Particular Business Models & Peculiar Valuations
Small Caps Earnings Review 02/09/2022
eDreams - 640m
The travel agency market isn’t growing very fast. Moreover, it is a very competitive business: by definition, you are facing the most price sensitive customers as the “business class” customers tend to book directly through airlines and take advantage of their loyalty programs.
However, eDreams innovated in late 2019 by launching a “prime” membership, inspired by Amazon. For £59.99 per year, you get access to the cheapest flights on the market and an exclusive customer service — something most would agree online travel agencies are not really good at.
The economics are really interesting. Initially, the program loses money as eDreams has to spend the same amount of money acquiring a customer as before but offers prices at which it makes a loss (it takes an average of two flights per year for the customer to break even on the subscription fee.).
However, once the customer is acquired, he will come back to eDreams on his own. Thus, eDreams saves the customer acquisition cost on all future purchases, which makes up for the discount. All is left is the subscription fee at 100% margin.
Therefore, as the program scales, eDreams experiences operating leverage on its fixed cost based due to prime subscriptions and essentially operates its legacy business at a 0% margin.
Furthermore, lower prices should, in theory, attract customers facilitating market share gains.
Though this sounds really interesting and innovative, there are reasons to be sceptical. The program’s success depends heavily on churn & customer acquisition cost. Assuming the CAC is 1x the subscription price, churn would have to be under 33% for this to break even if we assume 0% margin on the original business. There are reasons to think it may be higher.
A simple eDreams twitter search reveals that a lot of customers didn’t realize they were purchasing a subscription
And those aren’t isolated, there are literally hundreds of complaints. If you count the complains about refunds, perhaps thousands.
eDreams advertises the prime price and sticks in the subscription add-on right before paying. It is often cheaper to book with prime + subscription fee vs non-prime, especially for longer flights, so customers naturally do it thinking, “I am going to cancel”. However, eDreams makes it very hard to cancel.
This begs the question: How many of these prime members fit this profile?
Anyways, this isn’t a short sell pitch. I was actually interested in eDreams as a potential long, but this issue made it impossible for me to invest.
Edreams boasted 3.2m prime members at the end of Q1 (>3x YoY), and cash revenue margin was up 11% compared to pre-pandemic levels.
Braemar Shipping Services - 99m
Braemer is at the core, a shipbroker. It has taken the opportunity of the shipping bull market to divest its non-core operations and focus on shipbroking.
The group now has a solid balance sheet, with net debt down to 15m (1x EBITDA) and can now take fully advantage of its attractive position in a duopoly.
Results were really good, which isn’t surprising given the bull market we have seen in shipping. Revenue was up 21% and operating profit up 31%.
What interests me about this company is that it provides a diversified exposure to all shipping verticals, without taking the asset risk which often results in substantial dilution for most shipping companies. Though shipping is cyclical, Braemar has a lot more variable cost than a shipping company, making it able to weather the downturn without too much damage.
Trading at 5-7x 23E FCF, of which most is implied by the current orderbook, the valuation is attractive. Stock is up 17% YTD.
Sectra - 24 949m SEK
A quick look at the valuation would probably discourage most investors. Revenue growth has been volatile, averaging 13% over the last couple years, yet the stock is trading at 80x consensus forward earnings. Though I agree it doesn’t make a lot of sense, there is an interesting bull case which I’ll outlay here.
Firstly, Sectra is no ordinary company. Its legacy business, secure communications, has been providing services to some of the most secretive organisations in the world for a long time. In fact, Sectra is even mentioned in a James Bond book.
Though that business is hardly growing, the group as a whole is, due to another segment: medical imaging. They sell a subscription-based software for radiology. What’s interesting about this segment is that it was entirely bootstrapped.
Sectra has an incubator segment called “business innovation” which is effectively a collection of start-ups within the business. One of these initiatives, a technology that helps doctors analyse whether or not knee replacement surgeries are necessary has caught my attention.
More than a third of knee replacement surgeries are unnecessary, and they often lead to complications. The technology has academics supporting that it is very effective at identifying cases where knee replacement is unnecessary. If that is correct, the market for this is in the billions of SEK.
Moreover, they announced that they were working on a genomics project as of Q123.
Thus, the high P/E finds some justification in the numerous “hidden assets” of the business which could be spun-off or internally developed. They proved they could do it as medical imaging makes the bulk of the firm’s revenue now.
Also, Q1 saw medical imaging bookings rise a jaw-dropping 468.5%. Their strategy of expanding into the US market is clearly working, and we could see consensus expectations move higher over the course of the year if they keep this momentum.
The other thing to note w prime - at least as of last year, you could still find equivalent or cheaper fares elsewhere. So it's the equivalent of putting prices up, then putting up a members only discount sign.
Interesting concept but execution very shady for sure.