Description

We believe that Smiles SA (SMLE3.BZ) is an attractive long term holding with 50% upside in one year and substantially more in several years.  The key aspects of our thesis are:

1.    Attractive loyalty program business model with high barriers to entry, significant network effects and switching costs, negative working capital and virtually no capital requirements

2.    Secular growth from increased credit card penetration, loyalty membership growth and passenger air traffic in Brazil

3.     Incentivized and talented management team

4.     Potential cyclical growth from trough economic conditions in Brazil

5.     Compelling valuation at 12x trailing earnings and 7.5% dividend yield

Furthermore, we believe we can identify why the stock is mispriced and why these perceived risks are manageable, namely:

1.    Competition from new entrants, such as Livelo

2.    Current difficult Brazilian economy and political environment

3.    Stigma associated with financial distress of sister airline GOL and associated corporate governance risks

4.    Stale sell-side estimates

5.    Trading dynamics:  short term domestic Brazilian investors and “orphaned and forgotten” by international investors

We believe that at a reasonable valuation of 16x earning plus an expected 8% dividend yield, we have 50% upside in 12 months.

Business Overview:

Smiles was written up by nha855 in Dec 2013 so we would refer readers to that write-up as well for a summary and introduction to the business model.  We will not dive into all of the nuances and details of the business model unless there are specific comments in the messages section.  Smiles is a frequent flyer loyalty program for one of Brazil’s two major airlines, Gol Linhas (GOL).  The frequent flyer program was carved out in an IPO in April 2013 and has been public since, while GOL retains a majority interest.  The business model of a loyalty program is as follows: a) consumers “earn” points by spending on their credit cards, which they can use to “redeem” through rewards programs either at their issuing bank or (as most opt to do) through a frequent flyer loyalty program, b) the issuing banks then purchase points from frequent flyer programs to reward these customers, c) the loyalty program receives cash for these “miles” and d) generally after 9 months, the loyalty program purchases the ticket for the consumer.  Revenues are generated through 3 sources: 1) the “spread” or difference between the price of miles sold to banks and purchased from the airline, 2) the interest on the “float” created by when cash comes in (billings) and when it is redeemed, and 3) “breakage” or the portion of miles which are earned but not used.  

Readers familiar with loyalty programs will recognize the attractive network effects, high switching costs and attractive margin/cash flow dynamics of this business model.  In a loyalty program with a proprietary, low-cost access (due to the 20 year operating agreement between GOL and Smiles) to seats on a leading  national airline, the barriers to entry are even more significant.

Credit Card Penetration and Spending in Brazil Offers Long Term Growth

Smiles is also attractive given the low penetration of credit cards in Brazil and the low membership rate in loyalty programs, both of which should grow for many years to reach levels more comparable with other markets.

Management

Smiles’ management team has done an exceptionally good job of growing their business through very turbulent times and for the benefit of their shareholders.  Smiles leverages its relationship with the issuing banks in Brazil to offer them bulk discounts on miles (often 20%) in exchange for steering more customers to their loyalty program.  Smiles has also continued to manage the tricky relationship with GOL (their controlling shareholder) very well, and for the benefit of all shareholders, including minority shareholders.  The recent pricing agreement adjustment with GOL illustrates this, whereby Smiles negotiated a 5% reduction in the redemption cost of their “Classical Air Fare” tickets from GOL (which we estimate is ~70% of their redemption costs) in exchange for a 25% reduction in the price of miles sold to GOL (which we estimate is only 11% of their miles accrued), resulting in a net-benefit to minority shareholders:

Lastly, through internal organic programs such as Smiles & Money (that allows consumers to redeem for flights with a combination of miles and cash, thereby increasing customer engagement) and RocketMiles (a JV with Priceline/Booking.com that provides consumers with miles in exchange for booking hotels directly through the JV), management continues to grow their business beyond the rate at which their main competitor and the overall credit card and air traffic markets grow.

Brazil macroeconomic conditions

We are not macro-economic forecasters but given the political and economic turmoil of last 2 years, it is our working assumption that we are closer to the bottom than to the top of the Brazilian market cycle.  We could always be wrong and there is a lot of headline risk, but compared with economic conditions in the US, it is our belief that Brazil could be at a trough.  For a business that is levered to credit card consumption, we think this could be an attractive inflection point:

Valuation

Since Smiles’ IPO in 2013, the company has traded in a wide range, from north of 20x earnings when the Brazilian economy was doing well to less than 10x earnings at the peak of insolvency fears for GOL last year, with an average valuation of 16x trailing earnings.  We believe that such a multiple is fair today given our view that many of the variables that driven Smiles’ valuation are more favorable today than in the prior 4 years:  the Brazilian economy is expected to grow (albeit modestly this year) compared to shrinking 4% each of the prior 2 years, GOL’s financial condition has improved significant due to some improvement in earnings and some restructuring of operating leases and the Brazilian real has stabilized somewhat against the dollar.  

Why Is It Cheap?  Perceived and Real Risks

We believe that Smiles is mispriced because of some real (but overblown) and some perceived risks that aren’t without merit.  Specifically:

1.       Competition from new entrants, such as Livelo.  Livelo is a joint venture formed to compete with Smiles and Multiplus from two of the largest banks in Brazil (Bradesco and Banco do Brazil).  While there has been significant attention paid to the launch of Livelo in the industry, we think that the ultimate impact to Smiles and Multiplus will be limited for one primary reasons:  Livelo does not have access to low-cost airline seats that consumers want.  By design, both Smiles and Multiplus have a significant competitive advantage in their long-term contracts with their sister airlines to purchase discounted seats.  Livelo purchases seats through a large travel agency in Brazil called CVC but their costs are much higher than Smiles/Multiplus.  If Livelo were to offer flight redemptions at the same price as Smiles, it would burn substantial cash and we do not believe that is the intention of its banking backers.  Note:  there was some analysis done by UBS last year that suggested that Livelo was cheaper than Smiles/Multiplus but it turns out that was not entirely accurate because the UBS analysts conducting the studies were not members of Livelo and only looked at the headline cost (points required for products) and did not go to the end of the process and see additional fees/costs/points that made Livelo more expensive than the incumbent providers

2.       Current difficult Brazilian economy and political environment:  there is no doubt that Brazil is a mess right now in the aftermath of “Operation Car Wash” and this creates significant near-term noise.  On any given day, there is a headline about another political scandal and the entire Brazilian market will trade up/down.  We repeat that we are not Brazil macroeconomic analysts but we think that if you “skate to the where the puck is going” in a couple of years, Brazil will sort its problems out.

3.       Stigma associated with financial distress of sister airline GOL and associated corporate governance risks:   The “bear” case on Smiles for the last 2 years has been the financial distress of GOL and what would happen to Smiles if GOL were to become insolvent.  Given the operational (yields, CASK) and financial (lease restructuring) improvements at GOL, GOL’s stock has jumped 100% so far in 2017 and over 200% in the last year.  GOL’s 2022 bonds now trade above 90c for the first time since 2014, so we think the risk of a GOL insolvency have diminished substantially, though it still taints the valuation of Smiles.  In a scenario that GOL actually does become insolvent, we still believe  Smiles has value because GOL’s problem is financial (USD dollar denominated debt with a BRL denominated operating business) and can be cured in a debt restructuring without the need for an external partner (who may replace Smiles with their own loyalty program).  We also believe that there is strong opposition from any government from turning an airline over to a foreign owner.

4.       Stale sell-side estimates:   For a variety of reasons, several analysts have not updated their models or ratings on Smiles for several months or are using far too conservative estimates.  The two analysts with the lowest rating on the stock (MS and HSBC, both Sell rating) haven’t updated their numbers in months and MS will explicitly tell you that they are positive on the stock but just haven’t had a chance to update their rating.  As illustrated during the 4Q when Smiles grew EPS 44% y/y and beat Street estimates on every metric (billings, revenues, profitability), the Street has been slow to update numbers.

5.       Trading dynamics:  short term domestic Brazilian investors and “orphaned and forgotten” by international investors.  Domestic Brazilian investors are not particularly long-term oriented from what we gather and seem trade around headlines and near-term data points so it creates some volatility and a lack of focus on the long term.  We think you can see this by watching Smiles’ day to day trading (which is dominated by how GOL stock trades or what its bonds yield or what the Bovespa does that morning), which ignores the long term attractiveness of this business.  Consider that since Smiles’ IPO in 2013, Smiles has returned nearly 300% (even with multiple compression) while the Bovespa is up only 20% and GOL is down nearly 40%!  Yet on a day to day basis, these securities are nearly 100% correlated.   In 2013/2014, many US investors focused on Smiles and Multiplus as “back-door” plays on Brazilian credit card penetration (along with Cielo) but from what can gather, the inbound interest from US investors has dropped significantly in the past year or two given the Brazilian macro-economic picture.  In that sense, we think Smiles is somewhat of an “orphaned and forgotten” company with an attractive secular outlook.

Additional points / topics we are happy to discuss in the message threads:

Legacy points vs. Smiles points

Credit card penetration potential for Brazil and for GOL by Smiles (relative to Multiplus/LATAM and other loyalty programs)

Corporate Governance and General Atlantic’s exit of their investment

Regulatory initiatives regarding credit cards and breakage fees

Points price competition

Currency impacts and hedging

Impact on breakage revenue with lower SELIC

Valuation after the GOL operating agreement ends in 2033 (we estimate we will have recouped 150% of our cost in dividends by then but happy to discuss)

Supplemental Information

Unit economics

Summary Financials

Comparison of Brazilian Banks / Merchant Acquirer Cielo / Loyalty Programs

Catalyst

Continued growth in earnings and dividends

Stabilization of Brazilian economic environment

Analyst updates to ratings and estimates