Description

Trader Talk – dominant niche business with long-term 7-10% topline growth with beatable guidance trading at 10-12x 2024 FCF and capital returns coming

Introduction

OSW provides spa services on cruise ships. The stock originally came across our radar as a short pitch on VIC, which can be found here. Despite the short pitch, once the balance sheet was shored up, we liked its recovery prospects and owned OSW as part of a Covid Recovery basket. However, over the last three years, we have begun to appreciate the truly exceptional barriers around the business and its favorable growth outlook. At present, we believe OSW is set to beat and raise as global cruise travel recovers, regardless of whether the world enters a recession. Further, we believe the company will initiate a dividend this year or next at the latest.

Thesis

OSW is an exceptionally dominant niche business with a strong growth outlook that should compound in value over time. OSW is a quasi-monopoly with over 90% share of the cruise spa market. The primary barrier to entry is the difficulty onshore spa competitors face to replicate OSW’s scale. Would-be competitors simply cannot match OSW’s ability to provide consistent spa services on a global basis across numerous ships and ports. Operating at sea is vastly more difficult than single locations on land. OSW must handle logistics on a global basis, including inventory management in over 100 ports and managing 4,700 employees, several hundred of whom must be on call at any given moment in case staffing issues arise anywhere in the world. Competitors simply cannot match the breadth of OSW’s services. Further, OSW is also small enough that their customers, the cruise lines (CCL, RCL, NCLH, etc.), would benefit minimally from in-housing spa services, if they could even figure out how to do so. For instance, in my bull case, OSW will generate roughly $110MM in 2024 EBITDA. Compared to the cruise lines, for instance CCL, which has 40% cruise market share and is forecast to generate $6B in 2024 EBITDA, OSW profits represent under 1% of customers COGS. In addition, OSW pays roughly 50% of sales to the cruise lines yet operates at a 12% margin in our bull case, thus the operators are risking a great deal of money to switch. Historically, churn has been almost nonexistent. Niche business models like OSW that are too small for customers to pushback while too large for competitors to gain share are some of our favorite long-term investments.

The growth algorithm for OSW is relatively simply. Pre-Covid, cruise line passengers grew at a consistent 6-7% rate for several decades. Cruising has historically gained share versus on-land vacations, as cruises are typically 20-30% less expensive. At present, the difference is even more dramatic, in the 30-50% range. Further, OSW historically has outperformed overall passenger growth as OSW has added higher ASP services, such as Botox, and newer cruise ships have larger spa facilities. While the Covid downturn resulted in some cruise lines’ older ships exiting service early, and there may be an overhang of some Covid-cautious former cruisers still hesitant to vacation, we believe OSW is likely to achieve its historical 7-10% topline growth rate within a few years.

Regarding present conditions, our base case assumption is that rising interest rates results in a recession which pressures the leisure and travel market. However, we believe cruising overall, and OSW specifically, are still set to recover despite macro issues. First, the cruise industry has yet to fully recover from Covid due to ongoing cruise travel restrictions, which have only recently fully faded. Now that all of the boats have returned to service, we believe cruising will operate at full capacity by summer 2023. Second, while a recession will impact consumer spending on travel, cruise lines always operate at full capacity, when not prevented by the government, because of the low incremental cost per passenger. The cruise lines often must discount tickets to reach full capacity, which impacts cruise line profits, but the ships are always completely full when leaving port. While OSW must deal with a slightly less affluent customer during recessions, OSW has been able to maintain its business during prior downturns. The reality is, once someone is on the boat and on vacation, they are there to relax and enjoy themselves and there are a limited number of options available when at sea. OSW’s spas are almost always fully booked when not at port. In the 2008 downturn, OSW saw sales fall only 10% and EBITDA less than that.

Valuation and Estimates

For 2023, OSW guided to $660-$680MM in revenues and $64-$70MM in EBITDA, a 10% margin at midpoint. However, OSW achieved $20.7MM of EBITDA on $169MM in sales in Q4 2022, a 12% EBITDA margin, despite the fact that the cruise lines have not yet fully returned to service. To put 2023 guidance in perspective, in 2019, OSW had $562MM in sales and earned roughly $59MM in EBITDA. However, they were only operating on roughly 165 ships. In Q4 2022, OSW was operating on 177 ships, though not all were fully ramped. For 2023, OSW will begin services on an additional 10 ships with more launching in 2024. In addition, newer cruise ships are typically larger than older ones with much larger spa facilities, which drives a natural SSS benefit for OSW. Pre-Covid, OSW guided 2020 to $670MM in sales and $78MM in EBITDA at an 11.7% margin. Frankly, we believe this guidance is highly achievable and management has set itself up to beat and raise throughout 2023.

Assuming OSW only modestly slows and/or can maintain its current profitability as new boats launch, we reach $70-$100MM in 2023 EBITDA and $80-$110MM in 2024. Of note, OSW has de minimis taxes and capex. All OSW transactions occur on the sea, hence no taxes, and the cruise lines are responsible for maintaining the spas, which drives >90% EBITDA conversion to FCF. With ~93MM shares outstanding, we estimate $0.70-$1.00 in 2023 FCF/sh. And $80-$1.10 in 2024 FCF/sh. Applying a 15-20x multiple, which we believe may prove conservative, yields $11-$22 per share. We believe sales and EBITDA can compound at 7-10% a year from there.

Capital Returns

Prior to current ownership, OSW was previously part of a publicly traded company called Steiner Leisure before its 2015 acquisition by Catterton. While OSW’s cruise dominance was not lost on prior management, its cash flows had been misdirected into “de-worsifying” acquisitions in the beauty space. In contrast, we believe the current management is razor focused on cash flows and capital returns. Our conversations with both management and members of the board have always been productive and shareholder focused. Once OSW pays down its higher rate debt in early 2023, we believe OSW will move to return all excess cash flow to shareholders.

On the last call, management implied it could look to begin a dividend in short order:

Steven Wieczynski, ANALYST: Okay. That's perfect. I didn't think you were really going to answer that too much, but I took my best shot at it. Second question, uses of your free cash, look, again, if we go back to your guidance, it seems to us you'll be generating, let's call it, $60 million to $65 million of free cash flow this year. You only got $10 million left to go on your second lien. So that's going to leave a sizable amount of cash to be put to use. I just want to understand maybe how you guys are kind of thinking about that once you do pay down that second lien?

Stephen Lazarus, EXECUTIVE: Steve, I think I will answer that simply as it depends. Some of it will depend on what happens with interest rates and how they play out through the remainder of the year. But I will tell you that, as always, we evaluate uses for cash, given current interest rates, it's likely that we continue to pay down debt. But our overarching theme would be that we will continue to evaluate best uses of cash, including a dividend payment.

As OSW requires no capex to grow, and it is difficult to see how it would need to retain much earnings in the future, we believe OSW will become a cash flow return machine, which given its annuity like business and strong above market growth rate could result in a premium valuation over time.

Catalyst

• Beating Guidance
• Return of capital via dividends