Future Still Looking Good for Travelzoo

Includes: EXPE, PCLN, TZOO
by: Long Value

Travelzoo (NASDAQ:TZOO) has seen a rising tide of interest over the last few months based on stronger than expected Q3 results, the launch of local deals and most recently with Google’s (NASDAQ:GOOG) failed attempt at acquiring Groupon for $6Bn. While the Street has become more aware of TZOO as a result of these events, the company is still generally viewed as an expensive comp of Priceline (NASDAQ:PCLN) or Expedia (NASDAQ:EXPE), when the company is in fact more of a comp to a hybrid of Google and a newspaper due to its dependence on ad revenue, but with revenue and margin growth that is derived from greater circulation.

As a result of these comps and a misunderstood business model, the Street seems to view TZOO as overvalued. Short interest in TZOO over the past few months has grown substantially as a raw number (990K shares on 10/15 to 1.6MM shares on 12/31), although much higher trading volume since last quarter's earnings has lowered the days to cover the short position. With only two analyst estimates of $0.18 EPS (Wedbush) and $0.22 (Craig Hallum) for Q4, TZOO should beat these estimates handily, which may force another wave of short covering like that which pushed shares up 18% the day of last quarter’s earnings report and almost 70% since that report. Based on my estimates, I believe shares are actually trading at a more reasonable 20-25x 2011 EPS as "Local Deals" and a profitable European business should help fuel additional EPS growth.

Business Description

Travelzoo is a global media company with distribution to more than 21 million subscribers worldwide as well as millions of website users each year. Its core product is an e-mail service that alerts travelers about special deals on flights, hotels, rental cars, etc. The company also operates fly.com, which is a travel search engine similar to Expedia or Kayak (though this is a small part of its business currently).

The company’s main source of revenue is ad sales in North America and Europe via its websites as well as its e-mail newsletters. This past summer, they began to capitalize on the daily group buying phenomena by creating ‘Local Deals," a service that runs short term Groupon-style deals with big discounts on local restaurants, attractions and services.

Local Deals

While the Street has clearly recognized some of the revenue potential from the daily deal space, Groupon-like deals are still a relatively small amount of TZOO’s revenue, but have been growing exponentially, with significant upside yet to be realized. Since launching its local deals in a few test markets in July, TZOO has sold north of 150K deals through its website and earned gross revenue of over $8.4MM. Although it is hard to gauge exactly what the revenue share is on TZOO deals, marketplace comps would indicate around 40% of gross revenue goes to TZOO's top line.

Although Q3 only included a handful of cities and not even so much as an advertisement for Local Deals on the main homepage, TZOO managed to sell over 22K deals for north of $750K in gross revenue (~$300K net). Since launching to several other cities in Q4 as well as making it easier to find the Local Deals page (and some PR), they have sold ~$7.6MM in gross revenue, leading to ~$3MM of additional revenue to TZOO (at 40% revenue share). Because the Local Deals are a high margin product and don’t require a large sales force, around 75% of this revenue makes it to operating income. At a conservative tax rate of 38%, this should mean Local Deals will add ~$1.4MM, or $0.09 EPS. The below data can all be found via TZOO's website for Q4:

Oct. – 35,346 Deals
Nov. – 46.441 Deals
Dec. – 59,357 Deals

Gross Revenue
Oct. - $1,528,920
Nov. - $2,801,644
Dec. - $3,394,431

Today, TZOO is serving 27 markets, and has annualized gross revenue of $16.8MM in Local Deals, although I believe that it is not out of the question that TZOO could earn as much as $30-40MM in 2011 revenue on Local Deals. The keys for 2011 are going to be: 1) launching to several more large cities in both the U.S. and Europe, 2) higher ASP/deal, 3) running deals more than the average of once a week for large markets and once every two to three weeks in smaller markets.

I believe it will be no problem at all for TZOO to be in 25 large markets (13 now) and 25 medium/small markets (14 now) by the end of this year. In fact, they have already launched to five new small markets in January alone and I would expect two to three large city launches in the next six weeks. By simply hitting the first tier U.S. cities in which it does not currently operate (Atlanta, D.C., etc.) as well as several large European centers (Paris, Barcelona, Munich, etc.), this will be no problem at all. TZOO is in fact already hiring for Local Deals managers in several European cities, as seen here. What is also very smart about the TZOO expansion strategy is the hub and spoke model they seem to be employing. For example, Miami was the first major city launch in Florida and from there Orlando, Tampa, Jacksonville and Ft. Lauderdale have followed. TZOO launched London right before Christmas and just launched Gloucestershire this week ... likely places such as Liverpool, Manchester, Leeds, etc. will follow.

The second goal is going to be increasing the ASP/deal. For example, Q4 ASP (excluding the December 99 hour special) was ~$60.50. There were several higher priced deals that sold very well during the quarter as well as a number of large city additions, which pushed this average above the ~$35/deal average in Q3. While a growth in cities and an ASP consistent with Q4 will guarantee earnings growth, to push TZOO to become a portfolio double at this point, ASP is going to need to grow substantially.

A good way for this to happen would be moving into more high priced travel deals such as Living Social is doing now in its LS Escapes or Gilt's Jetsetter.

Finally, TZOO certainly has the ability to run more than one deal a week; whether they end up doing it is another question. For conservatism sake, let's assume they stay with an average of one deal per market, per week and look at the economics for 2011 ...

If Local Deals was to expand to 25 large and 25 small markets by FY2011 at its current ASP, economics would be as follows (realize that markets will be added throughout the year, so some markets will not have full year of revenue ... i have remained conservative to compensate by keeping ASP and number of deals run conservative):

  • 50 (cities) x 52 (1 deal/wk) x $60 (NYSE:ASP) x 500 (coupons sold/deal) 40% (Revenue share) = $31.2MM in net revenue to TZOO
  • $31.2MM x 75% (Op Mgn) = $23.4MM Op Income
  • $23.4MM x 38% tax rate = $14.51MM Net Income or $0.88 EPS
  • On an important note, at $75 ASP, Local Deals is worth $1.10 EPS in 2011
  • At a conservative 25x multiple on these earnings, Local Deals is worth between $22-28/share

Core E-mail Business

The e-mail distribution business is still Travelzoo’s bread and butter and where they get the majority of earnings. With over 21 million subscribers worldwide, TZOO’s distribution list is a powerful advertising tool as well as a good barrier to entry against all but their largest competitors. As of Q3, TZOO earned annual revenue of about $6.20/subscriber in North America and $2.83 in Europe. Historically, TZOO has been able to acquire NA users at a substantially lower price ($1.60 in Q3), while European subscribers have averaged around $3.70 over the last 12 months ($2.90 in Q3).

TZOO's management has been very focused on growth of the European market and as such, costs have been higher in the past several quarters. However, Q3 marked the first time that the European business generated a profit for TZOO as users reached critical mass and both sales and marketing as well as G&A costs were controlled. Over the past seven quarters, TZOO has added 300K net users in Europe each quarter and with the push for growth in Europe, there is no reason to believe this cannot be repeated in Q4. Assuming around 4.5MM European users in Q4 with higher sales and marketing costs (but lower as a % of revenue) and G&A roughly in line from Q3, the Europe business should earn around $7MM in revenue and $1MM of income from operations. Along with conservative net user growth of around 140K in the NA region, TZOO should earn almost $29MM in revenue from core operations for Q4.

European user acquisition costs tend to be difficult to predict from quarter to quarter as they differ according to markets all over the EU, but the general trend should be +/- flat or lower as TZOO gets larger. Generally, as an organization grows, it gets easier to acquire users and the cost should decrease as a function of click-thru and sign-ups. Think Facebook vs. Internet startup. Facebook’s brand recognition helps derive a higher click-thru rate and more people are likely to end up signing up as users. Under this assumption, Europe’s user base growth and lower user acquisition costs should help grow operating income and produce results at least inline with last quarter. My estimate is the core e-mail business should conservatively earn around $23MM in operating income in 2011. At the assumed 38% tax rate, this will result in ~$1.40 of 2011 EPS. If we apply a 20x multiple to these earnings, the core e-mail business is worth about $28/share.

In addition to the normal earnings growth of core e-mail business, I could see a scenario in which the more viral nature of the daily deal product could result in core e-mail user growth above the normal rates that TZOO has experienced in the past. This could result in a higher multiple being applied to core e-mail earnings as well.

Based on the conservative assumptions above, TZOO shares are currently slightly below fair value based on a 22-23x multiple applied to earnings. If shares trade at a more growth-like multiple, legitimized by much higher ASP or greater growth in core e-mail, shares have significant upside from here. Either way, I believe this quarter could be a blowout for TZOO and give the Street notice to the earnings power of Local Deals and TZOO as a whole.

Risks to Thesis

1. Significantly higher user acquisition costs would cut into margins. According to how many users are added and how other costs are controlled, this may or may not have a major effect on earnings. This is somewhat mitigated by the general rule that standard user acquisition costs should decrease as TZOO gets larger and has more brand recognition. Either way, unless acquisition costs are grossly higher, an EPS beat should still be achievable.

2. If Local Deals fails to grow past its current distribution or if the daily deal phenomenon loses significant steam, TZOO may not meet my forecasts in 2011. Lower ASP would also negatively affect the thesis. This is mitigated by the higher ASP in Q4, which has sustained in Q1 thus far as well as avenues of higher ASP growth such as travel packages.

3. A double-dip recession, significantly weaker economic environment or a terrorist attack/threat that causes airline and leisure travel to slow significantly would likely cause shares to trade down despite potentially little effect to the underlying ad-revenue based business.

Other Items/Conclusion

While the company provides additional positives to the thesis, I have left out the financial metrics of growing cash flow and a strong, debt-free balance sheet, the company's ability to re-acquire the licensed Asia business which was sold in 2009 and any upside provided by Fly.com as those are less important to TZOO as a whole (currently, at least) than the new Local Deals vertical. Based on the core operating model as well as the newly launched Local Deals vertical, I believe that not only will TZOO significantly outperform analyst estimates for Q4, but has significant growth potential going forward.