“My interest is in the future because I am going to spend the rest of my life there. ” -C.F. Kettering

Bottom up stocks pickers like ourselves, who run focused portfolios, often say they are “macro agnostic”. Rather than trying to time the market or predict the economic cycle, we focus on finding outstanding, competitively advantaged business that we think can do well across economic and market cycles. But while the short-term economic cycle is unpredictable, it is vitally important that investors understand the long-term economic forecasts embedded in their individual company valuations.

When valuing an individual company, the very long-term growth rate will be constrained by economic growth, the level of interest rates will significantly impact the financing costs of businesses that borrow money (99% of the S&P 500 borrows money), and interest rates indicate the “risk free” rate of return hurdle over which equity investors demand some level of additional return in exchange for taking on risk.

Last year we wrote a four part series about the risk of low growth. In part 4, we showed how a 4% long term growth trend for the US economy (as we’ve seen over the last decade) could result in very different (or possibly unchanged!) valuation levels compared to the 60 year period prior to the financial crisis when economic growth was about 5%.

In that post we went on to explain:

“What happens if the whole economy and corporate revenue growth slows from 5% to 4%? One thing that likely happens is interest rates decline… If you lower growth to 4%, the fair value PE for the market falls to 13.2… But if we assume [that] interest rates decline by 1% as well, then the fair value PE moves back up to 15.4.

But what about the equity cost of capital? Historically equity investors have demanded about 4% higher annual returns than debt investors in the same companies. In a low growth, low interest rate world, would equity investors still demand 9% annual returns, or would they be OK with the same 4% “equity risk premium” over now lower bond yields and thus price stocks to generate 8% returns? If after lowering growth and interest costs, we also lower the equity cost of capital to 8%, the fair value PE shoots up to 19x.”

What all of this means is that any time you see an investor say that a particular stock is worth a certain amount of money, whether they know it or not, embedded in this valuation is a forecast about long-term economic growth and the long-term level of interest rates.

In other words, it is impossible to be macro agnostic.

Even if you say “well, I just assume that future growth and interest rates will be the same as the average levels in the past,” the question becomes “what past time period?” Let’s look at the history of the 10-year treasury yield over the last 40 years. 40 years has got to be considered “long-term,” right?

(Source: Bloomberg)

Based on this history, it appears that interest rates perpetually decline over time. Extrapolating this chart into the future suggests the 10-year yield will have a yield of -8% 40-years from now. But while we can observe mildly negative interest rates in some parts of the global economy, it seems very unlikely to us that the 40-year trend of declining interest rates will continue for the next 40-years.

All we have to do is look at the prior 20-year period to see a very different trend:

(Source: Bloomberg)

Based on this chart, you might excuse investors in the late 70s for believing that interest rates would exhibit a perpetually rising trend over the long term.

But of course, investors are not simply backward looking in making their forecasts. Investors as a group tend to assume that the future will look similar to the average of the past, rather than assuming that all trends will persist perpetually.

Here’s a chart of the trailing PE ratio of the S&P 500 over the past 60 years.

(Source: Bloomberg)

Over the full time period, the trailing PE ratio (the price of the market compared to the past year’s earnings) has averaged 16.8x. Our calculation above suggested that the fair value PE should have been about 15.5x, but this is the forward PE ratio (the price of the market compared to the the coming year’s earnings). Since our calculations assume a 5% growth rate, the calculated 15.5x forward PE implies a trailing PE of 16.3x. So we can see that the actual average PE has almost exactly equaled the calculated average fair value of the market.

But the fact is that many investors think that low and even declining interest rates are here to stay for good. If you look at the PE ratio in the chart above, which shows as 21.7x, and convert it into a forward PE ratio you’ll see that it is very close to the 19x fair value we calculated if you assume that 4% GDP growth, 4% interest rates and just 8% annual equity returns is the New Normal. It is true that GDP growth has only averaged 4% for the last decade, so this outlook may be pessimistic relative to the longer-term growth rate, but it isn’t an unreasonable point of view.

However, interest rates are not 4%. The 10-year yield is currently less than 2%. Yet despite yields being this low, it does not appear that equity investors believe they will persist. If you assume that the cost of risk-free debt will remain well below the growth rate of the economy, you end up implying that the stock market should trade at a much higher multiple than it ever has in the past. Remember just the shift down to 4% sent the fair value PE to 19x. You get almost nonsensical results if you use 2% and yet also assume growth stays at 4% or even rises back to 5%.

Yet investors have been valuing conservative stocks, ones with low volatility and higher than average dividend yields, or so called “bond proxies,” as if these ultra-low rates will continue for good. We’ve written about this in the past in posts here and here.

The amazing fact is that low volatility, “bond proxy” type stocks have done as well or better than more economically sensitive and volatile stocks even over the long term. This makes very little sense in a world where risk and return as supposed to be related and in fact this observation has been termed The Low Volatility Anomaly as it flies in the face of classic understandings about how financial assets are priced.

Will this persist? It has gone on for a very long time. But note the chart above showing the 40 year trend of falling interest rates? Do you think they will continue falling for the next 40 years? If not, you should be acutely aware that the low volatility anomaly is very unlikely to persist and returns to low volatility stocks are likely to deeply disappoint investors despite the fact that low volatility investment products have been all the rage for years.

While interest rates have been falling persistently for 40 years, there has been medium term periods during which they have risen. So we can get a sense for how these sorts of stocks might perform during a period of rising interest rates.

The results are not pretty.

A couple years ago, Morningstar analyst Alex Bryan produced this outstanding analysis of the degree to which the performance of low volatility funds was being driven by declining interest rates. In his report, he showed this chart:

The S&P 500 Low Volatility index tracks low volatility stocks. The MSCI USA Minimum Volatility index is similar, except that it attempts to reduce the interest rate sensitivity of its performance in the way in constructs the index. The S&P 500 High Beta index is made up of the most volatile stocks in the market, while the Dow Jones Total Stock Market index just attempts to capture total market performance.

What you see in this chart is that over the full 25-year period that was examined, a period that saw the 10-year treasury yield decline from about 9% to 2%, the pure low volatility index outperformed high volatility stocks and the overall market. Yet the outperformance was only slight despite a huge decline in rates.

But look at the returns in Exhibit 1 during periods of rising rates that occurred during that 25 year period. The low volatility index returned just over 1% per year when rates were rising while the overall market returned over 14% per year and high volatility stocks returned an amazing 37% per year. While the MSCI Minimum Volatility index attempted to reduce the interest rate sensitivity of its low volatility strategy, the strategy only generated slightly better results than the pure low volatility strategy and still dramatically underperformed the overall market.

In this next chart from Bryan’s analysis, he shows the degree to which each of the indices have exhibited volatility (beta) and their sensitivity to interest rates.

As you can see, the low volatility indices showed the low volatility that they promised. But this came along with very significant interest rate sensitivity. While the MSCI index that promises low volatility with less interest rate risk did show less of an impact from rate changes, it also was more volatile and still had significant interest rate risk.

The negative numbers for interest rate sensitivity for the low volatility indices means that on average they underperformed sharply when interest rates were rising. The positive interest rate sensitivity of the high volatility (beta) index means that it sharply outperformed during periods of rising rates. While the near zero interest rate sensitivity of the overall market illustrates that equity investors can diversify away interest rate risk as long as they don’t also demand low volatility.

If you own less volatile stocks because you like the low volatility and history shows they do just as well if not better than the overall market, then you need to recognize that you are making a bold macroeconomic forecast that interest rates are going to remain in a downward trend over the long term. In our view, while that’s not impossible, it seems highly unlikely.

What all this means is that it is impossible to be macro agnostic. Like it or not, you must have a view about where growth and interest rates go over the long term. Even if you don’t make this forecast explicit, if you buy investments such as low volatility funds, you are implicitly assuming that interest rates are going to keep declining.

The short-term economic cycle is nearly impossible to predict. But investments in equities are explicitly or implicitly based on large sets of forecasts about the future. The only value of a stock is the cash flow it produces in the future and so while history can be a great guide, it does not tell us for sure what is going to happen. Thus, we are forced to make investment decisions based around our explicit or implicit assumptions about the future.

At Ensemble Capital, we don’t like making forecasts about the future because we know how hard it is. But we also refuse to hide implicit assumptions from ourselves by pretending we can be macro agnostic. What history tells us is not that low volatility stocks outperform over the long term, but that low volatility stocks do well when interest rates are falling and do pretty terribly while interest rates are rising.

At least for us, we think assuming interest rates continue declining materially in the decades ahead is a very low probability outcome. We think investors in low volatility stocks, who are specifically seeking to reduce risk, need to fully appreciate the inherent risks of that strategy in the event the 40-year tailwind of falling interest rates comes to an end.

For more information about the positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. The opinions expressed within this blog post are as of the date of publication and are provided for informational purposes only. Content will not be updated after publication and should not be considered current after the publication date. All opinions are subject to change without notice and due to changes in the market or economic conditions may not necessarily come to pass. Nothing contained herein should be construed as a comprehensive statement of the matters discussed, considered investment, financial, legal, or tax advice, or a recommendation to buy or sell any securities, and no investment decision should be made based solely on any information provided herein. Links to third party content are included for convenience only, we do not endorse, sponsor, or recommend any of the third parties or their websites and do not guarantee the adequacy of information contained within their websites. Please follow the link above for additional disclosure information.

 

One of our favorite investing scenarios is finding a company with a remarkable culture taking share from incumbents that seem unwilling or unable to change.

We’ve talked about identifying companies with virtuous corporate cultures, but today we’ll discuss the other side of the equation: incumbent laziness.

This is important because a culture’s value is relative. If every company in an industry has a positive corporate culture (i.e. customer-focused, willingness to change, etc.), the value of any individual culture is null. There can be no predator without prey.

Source: BBC

To be sure, incumbents are incumbents for a reason. They’ve been successful. They’re filled with smart people. But according to Richard Rumelt in his book Good Strategy, Bad Strategy, two themes expose incumbents’ weaknesses: inertia and entropy.

Inertia of routine

When there’s a blueprint for success, you want an Optimizer leader to establish processes that maximize efficiency. If the status quo persists, then “this is the way we’ve always done it” works just fine. Problems arise when there’s a shock to the system – a disruptive technology, a new regulation, or a change in consumer behavior. The processes and routines that carried the company’s success now have declining value.

On paper, these routines can be remedied, but as Rumelt notes, “The barriers are the perceptions of top management.” In practice, managers are reluctant to fire or reassign employees who oversee obsolete processes. (And who can blame them? We’re all human.) A generous dividend policy can be sacrosanct to shareholders and any effort to change it, even when strategically necessary, can be futile. This is especially true today, as dividend-paying stocks are trading at a premium in low-interest rate environments.

Indeed, one of the reasons we sold our position in Time Warner a few years ago and bought Netflix was it became apparent that Time Warner was unwilling to change its dividend policy to keep up with Netflix on streaming content spending.

Inertia of culture

When the status quo changes, the values and norms exuded by management and followed by tenured staff may not be what the company needs to compete and thrive. In 2018, the average U.S. bank had a Net Promoter Score (NPS) of 35 out of 100, according to SATMETRIX, implying their customers were unlikely to recommend them to their friends. A 2016 survey by Ernst & Young of 55,000 banking customers found that only 26% have “complete trust that their banks will provide truly unbiased advice.”

One explanation for low customer satisfaction is that most banks – large banks in particular – are driven to minimize overhead costs. This often results in a lack of personal service.

First Republic Bank flips that model on its head. By focusing on customer service (it boasts an 81 NPS when considered the customer’s “lead bank”), including getting assigned to a personal banker, First Republic doesn’t have to spend as much on customer acquisition. Between 2007 and 2018, 75% of the bank’s growth came from existing clients and referrals.

Inertia by proxy

Rumelt writes that “A business may choose (author’s emphasis) to not respond to change or attack because responding would undermine still-valuable streams of profit. These streams of profit persist because of their customers’ inertia – a form of inertia by proxy.”

We’ve written extensively about the decline of many consumer brands that relied on search cost advantages established and perpetuated by superior advertising and distribution. It can be tempting for companies who benefit from customers’ inertia – e.g. buying the same brand again and again – to raise prices too much and risk mortgaging their moat.

Gillette razors are a classic case in point. With a market share over 70% in 2010, Gillette felt it could raise prices without sacrificing market share. And that worked for a while. But it also opened up the opportunity for direct-to-consumer upstarts like Harry’s and Dollar Shave Club to dramatically underprice Gillette. Their rapid growth showed underlying customer frustration with Gillette’s prices.

In 2016, with its market share down to 54%, Gillette cut razor prices by up to 20%.

Entropy

Moat erosion typically begins behind castle walls. Without proper stewardship, a company – like an untended garden – will become disordered. Well-positioned competitors have a chance to storm the castle if management isn’t widening the moat.

Last year, we wrote about how the medical device company Masimo has been slowly taking market share in the pulse oximetry market from its once-dominant competitor, Nellcor (owned by Medtronic). We believe poor stewardship at Nellcor, when contrasted with Masimo’s exemplary stewardship, is a key reason this has occurred. Various owners passed Nellcor around over a 25-year period. In 2005, a federal court found that Nellcor (then owned by Tyco) had engaged in anti-competitive behavior to secure its then-70% market share in pulse oximetry.

Masimo capitalized on the opportunity to chip away at Nellcor’s dominance. Today, Masimo has about a 50% share of the U.S. pulse oximetry market.

Bottom line

It’s not enough to identify a company with a great corporate culture. For that culture to deliver consistent value, it must be up against competitors with weak cultures or poor stewardship. Knowing how to identify weak competition is critical to understanding the opportunity for strong companies.

 

For more information about the positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. The opinions expressed within this blog post are as of the date of publication and are provided for informational purposes only. Content will not be updated after publication and should not be considered current after the publication date. All opinions are subject to change without notice and due to changes in the market or economic conditions may not necessarily come to pass. Nothing contained herein should be construed as a comprehensive statement of the matters discussed, considered investment, financial, legal, or tax advice, or a recommendation to buy or sell any securities, and no investment decision should be made based solely on any information provided herein. Links to third party content are included for convenience only, we do not endorse, sponsor, or recommend any of the third parties or their websites and do not guarantee the adequacy of information contained within their websites. Please follow the link above for additional disclosure information.

On Monday, Ensemble Capital’s CIO Sean Stannard-Stockton appeared on CNBC to discuss Netflix and the threat of Disney Plus. In this clip, Sean explains why we see Disney Plus as more of a complement than a substitute for a Netflix subscription, and offer an explanation for why Netflix has rallied 17% since Disney Plus launched.


If you are reading this in an email, click here for the video.

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. The opinions expressed within this blog post are as of the date of publication and are provided for informational purposes only. Content will not be updated after publication and should not be considered current after the publication date. All opinions are subject to change without notice and due to changes in the market or economic conditions may not necessarily come to pass. Nothing contained herein should be construed as a comprehensive statement of the matters discussed, considered investment, financial, legal, or tax advice, or a recommendation to buy or sell any securities, and no investment decision should be made based solely on any information provided herein. Links to third party content are included for convenience only, we do not endorse, sponsor, or recommend any of the third parties or their websites and do not guarantee the adequacy of information contained within their websites. Please follow the link above for additional disclosure information.

Each quarter, Ensemble Capital hosts a conference call with investors to discuss the current market, economic conditions, and a few of our portfolio holdings.

This quarter’s call will be held on Thursday, January 9 at 1:00 pm (PST)

We’d love for you to join us on the call, which you can do by REGISTERING HERE or following the dial-in information below:

  • Dial: 1-877-830-2590
  • Conference ID: Ensemble

If you’d like to listen to our previously-held quarterly calls, an archive can be FOUND HERE.

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. The opinions expressed within this blog post are as of the date of publication and are provided for informational purposes only. Content will not be updated after publication and should not be considered current after the publication date. All opinions are subject to change without notice and due to changes in the market or economic conditions may not necessarily come to pass. Nothing contained herein should be construed as a comprehensive statement of the matters discussed, considered investment, financial, legal, or tax advice, or a recommendation to buy or sell any securities, and no investment decision should be made based solely on any information provided herein. Links to third party content are included for convenience only, we do not endorse, sponsor, or recommend any of the third parties or their websites and do not guarantee the adequacy of information contained within their websites. Please follow the link above for additional disclosure information.

“We built this company on pay per performance to begin with and its no secret that we did it with Google. Google and us have had a very good relationship together. We’ve both benefited tremendously.” -Glenn Fogel, Booking Holding CEO

Google is the gatekeeper to the internet. Once upon a time we had web “portals” that served as the “home page” where internet users started any exploration of the internet. But today it’s just Google. Whether you go to Google.com or type a search term into the URL bar of your desktop or smartphone browser, you are accessing the internet through Google.

We are a long-time shareholder of Google and have stated before that the company’s services “have become a required part of modern life, almost a form of oxygen for internet connected populations,” as well as claimed that “Google’s opening up of the collective knowledge of humanity to anyone with an internet connected device at no cost to the user can easily be seen as one of the most important social benefits ever created by any nonprofit or for-profit organization.”

But a lot of people just think of Google as a monster that devours profits that have historically accrued to other companies.

(Source: Robert Scott Lawrence)

Devouring other companies’ profits is not a bad thing. It is how capitalism is supposed to work. But if you are one of the companies whose profits are being devoured, you’ll take no comfort in this philosophical view. As Google shareholders, we are well aware of the company’s extremely powerful position and its ability to change the fortunes of other companies at a whim.

So it may seem irrational that one of our largest holdings is Booking Holdings, the leading online travel company operating in a space where Google has recently thrown its weight around. But while we agree that Google will continue to capture the largest portion of the online travel profit stream and grow their share, we think Booking is uniquely advantage within the publicly traded online travel peer group as being well positioned to dodge this threat.

Booking Holdings is an online travel agency (OTA). This means that it actually books travel related reservations. Expedia is the other big player in this space. The other main type of online travel company offers “metasearch.” Metasearch websites like Kayak or TripAdvisor are designed to search across multiple travel related sites to find the best deal and then earn ad revenue for sending users to those other sites to then book a reservation.

Both types of companies provide a type of service known as “vertical search,” which searches the internet, but within a limited domain of information. Vertical search services are not limited to traditional search engines. Amazon can be thought of as vertical search for shopping. More product searches start on Amazon then start at Google. While Google’s general search offering is outstanding, some categories of information can benefit from specialized search services. In certain niches, vertical search services from companies such as Yelp, Zillow, and LexisNexis have thrived despite Google’s dominance in general search.

But the thing about the travel-related vertical search industry is that it is big, big business. According to research by Skift, one of the leading travel industry research groups, Google’s travel related advertisements generate so much revenue that this one segment of Google business is more valuable than any of the standalone online travel companies. It is generally thought that Booking may well be Google’s single-biggest customer and that travel overall is one of Google’s biggest sources of advertising revenue.

But that’s not enough for Google. Like any good competitor, they aren’t happy being first. They want to win and win, and then win some more. They don’t just want to generate the most profits in the industry, they want to maximize profits, period.

One strategy Google has deployed to win a larger share of the travel industry profit pool is create their own vertical search products. Back in 2011, the company launched Google Flights, and today this search product is considered the gold standard for the vertical search category for finding airline tickets. Unlike general Google search, which returns a list of links to other websites, Google Flights allows you to search for flights using flight specific queries and returns results in a format that is most useful for comparing flights. This is the same service that other travel metasearch products offer.

Obviously travel metasearch companies think this is terrible! They were used to having the best product and capturing the ad revenue that airlines paid them when a potential customer clicked on a link to a flight. But Google Flights has been widely viewed by consumers as a fantastic innovation.

Scott’s Cheap Flights, is an online service that identifies when airlines put flights on sale or other deeply discounted airfares and alerts their subscribers. The service has been widely praised by many media organizations and I use it personally. And what does Scott’s Cheap Flights tell its subscribers is the very best tool for finding cheap flights? Google Flights.

But what have online travel companies said about Google Flights? They say Google is “increasing the ad load” and “degrading the user experience.” The implication of this point of view is that Google Flights is an ad product (which it is) and by putting it at the top of the search results they are pushing further down the page “organic” (ie. free unpaid links) search results that point to the travel companies’ own websites. Under this worldview, “paid” search results are “bad” for users and “organic/free” search results are what users are looking for.

But that’s wrong.

Google Flights is a paid search product, but it is also the best search product to find the best flight. Users aren’t being forced or tricked into using Google Flights simply because they have to scroll further down the page to see organic results. They are using Google Flights because it does a better job of getting them the information they seek.

But Google Flights isn’t a big deal to Booking Holdings, because the vast majority of Booking’s revenue comes from booking hotels. And very importantly, most of their hotel booking revenue comes from hotels in Europe and Asia, not the US, which we’ll explain the importance of a bit later.

About a year ago, Google rolled out Google Hotels. And guess what? It is a really good tool for searching for hotels.

Over the summer, Google began “optimizing” their travel products. Said more bluntly, they have been strategically updating their algorithm so that users are more likely to go through their paid travel search products.  When TripAdvisor, Expedia, and Booking reported their 3rd quarter results, the market did not like what it heard:

(Source: Bloomberg)

TripAdvisor and Expedia fell by 20%-30%. Booking declined as well, but the commentary from each company could not have been more different.

Here’s Skift’s analysis of what happened.

“The fact that Google is leveraging its dominance as a search engine into taking market share away from travel competitors is no longer even debatable. Expedia and TripAdvisor officials seem almost depressed about the whole thing and resigned to its impact.

“We believe our most significant challenge remains Google pushing its own hotel products in search results and siphoning off quality traffic that would otherwise find TripAdvisor via free links and generate high-margin revenue in our hotel click-based auction,” TripAdvisor stated.

Expedia Group CEO Mark Okerstrom in Bellevue, Washington, said Google is taking “more revenue per visitor, and I think it’s just the reality of where the world is in the Internet, and the importance of Google at the top of the funnel.”

Both Okerstrom and Kaufer complained that their organic, or free, links are ending up further down the page in Google search results as Google prioritizes its own travel businesses.”

But here’s what Booking Holding CEO Glenn Fogel said at RBC’s analyst conference a few weeks later:

“We built this company on pay per performance to begin with and it’s no secret that we did it with Google. Google and us have had a very good relationship together. We’ve both benefited tremendously.”

While all three of these companies are online travel businesses, there is something idiosyncratic about Booking Holding’s business model. And this distinction is the critical key to why Booking and Google should best be understood as engaging in a mutual beneficial relationship. Sure, they might both want to maximize the profits they each earn, even at the others’ expense. But their relationship is not a zero-sum game. They both can win over the long term, which is why at Ensemble we’re very comfortable being long in both stocks.

Key Distinction #1

Unlike TripAdvisor, which is primarily a metasearch site which earns advertising revenue by sending users to hotels or hotel OTAs to reserve a hotel room, Booking is primarily a hotel OTA. Google is in the search business. They don’t book reservations in either their Flight or Hotel product. For that matter, across Google’s entire search related business they don’t enable users to engage in transactions on their site for the most part. They are in the advertising business and they earn their profits by generating advertising revenue in exchange for sending users to other companies’ websites to engage in transactions.

So, Google Hotels is a direct competitor to TripAdvisor. However, the search results inside of Google Hotels includes hotel websites, but also Booking and Expedia listings offering the ability to reserve a hotel room that fits the search.

Key Distinction #2

Booking and Expedia are the two leading OTAs. But while Booking is mostly just hotels and mostly in Europe and Asia, Expedia has more exposure to airline tickets and far more exposure to the US.

Empty hotel rooms are like perishable inventory. If you don’t sell a hotel room one night, you can’t ever sell that room on that night again. This is why hotels are willing to pay OTAs a large commission for finding a traveler to book a room.

In the US, where Expedia is more exposed, the market is dominated by big branded hotel chains such as Marriott, Hyatt and Hilton. When a traveler heads to New York, rather than going to a metasearch or OTA website, they might just go right to Marriott or Hyatt or Hilton’s website. These companies have strong loyalty programs and are well known to customers. Their hotels tend to run with higher occupancy rates and so they aren’t particularly dependent on the incremental demand that OTAs can provide. Indeed, OTAs have had to negotiate much lower commission rates with the big brands.

But in Europe and Asia, where Booking is more focused, independent hotels are the norm. If a traveler is going to Milan or Bangkok or Paris, they are much more likely to stay at an independent hotel. These hotels don’t have loyalty programs or global brand recognition. They tend to operate with lower occupancy rates. With more “perishable inventory” going bad every night, independent hotels are much more dependent on OTAs and pay a much higher commission rate than branded hotels.

For independent hotels, Booking and other OTAs effectively act as outsourced digital marketing companies who are paid on commission. This is an incredibly valuable service for independent hotels who simply don’t have the resources or expertise to run global digital advertising programs.

This is why the hotel listings inside of Google Hotels will typically be direct links to Hyatt or Hilton or Marriott’s own website (bypassing the OTAs), but for independent hotels the links will typically be to Booking or other OTAs’ listing for the hotel.

Key Distinction #3

If TripAdvisor, Expedia and Booking all have their hotel listings inside of Google Hotels, why are Expedia and TripAdvisor moaning about it while Booking doesn’t seem to care?

Remember those “organic” or free links that TripAdvisor and Expedia are saying are being moved further down the page as Google “pushes” users into the Google Hotels product (or rather users choose to use Google Hotels because it is a better experience than general search)? That traffic is referred to as SEO (search engine optimization) traffic. TripAdvisor and Expedia have been free-riding on Google’s service while Booking generates its earnings stream from paid Google links.

This is the most important distinction of all.

While the companies’ do not disclose the amount of traffic they receive from organic vs paid links, the above analysis by Cowen & Company aligns with the companies own past comments and our analysis of the companies’ business models.

TripAdvisor and Expedia are dependent on Google’s free search results for the majority of their earnings. While Booking uses Google’s paid advertising search results to drive the vast majority of their earnings.

TripAdvisor and Expedia complain that Google is “increasing the ad load,” “degrading the user experience,” “pushing its own products,” and “siphoning off quality traffic.” But there is another way to think about what’s going on.

Here’s venture capitalist Chamath Palihapitiya speaking in his typically bombastic manner at the recent Phocuswright travel industry conference:

“If you are a business that thrives inside of this Google environment… you are f***ed. Ratably, tick for tick, every single person that feeds off of them, will see their profitability erode. That’s the unvarnished truth of what’s happening. If you are in the business of being a parasite on top of Google, your medium and long term prospects are terrible. You are an impaired company, even though you don’t know it.”

While Palihapitiya is prone to dramatic statements, venture capitalist Bill Gurley who is more balanced in his public comments retweeted Palihapitiya’s statement saying simply “this is accurate.”

Bottom Line

Booking and Google are not at war. Booking is one of Google’s biggest customers. Booking built its business model around paid links from Google. Google has found a way to offer metasearch for hotels in a way that offers a superior user experience and has the benefit of Google getting paid for sending users to other sites to book rooms. This is hugely disruptive to companies built on the idea that somehow they deserve to get free traffic from Google. But it is not disruptive at all for a company like Booking that has figured out how to pay Google even while it earns fantastic profits.

For more information about the positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

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