Monday, 20 May 2019

The problem with Ben Thompson's 'aggregation theory'

Ben Thompson, via his website Stratechery ('Strategy' and 'Tech'), has made a name for himself over the past decade popularising the concept of 'aggregation theory'. I invite readers to check out his material directly for a fuller explanation, but in short, his argument is that tech platforms have become so powerful (and profitable or potentially profitable) because in the internet era, the game has changed, and it has become far more important for companies to aggregate (and control) demand than to control supply (the latter of which Ben argues was the case in the past). Organisations that now control demand are the ones destined to prosper, and those companies are the large tech platforms.

Examples of demand aggregators are Netflix (that aggregates viewers of scripted content), Amazon (that aggregates buyers of (e)books and general online merchandise), Google (that aggregates internet search, and operates a toll booth redirecting traffic to the highest bidders), Uber (that aggregate people looking for taxi services) and travel and airline ticket booking companies such as Expedia,, Webjet, and AirBnB (that aggregate people looking to book flights and hotels/accommodation). The argument is, people that control demand are now more powerful than those that control supply, because if you control demand, you dictate what supply is able to receive any demand (i.e. what supply has market access), and therefore you make all the money.

Superficially, this theory seems to have a lot of explanatory power. Take the example of hotel booking platforms. These organisations are able to centralize the demand of people looking to book accommodation, and direct that traffic to available sources of supply. If you own a hotel and aren't on the platform, you can't reach buyers any more, and so your only choice is to use the platform and pay Expedia (for e.g.) a huge cut ('take rate') to make bookings on your behalf.

The problem I have with the theory is that it implies there is something fundamentally new or unique about the economics of the brave-new-world of tech, when in reality, the old economic rules still work just fine. This, in turn, creates the raw material to rationalize bubble thinking/valuations, instead of more level-headed analysis. The reality is that from time immemorial, it has always been the case that certain points in the supply chain make more money than others, reflecting differences in market power. Porter's Five Forces, for instance, has long been used as a framework for analysing where and how much market power exists, and explaining and predicting why some firms make more money than others. If your suppliers for e.g. have a lot of bargaining power, all else held constant, you tend to be less profitable, and vice-versa.

There isn't a lot that is novel about that insight, and the truth is, contrary to what Ben argues, demand and supply have always been of equal importance, and remain so. The real reason certain platform companies have become powerful is not because demand has become more important than supply, but because in many cases, the demand side has become more concentrated than the supply side, thereby giving it more market power. Demand has therefore become more 'consolidated' (an old-hat term which I prefer to the new-hat 'aggregated') on the demand side than supply has on the supply side, but this is not the first time that has ever happened. Carnegie and Rockefeller got rich by consolidating their industry and controlling the infrastructure that allowed both suppliers and competitors to access the market. If you 'aggregate' for e.g. all the railways that provide access to market, surprise surprise - you will make a lot of money (in this respect, 'aggregation' is just a synonym for monopoly). I also recently wrote a blog post about how PBMs (Pharmacy Benefit Managers), working in conjunction with health insurers, were getting rich by controlling which pharmaceutical products were able to achieve reimbursement (and hence have market access).

If we consider the example of travel booking platforms like Expedia and, after years of mergers/consolidation (and inadequate regulatory antitrust oversight, as the regulators have not understood the importance of regulating 'platform' market power), there are now fewer mainstream travel booking sites than there are hotel chains or airlines. Consequently, it ought to be little surprise that booking websites currently wield greater market power. People thought it was going that way with Netflix as well - you had one organisation apparently destined to control demand/eyeballs, whereas there was a larger and more fragmented number of organisations supplying content.

However, not all tech sectors are like that, and nor is it inevitable that the supply-side will always remain much weaker than the demand-side in many other segments. An example of an industry that is different is music streaming. In the world of music, supply is still more aggregated than demand. Three major studios control virtually all commercial music, whereas at present there are more than three major sources of platform demand (Spotify, Pandora, Apple Music, YouTube, and Amazon), as well as conventional ad-supported radio. Because supply is more aggregated than demand, music streamers aren't yet making any money, but the big music labels remain very profitable. In Ben Thompson's parlance, it could be said that the reason is 'supply aggregation theory'. In conventional parlance, it is because the supply-side is the point in the supply chain with greater market power.

Furthermore, in competitive free market economies, there is always an evolving competitive jostle for a greater share of the spoils, and 'aggregation theory' implies a degree of structural permanence that I do not believe should be automatically assumed. That, in turn, creates the risk of a lack of vigilance about some of the risks of change. When one part of the supply chain is profiting at the other part's expense, given enough time, one or both of the following things can happen: (1) the portion of the supply chain that is being under-remunerated has an incentive try to adapt and improve its bargaining position, including via market consolidation; and (2) disruptive competitive pressures are also usually eventually brought to bear on points of the supply chain that are over-earning relative to the level of their value-add, and 'new' platform businesses will be no more immune to this in the long term than 'old' businesses have been (after all, in the long term, the new becomes the old). And at present, many platforms are currently materially over-earning.

I listened to a podcast not so long ago where one of the tech-infatuated guests was arguing that tech is taking over the world and increasingly supplying everything we need, noting that on a recent visit to Sydney, he booked his flight through Skyscanner (Expedia); took an Uber for transport from the airport; stayed in AirBnB accommodation; and booked food delivery through UberEats (if memory serves). He also found activities to do through TripAdvisor, while booking restaurants through OpenTable. The implication was, how we live, work, and play is now being completely overrun and serviced by tech, and so of course tech stocks are increasingly conquering the world.

However, it doesn't take much reflection to realise that it is actually the real world, not the world of technology, that is providing all these services. All those apps are doing is providing an algorithm that lowers search costs and makes booking easy. Expedia didn't design, build and maintain the airplane that flew him to Sydney; build or operate the airport; train pilots; or find, produce, refine and transport the necessary jet fuel to power the plane over its continental voyage. Uber didn't design and manufacture the car used to transport him to his hotel; find, produce, and process the raw materials that go into it (such as steel and aluminium); or actually drive him from the airport to his hotel. AirBnB didn't design, build, maintain, or clean the house he stayed in, nor supply it with electricity. UberEats and OpenTable didn't grow and process any raw foodstuffs, or use them to cook a meal, and TripAdvisor didn't design, manufacture or operate any of the tourist attractions he visited.

In fact, all these companies did was write some pretty simple code that made matching buyers with sellers easier and more efficient, and the real question that should be being asked is whether these platform companies are extracting too much value from the supply chain relative to their value-add, and whether that is likely to be a sustainable situation in the long term, or will invite potential disruption and/or an eventual supply-side/regulatory response.

Take Webjet, for instance - and Australian flight booking company. The company takes about $30-50 per flight booking, which can easily be 10% or more of the price of the flight. Ask yourself, is Webjet really providing 10% of the value add? What about the pilots and flight staff; the maintenance engineers; the petroleum engineers finding, producing, and refining fuel; and the manufacturers of the aeroplanes, as well as their financiers (leasing cos)? The truth is, Webjet is actually providing something more akin to perhaps 1% of the realistic value add, and so it is therefore currently significantly overearning. It's like a stock-broker charging a 10% commission on a trade. Stock brokers also used to charge enormous commissions, but they were significantly overearning, and the forces of competition therefore lowered it over time, to levels that today are practically zero.

In capitalism, what is fair is irrelevant, however. Only market power matters. It doesn't matter how much money Webjet 'should' be making - only how much it is actually able to make. Because the airline industry is more fragmented than the travel booking market, Webjet currently has more power - it has indeed 'aggregated' more demand than airlines have managed to aggregate supply.

The question that should be being asked at the moment, however, is what happens next? Is the current situation sustainable long term? Or is it inviting disruption, with booking rates destined to be competed down to levels closer to their real value-add in the long term? There are many ways in which this might happen. There will of course always be new entrants attempting to enter Webjet's point in the supply chain, and provide a better service at a lower cost with increased convenience. For instance, perhaps a new start-up comes along that can use AI to automatically book you a flight using voice-activated instructions (maybe an Alexa app) - indeed maybe Google or Amazon comes up with such a service. If it's faster and cheaper, Webjet will quickly be displaced, and it's fat margins create a significant opportunity of anyone able to find a way to successfully supplant them.

However, another potential mechanism is for the supply-side to respond and improve its bargaining position, so it can recapture the value currently being ceded to demand-side aggregators. This supply-side response has already begun in certain industries. In the traditional media industry, for instance, studios have begun to aggregate supply to fight back against Netflix. Several megamergers have already happened, which have reduced the number of organisations controlling scripted content production, and content libraries. If they can aggregate supply in the manner the music industry has, while also supporting alternative streaming platforms, the power of Netflix will be undermined.

Other industries should learn from this. Major hotel groups should merge and/or co-operate and form their own hotel booking site, and either withdraw their supply from booking platforms, or (more realistically) continue to make them available, but at higher prices than on their booking sites (easy do do by cutting out aggregators' take-rates). Where applicable, they should also lobby to have archaic restrictions on the ability of hotels to offer prices on their own website lower than on external platforms. They will then be able to offer lower direct-booking prices to customers, allowing customers to find a room they like on an external platform, and then book the room directly and more cheaply on their website. 

In addition, new tech organisations are likely to spring up that provide booking tools that allow customers to more easily contract with independent operators without having to re-insert their credit card and identification details each and every time. If someone could create an ID authentication/payment plug-in app that enabled one-click purchasing on a variety of different merchants' sites, it would help independents' websites disintermediate the aggregators (this is a major business opportunity for somebody out there - I'm not going to do it so feel free to steal my idea).  

Airlines should also join forces and create their own flight booking platforms, put all their collective inventory on it, and then withdraw the supply from external aggregators (or charge Webjet et al significant price premiums to carry the same inventory). They should then advertise their lower rates to customers. In reality, the suppliers ought to have much more power than the aggregators, because Webjet doesn't have any of its own planes (unlike Netflix which can self-produce its own content). That the aggregators are making more money than the airlines is stupid. The dominant booking platform should be owned by the airlines. If they were smart enough and got their act together, they could capture this value themselves - use their 'aggregation of supply' to squeeze out demand-side rent-seekers that are earning huge amounts of money but adding very little value.

Different industries will have differing degrees of success with this, and it won't happen quickly, but tech investors should not be complacent. Tech platforms have been disruptive, but the history of capitalism shows that it is not long before the distruptors become the disrupted. In the very long term, replacement cost is the best estimate of value, and many of these tech companies sport huge valuations despite having technology that is very easily replicated. In some cases network effects exist, that mean the replacement cost is in fact very high (it would in fact cost hundreds of billions of dollars to displace Facebook's 2bn users by paying them to migrate platforms, highlighting the power of the network effect), but only a small minority of businesses fall into this category. What's the replacement cost of a flight booking app? It's ultimately just a bunch of code. 

In short, aggregation theory doesn't really add a whole lot to the analysis, in my view, other than simply restating the uncontroversial view that the balance between demand and supply matters, and that the players in the supply chain with the most market power will make the most money. These are not novel concepts, and there are too many 'this time is different' and 'the old economic rules don't apply to tech' connotations to it for my tastes. This sort of thinking is what lead to the 1998-00 bubble. It burst and people realised, actually the old rules still do apply after all.

It is going to be interesting to see how things evolve in coming years, but I would counsel caution about paying up huge multiples for platform/booking businesses with seemingly assured future rapid growth and prosperity. History shows that the future tends to surprise people, and that today's sure winners often prove far more susceptible to market forces/competition than is generally believed during boom periods.