JC Penney

JC Penney (JCP) is a company which I have followed with much interest since Bill Ackman publicly announced his position in the company during 2012's Ira Sohn conference. He has put together an interesting presentation on JCP that is available at this link should you wish to have a read. Since then, the turnaround of JCP has been lackluster, culminating in the ousting of former Apple retail guru, CEO Ron Johnson. Myron Ullman has been brought back as CEO, and the company announced a new five-year US$2.25bn senior secured term loan credit facility from Goldmans and other IB to try and buy some time.

Short Thesis
JCP is one of the most heavily shorted large cap stocks on the NYSE. The stock has seen a nice rally in the last couple of months due to (i) an announcement of George Soro taking a position in the company and (ii) a short squeeze as the US stock market rally continue unabated. A lot of financial professionals have been trying to call the top of this market rally and have been proved wrong so far. While I do think a correction is overdue, I believe that the momentum will continue on a short term basis. Many months back I was considering a long position in JCP, based on a turnaround of the company. Fortunately, I wasn't entirely convinced that the turnaround initiatives put forth by Ron Johnson will work and remained on the sidelines. After the disasterous recent 4Q2012 and 1Q2013 results, which showed a Same Store Sales (SSS) growth of -25.2% and -16.6%, I am certainly glad I sat on my hands. Now the company is caught with the old CEO, who got the company in this mess in the first place, without a coherent turnaround strategy. Ironically, I am now considering a position on the short side, through put options on JCP to hedge some of my US market exposure.

Liquidation Value
There are some investors who believe that JCP is an attractive real estate play. International Strategy & Investment Group estimates that JCP stores should be valued at US$70/square foot, whereas the average cost of ownership is recorded at book at US$5/square foot. Spinning off the top 300 JCP stores into a REIT will yield an entity with an enterprise value of about $40/share. However, Cushman & Wakefield has a much lower estimate of JCP's real estate, with its stores, distribution centers and HQ at US$4bn.

Valuing a company based on a liquidation value can be potentially dangerous. Just because something trades at a discount to its liquidation value doesn't mean that it can be liquidated and will be liquidated. A good example is Sears, which many fund managers have been arguing that the real estate carried on its book at cost is massively undervalued. That hasn't done much for the stock price. When a discount to liquidation value is the cornerstone thesis of a position, one needs to have some certainty on (i) the timeframe for the liquidation and (ii) the cost of liquidation. If liquidation takes a long time frame to execute, your IRR will be stretched out. That can easily be the difference between a mediocre track record and a fantastic one. In the case of JCP, liquidation will probably be a messy affair, involving litigation costs, and the cost of laying off a huge labour force. That is not only politically difficult but also rather expensive. And in the meantime, the retail operations continue to bleed cash, gradually reducing your discount and the associated margin of safety. Here, we will mostly be focusing on analysing JCP from a ongoing concern basis.

Investment Analysis

At this stage, there are two crucial questions an investor should ask before forming an opinion on this company.
1) Does the company have a coherent, realistic turnaround strategy?
2) Does the company have sufficient liquidity to implement the strategy without running the risk of declaring chapter 11?


We do not yet have an answer on question 1 since the new (or rather old) CEO just took over and have yet to formulate a strategy. My belief is that, Myron Ullman is merely a filler for the position while the Board search for someone else more suitable. Given JCP's track record as a career wrecker (it certainly ruined Ron Johnson's career), I do not think finding someone who is willing to take the job will be an easy task.

As for question 2, we can hazard an educated guess. As of end 1Q2013, JCP has equity of US$2.86bn, cash and equivalents of US$821m, total debt of about US$3.7bn, and off balance-sheet operating leases of present value ~US$1.28bn. From a debt/equity ratio perspective, JCP's leverage is high but not overwhelming so. More importantly, let's take a look at JCP's debt capital structure.

Long Term  Debt breakdown	US$m
5.65% senior notes due 2020	400
5.75% senior notes due 2018	300
6.375% senior notes due 2036	400
6.875% med term notes due 2015	200
6.9% notes due 2026	2
7.125% debentures due 2023	255
7.4% debentures due 2037	326
7.625% Notes due 2097	500
7.65% Debentures due 2016	200
7.95% debentures due 2017	285
Total	2868

None of the long term debt on JCP's balance sheet is maturing any time soon. The earliest maturing bond is due 2015 with a face value of US$200m.

Short Term Debt	US$m
Short term borrowings	850

Credit facilities   Revolving credit facility by JPM 1850 Amount drawn down 1000 Amount left 850 5Yr term loan facility by GS 2250 Amount drawn 0 Amount left 2250 Cash left 821 Total available cash for operatings 3,921

Although JCP has short term loans of US$850m (which I believe is drawn from the JPM revolving credit facility), there is still US$821m of cash on the balance sheet, US$850m undrawn from their JPM revolving credit facility, and an entirely new US$2.25bn loan facility from Goldmans. Based on the cash and undrawn credit facilities, JCP can raise up to US$3.9bn for its turnaround attempt. Just to put things in perspective, in its most recent quarter 1Q2013, JCP had pre-tax operating losses of US$547m, negative CFO of US$752m and Capex of US$196m.

Income Statement (US$m)	E2Q13	E3Q13	E4Q13	E1Q14	E2Q14	E3Q14	E4Q14	E1Q15	E2Q15	E3Q15	E4Q15
Revenue	2,720	2,781	3,690	2,635	2,856	3,059	4,059	3,030	3,284	3,518	4,668
COGs	(1,882)	(1,924)	(2,915)	(1,792)	(1,828)	(1,988)	(2,922)	(1,818)	(2,036)	(2,181)	(3,267)
Gross profit	838	857	775	843	1,028	1,071	1,136	1,212	1,248	1,337	1,400
SG&A	(979)	(1,001)	(1,218)	(949)	(971)	(1,040)	(1,263)	(1,091)	(985)	(1,126)	(1,214)
Pension	(40)	(40)	(40)	(40)	(40)	(40)	(40)	(40)	(40)	(40)	(40)
Depreciation and amortization	(142)	(142)	(142)	(142)	(142)	(142)	(142)	(142)	(142)	(142)	(142)
Real estate and other, net	0	0	0	0	0	0	0	0	0	0	0
Restructuring and management transition	(72)	(72)	(72)	(72)	0	0	0	0	0	0	0
EBIT	(395)	(399)	(697)	(360)	(125)	(152)	(309)	(61)	80	29	4
Net interest expense	(71)	(69)	(83)	(86)	(102)	(105)	(113)	(107)	(117)	(120)	(125)
Profit before tax	(466)	(467)	(780)	(446)	(227)	(257)	(422)	(168)	(37)	(91)	(120)
Tax	(176)	(177)	(295)	(169)	(86)	(97)	(160)	(64)	(14)	(35)	(46)
Net profit	(290)	(291)	(485)	(277)	(141)	(160)	(263)	(105)	(23)	(57)	(75)
CFO + CIO	(724)	(603)	(186)	(826)	(169)	(404)	313	(532)	(147)	(252)	631
Revenue (yoy) Growth	-10.0%	-5.0%	-5.0%	0.0%	5.0%	10.0%	10.0%	15.0%	15.0%	15.0%	15.0%
Gross margin	30.8%	30.8%	21.0%	32.0%	36.0%	35.0%	28.0%	40.0%	38.0%	38.0%	30.0%
Pretax margin	-17.1%	-16.8%	-21.1%	-16.9%	-8.0%	-8.4%	-10.4%	-5.6%	-1.1%	-2.6%	-2.6%
Net Margin	-10.7%	-10.4%	-13.1%	-10.5%	-5.0%	-5.2%	-6.5%	-3.5%	-0.7%	-1.6%	-1.6%

I did some quick modeling to see how much cash JCP could consume during the turnaround process. I assumed that operations will stabilise by end 2013 and revenue growth coming back in 2014 before accelerating in 2015. Margins will began to recover from beginning 2014 onwards. Based on my margin and growth assumptions, JCP has yet to be profitable by end 2015, but will almost be. Adding up total CFO and CIO till end 2015 results in a cash deficit of US$2.9bn. Without accounting for the cash inflow of US$631m in 4Q2015, the peak cash deficit will be US$3.5bn. This can be covered with JCP's existing cash and debt facilities, but there isn't a large margin of safety. Do I feel comfortable enough to short the stock? Probably no. With the current debt structure in place, JCP can keep operating for a long time, even if they continue to bleed. And in the meantime, any short squeeze and paying short interest/option premium will make this an unenjoyable ride.


Long Thesis?
Can we consider a long position instead? After all, George Soros has taken a position in the stock. To answer this question, let's look at the historical margins for JCP below. It was really from 2009 onwards that the company began to slip and struggle. What will be the right net profit margin for a turned-around JCP? Your guess is as good as mine here. Somewhere in the realm of 3-4% (which is what a typical discount retailer earns) should not be too far off the mark. Using my estimates above, 2015 will see a revenue of about US$14.5bn. Under the bullish scenario that JCP turns around completely in 2015, and based on a net profit margin of 3-4%, JCP will see between US$435m-US$580m of profits. Currently, JCP has a market cap of US$4.2bn. This translates into a PE of 7.2-9.6x. Peers listed on NYSE trades between 12-18x PE, with the average around 14x-ish. If we assume PE expands to 14x when the turnaround is successful, we will be looking at a gain of 45%-95%. The result can be very different depending on what you plug in as the net profit margin. On the higher end of the range, this results in an almost doubling of your position in 2.5yrs. At the low end of the range, this is an arithmetic return of ~18% a year. Both are very respectable results, contingent on the turnaround being successful.

	2007	2008	2009	2010	2011	2012
Gross Margin	38.6%	37.4%	39.4%	39.2%	36.0%	31.3%
EBIT  Margin	9.5%	6.1%	3.8%	4.7%	0.0%	-10.1%
Pre-tax margins	8.7%	4.9%	2.3%	3.3%	-1.3%	-11.8%
Net Margin	5.6%	3.1%	1.4%	2.1%	-0.9%	-7.6%

Conclusion
Although I was initially looking at JCP from a short perspective, I believe that the risk/reward favors a long position better. I do not yet feel comfortable that the turnaround is happening, in the absence of a new strategy from JCP. However, they do have sufficient liquidity to last them for quite some time. If they find a good CEO to take over the company, with a new turnaround strategy, I may consider a position. Until then, I have no conviction on either the long or short side. So it's back to the sidelines again.

Western Union

Western Union (WU) came to my attention where I was prowling the internet in search of ideas. It seems that a number of value investors have taken position in the company, believing that it is significantly undervalued. That certainly got my attention.

WU is a good vehicle for investing in the secular growth of money transfer between migrant workers and their home country. Many blue collar migrants typically do not have bank accounts and have to use other means of transferring money back home to their families. WU fulfills that niche. In America, it is the  hispanic workers that consistently need to send money home. In Singapore and Hong Kong, there is a similar trend in that the filipino domestic helpers and foreign construction laborers often need to send money home. As a matter of coincidence, a WU branch popped up here in my neighbourhood in Singapore, which was certainly surprising. Just a little of tidbit for the financial history junkies. WU is a very old company. It dates back to 1851 and was first traded on the NYSE in 1865. In fact, it was one of the original 11 companies included on the fist Dow Jones average listing.

Business Model
WU is the largest global money transfer and payment service operating, with a network of 510,000 agent locations in over 200 countries, 90% of which are outside of the United States. WU handled US$79bn in remittance volume in 2012, over 90% of which were done in the form of walk-in cash-to-cash transactions.

In this business, network is king. The more outlets you have, the likely it is for consumers to use your services. Since money sent is typically received at another WU branch, having more branches increases the convenience of consumers. Branding and reputation is another crucial differentiating factor. Consumers are only going to use money transfer agents they can trust. Being the industry leader here can bestow one with multiple benefits.

Generally WU operates through third party agents. The agents provides the physical location and staff to complete the transfers while WU provides the equipment, training and back-end transactions. Agents are paid a commission based on a percentage of revenue. For most agents, the cost of providing the physical infrastructure is typically covered by their primary business, which may be postal service, banking, travel, retail and etc.

Revenue Generation
WU separates its business into four different segments:
(i) Consumer-to-Consumer (81% of revenue)
Revenue in this segment is derived from transaction fees charged to consumers to transfer money. The money transfer can involve different send and receive currencies. Agents accept cash and sometimes debit cards to initiate a transfer. The receiver can choose to receive the money directly into their bank account, a stored value card, or through the issuance of a money order. Recipients generally do not pay a fee. The fee paid by the sender is determined based on the principal amount of the transaction and the send and receive locations. Revenue is also generated from the FX spread charged by WU to the consumer.

(ii) Consumer-to-Business (11% of revenue)
The C2B segment provides fast and convenient option to make one-time or recurring payment from consumers to businesses and other organizations, including utilities, auto finance companies, mortgage servicers, financial service providers, government agencies and other businesses. Consumers may make a cash payment at an agent or owned location, or may make an electronic payment over the phone or on the internet using their credit or debit card, through the automated clearing house system or via a wire transfer. Revenue is derived from transaction fees paid by the consumer.

(iii) Business Solutions (6% of revenue)
The business solutions segment facilitiate payment and foreign exchange solutions for cross-border, cross-currency transaction. The target audience are small and medium size enterprises. The majority of revenue generated in this segment is derived from the FX spread between what WU charges its customer and what is actually transacts at.

(iv) Others (2%)
This includes money order, prepaid services, mobile money transfer and other businesses and services.

The percentage breakdown of the revenue between the segments has remained relatively stable over time. The C2C business has always been the dominant part of the company. Let's take a look at the geographical breakdown and growth rates of the C2C segment.

C2C revenue as % of total	2011	2012	C2C revenue growth	2011	2012
Europe and CIS	24.0%	22.0%	Europe and CIS	3.0%	-6.0%
North America	22.0%	20.0%	North America	3.0%	-3.0%
Middle East and Africa	15.0%	15.0%	Middle East and Africa	4.0%	3.0%
APAC	12.0%	12.0%	APAC	10.0%	3.0%
LACA	9.0%	9.0%	LACA	7.0%	3.0%
Online	2.0%	3.0%	Online	37.0%	24.0%

WU is a global play on regional and cross border monetary transactions. The business is well-diversified geographically and covers a very wide area. The areas that are seeing across above average growth include APAC and LACA (Latin America and Central America). Their online money transfer business is growing very rapidly, but this to a certain extent cannibalises their brick-and-mortar operation.

The remittance market is highly fragmented. It is estimated that Western Union, the market leader, has a 17% market share, followed by MoneyGram at 4.4%, Ria Envia at 2% and DolEx at 1%. The other formal channels accounts for 36% of transactions and the remaining 40% of transactions goes through informal channels.

	2007	2008	2009	2010	2011	2012
WU Agents	335,000	375,000	410,000	445,000	485,000	510,000
Growth (%)	N.A.	11.9%	9.3%	8.5%	9.0%	5.2%
No of C2C Transactions (m)	167.7	188.1	196.1	213.7	225.8	231.0
Growth (%)	N.A.	12.2%	4.3%	9.0%	5.6%	2.3%
Moneygram Agents	143,000	176,000	190,000	227,000	267,000	310,000
Growth (%)	N.A.	23.1%	8.0%	19.5%	17.6%	16.1%

Moneygram is their main competitor, and also listed in the US. Comparing agent growth rates between WU and Moneygram, WU has lagged its competitor since 2010. Moneygram unfortunately does not disclose total no. of C2C transactions. Nonetheless, WU has been experiencing slowing transactional volume growth in the last few years. The World Bank forecasts that global remittance market will growth at mid-single digits over the next years. Onward to the financial statements.

Income Statement (US$m)	2007	2008	2009	2010	2011	2012
Transaction fees	3,989.8	4,240.8	4,036.2	4,055.3	4,220.2	4,210.0
FX revenue	771.3	896.3	910.3	1018.8	1151.2	1332.7
Other revenue	139.1	144.9	137.1	118.6	120.0	122.1
Revenue	4,900.2	5,282.0	5,083.6	5,192.7	5,491.4	5,664.8
COGs	(2,808.4)	(3,093.0)	(2,874.9)	(2,978.4)	(3,102.0)	(3,194.2)
Gross profit	2,091.8	2,189.0	2,208.7	2,214.3	2,389.4	2,470.6
Sales and marketing expenses	(769.8)	(834.0)	(926.0)	(914.2)	(1,004.4)	(1,140.6)
EBIT	1,322.0	1,355.0	1,282.7	1,300.1	1,385.0	1,330.0
Interest income	79.4	45.2	9.4	2.8	5.2	5.5
Interest expense	(189.0)	(171.2)	(157.9)	(169.9)	(181.9)	(179.6)
Derivative gains/losses	8.3	(6.9)	(2.8)	(2.5)	14.0	0.5
Other income net	1.7	16.6	0.1	14.7	52.3	12.4
Profit before Tax	1,222.4	1,238.7	1,131.5	1,145.2	1,274.6	1,168.8
Tax	(365.1)	(319.7)	(282.7)	(235.3)	(109.2)	(142.9)
Net Profit	857.3	919.0	848.8	909.9	1,165.4	1,025.9
No. of shares (diluted)	773	738	701	669	634	607
EPS	1.11	1.24	1.21	1.36	1.84	1.69

Revenue growth rate	N.A.	7.8%	-3.8%	2.1%	5.8%	3.2%
Net Profit growth rate	N.A.	7.2%	-7.6%	7.2%	28.1%	-12.0%
EPS Growth Rate	N.A.	12.2%	-2.7%	12.3%	35.1%	-8.1%
Gross Margin	42.7%	41.4%	43.4%	42.6%	43.5%	43.6%
EBIT  Margin	27.0%	25.7%	25.2%	25.0%	25.2%	23.5%
Net Margin	17.5%	17.4%	16.7%	17.5%	21.2%	18.1%

WU is mostly a mature business, with revenue growing at low to mid single digits. I expect revenue growth for WU to be in line with World Bank global remittance growth estimates, growing at flattish to low single digits. EPS growth has largely outpaced revenue growth because they have been gradually shrinking their shareholder base through share buybacks. While margins have mostly been stable I expect them to fall this year. In fact, the 1Q2013 results has already shown that. Money transfer is a commodity type business with multiple players. WU faces competition not only from other money transfer agents such as MoneyGram, but also faces competition from banks, credit unions, phone payment systems, etc. The industry is fairly fragmented and no single player has pricing power. In 4Q2012, WU made fee reductions in certain key money transfer corridors in order to gain market share. The management expects to maintain these reduction and may make further fee cuts in 2013. WU is the market leader in the industry. Smaller competitors will be compelled to follow the price cuts. Any market share gains by WU is unlikely to be significant. Instead, by initiating price cuts, what WU has done is to lower margins across the board for everyone. Unless weaker operators are driven out of business, lowering the intensity of competition, the price cuts are not going to do anyone any good.

	2007	2008	2009	2010	2011	2012
Net Profit	857.3	919.0	848.8	909.9	1,165.4	1,025.9
CFO	1,103.5	1,253.9	1,218.1	994.4	1,174.9	1,185.3
CAPEX	(192.1)	(153.7)	(98.9)	(113.7)	(162.5)	(268.2)
FCF	911.4	1,100.2	1,119.2	880.7	1,012.4	917.1

Regular readers should be quite familiar with this by now. WU generates significant free cashflow. Capex for the business is minimal since they do not usually own and operate the physical stores. While there have been cases of WU buying over some of their agents, this has not happened on a big scale. The WU management has put their free cashflow to good use by buying back shares. In this case, net profit can be used as a rough approximation to free cashflow. At last Friday's closing price of $16.65, WU trades at a PE of 10x, FCF yield of about 10% and a dividend yield of 2.5-3%. While I do think this is cheap, I do not feel comfortable including WU in my portfolio for reasons which I will elaborate below.

Risks to the Business Model
(i) Over the long-term, there are emerging alternatives to cash money transfer, such as online mobile payments. The electronic payment space is evolving very rapidly. Many new technology are springing up, trying to take the place of cash and credit cards in making payments. It is quite possible that new technology will emerge to challenge the place of traditional money transfer models.
(ii) Traditional money transfer agents appeals to the under banked population. Consumer with bank accounts normally refer to their banks for making cross border money transfers. As the general population becomes more affluent, WU could lose their customers when they start to qualify and sign up for bank accounts.
(iii) Margin are going to fall in the near term. This is a commodity type business. When margins fall in a fragmented, commodity-like industry, they tend to stay depressed.
(iv) There are signs that in some countries, regulators are going to enforce a non-exclusive money transfer agent model. Currently, it is mandatory that WU's agent do not use the services of their competitors. If those regulations are enforced, WU will be forced to share their agents with their competitors.

Conclusion
Over an investment horizon of 3-5 years, it is quite possible that WU will face a worse competitive environment. I do not think one has a sufficient margin of safety to buy WU at these levels. However, if WU falls to 8x PE, I might revisit my thesis.

Ira Sohn / Value Investor Conference 2013

It has been a busy week. While I have been looking through a number of companies, none seem cheap or interesting enough to make the cut for me to put it on this blog. Although I have been doing some work on Western Union, which I think is potential target for my portfolio, the work is going to take a few more days. Instead, let me divert your attention to the Ira Sohn Conference and Value Investor Conference that happened this week.

If you have not coming across this before, the Ira Sohn Conference is one of the biggest hedge fund conferences in the world. Industry legends such as Bill Ackman, David Einhorn and many others come to pitch stocks in order to raise funds for pediatric cancer research and care. If you are curious, Market Folly provides coverage of the event and a short summary of the pitches. On the other hand, the Value Investor Conference focuses on bringing together fund managers to pitch their best investment idea in celebration of Value Investing. Value Walk does some coverage of the event, with notes of each presentation. It is worth investing the time googling to find the presentations delivered during the conferences. I have learnt a lot going through these presentations, try to understand how industry leaders analyse businesses. For any budding investor, choosing a few favorite fund managers, tracking what they are holding in their portfolios, and reverse engineering why they are buying certain companies, is a very good way to learn tools of the trade. None to mention, this is a good source of idea generation, watching what smarter investors are buying.

This week has been an avalanche of ideas, especially after looking through the ideas pitched at both conferences and reviewing portfolio changes of a number of fund managers. In the next few weeks I hope to find time to investigate the following companies:

(i) Resolute Forest Products - a global forest products company.
(ii) Rosette Stone - a US based online language learning solutions vendor.
(iii) Netflix - Internet subscription based TV streaming vendor.
(iv) Clear Channel Outdoor - a global outdoor display advertising company.
(v) Virgin Media - UK provider of broadband internet, television, mobile telephone and fixed line services.
(vi) CTC Media - a Russia TV network operator.

On a side note, I have sold out Moodys and AutoNavi this week, bringing my portfolio cash level to 80%. There has been a lot of talk that the US market is overvalued, and corporate margins at a historical high. Brooklyn Investor talks more about this in detail on his blog. Even if you are an Asian investor and do not invest in US securities, it is worth tracking the US markets closely. Since the financial crisis, correlations between markets have been rather high. Professional investors/traders are always watching how other markets perform and take their lead from there. When the US market sells off, it is hard for Asia to escape unscathed. During the crisis, emerging market allocations were to first to be cut, resulting in deeper stock market corrections here compared to the US, despite having no direct relationship to the US housing debacle.

The strong performance of the US market this year has made me somewhat uncomfortable. There has been no meaningful correction and the momentum shows no signs of stopping. There is a sense of complacency in the air despite macro economic data from Europe still looking bad. Politicians are still not getting their act together. Spain hit an unemployment rate of 27%, which has certainly made me think twice about taking up position in Banco Santander. On a short term basis (3-6mths), I suspect the rally will still continue. However, long-term wise, I do think we are overdue for a correction. Unless I find a really compelling idea, keep cash on the sideline would provide some protection for the portfolio. In any case, one should always aim to have some dry powder, in case markets correct and valuations fall. To me, nothing is more annoying than watching valuations come down and not having the cash to invest.

TravelSky Technology

This is a company which I have been watching for many months. I missed its low point in 2012 and have been waiting for a better entry to get in since. It possesses many of the characteristics that I like in a business model - (i) generates free cashflow, (ii) easy to understand business, (iii) strong barriers to entry and (iv) high ROEs. For many of us who uses travel agents, the business model should not be too difficult to wrap your head around.

TravelSky Technology is a Global Distribution System (GDS). What they essentially do is operate the booking back-office booking for travel agents, allowing agents to to check the available inventory of flights and hotel rooms on specific days and match them to the demands of the end consumer. They are plugged into the IT systems of hotels and airlines so that the data is updated live. Without GDSes, agents have no way of accessing and filtering the amount of data to find the right flight and hotel room for the customer. For their services, a GDS typically receives a commission from the airline/hotel for making a booking and shares that commission with the travel agent.

History
GDS is an old business model. They have been around for decades and were initially started by airlines to distribute tickets. Many of the GDS today still have airlines as parent entities. Ironically, decades after, airlines have failed to generate much profit and it is the GDS that captures most of the value in the supply chain for tourism travel. Globally, over years of M&A and consolidation, there are three major GDS -
(i) Sabre created by American Airlines,
(ii) Travelport, which is a conglomerate of multiple smaller GDSes including Galileo, Apollo and Worldspan.
(iii) Amadeus, which is created by an alliance between Air France, Lufthansa, Iberia Airlines and Scandinavian.

In recent years, GDSes have made some progress integrating downstream into the travel agency business, especially online travel agents. For example, Sabre owns Travelocity and Zuji, and Travelport is a significant shareholder on Orbitz Worldwide.


Competitive Landscape
Warren Buffett dislikes investing in airlines for very good reasons.
(i) There is little customer loyalty in air travel (corporate air travel booking do have some degree of loyalty).
(ii) Price competition is rampant in the industry. Air flights are becoming like commodities and it is very difficult to differentiate yourself from your peers. The only exception I am aware of is Singapore Airlines, which have build a franchise in service and the image of the Singaporean Girl.
(iii) Capacity is not removed from the system when one of the existing players goes bankrupted. The planes are usually sold off and resurfaces under another airline's wing. This is very important because general overcapacity of the industry is not a good environment to foster price discipline.

Although the cost of flying has decreased substantially over the years and the number of people flying for leisure holidays exploded, airlines still struggle to generate decent profits. To their credit, airlines have tried a variety of initiatives to promote customer loyalty but with poor results. They pioneered the frequent flyer loyalty point and premium membership model many decades ago, which is now copied by many other businesses. Now, airlines are trying very hard to make their pricing model opaque to discourage price comparison. For example, charging additional fees for extra leg room, more luggages weight, or food and services is a function of that. The end total cost of flying on that airline is not obvious. It used to be that the earlier you buy a ticket, the cheaper it is. Now, ticket prices fluctuate widely from time to time and most consumers can't make meaningful guesses about trends of air ticket prices. But still, with low cost carrier carriers entering markets and smarter ways of comparing prices (meta search travel sites such as Kayak.com. I personally use Skyscanner which is awesome.), airlines continue to suffer.

While GDS have been the main beneficiary of the growth in air travel over the year, that status is coming under threat. In America, the airlines have undergo sufficient consolidation such that they began to have some bargaining power over GDSes. Some airlines have resolved to cutting commissions to GDS/travel agents in order to raise their margins. Other airlines tried to remove GDSes out the picture entirely by persuading travel agents to plug in directly to their inventory management system. This way, airlines avoid paying two layers of commission. Another initiative which airlines have started to encourage consumers to book air tickets directly from their website. This way, they do not pay any commission at all. Would TravelSky Tech also come under a similar threat?


China Travel Industry
The Chinese travel industry resembles that of the US in the early days. There are a number of regional airlines, each with their own hub. However, unlike the US or Europe, TravelSky Tech is a monopoly in China. Concerns that further integration in Chinese airlines would threaten the fees that Travelsky Tech earns is less relevant here. Chinese airlines also depends very much on travel agencies for distribution. If you have travelled within China, you realize that the older generation buys their tickets, tour packages from brick-and-mortar travel agencies. The younger generation tend to prefer free and easy travel plans and purchases theirs accommodation and air tickets from online travel agents. Few people purchase their tickets/accommodation straight from the service providers' website. The main inconvenience here is that, it is too troublesome to surf site by site to compare prices and dates.

However, there has been political pressure from developed countries for the China government to deregulate the Chinese GDS market. This culminated in the opening of the booking for non-chinese airline tickets to foreign GDSes. What this means is that, foreign GDSes can now compete in the area of making booking of air tickets from foreign airlines tickets. This I believe is restricted to mostly international flights. Domestic flights are covered by domestic airlines and remains in the grip of TravelSky Tech. The Chinese government has a history of grooming domestic champions to compete with international peers. Thus far, they have been very cautious when it comes to liberalizing any sector or industry. The CNY is one good example, where they have experimented with partial liberalization in Hong Kong to test the results. I believe the same will occur here in the travel GDS industry. Completion liberalization is probably going to take quite some time, perhaps in the order of 5-7 years. The current opening of foreign airline ticket booking to international GDSes will not hurt TravelSky Technology too much. As of end 2012, TravelSky Technology processed 330 million bookings for Chinese commercial airlines, compared to 16 million on foreign and regional commercial airlines. The monopoly is largely intact.

Booking on Chinese commercial airlines ('000s)	2007	2008	2009	2010	2011	2012
International	28,097	25,469	24,219	30,975	34,644	38,388
Domestic	167,853	177,318	216,173	249,678	271,085	292,282
Total	195,949	202,787	240,392	280,653	305,729	330,670
Growth (yoy)	N.A.	3.5%	18.5%	16.7%	8.9%	8.2%
Booking on foreign & regional commercial airlines ('000s)	2007	2008	2009	2010	2011	2012
Total	8,405	8,395	8,573	11,115	12,832	16,363
Growth (yoy)	N.A.	-0.1%	2.1%	29.6%	15.5%	27.5%

To prepare for the internationalisation the business, TravelSky Tech has been working on acquiring a larger inventory of international hotel rooms and international air flights. This involves negotiating with hotels and airlines in other countries to list their inventory and plug in to TravelSky Tech's system. A quick way to do this is to simply to form alliances with international GDSes, which in this case the partner is Sabre. I see this as an arrangement which benefits TravelSky Tech more than Sabre. Sabre wishes to tap on the growing population of chinese consumers that are travelling for leisure. However, they have limited distribution and inventory in China. The partnership gives Sabre the inventory, but they still need time and resources to build out their distribution network with chinese travel agencies. TravelSky Tech however, has an pre-existing distribution channel and relationships with domestic travel agents. By accessing Sabre's inventory of offshore hotel rooms and airline line flights, TravelSky Tech can immediately offering international hotel and air flight bookings to its customer base. Why does Sabre do this then you might ask? Because travel in Europe and the US is a mature market and growth rates are low. In order to grow, Sabre has to gain access to emerging market consumer, which China is the largest.

Income Statement (RMB m)	2007	2008	2009	2010	2011	2012
Aviation Information Technology Services	1,601	1,609	1,808	2,083	2,259	2,436
Accounting, settlement and clearing services	0	261	250	296	380	430
Data Network and others	301	402	561	675	1,033	1,195
Revenue	2,002	2,271	2,620	3,054	3,672	4,061
Busines taxes and surcharges	(66)	(82)	(92)	(109)	(134)	(104)
Depreciation and amortisation	(243)	(333)	(341)	(404)	(406)	(331)
Network usage fees	(84)	(94)	(81)	(74)	(55)	(56)
Personnel expenses	(272)	(430)	(487)	(617)	(678)	(855)
Operating lease payments	(69)	(79)	(73)	(54)	(98)	(122)
Technical support and maintenance fees	(154)	(171)	(154)	(161)	(192)	(212)
Commission and promotion expenses	(248)	(241)	(273)	(393)	(452)	(491)
Other operating expenses	(210)	(230)	(320)	(256)	(475)	(671)
Profit after operating expenses	657	612	798	988	1,182	1,218
Financial income, net	49	93	84	35	74	58
Share of results of associated companies	13	18	21	24	27	29
Profit before tax	719	723	904	1,047	1,283	1,304
Tax	(70)	(68)	(109)	(130)	(208)	(142)
Net Profit	649	655	794	917	1,075	1,163
No. of shares (m)	1,776	1,776	1,951	1,951	2,926	2,926

Revenue growth rate	N.A.	13.5%	15.3%	16.6%	20.2%	10.6%
Net Profit growth rate	N.A.	0.9%	21.4%	15.4%	17.3%	8.1%
EBIT  Margin	32.8%	26.9%	30.5%	32.3%	32.2%	30.0%
Net Margin	32.4%	28.8%	30.3%	30.0%	29.3%	28.6%

TravelSky Tech has seen consistent top line and bottom line growth averaging mid-teens over the last five years. 2012 was a slow down for the company as growth of the Chinese economy moderated. As the Chinese economy continues to restructure from export driven to a consumption based economy, I expect revenue to grow at mid to high single digits. However, when the world and export recovers, I believe revenue growth can rebound to ~15%. Operating and net margins have been very stable for the business.

2007

2008

2009

2010

2011

2012

CFO	721	470	700	1,303	1,319	N.A.
CAPEX	(568)	(363)	(259)	(2,345)	(212)	N.A.
FCF	153	107	441	(1,041)	1,107	N.A.

Historically, TravelSky Tech generates a decent amount of free cashflow. 2010 capex was abnormal for TravelSky Tech. That year, the company spent close to RMB2bn on land use right. That is not capex related to their business. Excluding that, FCF for 2010 comes up to about RMB1bn. For TravelSky Tech, the resource intensive part of the business is at the start, when it needs to construct its system and build relationships with travel agents, airlines and hotel operators. Once that has been done,  it does not take a lot of capex to maintain or growth its business.

2007

2008

2009

2010

2011

2012

EPS	0.37	0.37	0.41	0.47	0.37	0.40
DPS	0.13	0.186	0.134	0.157	0.120	0.133
PE	10.8	10.7	9.7	8.4	10.7	9.9
Ex Cash PE	8.2	8.2	7.4	6.4	8.2	7.6

TravelSky Tech currently trades at a trailing PE of 10x. I believe this is a fairly cheap for a business model that enjoys a monopoly, stable margins and generates decent amounts of cash. It has about HKD$1.1 of net cash per share sitting on the balance. Ex-cash, TravelSky Tech trades at a trailing PE of 7.6x. While I believe it is cheap, I have yet to initiate a position. My estimate for fair value for this stock is 12-13x PE, which is HKD$6-6.50. It doe not not hit my investment benchmark of identifying and buying stocks trading 40% below their intrinsic value. I would continue to watch this stock for sure. What I would really love here is a fall in the stock price.