Despegar: Further thoughts

Despegar: Further thoughts

Following on from my recent post I have some further thoughts on Despegar (NYSE:DESP).

The IPO

The company was clearly IPO’d at precisely the right time. 53% holder Tiger Global sold four million shares at $26 in an IPO that I think was clearly overpriced. It may have been an interesting short for somebody that did their reading. There were three key factors at IPO that made Tiger’s sale perfectly timed:

• El arranjo de pagamento (aka CIP), an arrangement that would cause Brazilian intermediaries (Despegar) to settle with suppliers at the same time as they receive cash from customers, minimising much of Desp’s working capital benefit of receiving cash before providing the product. This affects ~40% of sales and was due for implementation within ~2 years, by September 2018 (although implementation is “still unclear”, whatever that means).

• A withholding tax on Brasilian travellers abroad. Despegar had traditionally had a waiver for this tax,  the waiver was cancelled and replaced with a 6% tax while Despegar disputed the matter, and may in time be replaced with the full 25% tax. This was due for change by December 2019.
  

  source: Despegar prospectus

• An Independent expert report valuing shares at $15 during the sale to Expedia. Despegar sold ~15% of the company to Expedia at $28 a share, and the independent expert for this transaction valued them at $15. This was primarily due to the repayment provisions attached to the Expedia investment. It’s unclear whether this is a more fair reflection of the stock’s value or simply reflects EXPE wrangling a great deal for itself.
  

Still, 18 months after selling stock in a transaction that valued the stock at $15 and knowing the potential implications of CIP and WHT (tax) that could be implemented within 2 years of IPO, Despegar IPO’d at $26.  Good for it, and as far as I can tell this was all disclosed during the prospectus, but those who invested in the IPO didn’t do so well out of it.

In fairness, the CIP issue noted above may no longer be as serious given the change in Despegar’s working capital which I’ll get to below.

Fast forward to 2017

Major shareholder Tiger (53%) has been attempting to get out of the stock (indeed there’s a prospectus to do just that).  There are a number of things that stand out to me as things that a company might do if it wanted to boost its stock price.

For example, Despegar has implemented an aggressive new revenue recognition policy which is anecdotally one of the most aggressive in the industry, as well as anecdotally one of the more aggressive policies in Brazil:

This will bring forward revenue meaningfully, and given that a substantial amount of sales are made on an instalment payment plan, may even result in Despegar recognising non-cash revenue.

Market Power

There are several signs that Despegar has been exercising its market power, and/or potentially over-earning in commissions.

It recently increased commissions on hotels to above 15%, which is in my anecdotal research fairly aggressive for the industry, although others have suggested that the norm is between 12% to 20%.

Notably, Despegar was sued for this increase, and the court dismissed the proceeding. There are two elements to this, first is that regulation is at least passably fair, by dismissing a lawsuit that was attempting to block an attempt at flexing market power. I consider that overall a positive.

The second element is that Despegar is attempting to boost its earnings via increasing the amount it is earning from its current customers – which is fine, but it does raise the question of how much market power Despegar has and at what point it might start over-earning in this segment (noting that the market is highly fragmented and competitors like Booking.Com are very capable).

If Tiger or Despegar are trying to boost the stock price, the company may go too far in attempting to maximise the value of its current business, maximising short term earnings at a cost of long term market position. With a business like this I think the primary goal should always be maximisation of long-term market position, not maximising pricing.

That said, transaction numbers over the past few years are moving generally in the right direction with approximately a 10% CAGR over the past 3 years:

Gross bookings are also coming along reasonably well in USD terms (blue line), also up at about a 10% CAGR, despite local currency weakness and obvious volatility in the results:

Now this is where we get to the interesting part. There are two types of business model in the booking industry:  Agency and Merchant.

In an Agency model, the booking platform is the agent between the supplier and the customer. The customer pays cash up front for the service, this cash goes to the supplier without being held by the booking platform. The booking platform receives its commission & booking fees largely at the time of booking (although sometimes there are additional rebates etc).  The booking fees for the Agent are often recorded as deferred revenue until the time of check-out, if for example there are free cancellation policies or similar. This appears to be the norm in the industry, which is why Despegar’s new revenue recognition policy stands out.

A Merchant model, conversely, involves the booking platform actually holding customer cash. In this model, the customer pays cash up front to the booking platform. In addition to receiving its booking fee up front, the booking platform holds the supplier’s cash for several months (usually until after customer check out) when it passes the money along to the supplier. This “free loan” is very favourable and can let a company grow substantially quicker; a similar effect has aided Amazon’s rise. A Merchant company could theoretically spend this customer cash on acquiring customers (marketing etc) and if the number of customers is growing, the size of the “free loan” continues to grow via more cash coming in. In a way, the early suppliers can be paid by the cash provided by customers coming in later.  This is why the CIP program in Brasil, which would cause merchants to settle simultaneously with suppliers, could potentially affect this part of the business.

The Merchant model appears more favourable than the Agent model, although almost all booking companies have a mix of both due to the complexity and diversity of products they offer. Here is a chart showing the percentage of merchant revenue across the majors:

 

Despegar consistently reports above 80% of its revenues from the Merchant business, by far the global leader in this respect (although not all companies disclose the split). With this favourable treatment, Despegar should be the clear king in terms of the economics of its business. However, the balance sheet does not appear to support this, and its cash flows have also been weak.

The way that I have chosen to measure this, which is rough (I am open to better suggestions) is by dividing travel related payables via travel related receivables. The logic is that a company that receives supplier cash up front (Merchant model) will have lower receivables and higher payables, relative to Agency model competitors. This should(?) measure the working capital benefits of selling a product in advance of having to pay suppliers.

In this model I divided travel related payables (excluding deferred revenue) by travel related receivables. However, the overall picture looks very similar if I include deferred revenue, and also if I simply divide current liabilities (as a whole) by receivables.

Makemytrip and Lastminute have similar ratios to Booking.com (yellow line) but don’t disclose their agency/merchant model revenue breakdown so I haven’t charted them. Annual reports for all of these companies should be out in the next few months which will add another data point.

With the caveat that I am not across the accounting policies of all of the companies and this is only a rough comparison, Despegar’s business is not performing in the way that I would have expected it to. Its cashflow is also poor, relative to peers:

Contrast this with Expedia (note in particular the vastly higher OCF, despite Expedia’s sharply lower % of Merchant revenue):

And O Chefe, Booking.Com:

One obvious possible explanation for Despegar’s results is the fact that its working capital ratio (payables/ receivables) has declined over the past few years. This has led to much lower cashflow than peers and intuitively makes sense. What is not clear is why the ratio has declined given the high level of Merchant sales.

Maybe I’m going about this the wrong way. It is clear that Despegar’s working capital position has substantially worsened in the past few years and its aggressive revenue recognition is a fact. Perhaps it has internally begun implementing policies to comply with CIP before it came into effect? I am not entirely sure, and if you have spent any time on it I would be interested to hear your thoughts.

What does this mean? 

None of this means the company is uninvestible. However, it does look as though Tiger is keen to exit the stock, and is also looks as though some of Despegar’s underlying numbers may not be as good as they appear on paper. This makes valuation and risk monitoring more important (and that’s before considering emerging market and currency risks) and does make me question the rationale behind the aggressive revenue recognition, for example. Ultimately I don’t think Despegar is a stock that deserves a premium.

I am very interested in this type of opportunity over a 20 year time frame. Is it cheap enough to buy and have a good probability of attractive risk adjusted returns?  Unsure.

Is Despegar the type of company that can protect its number one position against arguably more competent and better funded competitors like Booking.com?  Unsure.

That said, the triple theme of booking industry consolidation, increase in citizen travel budgets, and greater internet penetration is certainly interesting.  What would you want to see change, before investing here?

Food for thought.

As noted previously, I hold 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.