April 12, 2011 - 11:21am EST by
2011 2012
Price: 9.20 EPS $0.13 $0.40
Shares Out. (in M): 15 P/E 70.0x 23.0x
Market Cap (in $M): 138 P/FCF 50.0x 20.0x
Net Debt (in $M): -6 EBIT 3 8
TEV ($): 132 TEV/EBIT 42.0x 17.0x

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This stock has been volatile in recent years.  I've written up PCOM on VIC twice before.  The first time in 2008, disastrously, or as I would prefer to call it, "prematurely," at almost three times the current price, and then in 2009, "presciently" as I prefer to call it, at a bit more than one third the current price.  If the name seems vaguely familiar but the price looks wrong, that is because of a one for ten reverse split earlier this year that changed the symbol and reduced the share count to about 15 million.

The volatility hasn't been surprising: one could make a case, as I do, that PCOM has developed a near monopoly position as the key middleman in an emerging alternative currency market, loyalty club (frequent flyer) points and miles.  That market is massive in size: in a 2005 article The Economist estimated the dollar value of unredeemed miles and points at about $700 billion.  Two months ago a British consultancy claimed that total number of accounts in rewards programs worldwide have now reached the one billion level.  Those numbers may be too high, but a company in a strong position to get a piece of the action on even a tiny percentage of the transactions in such a currency should ultimately be worth a billion or more, versus PCOM's current market cap of about $140 million.

On the other hand, a combination of fixed costs that have taken a while for revenues to overcome, and some turnover in big name clients, has until very recently prevented PCOM from actually making any money.  Hence the recurring pessimism and downdrafts in the stock.

I believe these factors are resolving for the better.  Revenues have been growing nicely and costs are relatively fixed, leading to operating leverage that is on the verge of making the stock look very reasonable in terms of the usual ratios. The company has been in the black, albeit modestly, for five straight quarters.  If nothing else, revenues, free cash flow and profits should all be on a strong upward trend over the next few years, even in a down economy, as the company continues to add more clients and existing client expand the services that PCOM provides to their member base.  Loyalty clubs are increasingly using PCOM's offerings as a competitive tool, to keep their members happy even if packed planes, the economy, or other issues make the members less likely to use their miles for travel.  And the percentage of loyalty club members using these features continues to grow.

The wild card is a recently announced business deal with PayPal, which, if it develops as planned, could have an explosive effect on PCOM's numbers and stock price.

Compared to even a year ago, I think the downside risks are much diminished, the upside potential substantially enhanced, and this is not yet reflected in the current price.

Loyalty Programs' Strategies

To see why PCOM is in a key position that could be immensely lucrative, one has to understand the industry it serves.  Although there are hotels, retail chains and financial companies that have rewards programs, airline frequent flyer programs are the most well known, so I'll confine my examples to them.

These programs are very valuable to the sponsor primarily because they really do promote loyalty.  Someone collecting XYZ miles to use for vacations will prefer to take business trips on XYZ Airline, even if it isn't the most efficient route to the destination.  Loyalty club members are always an airline's best customers.  True, giving out miles for travel adds a liability to the airline's balance sheet, but it takes some time for a member to cash them in.  Also, given the capital intensive nature of the airline business, they are a valuable financing tool.  AMR, for example, regularly raises billions of dollars by selling its miles in advance to banks who then use them as an inducement for people to use their credit cards.

A sponsor manages a loyalty club with inherently conflicting goals.  In one respect, it would be ideal if its members accumulated miles and never used them for anything.  The miles would then grow as a theoretical liability, but there would be no actual expenditure (or loss of cash flow when a seat is paid for with redeemed miles rather than cash) needed to discharge that obligation.  Some sponsors thinking in that direction have been known to make it very difficult for their members to use their miles.

The trouble with that strategy is that the members aren't stupid.  If the operator makes it too tough to use its miles, members lose interest in accumulating them, and the operator loses both their loyalty and the financing gravy train from the banks.

The conflict in goals is particularly intense now, due to changes in the airline industry that cause planes to fly with fewer empty seats to give away for miles.  Sponsors are starting to realize that if they can offer members attractive alternatives for spending their miles other than travel, that tactic would cost the sponsor less than taking a seat from a paying customer, and possibly generate some extra fees, while keeping members happy and loyal.  Many of PCOM's services allow the sponsors to do exactly that.


PCOM's Private Label Business

PCOM's basic business is a private label bookkeeping and incentive service for companies' rewards programs.  Its clients include most major airlines in the US and some significant foreign ones, such as BA and KLM-Air France.  There are numerous hotel clients, financial companies such as Chase and American Express, and retailers such as Best Buy.

In earlier days, the only thing one could do with accumulated points was to turn them in for goods or services offered by the sponsor, e.g. using miles to get airplane tickets or upgrades.  That is still by far the most common activity, and PCOM makes no money when a member does that, other than some small fees it gets for managing the bookkeeping to keep the debits and credits accurate.  Where PCOM gets its revenues is in transactions other than travel redemption, mostly when people buy additional miles to get over a threshold for a ticket or upgrade, but also when people want to transfer, exchange or gift their miles.

In other words, when one goes to XYZ Airline's website to buy say 2000 miles needed to get over a certain threshold, one is actually buying them from PCOM, which has bought them at a discount from the sponsor.  Gross margins for PCOM range from single digits for certain high volume clients, to close to 30% for smaller partners.

In theory, there is no reason why an airline or other rewards program sponsor can't do this itself, and up to the late 1990s they all did.  But with limited computer systems talent on staff, numerous sponsors have realized that it was easier and cheaper to adopt PCOM's increasingly robust and flexible program for their loyalty club, and save their in-house computer experts for their core business.

PCOM has no real competition in this business, other than the IT departments of its clients.  PCOM's biggest client loss since its founding in 2000 was in Q3 2009 when Delta Airlines acquired NWA and switched to NWA's home grown system to manage the merged loyalty clubs.  Delta at the time represented about 50% of PCOM's revenues, but the PCOM's success at adding new partners and increasing activity at existing partners was such that revenues in 2010 rose 20% despite that major set back.  PCOM still does a small amount of business with Delta, and believes it has a chance of winning back the entire account someday, at better margins than before, although that isn't in any projections. 

The only other major US airline that doesn't use PCOM is UAL.  It has acquired Continental, a PCOM client, and has indicated that it will merge the loyalty clubs probably January 2012.  If the system running UAL's club is the survivor, PCOM will lose Continental, which for a variety of reasons has not been a huge revenue generator.  Since Continental's system (i.e., PCOM's system) has many advantages over UAL's home grown software, PCOM is working hard to convince UAL to adopt it for the merged programs.  The decision will probably come in the late summer or fall.  The loss of Continental, if that happens, will be a minor setback, while the gain of United, if that happens, will be a much bigger win.

If all PCOM did for clients was provide a software system to handle transactions and keep the books, then someone could possibly develop something similar and take away market share.  An airline would never allow data on the members of its loyalty club members to fall into the hands of a competitor, but in theory another independent such as PCOM could compete.  But running the books of dozens of clients over many years has given PCOM valuable marketing insight into what deals and promotions are likely to work best.  It can then craft offers that will get a better response than what a loyalty club, working on its own, might try. 

Although its degree of involvement depends upon the partner, in general PCOM is not just a passive bookkeeper.  With some smaller partners it handles most of the marketing to the loyalty club members, offering deals and specials to get them to do something with their accumulated miles that brings in fees to itself and its partners.  The bigger partners have their own staff that does most of that, but PCOM increasingly participates and advises on the marketing.

This business is growing well, with three drivers: 1) PCOM has been adding new partners, since its software for running these functions is better than anything the operators can cook up and maintain themselves, 2) the partners have been adding more modules to add to the attractiveness of their loyalty club offerings, and 3) the percentage of loyalty club members who do a transaction over the course of a year that generates a fee or gross margin, probably not much more than 2% on average, continues to grow.  For some smaller partners, where PCOM has a larger involvement in marketing, the percentage is much higher, and PCOM uses that success to argue for being given more marketing responsibility with its larger clients.

Over the last several years most of PCOM's partners shifted from an agency model, where PCOM was paid a fee per transaction, to a principal model where PCOM commits to buying a minimum level of miles from the partner at a discount and resells them to the members.  The clients like the minimum purchase obligation, but in fact the amounts are set so low that there is little real risk that PCOM will have to buy what it can't sell.  A clue that that was a problem would be if there were miles inventory building on the balance sheet, but the total is zero.

The structure of these deals does have an impact on the income statement, in that the clock starts again every January 1st, with the discount from list price that PCOM pays for miles starting at a certain level, depending upon the client, and increasing over the year as the volume builds.  Thus PCOM's gross margin will be lower in Q1 than in Q4, by which time PCOM's accumulated purchases will merit bigger discounts.


The Points.com Website

Points.com, a free consumer facing website, represents only about 5% of PCOM's revenues in 2010, but has the potential to be as big or bigger than the rest of its business.  At its most simple, points.com is a place where one can register one's loyalty programs and check all balances at one website visit.  Many people have balances in ten or more programs, so this saves some time.  As a result of a recent revamp of the site, membership is starting to grow again, and is up to 2.8MM members.

The focus of the site is opportunities to do something with miles other than just use them with the sponsor, plus shopping opportunities that will earn more points.  As is the case with some of its partners' own websites, the points.com site is loaded with offers from major and minor retailers for gift cards in exchange for miles.

As those who obsess on maximizing the value of their frequent flyer miles always point out, these offers do not give the holder great value for their miles.  The best and highest use of miles is always to use them with the program sponsor, where the value of a flight using miles might work out to as much as three cents a mile, far better than Apple or Amazon gift cards from the points.com site, where miles are valued at closer to a half cent each.

Good advice if you want to fly someplace served by the airline with which you have accumulated miles.  But if you were thinking of a vacation in Hawaii rather than Akron, those USAir miles you have accumulated on business trips may not be of much help.  Using them in lieu of cash for other purchases might be the highest and best use for the miles in that case.

Or you can trade them in for miles in another program altogether that will get you where you want to go.   The only place in the loyalty club world where that can be done is on points.com site, using its GPX platform. In most cases trades take place at about the one mile for one mile ratio, but depending upon how motivated the buyer and seller are, the ratio could differ.  Trading on GPX so far has been modest, partially due to a lack of awareness, and partially due to some of the sponsors charging high fees to do the trades.  But over time those constraints may diminish, and PCOM's natural monopoly, coming from being the only party able to debit and credit individual accounts at multiple programs, will prove lucrative as trading rises.  Not all of PCOM's partners allow its members to trade miles across programs, but a growing number do.


PayPal now, and what may be coming:

A few months ago PCOM and PayPal announced a deal whereby members of participating programs, initially AMR, USAir, and Aeroplan (connected with Air Canada) can cash in their miles for PayPal cash.  In one sense, this is trivial; most programs already allow holders to redeem miles into gift cards for numerous retailers, and the cash per mile from PayPal isn't much different than from the gift cards.  It is more significant as a reminder to the tens of millions of people with balances gathering dust in a loyalty club that miles are an asset in their personal balance sheet, and can be turned into cash if needed

In addition, PCOM and PayPal have been working on a second phase of their relationship with the goal of introducing it later in 2011.  There is still a lot of work and negotiations to complete, but it appears to be something that could have a massive positive impact on PCOM's business.

There are millions of merchant websites in the world that accept PayPal, and more than 100MM people who have PayPal accounts.  Almost none of those merchants can offer their own loyalty club except in a crude way, and none of them are big enough to work out a deal with a large, well known loyalty club to be able to offer those currencies as an incentive to customers.  Meanwhile, PayPal wants to be competitive with credit cards that give airline miles to users.

PCOM and PayPal are aiming to create a mechanism where any PayPal merchant will be able to offer one or more brand name loyalty rewards to customers who pay with PayPal.  PCOM will buy the miles from the loyalty clubs, sell them to PayPal, which will sell them to its merchants.  When a consumer buys something from a merchant that offers that incentive, she will register with points.com and PCOM will credit her account with the miles, where she can accumulate them, trade them for another program, or just turn them back into PayPal cash.

If the two companies can put this together, it will be very powerful because it solves a lot of problems for a lot of players: even small merchants will be able to offer a brand name incentive program without having to create and run one themselves, PayPal will give consumers a reason to use its service rather than credit cards, sponsors of loyalty programs will raise money by selling more miles and also get more loyal customers.

PCOM would benefit from a markup on selling the miles, and over time the membership of points.com would soar as consumers register to claim and then use their incentives, which would generate more fees and open up the possibility of income from advertising at the site.  Most important, it would change the relationship of PCOM to its partners, from a back office operator that generates fees for both itself and the partners mainly by helping consumers reduce their mile balances, to a conduit that helps finance the partner by purchasing miles for wide distribution.  This makes PCOM much more valuable to its partners, and that should benefit PCOM in all its dealings with them.



As a result of its growing business and relatively fixed costs, PCOM is starting to see the effects of positive operating leverage.  Official company guidance for 2011 is for revenues in the $120 to $130MM range, an increase of 25-36% over 2010.  It expects EBITDA of $5-8MM and earnings (untaxed due to previous losses) of $3-6MM, or $0.20 to 0.40 per share.  My sense of management is that it is very conservative on projections, and that if the company misses those ranges it will be because it exceeds them.

Even assuming that the second phase of the PayPal partnership does not get introduced, or flops for some reason, continued growth in PCOM's private label business because of more new partners and more usage by their membership base should have revenue in 2012 growing another $30MM anyway.  Since transactions are handled by its software, PCOM is capable of substantial revenue base with no significant increase in headcount or cost structure.  Accordingly, one could reasonably expect the increase in 2012 revenue would add at least another $6MM to EBITDA and $5MM to earnings, putting the latter somewhere in the $0.60 area.

If the second phase of the PayPal deal gets introduced and takes off, or the company either gains back the Delta account, or it convinces UAL to use its system for the merged Continental rewards program, then these numbers will be easily dwarfed.  Even without those bonus possibilities, PCOM's unique, near monopoly position and massive potential, its current valuation at less than one times 2012 projected revenues and about 15 times that year's plausible earnings seems very modest.

PCOM's balance sheet is hugely cash rich, but that isn't quite all that it appears.  It typically gets paid by consumers for mile purchases first, then pays for the miles in the middle of the following month.  Cash items on the most recent  balance sheet came to about $37MM, including about $1.7 MM in restricted cash, but most of that was needed to pay partners $31.3MM within a couple weeks of the balance sheet.  So the EV isn't quite as favorable as meets the eye.  With the company now solidly in the black, the percentage of its cash that it can really call its own should rise considerably.    

On the positive side, this is a business that could grow massively with minimal need for capital expenditures, other than adding some servers.



I think the rise of people's awareness that their loyalty club points have real, monetary value, and the desire of PCOM's partners to keep their members loyal by offering them alternatives that PCOM can provide, all work in PCOM's long term favor.  Nevertheless, there are risks, besides the obvious one that the stock isn't cheap on 2011 numbers and could easily go down in a bad market.

The biggest issue is that its major clients are airlines.  In 2008, when oil unexpectedly shot to $150/barrel and a number of airlines were worrying about bankruptcy, they demanded that all suppliers do something to help them out.  PCOM had no choice in some cases but to agree to cut its margins.  This could happen again, although perhaps not this year in that the rise in oil prices has been steadier and more widely predicted.  Another airline risk is if another 9/11 type incident shut down air travel for a while.  Hard to say how that would affect loyalty clubs, but sponsors going under probably wouldn't help.

In general I would feel better if it had a lot more cash other than what it has to turn over to partners a few weeks after the end of a month.  The rise in cash flow I expect over the next year and beyond should solve that problem.  


Operating leverage manifesting itself in sharply rising earnings in 2011 and 2012

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