Short break online retailer On The Beach (LON:OTB) delivered a profit warning today, citing weak Sterling currency as a prime reason in full year performance below expectations. The shares dived 20% initially, but since have recovered:
In the context of the bigger picture, this drop is not so bad. The price of a share was approximately the same at the start of 2019, and overall the price has shown good growth since flotation. This is at odds with many other profit warnings which drop the price to multi-year lows.
It is also perhaps no surprise that a travel firm is issuing a profit warning as there have been many headwinds within the sector. Both Thomas Cook and TUI have had issues and released their own profit warnings. Both are much more complex situations than On The Beach, but OTB have concentrated down into a rather narrower market: mainly beach holidays, mainly UK-focused. There is no secret about the macro winds blowing here: greater uncertainty and a weaker currency.
The warning comes in a trading update RNS. The warning is straight to the point and is contained within the first paragraph:
On the Beach operates a flexible model incorporating dynamic rather than currency hedged pricing for the packages that it provides its customers. With the increased likelihood of a no deal Brexit, Sterling has significantly devalued against the euro since the beginning of May and this accelerated at the end of July, continuing into August. Whilst the Group has seen a strengthening of demand in H2, this weakening of Sterling leads to a significant increase in OTB prices versus full risk competitors with currency hedges. As OTB remains focused on profitable growth, these relative price increases make it difficult for the Group to gain share of market while maintaining margins.
As a result, the Group anticipates delivering a full year performance below the Board’s expectations.
There is no quantification about what this may mean, and there are no broker notes available to help us out here. It may be plain that bigger competitors have some natural currency hedging in place as they can collect payment in various currencies, but it seems that the flexible model was a choice rather than a necessity.
Off the bat, we can see why On The Beach has been so highly revered by the market. The level of growth has been excellent, with turnover set to triple within six years. This has not been done by simply discounting into the market to get that growth, as margins have held up tremendously as well, in a further vindication of their model.
The legacy problems surrounding firms like Thomas Cook and TUI were well known, having large costs associated with operating shops when most people were transitioning to the internet. They now have vertically integrated models (owning both hotels and airlines) but margins have struggled to go over a couple of percent. On The Beach is unburdened by any of this, and has an operating margin in the region of 25%, which is excellent.
Cash conversion rates are excellent, although it has only been recently that dividends have begun to be paid (and quite modest ones at that).
Although to an extent this is to be expected: companies such as this collect money in advance from customers (in some cases very far in advance) but pay suppliers in arrears. There is a low level of capex, but the real expense in this company is marketing, which comprises a third of revenues. It is such the case that while On The Beach are expanding overseas, the costs needed to advertise are dragging this segment into a large loss, although clearly the hope will be that this will end up paying for itself as the brand gets traction.
Capital expenditures have increased sharply in the past year owing to an acquisition and move to new premises. Development spend is also capitalised, so is something to keep an eye on.
Cashflow can also be a big issue for companies such as this, as liabilities accrue much later than when the money was received. This in part did for Flybe. It may be plain to see that the cash balance may vary heavily with seasonality, as beach holidays also tend to be quite seasonal. There is a borrowing facility in place which reads as such:
This seems fairly cheap, and the covenants seem pretty safe unless EBITDA drops sharply here. Which even with the currency woes, seems quite unlikely at present.
Overall it is hard not to have a positive view of this business. Growth seems to be well managed, and their initiatives for further growth seem to make some sense. For instance, long-haul is also being targeted now, and with the acquisition of Classic Collection Holidays, there is a degree of diversification into other types of holiday. It could have been this profit warning may have been foreseen by the market, as the price has drifted down steadily. If we can believe that the growth can be maintained, the valuation does not seem too punchy.
There are some bear notes, in that the quantification of this profit warning is missing. And considering that most of its income would have been in sterling, and most of its liabilities in other currencies such as Euros, it may have been prudent to hedge to protect itself against a devaluation. Sterling has not dropped off a cliff but rather undergone a gradual but marked fall. There are also no notes to infer whether any hedging might take place in future, in case the currency gets even weaker, which it may do if a no-deal Brexit occurs.
The longer-term prospects for the business are also not well-known. To be sure it has grown remarkably in the past few years, but a bigger expansion would put it up against the likes of Expedia. Operationally I would see it as quite difficult to get any advantages to stick, as I would expect to be able to get the same product on multiple sites and perhaps cheaper if they do not have to price for currency risk.
I can’t argue with the good work that has been done so far here though, so I will have to sit on the fence. 3/5.