Despegar: Too Hard
I’ve sold my 10 shares in Despegar. I wrote about the company here and here and wanted to like it but couldn’t get comfortable. There were a few key issues:
- High margins and commission rate relative to mature global peers
- Among the most aggressive revenue recognition in the industry
- Terrible working capital
3a) Growth likely driven by expansion of credit rather than organic growth
- Unclear how much of its receivables the company is factoring
- Adjusted EBITDA
- Huge prepaid expenses in FY19
These were compounded by the fact that investor relations responded very quickly to my first email and did not respond at all to subsequent emails. I’ll run through these quickly:
- High margins and commission rate
This is not a dealbreaker, I think high margins are a feature of emerging markets; the lack of competition is generally favourable. One of Despegar’s biggest competitors is bricks and mortar travel agents. Over time it was (and remains) my theory that Despegar will aggregate the travel market and essentially “steal” purchasing power away from travel agents and hotels and keep it for itself.
There is however a small risk that competition intensifies and margins shrink drastically before the company entrenches itself as a dominant provider in South America.
2. Aggressive revenue recognition
I shared an image of revenue recognition in this earlier post on Despegar. Despegar recognises revenue (and a provision for cancellation) aggressively at the time of booking, instead of waiting until the customer checks out to recognise revenue, which is more common in the industry.
It was my view, fairly or unfairly, that this was a function of Despegar being backed by hedge fund Tiger Global. It makes sense to have aggressive revenue recognition to make earnings look better if you are looking to IPO and/or exit the stock. Even though this approach introduces some potential to manipulate earnings, it was my view that this could be adjusted for.
3. Terrible working capital
Despegar has primarily a merchant business model. It receives customer cash up front, holds it for several months, and then pays the cash on to the supplier, usually after customer checkout. It should be immensely favorable – most other online booking portals don’t hold customer cash, they just take their clip of the ticket and the cash goes straight to the supplier. Typically, Despegar receives customer cash within one month of booking in all markets except Brazil.
The problem is, Brazil accounts for 43% of sales and in Brazil it looks like Despegar takes a long time to get paid. The receivables appear to be growing in line with Brazilian revenues, suggesting Despegar could take up to a year(?) to get paid. In Brazil, Despegar provides installment plans via local banks that let the customer pay over time:
In Brazil, we generally receive payment from the installment financing bank only after each scheduled payment due date from the customer (whether or not the customer makes the scheduled payments to the bank). In some cases, we elect to factor or discount these longer-term Brazilian installment receivables, allowing us to receive the payment of the purchase price more quickly. More than 55% of our transactions in both 2018 and 2017 were completed using an installment plan.
In Brazil, during 2018, we have started to work with a provider for purposes of financing purchases without credit card in up to twelve installments with an interest rate of 1.85% monthly for our customer. The provider bears the risk of payment and fraud. We have made this payment option available in 2018 for refundable hotels sold through our sales call center.
Despegar’s receivables as a % of revenue have been expanding rapidly:
Brazil is also the major driver of the company’s growth and so I think this is likely due to the provision of credit to customers in Brazil. When I emailed Despegar IR to inquire, they encouraged me to calculate payables and receivables as a percentage of gross bookings instead of revenue. That calculation also seems to show a similar effect. Subsequent follow-ups to IR asking if the expansion in receivables was due to growth in Brazilian customers using credit to make purchases went unanswered. I don’t think it’s bad per se that this is expanding – extending credit to people who have never had the ability to travel on installment before would naturally cause this to increase – but not getting an answer made it hard to get comfortable. Likewise, adjusting the numbers to exclude the increase in credit suggests that Despegar is otherwise not growing very fast at all.
If this is what’s happening, the consequence is that when you take a business model that generates cash before incurring expenses, and turn it into one where you incur expenses before receiving cash, you turn a good business into a bad one. It’s possible that suppliers for Brazilian suppliers are getting paid before Despegar receives all of the money from consumers, which could lead to the bad cashflow and expanding receivables we’ve seen here.
This implies that Despegar’s revenue recognition policy is suboptimal, as – if I understand correctly – it does not in my opinion accurately reflect the underlying economics of the Brazilian transactions. Currently, revenue is recognised a) well in advance of the trip and b) well in advance of receiving customer cash in Brazil, the largest market.
4. Unclear how much of its receivables the company is factoring
Despegar factors (“sells”) some of its Brazilian receivables to improve its cashflow. If you are concerned over the expanding receivables balance it would be useful to know how much of these Despegar is financing. Unfortunately the company does not appear to disclose this and IR did not respond to me when I asked about it (twice).
I don’t know enough about US accounting standards to know if it would be possible to calculate factored receivables from the financial statements.
5. Adjusted EBITDA
The company uses an Adjusted EBITDA calculation which makes it look “profitable” despite excluding stock-based compensation and this and that. It’s a generic red flag that I can kind of convince myself is OK (it’s not) in this era of technology companies, but it is another concern on top of an not-inconsiderable list of other issues.
Approximately half of the adjusted EBITDA is due to excluding financial expense (factoring those receivables), tax, and stock-based compensation. Unlike some situations where adjusted EBITDA might be reasonable, this is a BS metric.
6. Huge prepaid expenses in FY19
In the recent annual report Despegar disclosed prepaid expenses of $31.5m, far greater than anything the company has reported in its history (typically around $1-$4m), a huge level of expenses relative to the $67m in “Adjusted EBITDA” reported:
Despegar IR did not return emails regarding this and there was no footnote or commentary that I could see. The only possible explanation I could come up with is that somehow the acquisition of Falabella is included in prepaid expenses and advance to suppliers, but that would surely be a bit weird if it were on the books at December 31 2018 and not announced until April 2019. Ironically, as a result of incurring these expenses in 2018, Despegar might report great earnings this year.
Complaints 1-5 individually I can get past. Put them all together and slap 6 on top and it’s a No from me. I sold my Despegar at $13, losing $2/share. I hope to visit Argentina and meet the company later this year, but for now, things do not look great.
I have no position in Despegar or any company mentioned. This is a disclosure and not a recommendation.