Description

PTSEF is a plausible triple or more over the next couple years.  You may have done business with the company without knowing it if, for example, you have ever gone to an airline's website and bought more frequent flier miles to get over a threshold.  PTSEF's software handles those kinds of transactions at the loyalty clubs of around fifty of the largest consumer companies, often acting as middleman.  [Note, the stock trades in Canada as PTS.  I am using the US symbol.  Prices and numbers are all in US dollars.]

PTSEF is a bit complicated, but the story behind it, however, is actually quite simple:

1)   The value of points and frequent flier miles held by the public members of loyalty clubs is well over $100 billion, yet under 2% of members do more than accumulate miles and later redeem them for flights or other services offered by the club sponsor.  Most consumers have built up points balances in several clubs that they know they will likely not redeem with the sponsor.

2)   Loyalty clubs can be a rich source of fees and financing for their sponsors.  Operators make money by selling miles to members and charging fees for members to transfer, give, or spend the miles other than normal redemption.  To the extent that an operator treats its members fairly and offers attractive alternatives for miles not needed for redemption, it generates loyalty and creates an attractive currency, which it can then sell to banks for use on credit cards.

3)   PTSEF dominates the business of providing the critical software and services that help operate loyalty clubs.  PTSEF's revenues mainly come from member activity other than normal redemption, with the biggest item being selling miles to members.  By adding more features, deals, and options, including allowing trades of points between members of different loyalty clubs, PTSEF has been building a system that is increasingly compelling versus what its partners could build on their own;

4)   With a major revamp of its operating systems holding down costs, and higher margins and new business more than compensating for the recent loss of a big chunk of low margin business, PTSEF now has substantial operating leverage.  It should demonstrate that over the next year as it benefits from the increases in activity by loyalty club members.

Although no bargain on 2009 or 2010 numbers, PTSEF's high degree of operating leverage going forward, plus its strong growth potential in both revenues and gross margins, makes PTSEF quite cheap on plausible numbers two to three years out.

Background:  Loyalty programs have been around since before there were computers, a classic example being stores issuing S&H Green Stamps starting in the 1930s.  In modern times loyalty clubs have grown to massive proportions, with recent figures claiming unused miles or points in the ten trillion area, with a value estimated at $165 billion.  (No statistic on the industry will be very accurate, because what each mile is worth depends upon how it is used.  As a general rule, figure that a mile redeemed for products or services in the program sponsor's main line of business is worth as much as 3 cents, while one used elsewhere is worth a penny or less.) 

There are thousands of loyalty programs in existence, with the biggest ones being travel related businesses and credit cards.  Total memberships in the US are in the 1.3 billion range, with the average consumer being a member of a dozen different programs, although they may be active in only a few of them over the course of a year.

Over time these programs have become very important to many of the sponsors' businesses, both to encourage customer loyalty and as a source of financing.  American Airlines, for example, regular sells billion dollar chunks of AAdvantage Miles to Citibank, which issues them to credit card users.  While at times club sponsors try to reduce their obligations by making it harder for members to use miles, if they make their club's currency too unattractive, people won't use the credit cards that issue them, ending that source of financing, and will switch their business to competitors whose points seem more useful.

Nearly every airline has its own loyalty club, as do many hotels, car rental companies, elite credit cards and stores.  The back-office software to operate the programs were originally all home grown and fairly simple, since there wasn't too much members could do with their miles other than accumulate them and eventually redeem them with the sponsor.  PTSEF got its start early this decade writing software for loyalty programs to allow their members more flexibility, such as buying, gifting and transferring miles, and got paid for its work by fees based upon usage.

As loyalty programs have gotten more complex, more of them have outsourced their operations with PTSEF such that now about fifty of the world's largest loyalty clubs are customers, or as PTSEF calls them, partners.  This is what PTSEF calls its e-commerce business, representing 95% of its revenues.  It is essentially a private label business: as a holder of points in some program you would encounter PTSEF when you go to the program's website, which PTSEF typically hosts and manages with the partners' corporate look and feel.  Clients include most major US airlines and many foreign ones, with the most recent new customer being KLM/Air France.  Hotel partners include Starwood, Intercontinental, Marriott, and Wyndham.  Financial industry partners include American Express Rewards cards and the recently announced Chase Ultimate Rewards card.

PTSEF's accounting is affected by how the deal with each partner is structured.  For example, when someone wants to get over a certain threshold by buying miles, if their airline had an agency deal with PTSEF, the latter would be paid a certain percentage of the transaction as a fee.  On principal deals PTSEF doesn't make a fee, but instead a gross margin between the price the user pays for the miles versus its cost.  Initially all partners were set up as agency.  As most have switched to principal, that has boosted reported revenues and costs, since they both flow through PTSEF's income statement rather than just the agency fee, which is equivalent to the gross margin.

The switch to principal deals also reflects PTSEF taking a larger role in managing this aspect of its loyalty clubs.  Some of its partners recognize that PTSEF now has the experience to know which offers and promotions its members will find most attractive, and a principal relationship gives PTSEF more flexibility to do that.

PTSEF has almost no competition as an independent supplier of back office services to loyalty programs, other than the IT departments of its own partners.  Usually a partner will continue to use its homegrown system for some aspects of its loyalty club and use PTSEF's system for others.  Some partners over time have turned over more of the business to PTSEF to avoid having to commit their limited IT systems staff for maintenance and development of what is a bit of a sideshow to its primary business of flying people around, running hotels, etc. 

Recently, for the first time in the PTSEF's history, a major partner, Delta Airlines, took some functions back in house, effective the end of Q3 2009.  The situation was an unusual one, and not likely to be repeated with any other customers.  Earlier this year Delta acquired Northwest, which had its own loyalty club platform, and, I believe for internal political reasons, moved much of its Delta loyalty club functions from PTSEF's system to the Northwest one, rather than the other way around.  Although this represents a big loss of principal revenue to PTSEF, those functions were priced at extremely low margins, to the point where the contribution to operating income was quite small.  Delta continues to use PTSEF for other loyalty club functions that the Northwest system can't handle.  PTSEF believes that the Northwest system is fairly primitive compared to what it offers, and that perhaps in the future Delta will want to return on a basis that makes more sense for PTSEF. 

With the high volume, low margin Delta business gone starting in the current quarter, expect to see a big leap in gross margins, reflecting both that and the much higher margins built into the contracts of new clients.

About 5% of PTSEF's business is direct with the public through its www.points.com website, which has about 2.2 million members.  There people can register their loyalty programs and be automatically updated with their current balances, a service only PTSEF can provide since only it has access to all those accounts through its e-commerce partnerships with the sponsors.  The site offers the opportunity to spend one's points with hundreds of retailers, such as Amazon, Apple, Gap, Sears, and Starbucks, by trading them in for gift cards.  These don't place a very high value on the consumer's points, but if they reside in a program where redemption seems unlikely, this is a way to cash in those unwanted miles.

Points.com is also the locus of GPX, a marketplace that allows one to trade miles in one of PTSEF's partner's programs for points offered by a member of another program.  If, for example, you needed some AA miles to get a business class upgrade, you could either buy them at the AA site or, depending on what is offered at what ratio, trade some extra Alaska Airlines miles that you don't need but someone else wants and will give you AA miles for.  Either way, PTSEF and the program sponsor makes money.  Although it hasn't taken off as yet, eventually I expect GPX to be very popular, especially to the extent that PTSEF can add more partners, and convince them to lower their fees per trade to stimulate more volume and maximize their total fee income.

GPX is the sort of service that only PTSEF can offer because, handling the back office for so many programs, PTSEF has the ability to verify balances and debit and credit the accounts at both loyalty programs for both individuals involved in a GPX trade.  The ability to transfer points from one loyalty club to another is the sort of flexibility that makes those clubs' points a more valuable currency.

While the points.com site is a small part of PTSEF's business and not necessary for the bullish case, it is strategically valuable to the company.  To the extent that the ability to make better use of one's excess miles at points.com becomes considered by the members of a club to be a valuable feature of a particular loyalty currency, it makes it less likely that the club operator would ever leave the PTSEF fold.

PTSEF's Longer Term Earnings Potential

Although the company hasn't demonstrated it yet (despite my VIC write-up on PTSEF two years ago at a much higher price, the misjudgments of which I'll discuss in the Q&A if anyone is interested), I believe that the company is on the verge of substantial revenue and earnings growth that could move the stock to many times its current price over the next few years.  The key is rapid growth in higher margin revenue which, combined with a relatively fixed cost structure, should produce impressive growth in earnings and cash flow, all without major capital investment or excessive start up expenses.  Some factors include:

Partners Encouraging Activity:  Less than 2% of the members of its partners' loyalty programs over the course of a year do even a single transaction that earns PTSEF any money.  If PTSEF isn't earning any fees, then neither is the partner.  In the tougher economic climate, companies with loyalty programs are realizing that by alerting the members to attractive choices and opportunities they will generate fees for themselves (as well as for PTSEF.)

One impediment to non-redemption activity at loyalty clubs are the fees themselves.  Many operators try to maximize the fee per transaction, whereas if they charged less per transaction the resultant increase in activity would sharply boost total fee income.  PTSEF has been pushing its partners for years to test the elasticity of demand by lowering fees, and is making a little bit of progress recently, at least in terms of the fees charged at points.com for GPX trades. 

Looking at its partners' promotional plans for the next year, PTSEF believes that they will be more aggressive with various promotions that should induce more activity.  If that moves the dial to 3% of members doing something fee generating with their miles, and induces a little extra activity from the original 2%, PTSEF in theory could double its revenues without any other thing on this list happening.

More Products per Partner:  Partners typically use PTSEF for only some of the features of their loyalty program.  If PTSEF can get its partners to add a full set of features, the fees those modules generate would come close to doubling its revenues without anything else on this list.

New Partners:  PTSEF says it has a robust pipeline of potential new partners.  Among bigger players, it recently added KLM/Air France and the Chase Ultimate Rewards credit card.  Because its systems development is supported by revenue from dozens of partners, PTSEF has an up to date platform.  PTSEF's stable of partners lets a new partner create added value to its currency by giving members options to spend and trade its points away from the original currency.  While PTSEF already has a large number of the biggest programs as partners, there are many still going it alone, especially outside North America, that could benefit from moving many of their loyalty club features to the PTSEF platform.

New Technology Platform:  When PTSEF was first getting started, its software had a large amount of customization to handle the vagaries of each client's particular accounting, website, and operating systems.  As a result, whenever an existing client subsequently wanted to add a feature, it would take much expensive custom programming on PTSEF's part, and require considerable effort and work on the part of the partner's IT staff, to implement the change.  Often many months would pass between when a client agreed to expand its relationship with PTSEF and when the new features would actually be up and running and generating revenue for PTSEF.  New clients involved similar delays and expense.  This year PTSEF completed a major revamp, called Project ePoch, to its technology platform, which standardizes much of what once was custom.  This will let PTSEF cut expense and speed implementation of new business, and requires much less coordination with the partners' often overworked IT staffs.  The first two small partners have been set up on the new platform and it is working smoothly so far.  Over the next six months or so PTSEF will migrate its existing partners as well.

Points.com potential:  PTSEF's free direct consumer portal, Points.com, lets members track their balances in all their programs updated automatically, spend points on gift cards from over a hundred name brand retailers, or trade them through GPX for those they do want.  There are 2.2 million registered users at the site, still far below the potential of 80+ million unique members of PTSEF's partners' loyalty clubs.  With a major site revamp coming in spring 2010, and the ability of PTSEF to cost effectively reach potential points.com members through marketing emails to its partners' club members, the company thinks it can grow membership to more than 10 million over the next few years.  Should that happen the site will be very lucrative from both fees for transactions and income from advertisers.  It is still too early to count that into the bullish case.

Catalyst: Near Term Margin Expansion

With the loss of the very low margin segment of its Delta business starting in Q4 2009, one would expect to see a jump in margins along with a drop in revenues.  What will attract buyers to the stock, I believe, will be the awareness that PTSEF is quickly replacing the lost Delta revenue with new business at much higher margins, and a demonstration of the excellent operating leverage inherent in the model.  This is business run on computers--revenues from a given customer could double, and the cost of the computer capacity to handle the business would barely move up if at all.  PTSEF did not demonstrate this leverage potential in the last few years, partially because so much of its growth came from its lowest margin partner, but it should be much clearer over the next year or so.

Here is a very condensed spreadsheet showing my projections:

PTSEF, although based in Toronto, reports its numbers in US dollars.  The estimates above are based on a combination of company guidance and my own  interpretation of other comments made by management in their conference calls and other presentations.  PTSEF has a tax loss carry forward; rather than deal with those complexities, I just put down what I think the EPS would be as if fully taxed at 35%.  Usually EBITDA isn't wildly different than operating profit, because net interest income or expense is minimal, and depreciation and amortization are only about $200,000 per quarter.  The latter will go up as PTSEF's investment in installing its new technology platform for its e-commerce partners and revamping the points.com website will initially be capitalized, then amortized.

How the company talks about its numbers, and how they are reported in its income statements, are slightly different.  PTSEF refers to its "company wide gross margin", which combines the gross margin it makes on those transactions that are handled on a principal basis (principal revenues minus cost of principal revenues) plus the gross margin on its agency business (fee income minus processing fees), divided by sales.

Gross margin, thus defined, was on the way up anyway (15% in Q2, 18% in Q3) and should be in the 25% range in Q4, helped by the elimination of the very low margin Delta business and the addition of new customers at higher margin. Also, there is usually a little extra kick in Q4 as members of points.com trade in points for gift cards, which earns PTSEF high margin fees.  With non-Delta business continuing to grow in the 35% range as it did in Q3, Q4 should be profitable, enough to bring EBITDA for the year back into the black.

Official company guidance for 2010 is for revenues of $60-70 million, but my sense is that range is excessively conservative, so I am estimating a bit above that.  The main thing I hope to see in the reports from 2010 is a demonstration of the operating leverage inherent in the business.  Revenues will grow (ex-Delta), perhaps even exceed 2009's total without excluding Delta, gross margin will jump considerably because of mix, and most operating expenses won't go up much.

Operating leverage is a critical aspect of the bullish case.  In theory, other than perhaps needing a few extra servers, operating expenses should be relatively fixed even if business for a given e-commerce client doubled or quadrupled.  Adding additional partners would entail sales expense and initial start up costs to get their system up and running, but the latter should be a lot less than in the past due to the comparatively standardized nature of the new Project Epoch platform   

My 2011 estimate may look too aggressive, but right now I don't think so.  As discussed above, there is enormous headroom-PTSEF could be doing hundreds of millions of dollars of business if it could convince all its major partners to focus aggressively on their loyalty clubs as potential profit centers.

Here is another way to look at it, an economics analogy:  Think of the trillions of miles piled up in these clubs as a currency with a massive M-1 and a minuscule velocity; get that velocity to rise and charge a small fee per transaction, and there are billions in fees to be generated for both the partners and PTSEF.

The weak economy seems to have started them thinking in that direction.  PTSEF reports several of its partners are getting much more active in giving its club members incentives to do various things with their miles other than normal redemption.  Given that less than 2% of members normally do that in a given year, the partners don't have to be wildly successful for the revenue estimates I have above to be easily surpassed.

Finances

Depending on how you want to look at it, PTSEF either has a lot of money, or it doesn't.  Arguing in favor is the total of cash and equivalents, short term investments, and deposits of over $30 million as of September, with another $3 million due from credit card processors, a total representing more than half its market cap.  Arguing against is that PTSEF always carried high balances of money owed to its partners, $29.4M as of September.  This reflects the way principal trades work:  Suppose someone buys miles from one of PTSEF's principal basis airline partner on the 10^th of a month.  PTSEF usually gets the cash within a week from the credit card that the member used, but on the 15^th of the following month it has to buy and pay for the miles.  The cash is there, but since PTSEF cannot use it for very long, I did not count it in calculating enterprise value. 

That said, while I would be happier to see higher net balances, I am not too worried about its finances.  The company has no interest bearing debt.  After a couple million in spending between now and next spring to move e-commerce partners to the new platform and launch the new points.com site, capital spending will be tiny regardless of growth.  Rising profitability should show up as rising cash starting next spring.

Risks:

With small companies one must divide risks into two categories: what might prevent the stock from working out? And, what might drive the company under?

In the case of the former, what bothers me most is that PTSEF is a mouse amongst elephants.  PTSEF can work hard to persuade its partners to add its features to their loyalty clubs, to cut their fees per transaction to stimulate a huge increase in transactions, to promote the benefits of their members joining points.com as members which would open up great flexibility in how they can use their points.  All these things would help the loyalty club members, help the operator, and help PTSEF.  In theory it is win-win-win, but in practice, the big operators do what they like.  As PTSEF demonstrates its ability to bring in rising fees to the operators its voice will become more persuasive.

Beyond its control also is the economy.  While in theory a weak economy might induce points.com members to spend their points balances for gift cards in lieu of cash, in fact in the last year there hasn't been a major surge of that activity, perhaps because consumers were cutting down their total spending. Still, people who collectively have points balances worth billions that they will never redeem are mostly unaware that they can cash them in at points.com.  Perhaps the new marketing program in connection with the relaunched website in the spring will raise awareness and get the public in the habit of spending unneeded miles when cash is tight and their credit cards tapped out.

PTSEF's biggest money maker is the selling of miles in programs to people who need a bit more to get to a certain threshold.  The weak economy cut vacation travel and hence the desire to top off miles totals.  That said, despite the severity of the recession and the sharp drop off of business and leisure travel, there wasn't a big negative effect on PTSEF's business.

Another thing to consider is that, despite some diversification such as the recent deal with Chase Bank, most of its partners are airlines, which have the annoying habit of going bankrupt.  Usually, the frequent flier club is unaffected.  Yes, miles are an unsecured obligation that one would think would get wiped out in a reorganization, but in fact they almost never are.  The last thing an airline hoping to come out of bankruptcy would ever do is alienate their best customers, and even secured creditors at the highest level recognize this.  Sometimes, though, especially with the smaller ones, they never make it out of bankruptcy.  ATA, a small carrier that was a PTSEF partner, closed up shop, liquidated, and eliminated its frequent flier club.  If that happened to several of PTSEF's partners, that would hurt, as would any 9/11 type terror situation that restricted travel.

These things just mentioned wouldn't destroy the company, but would take away a lot of the growth potential and operating leverage, and the stock would go nowhere at best.

In terms of things that might knock PTSEF out of business, I can think of a couple.  A liquidation, including the elimination of the frequent flier club, of one of PTSEF's major clients, like American Airlines, might make the operating leverage hurt rather than help.  Also, PTSEF has commitments with some of its partners to buy a minimum amount of miles per year.  The minimums are easily achievable in normal conditions, but if another 9/11 came along and froze travel PTSEF might be committed to buying more miles than they could sell.  If that happened soon, before the big growth in earnings I project for the next few years, it may not have the capital to meet its commitments.

Summary 

As my risks section, and the more expanded one in the company's 10-K shows, this stock is no sure thing, as one might suspect given its stock price in the pennies.  But PTSEF is a business whose clients, if not yet the stock market, respects, in the sense that some of the biggest companies in the world rely upon it to handle their relations with their best customers.  So far it has made no money, but its cost structure is set up so that an increase in business from here will have a very positive effect on its earnings.  While I wouldn't call it a perfect moat, PTSEF is working hard to make itself the central marketplace for a massive, unacknowledged currency.  Compared to most companies with as trivial a market cap, this one seems worth a shot. 

Catalyst

Over the next four quarters, sharply rising margins and an inkling of the operating leverage that lies ahead.