Description

For a good background on the company, please see finn520’s write-up from June 15, 2018.  Though it has only been about 6 months since that posting, the stock is down another 45% and I thought that I could add to the discussion on why I believe this is an attractive business that presents a good risk/reward at the current price.

Before diving in, I will note that the stock is most down on a combination of global economy/emerging market concerns particularly around Brazil and Argentina.  Additionally, there seems to be selling pressure due to Tiger Global’s exit by distributing shares to their LPs. I do not have any particular insight into where things in Latin America will shake out nearer term, but I believe that DESP will do well over the medium to long term.

As the previous write-up mentioned, the Latin American online travel market is attractive because it should grow in the high single digits on increasing internet usage/online travel penetration along with a growing travel market overall.  Additionally, this is a market that really needs a middleman as the supply base is rather fragmented. The top 10 hotel chains are 14% of the market versus the US at 50% and the top 4 airlines are 38% versus 63% in the US.

As the #1 player in the region, I believe that DESP holds significant competitive (cost) advantages that are difficult to displace:

• Traffic acquisition - Having been around since 1999, Despegar is probably the most recognizable brand in the region and has over 50% of its traffic coming directly to its websites, bypassing expensive search and metasearch channels.
• Marketing effectiveness - Similar to BKNG and EXPE, DESP has a lot of data on consumer behavior in its markets and can test and learn to drive more efficient marketing and conversion on its website.
• Hotel supply - DESP is a leader in hotel inventory in the LatAm market along with BKNG with many years of time invested in contracting with independent hotels in the market.  A high level executive at a competitor commented to me that the inventory at DESP and BKNG is so far ahead of others that they act as “bed banks” for other OTAs and can charge competitors ~1/3 of their take rate.
• Financing - Installment payments appear to be ingrained in the Latin American market for many larger ticket purchases and DESP has built up important relationships with financial institutions to offer this option to its customers.  With larger scale, they can likely get somewhat better terms from partners. Installments account for ~55% of transactions.

The above should allow DESP to grow somewhat faster than the market, which can actually increase these scale advantages over time.  Also, while it appears that 13-14% EBITDA margins, with a medium term target of 20+%, look pretty ripe for competition, the OTA business is characterized by extremely low margins when looking at EBIT as a percentage of gross bookings.  This margin for DESP would be just over 1%. When one considers that DESP acquires traffic more cheaply, converts traffic more efficiently, receives a higher take rate, and has lower cost financing, DESP’s margin as a percentage of gross bookings doesn’t seem to leave much room for smaller players.

Competition

In terms of the large global OTAs, EXPE owns ~14% of DESP and supplies it with North American inventory, so I consider them to be more of a partner and not a competitor.  That leaves BKNG, which is a formidable competitor in the region, especially on the hotel side. However, as mentioned earlier, installments represent more than half of DESP’s total transactions and represent an important element of the market in Latin America.  While it’s always possible that they can make an exception, my diligence has indicated that BKNG has no intention to move from an agency model to a merchant model in the LatAm market to be able to offer installments. Therefore, I believe that they target a somewhat different customer who values the convenience of the agency model.

While OYO has not entered the Latin American market, it is worth noting that the company has been quite disruptive in India.  It appears to be spending a lot of SoftBank money in order to drive market share, which has put a lot of pressure on MMYT. Industry insiders question the sustainability of the business, but the company seems to have significant cash to burn.

Macro

The macro environment is obviously a concern, but DESP has been able to manage choppy waters in the past.  Its largest market, Brazil, experienced (3.8)% and (3.6)% declines in real GDP growth in 2015 and 2016, respectively.  Argentina also experienced a (2.3)% contraction in 2016 before rebounding with 2.9% in 2017. Against this backdrop, the company grew revenue by 24% from 2015 to 2017 while showing good operating leverage with EBIT going from a loss of $(67) million to a $54 million profit.

Arguably the economy is even worse this time around, but I think that management is doing the right thing by investing in market share and putting pressure on competitors.  This business has a lot of fixed cost that can be leveraged down the road if/when things improve.

Valuation

The business appears very cheap on an absolute and relative basis.  Additionally, I think there is a good margin of safety as the balance sheet is pristine with a large net cash position.  

At an enterprise value of $500 million, DESP now trades below 1x revenue vs. EXPE at 1.5x and emerging market comparable MMYT at over 2.5x.  On EBITDA (excluding the financing costs for installments), I have it trading at about 10x 2018 numbers. EXPE trades at over 12x without adding back stock comp while MMYT is still losing money.  

Over a three year period, it seems reasonable that DESP can grow revenue by 25-30%, achieve a double digit operating margin, and generate ~$50 million of net income.  At a high teens multiple of earnings plus the net cash, this would be worth $18-$20 per share.

Catalyst

N/A