating Leverage. Software companies – especially in this era of Cloud Computing – are highly scalable with high operating leverage. It’s all about cost structure. If most of the costs are fixed, it doesn’t take much to sell more of the product. Economists would probably like to tell you – the Marginal Cost of software delivered via Cloud – is almost Zero.

DoorDash and AirBnb have a big software component to them but they do operate in the physical world, unlike, say, Adobe or Salesforce. Ultimately, the products and services sold in DoorDash or AirBnb marketplaces are generally physical. This spikes up their marginal cost of selling the product or service. In the physical world, it costs money to make and ship an additional product.

DoorDash makes money when people order food or groceries or something else. They charge a service fee to both the customer and the seller. And from that service fee, they pay the “Dasher” or the delivery person and keep the rest. The Dasher fee is their marginal cost. In their S-1 filing, DoorDash provided an illustration of how their fee structure works:

AirBnb didn’t draw us a Flywheel. It is, however, the more scalable company. They still run into the limits of the physical world – such as, say, number of apartments in the world in a given year – but until that limit is reached, the marginal cost of selling an additional product is very, very low. Most of their costs are fixed and centralized. They don’t need to pay anyone to rent an additional apartment. They don’t even own the apartments or houses. They get a fee every time a customer rents a place or books an AirBnb Experience. As the number of bookings increase, so does the profit margin. Here’s AirBnb’s fee structure illustration from their S-1 filing:

We normally spot Scalability with high profit margins. In the Income Statement of a firm, Cost of Goods Sold generally accounts for most of the Variable Costs. Revenue minus Cost of Goods Sold is Gross Profit. Gross Profit divided by Revenue is Gross Margin – higher the margin, the more scalable a business usually is. Here’s how the Gross Margins of DoorDash and AirBnb compare:

To be upfront, I’d like to mention a couple of caveats about the data:

  1. DoorDash numbers are estimated – they are annualized versions of “Nine Months ending September 30th, 2020”. That’s because the S-1 was filed before 2020 numbers are due to be reported. And 2019 numbers are too conservative for a fast-growth e-commerce company in these pandemic times.
  2. For AirBnb we’ve used “as reported” 2019 numbers. We decided that 2020 numbers – such as “Nine Months ending September 30th, 2020” – would be too conservative for a travel-based company in these pandemic times.

I bring up Scalability because it’s a major part of our Expectations Investing approach. We ask ourselves: what revenue growth do we need to believe for us to buy the stock at current prices? A firm’s cost structure determines the answer. If the costs are mostly variable, the business is not as quickly scalable, and we need to believe much higher growth than would be the case with the alternative. The alternative is that most of the costs are fixed, in which case we wouldn’t need to believe a super-high revenue growth for the firm to generate a respectable amount of Free Cash Flow – the most non-BS measure of profit.

We put these two hot stories through our Expectations Investing test.

What do we need to believe?

We’ll get right to it. Here are our estimates of the “revenue growth we need to believe in order to buy the stock at current prices”:

I should reiterate that these revenue growth numbers are cumulative, not annualized. So, we’d need to believe that over 2, 3, 4, 5 years, these companies would be able to increase their revenues massively.

Honestly, we were surprised how close these numbers are. We expected DoorDash’s number to be much higher than AirBnB’s. To break these numbers down a little more, I’d like to go back to the cost structure difference. Check out the difference in their cost structures – between Fixed and Variable:

Put together, the 2 charts do suggest that AirBnb’s revenue growth estimate is more believable IF the company can keep its Fixed Costs under control. There are, of course, other issues – competition, regulations, travel trends etc. – that we’ll need to estimate to answer the question, “do we believe in that revenue growth number?”

To answer that question, we like to break down revenue into its basic components: Price and Volume. Every company has different price and volume variables. For DoorDash, we would try to estimate “what do we need to believe” numbers for the following:

  1. Gross Order Volume (GOV: total $$ ordered in a given year)
    1. Number of orders per year
    2. Average Price per order
  2. Percent of GOV kept in fees

For AirBnb, the breakdown would be similar:

  1. Gross Booking Volume (GBV: total $$ booked in a given year)
    1. Number of bookings in a year
    2. Average Price per night per booking
  2. Percent of GBV kept in fees

Normally, we like to depict this in a matrix format, so we can make more educated guesses about revenue growth. For example, we did this recently for Pinterest:

We’ve done this type of matrix for other companies as well – they form the crux of our theses. In this case, it looks like the matrix will be 3-D. We don’t know how to show that on a 2-D screen. But we’ll figure out a way.

We’ll follow up with a thesis on either AirBnb or DoorDash next week.

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