D̶o̶n̶'̶t̶ hate the playa, hate the game

I just came across this graphic re Zoom that caught my eye:

Zoom being worth more than all the seven major airlines today isn’t exactly shocking. As I’ve previously argued, aviation is a terrible industry to invest in during the best of times. These are not-so-good times. So, the stock market which is a rough vote on expected future cash flows is naturally not too giddy about the sector’s future. To be fair, you can hardly question Mr. Market once you look at the debt-laden balance sheets and the cost base of most players. I digress. However, airlines do provide our society with something that Zoom will never be able to. Not even if it scaled to one billion+ daily active users. And no, I’m not referring to the ‘experience of travel’ or some other wishy washy stuff here.

What the airlines give our society is large scale employment. And the associated satisfaction for millions of individuals for having meaningful work and lives. In an age of 100-person teams being worth ‘billions’, airlines with their ‘inefficient’ business models represent a refreshing change of pace.

Let’s look at the numbers. Here are the direct employment figures for the 7 airlines included in the graphic (2019 pre Covid figures)

American Airlines: 128,900 employees

Southwest: 60,590 employees

Delta: 86,564 employees

United: 96,000 employees

IAG: 66,034 employees

Lufthansa: 138,353 employees

AirFranceKLM: 86,138 employees

Total: 662,579 employees

Here’s Zoom on the other hand:

Employees: 2,532

Now, I’ll be generous and assume that the pandemic has caused Zoom to supercharge hiring and the company has suddenly scaled to 10,000 FTEs within the past few weeks. Even at that level, the company still provides only about ~1.5% the number of direct jobs that airlines did. And once I start counting the ancillary employment that airlines generate, it is no match. Consider sectors like airports (JFK alone employs 40k staff so you can do the math!) and hospitality and you realize how important airlines are to the actual economy. What ancillary employment opportunities does Zoom provide? Maybe they have 3 account managers at Cloudflare assigned to their domain? But I can’t think of much else.

But see, this isn’t Zoom’s fault. Its ours really. Let’s go back in time a bit.

Back in 2011, Marc Andreessen uttered the most famous words in tech. And most of us cheered on as his prognostication came out to largely be true. Industry after industry got disrupted by tech until it became a boring fact of life. But the real price of software start-ups was a declining share of output to human capital. We all continued to cheer on as Google and Facebook announced 70% gross margins and 40% EBIT margins. You know what those margins were? Rents on our society. Money that got returned year after year as capital to a few shareholders. We invented elaborate language and math to celebrate the success. Wall Street spoke highly of asset light businesses. HP did a great job by outsourcing manufacturing to China. Oh yes, offshoring production means that asset base is lower - ROA increased, hence ROE is higher. Yes, yes - the markets love that. Stock prices go higher and management gets compensated.

Silicon Valley professed to love software businesses. Software businesses ‘scaled’ very well. You know why they scale so well? Because after a certain point, there’s virtually no underlying cost base. Microsoft Office makes $30B in revenue year despite being a 30-year old product that has zero innovation attached to it. That is the power of software scaling. That is the power of SaaS retention/stickiness. But Office doesn’t employ 100k employees at Microsoft. Microsoft could add another 10k engineers to the Office team and pay them $150k to play Minecraft at home. That would cost the company $1.5B. And yet this would only cause the company’s margins to shrink by 1.1%. Investors won’t even notice as the company could call this R&D as Google has done with ‘Other Bets’ which has cost Google >$20B over the last 3 years.

The most commendable companies here interestingly enough are banks, consulting firms and law firms. Staff costs at banks typically average 70-80% of total revenue. And once all other costs are factored in, Western banks eke out a single digital returns on equity for shareholders. Consulting firms and law firms are no different. All employees at these firms are typically pretty well compensated. And while partners keep the lion’s share of earnings, the actual split between partners to associate is rarely >10:1. The comparable figure at blue-chip firms is often >100:1. Ironically enough, banks and consulting firms - the institutions that embody the capitalist machine, are the most egalitarian in their distribution of output. Karl Marx would be proud of them.

Questions about returns on capital are trickier ones. The pandemic has been eye opening for many in terms of revealing what a charade the whole system is. Don’t get me wrong. I am not trying to make a ‘the system is rigged’ type of rant. We will hear enough of that in a few months in any case. I hope to make a more subtle point here. Modern day accounting, financial engineering, venture capital et. al are merely tools of thought. They are not grounded in any actual reality. Reality in the sense of gravity - a term that explains a naturally occurring force that affects us and our interactions whether we acknowledge it or not. On the other hand, a call option is an imagined reality. You might get impressed with the math if you study something like Black-Scholes. You might even be fooled into thinking there is some science behind the pricing of these options. But the reality is, no one uses this crap. Options are priced on supply and demand for similarly priced products and underlying assets. So, Ketchup Economics 101. It is a type of Gel-man Amnesia when folks say ‘Bitcoin isn’t real’ while simultaneously believing stock prices or debit-credit systems represent some deeper reality.

And, let’s not also not forget how recent all this is in its construction. Ninety-five percent of these concepts were not even around a century ago. Andrew Yang made this point during his campaign that folks need to realize when they say they lose their jobs, its more often than not to automation than immigrants. It’s not like you go to a car manufacturing facility in Detroit, you see hordes and hordes of immigrants lined up against walls. No, you’d be amazed at the presence of hundreds and hundreds of robots of different sizes. And these robots represent a form of rent being returned to owners of capital.

We as a society need to come up with new terms to judge and allocate economic output. I’ll leave discussions of UBI and wealth re-allocation to politicians and experts like Piketty. But I will leave you with my final thought on the matter:

Imagine I told you a bank was charging 25% APR to customers. Naturally, most of you would be disgusted and would want to know the name of this organization. The regulator would likely get involved and fine these institutions. You would likely avoid that institution then for the rest of your life.

We need to add the same level of nuance around rent extraction by tech companies. Consider these items in the news recently:

  • From CoStar Group’s (owner’s of Apartments.com) earnings call:

    “Apartments.com, RentPath and Zillow all relied to one degree or another on Google to drive traffic to their websites. The price of many popular apartment rental key words or SEM has soared over the past two years, climbing several hundred percent. For example, in '18, the keyword for Downtown Los Angeles apartments could be purchased for $0.42. By 2020, it's reached $7.56 for an increase of 714%. "

  • The Amazon Associates program is set to cut commission rates for furniture and home improvement products from 8% to 3% and for grocery products to just 1%, down from 5%, CNBC first reported Tuesday. Everyday item categories will be especially hard hit, with Grocery, Health & Personal Care and Amazon Fresh to see commission rates whacked down to just 1%.

  • ServiceNow announced record results for Q-1 2020. The company made subscription revenues of $995 million in Q1 2020, representing 34% year-over-year growth. The company made gross margins of 87% and free cash flow margins of 39% for the quarter.

Just as we would be outraged at this hypothetical bank charging an exorbitant APR, discussions around SaaS margins or platform take rates should make us feel the same way. It is unrealistic to expect consumers to lead this fight as most aren’t close to these issues. Regulators need to lead the way here. We need a new paradigm beyond discussions of Herfindahl-Hirschman index and definitions of market power. We need a better way to incentivize hardware businesses. We need a way to discourage asset-light business models and a way to cap the rents charged by marketplace platforms.

Until these issues are legislated and addressed, a call to build will only lead to more concentration of wealth and power.