|Shares Out. (in M):||20||P/E||N/A||N/A|
|Market Cap (in $M):||755||P/FCF||9.5x||8.0x|
|Net Debt (in $M):||440||EBIT||160||200|
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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.
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:
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:
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.
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.
Time, Investor understanding of the quality of the business
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