Chit Chat Stocks - Why We Don't Own Airbnb (Ticker: ABNB)

Episode Date: July 4, 2023

This is our monthly Arch Capital episode. About once a month we will publish an episode that covers a company in the Arch Capital Investors Fund. These episodes will be modeled after our Not So Deep Dive episodes and will also be available on YouTube. Airbnb, Inc. (ABNB) is a global online marketplace for lodging that provides a convenient platform for individuals to rent out their properties or book accommodations, though it navigates regulatory complexities and travel demand fluctuations. Brett and Ryan dive through Airbnb and outline the investment thesis for why we don't own the company in our Arch Capital limited partnership. ****************************** What is Arch Capital? Arch Capital is a concentrated, long-only equity fund aiming to compound capital at an above-market rate. Arch managers are perpetual learners with a long-term focus that strive to build wealth with our partners through intelligent capital allocation. Learn more here: https://www.archcapitalfund.com/ ****************************** Timestamps Company Background | (4:29) Income Statement | (23:14) Competitive Advantage | (35:40) Valuation | (59:45) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. On this show, hosts Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or a recommendation. Now, please enjoy this episode. Welcome into Chit Chat Money. My name is Brett Schaefer, and I'm joined as always by my co-host, Ryan Henderson. And today we have our monthly special Arch Capital episode

where we cover a stock that either we own, have owned in the past, are interested in, or anything around the investment fund that we run called Arch Capital. If you're interested more in how we do things over there, you want to learn about more what the fund is, we'll have a link in the show notes for this episode that goes to the website. You can learn all about it there. We don't want to spend too much time on this episode doing that. Ryan, anything to add? I want to maybe talk about our process so people get an idea of why we do these episodes. For those people that aren't regular listeners, or maybe even if you are, we do our not so deep dives once a week where it's kind of a surface level look, or maybe not

surface level, but it's the first time we're looking at a business oftentimes, or it's the first time we're kind of digging into the actual SEC filings and really getting a better grasp on the actual investment itself, that's kind of the top layer of our investment funnel. And then as it trickles down, as we do more research after the not-so-deep dive, if we're more interested at the end of the show, we keep researching, it's on the watch list. Eventually, Brett or I will pitch something internally to one another, pitch a company, and that is the pitch for Arch Capital. That is to include it or to say, this is a business we should own at some point because

we like it, I guess, spoiler alert, that's kind of where Airbnb is going to be on our list, but we pitch it to one another. And then we say, when it gets to a certain price, this is why we'd like to own it. So that's kind of the process. Am I missing anything there, Brett? Yeah, just we're sharing our research process publicly with everyone. We hope everyone enjoys that. And these episodes are companies that we're more interested in.

We titled this why we don't own drop or excuse me, Airbnb Dropbox Dropbox was on my mind for some reason. That is something we do own at this time of recording, but we've covered since we don't own very many stocks, we have covered everything we've owned basically, or everything that's really kind of a listenable show or something that's not too illiquid where we wouldn't want to share it publicly because it's just not, we're not comfortable doing that. So we're going to go with stuff that is on the watch list, but either for whatever reason, which we'll get into during this episode, we are not buying today, but I have some things

we're looking at for hopefully in the future, the price gets to where we would be comfortable buying shares. And today we are covering Airbnb. So we're going to go through the same format where it's almost a cross interview between each other. we have a couple of topics that we're going to cover and uh i did one that ryan does one then i do one that ryan does one and then we cover to conclude we do our sort of pre-mortem that we do with a lot of our interviewees uh but basically we're covering the risks at the end that we're

both worried about so before we get started ryan is there anything i think if you want to you know read our show notes subscribe to the newsletter it's free it'll be in the show notes uh if you If you want to click that link and then search Chitchat Money Substack, if you want to find it there, you'll be able to follow along with the episode. We think it'll be great. Do have a nice meme in there this week. So I think people will laugh. Anything else though, before we get started?

I guess just full disclosure, this is one that Brett has pitched to me internally, and we've both come to the conclusion that we do want to own it at the right price. And so that we're going to, we're going to talk about why, but let's start with kind of what, what Airbnb did. I'll kind of ask you this question. How did Airbnb really begin and what got them to where they are today? Yeah. So there have been a ton of histories, audio books, or audio podcasts, a few books out there covering the deep history of Airbnb and how the company started. There's a lot of Silicon Valley lore around this company. I'm going to keep this part short, but I just want to have enough context for the listeners to basically so you can understand fully why the business is at where it is at right now. So there are a lot of corporate histories, but in 2007, founders, Brian Chesky and Joe Gabia, I think I'm saying that right. Ryan, do you know if I'm saying that correctly? I'm pretty sure it's Jebia.

Jebia. Joe. Jebia. We're just going to probably go first name or last name with Chesky or Brian, Joe, and then the other founder is Nate, but he has a last name I do not want to pronounce because it's very, very hard. So these two guys were looking for some extra money to pay for rent in San Francisco because either their rent was going up or it's just really expensive to live there.

So these two decided to rent out their extra space during a weekend when there was a big conference in the area. They made a site called Air Bed and Breakfast, and then they found some people to rent out the space during that weekend because all the hotels were either booked or jacking up prices. after the weekend the two realized there was something to this idea of renting out spaces that aren't formal or you know hotels and stuff for travel and they contacted their engineering friend nate um apologies to nate if you are somehow listening to this because i do not want

to spell your last name it is very hard to pronounce and i do you know it's i think i've got it i think i've got it if you want me to say it okay try it out ryan i believe it's nathan lecharzik maybe uh you know yeah i have no clue but i'm gonna call him nate if we ever refer to him again throughout the episode and he was a bit of a coding savant that was their friend from harvard um then they kind of sputtered around in obscurity for like a year or so they actually tried to launch a few times but failed to get really any traction this kind of in the 2007-2008 period they actually reached out to a lot of investors and they got zero luck with fundraising then at the 2008 democratic convention they launched again but with a unique marketing

strategy by selling an obama style cereal as long as a i think a john mccain one as well and inside the cereal that they sold in the street which you know worked well at a political event And they had a promo for Airbnb inside. At this point, I'm not sure whether it was called Airbnb or Air Bed and Breakfast, but at some point they shortened it, which is definitely a good choice. Y Combinator took notice of this, that they had a really successful weekend there, that it kind of was very unique, creative with that strategy. They put them in their accelerator program.

They improved the product. Then they got a $600,000 initial investment and the rest is history. They went on a classic blitz scale. And by 2011, they had 1 million nights booked on the platform. They kept raising billions and billions of dollars from venture capitalists and grew to become one of the premier unicorns in the Valley. So to sum things up, at the start of the business, the three guys had a novel idea, then they blitzscaled it. The company had a classic grow at all costs, Silicon Valley mindset that got them market share fast, but in an unprofitable manner. And then next, the pandemic hit.

So Ryan, what changed during the pandemic for Airbnb and how have they managed it and recovered since then? yeah so a number of things have changed and if you're really interested and frankly if you just want to get bullish on airbnb i recommend listening to brian chesky he is he is uh i mean he's charismatic but also yes in particular at the recent morgan stanley technology conference he goes into i mean he gives just really a wonderful speech all around but he goes into the transition that they experienced throughout covid and he kind of breaks it down into when he's talking, it breaks it down into two changes. There's the external changes, so changes to the

market overall, and then the changes that Airbnb made internally. So if we start with the overall market change, he says this, he says, I think a lot of things have changed, but I think the biggest thing that's changed is suddenly people have realized they can do their entire job from a laptop. There is an unmistakable trend that people are permanently more flexible. And I know a lot of people debate around remote work, whether it's here to stay, yada, yada, yada, but it's clear that they've been beneficiaries of... The proof of remote work and worker flexibility is you can see it in Airbnb's revenue trajectory, and we'll talk about that in a second. But he talks about how that shift of more flexible places to work has really resulted in longer-term stays,

And then he goes on to say, I think travel has changed forever. Business travel still exists, but a blurring between business and leisure is probably where it's all going. I think we're seeing that play out right now. even if you're a remote work skeptic, I think it's pretty indisputable that the changes to the travel market brought about by the pandemic are ultimately going to benefit Airbnb, or at least kind of that. If it's not Airbnb, it's going to benefit the longer term stays type model where you can go and live somewhere for two and a half months. Brett, you've done this before in a number of different countries. You can work from there. You don't have to be somewhere locked in for your lease. You don't have to go work exactly where your company is. I think a lot of people already know this, but not to mention the rise of gig work and online gig work, it's becoming more and

more common. And so this market dynamic or this trend really accelerated throughout COVID. And so that's the market changes. Now on the internal side, there were a number of big changes that Airbnb made. So prior to the pandemic, Chesky said that Airbnb had become very divisional. They had their homes division, their experiences division, transportation, China. I think they had a magazine division. They had a bunch of stuff they were trying out and it was all segmented division by division. And the decision-making was all made at the division level. So basically, and I guess I'll also add, in addition to having basically separate organizations within your one organization, they were spending about a billion dollars a year on performance

marketing. He even said he was getting frustrated. He came back from a trip and he was getting frustrated with what Airbnb had become. He wasn't very excited about the business and it became very bureaucratic and all that stuff. And here's a quote. He says, our product was looking less different than our competitors every single year. It was getting really hard to get work done.

It was bureaucratic. It was political. Basically, we were suffering from big company syndrome. So it sounds like the pandemic may have actually been the spark Chesky was kind of hoping for. Obviously, I don't think he would have hoped for his business to disappear as quickly as it did when the pandemic first came about, but it allowed him to make the changes and frankly, have a little bit of an excuse to make changes that maybe they needed to begin with. And he even says, then the pandemic occurred. We lose 80% of our business in eight weeks. We have

to rebuild the company from the ground up. And I thought this is a moment for us to build a different kind of company. So in April of 2020, at the height of the pandemic, a lot of people were saying, or kind of calling for the demise of Airbnb. Airbnb had to make some significant changes. First of all, they shut down all marketing. And people that have followed the Airbnb story have probably heard this now, but Chesky says, what happens if you shut off all your marketing? The answer was hardly anything. That's when I realized performance marketing is a drug. And he basically says, this is the dream of every chief marketing officer, cut marketing to zero, see what happens. And he said pretty much nothing. The brand really carried on its own.

They had become kind of a verb by this point and it grew organically. They did not need the performance marketing. So I thought that was just really interesting. Obviously, it also helps the P&L. Brett, you looked like you were about to say something. I was going to say, he said that every time he's had a public appearance. I think that's his go-to story every year since, I don't know, 2021, right? Yeah, 100%. And then he also talked about shutting down a lot of the divisions. So there was a whole bunch of kind of, what's it called? Skunkworks type of divisions that- Or just, yeah, other bets maybe or adjacencies or, yeah. They weren't core to the Airbnb business. And so he says they shut them down and really consolidated everything into one business. And he says, we went back to a functional organization like a startup. We had a marketing department, a design department, and an engineering department, and we centralized all decision-making. How has that ended up for the company?

Pretty damn good. So trailing 12-month revenue, I'm going to compare today versus pre-COVID, Trailing 12-month revenue is expected to hit $9 billion when they report this upcoming quarter's earnings. That's 90% higher than Airbnb's pre-pandemic levels. However, the real change has come in profitability. EBIT margins, or earnings before interest and taxes, which I think is probably the best way to value the business, maybe. I guess they could be getting some interest income in a higher-rate environment because of the working capital. We'll talk about that a little bit. We will talk about that, yes.

So their EBIT margins have gone from negative 10% pre-pandemic to positive 22% during the last 12-month period. So clear transition in profitability. A lot of that was like they changed on a dime. Marketing as a percentage of revenue is half of what it was pre-pandemic. Most of that is not performance marketing. It is brand marketing, trying to really sell the brand, not only to customers and travelers, but also to potential hosts. Now, I will say part of that profitability has been driven by the supply and demand imbalance. So their demand grew really quickly and supply did not grow quite as quickly, which meant that the average daily rate, or it was more competitive bidding on lower supply, boosted the average daily rate.

The average daily rate really helps the P&L or the profit and loss income statement for Airbnb. And it's kind of stabilized. Somewhat, but I mean, it's basically all variable, right? But I guess, yeah, it's going to help revenue, but as I'll get into when I go cover the business model, yeah, I mean, if the rates are higher, since they have the take rate, they're going to earn more. But I think that cover, I mean, when you look at this, it was very much a Silicon Valley venture capital, grow at whatever costs.

You've basically took on a lot of private funding, you raised a serious IPO, and you've got probably a lot of employees that you don't want to let go, some bureaucracy and some pain points in the business that are just too hard to address. And COVID, frankly, gave the management team at Airbnb an excuse to say, we're shutting a lot of this down. We're going back to being sort of like a startup and we don't need to have all this pointless performance marketing spend. So it was they went from a young, nascent private company to almost a mature cash flowing business in like a year. That's really a transition. I don't think I've seen any other business make that quickly. Yeah, it's been quite impressive. And the management team has been very strong. Ryan, you'll hit that. I don't know if it's the next one after mine, but yeah,

you're supposed to ask the question here. So why don't you go? How does the actual business model work? I think a lot of people generally know, but can you go through the actual details? Yeah. So for a company of its size, which as Ryan mentioned, $9 billion in revenue a year or trailing 12 months, Airbnb's business model today is incredibly simple. And in my opinion, quite elegant. As a marketplace with two groups of people looking to make transactions, you have the host or the sellers on one side and the guests on the other side as the buyers. Airbnb just takes a cut of every dollar spent through its service. Famously, it has kept its host fee at 3%, so 3%

of the transaction, but the fees applied to the guest is much higher in the 10% to 15% range. They don't give out, say, their take rate every quarter. And it's a little bit hard to calculate because they report their revenue, which is kind of what they're... They earn the revenue when the guest checks into the place or finishes. They earn the revenue once the thing is fulfilled. That's kind of how it works in gap accounting. But they also report their gross booking value, which is how much is booked on a dollar amount in a certain time period. And that could be something that is booked not during that time period.

It could be booked for something six months later. However, I think it's generally okay to use basically revenue divided by gross booking value as a rough approximation of a take rate during a high growth period. This may seem like there is a lower take rate because they're doing a higher booking value versus the revenue they're earning during that time period. But over a 12-month period in a normalized environment, I think you can use that. So with that being said, if we take 2022 revenue and divide it by 2022 gross booking value, we get a take rate of about 13.2%, which I think is right in the ballpark.

And that's kind of the take rate if you blend it together of the host and the guest fee. of what they're going to earn. And really, today, that's their entire business model. I mean, yes, we'll talk about the interest income on their cash balance and their working capital advantage that allows them to earn even more interest income. But what investors need to know is that they charge a small take rate to host and a larger one to the guest. And they'll include taxes and stuff inside there as well for everyone. I think another important note is that Airbnb processes payments itself. So since this is the payments month, I think I wanted to discuss this because it's hard to see how this relates to all the payments companies, but I honestly think it does

because that's one of their core advantages. Essentially, they have built their own payment processor without the need for an add-in or another checkout solution or a Shopify checkout type solution or whoever that would be. They basically built their own add-in for cross-border payments, which I think is pretty incredible. And what's even more incredible is that they built this from scratch as a startup in their early days, and it now works seamlessly around the globe. And that's why one of the important people at the company is Nate, the co-founder, the engineer guy, because I believe he is the one that spearheaded this at the start and really built this from scratch. And there's a lot of... In the book on Airbnb, I think it's

book on Airbnb and Uber. They talk about how people were just amazed that they could build something like this on their own. And it was kind of one of those similar to Spotify, how they invented the first streaming solution way back in the day with the older tech. And people were amazed at how fast it worked. I think this is a similar innovation and gives them an advantage because there's very, very few companies that make their internal payments. Do you have any, or excuse me, an internal payment solution? Is there any examples you can think of, Ryan? Shopify, right?

Shopify, yeah. That's a good example. Shopify has one? But they're also not a customer-facing solution. True. The other thing is they do partner in some ways with the merchant acquirers. I know they recently partnered with Stripe, but I think that's for direct bank payments for the hosts. So it's a different part of the transaction.

And they also partnered with Klarna. I have an example here, and that'll be in the newsletter about how you can do buy now, pay later with Klarna. But yeah. And I think the important thing to note for the checkout part is that they are the merchant of record with payments. They hold the customer funds before paying the host, which allows them to invest the cash into short-term treasuries. And this is what we mean by a working capital advantage.

So this is not money that they can take home to the bank, or it's in their bank account, maybe. But it's not money that can be distributed to shareholders. And as of last quarter, I believe it was $7, $8 billion of this sitting on their balance sheet. And it changes seasonally. Each quarter, there might be a little lumpy, but they can take that cash and buy short-term treasuries and earn a pretty good clip.

I mean, if they have $10 billion in cash there, that is funds held for customers, and they can buy bonds yielding 5%, that is $500 million. It's pretty darn good. And that interest is cash that can be paid to shareholders. That's true. That is true. Now, I wonder if they're going to, it'd be interesting to see if they start giving that back to the hosts over time a little bit. It'd be quite, I think it'd be interesting, but let's continue.

I think we need to, we like to go through kind of the line items of the income statement and look at, okay, what are the contribution margin? what is our definition of a contribution margin, and come to a conclusion of what a company's steady state or what their potential operating margin could be at scale. And this is going to not include the interest income, which I think is just a cherry on top and could change depending on interest rates. So first, cost of revenue. These are the payment processing distributions. So they got to pay the mob, credit card companies. We talked about that on the Visa episode. Hopefully, if you've listened to all of our podcasts

that you know about how this stuff works now at this point. They also have cloud hosting fees, which again, you pay the mob, AWS. And then they have some amortization of internally developed software and then some fraud costs there as the merchant of record for the host. This was 17.8% of revenue in 2022

and gives them gross margins above 80%. Next is operations and support. I would probably argue that this could get included into cost of revenue. As you might guess, this is just support contractors, all that stuff. When you call up Airbnb, this is the cost that goes there. They have a lot. It's a huge part of the business here. It's very, very important that they have that scaled.

And they spend a lot of money on it. It is 12.4% of revenue in 2022, which leaves, if you add these two numbers together, 70% of every revenue dollar left over from after operations and support and the cost of revenue that leaves a 70% contribution margin that they can plow into R&D,

sales and marketing and pay for overhead costs or toss it back to shareholders as net income or cashflow. Now, let's see. It's gone long. So what's next on here? I'd say this is a pretty attractive business model, gives them a lot of optionality to invest in new initiatives, which we will cover later. And given the dynamics Ryan talked about, they have started to generate healthy cash flow or excuse me, operating margins, which, as Ryan mentioned, gap EBIT margin was over 20% in 2022, even with major foreign exchange headwinds. In a lot of regions, many regions still down from COVID-19, especially at the start of

the year, and still for most of the year in the Asia Pacific region, and they still had 18% of revenue spent on product development. So taking all this into consideration, I'm curious to hear your thoughts, Ryan, as we've looked at this business again, I think we can model the business closing in on 25% profit margins sometime soon, but probably not much higher given management's commentary on pushing for growth and reinvesting into product development. Yeah, I think that's probably a good estimate. It's also worth mentioning that they still see a lot of opportunity to advertise and try to scale on the supply side of things. So trying to garner more hosts, that means they're

still in big time investment mode. They talked about that this quarter as well. They're pushing marketing and they push it a little quicker before the summer season. So you're going to see kind of an uptick this quarter most likely, but then it should be about the same percentage of revenue for the full year. But I wouldn't necessarily just forecast incredible margin expansion because I think they're pretty keen on reinvesting a lot of the money back into the business and trying to garner more hosts. And so far, they've done a really, really good job of that. What's nice though, is I think they could get to 40% margins if they really wanted to, but it's not going to be a while given that they think they have a long runway to reinvest.

They still say, as Ryan's going to talk about later, are in land grab mode. But the next topic we want to hit is covering the management team. If you haven't listened to any of these episodes before, you should know that we have three main criteria when investing in a company. They have to pass our management checklist, which is basically, do we trust management to act rationally for us? And it has to pass the predictability standpoint, which basically says, do they have a competitive advantage that we understand? And do we believe the industry is durable? And third, it has to be trading at a reasonable price. And we will get to the reasonable price one and how it doesn't check off our list right now for airbnb but let's hit the

management checklist why do we like him why is that checked out for us yeah brian chesky is like ultra charismatic he's very maybe dangerous maybe dangerously yeah and that can be misleading sometimes and you know there's i don't know how much this matters to like the investment case but But there's a lot of CEOs out there that are very concerned about public perception. And maybe it's just because Brian Chesky is so charismatic, but he seems to be genuinely focused on building a better business as opposed to just building the best public reputation he can for himself and making money along the way. He really does seem tied to this.

And I think part of that is probably because he's the founder. And I truly think he possesses that same kind of insatiable, bit crazy customer focus that Bezos had in the early days and probably still has. But here's an example. On May 3rd, Brian Chesky tweeted, and I recommend following him on Twitter. You're going to get a pretty good glimpse of who he is as a manager or CEO. But he says, you told us what you don't like about Airbnb. Here are the 50 things we're doing about it. And released a long thread. I'm a thread hater, but it had tons of different new product rollouts and product changes that were made in response to customer feedback. here's a list of the top 10 upgrades they've made total price display so customers really upset that they were getting basically this it would be like you know 50 bucks a night or something like that and then it'd be like 600 in total for two nights that's okay you know that's very disingenuous dishonest is what it feels like that's a bit of an exaggeration but i think listeners have all experience this there's a lot of added fees and so the first thing they did was prioritize total price display they added new mini pins on maps i'm not sure what all of these are just be clear

redesigned wish list improved monthly search transparent checkout instructions pay over time so basically added their own native buy now pay later solution and and like i mentioned earlier they are partnered with the clarna or at least when i did an example checkout they offered a klorna solution interesting okay there was the one in your picture there that made it seem like it was their native solution but i could be wrong yeah well yes yes look if you look at the picture it's they have klorna and airbnb i don't know but they also have the uh it's not really a buy now pay later because they just say pay and it's like there's no interest fees you basically can still cancel it's not really buy now pay later it's just you can pay in

installments. Yeah. Because it's all before you're listening. Excuse me, your stay. He goes through all these different product upgrades. And then the same day he turns around, he tweets, what else can we improve about Airbnb? We will prioritize your top suggestions. Got a whole bunch of suggestions that he said, all right, going to work on these over the summer. And he's been rolling out a number of these. And if you actually look at two of the big recent product rollouts. Let's take categories and air cover. They are very clearly addressing or focusing on the customer on both sides. So categories, I don't know if people were clamoring for this, but it helps inspire probably more trips. It inspires people to find new ways

to travel. And for those that don't know, it's just like you're able to classify your, or you're able to search your travel destination based on certain categories like the beach or mountains or, and they can go specific to like a frames or something like that. So it's, it's very comprehensive for they, the reasoning they said is they want to be the place where people are, you know,

they're inspired to say is this example, I want to go to the beach. Then they start on Airbnb for that search. And I think it's great because you want to be the starting search as opposed to having to pay for that performance marketing on Google, right? Yeah, 100%. And the other one is AirCover. This was, I think, brilliant on their part because so much of the, I guess, the number one problem if you're going to be an Airbnb host is you don't want people to ruin your home. You're worried about, okay, what's going to happen to my house?

What's going to happen to this place I live if other people come in here? And air cover is basically it gives hosts access to $3 million of protection against theft or property damage. It requires identity verification for all customers, I believe, that use it. It's just kind of a weight off the shoulders if you're a host and reduces the friction involved to getting up and listing a room or your house, your entire house on the Airbnb platform. So really liked both of those product rollouts. Just in general, the execution, the product execution has been top class at Airbnb, especially when you look at it against really any other business. i i was scrolling through some of the apps paypal right i was scrolling through some of the apps on my phone these products haven't changed they've marginally changed over the last i'd say three years the only one that comes close when i think airbnb is better is probably spotify

i was gonna say spotify um hinge has been good and still i don't know it hasn't changed much i It'll be more buggy than you think. I just got an update and it said you have 50 notifications and it was all not. It was weird. They have a lot of bugs, I think, comparatively.

I guess Match Group is kind of notorious for not perfecting their product. Not perfecting it, yeah. But yeah, the execution has just been really remarkable. And they keep going after new ways to get hosts onto the platform.

they're trying to go after the apartments market. It's difficult for them to disrupt that since so many apartment complexes have restrictions built in that say you can't Airbnb it out. But if people that are looking for rent, I'm going on a tangent here, but if you're looking to rent an apartment and you see that, oh, okay, this apartment complex allows you to rent on airbnb because you can go to airbnb and you can check there's there's a lot of value there because then you can make money while you're out of town and you can be flexible and you can be flexible so the renters like they can charge higher rent and it might be a better value proposition for the the not the what's not the landlord the the leaser yeah and so it kind of encourages the

apartments that aren't doing it to say, well, you know what? If someone's going to my competitor across the street because they allow Airbnb rentals, maybe it's good for me to do it too. And so I think they're kind of- Well, here's, or go ahead. Sorry, finish that thought. I have a follow on. I was going to say, I think they have that poll now where they are like the platform of choice, at least in the US, where they can start to dictate and change some of the market dynamics. In Toronto, every arrival is a statement and nothing says it better than this. Cadillac Optic was the number one selling luxury EV in Canada for 2025.

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for the Cadillac Definition of Luxury. Yeah. And I want to hit, we're going to lead into competitive advantage next, but maybe hit this because you talked about regulation here. A lot of say, when we're talking online with other investors or basically anytime you bring up Airbnb, someone brings up the bear case being regulation. And they've always had headwinds of regulation in the past. But do you think that that actually insulates them as a competitive advantage as they're the only scaled or one of the, excuse me, one of the only scaled players who can target this regulation and all these local markets try to work with these communities and basically say, we're going to get this on the market. books. We're going to make this work. Everyone's heard of the famous stories of all the different areas, New York City being the number one as one of their biggest pain points during the early days. I think it's similar, and people may be calling it crazy, to Visa, where getting the regulations for working everywhere, or similar to some of the other foreign exchange companies where we talked about Wise having to work in every single local market to get payments set up. And there's a lot of government regulation here uh with payments and for lodging there's also similarly lots of

government regulations i think it's honestly to their advantage at this point like it's flipped from being a big headwind so yeah being a headwind today but they're the ones that can deal with the headwind much better than anyone else and i think we're seeing that show up in host growth which i talk about that in a little bit but the the number of active listings are really starting to roll in now at an accelerated pace. A lot of that work is starting to show up. On the incentive side for management, there were some hefty bonuses for some of the executives, but I think the executive team is properly aligned. Joe Gebbia owns 27% of the company. Chesky owns 31%. This is of the voting power they have one of those triple class structures not economic value to be clear

nathan blacharczyk if i'm saying that right which he's still the chief strategy officer owns 20 so combined the three founders own 75 of the company i think that's enough to say that they have a very clear incentive to drive long-term shareholder value yeah we talk about this being a little bit overrated, but it's not a bad thing when it's there. There's a lot of founder-led companies that I don't like, but frankly, that is the ideal ownership structure. You have someone with huge ownership in the company, doesn't need to be paid ridiculous stock options, and can just live off maybe selling a little stock here and there, or get loans with post their shares as collateral kind of thing

where they don't have to take it out of the payroll and out of the shareholders' pockets to pay management. This is kind of the ideal structure. Yep, and they do end up treating the companies more like their baby or their child as opposed to something they can milk for three years, which you see time and time again with a lot of mercenary CEOs. Agreed. Let's talk competitive advantage. Do you think, or do we think Airbnb has a strong one? Which direction do you think it's heading?

Yeah, so we want to talk about here whether Airbnb's competitive advantage is there or how strong it is and whether it is growing. I think that's an important note for people to talk about whether something is growing or shrinking. This is the part of the episode, I may have a disclaimer here, that people might start disagreeing with us.

I know there's a lot of pushback on Airbnb, and if you have any pushback on our bullishness on Airbnb's moat, we welcome all comments. obviously do not like you know be respectful but it is not disrespectful to disagree with us about a stock this is a part of the game and we if you find something that we missed that stops us from making a mistake well thank you for it so that being said the first topic is why we think airbnb has a strong competitive advantage so the core of the competitive advantage We talked about the regulatory stuff, but the core and the most important thing comes down to a network effect.

I'll read off the definition of a network effect so people can understand. Quote, the term network effect refers to any situation in which the value of a product, service, or platform depends on the number of buyers, sellers, or users who leverage it. Typically, the greater numbers of buyers, sellers, or users, the greater the network effect and the greater the value created by the offering. Airbnb has two sides to its marketplace. First, you have hosts who are either the lodging or experience hosts. And then you have guests, the people purchasing things. As the number of listings on Airbnb grows, the value proposition for guests looking for places or things to do also grows, especially if listings are growing at a faster rate than

the competition and you have unique listings. I think this is key here that you can't find on any other platform. In our mind, this is why the most important KPI for Airbnb by far is supply growth. Unfortunately, management does not state the exact number of listings or whatever you would call it every quarter, but they have been good about giving some data points recently. I have a table outlining some of the things here. I think I'll share the screen for anyone watching, but it's pretty easy to describe.

First up here, it's loaded, right, Ryan? Okay, so we have, this is basically active listings commentary since they've gone public, which was in Q4 of 2022. In Q4 of 2020 and Q1 of 2021, they talked about listings being flat over that time period, generally around the same. And I think that makes sense. It was the heart of the pandemic.

Then in Q2 of 2021, as a lot of places started coming out of the pandemic, they said that listings hit an all-time high. In Q3 2021, listings hit an all-time high. Q4 2021, listings hit an all-time high and surpassed 6 million. Then in Q1 of 2022, they saw 15% year-over-year growth. In Q2 of 2022, they exited the China business. So I think that hurt their overall growth rate, but they still said they had 6 million listings overall. So not a giant hit to the business. In Q3 of 2022, they had 15% year-over-year growth. In Q4 of 2022, they had 16% year-over-year growth and had 6.6 million total. And then in Q1 of 2023, the last quarter we've seen 18% year-over-year growth. I think the importance is that throughout

2022 and early 2023, we've actually seen a slight acceleration of listings growth, which is what Ryan mentioned earlier. Conversely, if we look at the guest side of things, the more active guests that are searching for places to stay on Airbnb, the more valuable it is for the average or median host to put up a listing on the platform and therefore has a higher chance of earning revenue. And what's nice about this is that Airbnb is playing a non-zero-sum game with these three stakeholders, which would be shareholders, guests, and hosts. If they get more supply on the platform and get more guests to spend money, the customer experience improves and Airbnb earns more in revenue since they just get a rake on all

transactions. Ryan, anything else before we go to why the moat is widening? No, no, you can probably stop your share. It's the... Oh yeah, right, right, right. Thank you. So it's obviously the more people that are using Airbnb on the customer side, the greater incentive there is to list your property. The other thing I'll say is, this is more anecdotal, but the people I know that have properties listed on Airbnb, I'd say three or four years ago, if they had something listed, they'd maybe listed on multiple places.

vrbo uh airbnb i think those were probably the big two maybe there were some other places i think yeah booking's getting into it now but they're more they're not as big in the u.s now nowadays i don't really see that as much i see people either most of the people i know just say like yeah i get all my bookings off airbnb and so that's a good anecdote right there and it's and it's like a chalk like their calendar's full or the available days are full and they're constantly getting new bookings. There's just no need. And so not to mention the average daily rate is up so much right now that people are really earning the more given that the average daily rate is so high. I do think if you get this huge slug of supply that comes online, the average daily rate

could come down a little bit just simply due to marketplace dynamics. And they said they're trying to force that a little bit to hurt themselves in the short term, just because they think it's healthier for the marketplace long-term they want to make like they they obviously aren't going to kick off the luxury places but they want more supply in the lower end just so all types of travelers can afford their their stuff so the next topic here is why we think airbnb's moat is widening or expanding why we think their competitive advantage is getting stronger so if we look at airbnb's moat or really if you look at it the lack thereof or people that kind of disagree with this. You can talk about this ad nauseum. You can go paragraph after

paragraph after paragraph, put your head in a pretzel about whether or not Airbnb has a moat and whether it's getting better. I want to make it incredibly simple. Airbnb's moat is growing if the supply on the platform is growing. I think that's it, plain and simple. And looking at the past few quarters, the moat expansion is actually accelerating. Ryan? I'd add that if it's growing faster than competitors, its moat is growing. Sure. Yeah. That's a good caveat. Yeah. And I think to close things out before we play a fun game, what's special about Airbnb's competitive advantage is that unlike other marketplaces like Uber, dating apps, food delivery services, grocery delivery, used goods, used good marketplaces,

Airbnb's network effect applies globally. While all those, it only matters in your geographical area that you are. Now, Uber can maybe be a little bit different because you might travel to a different city and still have the same app. But in reality, it's not that hard to download a new app and get a new ride share. So I think it makes Airbnb much less vulnerable to disruption compared to a marketplace like Uber, at least in my opinion. Someone could go after Uber in a local city and get given enough capital. We've seen it before. I mean, they've really defended themselves well, but you could maybe start stealing some market share. But Airbnb is in 100,000 cities and their guests are looking

forward places to travel all throughout the world. So if you want to disrupt Airbnb, you need to beat its entire supply around the globe, or at least in a very large geographical area, like a whole country or a whole continent or a whole region. In my mind, this reminds me a lot of Visa and the card networks. Now, we're going to get to speaking of Visa. I want to play a game. where would we rank airbnb's moat of businesses either we've covered or owned in the past i'm going to start with like strong ones or companies that we think have strong moats and i'm going to keep going down so the first ones i think are obviously ryan you're going to choose uh that airbnb is not as strong first one is amazon

i think amazon's is stronger okay alphabet this one i think's a little closer given that there's more of a physical component to airbnb and i mean google's proven time and time again that it's pretty difficult to disrupt but if like the major if there was a major platform shift i think there's a chance that google quickly loses share or something like if it moves to vr or something like that it might it might hurt them a little quicker just because it's purely digital and stuff and it's it's based on the major computing platforms but airbnb i think it's closer i'd still give it to google visa visa i would take visa yeah i think i can people might not like this because i don't know i compare the airbnb moat to visa just because it's all about

growing that supply you know for visa it's all about growing the merchants and growing the guests or excuse me the the people that own cards and visas you know obviously much farther along that journey than airbnb um let me just scroll through some of the episodes we've done oh american express i think the card networks beat all the major card networks beat airbnb okay okay i want to get to one that maybe is like the same pepsico i'd probably take airbnb there i mean there's like okay here's a little more retail because yeah let's do something more similar let's do something more similar uber yeah i was hoping you'd say that one i will take gosh they're they're very similar and in terms of modes i think the on the core ride sharing for uber on eats i mean doordash

is is really a formidable competitor there i think i would give it to airbnb because they well for one that's really their core business is I think self-driving differentiated

self-driving kind of takes the cake for me as a risk for Uber yeah I suppose the here's a fun one

or sorry you have another thought there I was just going to say that like eats is a decent size part of the business and that's pretty competitive right

right okay couple more then we'll move on match group Airbnb Venmo Venmo doesn't make any money

so I guess it doesn't matter I know I mean Venmo's sticky as hell but Airbnb I guess Shopify Airbnb Autodesk

last one uh autodesk probably yeah i go with i don't know it's like just different it's a different one yeah because that one's the last it still has a little bit of network effect i would say but we're not covering autodesk on this episode go listen to our show on them search up in your podcast player you'll find it let's keep moving on ryan our next question we have here is growth i think people worry about growth you know the business is already quite large We got, what, over $60 billion in GBV last year. They're probably closing on $100 billion relatively soon.

That's quite a lot of spending across their platform. Even though the travel industry is large, there are a lot of players. They're not going to disrupt some of the core hotel stuff. People worry that this market is saturated. Now, obviously, since we like the business, we think that the growth is still, there's a big potential here. So what do we think drives growth over the next three years and beyond? I mean, I think there's a number of ways to create kind of incremental or additional revenue streams. But I'll talk about some of those in a second.

But ultimately, the number one way and the clear focus of management today is driving listings growth. Like we just talked about, Chesky recently said, our brand is mainstream. Airbnb has been used 1.5 billion times. were now used all over the world, but hosting is a little more underground. He talked partly about the regulatory problems that has led to them not being able to promote enough for the hosts. He even said, we built the demand muscle, but we did not build a supply muscle. And so they've really been, now that they kind of have some of the regulatory parts resolved, I think 90% of their top 20 markets, they're able to now promote for hosts. For some reason, there was something

prohibiting them from doing that. They've been seeing the success of it. At the end of last year, Airbnb, as Brett mentioned, had 6.6 million active listings on the platform. And in the most recent quarter, they grew that figure by 18% year over year. That is the highest growth rate for active listings since their IPO. So I think they're able to continuously grow that. And the more it's like, you just talked about it, the marketplace dynamics, the more that active listings grow, the more customers will go to the platform, the more customers to grow, the more incentive there is to list your property on there. And I think there's a lot of dynamics now where, whether it's the rooms component, so you can list a room in your house, which I know is a little foreign to

some people and might feel a little weird or the apartments component. I think it's really easy to drive incremental or additional listings. Yeah. And one note, and you got to take their word for it. They have consistently said that they have always been supply constrained. That's a great sign, right? Yeah. I would say it feels that way as a customer. It's expensive still, right? Yeah. It's expensive. And any of the good deals feel like they're booked out for a long time. So it's hard to find some stuff. I would say that I think my experience on the platform supports what they're saying. But like I said earlier, there are a lot of other levers they can pull to kind of juice revenue. And one of those, probably the one that investors want to see the most is sponsored listings. Think about this very similar to Amazon, how they have the promoted products. I don't know if this would be directly paying to be a sponsored listing, or maybe it's like you give a higher take rate to Airbnb when a user converts, but it's just simply preferred

placement in searches. But Chesky kind of has some interesting thoughts here. He was asked about this in a recent conference. He says, my CFO is from Amazon. And he used to use this Jeff Bezos quote that you want to focus on the most perishable opportunities first. And the great thing about sponsored listings is it's not perishable. In other words, Chesky wants to defer this kind of monetization as long as they can, since it's such an easy lever to pull. So instead, let's get as many hosts as we can on the platform. That's the more perishable opportunity. That's the stuff they have to win now because they can monetize later. He even says monetization is great at scale. So you want to get as much scale as possible. And we still feel

like we're in land grab mode. I really like the way they think about that. I think someone that was managing for the quarter or for the year, or a CEO that was kind of a mercenary would probably play this as soon as they could. And you're seeing that he's willing to kind of focus on the long-term value right now. Yeah. And this does remind me, businesses complain about sponsored listings on Amazon. And there's a couple other examples. I might give one here where Airbnb is essentially already doing this for the guests. So the guest side of things wouldn't change except for obviously the disclosure that it's a sponsored listing because they're already trying to work as hard as possible to get

the best matching for that guest because they want them to have the best trip possible and they want them to, you know, purchase a listing. so it's still like they're already providing this value to the host and they just aren't charging for it yet i find it very similar to spotify is maybe a little bit more mature on their range they just started doing promotional stuff on their marketplace and it's very similar because they were the ones that again were already you know trying to get the right music for someone to listen to. And they're providing a ton of value to artists for doing that. And now they're charging a little bit for it. Yeah. And I think the truth is

when you look at, if you think of active listings as like SKUs or like inventory comparable to Amazon, there aren't that many active listings. So it's like, if you had a hyper-targeted search for a certain area, maybe a sponsored listing wouldn't be of that much value. That's why I think it's so important to go after the host and try to get to 10 million active listings or something like that. If they think the opportunity is there, going for it. The other big driver of growth, at least in the short term, I think would be the resurgence of travel across their Asia Pacific regions. In the most recent shareholder letter, Airbnb said, in Asia Pacific, Knightson Experiences book saw the most significant year-over-year growth as travel continues to

recover in the region. This region has historically been reliant on cross-border travel while still down compared to pre-pandemic periods. We have seen continued sequential recovery in the region with 48% growth in nights and experiences booked versus the year prior. I don't know if this will ever be the same size as kind of the North America opportunity, but it seems like that recovery is coming along gradually and that's going to lead to just more and more revenue growth, at least in the short term. And having that marketplace dynamic in place over there, It's great. I'm not really 100% sure on the competitive dynamics over there.

So it's kind of a guess, but obviously huge opportunity in that area. Last thing I'll say, there's a number of other ways to potentially grow. Some sort of a loyalty or membership program would be interesting, but he kind of shot that idea down. Chesky did in the recent conference. There's also potential for a credit card program. You could have more hosting adoption from like apartments. That's another way.

I mean, the possibilities are really pretty endless. The experiences thing that people have kind of seen those, they pause kind of the investment in that, they let people still do it, but they really didn't have many more people onboarding. And now they're doing that again. I'd say, for example, when I was in Chile, there was this experience that was like, is very, very like, it was a big one. It was like an all day thing. They drive you up to some sort of nature area and they make food for you. Something like that. Basically the gist. i would look for to see if it was open on a weekend because like oh that's something i might want to do it was like 150 bucks a pop and it was booked out every single weekend and what's interesting is that when you book like a place especially in a foreign country they always toss out like 10 experiences in your local area that are right next to you i think that's just a great way to add on as well but and then i mentioned on apac uh before we get into the next section they still get outbound

from China so that's it was the biggest market over there so that's important that it was the last country to come out of COVID

yeah let's talk about the stock a little more yeah so this is you like throwing the numbers down for the episodes so why

do we think the stock is too expensive at these prices and what are we kind of looking for as a potential entry point as long as

things don't change materially Yeah. So I think it's fair to say that we believe Airbnb checks most of the boxes we'd look for in an investment. They, in our opinion, have durable competitive advantages that should enable them to grow revenue at a double digit rate for a long time while increasing their profitability. However, even while they're checking those boxes, I don't think the returns are that

good given the current valuation or the expected returns. And I'll go through some of the numbers. At the current share price, which is $128 as the time of this recording, Airbnb has a market cap of $82 billion. They have about 8.6 billion in net cash. So that comes out to an enterprise value of $73 billion. In the last 12 months, they generated about $2 billion in earnings before interest and taxes, which I think is probably the best multiple to use or the best valuation metric is the EV to EBIT. And that currently stands at 36.5 times. So well above the average market multiple. And it clearly indicates that investors think it'll grow, which I think is a fair assumption

to make. But let's put some numbers on it. So if you assume that Airbnb grows its revenue by 15% this year, then 10% the two years after, I know this seems conservative, but we're still talking about double-digit revenue growth. I think it's fairly realistic, I'd say. Yeah. I mean, there's the chance that ADRs come down and that can have an adverse impact on revenue growth in the short term. So I think 10% is a realistic estimate. That would result in $12 billion in revenue for the year 2025. Now, if you believe that margins can expand gradually to 25%, 24%, you're looking at about $3 billion in operating income. So let's assume investors value them at 30 times market cap to EBIT in 2025, which that would be some multiple compression

from here, but it's still a premium to the average market multiple. That would imply a $90 billion market cap, which is only about 10% higher than the current price. So that means you're you're assuming above market multiple, double-digit revenue growth, and expanding profit margins. If you assume all of those, you're still looking at potentially a low to mid single-digit annual return, which we just think there's better opportunities available. Now, if Airbnb begins to trade into the $80 range, those same assumptions would result in returns above what we hope to achieve which is 15 or hurdle rate as they say so 15 per year yeah yeah yeah that is our i guess target i think i'd and it's traded in there recently if i'm not mistaken right uh it was

briefly close to that at the end of 2022 but for a very brief time period let's not do that during the holiday season guys come on uh it got 285 right or 82 and a half right at the end of 2022 but let's not do that during the holiday season guys we always take christmas to new year's off and maybe we shouldn't because last year that was one of the best opportunities were yeah so somewhere in the 80 range and you know if if their results outpace what we're expecting or our assumptions, that means we can kind of up that price too. Basically, I would say if it starts to trade around 15 to 20 times that $3 billion estimate we have for operating income for 2025, and that means current, that's where we would buy. Would you agree?

Nope. I am all for that. Well, I'm the one that made that. So yeah. All right. What are the risks? What's our sort of pre-mortem here? Yeah. We're going to each do this. I'm going to do a short-term one first and I have a travel slowdown. Everyone has this recently. It feels like every quarter, the last five quarters, everyone's talked about a travel slowdown. But there could one eventually could occur after the kind of the post-pandemic bonanza, along with an increase in supply in the US that people talk about, you know, Lisa declined daily rates. I want to share, as you have this one as well, but I want to share a chart outlining the decline in daily, or excuse me, the increase

in daily rates over the last couple of years or basically post pandemic. So we look at this for any of the listeners from 2015 to 2019, average daily rate across the platform was fairly stable for in between a hundred and 115 ish, probably in between really like 110 and 120 During the pandemic, it got up to over $150 and has stayed there since. Now, there's some inflation that was high recently, right? But it is definitely outpaced inflation. And that is a concern because if their average daily rate lowers, the revenue growth is going to be a big headwind to revenue growth. Now, another one, I say, actually, I mean, yeah, I had a recession.

And, you know, interest rates eventually impact the economy and it's worse and hard landing, blah, blah, blah, blah, blah. Counterintuitively, though, I'd say since we don't own shares today, this is something I want to happen. As I want the stock to go down a lot so we can buy shares when people misinterpret these short-term headwinds. I agree. What do you think about that? Yeah. Yeah. I think the average daily rate should probably grow more in line with real estate prices. Yeah. Or inflation, which I guess is real estate prices. So yeah, a couple of percentage

points a year maybe. Yeah. Because I mean, a lot of these people use them as investment properties. You're trying to fill out your mortgage by getting renters. So I think it's a fair assumption to say The ADR should improve with real estate or asset prices. But we might get a reverse back to trend. Yeah. If anyone, I mean, that was a big, big jump. Now, long-term, and I actually worry that I don't have very many concerns with this business, which always scares me.

But I worry that even though I love the product, I always go there when I'm traveling. I think the mode is strong. There are a lot of other travel and hosting platforms out there that could succeed. There's Vrbo, Booking, et cetera, et cetera, et cetera. There's a lot of other ones. Hilton, Marriott are very strong. A lot of these hotel chains are really on the ball and the commodification of the service could lead them to need to spend more on performance marketing, which again, you know, all else equal reduces margins, reduces cash available to shareholders. I have confidence this is not the case, but this is why, you know, tracking the total number of listings, listings, excuse me, is the key, I'd say.

I agree. all right what about yours what as we close things out here yeah it's kind of the same as yours which is if there's the risk that if you bought it today there it could be some serious price and stability on the adrs or the average daily rates especially if we have any sort of uh real estate slowdown the which we might it looks like we're kind of heading into that it depends how sharp it'll be Right. So that seems like a big risk if you're owning the shares today, but at the same time, like you, I hope that happens because over time, ADRs will work themselves out. And if the stock sells off on that, I would say that's potentially a good time to buy because it should

grow over time steadily. Maybe not from today's current ADR, but relative to the 2019 levels, it's it should still be higher uh other things i i mean i'm really not that worried about the competitive environment in the u.s they've become like an absolute verb and there are people that there are tons of real estate businesses being built on the airbnb platform but they say thousands right i mean it's changing the way yeah it's changing the way people live and travel for example i'm you know i'm thinking about moving right now we want to go to a new city i've never been there um that's it out for two weeks yeah it's like well why don't we just bridge the gap with a one month or a two month rental via airbnb and then you know if we if we find a longer term

stay we can lock into that one year but for now you know i think part of the most one of the big attractions of Airbnb is the like reluctance from apartments and like longer term situations to give any sort of flexibility on lease duration. So as long as that continues, well, Airbnb is going to benefit. Yeah. I mean, and just think about it personally, like Airbnb has provided so much value to my life. I think that's a good indicator that I should follow the business going forward as we wrap things up i don't i mean if you want like any comments or any pushback or any whatever you know if you're on youtube you can comment there we'll definitely respond follow us on twitter you can respond there we'll definitely have some engaging you know we'll

engage with you there um follow the subscribe to the newsletter you can comment on there uh all the links to this will be in the show notes besides that i think that's it ryan if If you're interested more in the fund and what we're all about and covering companies like this, like Airbnb, which we think are growth compounders that we want to buy and wait for the right price, the link to that will be in the show notes as well, but it is archcapitalfund.com. I think that's it. Remember, we are not financial advisors.

Anything we say on the show is not formal advice or recommendation. We are general partners at Arch Capital and clients may hold securities discussed in this podcast. it is important we note to that during these episodes especially that it's a may or like you know you could be listening to this a year from now and we may own the shares then so again have that full disclosure we are a little biased have that understanding okay thank you everyone for listening to this should we tease the next quarter's themes ryan no all right we'll do that next time. Thank you everyone for listening. We'll see you next time.