Description

GATE:SW Investment Thesis

While we're generally not in the business of buying companies that are up 160% from their IPO price of less than a year ago, we're making an exception for Gategroup (GATE). We feel comfortable buying a business of this quality at 7.5x EV/EBIT with a FCF yield of about 10%. And those numbers are calculated off the depressed actual results of 2009 - not some figment of the imagination of ridiculously bullish sell-side research departments predicting mid-cycle earnings in 2012. On a realistically normalized basis, GATE trades at lass than 6x EBIT and a 14% FCF. This valuation is on a business that earns a +30% after-tax ROIC and has solid long term prospects for growth and high-ROI capital commitment.

Company Description

Gategroup can best be described as an under-the-radar (of consumers) company that provides various outsourced services to the airline industry (although it has recently moved to providing its slate of services to the rail industry as well). Gategroup was originally the catering division of SwissAir before it was spun off as an independent unit in the early 1990's. It was acquired by TPG in 2002, and since then has become, through acquisitions, a conglomeration of 11 different divisions specializing in services beyond simply catering. That said, catering and other food-related business remains ~75% of the revenues of the company as it stands today. The services and related companies that comprise Gategroup are:

• Gate Gourmet and Supplair - These divisions handle the 75% of Gategroup revenues related to food. Gate Gourmet handles first/business class food from preparation (both in-air and in kitchens located in airports) to logistics (getting the food on and off the airplane, efficiently stocking and cleaning the food carts, managing food and dishware inventory, etc.). Supplair deals with packaging food (again preparation plus logistics) that is used in economy class.

• deSter, potmstudios, and Harmony - these divisions deal with designing, and in some cases manufacturing, the stuff that is actually used by passengers on board (mostly in first/business class). deSter's focus is on designing and manufacturing high end trays and tableware specifically suited for flight; Harmony provides high end amenity kits and comfort items; and potmstudios is a design agency that works with deSter and Harmony as well as directly with airlines on designing trays, tableware, amenity kits, etc.

• Performa and Elan - these provide solutions to airlines in the area of customer service. Elan recruits and trains customer service personnel, as well as operates a cabin crew leasing program geared toward new airline start-ups (think Asia-Pacific) or existing airlines that need to meet peak demand. Performa is a consulting segment that designs and manages airline VIP lounges.

• Gate Aviation, Gate Safe, Pourshins, and eGate Solutions - we include all these together in the "miscellaneous" category as each of these divisions provides a different outsourced service to airlines:
  • Gate Aviation runs specialty services such as de-icing, exterior washing, and interior cleaning in 20 airports around the UK and Ireland.
  • Gate Safe provides security services such as cargo screening, patrolling airline property, and aircraft search sweeps after everyone gets off the plane.
  • Pourshins provides supply chain management consulting, sometimes with other Gategroup divisions that actually provide the prod cuts.
  • eGate Solutions provides technology to manage on-board services such as on-board retail, galley planning (it's more complex than you think), and any other in-flight service that is customizable (seating, invoicing, and forecasting  an airline's on-board product needs based on its schedule).

Recent Financial Results

Below are the basic financial results for Gategroup for the last two years in Swiss Francs.

Just a note on the ROIC that we calculate - we use the "Little Book" method for calculating capital employed in the business, which means that we're excluding intangible capital and non-interest-bearing current liabilities. You'd be right to comment that this doesn't properly account for management's ability to re-invest its capital wisely through acquisitions but for now, we are trying to focus on the core characteristics of Gategroup's business.

Present Operations and Levers for Improvement

We think the businesses Gategroup is in are high quality in the sense that there is very little competition save for the airlines themselves, the actual capital employed in the business is quite small with corresponding return on that capital fairly large, and the barriers to entry are formidable - it would take years for a new company or airline spinoff to become as well-respected and relied upon as Gategroup is at present (remember that food and logistics are a relatively small part of airlines' costs but still very important - it's not worth screwing that up for a small break on price). All that is well represented in the quite-high returns on invested capital shown above. We'd also keep in mind that those returns were generated in 2008-2009, not exactly the best time to be operating a business dependent on first class business travelers and the airline industry in general.

That brings us to our next point: Gategroup was able to maintain its copious cash flows and high returns on capital employed due to its flexible cost structure. While 2008 and 2009 were certainly worse than average years for Gategroup's business, they were not disastrous as 70% of Gategroup's cost structure is variable, i.e. dependent on the number of flights and passengers it serves. While management doesn't expect 2007 levels of business travel to reappear until 2011, they think their present overhead allows them to operate with as much as CHF 3.3B in revenue (at that level, they expect EBITDA margins to come in at the 9% range). The key here is to realize that due to the company's cost structure, the downside protection on cash flows is pretty robust.

On the upside, there are a few points we would make:

• We think the 7.5% EBITDA margins are bottom-of-the-cycle margins. As an investor doing work on Gategroup, you basically get to see only their 2009 annual report and not the annual reports before that , as the company was then privately held. Thus, you're looking at 2008 and 2009 numbers and end up valuing the company based on only those numbers. Management is targeting 9-12% EBITDA margins over the next few years, and while we wouldn't necessarily take that to the bank, we think taking the lower end of that range - i.e. 9% - is fair in coming up with a normalized earnings number. It's certainly not a huge stretch given that '08 numbers were 8.4% in what was a sub-par year for the industry.

• If you're wondering why we detailed above all the stuff that Gategroup does - even the stuff it does in only 20 airports around the world - when the vast majority of the business is basically first class food, it's because if you look at all the above services, it's impossible not to notice how many cross-selling opportunities there are for the company that it doesn't (yet) take advantage of. Simply having a place at the table (no pun intended) by being the go-to source for food gives Gategroup economies of distribution, allowing the company to also pitch its other services. Many of the non-food businesses were acquired in 2007 and due to the economic collapse of the last two years, there's still a lot of low-hanging fruit to pick in terms of cross selling. We say this even as we're typically skeptical when management teams talk about "synergy and cross-selling," which are generally just excuses to make stupid and/or overpriced acquisitions. With Gategroup, you're not paying for any positive outcome of cross selling. The as-is valuation is on the cash flows of a company that cross-sells like Citigroup with a free option on moving toward becoming more like Wells Fargo.

• The fastest growing region for Gategroup is, of course, Asia. We will not belabor the whole Asian growth story and we're not pitching Gategroup as a "great way to play China." Due to our psychological need to remain social outcasts, we hate it when an investment idea contains a "plus, there's China" element to it. In this case, Asia currently accounts for about 11% of total revenues, and we're only making the claim that Asian business travel will grow faster over the long term than European or North American business travel. Margins and returns on capital for Gategroup are higher in Asia and Europe than in North America due to the more fragmented airline industry and higher proportion of international and long haul flights in these regions. All other things being equal, faster Asian travel growth will mean higher margins and returns on capital for Gategroup.

• A quick comment on management while we're describing the upside for GATE:
  • Management owns 4.3% of the company and has stated that they have substantial portions of their net worth tied up in the equity of the company.
  • Management is quite realistic when it comes to assessing the macro environment they are in and downright conservative when it comes to projecting their own revenue and margin growth. It's worth listening to their annual update call to hear the sell side badgering them about "not understanding" why the growth projections are so low.
  • We got the impression that management is pretty grounded when it comes to assessing ROI for contract bidding and M&A. ROI considerations played heavily in the decision in 2009 to lose the contracts to British Airways' North American business as well as BA's short haul business in Heathrow. When it comes to M&A, we think management has shown similar restraint/skill, most recently in their decision to expand their Asian business by acquiring in 2009 the United Airlines' flight kitchen in Tokyo-Narita. The acquisition was accretive to per share earnings for 2010. We think a large stupid acquisition of some Asian business is the biggest risk to this thesis, but management actions thus far have impressed us.

Finally, we should point out that Gategroup's business is pretty close to a recurring revenue stream. Management estimated that 90% of 2009 revenue came from contracts that run through the end of 2010, 80% from contracts that run through 2011, and 75% from contracts that run through 2012. This makes a massive company-specific screw-up unlikely, and we'd argue should command a higher than average multiple.

Macro Considerations

Turning from company-specific levers for improvement to macro considerations, we think the following macro-level factors will affect Gategroup over the medium to long term. On the downside, given that the vast majority of revenue and profit come from food and logistics to legacy carriers, the rise of discount carriers, especially on the European international scene, and their continual growth as a proportion of passenger traffic is a net negative to Gategroup's current business. Naturally, there is less "stuff" that needs to be outsourced to Gategroup when it comes to the LCCs (in terms of food, logistics, etc).

Additionally, while videoconferencing and technology have been touted as potential replacements for business travel for the past decade without much effect, we think the combination of the Great Recession and the rapid improvement of the aforementioned technologies will accelerate the competitive threat. This has already manifested itself in the shallower decline and faster upturn of economy traffic growth vs. first/business class traffic growth.

On the other hand, there are also a few upside macro effects to weigh. First, while LCCs have significantly fewer food needs to outsource to Gategroup, the growth of buy-on-board retail services on both LCCs and legacy carriers is potentially a huge revenue driver for Gategroup in coming years. Carriers are trying hard to generate as much in ancillary revenues as possible, and this is probably less detestable than charging for your carry-on luggage. These retail services encompass both food and general merchandise, and Gategroup is building up its capability in managing the entire retail operation for the airlines.

Another macro positive is that as airlines in general cut costs, they're looking to outsource more of their non-core operations. While Gategroup's position in food might be declining at a particular airline due to the airline no longer serving food, Gategroup might pick up the slack with other operations the airline might be outsourcing. In the past, this was not an option given Gategroup exclusive focus on food-related services. At present, the conglomerate nature of the company will allow for this type of corss-selling or revenue offset.

Overall, we think Gategroup's efforts in the non-food realms will more than offset the macro headwinds in the airborne food arena.

Valuation and Risk

Using 2009 numbers, the normalized FCF yield on Gategroup at present is 10.3%. By normalized FCF, we mean EBITDA minus maintenance capex minus interest costs minus taxes at the normal rate (i.e. not counting any NOLs). For 2009, that gets us CHF 200M in EBITDA minus CHF 40M in maintenance capex (management says maintenance capex is 1-1.5% of sales and we're using the high end of the range) minus CHF 45M in interest costs, taxed at 32%, which comes out to ~CHF 80M. On a market cap of CHF 770M, that's a bit more than 10%. Using more normalized revenue and margin numbers, we think the realistic FCF yield of GATE at present is closer to 14%. On an EV/EBIT basis, using a similar methodology as above, you're look at a 7.5x EV/EBIT on 2009 numbers and <6x on more normalized revenue and margin numbers. For a company of this quality, with real upside to our normalized margin estimates, at a time when triple C debt yield 9.2%, we're pretty excited about this.

The financial position of the company is pretty strong with CHF 250M of cash on the balance sheet and gross debt of CHF 650M. To be honest, we wish the company had a bit less net debt relative to EBIT, but management has stated that it intends to delever over time. The debt level, though, is not what worries us. We think the biggest risk is management doing a large and stupid acquisition in Asia that is predicated on "growth." We are somewhat comforted by management's conservatism here as well as its decent insider ownership, as stated above, but if anything would keep us up at night concerning this investment it's the possibility of stretching for growth. On the other hand, we're much more sanguine about the possibility of a double dip recession simply because we already know what Gategroup generates at the lows of the cycle.

As for the company's 160% run-up since its IPO, we think it's the result of an undervalued IPO price and the market slowly coming to the realization that at the offering price, GATE was trading at less than 4x 2009 FCF. While that price clearly didn't make sense, neither does <10x.

Catalyst

Time, Investor understanding of the quality of the business