Despegar: Thoughts so far

Despegar: Thoughts so far

I don’t get a lot of time to research these days. After a month, I’m currently about halfway through researching one stock and I want to get some thoughts down on paper. My research is necessarily incomplete and I am writing this post from memory at an airport at 1am so do be aware there are likely numerous errors in this post. Please feel free to correct them. I have only read half of the company’s filings, and not done any of the legal or macroeconomic research that would inform a thorough view on this company.

Bottom line I think it is possible Despegar stock continues to fall for the next few months especially if the near term impacts below are felt. Very interested in discussing it further with anyone who’s spent time on it.

Despegar (NYSE: DESP)

Despegar is the “Latin American Expedia” and the thesis behind the company is very straightforward. It had a disastrous IPO in 2016, is deeply out of favour both on fundamentals and also due to a weak IPO, major shareholders selling, and emerging market fears. Still, it’s got a billion dollar market cap, a couple of hundred million in net cash, Expedia as a major shareholder and supplier, and the stock is priced at about 25x 2017’s net income (its FY18 year ends 31 Dec 18) and much less on an EV basis. Overall it trades on about half the multiple of Expedia.

Despegar businesses have the largest market share in Latin America, between about 10% and 15% depending on whether you consider flight bookings or total travel bookings. Despegar stands to benefit long-term from rising levels of income as well as growing levels of internet penetration. Internet penetration looks decent on paper, at around 50% (USA for example scores around 70%) but a little further looking suggests the actual prevalence of online booking and ecommerce etc is much lower than a comparison of penetration would suggest.

This is good, because you theoretically get a combination of rising real wages (= increased budget for travel) as well as increased internet penetration and usage (= increased hotel/airline inventory, lower barriers to customer booking, better advertising ROI, etc).

The bull story is very attractive and in an ideal world Despegar is a company that should grow and grow and grow. But…

List of problems

When you look closer there are a few problems with the model. These may be resolveable but some are outside of the company’s power, and they definitely stand out – I’m not sure yet what to make of them. So far my conclusion is that Despegar was IPO’d at precisely the right time.

Despegar was IPO’d knowing full well that CIP (see below) would likely come into effect within 18 months, and also that its temporary relief from VAT-like taxes would not last. At the time of IPO the company had been VAT-free for several years, before having a temporary 6%(?) VAT levied (instead of the usual 25%) with a final decision expected in June(?) 2019. These taxes just affect one local jurisdiction each (Brazil and Argentina respectively iirc) and not the whole company, but the impact will still likely be meaningful. The VAT doesn’t cost Despegar anything directly but a 25% impost on every purchase you’d think would almost certainly reduce sales volumes.

  • Working capital problems (CIP)

A major attraction of this type of business is that the customer pays up front and then Despegar pays the supplier several months later, getting essentially a free loan for that period. The quicker the company grows, the quicker the ‘free loan’ grows, which can bring forward expenditure on customer acquisition and things like that (which further accelerates growth and grows the available cash from the ‘loan’).

However there is a policy in Brasil called Câmara Interbancária de Pagamentos (CIP), which was implemented in September 2018, and looks as though it will have a fairly severe impact on Despegar’s working capital position.

CIP forces intermediaries like Despegar to settle transactions with suppliers simultaneously, via a regulated network of bank payment providers. It is designed to minimise the risk of insolvency at intermediaries (where a service gets booked but the supplier does not get paid due to intermediary failure). It appears as though this will effectively remove the working capital benefits of being paid in advance for Despegar’s Brasilian business, which accounts for around ~50% of group sales. Asides from the short term ruction from the hit to working capital, the long term impact of this is probably fairly modest, although I would expect it to reduce the growth rate somewhat.

General working capital issues

A unrelated but similar issue is that Despegar often takes bookings for services in different currencies to what the order is for. I.e., a Brasilian customer will book a flight to the US or Argentina. The purchase is made in Reais for example, but the service must be acquired in say Argentine Pesos or US Dollars.

So Despegar might get a ‘free loan’ in Brasilian Reais, but it is then effectively short the currency that the service must be paid in.  Say you receive 10,000 Reais (or whatever) for a holiday in the US, what you actually have is an obligation to hand over US$2,500 in a few months, which 10,000 Reais may or may not cover at that time. For this reason Despegar either brings forward or pushes back its obligations to better match its liabilities to its assets. This is obviously problematic for emerging market currency transactions, although fortunately only a small portion of sales are outside LatAM. 

I have not looked at the company’s cash flow in any great depth but it is fairly clear already that Despegar is not generating the cash flow I would expect given the sell-first pay-later model that it employs. Anecdotally the company has also changed accounting policies to employ more aggressive revenue recognition. 

Lack of wage growth

It appears that Argentine and Brasilian wages are not growing in real terms. If you earn $12,000 a year and it costs you $11,500 a year to live, you aren’t doing much travelling – and if wages don’t grow in real terms, that isn’t going to change. As it happens a large portion of Despegar sales already come from customer credit instalment programs. This removes another pillar from the bull case as if wages aren’t growing, neither are travel budgets.

Customer use of credit

Despegar takes no credit risk, but it offers payment instalment arrangements with local banks. Customers arrange payment plans with their bank where they can pay in instalments up front before they travel. This is a valuable service but to my mind it gives you a clear idea of the scale of the wage problems (and opportunities) with about half (?) of group sales  coming from instalment plans.

Despegar talks about a growing availability of credit being a positive for its business and, while that’s kind of true, it’s only half the story. Greater credit card availability will certainly improve the business by lowering payment barriers, even if the overall amount of credit doesn’t increase. However, it won’t be a huge improvement if wages don’t go anywhere. Essentially I think if you own Despegar you are effectively directly long the Brasilian and Argentinian economies. Compare this with something like Expedia where your customers already have enough money to spend on your service, so while you are benefiting from the global economy, the business is probably driven a lot more by Expedia’s ability to grow its business & sell its products vs its competitors.

I’m optimistic about Argentina, Brazil & their residents, but should you pay 25x earnings for an investment that depends at least somewhat on Argentine wage growth?  Open question.

Economic disruption

This is a bit of a cop-out – every EM stock thesis lists “economic troubles” as a risk – but Brasil has just elected a new president who in my opinion is another ideological fool and not the sharpest tool in the shed. Unlike all the other moron politicians getting around (Looking at you AU, USA), he has a far weaker institutional framework and a far weaker economy to play with.

Australia’s greatest blessing is that our strong institutions keep the country running just fine despite a collection of coup d’etats that would make any warlord proud.

Market power

One last observation, and I think it is a crucial one. My feeling from the reports and Despegar’s audited statements is that the company does not have the market power of an Expedia. With so many bookings conducted offline, limited internet and limited mobile availability relative to wealthier markets, Despegar and other internet aggregators do not have the power in Latin America that Expedia wields elsewhere. This is both an opportunity and a risk for reasons that should be obvious. This will likely change over time but it is my preliminary guess that it will take anywhere from 5-20 years for a Despegar thesis to play out.

**Edit:  Here is a link to a recent list of tweets with screenshots of relevant links including CIP, for those that are interested in further reading.

I’m only about halfway through my research though so some of this information may be invalidated by later filings that I have not read yet. Food for thought.

A month ago I bought 10 shares of Despegar at US$15 via online brokerage platform Stake which I am trialling (and I may write a review of Stake in time). I’m not sure if I’ll keep holding these shares. DYOR.

I own 10 shares in Despegar. I have no real conviction in the position and may buy or sell at any time without notification to readers. This is a disclosure and not a recommendation.

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