Value Investors Club / Smiles (SMLE3 BZ)

Description

The recent carve-out IPO of Smiles has caused its underlying earnings power and the strength of its business model to be obscured by accounting adjustments mandated by Brazilian GAAP. These accounting adjustments make an otherwise low valuation and great business look like a high valuation and mediocre business. Once an investor cuts through these temporary distortions, it is possible to see that the stock is trading at slightly less than 11x 2014E Ongoing FCF (with a net cash balance sheet) and that the business earns an approximate infinite return on invested capital. I also believe that there are secular growth drivers that should allow the frequent flier industry to grow in excess of 20% per year for a significant period of time due mainly to increasing use of credit cards in Brazil. Above and beyond the secular growth story, the Company has a meaningful catch-up opportunity relative to its closest competitor Multiplus, which is currently more than 2x as penetrated in its affiliated airline and more than 15x as penetrated in merchandise rewards. Fully closing this gap could result in revenue more than doubling.

As an upfront note, this writeup will be brief and will not cover too much on the catch-up opportunity, the big competitor (Multiplus), foreign exchange, the partner airline Gol, recent agreements with the banks, or the outlook for Brazilian credit card spending and the middle class. If you have a question about these things, please put it in the comments and I will do my best to respond to it.

Quick Business Overview

Smiles operates the frequent flier plan for the airline Gol, which is the second largest airline in Brazil with about 40% domestic market share. The Company has a big barrier to entry (it's affiliated with a big airline and it's not easy to make a big new airline), has a nearly infinite return on invested capital, and is protected by a 20-year contract with Gol to serve as its exclusive frequent flier program (we're in year 1). Minority investors are further protected by the presence of General Atlantic as a ~17% shareholder with board representation and veto rights over related party transactions between Gol and Smiles. The basic way the business works is that Brazilian bank customers collect bank points, which are primarily earned on credit card spending. Bank customers can then choose to spend their points with the banks or transfer them to a reward program, such as a frequent flier program. Based on our checks, we believe that the majority of bank customers choose to transfer their points to a frequent flier program. Smiles is the second largest such program and is affiliated with Gol. Multiplus is the largest frequent flier program and is affiliated with TAM, the largest airline in Brazil. When a customer chooses to transfer his bank points to Smiles miles, the bank purchases the miles from Smiles, the miles are deposited in the customer's Smiles account, and Smiles books an account receivable (generally collected in < 30 days). At this time, a "gross billing" is generated. On average, the customer will redeem 85% of those miles ~9 months later for an airplane ticket. When the customer chooses to redeem his miles, he generally goes to the Smiles website and he sees dynamically generated flight costs (in Smiles miles) so that Smiles can be sure to charge the right price per ticket. On average, we expect Smiles will earn about a 30% gross margin on its tickets purchased with miles alone and a 50% gross margin on tickets purchased with "Smiles and Money," which allows customers to use a blend of cash and miles for a ticket. The other 15% of miles, on average, become breakage revenue, which means they expire worthless and have 100% gross margin associated with them.

Accounting Review: Getting to Cheap

The carve-out IPO in conjunction with Brazilian GAAP and mileage presales has caused five major accounting distortions that I detail below:

1. Revenue recognition: Under Brazilian GAAP, revenue from frequent flier programs is recognized when points are redeemed rather than when points are earned. This is inherently conservative because it means that cash is received on average ~9 months before revenue and matching expenses are recorded, but for GAAP this is probably appropriate since redemption is the time at which the service is truly delivered. As a result of the carve-out nature of the Company's IPO, Smiles is currently only recognizing revenue for points which have been both earned and redeemed after its carve-out on January 1, 2013. Accordingly, in its Q3 results, Smiles only recognized revenue and expenses for 54% of the miles redeemed in the 100% miles product in this period. Even though the other 46% of miles are technically miles redeemed under the Smiles program, Smiles does not recognize these miles since Smiles was only formed this year. GOL is responsible for the other 46%, which are miles earned before Smiles' creation on January 1, 2013. This under-recognition of revenue will no longer be an issue by Q1 2016, though I estimate it should be largely gone in 2015.

2. Breakage: Smiles requires that members redeem their miles within 3-years of earning them. Miles not redeemed during this period expire worthless and the cash that was received for the miles is recognized as revenue ("Breakage Revenue"). Breakage revenue has a 100% gross margin associated with it. Smiles utilizes an estimation method to determine its breakage revenue in any given period but in order to be conservative, the Company accrues only a portion of what it expects its final revenue to be. Based on our conversations with the Company, we believe that the Company is targeting ~15% breakage. This looks very reasonable when compared to a program such as Aeroplan, which currently targets 12% breakage, but which does not ever allow points to expire. Due to the conservative nature of Smiles accumulation policies, we estimate that breakage will be BRL70 million in 2013, BRL43 million in 2014, BRL46 million in 2015, and BRL180 million in 2016. As a percent of gross billings, we forecast breakage at 7% in 2013, 4% in 2014, 3% in 2015, and 9% in 2016 (and ~9% thereafter). Breakage revenue as a percent of gross billings jumps up in 2016 because this is the first year in which miles accumulated post-IPO are able to expire worthless and the conservative accounting policy of Smiles means that they don't recognize much breakage revenue until the miles actually expire.

3. Revenue per Mile: In conjunction with the IPO of Smiles, the Company chose to presell about $400 million of miles to its bank partners at a discounted price. This action was directed by GOL, which controlled Smiles at the time. Ultimately, this was a method to increase the cash GOL would receive since all of the cash from the IPO and the mileage presale was used to prepurchase discounted tickets on GOL. In conjunction with this presale, GOL not only gave the bank partners of Smiles a discounted price, but GOL also allowed the banks to lock-in the (in hindsight) very advantageous exchange rate of 2 BRL / 1 USD. As a result, we estimate that the current revenue per mile from bank partners is 15+% below the level at which it will reset once the pre-sold tickets have been fully utilized. Importantly, the redemption cost per mile from GOL will not change, so this incremental revenue will have a nearly 100% flow-thru to incremental pre-tax income.

4. Balance Sheet & ROIC: As previously mentioned, the IPO proceeds and the presale of miles to the banks were used to prepurchase discounted tickets on GOL. Under their corporate governance agreement with General Atlantic, the Company has agreed to limit prepurchased tickets in the future to 1-year of expected ticket needs in comparison to the current level on the balance sheet of around 3-years of discounted ticket inventory. The drawdown of approximately 2 years in prepurchased ticket inventory will generate a big cash inflow over the next two years, though this will be somewhat offset by a decline in deferred revenue as the miles that were presold to banks are redeemed by customers. On a net basis, we expect working capital to generate ~9 BRL / share in cash inflows over the next two years. Importantly, the Company has committed to returning to shareholders this cash inflow from working capital normalization. The current bloated balance sheet also makes the Company's ROIC look low. Depending on how investors look at invested capital, we believe that there will be negative invested capital in the business (net debt + equity - where prepurchased tickets are treated as a financial asset in net debt) or ~0 invested capital (net debt + equity - but ignoring prepurchased tickets). Either way, ROIC is nearly infinite.

5. Interest Income: Under Brazilian GAAP, the discount on the prepurchased tickets accrues as interest income (currently at an imputed interest rate of 12.5%) and the cost of goods sold for these tickets reflects their stated cost based on the 20-year contract between the parties. Accordingly, the Gross Margin is not affected by the discounted tickets but the pre-tax income properly reflects the discounted tickets. To balance these out, interest income is much higher than it otherwise would be based solely on the Company's cash and securities holdings. We expect interest income to deflate as the prepurchased ticket inventory declines back to 1-year.

Ongoing Earnings Power:

We believe that the best way to look at the value of the company is to compare its stock price adjusted for the pending special dividend to the Company's FCF per share adjusted for all of the above accounting distortions as though they don't exist. We make a further adjustment by counting future redemption costs in current year expenses and ignoring past redemption costs thus matching future costs with current period billings. We prefer this method to a normalized EPS method because it better captures the current earnings power of the business as represented by current period gross billings rather than the earnings power of the business in the past as represented by current period revenue. Based on our 2014 gross billings estimates, we see FCF as follows:

Putting It All Together:

It's pretty rare for me to be able to buy great businesses like frequent flier programs and even rarer to find them when they're cheap. It usually involves something going wrong in the business, but in the case of Smiles I think we're fortunate that something has simply gone wrong with the Brazilian GAAP accounting but the business is in good shape. I think this is one of the rare times you get a trifecta: high quality and growing business, low valuation, and catalysts (special dividend near-term and accounting normalization medium-term).

I do not hold a position of employment, directorship, or consultancy with the issuer.
Neither I nor others I advise hold a material investment in the issuer's securities.

Catalyst

1. Rapid compounding in intrinsic value due to growth

2. Payment of special dividend

3. Normalization of financials by 2016

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			2013	2014
Price:	32.32	EPS	$0.00	$0.00
Shares Out. (in M):	122	P/E	0.0x	0.0x
Market Cap (in $M):	3,950	P/FCF	0.0x	10.7x
Net Debt (in $M):	-1,101	EBIT	0	0
TEV (in $M):	2,848	TEV/EBIT	0.0x	0.0x