Description

We believe eDreams ODIGEO (“eDreams”) has reached a dramatic profit inflection in its business.

Over the last three quarters, Cash EBITDA has stepped-up from 11M to 14M to 21M.  Within 24 months, we believe Cash EBITDA will reach 50M/quarter (consistent with company guidance).  A year after that, Cash EBITDA should exceed 65M/quarter, or 250M+ per year.

For context, the current market cap is roughly 400M.

This large increase in profits, alongside high cash conversion ratios, should position eDreams to return the vast majority of today’s market cap to investors over the next three years.  We anticipate significant capital returns (i.e., share buybacks) are imminent.  This will both create significant value and provide a consistent bid to the shares.

In addition, less than two weeks ago a major share overhang was removed.  Ardian, a French private equity firm with a 15.6% stake held for more than a dozen years (since pre-IPO), needed to sell its position as this was the last holding in a 2008-vintage vehicle that was terminating at the end of 2022.  The Ardian overhang was well-communicated to the market for nearly a year, impacting the share price.

On Friday, December 9, the Ardian block was finally placed with two long-term-oriented hedge funds, Conversant Capital in Connecticut and Polus Capital in London, who are highly motivated to drive shareholder value.  We expect Conversant and Polus to nominate new Directors to replace the two departing Ardian Directors, and to be strong voices for a shareholder-friendly agenda.

https://www.edreamsodigeo.com/press-releases/2022/12/strong-investor-support-for-edreams-odigeos-strategy-to-continue-revolutionising-the-industry/

eDreams has been written up on VIC a couple times before.  However, with the profit inflection here and the share overhang gone, we believe it’s finally time for the stock to work in a meaningful way.

OTA’s (online travel agents) like Booking.com have historically traded at 15x+ EV/EBITDA.  Growing, high-margin subscription software businesses have historically commanded EV/EBITDA multiples of 20-25x.  We don’t know exactly what the right multiple should be, but looking out 2-3 years we have eDreams trading at less than 2x EV/EBITDA based on the current stock price.

In our view, the combination of meaningfully growing profits, large and imminent capital returns, and no share overhang presents eDreams with a clear and timely path to being worth tens of Euros per share vs. the current share price of 3.50/share.

From “Transactional” to “Subscription”

VIC members will be well-acquainted with businesses transitioning from “transactional” to “subscription” business models. 

Subscription businesses tend to be higher margin, more predictable, and more resilient – as a result, they are rightly awarded far higher valuation multiples in the public markets.

The issue companies face is that the transition from transactional to subscription can be painful from a GAAP/IFRS perspective.  Up-front sales are converted to deferred recurring revenues that are only recognized over time.  Subscription customers – who are more valuable than one-time customers – are also more expensive to acquire, front-loading costs in the P&L.  As a company shifts its mix from transactional to subscription, the GAAP/IFRS financial statements show a business that looks like revenues and profits are flat-lining…even if, under the surface, the company is adding meaningful economic value every day.

And then the inflection happens.

Eventually, the subscriber base hits critical mass.  The weight of the higher-margin recurring subscription revenue begins to outbalance the front-loaded costs.  Profits rise, and then accelerate upwards.  This is when the stock works.  We’ve seen this in the past with other companies who successfully pivoted from “transactional” to “subscription” such as Adobe (ADBE) and Franklin Covey (FC).  When the profit inflection happens, the stock goes up.

eDreams fits this set-up to a “T”.  As disclosed in the company’s public materials, eDreams earns a 19% profit margin on year-1 subscribers (as costs are front-loaded) but a 49% profit margin once those subscribers flip to year-2 and beyond (see Exhibit A). 

                Exhibit A

eDreams started seeing large increases in year-1 subscribers as travelers began returning post-COVID in early-mid 2021.  One year later, as subscribers anniversaried into more-profitable year-2+ cohorts, eDreams began to see the large quarterly step-ups in profits mentioned in the intro.

With gross subscriber adds continuing unabated, and barring an unexpected change to churn rates (the company has disclosed churn rates have actually been improving, slide 30 of H1 FY23 investor presentation), we can have confidence that profits are likely to continue stepping-up quarter-over-quarter for the foreseeable future.

eDreams has become a predictable, consistent subscription business where profits are driven not by month-to-month variations in travel trends, but by the maturation of its subscriber base.

Background on OTA’s

OTA’s are digital marketplaces that act as a one-stop “middleman” between millions of travelers and millions of travel service providers (airlines, hotels, rental car companies, tour operators, etc.).  OTA’s provide a critical service to both travelers (by organizing and simplifying the travel purchase) and sellers (by sourcing leads/customers).  OTA’s are paid by travel service providers via rebates that can be considerable (from single digits up to tens of percent of the booking value).

Many OTA’s are now household names. In the US, the most popular OTA brands include Priceline, Tripadvisor, Expedia, Booking.com, and Orbitz. Other countries or regions have different leading OTA brands such as Trip.com in China, eDreams in Europe, Webjet in Australia/NZ, On the Beach in the UK, and Despegar in Latin America.

OTA’s tend to be wonderful businesses. They are asset-light and therefore require little capital to grow. Their cost structures are variable, making them resilient in a downturn but also quick to respond to demand surges. With both a fragmented customer base and a fragmented supplier base, OTA’s at scale have pricing power; due to this favorable dynamic, most tier-one OTA’s operate with healthy EBITDA margins of 20% and best-in-class operators can approach 35-40% EBITDA margins.

In region after region, the OTA competitive landscape has consolidated to a short-list of firms with the technology, data, customer lists, supplier relationships, and brands to maintain and strengthen their leading positions. It is difficult to build a scale OTA, but once the flywheel is spinning, it is the very definition of a high-quality business.

The “Costco” Model

eDreams’s subscription model is unique in the travel industry.  Called PRIME, the model is actually more akin to Costco’s business model as subscribers pay an annual fee of €55 and then get access to discounted pricing (below retail or direct pricing) when booking travel.

The model works for two reasons.

First, the primary expense line-item for an OTA is customer acquisition cost (including marketing), which can account for 30-45% of an OTA’s cost base.  PRIME subscribers, however, book directly through the eDreams website or app, reducing CAC/marketing by 90% or more.  eDreams splits this considerable savings between itself and its customers, leading to higher margins and better pricing for PRIME subscribers.

Second, the more leads eDreams provides its travel partners, the more negotiating leverage eDreams wins to earn even higher rebates.  PRIME subscribers book 3x as often as non-Prime customers.  The additional traffic/liquidity eDreams provides to its partners results in an even larger profit pool eDreams can split between itself and its customers.

The model is self-reinforcing.  The more PRIME subscribers, the more negotiating power for eDreams, the more eDreams can share incremental profits with its customers via lower prices and by investing in better service (PRIME has industry-leading NPS scores and customer engagement, which improves subscriber stickiness/retention).  As the flywheel kicks in, it becomes incredibly powerful (see Exhibit B).  With 4 million PRIME subscribers and growing at a rate of 300-400k net new PRIME subscribers per quarter, the model has reached critical mass.

                Exhibit B

For any subscription business, churn rates are important to understand.  We have done a lot of work on eDreams’s churn, and believe it is better-than-average for a B2C company, hovering around 2.5-3.0% monthly churn.  That said, we believe that 75-80% of the churn is “involuntary” (i.e., credit cards expiring, which happens more regularly in Europe than the US) and only about 0.5% monthly churn is “voluntary” where a customer chooses to cancel.  This allows for low-cost retargeting of involuntarily-churned customers, and implies the economics of the business are closer to a 1.5-2.0% monthly churn B2C business (as some involuntarily-churned customers are quickly reacquired at low cost).  This places PRIME toward the top of the league table of “best” B2C subscription businesses.

Barriers to Entry

If the subscription model is so powerful, why haven’t other OTA’s replicated it (or why won’t they in the future)?  This is a critical question.

In our view, creating a successful subscription model in travel is challenging.

First, it requires whole-of-firm buy-in to commit all aspects of the organization (technology, marketing, customer success, etc.) to driving the subscription model.  The entire tech stack must be re-architected onto a single platform with a single point-of-truth for every customer.  For most OTA’s which operate different brands on different technology platforms (Expedia is a good example), this would take years of effort and may well be impossible to execute.  From the jump, almost no OTA’s are foundationally set-up to pursue a subscription model without years of investment and organizational change.

Second, a subscription model self-cannibalizes metasearch.  For companies with large metasearch offerings (such as Booking.com), it would make little sense to launch a subscription product as it would merely be shifting profits from one pocket to another.  It’s no surprise that Booking.com’s playbook has instead been to acquire metasearch providers (like eTraveli) rather than attempt a subscription service of its own.

Finally, a subscription model takes years of investment and testing to perfect.  eDreams has launched, trialed, and learned from tens of thousands of iterations of its subscription platform since the mid-2010’s.  In technology, that kind of head start in both years and data-driven learnings is a lifetime.  eDreams is so far ahead that a peer successfully launching a genuinely competitive product seems a low probability.

Considerations and Risks

As with any investment, there are a number of considerations and risks to take into account.

• Balance Sheet.  eDreams currently has a net debt position of 382.6M.  This consists of 375M of senior notes due July 2027 with a 5.5% fixed rate, 55M on the company’s 180M revolving credit facility, and 3.8M of Spanish Government Debt, offset by a cash position of 41M.  The Spanish Government Debt must be retired before the company can execute a share buyback program, and this debt can be repaid any time.  The 375M senior notes are exchange-traded and currently trade for ~80c on the dollar, or a YTM of 13-14%.  We view the senior notes as “money good” and believe they are attractive at current levels.  In addition to buying back shares, we have encouraged the company to consider repurchasing its senior notes as well.

• Financial Statements.  eDreams screens poorly…for now.  While Cash EBITDA reached 21M last quarter, IFRS accounting shows a lower EBITDA number and negative net income as cash received today is only recognized over time in the P&L.  IFRS numbers will in due course catch up to the cash numbers, and we expect eDreams to screen increasingly well each quarter that passes as IFRS EBITDA and net income step-up alongside Cash EBITDA.

• Seasonality.  Travel has historically been seasonal, with eDreams’s fiscal Q3 (November-end) the low quarter of the year.  We expect seasonality to gradually diminish in importance for eDreams as subscription profits become the dominant driver of profitability; however, at this point some seasonality remains.  In FY22, Cash EBITDA fell 2.2M from Q2 to Q3.  With a larger contribution from PRIME in FY23, we expect Cash EBITDA to counter-seasonally grow from Q2 to Q3 (perhaps to 21-22M), followed by a larger step-up in Cash EBITDA in Q4 (to 27-29M) and into the 30M’s and beyond thereafter.  We generally forecast quarterly Cash EBITDA to grow quarter-on-quarter by 3-5M per quarter going forward, with modest adjustments up or down based on travel seasonality.

• Management.  We consider eDreams to have a strong management team.  eDreams’s leadership is pan-European, with an American CEO (ex-McKinsey, AOL, easyJet), a Spanish CFO, and a senior team composed of Dutch, German, and other nationalities.  To the best of our knowledge, the company has never missed a financial target set out by the CEO.  We have been impressed by the company’s operational execution and Western-style leadership team.

• Spain and a Potential Stock Re-Listing.  eDreams is headquartered in Barcelona and the company’s shares are listed on the Spanish Stock Exchange (Madrid).  We note that companies on the IBEX35 tend to trade for high valuation multiples – often higher than in the US and other markets.  At this time, eDreams is too small to qualify for the IBEX35.  As a result, there are ongoing conversations about whether the company should re-list to the NASDAQ.  Should the company expand its subscription platform into the US (a strong possibility) such that a material portion of its business comes from the left side of the Atlantic, and the company still not be included on the IBEX35, a NASDAQ re-listing is a strong possibility.

• Capital Markets.  Sell-side coverage of eDreams is poor.  Spanish analysts do little independent research and generally parrot back the company’s statements.  The two international banks who cover the company, DB and Barclays, have provided middling analyses that generally miss the crux of the thesis.  A major goal of the company is to expand and improve its sell-side research coverage.  We believe eDreams will be successful in adding higher-quality research coverage in the near term.

Conclusion

eDreams has reached an important inflection point in the profitability of its business.

With large cohorts of PRIME subscribers maturing from year-1 to year-2+ in the quarters ahead, we expect to see substantial increases in Cash EBITDA.  This should provide significant funds for capital returns while de-levering the balance sheet at a rapid pace.

History shows that when a newly-converted subscription business hits this part of the profit J-Curve, the stock price follows in a big way.  We think eDreams therefore represents an outstanding risk/reward from the current price of €3.50/share, with upside to the tens of Euros per share and downside protected by significant and recurring subscription profits.

Disclaimer

The author of this posting and related persons or entities ("Author") currently holds a long position in this security. Author may purchase additional shares, or sell some or all of Author's shares, at any time. Author has no obligation to inform anyone of any changes to Author's view of EDR SM. Please consult your financial, legal, and/or tax advisors before making any investment decisions. While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note. The reader agrees not to invest based on this note, and to perform his or her own due diligence and research before taking a position in EDR SM. READER AGREES TO HOLD AUTHOR HARMLESS AND HEREBY WAIVES ANY CAUSES OF ACTION AGAINST AUTHOR RELATED TO THE NOTE ABOVE. As with all investments, caveat emptor.

Catalyst

-Profit Inflection - Cash EBITDA grows from 20M/quarter to 65M/quarter over the next 36 months

-Share Overhang Gone - The sale of the Ardian stake removes a major overhang in the shares

-Capital Returns - Imminent Share and Debt Buybacks accrue value to investors

-Improved Screening - Profit growth flows through to IFRS financials at the same time net debt is declining, allowing eDreams to screen as an attractive stock

-Re-Listing - eDreams is likely to either make it onto the IBEX35 or re-list to the NASDAQ over our investment time horizon