June 23, 2009 - 11:06am EST by
2009 2010
Price: 11.21 EPS $0.80 $1.35
Shares Out. (in M): 19 P/E 14.0x 8.0x
Market Cap (in $M): 209 P/FCF 14.0x 8.0x
Net Debt (in $M): -22 EBIT 19 35
TEV ($): 187 TEV/EBIT 10.0x 5.0x

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This is an updated version of my first post on EPAX. EPAX is a student travel company that earns 50% on tangible capital and trades for 5-8x normalized after-tax free cash flow.

Student travel programs are typically marketed to teachers, who serve as trip leaders and are responsible for recruiting student participants. Trips generally last 1-3 weeks, are priced in the range of $2,000 to $4,000, and can be touristy or educational in nature.

Most of the competitors in the industry are "mom and pops" that lack the scale necessary to be consistently profitable. Often they are founded by strong believers in the value of travel for young people, and as such are mission driven rather the profit driven. There are a handful of larger competitors, which travel tens of thousands of students per year. These enterprises have more of a commercial orientation and are more profitable than the rest of the industry, but their trips are in most cases undifferentiated. Student travel overall has not grown meaningfully over the past decade.

EPAX is a standout in an otherwise stagnant and unattractive industry, because it possesses a unique franchise that has allowed it to grow and take market share for the past 40 years. The franchise is based on the company's affiliation with a nonprofit organization called People to People International (PTPI). PTPI was founded in 1956 by President Dwight Eisenhower, with the mission of fostering peace through international understanding.

One of PTPI's core activities, and its primary source of revenue, is The Ambassadors Programs. These are the student travel programs administered by EPAX. PTPI's White House affiliation inspires deserved trust on the part of parents. Various connections to local politicians, activities, and attractions, which have been cultivated over a long history of operations, enable the programs to offer enriching itineraries. As a result, the trips are uniquely rewarding to participants. In many cases, students are profoundly affected by their travel experiences. Unlike other student travel programs, The Ambassadors Programs garner a meaningful amount of repeat travel. It is not uncommon for alumni who traveled decades ago to remain involved with the programs to this day, by participating in the informational meetings that EPAX conducts as part of the marketing process. The satisfaction rate for the trips is 98%.

PTPI receives a small fee for each student traveled, but EPAX captures most of the economics of the programs. These economics are highly attractive, because of the franchise's pricing power, and because little tangible capital is needed. In 2008, the average revenue per student was over $5,000. The average price of EPAX's international programs, the most important contributors to revenue, was $6,300. To my knowledge there are no competing programs that command prices as high. Historically, gross margins have been 34%, and operating margins have been 15%. In 2009, I expect the company to generate about $15 million of after-tax free cash flow (equal to $0.80 per share), compared to roughly $30 million of fixed assets on the balance sheet.

The past two years have been difficult ones. EPAX conducts its marketing campaign from May through September each year, garnering enrollments for travel in the following year. In 2007, the campaign suffered from a defective name list used in the direct mail program, which is the foundation of the marketing effort. This and a worsening economic environment negatively affected 2008 enrollments, which were down 20%. In 2008, the marketing campaign coincided with a sharp deterioration in economic activity and consumer confidence. 2009 enrollments are expected to number about 35,000, again down approximately 20% from the previous year.

One way to measure the difficulties that EPAX has faced is to calculate the cost of acquiring a student-the student acquisition cost (SAC)-by dividing the company's marketing expenditures by the enrollments produced. From 2003-2007, this number was relatively consistent and averaged $620, while in 2008 and 2009 it was about $1,000.

SAC eventually should return to its historical level, because the causes of the recent increase are temporary: the faulty name list has been replaced, and the recession will end. In fact, the challenges EPAX is facing have spurred the company to make operational improvements that could eventually push SAC below $620. It is possible that the opportunity to make these improvements resulted in part from complacency engendered by a decade of nearly uninterrupted success. The 10-year CAGRs of revenue and net income between 1997 and 2007 were 20% and 17%, respectively.

For example, prior to 2008, EPAX's marketing effort had been led by an employee without professional marketing experience prior to his time at the company (he had been a basketball coach). The new head of marketing is an experienced hire. An example of the suboptimal marketing practices of the past is that until recently, there were distinct websites for different types of trips, and the websites were graphically and technologically primitive. In November 2008, the company launched one consolidated website, and it is significantly more effective in communicating the unique value of the programs. EPAX has also consolidated the number of itineraries to 57 from an arguably unwieldy 97. The simplified product offering will generate economies of scale for the remaining itineraries, if capacity utilization is increased, as is expected.

EPAX's earnings power will increase substantially if the SAC decreases from $1,000. At the current level of marketing expenditure (about $40 million per year), I estimate that a SAC of $850 (the average of the historical level and the recent level) would produce free cash flow of $1.35 per share. A SAC of $620 would produce $2.35 of free cash flow per share.

The potential to increase enrollments is large. There are about 29 million people between the ages of 11 and 19 in the US, and a large portion of them could travel on the Ambassadors Programs. EPAX also expects to begin marketing its domestic trips to foreign students. The company aims for 15% annual unit growth, through a combination of additional marketing expenditures, increasing efficiency in lead generation, and increasing conversion rates. Fifteen percent unit growth would produce higher revenue growth, because of price increases that have in the past exceeded the rate of inflation. The growth rate of free cash flow can be expected to exceed that of revenue, because capital needs are minimal, and there is operating leverage.
In light of the long-term growth potential, the future cash flow stream is worth a high multiple of the current normalized level. I think that a private buyer would earn attractive returns purchasing EPAX for 20x free cash flow.

EPAX shares trade for $11.21. Adjusting for excess cash of $1.16 per share, the enterprise value (EV) is $10.05 per share. The following are the current trading multiples:   

                                  Free cash flow (FCF) EV / FCF 
Estimated 2009            $0.80                     14x
Normalized, SAC = $850 $1.35                    8x
Normalized, SAC = $620 $2.35                    5x

At a valuation of 20x FCF, the stock would trade for between $28 and $48 per share, before considering two additional sources of value.

The first is the float generated as a result of the trips being paid entirely in advance. The balance of travelers' deposits averaged $66 million over the past year, and was invested conservatively in low-yielding fixed income securities. Assuming a 2% after-tax yield, the float generates $1.3 million of income annually. Because the float will increase as a function of revenue, the earnings of the float will grow at a rate similar to that of the business, justifying a similarly high multiple. A multiple of 20 yields a float value $26 million, which is equal to $1.41 per share. If interest rates rise, it is possible that the float could be worth substantially more.

The second additional source of value can be thought of as a free option. Earlier this year EPAX announced an agreement with Discovery Education to market a new travel program called Discovery Student Adventures. I believe the economic structure of the relationship is similar to that of the relationship with PTPI. Discovery Education is one of the most well-known and well-liked brands among young people in the US. Through its educational content, Discovery has a presence in 1 million US classrooms, representing 35 million students. Even a small penetration of the market opportunity could be meaningful to EPAX. The investment EPAX is making to launch the new initiative is only about $3 million (16 cents per share). The first trips are slated to occur in the summer of 2010.

In October, EPAX will report preliminary 2010 enrollments along with third quarter earnings. I believe there is a good chance that enrollments will show year-over-year growth. An end to the declines of the past two years could serve as a catalyst for the stock.



Preliminary 2010 enrollments to be accounced in October.

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