Description

THESIS

Ambassadors Group (EPAX) has an unleveraged ROE of over 30%, a significant and widening moat, a long growth runway, and is selling for 8-11x its 2010 earnings power. Mr. Market has severely overreacted to an (admittedly dramatic) aberration in EPAX’s results, providing an opportunity to buy an excellent franchise at a large discount.

Stock price: $17.14

Diluted shares: 21M

Market cap = $360M

Cash: $86M

Debt: $0

EV: $274M

BACKGROUND

I will spend some time describing EPAX’s business and how it is unique because the information is relevant and generally not available in the 10K.

EPAX operates in the US student travel industry. Student travel companies market and organize trips for grade school and high school students. The trips usually occur during the summer or spring break, are mostly to foreign destinations, and generally last 1-4 weeks. Implementation of the trips is usually outsourced to foreign-based partners. The industry is populated by a few scale competitors and a fragmented slew of smaller operations. The typical student travel company markets its programs to teachers, who serve as trip leaders. Teachers in turn recruit groups of students. The student travel industry has been stagnant for some time because of geopolitical events like 9/11 and the London Bombings. Operators I have spoken to say they are still flat or down from pre-9/11 levels.

EPAX’s business model differs markedly from that of its competitors, as illustrated by the fact that EPAX has grown its business significantly since 9/11, traveling twice as many students in 2007 as in 2001. EPAX markets trips to families through a direct mail campaign. The brand under which the trips are marketed is “People to People” (PTP), a nonprofit organization founded in 1956 by Dwight Eisenhower. PTP’s Honorary Chairman at any given time is the President of the United States. The trips are not merely a side activity for PTP, but actually a core program that directly supports its mission of “fostering international understanding.” PTP granted EPAX the exclusive right to the PTP brand through 2020, in return for royalties paid on a per-student basis, which are PTP’s primary source of revenue. EPAX conducts the marketing, but PTP is the public face of the trips.

EPAX obtains leads from student testing organizations (e.g., the College Board) as well as from internally developed lists and referrals. Families receive a letter on PTP letterhead, which prominently displays the organization’s White House affiliation. The letter states that PTP has invited the student to travel and study in a particular foreign country, and encourages him or her to attend a local informational meeting.

Students (and parents) often feel honored to have been invited, and often view the trip not only as an enriching experience but also as a way to get a leg up in the college admissions process. About 90% of EPAX’s gross revenue derives from international trips (EPAX also has a program offering domestic destinations), which were priced at approximately $6K on average in 2007. Students raise a substantial portion of the needed funds through donations, mostly from individuals but also from community organizations, local businesses, or the local government. EPAX says that on average, 40% of students raise 40% of trip costs. Among lower-income families—with annual income of $30-50K—80% of students raise 80% of trip costs through donations.

MOAT

EPAX’s reputation derives from its affiliation with PTP, which (because of its long history and connection to the White House) enjoys superior and non-replicable prestige. This is crucial for fostering trust in parents, and is advantageous in positioning the programs as a differentiating factor for college admissions. The PTP connection also enables EPAX to arrange meetings for students with prominent political figures from the host countries—experiences mostly unavailable in competing travel programs.

EPAX’s reputation is excellent within schools and among its competitors. Trips are typically oversubscribed by teachers (6,500 signed up in 2007, of which just over 5K were accepted to lead trips). This is not only an indication of EPAX’s reputation, but also an advantage that affords selectivity. Some competitors do not even conduct teacher background checks.

EPAX’s satisfaction rate runs at 98%, and many alumni become passionate about the experience. Internally generated leads (including alumni and teacher referrals) have grown from fewer than 5K in 2002 to over 10K in 2007, an indication of EPAX’s growing recognition and reputation within schools. On average, 10% of participants travel again the following year, and 15% travel again in a subsequent year. In well-penetrated markets, I have heard anecdotally that repeat-travel rates are as high as 30-50%. Competitor repeat rates are negligible for low-end trips and <5% for high-end trips.

The competitors I have spoken with uniformly praise EPAX for the quality of its programs (activities, safety, hotels, food, etc.) and the integrity of its employees and management. They are also quick to point out that they do not try to beat EPAX at its own game. For example, the largest US student travel company, EF Tours, positions itself strictly at the low end of the market: 1-2 week, touristy trips that cost less than $3000. At the high-end of the market—where trips cost in excess of $5K, are typically 3-4 weeks, and have an educational bent—EPAX has no scale competitors.

In short, EPAX has a unique brand and business model, and its competitive moat widens as its recognition and reputation grow.

PROFITABILITY

EPAX will have a gross margin of 35% and a net margin of about 11% in 2007. Competitors generally have <15% gross margins and earn low-single-digit net margins.

EPAX earns an ROE in excess of 30%, with no leverage. This is impressive enough, but ROE understates ROIC because of EPAX’s negative working capital, which results from its receiving the full payment for each trip in advance. In fact, EPAX’s invested capital base historically has been negative, and after its recent $20M investment in a new headquarters, invested capital will be roughly $7M, vs. estimated 2008 EBIT of $26M.

GROWTH

Between 1996 and 2006, EPAX enjoyed compound annual revenue and net income growth of 21% and 25%, respectively (while the rest of the industry was flat-to-down, as mentioned before). During that time, the company had only 1 down revenue year—2002, when revenues declined 17% following 9/11.

I estimate that EPAX can grow to 2-3x its current size in terms of students traveled, from its domestic opportunity alone. There are about 29M 11-17 year-olds in the US. EPAX is able to travel students with family income levels as low as $30-50K because donations defray the cost of the trip (EPAX also recently partnered with a student loan organization). Therefore, according to US census data, less than 5% of the 29M are strictly out of reach based on affordability. Another way to approach the calculation is to start with high school graduates, of whom there were about 3.4M in 2007. Multiplying this number by 7 (the number of classes EPAX markets to) yields nearly 24M. I assume the addressable market for the mail campaign is 20-25M.

EPAX’s growth is driven by 3 factors: 1) sending more mail; 2) improving mail response rates (percentage of recipients who attend a meeting); 3) improving meeting conversion rates (percentage of meeting attendees who put down a deposit). The company has targeted 5% annual growth from each of these factors, for 15% overall growth in students traveled. Historically it has exceeded this target.

I estimate EPAX sent 10-15M pieces of mail in 2007 (assuming response rate = 1.0-1.5%; conversion rate = 1/3; withdrawal rate = 1/3; and students traveled = 37K), implying it can increase mailings over time by roughly 50-100%. There is also room for continued improvement in response and conversion rates, but this is too difficult to quantify. Intuitively, it stands to reason that EPAX could reach at least 100K students traveled, given that EF Tours (the largest competitor in international trips) and World Stride (the largest competitor in domestic trips) each travel over 100K students annually.

Longer term, there is a huge opportunity to travel foreign students both into the US and between foreign countries. EPAX will have a significant competitive advantage in addressing this opportunity because of PTP’s reputation and political relationships. 

RECENT STUMBLE

EPAX’s extraordinary record makes it particularly jarring that enrollments for 2008 are down by about 30%, which EPAX announced along with 3Q results this year. (The marketing season for 2008 trips ran from Labor Day through Thanksgiving in 2007, so we have good visibility into what 2008 is going to look like.) Mr. Market sent the shares down from about $40 to where they sit today at $17.14.

On the 3Q call, management offered 3 reasons for the decline:

1. Trip prices rose  by more than 10% due to EPAX’s decision to pass through higher airline ticket prices and program cost inflation resulting from the weak dollar;
2. The weak economy, and particularly the wealth effect resulting from declining home prices, reduced willingness to spend on discretionary items;
3. One of EPAX’s 3 key-name databases severely underperformed expectations.

A little digging surfaced an additional factor that contributed to the weakness. In 2006, EPAX mistakenly sent an invitation to a family in Iowa whose child had passed away in 1993. As was standard practice, the letter stated that the child “has been recommended for the honor by a teacher, former Student Ambassador or national academic listing.” This understandably resulted in outrage and negative press coverage, and eventually prompted the Iowa Attorney General to force EPAX to alter the language it uses in its letters and other marketing messages. In short, EPAX no longer states that students have been “recommended” but rather have been “invited.”

EPAX elected to make the change on a nationwide basis, rather than only in Iowa. Small changes to a mailer can have large effects on the effectiveness of a direct mail campaign. This constitutes an adverse change to EPAX’s core marketing message, and I believe accounts for a significant portion of the weakness in the company’s 2007 marketing season.

NUMBERS

The confluence of the four factors discussed above—10%+ price increases, weak economy, underperforming list, and wording adjustment in the mailings—increased EPAX’s student acquisition cost (sales and marketing spending per student traveled, “SAC”) from approximately $600—the level EPAX maintained from 2003-2006—to approximately $1K in the 2007.

I believe that three factors entirely within EPAX’s control will enable it to reduce its currently inflated SAC of $1000, eventually back to $600.

• The faulty name database has been replaced. The new database will perform better, but because it will not have been tested, it is unclear how much better. Over time this issue will be resolved completely. The big picture is that EPAX’s ability to run its mail campaigns did not suddenly disappear. (Also, I heard that EPAX recently hired a career direct marketing expert from outside the student travel industry.)

• I am assuming that EPAX drops the prices of its student international programs by 7.5% in 2008, for an overall price reduction of 5% (I assume it raises prices on domestic and adult/athlete trips by 2%, as it has historically).
• The change in wording to the letter not only affects response rates but also reverberates throughout the rest of EPAX’s marketing campaign. That is, many elements of the marketing effort might need adjusting, most notably the way in which the meetings are conducted, because recipient expectations are different than they have been in the past. The 2007 marketing season was a learning opportunity for the company, and set the groundwork for future improvements. The key here is that all effects of the wording change are entirely reflected in the $1K SAC number, and improvements will serve to lower that number.

Given these three factors plus the underlying SAC improvement that EPAX targets (from improving response and conversion rates), I believe the company can reduce SAC by at least 10% annually over the next three years, from $1000 (2007) to $730 (2010). This would imply that 2010 SAC will still be more than 20% greater than it was in 2006, and will be comparable to what it was in 2002 (which remember was adversely affected by 9/11). I would not be surprised if SAC improves far faster.

Here is what my numbers look like:

                                                2008                2009                2010

Students traveled                    36,865             39,410             43,351

Y-o-y growth                          -30%               10%                 10%

ASP y-o-y growth                   11%                 -5%                 2%      

Gross receipts ($M)*             216.1               226.3               253.9                          

Y-o-y growth                          -22%               5%                   12%

Gross margin**                      36%                 30%                 30%

Sales and marketing ($M)      36.4                 36.1                 35.7

SAC                                        $900                $810                $730

SAC y-o-y growth                  -10%               -10%               -10%

G&A ($M)                              14.3                 14.7                 15.1

% of gross receipts                 7%                   7%                   6%

EBIT ($M)                              26.0                 17.9                 24.6                

% of gross receipts                 12%                 8%                   10%

Net income ($M)***              19.7                 14.7                 19.7

% of gross receipts                 9%                   7%                   8%

Plus ($M):                             
D&A                                       2.6                   2.6                   2.6

Stock-based comp                  1.9                   1.9                   1.9

Deferred revenue                    3.6                   5.8                   6.5

Less ($M):

Interest income after tax        2.3                   2.7                   3.2

Capex                                      2.6                   2.6                   2.6

FCF ($M)                                24.7                 19.8                 25.1

*Gross receipts does not correspond to revenue on the income statement. For its international programs, EPAX reports revenue net of program costs because the programs are implemented by foreign partners.

**Gross margin is here defined as gross profit / gross receipts, and therefore differs from gross margin on the income statement.

***Assumes 33% tax rate and 3% interest income rate.

A few comments on these assumptions:

• The top-line assumptions for 2008 reflect what we already know: delegates fell approximately 30%, while prices increased in excess of 10%.
• I assume a huge drop in gross margins, but it is worth noting that EPAX has a substantial ability to lower its program costs, which it has not yet tapped into. Low-end operators spend approximately 15-20% less per student than high-end operators, and I have heard that EPAX provides the most expensive programs even at high-end. A 15% reduction in per-student program cost would increase EPAX’s gross margin by approximately 10 percentage points. EPAX clearly has the levers to eke out a couple percentage points of gross margin; the fact that it has not done so indicates its commitment to providing quality programs.
• EPAX has implemented a hiring freeze, which given its 20% annual employee turnover implies the elimination of 50 positions. Between this and other cost cutting measures, such as the postponement of discretionary growth projects, I expect EPAX to reduce G&A by at least 15% or $2.5M in 2008, which is what I am modeling here. In the subsequent two years I assume G&A inflates by 3% annually.

VALUATION

I will focus on two valuation metrics: FCF (operating cash flow less capex, excluding interest income) and FCF – deferred revenues. The former will exceed the latter as long as the business is growing. Because I believe the company will be growing for a long time, I view FCF as a better measure of EPAX’s earnings power.

Calculating excess cash also requires some judgment. At the end of 3Q07, EPAX had $86M of cash on the balance sheet and no debt. The company reports a metric called “deployable cash,” which is the “cash available to deploy for future business opportunities.” Deployable cash is cash + prepaid expenses – A/P and accrued liabilities – participants’ deposits. It stands at $54M.

I think the best calculation of true excess cash is total cash less the cost of programs EPAX will incur to travel the participants whose deposits it has on the balance sheet. Participants’ deposits were $21M at the end of the quarter. Using my 36% 2008 gross margin assumption, 64% = $13M is subtracted from $86M, leaving $72M of excess cash.

These assumptions imply the following valuations:

2008                2009                2010

FCF / share                             $1.17               $0.94               $1.19

FCF less def. rev. / share        $0.92               $0.66               $0.88

Stock price                              $17.14             $17.14             $17.14            

Excess cash / share                 $4.72               $5.79               $7.13

Adjusted stock price               $12.42             $11.35             $10.01

P / FCF                                   11x                  12x                  8x

P / FCF less def. rev.             14x                  17x                  11x

I will leave it to the reader to decide if these valuations are attractive. I personally think that EPAX’s high ROIC, strong and growing moat, and long growth runway make a 20x multiple very reasonable. This would imply $31 stock price on 2010 FCF, yielding 80% upside over three years (sooner if the market discounts the results in advance, which it usually does).

If EPAX fails to live up to my expectations, I venture that this would be because of timing and not because the company is broken. The big picture is that EPAX’s economics and growth prospects are about as good as it gets, and that this is not going to change for a long time. I think patient investors will be rewarded for buying at this time of maximum uncertainty.

A few last thoughts:

• John Ueberroth purchased the company in 1995 and is the Chairman. He and his family own over 10%. His family has a spectacular reputation for integrity and shareholder friendliness.
• CEO Jeff Thomas has been with the company for over 11 years and has been CEO since 2002. He enjoys a very good reputation within the industry. He and his wife, who is also the COO, together own over 1M options, in addition to over 5M of stock.
• In the first 9 months of 2007 (when the stock was much higher than it is now), EPAX bought back $35M of stock. The company currently has just over $20M of repurchases authorized (~6% of the market cap).
• EPAX makes a logical acquisition for a strategic or financial buyer. The company has the premier brand in the industry, generates substantial FCF, and is over-capitalized. Additionally, the nature of the business does not lend itself to being public. EPAX downplays its for-profit side (remember that PTP is the company’s public face), which is obviously more difficult if the company is publicly traded. A take-out might be lucky for shareholders if operational issues play out worse than I expect. Otherwise, I would be happier to own the shares for a long time.

Risks:

• The most obvious risk is that I’m completely wrong about the causes of the decline in 2008, and there is a permanent problem (e.g., students just don’t want to travel on trips like this anymore). I obviously don’t believe this to be the case.
• Although my thesis is that the marketing adjustments necessitated by the change to the letter will ultimately result in improvements, it is possible that EPAX missteps along the way
• A recession could hurt the business temporarily
• Any major geopolitical event that would affect people’s desire to travel would also pose a temporary problem

Disclosure: This is not a recommendation to buy or sell EPAX shares. My fund is long shares of EPAX and may increase or decrease the position at any time.

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