Points International's (PCOM) CEO Rob Maclean on Q2 2014 Results - Earnings Call Transcript

| About: Points International, (PCOM)

Points International Ltd. (NASDAQ:PCOM)

Q2 2014 Earnings Conference Call

August 6, 2014 4:30 PM ET

Executives

Kimberly Esterkin – IR

Rob Maclean – CEO

Anthony Lam – CFO

Analysts

Mike Malouf – Craig Hallum Capital Group

Pardeep Sangha – PI Financial Corp

Andrew De Silva – Merriman Capital

Ed Woo – Ascendiant Capital

Operator

Greetings and welcome to the Points International Second Quarter 2014 Earnings. At this time all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. (Operator Instructions) As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Kimberly Esterkin, Investor Relations. Thank you. You may begin.

Kimberly Esterkin

Thank you. Good afternoon, everyone. And thank you for joining us today to discuss Points International’s second quarter 2014 financial results. Joining me today on the call are Rob MacLean, Point’s Chief Executive Officer; and Anthony Lam, Chief Financial Officer.

Before we begin, we would like to remind you that the remarks on this call contain or refer to forward-looking statements within the meaning of Canadian and U.S. Securities Laws. Management may also make additional forward-looking statements in response to your questions. Although management believes these forward-looking statements are reasonable, such statements are not guarantees of future performance or actions, and are subject to important risks and uncertainties that are difficult to predict. Certain material assumptions are applied in making forward-looking statements and may not prove to be correct. Important factors that could cause actual results to different materially and the assumptions used in making such statements are included in our second quarter 2014 financial results press release, as well as other documents filed with the Canadian and U.S. security regulators. Except as required by law, the company does not undertake any obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

With that said, I will turn the call over to Rob MacLean.

Rob Maclean

Thank you, Kimberly. Good afternoon, everyone, and thanks for joining today’s earnings call. I’m pleased to report that the 2014 is off to a very strong start with Points delivering solid results in the first half of the year.

Strong revenue growth we reported in the first quarter continued with second quarter revenues up 68% year-over-year driven by the successful on boarding of new loyalty partners over the last 12 months, and strong year-over-year growth from our existing partnerships. As a result, total points and miles transacted across our platform was $5.8 billion, up a full 50% from Q2 2013.

In terms of profitability, Adjusted EBITDA expanded 119% during the quarter, lead by our continued revenue and gross margin dollar growth. Strategic investments in our future growth included investments in our platform will continue throughout the year and as such we are pleased that our solid balance sheet including over $59 million in cash and cash equivalents provides us with a flexibility to make these investments. I’ll discuss our platform advancements in further date to detail later in the call.

Overall, we are encouraged by these positive results, particularly our ability to drive strong organic growth through continued targeted marketing and merchandising efforts. The growth experienced in the second quarter was broad based across the globe, with North America and Europe, both posting strong double digit increases. However, as we look at the full year picture, we expect demand to continue to be very robust amongst our North American partners, but our European partners are showing some lingering softness, largely we believe reflecting the broader economic concerns of the region.

As a result, we maintain a conservative stance on the overall performance of the Europe region for the year. With that said, our European partners remain highly engaged, and we continue to work closely with them to drive growth. In fact, we’re thrilled to announce the expansion of our relationship with Air France-KLM and launched our core transfer product with them in mid July.

On the new business front, we continue to execute our – against signing and watching new partners in 2014. In June, we officially launched the Hilton HHonors Program on our platform as planned. Hilton currently engages our buy, gift, and transfer of core products, as well as our Points gift registry. We expect to see meaningful contribution from Hilton in the second half of 2014 and we are thrilled to have one of the world’s largest and most successful hospitality loyalty programs participating on our royalty commerce platform.

Along with Etihad and Spirit Airlines which we announced at the end of last quarter and the four new partnerships we added from our PointsHound acquisition, we’ve added seven new loyalty programs to our platform in 2014. We also continue to execute against our very strong partner pipeline which includes perspective partners across the retail, airline, financial and hospitality markets. Despite the significant progress in executing against our pipeline, we’re still in a very early innings of the total opportunity. We believe the estimated total addressable loyalty market is roughly $2.5 million to $3.5 million for our products and services. So there is a lot of green field out there for us to pursue. To be clear, this opportunity does not contemplate any particular timeline but rather acts as a longer term benchmark for the market that we are excited to be pursuing worldwide.

We expect PointsHound to continue to operate as a source of new and expanded business relationships for Points, but also more broadly, a great platform from which to expand our consumer business longer term. Since acquiring PointsHound in mid April, two of our existing partners, Cathay Pacific and JetBlue, have begun participation on that side. In addition, we opened our first West Coast office in San Francisco at the end of June which will house the new members of the Points team. We expect that our new West Coast team will become an important contributor to the continued progress on our loyalty commerce platform, particularly as it relates to consumer opportunities.

With respect to MasterCard, we continue to be excited about the long-term opportunity as this partnership offers for us in the financial service sector. We’re currently ramping up the integration of our respective platforms and expect to begin initial sales outreach shortly thereafter. However, as we communicated previously, we do not expect any material impact from MasterCard in 2014. Before turning the call over to Anthony I would like to take a few moments to speak in further detail about our continued platform investments and progress against our open platform strategy.

In order to maintain solid organic growth and capture the significant opportunity in front of Points, we have, and we’ll continue to make investments in our people and technology. With respect to our open platform strategy, we continue to make advancements and are pleased with our progress to-date. Since we last spoke, we’ve added additional product functionality and made several more loyalty partners available to third-party products providers via our Open APIs. In the second quarter, in partnership with the third-party product provider, we successful launched Aeroplan on our auction product, seamlessly connecting both parties via our Open APIs.

For the remainder of 2014 we’ll be focused on building out additional transactional capabilities and functionality for the platform. We’re very excited about the work that’s been done, and we’ll continue to seek and invest in opportunities to innovate the way in which the loyalty commerce industry transacts business. We look forward to keeping you abreast of our progress.

And with that, I’ll turn the call over to Anthony to discuss our second quarter results in further detail. Anthony?

Anthony Lam

Thanks, Rob. As I review the results for the second quarter of 2014, please be reminded that all the numbers mentioned on our call today are in U.S. dollars, and all the figures are presented in accordance with International Financial Reporting Standards.

We are very pleased to report record quarterly revenues of $70.4 million, an increase of 68% from $41.9 million in Q2 of 2013. Our strong revenue growth can be attributed to ongoing growth in our buy, gift, and transfer transactional activity. The addition of new loyalty partners onto our platform in the past 12-months has been a significant driver of this expansion, with a significant amount of our growth coming from these new opportunities. At the same time, we continue to see growing success from our marketing activities with our current loyalty partners. Year-to-date, revenue from our existing partners and products has grown over 10% on a year-over-year basis.

Principal revenues accounted for nearly all of the revenue growth during the second quarter, increasing 70% to $67.9 million, up from $39.9 million in the prior year period. Gross margin dollars totaled $10.8 million, up 46% from $7.4 million in the prior year period. This metric continues to be what management views as a key metric in measuring our success as per the gross margin percentage. Over the past 12-months, growth and gross margin dollars has been under 30% range. As previously mentioned, this metric reflects the contribution from new partnerships launched over the last 12-months, as well as increased transactional activity from our existing partnership base.

As of percentage of sales, gross profit margin was 15.3% in the period, down from 17.7% in the prior year quarter, and up sequentially from 14.2% in the first quarter of 2014. And this reflects the relative mix of partner and product activity. The shift in margin percentage can be attributed to the transaction growth in larger partner products which typically carry a lower gross margin profile. In addition, we’ve also shown in previous years, we start the fiscal year with lower gross margin profile and end at a higher gross margin profile as we realize volume based incentives throughout the course of the fiscal year. Overall, we continue to expect gross margins to be in the 15% to 16% range for the full year.

I’ll now move on to discuss some of our key operating expenses for the quarter. Total ongoing operating expenses which consist of employment expenses, marketing, technology, and other expenses were $8.2 million, an increase of $2 million or 32% from the second quarter of 2013. Growth in our headcount was a primary driver of increase in this on a year-over-year basis. Employment cost in the quarter totaled $6.2 million, up from $4.4 million in the second quarter of 2013.

Including our PointsHound acquisition, we’ve grown the Points team to 166 staff at the end of the second quarter, up from 131 in the year ago period. As mentioned on previous calls, we continue to invest in key roles in the areas of R&D and marketing that are focused on advancing our open platform strategy, as well as improving data and transactional capabilities. We’ll continue to make the strategic investments for the balance of 2014 as we continue to execute on expanding our key core products and evolving our open platform strategy.

Marketing expenses were $328,000, up from $307,000 in the prior year period, and $198,000 in the first quarter of 2014. Let me head for the second half of the year, we can expect this slight under being around the $400,000 in each of our last two quarters. Technology expenses, which cover the cost of maintaining and protecting our production environment, these are application licenses, as well as general technology upkeep enhancements with $280,000 in the period as compared to $323,000 in the prior year period. We continue to expect to see this expense line in course of marginal growth to put the $400,000 level for each quarter for the balance of the year.

Other operating expenses comprise of rent, insurance, professional, legal, accounting and any public company related cost. This line item was $1.5 million in the quarter, up from $1.2 million in the prior year period, largely due to cost incurred around the PointsHound acquisition. Looking forward, this expense line is expected to remain at the $1.3 million level in each of the last two quarters of the year.

Adjusted EBITDA more than doubled for the period, increasing 119% to $2.6 million, up from $1.2 million in the second quarter of 2013. This improvement was largely due to the growth in transactional activity from our partners launch over the last 12-months, as well as organic growth in existing partnerships offset by increases in employment costs. Amortization expenses decreased to $304,000 or 36% to $544,000. This is decrease can be attributed to certain assets being fully amortized at the end of the period, or at the end of 2013 along with a change that we made in the prior year quarter to move from declining balance to straight line on certain asset classes.

Finally, the company reported second quarter net income of approximately $1.2 million or $0.08 per diluted share, compared to $218,000 or $0.01 per share in the second quarter of 2013. As of June 30, 2014, total funds available comprised with cash and cash equivalence together with restricted cash and announce with our payment processors totaled approximately $68.1 million, and we remained debt free. Net operating cash which we define as total funds available less amounts payable to loyalty program partners, totaled $17.4 million at the end of the second quarter, compared to $13.4 million as of June 30, 2013. We are very pleased to continue to generate sufficient cash to fund our current and working capital requirements, as well as any anticipated capital expenditures.

As of June 30, 2014, we have weighted average shares outstanding of 15,401,248 shares and 15,644,840 shares on a fully diluted basis.

Thank you all for your attention. With that, I’ll hand the call back over to Rob.

Rob MacLean

Thanks, Anthony. As anticipated, the first half of 2014 demonstrated strong year-over-year growth with revenues up 63% for the six month period. As a result, we remain on track for revenue growth of 25% to 40% for the full year. As we mentioned before, we do expect growth in the second half of the year be lower than the first half, reflecting the impact of several new partners coming on board in the second half of ‘13.

We continue to expect Adjusted EBITDA to be in the range of $16 million to $20 million with more meaningful contribution in the third and fourth quarters. Of note, this is prior to any strategic investments which following the PointsHound acquisition is expected to be in the range of $5 million to $7 million. We’re excited for the many opportunities that lie ahead of us, both with current partners and new business, so we remain cautious as we work through continued softness in Europe.

Throughout the remainder of the year we will continue to invest in our core product development, improving data and transaction capabilities, all while expanding and enhancing our open platform strategy, and continuing to engage our business development expertise to strengthen our new business pipeline. In doing so, we’ll be able to facilitate growth and innovation in the world’s largest currency market, the loyalty’s base.

That concludes our prepared remarks. Anthony hopes to see many of you next week in Boston at the Canaccord Genuity Growth Conference.

And with that, we’ll open up the call to your questions. Thank you.

Question-and-Answer Session

Operator

Thank you. Ladies and gentlemen, at this time we’ll conduct our question-and-answer session. (Operator Instructions) Our first question comes from Shumik Reynolds [ph] with RBC Capital Markets. Please state your question.

Unidentified Analyst

Thanks very much, good afternoon. Just two questions for me, first on the 10% organic growth from existing partners, I’m wondering Rob, if you can just kind of flush out, is there a big differential between kind of your older partners versus your new partners in terms of growth, and is there any further granularity you can leave us with underneath the hood there? And secondly, just looking at your cash position of $17 million, net of partner amounts, just what is your intention for that cash, you’ve obviously made recent investments in taking acquisitions. Is that something we expect to see going forward? Thank you.

Rob MacLean

Great, thanks. On the first question, organic growth, yes, we’ve had a pretty long run of good solid organic growth as Anthony indicated. We’re north of 10%, I think practically speaking, Q2 – that was a very, very strong quarter, we were north of 20% specifically in the quarter, year-to-date, and the last 12-months we’ve been north of 15%. We just – we’ve had good solid organic growth, it’s a pretty good mix between our newer partners and our older partners. Again, we see ourselves on a pretty early stages of the ride here and the longer we spend with our partners as they get into our marketing and merchandizing mix, we’re pretty consistently able to drive a strong solid organic growth out of those products. So, we really like how that baseline business performs, and particularly to get second quarter on that, I wouldn’t think every quarter is going to be north of 20% but we’re pretty comfortable we’re in double digits.

In terms of cash intentions, now we do see some opportunities, not unlike what we’ve done over the last of the while with small tuck in investments, investment in China in terms of expanding our reach and really trying to capture that global opportunity that we see out there. There are a couple of more of those that we look at so often, and so I think we’ll be – we would certainly consider that. We also have uses of capital in terms of internally pushing this business as hard as we possibly can to capture that $2.5 million to $3.5 million opportunity. In some of that, you’re seeing us reinvest into the business through our – what we try to provide in terms of transparency around various investments. So, we really like the way the cash is building and $17 million, $18 million that we report of our operating cash in the second quarter is up and continuing – we continue to see that cash growing as we look out into the future, but still pretty early days in terms of building a cash position that will make good use of it.

Unidentified Analyst

Thanks very much.

Operator

Thank you. Our next question comes from Mike Malouf with Craig Hallum Capital Group. Please state your question.

Mike Malouf – Craig Hallum Capital Group

Great, thanks for taking my question. I’m wondering if we can just talk a little bit about clients, I know that you hate to talk specific clients but can you help us at least size some of these large clients that you’ve brought on board, and you take something like Hilton, for example, how big can that be or maybe even use a generic size of a large airline or hospitality client. Just give us a sense of how big that could be for you guys. Thanks.

Rob MacLean

I think your all these statements is right, we’re Radisson [ph] to speak to specific partners and really I thought of respect to their own internal business and confidentiality etcetera. So while I was naming names, we – let me try to tackle it this way, when we started this business we were seeing opportunities with programs and again, think about us coidenting many of these products with the industry, maybe $1 million opportunity. It’s been just pretty interesting to be able to create or invent alongside the industry. As we’ve evolved the businesses, as we’ve gotten smarter about how do we tap into the consumers that these products are relevant to, that scale of the opportunity has changed dramatically. When we see some of the big airline frequent flyer programs around the world, which in their own right are multi-billion dollar businesses, that isn’t really widely distributed or widely known inside the industry or outside of the industry I should say. I think it’s – we’ve been very pleased with the capacity for growth around these respective products, particularly around the retailing of miles and point. So, clearly and comfortably say, these big quicker flyer programs, we’re helping them grow their multi-billion dollar businesses to the tunes of tens of millions of dollars annually for these kinds of program. So – and every – to be very honest, every quarter, every month, every new campaign, and every new opportunity that we learn or test, we’re seeing to be a bigger opportunity than we previously thought. So lots of big, big business opportunities with some of these big partners. I would say other categories outside the airline specific space or the frequent flyer specific space, really tracking slightly different ways. If I think about other hospitality type programs, increasingly replicating the big airline frequent flyer programs in terms of size and scale, in terms of membership in particular, you see some of the big frequent flyer programs with 55 million, 65 million, 75 million members, some of these big hospitality programs are in/or around 30 million, 40 million, 50 million, 60 million members. So they are starting to really replicate the frequent flyer programs. A little bit further behind in terms of the monetization experiences and so they tend to be a little bit smaller but still growing very, very rapidly. So when we think about a big hospitality program or partner, we see them perhaps not quite as big economically as the big frequent flyer programs, but quite substantial in their own right. And then you get other categories like retail and financial services that are moving more in those directions, moving towards the template that the airline frequent flyer programs have really put out into the marketplace. The interesting thing with those types of programs is that the membership basis are massive, and we’re seeing industry quotes that would say, there is more membership in financial institution, loyalty programs today then even in the airline frequent flyer programs which is a relatively new phenomenon. Again, we’re very optimistic that as those programs move into kind of monetization phases, there are some really interesting opportunities for us, but these are our big business opportunities and you’ve seen that reflected in our growth as we see record quarters like this where we have $70 million quarter, up almost $30 million, up 70%, I mean these are record results driven, both by strong organics, as well as the value of bringing on those net new partners. So, we’re pretty excited about just how big each of these business opportunities are.

Mike Malouf – Craig Hallum Capital Group

Great, thanks a lot for the color.

Operator

Our next question comes from Pardeep Sangha with PI Financial Corp. Please state your question.

Pardeep Sangha – PI Financial Corp

Thank you. Just with regards to – just only if you can give us any sort of highlights with regards to American Airlines and the status of that, if that’s anything going on with regards to consolidation there?

Rob MacLean

Yes, I think pretty consistent to what we’ve been saying over the last couple of quarters. Obviously, the U.S. Airways, American Airlines deal has closed and the New American has emerged out of that. For us, we do a lot of work with both of those programs, as you would expect, we’re in regular dialogue with the team at the New American in really showing them how all the things we did with U.S. Airways, all the things we did with American Airlines, how we think all of those things can grow quite substantially in the environment with a very healthy large program like the New American. So what they said publicly I think is that they’ve indicated to their membership that they begin to combine programs in ‘15 and at some point in ‘15 they would be operating of a single program which is great. And for us we think there is a great opportunity there to participate in a bigger way than we have to-date.

Pardeep Sangha – PI Financial Corp

So you feel that in 2015 and beyond, you’ll have greater sort of penetration and greater revenue than – from American and U.S. Air than you have currently today in-built last year individually?

Rob MacLean

Look, we’re not providing guidance, certainly not at a partner-by-partner level but we’re optimists, and we’ve had great experiences and great results with both of those programs and so, we get excited about what the future could look like in the New American with some of the things that we’re having some success there, so we’re pretty optimistic.

Pardeep Sangha – PI Financial Corp

Okay, that’s good to hear. I think your headcount number was 166, is that – did I hear that right? And then if I – if we can just also get a bit more clarity on that, I mean how many of those are sort of technology services or R&D related people?

Anthony Lam

Pardeep, it's Anthony here. You’re correct, 166 is the number that I mentioned. In terms of – it’s important that makes up from a technology perspective, I would say right now as I look down the list – quickly, more around 75 of them on product development or technology based in their background, engineering type resources.

Pardeep Sangha – PI Financial Corp

So 75 of the 166 roughly?

Rob MacLean

One thing I would comment on that, as we’ve indicated to the market and as we had a – have a plan through 2014 in terms of key hiring, we’re doing – we’re very pleased with the way that has gone, the key positions that we’ve identified to really continue to execute against our plan to drive this rapid growth and cash for the opportunity, we’re having great success in bringing great people into the company and we’re doing that in direct hiring here in the Toronto marketplace, we’re seeing opportunities to bring people in on the business development account management side in different parts of the world whether it’s in Europe and the U.K., and then as the PointsHound acquisition has given us an opportunity to bring some very talented people on to the team as well. So very pleased with our ability to execute against our hiring plans in support of driving the business forward.

Pardeep Sangha – PI Financial Corp

Okay. Just taking a step back over the bigger pictures, when do I start getting this right, you’re saying that your year-over-year revenue for the second half of the year is not going to as great percentage-wise compared to what we’ve seen in the first half of the year. However, we do expect to see revenue increase as historically we’ve seen revenue in Q3 and Q4 to be higher incrementally from Q2, am I understanding that correct? And then secondly, what I’m understanding here is that your operating cost don’t seem to be – lastly thing you said so far, I don’t think you’re really ramping up for Q3 or Q4, they seem pretty flat. And so, with revenue increasing and you’re operating expenses flat, we should see some significant EBITDA for the second half of the year. Just want to make am I understanding that right?

Rob MacLean

I think your math sounds right. And that would be consistent with history, as well. I mean, our seasonality has pretty – has been reasonably consistent overtime, certainly the fourth quarter typically is the strongest quarter, we probably experienced that in our whole existence. I think your kind of assessment of what you would expect, tied into our guidance, tied into our historical activity, so I think you’re on the right track.

Pardeep Sangha – PI Financial Corp

Okay, thanks again.

Operator

Our next question comes from Andrew De Silva with Merriman Capital. Please state your question.

Andrew De Silva – Merriman Capital

Hey, good afternoon guys, thanks for taking my call. So there has been a lot of chatter about your pipeline in recent months, now can you define what you consider your pipeline versus overall opportunity. And provide a little bit more granularity as to the size of your pipeline compared to the total opportunity as a stance; assume current product deployment ratios and membership penetration rates essentially stay constant.

Rob MacLean

I think when we think about addressable opportunity, $2.5 billion to $3.5 billion annually, I think I would say upfront I would – shareholder should expect that we have a pretty robust pipeline for a long time to come. For us to really be as excited as we are about that addressable opportunity, a significant component of the growth comes from continuing to knock down businesses and relationships the way we have over the last – in the last number of years. So, that shouldn’t come as any surprise that we have a robust and exciting pipeline. We think of the pipeline at a global level, we’re going further at deals, this loyalty opportunity is certainly a global one, so we see opportunities that were in China, that were in throughout Asia, in a bunch of different geographies, a bunch of different verticals, the MasterCard relationship really allows us to enter into some financial services opportunities in a way that we haven’t done in the past. So when we look at all of those different geographies and different verticals, we get pretty excited about the pipeline. We only get excited about the pipeline in front of us because we have a very good track record and experience in being able to translate those discovery sessions and those proposals into live, successful launches that generate economics for our shareholder. So when we combine those two types of situations, great kind of footprints or availability in front of us, and a good track record in being able to close these relationships, we get pretty excited about the pipeline. So, it is – as we have said in the past, significant value to us when we look at that on an ongoing basis. We do want a pretty traditional pipeline management system where we would have partners that we would view as being in prospecting mode, we have partners that – respective partners that are in discovery where we’re exchanging information, we’ve got others that we would characterize being in formal proposal stage, we’ve got others that are at approval, and we have – and then in development, kind of launching programs. And so I would say we have new partners in all of those categories today, and that’s really what enables us to be optimistic and as bullish on what’s ahead of us as has been in the past.

Andrew De Silva – Merriman Capital

Right. So – maybe [ph] were that a little different – so, about maybe a year, gosh, two years ago you said your pipeline was at $50 million, for example, and what exactly did you consider that $50 million? Was it transactions you believed you could close in a year or two years, I mean just for something to be discussed in a pipeline, is there a timeline associated with that at all or is it just companies you’re in discussion with?

Rob MacLean

I think when we – that specific reference that you’re making for us was important, we felt that was important because we have had good success on knocking down deals to ensure the marketplace understood that just because we were knocking down new deals, our pipeline was in the back rating as a result of that. So we wanted to provide an indication that it was still quite robust, that we look – we put a number out there that it was greater than $50 million that we were actively in discussion with. I think we were successful in delivering substantially higher than that. And I would reiterate that that the pipeline is worth well over $50 million today and we’re working hard to knock those down. By and large, we wouldn’t throw numbers like that out unless we had a high degree of confidence or that we were in reasonably advanced conversations with elements of the pipeline. That doesn’t mean we can predict easily when it all falls, but it is a reflective of our certain [ph] high degree of confidence that our opportunity in front of us, stages of those conversations, and our track record of being able to close, are all very positive.

Andrew De Silva – Merriman Capital

Great. And then, kind of switching back to what the previous question was, while American Airlines and U.S. Airways, one of them is a principal partner in U.S. and then American is more of an agency/commission partnership. Can you kind of elaborate some of the value adds you bring to American, if they were to take combined loyalty program as a principal partnership? And then maybe elaborate on some of the transactional positives that happened when U.S. Airways became a principal partner. I remember listening to a call couple of years ago and hearing that transactional volumes more than doubled when they became the principal partners. So obviously, there could be value at the correlation just to that.

Rob MacLean

Yes, I don’t – we wouldn’t – in normal course, we wouldn’t speak about any kind of transactional activity with any individual partners. So I’m not sure you would have remembered that quite right. What I would say, maybe I could characterize it in general, what we see, as agency relationships move across to principal relationships. And we’ve had a number of those over the years, and then kind of in the context of the things we do under the principal model. So, on the first point we have seen dramatically stronger growth under the principal model than we’ve seen under the agency model. And pretty consistent, when we look at our agency partners, and we look at our principal partners, the growth profile of the principal partners just tends to be significantly stronger, and that’s quite broad. We have a number of both of those kinds of relationships, and that would hold true for big airlines, it would hold true for hotels, it would hold true for other categories. But things that influence that, the kind of components of the principal relationship that we apply in the principal model that drive that – it really focus primarily around our activity on marketing, merchandising, the targeting that we do specifically, which is oriented to drive out yield and profit for transaction. The things that we do around broader distribution so that we take and bring our resources to bear and allow programs to kind of tap into consumers, not just through their database of consumers but also into other distribution channels that we can drive in a more effective way. Those are all the kinds of things that we do under our principal model that really facilitates much more rapid growth. We tend to do a lot more activity around pricing strategy and pricing optimization in our principal models than in our technology oriented agency models, and that’s proven to be to produce some really interesting returns on profitability, as well for us and our principal partners. So it is a reasonably robust set of value ads that we bring to the table under the principal proposition. One of the other things that’s really important as we tend to do more of that heavy lifting in the principal model. So, many of our partners who are very focused on other elements of their business don’t have a lot of resources to really push these kinds of products, and so when we take over from a principal standpoint, we have a team of really dedicated, really smart, really engaged people here that wake up every morning and push these products smartly, and that drives a big difference in terms of growth. If you just have a bunch of people focused on a product, it tends to outperform a product that otherwise is sitting there and not being actively managed. So we see all of those things contributing, they tend to give us great ammunition and great content when we go into talk to new partners or existing partners that we’re interested in, and showing them ways to grow their business, that’s really where we’ve driven a lot of the big growth for our business, as well as for our partners is really under that principal approach.

Andrew De Silva – Merriman Capital

Got it, last question, sorry for taking up so much time. You provided some color as far as your operating expense is going up by about $5 million to $7 million in strategic spending, can you explain exactly what that $5 million to $7 million is going to – is it more related to making the platform more robust? And then take stripping out that $5 million to $7 million, the strategic spending, now what could the core business look like on a revenue standpoint without any new additions as far as – how big could the top line really get before you have to add to the core operating model?

Rob MacLean

So trying to take this second one first. I think if I understand your question, for us – we’re constantly at the board level making decisions to try to balance the – how much of our contribution and profitability till we reinvest into the business to more rapidly capture the big opportunity. It’s a very reasonably simple analysis for us at a board management level which is, if the opportunity continues to be that big, $2.5 billion to $3.5 billion opportunity, we’re employing about $400 million across the platform today then we have a lot of opportunity to pursue. If we did have that opportunity to pursue, we probably wouldn’t invest very much to go pursue it. The fact that there is a great opportunity and we’re still at the very early stages, we push hard to see, okay, how much of that we deploy effectively to capture more of that profitability and growth for our shareholders. So as long as there is going to be – as long as we see big opportunities in front of us, I think you’re going to expect to see us as making investments to capture it. So it will be part of our profile as a company I think for sometime to come, just given the fact that we think there is a lot of opportunity in front of us.

I think the first part of your question was around what kinds of things are we investing in. I think as Anthony outlined, vast majority of the investment goes into the – our people around R&D, particularly in the areas of platform and product development, data management, we’re finding as we bring in really smart folks around, data scientist regime, we’re seeing those folks create really interesting models for us that we can then deploy against our loyalty program databases very efficiently and effectively. So we’re bulking that up for sure, we just see that as having a real nice near-term, as well as long-term return. Marketing resources, as you well know Andrew, one of the big drivers of our business is how do we get deeper into the databases of our loyalty programs, how do we get closer to the members of these loyalty programs, how do we ensure we’re giving them all opportunities to be aware of our products and participate in them, and a lot of that is really being undertaken through the marketing department and these folks are getting just better and better every day. So, we’re seeing investments on that side of things.

Then, we have investments that are slightly different, something like what you see as doing with PointsHound, so it’s an M&A transaction and it’s an acquisition in its purest sense, but we then bring a lot of those costs in and we’re investing there on taking advantage in some of the smarts in an organization like that to really advance some of our consumer strategy. And that’s still early days but we do think that’s always been a very significant opportunity for us and you’ll continue to see us invest in the consumer piece as we go forward as well. So all things that we get pretty excited about, all things that we have created visibility on returns and again, I think you’ll continue to see us make those kinds of smart decisions.

Andrew De Silva – Merriman Capital

Great, thanks guys.

Operator

Our next question comes from Ed Woo with Ascendiant Capital. Please state your question.

Ed Woo – Ascendiant Capital

Yes, thanks for taking my question. You mentioned previously about somewhat possible disruptions from the devaluation of some of your knowledge program partners, do you see any impact in the current quarter? And then also what’s your outlook for that?

Rob MacLean

Yes, that’s a great question. And you know, I think as we outlined in our – as we laid out guidance for the year, there is a fair amount of change that the programs do on a year-by-year basis and when you start to get to a size of scale that we are where we got 50 to 60 programs that are interacting what us, there is a number of those transactions going on and those changes going on at any given time. I think we did see some of that in the second quarter, I would describe without naming the specific programs, I would describe our experience as being reasonably consistent with what we’ve seen in previous iterations or previous years where there has been some revaluation of currencies. We initially, pretty consistently see if there is a dip in overall performance, and then see the consumer engage with that and a roll back through, and then into a larger growth trajectory once the market has absorbed any of these changes, whether it’s increased pricing in some of our products, or it’s more miles, take that trip to Hawaii, etcetera. It happens a lot and it has happened for many years, I would say that most of our programs are pretty sophisticated and have a pretty good understanding of what their customers will accept and what they can accept, and so they are by and large pretty smart in making changes that they know there may be a short-term drop as things are absorbed but they don’t do something that is designed to – if I can say, just piss off their best customers. They are really doing it to improve the overall profitability of their respective programs which allows them then to provide more value to member’s overtime. So we have seen some of that but it’s behaving very much as we would have expected and what we’ve seen in the past. And when we look out for the rest of the year, we’re not concerned at all about what’s kind of pending or outstanding the way we were as we entered the year.

Ed Woo – Ascendiant Capital

Great. You mentioned earlier about how you are seeing some softness in drop – what’s the overall outlook in terms of the travel initiative, like it’s doing relatively well. And do you think that has a correct impact on your business? And what’s outlook I guess, for the rest of the year?

Rob MacLean

Another good question. I think we’ve seen travel rebound quite nicely, our business obviously with record growth of 68% and that kind of activity that we’re delivering here in the second quarter is pretty reflective of that but generally I would say the second quarter was quite strong, both in Europe and in our North American business, and obviously that’s reflected in our results. As we look out in previous quarters and we look forward, we still see very strong fundamentals in the North American marketplace, we’re quite optimistic that that market is feeling very robust, we’ve got membership very engaged which our partners are feeling very good about their businesses, you’ve seen some of our partners report excellent results, so that is all quite consistent. I would say in Europe, notwithstanding the fact that we had a very, very robust second quarter and we saw year-over-year growth in the second quarter, north of 20% on the European business. So it is more spotty when we look at the overall year, we’re little more conservative than that. We think overall total margin dollars are up this year on the European business, but it’s not going to be – we don’t see it growing nearly as strongly as we are expecting in the North American marketplace. What I would say in Europe though is, we still – we see a very engaged partnership base, so our partners that sit in the European environment very engaged with the things we’re doing, most of what we see kind of slowing down Europe is really around macroeconomic issues, it’s certainly not interest in engagement from our partners, and that’s demonstrated by new launches with Etihad recently, and we just announced today that one of our core partners or core products transfer went our launching with KLM-Air France is one of our large partner. So, very pleased with the way that is going and we’re hopeful that we can help some of our European partners bend us some of these macroeconomic issues.

Ed Woo – Ascendiant Capital

Great, thank you, and good luck.

Rob MacLean

Thanks.

Operator

Our next question comes from Peter Hommins with RCW Wood Company [ph]. Please state your question.

Unidentified Analyst

Great quarter. I had four questions which I would – maybe in the interest of consistency ask at the beginning and you can sort of address them one by one. Pipeline, how do you define pipeline, that is to say in what period of time master deal be closable [ph] on amount, specific amount be closable to make it into the pipeline, or do you define it differently from that. And how often does your VP of Sales and Marketing scrub with the entire sales team that closable size? Related to that is the pipeline growing faster or slower or sort of just steady as you go in dollars or percentages?

Rob MacLean

Okay, that’s four or two?

Unidentified Analyst

That’s two. I found myself talking too much.

Rob MacLean

Hey, Peter. So first question, one that been around our definition. As I described earlier, it really we think about operating our pipeline in pretty traditional sense you’d have three or four different phases or four or five different phases in the pipeline. So whether we’re prospecting with somebody that we’re having initial introductions were in discovery where we’re exchanging data and information which is usually – we have good close rates when we get to that stage. We get to proposal stages where we’re exchanging paper and then verbal agreements is the next stage, and then the last which we typically we’re in development.

And so I would say, when we think about the pipeline that I described today, we have partners in all of those stages. So that would be probably the short answer in terms of how we define it, we don’t define it in terms of a [indiscernible] will be launched in 12 months or 24 months or two months, partly because the kinds of organizations that we work with, the timing is not easily predictable. So we spend more of our time thinking about as they get to these different stages, what’s our likely close rate, and that’s something we as a group – and I spend a lot of time as you would expect on the business development side and with our business development team.

The second part of that question really is around how often are we scrubbing it and evaluating it. I would say we’re doing that on a weekly basis for sure. And part of that comes from the fact that, as we add resources and we’re in new markets, whether spending more time in Asia, or Latin America, or the Middle East, we’re just getting evidence of more opportunities than we frankly recognize previously. So, overall there are very few periods that we look at the pipeline and think it’s gone anywhere but in terms of opportunity. Generally speaking, the short answer to your question is it growing faster or slower, it’s growing faster, particularly from the perspective of the kinds of companies that are interesting to us.

I will reiterate, typically we think about the pipeline and think about the kinds of companies that we want to work with and that we can bring value to – really meeting a couple of key criteria, one big million plus members, have a standalone or fungible currency that we can monetize on their behalf. And then third, the programs that are moving or acted in or moving to kind of profitability motives are really interesting to us. And so those three characteristics when I look at the opportunity or the number of companies that would fit those criteria, it’s bigger today that it’s ever been. And part of that is, these are very healthy industry, there is hundreds of thousands of new members joining loyalty programs every month, and so our opportunity just will continue to grow.

Unidentified Analyst

As you said earlier, that’s one of the things the vast majority of investors are completely unaware of. The last two questions are probably, fairly simple. This is the first quarter in which the cost of principal declined in the last five quarters. Was there any particular reason for that? And should we expect to sort of stay around here or decline or move back up because that’s a phenomenon of – that’s one. And then, most importantly for you’re capturing the $2.8 billion, do you have a sense of the percent penetration of your largest partners, members, whom you will consider or they would consider regular generators of revenue for PCOM?

Rob MacLean

So let me – I think I’ll get this. I think your first question is really around gross margin percentage, it’s really late [ph] for that. So, and we’ve indicated we would expect – back half of ‘13 we were tracking in or around 15%, plus or minus gross margin percentage. As you would know and many of our investors would know, we typically start the beginning of the year as Anthony outlined, at the lower gross margins and then we will advance and improve those gross margins, really a combination of mix and also a combination of the fact that as we move through volume based incentives, we get some positive pressure on margins. And I think I indicated after the first quarter that some of those threshold pricing, given the growth we experienced in the first quarter and obviously continued and built upon in the second quarter, we move through a number of those volume based incentives pretty early this year. So we’re starting to see some of the value associated with the increased margins on those deal. So I think that’s why you’re seeing a bit of a reset in the first quarter of those thresholds get reset and now we expect it to be in the 15% to 16% as Anthony said through the course. So I think that’s really the implication of your first question.

Percentage penetration for our existing partners, let me tackle it this way. We think about the opportunity for our products and one of the legs of the stool would be, how deep into the databases of our partners can we expect to get. So when we think about today, plus or minus 2% of our – on average our loyalty programs, the active members about – plus or minus 2% of those active members interact with our products in any given year. We think the opportunity is closer to 8% to 10%. What that means is that we don’t add new partners earning in products that we’re successful in getting to that kind of penetration, he is going to drive four to five times the activity and transaction and therefore economic. So we get quite interested in making sure we become really good and get better on a daily basis against that objective.

To answer your question, we do see some of our partners where that penetration rate today is approaching or right around 7%. So we get – that provides us with some optimism that we’re not trying to reach for something that’s unachievable, we’re already today with some of our sizeable partners approaching 7% penetration. So I believe and I know the team here believes that if we can get all of our partners, just to the existing high water mark, we should be able to deliver dramatically more value to them, but also to ourselves and to our shareholders because as we make more penetration into those databases, we do that typically very efficiently, and you’re going from that same product mix to just deploy much more transactional activity and therefore, much more profitability against the business. So we like the idea of dragging everybody up to that high water mark at plus or minus 7% and then frankly we think there is opportunity from there.

Unidentified Analyst

And that is every bit is important to my opinion as the signing of new content providers and that sort of thing, or perhaps more, for access – is a pretty good efforts.

Rob MacLean

Yes, for sure.

Unidentified Analyst

Thanks very much.

Rob MacLean

Alright, thanks, Peter.

Operator

Ladies and gentlemen, we have run out time for questions. This concludes today’s conference. All parties may disconnect. Have a great day.

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