Description

Orbitz Worldwide (OWW)

Summary

Our fund generally focuses on smaller companies with “Ft. Knox” balance sheets and large and sustainable free cash flow yields. We are often seeking a mid-teens FCF yield or higher on an unleveraged basis. The objective is for the sustainable FCF to eventually drive up the share price to a more reasonable valuation through share buybacks, debt reductions, dividends, or accretive acquisitions. Obviously, it is important we have a management team that cares about shareholder value.

Orbitz Worldwide (OWW) is an under-valued online travel advisory business (a.k.a. online travel agency or OTA) with an asset-light business model, modest capital expenditures, and excellent long-term growth prospects. OWW trades at about 1.3x revenues, 7.5x adjusted EBITDA, and a 10% unleveraged free cash flow yield with attractive prospects to grow adjusted EBITDA and FCF at least 10% p.a. over the next couple of years. Importantly, OWW has a conservative balance sheet, with net debt of about $200m or about 1.3x LTM adjusted EBITDA of $155m. We expect OWW to further deleverage over the next couple of years, absent any share repurchases, dividends, or niche acquisitions.

We believe OWW gives investors an opportunity to participate in the long-term growth of the global travel industry growth and increased penetration of OTA’s within that growth, as travelers increasingly make and book plans online. Online Travel Bookings are expected to grow about 15% p.a. from about $463b in 2014 to $714b in 2017, with growth of 25% p.a. in Asia Pacific, 20% p.a. in Latin America, 10% p.a. in Europe, and 9% p.a. in the U.S.

Originally formed by a consortium of airlines to provide online airline travel reservations, OWW has shifted its focus in recent years to emphasize hotel reservations which have higher margins and greater profitability. OWW operates travel websites around the world and is located in Chicago, IL with about 1,400 employees worldwide. OWW, through its travel websites, connects consumers and businesses to airlines, hotels, car rental firms, and offers millions of packages. OWW is a leading player in online travel with strong global brands and multiple avenues for growth. OWW key travel websites are www.orbitz.com and www.cheaptickets.com in the North American market; www.ebookers.com in Europe; and www.hotelclub.com in the Asia Pacific market.

OWW has about 115m shares outstanding trading at about $8.30 per share for a market cap of about $950m. OWW has a net debt position of about $200m as of 9/30/14 for a total enterprise value (EV) of about $1,150m. LTM revenues are about $909m and LTM adjusted EBITDA is about $155m. LTM free cash flow (cash from operations less capital expenditures) is about $119m for an unleveraged FCF yield of about 10%. We believe adjusted EBITDA can grow 10%+ p.a. to about $190m in 2016 with net debt of near zero by year-end 2016. We think with OWW’s high margin (80% gross margins, 17% adjusted EBITDA margins), high ROIC, cash-generative business model, attractive growth prospects, and current low interest rates, OWW could trade for 10x adjusted EBITDA less zero net debt at year-end 2016 or a market value of about $1.9b or about $16.50 per share (or about 100% higher than $8.30 per share today).

OWW was formerly part of Travelport, which was a private equity investment offering travel commerce services owned by Blackstone Group. Travelport recently went public and trades under the ticker TVPT. About 40% of OWW was spun off from Travelport in 2007 and the IPO did extremely poorly, with OWW’s share price dropping near $2 per share in 2008 and 2010. Travelport retained a 52% stake in OWW until mid-2014 when Travelport sold almost all its position in OWW as the strategic rationale for owning OWW became less important.

Business Description

OWW’s consumer facing brands include Orbitz (#2 OTA in the U.S.), CheapTickets (value oriented U.S. OTA brand); ebookers (European online travel agency with points of sale in 12 countries in Europe), and HotelClub (global hotel-only player with Asia Pacific focus). OWW also offers solutions for corporate travel clients and private label partners. Orbitz for Business includes over 700 corporate travel clients, from start-ups to Fortune 100 companies, and has a retention rate of 95%. Orbitz for Business customers include IBM, Fidelity, Petco, GoDaddy, and Yamaha.

Orbitz Partner Network provides a wide range of industry leading private label solutions for partners of all sizes. Orbitz Partner Network recently acquired Travelocity Partner Network, which adds clients and capabilities in the bank loyalty market. Orbitz Partner Network operates across U.S., Europe, and Asia Pacific. Orbitz Partner Network partners include Visa, Amtrak, Air Canada, Hawaiian Airlines, American Express and an agreement was recently signed with Bank of America to power its travel rewards program starting in 2015.

OWW business model is driven by gross bookings and the net revenue margin on those bookings as shown in the Detailed Income Statement and Net Revenue below. Net revenue margin is significantly higher on hotel and non-air bookings than for air bookings. The net revenue margin on air bookings has averaged about 3.3% over the past few years as compared to a net revenue margin of over 15% on non-air bookings. This makes sense because the value-add to providing additional customers to hotel and non-air activities (e.g., vacation packages and car rentals) is much higher than for air bookings, which are more commoditized and price-competitive.

In January 2009, a new management team led by CEO Barney Harford was brought in to turn around the business. Harford has extensive experience with online businesses and spent significant time in various roles at Expedia, a competitor of OWW. Harford and his team have dramatically shifted the focus onto the higher margin hotel and vacation package segments. Hotel and vacation package revenues have been the major driver of overall revenue growth and OWW’s strategic focus there is driving a favorable shift in mix and a resulting higher take rate, which is the total net revenue divided by gross bookings. In 2010, 36% of revenue was from air and 42% was from hotel and vacation packages. In 2013, 29% of revenue was from air and 52% of revenue was from hotel and vacation packages. Harford and his team also dramatically improved the customer value proposition in 2009 and 2010 through reduced hotel booking and other fees to make its product more competitive and improve the quality and stability of revenue.

While lower margin air bookings still dominate total bookings due to the company’s legacy background with the airline industry, we expect OWW to continue to drive air booking customers into incremental hotel bookings and believe this is an excellent growth opportunity over time. We believe the higher share of total revenues contributed by hotel, vacation package, and other non-air segments over the past few years has created a much stronger business model.

We believe OWW has multiple avenues for growth in revenues, adjusted EBITDA, and FCF over the next few years. These include: (1) an online travel market that is growing at about 10% to 15% per year across various key geographies; (2) a continued strategic focus on the higher margin hotel segment; (3) a loyalty program at www.orbitz.com (and recently launched at www.ebookers.com) which differentiates Orbitz’s website and is increasing share of customer wallets through incremental hotel purchases; (4) a mobile strategy which is being embraced by customers (31% of Q3 reservations were made online); and (5) an international expansion strategy, especially into an under-penetrated Asia Pacific market, which has great potential.

Moreover, all the above growth programs are being invested in while the Company generates strong FCF, which totaled $119m for LTM 9/30/14. Finally, OWW is well-positioned to make strategic niche acquisitions (such as Travelocity Partner Network acquisition for about $10m plus earn outs in February 2014) to build out its geographic coverage or its technology capabilities.

OWW has an asset-light business model with limited capital expenditure needs and a net working capital model that is significantly negative due to large prepayments by hotel customers in advance of hotel stays. OWW’s accounts receivable are well controlled and inventories are minor and, consequently, OWW has a business model with ROIC of 100%+.

OWW’s financial strategy has focused on: (1) strong revenue room night growth and resultant growth in adjusted EBITDA; (2) a continued shift to the strategic hotel segment, which has a higher take rate; and (3) a tight control of costs that are not driving revenue as well as discipline in capital expenditures, resulting in strong FCF generation.

Competition and Loyalty Program

Key competitors for the Company include larger players Priceline (PCLN) and Expedia (EXPE) (see Comparables). Overall, management believes its market share has been stable in recent years and notes that the growing industry has enabled all three players to grow at healthy rates. Hotel room nights in 2014 year to date for PCLN and EXPE have grown faster than OWW but the Company’s hotel room nights have still grown at a healthy 15%+.

OWW believes its loyalty program with Orbucks, established in mid-2013, is the simplest and most attractive program in the industry and enables it to further differentiate itself from competitors. Orbitz’s loyalty program enables customers to earn Orbucks on air, hotel, or other transactions and immediately use these Orbucks on hotel transactions, which enables OWW to drive incremental hotel revenue. Management does not believe its major competitors, who have a higher concentration of hotel business, are likely to offer a similar program, since it would more greatly reduce their profit margins. OWW has recently expanded its loyalty program to its www.ebookers.com website and initial results have been favorable.

Air revenues and net revenue margins have been extremely competitive in recent years and OWW has indicated that air net revenue margins will be down in 2015 based on agreements renegotiated with airline carriers and expected renegotiations in the near future. In 2011, Expedia reduced pricing and net margins on its air agreements and OWW matched these reductions and this was one reason why the stock was hit very hard. Investors assumed OWW was heavily dependent on air revenues and might not be able to recover. Instead, management aggressively shifted focus towards the hotel, vacation package, and other non-air segments and was able to stabilize and then grow revenues and adjusted EBITDA.

Overall, we believe OWW is in a much stronger competitive position today, due to the reduced reliance on air bookings and value-added products like its loyalty programs and mobile capabilities.

Recapitalization and Major Shareholders

In order to further strengthen its balance sheet, in February 2010, the Company sold to Travelport/Blackstone and PAR Capital $100m of common stock at about $5.50 per share, with PAR Capital exchanging senior debt it had acquired for the equity stake. Travelport/Blackstone, which owned about 52% of common stock, sold almost all their shares in multiple secondary share offerings in mid-2014 and PAR Capital sold some of its stake in 2013 but still remains a large OWW shareholder. We believe Travelport/Blackstone sold due to reduced strategic importance of OWW to its operations and to further deleverage.

Working Capital and Seasonality

The Company has a favorable working capital model, with hotel customers paying in advance of hotel stays, resulting in a sizeable negative working capital position. At year-end 2013, current assets, including $117m of cash, were $243m and current liabilities, including $337m of accrued merchant payables, were $558m, or a negative working capital position of about $315m. At 9/30/14, current assets were $424m and current liabilities were $721m, or a negative working capital position of about $297m.

The Company’s business is seasonal and a majority of its customers are booking leisure travel rather than business travel. Gross bookings for leisure travel are generally highest in the first half of the year as customers plan and book their spring and summer vacations. In terms of adjusted EBITDA, Q1 generally the weakest quarter, Q2 and Q3 are stronger quarters, reflecting increased travel and reservations, and Q4 somewhat weaker. Q1 tends to be a strong quarter for cash generation, as merchant payable accounts build. Q4 tends to be less strong in terms of cash generation, as merchant payables are reduced on a net basis.

Strong Technology Platform and Mobile Position

In 2010 and 2011, the Company completed a major program to upgrade its global technology platform and to migrate all of its consumer businesses onto this platform. Further, management believes it has “over-invested” in its mobile technology, which we take to mean they believe the Company is well-positioned in mobile. 31% of hotel bookings in the most recent Q3 were made from mobile devices and this percentage has been trending up over the last several quarters. While we are not sure mobile is really a competitive advantage for the Company, we believe OWW is well-positioned.

Operating Costs and Marketing Expense

OWW operates a service business and much of its cost structure includes labor-related expenses. Cost of sales is disproportionately call centers, where technology has enabled increased efficiencies over time. With regard to SG&A expenses, as a result of its global platform, the Company has been able to be more efficient and effective with its SG&A dollars. OWW’s goal over time, as it grows revenues, is to increase SG&A expense at a slower rate than those revenues, thus allowing the Company to leverage its SG&A expenses.

Marketing expense is a major investment for the Company and represented 35% of total revenue in 2013 and 36% in Q3 of 2014. Marketing expense includes both online and offline expenditures, with online expenditures, such as SEM, dominating total expenditures. Management has indicated that it focuses marketing expenses in the highest ROI areas in order to drive revenues. While marketing expenses jumped in Q3 of 2014, partly in support of the www.ebookers.com loyalty program, management has indicated it expects marketing expenses to be relatively flat in 2015 as a percentage of total revenues when compared to 2014. We believe OWW is highly analytical about how it allocates marketing expenses to the higher ROI opportunities and these expenditures are a major investment to drive topline over the longer term.

Resilient Business Model, Solid Results in 2008-9 Recession, Counter Cyclicality

OWW generated strong cash flow over the past six years, with cumulative cash from operations from 2009 to 2013 of about $580m or 50%+ of today’s enterprise value (EV). Even during 2008-10, cash from operations remained solidly positive and the Company generated FCF. We believe this reflects the strong business model and value proposition its services offer to customers.

You would expect a company heavily linked to the global travel industry would be severely impacted during the 2008-9 recession, but financial results held up well. There is probably no better test of a business model than how it fared during these very tough years. Although OWW’s revenue dropped from $870m in 2008 to $736m in 2009, adjusted EBITDA actually increased. Adjusted EBITDA was $136m in 2008, $144m in 2009, and $152m in 2010. Gross margins remained stable and management sharply reduced operating expenses to protect adjusted EBITDA.

We believe this speaks to the strength and flexibility of the business model and the capabilities of management to react to potential exogenous shocks to the travel industry. We also believe there is some counter-cyclicality in the Company’s business model, as hotel owners, with huge capital investments and high fixed cost structure, are highly motivated to attract incremental customers and traffic when the economy slows.

We like businesses which have the capability to hold up well during economic downturns. We certainly do not believe that OWW is immune from an economic downturn or terrorist attack but it seems the business model and management team have been tested once already and are still around to talk about it.

Strong Cash Flow Generation and Solid Business Model

OWW has modest capital expenditures and negative working capital requirements and a high ROIC of 100%+ based on FCF divided by the sum of net working capital plus net PPE. LTM adjusted EBITDA is $155m. We think adjusted EBITDA could grow to $190m in 2016. Capital expenditures over the past few years have averaged $40m to $50 m per year. Working capital dynamics are highly attractive. OWW has a meaningful NOL which should limit cash taxes for the next few years.

As noted, over the past six years, cumulative cash from operations has been about $580m or 50%+ the current EV. OWW’s highly cash-generative business model enables it to convert a large % of adjusted EBITDA into FCF (LTM adjusted EBITDA of $155m and LTM FCF of $119m). We believe it would be reasonable for this asset-light, cash-generative business model to trade at a high multiple of adjusted EBITDA (10x or higher).

Favorable Working Capital Business Model

OWW has a favorable working capital model, where it receives payments in advance, particularly on hotel reservations, and has virtually no inventories and modest receivables. The result is a negative working capital model, where OWW gets paid in advance, and this has a favorable impact on FCF generation.

Strong Balance Sheet and Expected Continued Reduction in Net Debt

OWW has a conservative balance sheet. The balance sheet at 9/30/14 had net debt of $199m or 1.3x adjusted EBITDA. OWW was able to generate solid cash flow even in the depressed economic conditions of 2008-10. We expect net debt to decline at about $100m per year, assuming no expenditures for share repurchases, dividends, or niche acquisitions.

We believe the continued reduction in net debt will highlight OWW’s attractive business model and could result in an improved valuation.

High Gross Margin and High Adjusted EBITDA Margins

OWW’s gross margins have consistently exceeded 80% over the past several years. Even small amounts of revenue growth can result in significant incremental gross margin dollars. These high gross margins enable OWW to make significant investments in marketing, selling, and product development which help to further strengthen the business model and drive additional long-term revenue growth.

Industry Consolidation Prospects

There are several industry players that are well-capitalized (see Comparables below) and acquisitive in terms of adding smaller companies to increase their client and service portfolios. We believe industry players could be attracted to OWW as a result of its well-established brand name, extensive vendor relationships, high margin and high ROIC business model, and excellent growth prospects.

2014 Results Provide Solid Momentum into 2015

The Company’s results for 9mos of 2014 were solid, with total revenue up 10% to $711m and adjusted EBITDA up 10% to $120m or 16.9% of total revenues compared to adjusted EBITDA of $110m in prior year. LTM free cash flow (based on cash from operations less capital expenditures) was strong at about $119m.

We believe the positive momentum of 2014 can carry over into 2015 and beyond, driven by revenue growth from favorable industry dynamics, continued hotel penetration, loyalty programs which are working, a successful mobile strategy, and increased geographic penetration in favorable international markets. OWW should also benefit from well-controlled operating expenses and capital expenditures, as well as its favorable working capital model, which should help to drive growth in adjusted EBITDA and FCF over the next few years.

Attractive Shareholder Value Enhancement Strategy

OWW has grown revenues and adjusted EBITDA steadily over the past few years. OWW has a goal of high single digit organic growth over the next few years, backed by strategies which include: (1) organic revenue growth from its leading position and strong global brands in the OTA industry which should benefit from an online global travel industry expected to grow at 15% annually through 2017; (2) a continued strategic focus on the higher-margin hotel segment, driving higher take-rates; (3) loyalty programs to increase share of customers’ travel spend and drive incremental margin; (4) a mobile strategy which is being embraced by customers through increased hotel bookings via mobile (31% in Q3 2014); and (5) international expansion through deeper presence in faster growing international markets.

OWW strategy to drive free cash flow includes: (1) revenue growth (via programs discussed above); (2) cost efficiencies (through cost of sales leverage on global platform and SG&A leverage as business grows); and (3) free cash flow conversion improvement through lower interest payments on debt refinancing, capex leverage as business grows, and attractive working capital generation profile.

Excellent Potential for Share Repurchase or Dividends or Niche Acquisitions

OWW has not repurchased significant shares to date but, as the balance sheet gets even stronger, we believe a major share repurchase program and/or dividend becomes a strong possibility. Strong cash generation and conservative balance sheet provide multiple levers to drive shareholder value. On the Q3 conference call, management disclosed that the Board is considering a share repurchase program, given the strengthening balance sheet.

We also believe there is excellent potential for niche acquisitions (such as Travelocity Partner Network in February 2014) to expand its strong technology platform into new market segments, to add or strengthen geographic coverage to selected international markets, or to supplement its existing technology capabilities.

Pension Costs

OWW does not have significant pension obligations which it has to fund.

Conclusion and Target Price

Based on 10x our adjusted EBITDA estimate of $190m in 2016 and zero net debt by year-end 2016, we believe OWW could trade for a market value of close to $1.9b or about $16.5 per share versus $8.30 per share today (+100%). We believe a 10x adjusted EBITDA multiple is not unreasonable, given the high-margin, cash-generative, non-capital intensive nature of the business model, the strong and well-known brand name, and current low interest rates. Further, we believe the high ROIC online travel business, its well-known franchise, its global online positioning in key markets around the world (North America, Asia, and Europe); plus its diversified base of vendor relationships could prove attractive to a strategic or financial acquirer.

1. Excluding non-recurring items.

2. Shares outstanding reflect $100m of common stock sold for about $5.50 per share or 17m additional shares issued in early 2010.

Detailed Income Statements (1)

Detailed Net Revenue Analysis

Detailed Quarterly Income Statements

Catalysts

1. Low valuation (10% unleveraged FCF yield; 7.5x LTM EBITDA; 1.3x LTM revs).

2. Steadily deleveraged balance sheet: $200m net debt today to zero projected net debt by 2016 year end.

3. Continued high conversion ratio of adjusted EBITDA into cash from operations resulting in strong FCF due to low capital expenditures and favorable working capital model.

4. Projected 2016 adjusted EBITDA of $190m due to revenue growth from growing online travel industry, loyalty program, mobile position, international growth, tuck-in acquisitions, etc. combined with tightly controlled expenses.

5. Recognition of highly cash-generative business model with high ROIC trading at below market multiples.

6. Increased revenue from greater international penetration.

7. Share repurchases and dividends from excess cash and FCF generation.

8. Possible acquisition of OWW by a strategic or financial purchaser.

9. Increased analyst coverage and recognition of OWW’s attractive business model.

Risks

1. The U.S. and/or global economy declines, impacting OWW’s business model.

2. Terrorist attack or other exogenous shock hits travel industry and OTA’s

3. Larger global players in Priceline.com (PCLN) and Expedia (EXPE) in online travel industry.

4. Higher than expected marketing expenditures reduce long-term adjusted EBITDA margins.

5. Change in relationship with vendor partners.

6. Changes in technology impact OWW’s online business model.

7. Misallocation of capital into a poor acquisition.

8. Management turnover.

9. Litigation with various local government bodies.

10. Large amount of stock options are outstanding.

Disclaimer

Disclaimer: We own shares of OWW. We may buy or sell these shares at any time without notice. The information in the write-up is believed to be correct as of the date written but readers should do their own verification of this information and analysis of this potential investment. We undertake no obligation to update this write-up if new information arises at a future date.

Catalyst

See above