When a highflier like Travelzoo (TZOO) misses earnings, the aftermath is generally not pretty. In the two weeks prior to its earnings release, Travelzoo shares gained about 15% as investors were expecting robust earnings like the company announced in the previous quarter. When investors learned that the company not only missed the bottom line by nine cents (0.30 versus 0.39) but that even the top line was lighter than expected, Travelzoo's shares were crushed, falling 30% the next day.
At $55, the shares are about 45% off of the 52 week high, but still up nearly 40% from the start of the year and more than triple the level they were at just a year ago. At current levels, shares still trade around 35x 2011E EPS and ~23x 2012E EPS. While I wouldn't go so far as to say the shares are a steal at current levels, I do feel that there is a unique opportunity to profit off of the implied volatility in Travelzoo shares.
Given the massive premiums in the options, there is a great play here that could generate a 200% return on invested capital over the next nine months with considerable downside potential. Also, in my opinion, though analysts seem to be doing a good job estimating current year earnings, I think most analysts are not giving the company full credit for next year's potential. This is all the more true given the doubts arising in investors' minds following the earnings disappointment.
Let's look at the disappointment first. Analysts were expecting 39 cents on $39 million of revenue. Not only did the company miss by nine cents due to higher than expected spending, but it even missed the top line by $1.4 million. The higher spending seems to not have been properly communicated by management. Apparently management believes it indicated that it would be running some TV ads as a test. Unfortunately, investors did not realize the results would be so horrible - $2 million in ad spend with no positive results!
Also, given the fact that Travelzoo does not provide forward guidance, management could have done a better job in communicating that it will be investing in the Local Deals rollout. That said, I'm not sure how investors could assume that the company would build a $100 million revenue run rate business in less than a year with no investment. Its only appropriate that the company had the biggest jump in employees in its history.
I think this is a positive given the traction in the Local Deals business and the fact that this new business has jumpstarted an otherwise stagnating company. Lastly, given the nine cent beat last quarter, it is possible that some of Travelzoo's customers may have spent more of their vacation dollars in the previous quarter which adversely affected Q2.
In any case, I believe Travelzoo's long-term growth prospects remain intact, and management has done a better job communicating their growth strategy on the latest earnings call.
Following the company's Q1 earnings announcement, analysts significantly increased their expectations for this year and especially next year given the rapid traction in the Local Deals business. Similar to GroupOn (GRPN), Living Social and others, Travelzoo began its Local Deals offering about a year ago. With over 20 million affluent travel-savvy consumers who have opted to receive Travelzoo's exclusive, curated travel deals newsletter each week, TravelZoo was ideally positioned to provide such a service.
In just a year, the company has expanded the Local Deals offering to 75 markets in six countries. In the latest quarter, it added 27 new markets, up from 18 in each of the previous quarters. Most of the increase in headcount (up from 296 to 343 in the latest quarter) was related to the expanding Local Deals business. Management indicated it is currently generating about $33,000 in gross revenue on an average deal, which has remained constant in recent quarters.
Established markets are generating higher revenue per deal; however, given the pace of expansion, new markets are holding the average down. If Travelzoo is in 100 markets next year (it should be in 100 markets within a few months) and continues to generate $33,000 per deal (it should generate more next year) and it offers 2 such deals per week, the company could generate over $340 million in gross revenue.
Management previously indicated that it receives 30-40% of gross revenue, which is in line with the nascent markets norm of 30-50%. Assuming that competition limits the company to 30% of gross revenue, Travelzoo should still generate over $100 million in additional revenue from the Local Deals business. Based on reported gross revenue of $26 million in Q2, the company is already doing over $100 million in annualized gross revenue ($30-35 million net based on 30-35% take).
Travelzoo's core business is expected to grow at a page of 15-20% per year next year, similar to this year. That suggests the core business should generate about $130 million this year and possibly $150 million next year. Add to that the local business and you get about $162 million for this year and possibly $250 million next year. Analysts are estimating on average $162 million for this year but only $210 for next year.
Based on this analysis, I believe analysts' estimates properly take into account the trajectory of new revenue opportunities for this year, but significantly underestimate next year's potential. Even if the company is unable to expand margins despite a much larger business, based on 25% margins and a 37% tax rate, Travelzoo could generate EPS of $2.43 next year. A 200bps increase in margin would equate to EPS of over $2.60. 22x forward earnings is a pretty reasonable multiple for a company that is growing 40-50%.
In my opinion, the ideal way to play this stock is by selling puts. There is so much implied volatility in Travelzoo's shares, that the premiums one could earn for selling deeply out of the money puts is about as impressive as I've seen in a while. One could sell December $40 or $45 puts and earn a 15-20% return, respectively, without risking a single dollar of losses unless the stock declines a further 35-40%.
Most options investors have margin accounts, which results in a 200% return in less than 9 months since selling such far out of the money options generally only requires an investor to hold 10% of the strike price as collateral plus the options proceeds. If you want to be even safer, and especially if you are unsure whether the company can exceed expectations in the near-term, you could protect yourself by buying September $40 or $45 puts for just $1-1.50.