Business Breakdowns
· Matt Reustle
[00:00:00] S0: Mission critical things like those systems require some thinking around the financial positioning of your counterparties. Taking it down a level on the margin side of things, I have some understanding they are a network business connecting different parties here. What does that look like from a margin perspective? Where have they ranged historically? I know there's differences between the segments but at a consolidated level and to the extent that the nuances to each segment is relevant, what would you point to there?
· Ben Needham
[00:00:00] S1: The gross margins are very attractive. They're mid-seventies and they've been pretty consistent every time, which is remarkable really given how embryonic the hotel IT business is within that. They've been scaling that business for 10 years. There's been some dilution there from the scaling of that hotel IT business. EBITDA margins are in the high 20s that touch 30% a few times. When you are processing an incremental booking for Lufthansa or Air France or processing an incremental booking on the distribution side of the business, the incremental cost is next to nothing. The business is very scalable that affords nice economics within the business. They reinvest that when they are scaling and when there is growth and volume with the airlines that will reinvest it. And so if you look at their R&D spend over time, the R&D to sales has actually reached new highs more recently. Currently at the 22% level, which is very high. If you look back 15 to 20 years ago that was actually 10%. They've been investing in their Nevio proposition in their IT, they've been investing in NDC within the distribution business, there's a Microsoft partnership, there's been a re-platform of the business to make it cloud enabled, enable them to sell native products where the costs are gonna be dramatically improved because of that. Despite all of that and despite an embryonic hotel IT business, they're still almost making peak margins at the 30% level. The financial model is a good one and it's worth just noting as well. The cash conversion is good, so they have a negative working capital balance. They do capitalize customer implementation, so when they're doing a big IT project, if they're installing Nevio or installing their hotel IT proposition with the various customers they take on that cost themselves, then they capitalize that cost. They make up for it when the room bookings or the airline bookings come through on a 10 to 15 year view, which is a nice thing for the value chain in that you're only actually spending once bookings are happening, you are not actually spending the money as a hotel provider on that transition. That's also why you need to be well capitalized and that is a big differentiator of them versus their competition.
· Matt Reustle
[00:00:00] S0: I kind of bucket R&D into capital allocation in a similar vein to CapEx, but what do they do with excess capital in terms of distributions? How do you think about them beyond some of the operational needs from a capital allocation standpoint?
· Ben Needham
[00:00:00] S1: First of all, foremost, they'll reinvest in their business organically and where they think their return on capital stacks up. You can see that, as I said in the R&D spend over time and an interesting stat there on the R&D spend is their R&D spend is actually equivalent to the total revenues of the number three player within distribution, Travelport. And their R&D spend is equivalent to 50% of the revenues of their second nearest competitor, which is Sabre. They're reinvesting a lot of capital to fortify and differentiate themselves versus the nearest competition and that's a really important point to make. They will also do inorganic spend and I think their track record has been very good here. So they bought a business called Navitaire in 2016 that was a passenger service system in the air IT vertical but overweight low cost carriers. Amadeus, because of its history with Air France and with Lufthansa, et cetera, was overweight the full scale carriers and the hybrid carriers and it had a gap in its portfolio, which was the low cost carriers. Navitaire is a leading business there. It's actually got Ryanair as a major customer and they also bought a business called TravelClick in the hotel IT space and that was to give them more penetration with the independent hotels, so doing exactly what they do with the likes of Accor, Marriott, Ascott Limited now or soon to be and InterContinental Hotel Group in the independent channel. There's larger deals that are done we think make a lot of strategic sense and the return on capital has been good. Their capital structure is very good and their leverage is less than one times today. They de-gear very quickly because they are very cash generative with high margins and a very good cash conversion. They do have a sensible dividend policy, so payout today about 30% to 40% of their free cash flow in a dividend, which steadily grows over time, pandemics aside. They're increasingly doing share buybacks. The multiple we think that they trade on is actually pretty low given the growth opportunity. They started to do share buybacks with their excess cash, which we think is a very sensible form of cap allocation.
· Matt Reustle
[00:00:00] S0: On the valuation point. I'm curious to hear how you'd frame it. Much of my research about the business beforehand, it's pretty clear they're in this funny spot where they're grouped in with a lot of the airlines or transportation stocks despite being more IT software-ish in nature. How do you approach valuation? How do you think the market approaches valuation in terms of there being a difference there? Any commentary around that would be interesting to hear.
· Ben Needham
[00:00:00] S1: I absolutely agree with you on that observation. The stock's kind of in no man's land in that it's covered by airline analysts who are used to horrible cap intensity and cyclicality, and so I think it gets tarred with the wrong brush there. But then for tech analysts it's almost not cool enough, not AI enough even though they're doing quite a lot themselves with AI. But I think because of the pandemic as well, the market is absolutely schizophrenic about the cyclicality, but the pandemic is the wrong anchor because in typical travel downturns, the volume headwinds in global traffic are not that bad. They're minus two, minus 3% is what you saw in the great financial crisis, and that's a very bad recession for kind of those broad reasons that constrains the multiple Amadeus trades on. When we think about valuation, the qualitative side of things is really important and we think Amadeus has an abundance of untapped pricing power, which it can unleash over time. It is extremely well invested as well and their R&D spend is approaching new highs and you could argue that they're about to embark in a harvesting phase where they've got their product propositions ready, they're getting commercial gains with those new product propositions, there's increasing evidence of that and as those gains come through, the R&D spend can start to go down over time. They embark on this financial model attractive phase of their history. So we like it from that lens. The cash generation profile group's very good. Pandemics aside, the free cash flow per share trends have been in the high single digits. We think it can be better than that on a forward basis with buybacks, particularly at the share price at this high teens multiple, which trades on today and also because of these new propositions that are coming through and we think Nevio's a really interesting angle in the investment case. Free cash yield today is in the 5% to 6% area, 5.5.%. You've got a business which has that type of free cash yield, which is supported, but can grow its free cash flow per share. We think in the low double digits on a risk adjusted basis. The expected return is quite juicy. We'd be very disappointed if it was less than low double digits.