Geoff Gannon December 5, 2019

Points International (PCOM): A 10%+ Growth Business That’s 100% Funded by the Float from Simultaneously Buying and Selling Airline Miles

Points International (PCOM) is a stock Andrew brought to me a couple weeks ago. It always looked like a potentially interesting stock – I’ll discuss why when I get to management’s guidance for what it hopes to achieve by 2022 – but, I wasn’t sure it’s a business model I could understand. After some more research into the business, I feel like I can at least guess at what this company is really doing and at how this helps airlines. My interpretation of what the company is doing is sometimes a bit different than what I’ve read about in write-ups of this stock on Value Investor’s Club, Seeking Alpha, etc. The company’s own investor presentation doesn’t lay things out quite the way I will here. So, everything you read in this initial interest post should be consumed with the understanding that it’s my best guess of how this business works – and that guess could be far off the mark.

Points International has 3 segments. One of these is “Loyalty Currency Retailing”. That segment produces more than 100% of the company’s economic profit because the other 2 segments together add up to a slight loss, break even result, etc. depending on the exact year or quarter. At this point, I see no reason to assign any value – positive or negative – to the other two business segments. Points International also says it serves a lot of different clients. It mentions a total of 60 clients who it does some work for. However, only 30 use even one of the company’s “Loyalty Currency Retailing” functions. As a side note: in a YouTube video I saw, the company’s President seems to mention the number 36 in reference to Loyalty Currency Retailing – so, when I say “30” going by the company’s reports to regulators and so on, the actual number may now be 36 but I’m not 100% sure that’s what the President was referencing. So, I’m going to keep saying they have about 30 out of 60 clients actually allowing them to do any Loyalty Currency Retailing. Loyalty Currency Retailing is the only business that produces value here. So, all profits are from only 30 (or so) “partners”. Customer concentration seems extreme here if you read the note that 70-75% of revenue comes from 3 partners. However, gross profit is the more meaningful measure here. I would just cross out revenue and replace it with gross profit for most discussions of this company. The one exception would be “float”. I’ll discuss that later. It’s possibly best to treat gross profit as this company’s top line revenue and to treat the reported revenue as a form of “billings” as other marketing companies might put it. So, gross profit concentration is such that 80% of gross profits comes from 12 partners. Based on other things the company says, I would assume these partners are airlines based in the U.S. and Europe. I think the concentration here is really that almost all profits probably come from “Loyalty Currency Retailing” operations done for about a dozen airlines in the U.S. and Europe.

What is Loyalty Currency Retailing? Here is where I’m going to describe the business slightly differently than I’ve seen it described by others. I think this company runs marketing promotions to sell airline miles on a “retail” basis (that is, to individual people who fly with the airline). For accounting purpose – whenever Points International is acting as a “principal” instead of as an “agent” – this is treated as Points International buying airline miles at a wholesale cost from its airline partner and selling the miles to the flier who will eventually use these miles. I think describing the business that way could be somewhat misleading to an investor. First of all, you might assume that if Points is buying from airlines at wholesale and selling to fliers at retail that it is first buying and then selling. However, that’s not the case. Points International doesn’t normally go “long” airline miles at all. You can see this by checking the company’s balance sheet. It usually carries truly minimal amounts of airline miles on the balance sheet. And the company explains what causes it to ever carry any miles at all. This explanation – that it only has airline miles on its balance sheet when it fails to sell as many miles in a year as it has promised to buy under the guaranteed purchase obligation it has contractually with an airline – implies that in all other circumstances, Points International is not buying airline miles before selling them. It buys them as it sells them. In fact, on a cash basis – it really buys them long after it sells them. Points sells airline miles to people who pay with their credit cards. The payment processor then deposits money in a Points International bank account about 2 days later. However, Points International doesn’t pay its airline partners anything in cash for the miles it buys till 30 days after the end of the calendar month in which Points International bought the miles. If we assume that Points International has an equal chance of selling miles on all days of a given calendar month, then we’d assume that at the end of a given month they have already gone about 15 days on average (half a month) since selling the points before the clock starts ticking to pay the airline partner in 30 days. Therefore, I would assume that Points International is paying cash for the points it sells about 45 days after selling those points. It’s collecting cash for the points it is selling about 2 days after selling them. So, in a very rough way, it should have about 43 days worth of points in cash. That’s about 12% of a year. So, if you take the annual revenue of this company – you’d expect it could (on an average day) have about annual revenue times 0.12 equals cash on hand. This is if the company was not piling up any earned cash. And, recently, it hasn’t been doing that. It’s been using the cash in excess of this float to buy back its own stock. It seems to be on pace to reduce share count by about 5% this year. Because of the nature of the float I’ve been discussing – Points International seems to have an excellent financial position. There is one meaningful financial risk they have. I’ll discuss that in a second. But, normally they are borrowing literally nothing from any bank while having a very large cash position – it’s been over $50 million in cash for a company with a market cap of $170 million – with the only meaningful liability being payables due to airlines for the miles the company has already sold. Generally, airlines tend to renew with Points International (they claim a 95% renewal rate, initial contract terms are 3-5 years, but it seems that annual renewals after the first contract term ends are common) . And, at least in recent years, it’s very clear that existing airlines have been selling more and more points through Points International. This means the amount of sales increases over time. This means the size of the roughly 1.5 months of sales increases over time. This means float increases over time. This means cash on hand increases over time. So, it’s a very liquid and very safe balance sheet.

There is, however, a large off-balance sheet obligation. I don’t think it’s especially large relative to Points International’s business. However, the last I checked – the company had around $400 million in minimum purchase guarantees. This is spread out over several years. It’s usually very low for the current calendar year – this is because Points is getting closer and closer to reaching the annual requirement as the year progresses, thus causing the remainder of the guarantee (not the original promise) to appear smaller in the company’s footnotes as the year gets closer to the end of December. The minimum purchase guarantee is usually going to be biggest for next year. I think Points has promised to buy like $150 million worth of airline miles in 2020, for example. This doesn’t really concern me much, because I don’t see the size of these promises as being especially large versus sales. Right now, it seems like Points International has promised – over the next 5 years – to buy about 1.5 years of normal revenue for the company. This isn’t a big promise compared to companies that invest in stuff like the rights to show movies, TV shows, sports, etc. And it’s only airline miles that can’t be sold at year end that present much of a problem. And, honestly, because of the working capital cycle here – it’s really only a major concern to me if it becomes difficult for Points to sell airline miles on behalf of any of its clients. It’s not a big deal if a couple airlines have miles that can’t be sold that Points has to buy, because this will be a modest amount of “make good” that Points has to buy versus the float on hand from all the other airlines where it could sell the miles. For example, it was recently at like $1.5 million in points it had to buy for failing to reach the minimum purchase requirement versus float of closer to $60 million. Even like a 10 or 20 times increase in the amount of shortfall in terms of points sold versus points promised to be sold wouldn’t be a huge concern versus the cash position. To put it another way, imagine that the company is selling around $350 million a year in airline miles. It is promising to sell $150 million. That means it’d have to sell nearly 60% less miles to – across all its airline partners – have a deficit it has to buy up. Now, each contract is separate. So, it’ll have deficits with one airline and not another. But, that’s not a concern as long as there is float from the other airlines. For example, it doesn’t matter much if they have to make up $5 million in purchases with one airline if they have $50 million in float giving them cash on hand of $50 million with which they could buy up those airline miles if needed. The concern is much more what I described above with promising to buy $150 million and averaging sales of $350 million. A huge plunge in sales – relative to minimum purchase guarantees – would cause two things to happen at once. One, the company would need to buy up airline miles using cash. And two, the dollar amount of float would fall along with the failure to sell miles. So, the company would basically have additional cash obligations at the same time it had a declining cash balance.

How big a risk is this?

Honestly, I think it’s small because of what we’re talking about here. Points International is a marketing partner for airlines targeting members of these frequent flier programs. To promise to buy a lot more miles than they can sell – Points International (and probably the airline partner too) would need to be miscalculating the effectiveness of a planned marketing promotion by quite a bit. This miscalculation would probably be about 1-year out. But, in theory, it could be longer. Points has promised to buy $100 million worth of miles in like 2024 and beyond. So, it’s possible you could miscalculate badly in something like that kind of further out purchase obligation especially if you had a huge recession or more likely a serious terrorist attack involving planes. Points International was only founded in 2000. The influence of September 11th, 2001 just don’t show up in a way that’s helpful for us to gauge how this company would perform in a future year with a terrorist attack of that size or greater. The financial crisis and Great Recession also don’t help much here because I feel the company has just changed too much in the last 10-12 years. The 5-year record is probably a more accurate predictor of the company’s future. But, unfortunately, we don’t have anything in the last 5 years that really helps us see what would happen in a big turndown for airlines. It’s also a little complicated by the fact this company is selling airline miles. You can’t just remove all planes from service when demand plummets – so, the amount of empty seats goes up when the airline industry hits a downturn in demand. It’s hard for me to know exactly how this influences marketing of airline miles, because on the one hand airlines would obviously want more redemption of miles when they are flying relatively empty than when they are flying relatively full. On the other hand, they might be less likely to spend on marketing. And marketing effectiveness might be lower in a bad economy. But, this kind of marketing does actually guarantee cash flow for airlines. The one thing I do feel pretty sure of is that contract renewals and renegotiations that happened at a bad time for the airline industry would be more likely to include concessions on Points International’s behalf to its airline partners. They’d want them. And I think Points would grant them.

What makes the stock attractive?

Management is guiding for 2022 growth that suggests like 13-17% annual increases in gross profit. The increase in their favorite measure – adjusted EBITDA (which excludes some stuff I’d want included, but on a CAGR basis should be a decent measure of earnings power growth) would be up like 30% a year for the next 3 years. The stock isn’t expensive right now on a market cap basis. It’s very cheap if you use enterprise value. I wouldn’t use enterprise value. But, I would consider the presence of float to mean growth costs nothing here. So, if you have a stable multiple over the next 3 years, you’d get a stock price increase of close to 30% a year in Points. The stock pays no dividend. But, that brings up another point. If management really is going to hit the 3-year growth goals and it’s going to do it primarily with money coming in from the core “Legacy Currency Retailing” business, I’d expect cash flows that need to be sopped up by something. The most likely something would be buying back like 5% of shares per year for the next few years. I don’t know if the company will do this. But, it should have the cash available to buy back stock as it grows.

I don’t have a good feel for management here and whether they are realistic enough. From what I can tell of the recent growth performance of the Legacy Currency Retailing business this guidance on the growth profit line isn’t actually aggressive. The company has now been growing pretty quickly for quite a while. They aren’t predicting a dramatically different trajectory. They do now have a partnership with Amadeus. However, I think the guidance is probably related more to expected organic increases in sales to their biggest existing airline partners. This seems to have been the source of a lot of the profit growth recently.

Management here may be too aggressive in their estimates. They own very little stock. I don’t see any insider really owning more than about 2% of this stock.

I don’t like relying on management’s guidance when valuing a stock. And I don’t like betting on a management that has put out the kind of presentations, reports, etc. this one has. They’re not extremely promotional exactly. But, I don’t get any sort of vibe of extreme conservatism and candor in anything I’m reading in stuff prepared by the company and intended as communication with investors. So, management and the realism of their expectations for the next 3 years is by far my biggest concern here.

Nonetheless, this is a business that seems safe, high quality, and capable of growth without needing any cash to finance it. On top of that, the stock is also super cheap today versus what management says it’ll make in 3 years.

This one goes to the top of the list.

Geoff’s Initial Interest: 90%

Reconsider Price: Already interested at today’s price

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