The last post, How Airlines Generate Float, compared the similarities between airline mile programs and insurance companies. I argued that airlines are now essentially generating float through their miles programs. Turns out it’s not that original of an idea (as much as I wish it was!) as there are at least two publicly-traded mile program managers in Brazil.
One of these mile program managers is Smiles (SMLE3 BZ). Smiles actually directly calls out the “float” element of their revenue stream.
In essence, Smiles derives its revenues via the following ways:
- Mile Sales – Smiles sells miles to program partners (e.g. airlines and banks). Partners give these miles to customers as a way to reward loyalty such as through airline frequent flyer programs and credit card points. From Smiles’ perspective, mile sales generate revenues as well as a future obligation to honor mile redemptions.
- Float – Since mile redemptions occur months or perhaps years after customers earn/purchase miles, Smiles’ business model generates float. Like Berkshire’s insurance businesses, this float is carried as a liability but can be used/reinvested by Smiles to generate further revenues.
- Breakage – And lastly, breakage, which refers to the revenues that is recognized from miles that expire/are never redeemed. Note this is primarily an accounting concern (earned when miles expire), while from a cash flow perspective, there is no additional cash inflow associated with this revenue.
Smooth Sailing Through Stormy Skies
So how does this type of business model perform? Quite well actually.
Below are recent performance figures pulled from the latest Institutional Investor Presentation (March 2017). Despite the deep recession in Brazil and challenged airline industry, Smiles has been able to grow EBITDA margins over the last 2 years. 3Q14 – 1Q15 appear to have been the most challenging periods over the last two years (which saw earnings pressure), but the company appears to have been able to adjust fairly quickly and return to 40-60% YoY earnings growth by mid-2015. That is remarkable.
One other thing I’d point out is the growth rate differential between miles accrual and miles redemption (both ex-Gol, more on this in the next section). Except for the last 3 reported quarters, miles accrual growth rates far exceeded miles redemption growth rates. However, even though miles redeemed has been out-growing miles accrued, miles accrued is still growing faster on an absolute basis because it is a much larger number. Smiles references a “burn/earn” ratio, which came in at ~80% in the last Q. The faster growth in miles accrued vs miles redeemed is something that I argued would likely be the case in my previous post, and it is an important factor in driving the growth of float.
Finding the Pocket of Turbulence
As wonderful as this business appears to be, there are reasons why this company trades at only 14x LTM P/E despite a 6.7% dividend yield, HSD-to-teens revenue growth, and MSD-to-HSD EPS growth…
The largest concern is around Smiles’ ability to control its own destiny since it is closely linked to Gol, one of the largest Brazilian airlines. In fact, Smiles was created from within Gol to operate the miles program. A very significant proportion of Smiles miles is redeemed for Gol flights, and thus the value of Smiles miles is highly dependent on Gol’s operations. Unfortunately, Gol is highly levered and not particularly profitable. To make it more complicated, Gol remains a 54% owner of Smiles.
Although Smiles has operated admirably well during the recent recession in Brazil, Smiles’ equity hit major pockets of turbulence as Gol’s fortunes rose and fell.
But there is always a price. What price is appropriate for this kind of a business model if the company is not fully in control of its own destiny?
Smiles has a fascinating business model and validates a number of arguments in my prior post.
But I do wonder about two things:
- What is this type of business mode capable of if the float is used for investments similar to how Berkshire reinvests insurance float (or excess cash flows generated from his operating businesses)?
- Although airlines have attractive miles programs that generate float, they are used to finance cyclical operating businesses that have been prone to irrational competition. Although Smiles is a publicly-listed miles program pure-play, it is not free from the influence of an associated operating airline business. Would it be possible to isolate the advantages of the miles program and limit the exposure to the pure operating business?
Disclosure: I have no direct beneficial interest in SMLE3 BZ as of publishing date and have no intent to initiate a position within the next 48 hours.