[show_to accesslevel=’almanack’] We explore the business of India’s leading software products company that caters to the airline and travel space.
Statutory Warning: This is NOT an investment advice to buy or sell shares. Please make your own decision, as blindly acting on anyone else’s research and opinions can be injurious to your wealth. I do not own the stock, but my analysis may be biased, and wrong. I have been wrong many times in the past. I, Vishal Khandelwal, am a registered Research Analyst as per SEBI (Research Analyst) Regulations, 2014 (Registration No. INH000000578).
The Big Picture
A 23-minute flight over Tampa Bay, Florida, on 1 January 1914 changed the world. It marked the beginning of commercial aviation, the brainchild of three visionaries – Percival Fansler, an entrepreneur who saw commercial opportunity in the technology of flight, Thomas Benoist, who built the aircraft, and Tony Jannus, who piloted the plane to its destination.
But it was a fourth person who made their vision a reality – by purchasing a ticket. Abram Pheil paid US$ 400, the equivalent of US$ 9,500 today, in an auction for the privilege of being the sole passenger on the first commercial flight. Not long after, however, one-way tickets regularly went on sale for US$ 5. It took only slightly longer for the St. Petersburg-Tampa Airboat Line to cease operations, highlighting a challenge that the aviation business continues to face to the present day.
There was, however, no turning back. Air travel was off and flying as a business and from a single aircraft, a solitary route, and a lone passenger has grown into an industry that transports 3.5 billion passengers every year on more than 50,000 routes; boasts a global economic footprint of US$ 2.4 trillion annually; ships US$ 6.8 trillion worth of air cargo yearly; and supports 58 million jobs worldwide. (See more stats from the airline industry on the next page)
In the past 100 years, more than 65 billion passengers have travelled by air. And the world has benefited from the advent and advance of commercial aviation. Economies have thrived, cultures have been experienced and exchanged, families and friends have been reunited – all thanks to air connectivity.
But then, airlines globally have never been a profitable business. In fact, when someone once asked Sir Richard Branson, the much-acclaimed chief of Virgin Airlines, how to become a millionaire, he replied, “That’s easy. First you become a billionaire and then you buy an airline.” Here is what Warren Buffett wrote in his annual letter to Berkshire Hathaway shareholders in 2007 –
“The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favour by shooting Orville down.”
The industry’s demand for capital ever since that first flight has been insatiable. Investors have poured money into a bottomless pit, attracted by growth when they should have been repelled by it. Ever since the invention of the airplane, the industry has been one of the world’s most eye-catching. The appeal of global air travel has always drawn capital to the industry. So finding money has never been the problem – making consistent profits has always been the challenge. The industry is much better known for losing money than for making it.
Anyways, air traffic over the last 40 years has grown at 1.5x world GDP and the passenger airlines clocked around US$ 750 billion in revenues in 2014. Post-tax margin stood at just 2.2%, though better than 1.5% earned in 2013 (Source: IATA). The industry earned an ROIC of 6.5% in 2014, which was better than its 10-year average ROIC of 4.3%, but less than its cost of capital.
Airline business, which was a monopolistic and profitable business till mid 90’s, is now one of the most complicated, competitive and vulnerable businesses in the world. Rising fuel prices, major government pressures on tougher security measures and a tough global economy have cut profits and airlines are working hard to operate within parameters of costs and budgets.
Now, despite the poor performance that has hurt the industry players for long, there is no denying that air transport is one of those few industries that have radically transformed the world. Over the past forty years, air travel has expanded ten-fold and air cargo fourteen-fold, compared to a three to four-fold rise in world GDP. Yet over this period, airlines have only been able to generate sufficient revenues and profit to pay their suppliers and service their debt. There has been nothing left to pay investors for providing equity capital to the airline industry.
Does this matter? Well, now that 75% of the world’s airlines are at least majority owned by the private sector it should be a concern that today’s ROIC do not justify retaining the existing capital invested in the airline industry. Of even more importance is the need to attract US$ 4-5 trillion of new capital over the next two decades to buy aircraft to meet the needs of expansion. Improving the efficiency of use of existing capital, and the returns it generates for investors, will be essential to attract new investment to the industry.
While the industry has done some work over the last decade on the cost reduction front, like reduction of travel agent commissions, e-ticketing, global alliances, and code sharing, one of the key initiatives towards improving profitability has been to outsource most of the non-core processes like aircraft maintenance, repair and overhaul (MRO) providers, catering, ground handling, and technology. In fact, such has been the scale or outsourcing that investors have earned ‘excess profits’ i.e., a higher return than they would have got by investing elsewhere, in these outsourced processes.
Consider the chart on the next page that shows the ROIC vs cost of capital for various entities in the airline value chain. The chart makes it clear that airlines are surrounded by stronger business partners. In fact, every supply sector and every distribution sector earned a higher return on capital during the past business cycle than airlines. Most earn more than or close to their WACC.
Many of the suppliers to the left of airlines in the chart above earn returns on capital higher than their cost of capital. Services (MRO, catering, ground services), which have been outsourced by around half the industry, earn an average return of 11% compared to cost of capital of 7-9%. The highest returns in the air transport supply chain are earned in the distribution sectors. Computer Reservation System (CRS) services provided by the Global Distribution Services – GDS, which is a network operated by a company that enables automated transactions between travel service providers, mainly airlines, hotels and car rental companies, and travel agencies – earn an average return on capital of 20%, double their 10-11% cost of capital.
It is no surprise that CRS has seen some high-niche, tech-oriented businesses that have built solid competitive advantages over the years. The industry is consolidated among three big players – Amadeus, Sabre, and Travelport. These companies are also engaged in providing various technology solutions to the airlines industry, along with airline-owned companies like Lufthansa Systems. And then there are third party players like NIIT Technologies and Accelya Kale, the company I’ve analysed in this report.
About Accelya Kale
Accelya Kale Solutions Ltd (AKSL) is a leading solutions provider to the airline and travel industry. It was earlier called Kale Consultants, but changed its name to the current one post its acquisition by Spain based Accelya Holdings in 2010.
AKSL’s expertise spans across the following areas of an airline company’s technology requirement – Revenue Accounting, Audit & Revenue Recovery, Credit Card Management, Miscellaneous Billing, Finance & Accounting Processes, and Decision Support & Analytics. The company is especially strong in the Revenue Accounting space where it serves around 13 airline companies and holds a 6.6% market share.
Revenue Accounting, as I understand from my reading of a few research papers on the subject, is a critical function that involves sharing of revenue on a prorate basis between interline carriers. A typical airline Revenue Accounting process is characterized by –
• Critical impact on financial performance of an airline
• High level of complexity requiring specialized handling
• Demand for specialized trained professionals – having intimate knowledge of business and airline accounting practices
• Highly people-intensive
• Time consuming operations
With global air passenger traffic slated for positive growth averaging more than 5.0% per year (as per Global Market Forecast by Airbus), airlines are expected to face an increasing load on ticket processing, and thereby increased need for revenue data. Besides resulting in higher operational costs, this can lead to difficulties in verification of interline billings and increased gaps in revenue collection. Given the dynamic market environment, greater need for timely revenue information and limited specialized human resource, it is becoming increasingly challenging for airlines to maintain revenue accuracy and reporting schedules. In this context, many airlines are incorporating outsourcing as a strategy to efficiently manage their Revenue Accounting function while focusing on their core competencies.
As per a white paper from NIIT Technologies, traditionally, the market for Revenue Accounting system providers has been segregated based on their geographical locations. While some airlines in Asia Pacific, stick to their in-house solutions, others have migrated to AKSL’s revenue accounting product called Revera. The best part about AKSL’s business is its pay-per-use business model, which helps its clients avoid capital expenditure and achieve business growth; it also provides the company annuity revenue streams.
With most airlines plagued with huge fixed costs, it is imperative for them to take decisions with regards to their capex and opex, and a high level of agility to overcome these obstacles. This is where the opportunity lies for AKSL, which is a known brand in the “third party” airline revenue accounting space, through its Revera platform.
As per the AKSL’s product brochures, Revera is an automated passenger revenue accounting system that helps audit and verify airline ticket revenue, and therefore provides transparency to an airline’s revenue flow, trends, and analysis, as well as statistical data that is important to other departments like accounting, finance, and marketing.
While the company also sells other solutions in spaces like cost management and billing, a majority of airlines that count AKSL as a key vendor do so for its revenue accounting capabilities.
Anyways, let’s now analyse AKSL’s business using a set of questions to test the underlying business and management quality.
1. Has the company done well in terms of sales and profit growth over the past few years?
Extremely well. AKSL’s sales and net profit have grown at average annual rates of 17% and 31% respectively over the past 10 years. Growth over the past five years has been impressive too, at 13% and 23% respectively for sales and profits.
A significant part of this growth happened during the FY10-13 period, post its acquisition by the Accelya Group in 2010. AKSL’s revenue and net profits grew at an average annual rate of 22% and 47% respectively during this period. Prior to the acquisition, AKSL’s revenue growth was lopsided on account of licensed sales, which generally are lumpy. However, post the buyout, AKSL has focused predominantly on annuity revenues. This has helped to improve revenue predictability and trim volatility. As a matter of fact, the share of annuity revenue in AKSL’s total revenue from the airline industry increased from 42% and 70% in FY02 and FY04 respectively to 94% in FY13 (till data is available).
As per KPMG’s 2014 analysis of the airline revenue accounting market, demand for such outsourcing is expected to grow at a rate of 25% per year over the next five years. The agency expects that in the next five years, outsourced solutions will absorb the lion’s share of new revenue accounting implementations for airline companies. While smaller, low-cost airlines will lead the way in moving towards outsourced revenue accounting systems, even the larger airlines in North America and Europe that are currently satisfied with their in-house systems, will soon begin transitioning to outsourcing solutions since their legacy systems are no longer able to handle increasingly complex processes.
As a matter of fact, the International Air Transport Association (IATA) counts 240 airlines as members, about 84% of total air traffic. Around 25% of its members are low-cost airlines. Currently, there are around 50 carriers with outsourced revenue systems, leaving 200 to 250 as potential targets for outsourcing. It is estimated that, annually, 10-15 carriers outsource all or part of their revenue accounting systems. With well over 50% of the market working on a legacy platform, there is a large opportunity for outsourcing among large carriers particularly in North America and Asia Pacific regions with specific segment opportunity in Europe, especially among emerging carriers. All this spells great news for AKSL, as it expects to garner a bigger share of such outsourcing. While repeating 30% profit growth achieved in the past may look difficult as it was on a lower base, the company still looks to be on a good ground to grow strongly in the future.
What is more, as the airline industry witnesses rising passenger volumes – global air passenger traffic grew by 6.5% in 2015, the fastest pace since 2010 and well above the 10-year average annual growth of 5.5% – carriers would have to continue to improve their technological systems, including revenue accounting. This could create a bright growth opportunity for AKSL.
2. How profitably have retained earnings reinvested?
Being in the software products industry that has a high operating leverage – profits grow at a faster rate than revenue after initial product development costs are recovered – AKSL’s is a high ROE business. The same has averaged around 35% over the past ten years, and 48% over the past five.
Given that the business continues to generate more cash than it consumes, AKSL is retaining a small part of its incremental profits while giving away a large portion to shareholders as dividends. The return on what has been reinvested has been great.
3. Does the company need to constantly reinvest in capital?
AKSL’s business is not asset heavy, and thus does not require heavy/constant capital investment. Depreciation has approximated capital expenditures over the past decade – both have averaged around Rs 130 crore over the past six years – and typically consumes between 4-5% of sales.
The combination of the company’s high margins and low requirements for capital investment results in significant annual cash flow as shown in the below. As a matter of fact, AKSL’s average free cash flow has been around 96% of its net profit over the past five years, which is remarkable.
4. Does the business have a durable competitive advantage?
When one observes a business with favorable economics, it is important to consider whether the same is transitory in nature or enduring. In AKSL’s case, one kind of moat that looks sustainable is its technological competence and intellectual properties (IP) built over many years. The company was not able to scale the business in the pre-Accelya days which could generate the amount of cash that such product-led businesses had the potential to generate. But post its acquisition by Accelya, this scale was available and the results have followed in terms of high sales and profit growth. The business now operates at 40%+ operating margin and 22%+ net margin and is a great cash spinner.
One other aspect of AKSL’s moat that is worth noting is the fact that switching costs could be relatively high for its customers. A software solution that is integrated across and deep into the systems of a company certainly creates switching costs in the long run. In addition, as long as the vendor is doing a good job and is staying up to date on technological advancements, carriers would have little incentive to change to another vendor and risk disruptions that could be very costly to the business and to their own customers. Inertia resulting from a satisfactory status quo situation can be very powerful, which I believe could make AKSL’s moat to endure for a long period of time.
Overall, AKSL looks to be standing tall on account a factors like cost arbitrage (that’s enjoyed by most Indian IT companies, good visibility of business, high stickiness among clients, high barriers to entry for new players and non-discretionary nature of its service. But one still needs to consider whether these advantages are sustainable, which they look to be as of now.
5. How has the management fared?
If one goes by AKSL’s history and financial performance over the years, the management comes out as clean and highly capable of sound capital allocation. The company’s promoter Mr. Narendra Kale who started AKSL 30 years back along with seven other members, stepped down from the role of Chairman in 2011, and was succeeded by Philippe Lesueur, who is also the Chairman of Accelya Holding World SL and all Accelya Group companies worldwide. The business, under this new leadership has done extremely well, and has also shared the spoils with shareholders in the form of high dividend payouts.
6. What are the risks to the business?
The biggest risk for a technology company is obsolescence, and AKSL’s case is no different. While the existence of just around 11 companies globally that service the space that AKSL does talks about the competency the company possesses, it still needs to remain on top of advancements, especially in the airline revenue accounting space.
Another key risk for AKSL is that of losing a big customer. While the industry trends are suggesting otherwise, it may happen that a big airline and AKSL’s customer decides to bring the system in-house and hence not renew the contract with the company. AKSL in fact lost a big customer last year, but that was due to the merger of that customer with another company.
AKSL’s stock is currently trading at around Rs 928, which implies a P/E multiple of 20.0x its trailing 12-months earnings of Rs 46.4 per share. This isn’t deep value, but then for a company that has built a strong intellectual property as AKSL, earnings are not the right barometer. Cash is.
For any new company that wants to build a business like AKSL’s, it needs to spend a lot of cash on building its own IP, brand, customers etc. On the other hand, an established IT business like that of AKSL would generate a lot of cash as such initial investments have mostly been incurred, which is true in case of the company.
Now, for such a business where capex requirements are small to nil, and which generates a lot of cash, capital allocation is of paramount importance. And AKSL has a stellar record on this front. Apart from allocating its capital well, the company has been paying a large part of cash as dividends. Its dividend payout (dividend divided by net profit) has averaged around 95% over the last four years, and the current dividend yield (dividend per share divided by current share price) stands at around 4%.
So, while the current multiple is not outrageously high in light of potential earnings growth and the cash generation abilities of AKSL, we need to also consider the underlying risks of the business. You, as an investor, must consider both sides of the case – opportunities and risks – plus ensure sufficient margin of safety in the stock’s price, before making any investment decision.
Statutory Warning: This is NOT an investment advice to buy or sell shares. Please make your own decision, as blindly acting on anyone else’s research and opinions can be injurious to your wealth. I do not own the stock, but my analysis may be biased, and wrong. I have been wrong many times in the past. I, Vishal Khandelwal, am a registered Research Analyst as per SEBI (Research Analyst) Regulations, 2014 (Registration No. INH000000578).[/show_to] [hide_from accesslevel=’almanack’]
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