Description

Thesis

Despegar is the leading regional online travel agent (OTA) for travelers in Latin America and appears to be selling for a very low price relative to its intrinsic value. Over the next 5-10 years, Latin Americans are likely to a) become wealthier, b) travel more, and c) and purchase more of their travel online, and Despegar will be the largest beneficiary of these trends. Among the local players, it is the region’s largest operator, is the low-cost provider, has the best technology, and holds $400m (USD) cash on its balance sheet in an industry full of struggling companies. Excluding the cash, Despegar is selling for a diluted EV of approximately $250m – a fraction of the $1.5bn it has spent building its brand in Latin America over the past 20 years, and a far cry from the $2.4bn market cap at its peak in 2017. As earnings recover, the current market cap will likely prove to be at a low-single-digit P/E – a price too low for a scalable OTA with secular (though bumpy) growth.

History

Following their Christmas holidays in 1998, a group of Argentinian students (Roberto Souviron, Martin Rastillano, Christian Vilate, Mariano Fiori, and Alejandro Tamer) were traveling back to the US from Argentina to continue their MBAs. There was a snowstorm in the US and all the flights were canceled, so they had to search for new tickets, one airline at a time. There was no tool which allowed them to search simultaneously between all the carriers; the following year, in 1999, they founded Despegar.

Over the following 20+ years, the company expanded across Latin America, using the profit machine in Argentina to subsidize the other markets in the region. In 2007, Tiger invested in the company (and today still owns 13% of the undiluted shares). In 2015, Expedia acquired 16.4% of the company for $270m (at an implied valuation of $1.65bn).

Despegar went public in late 2017, raising more than $300m (much of which is on the balance sheet today). The market cap peaked just below $2.4bn and today is down nearly 80% from the peak (undiluted) as a result of Latin American macroeconomic crises and COVID-19.

Background

Despegar, like other OTAs such as Booking and Expedia, is a marketplace that connects suppliers of travel with consumers of travel. Scale begets scale because more supply attracts more customers and larger OTAs are able to receive higher commissions from suppliers (GDSs, airlines, hotels, et al.) and can therefore enjoy higher margins or the ability to offer lower prices. On the cost side, the large share of fixed costs (fulfillment, technology, G&A, S&M) can be spread over more sales and result in lower unit costs.

The Latin American market is a difficult market to operate in given the political instability and economic volatility which has a large impact on exchange rates. When local currencies depreciate, travel (and in particular, foreign travel) becomes more expensive, which results in lower frequency of travel and a lower amount spent on travel (and hence, a decline in gross bookings in dollar terms).

On the other hand, the Latin American market has a few advantages compared to other markets. In the US, the top 4 airlines generate nearly 60% of gross bookings. In Latin America, this figure is closer to 30%. The top 10 hotel chains generate 50% of gross bookings in the US, while in Latin America, this figure is 7%. This fragmented supplier base results in lower bargaining power from Despegar’s suppliers.

In 2018, the Latin American travel market was worth around $116 billion. A little more than 40% was transacted online, which equates to around $48 billion. Despegar’s 2019 revenues were >$500 million on a take rate of 11%, implying travel purchase of ~$5 billion and hence a market share >10%.

Despegar generates revenues from three different sources (approximately 1/3 each): customer fees, commissions from partners, and incentives from the GDS systems. In contrast to Europe and US where customer fees have largely disappeared, in Latin America these fees compensate for the cost of financing customer installments (sometimes paid by Despegar, sometimes by partners).

Management

Despegar is led by CEO Damian Scokin and CFO Alberto Gaffney. Damian joined the company in 2017 when Tiger was professionalizing the company for the IPO that year. The majority of his career was spent with LATAM Airlines, where he led the M&A process of LAN (Chile) and TAM (Brazil), as well as with McKinsey. He is described by employees as very data-driven and a strong motivator at the company. Both Damian and Alberto are strong operators who also think critically about capital allocation. They have completed a couple acquisitions at excellent prices and repurchased shares when they were cheap. Because they are “professional managers” and not the company’s original founders, they unfortunately own very little stock (Damian owns 61k shares and Alberto 17k), and are incentivized largely through stock options.

Competition

The first competitor of Despegar is offline travel. People who purchase offline are less tech-savvy and believe in the trustworthiness and advice of offline travel agents. In 2018, 55% of Western European and 61% of US gross bookings were transacted online, compared to only 41% in Latin America. Over time, online penetration of travel in Latin America should increase.

When considering Despegar’s online competition, one should focus on Latin American travels and ignore inbound travel to Latin America (for example, a Caucasian guy from NYC going to Brazil is not going to book his travel on Despegar). Despegar competes with both international players like Expedia, Airbnb, and Booking and local players like CVC (publicly-traded in Brazil – largely an offline model but with recent acquisitions and a foray into online). Booking is the clear winner in hotels and Airbnb is the clear winner in alternative accommodation given the supply they have accumulated and the user experience they offer, even in Latin America, but Despegar has certain advantages over these different groups.

Compared to the local players, Despegar has the highest brand awareness, the lowest cost to serve, the best technology, and the best balance sheet ($400m in hard currency, compared to others operating with local FX and less access to capital). These advantages increase over time given the operating leverage as the business grows (discussed later).

Compared to Booking, Despegar’s greatest competitor, Despegar offers its customers the ability to pay in installments in local currency, a very common payment method in Latin America (and >50% of Despegar’s transactions) as well as in alternative payments such as boletos in Brazil. For the customer, installments offer the benefit of dividing an expensive payment into several transactions and paying in local currency. Because Booking doesn’t have a local operation in Latin America, and because it charges its suppliers (the hotels), not its customers, it is not able to offer installments as a method of payment. Customers are required to pay the hotel upon arrival, and this could be in a foreign currency if it is overseas travel. Because Latin American FX rates are supremely volatile, any Latin American customer booking overseas travel on Booking is exposed to currency depreciation before arriving at the hotel (which could be months later). If the local currency depreciates relative to the currency of the hotel prior to the trip, the traveler will be required to pay a much higher price in local currency terms.

Expedia is also a competitor to Despegar (far less so than Booking), but it is interestingly also a partner and a supplier. The two companies share inventory (Expedia globally, and Despegar in Latin America), and Expedia is a shareholder in Despegar. On September 19, 2020, Expedia’s exclusivity agreement with Despegar expires, and Despegar will be allowed to enter into an agreement with Booking. This could be a source of additional negotiating leverage with Expedia in the partnership agreements, or it may accelerate Expedia’s desire to acquire Despegar to prevent any competing partnerships.

In summary: compared to local peers, Despegar has scale benefits; compared to international players, it has a more relevant product offering tailored to the local markets.

Valuation

Share price: $7.92

Shares outstanding: 70m

Treasury shares: ~5m

Potential dilution: 16.4m

Diluted shares out: 81.4m

Diluted market cap: $645m

Cash (est.): $395m ($57-77m will be paid for Best Day in 3-4 years)

Diluted EV: $250m

The company’s structural costs are $28m in Q3 2020 – so in the absence of any revenues (which is not entirely the case), the company will burn under $10m per month. New preferred stock agreements with L. Catterton and Waha Capital will result in an increase in interest expense. These agreements were likely not necessary for the survival of the company but offer Despegar more capacity to consolidate the industry.

Prior to COVID-19, management’s objectives through 2024 were 20% annual local FX gross booking growth, a take rate above 11.5%, and an EBITDA margin above 20%. This would have implied ~200m FCF, which is no longer a reality given the effects of the pandemic on both travel and FX depreciation. It is difficult to predict Despegar’s future earnings, and simply understanding the historical earnings is a challenge because the company presents in USD while it earns in local currencies. These local currencies, have severely depreciated the past few years, resulting in fewer USD in translation and also lower demand for travel, in particular higher value international travel. In attempting to understand the earnings power of Despegar, a few data points are valuable:

In 2017, Despegar generated nearly $50m of profit. While Despegar does not disclose profitability by country, it is well-known that Argentina (at least historically, prior to the crisis the past couple years) was a profit machine for the company. These profits were used to subsidize growth in other countries, which in recent years were directed to Brazil and Mexico in particular. Hence, we should not be led to believe that a “break-even” Despegar implies a company that is not generating profit anywhere. Rather, the company is utilizing the profitability of certain countries to re-invest in others.

Assuming travel one day recovers following COVID-19 (and that Despegar will be less affected given its focus on leisure travel as opposed to business travel), and considering the effect of Despegar’s recent acquisitions, Despegar should exceed 2017’s USD gross bookings at some point over the coming years. The mix of these bookings is also important, as air has the lowest gross margins but is becoming less important compared to “packages,” one of the strategic priorities of the company. Packages are attractive because Despegar can bundle a 500 BRL hotel and 1000 BRL airplane ticket and offer them to the customer for 1300 BRL instead of 1500 BRL if purchased individually. By bundling them, Despegar earns a larger profit because suppliers offer heavily-discounted services if their pricing is not disclosed and instead, they are bundled. For example, a hotel may know well in advance that it will not sell a particular room but does not want to offer it for an absurdly low price. Filling that room has little incremental cost, so the supplier can offer it to Despegar for a very low price as long as this low cost is not made apparent to the customer (and hence does not diminish the brand value of the hotel).

Simultaneously, the company’s efficiency is increasing, which we can assess in each line of its income statement. Cost of sales includes the cost of installments (variable), credit card processing (variable), fulfilment (fixed, but more variable after the outsourcing), and fraud & error (fixed). The unit cost per transaction of the installments depends on the prevailing interest rates and hence has varied (the higher the rates, the more costly it is to finance an installment). But Despegar’s fulfillment and fraud & error costs per transaction have declined significantly, from $12.5 per transaction in 2015 to $6.70 per transaction in 2019. With the recent call center outsourcing, there should be further leverage in this cost item when volumes recover.

The company’s operating expenses can be broken down into advertising, sales & marketing, general & administrative, and technology. G&A and technology costs have exhibited operating leverage, from approximately 18% of sales each in 2015 to 13% each in 2019. Meanwhile, S&M and advertising (mostly in USD to Google) has remained stable. Overall, assuming a recovery of travel volumes, it is clear to envision why margins ought to expand.

Last year, Despegar completed the acquisition of Viajes Falabella (primarily Chile), and this year, it completed the acquisition of Best Day (Mexico) following a renegotiation of the price agreed to just before COVID-19. Both these acquisitions were performed at excellent prices (considering synergies and the recovery of travel). It is likely that the company will use its $400m war chest to continue its consolidation spree. These acquisitions are beneficial both to revenues and costs because commissions from suppliers  are often progressive in nature and increase as the revenues of the target are added to Despegar’s, and many costs are eliminated as the target is onboarded to Despegar’s platform. Last year, Despegar also bought back stock when it was considered the best use of the company’s capital.

Risks

There are various risks to an investment in Despegar. The first is macroeconomic in Latin America. Macro problems result in less travel and depreciating currencies (mitigant: Despegar’s USD cash represents a majority of the market cap). The second is the uncertainty around travel with COVID-19 (mitigant: “this too shall pass”). The third is increased competition from international OTAs and also Google (mitigant: the company’s share of direct traffic has been increasing and Google needs to be wary of antitrust). The fourth is the inability to retain quality employees given the significant risk from companies such as Mercado Libre, which unlike Despegar strengthened during COVID-19 (mitigant: difficult to mitigate, but hopefully there is enough talent to go around).

Catalyst

Recovery of travel

Expiration of Expedia agreement

Latin American consolidation

Acquisition target