SABR - Sabre: An Attractive If Overly-Levered Business At A Crossroads (Rating Upgrade)

2023-12-10 22:49:50 ET

Summary

• Sabre is a speculative stock with a challenged balance sheet as it is engaged in a significant change to its business model.
• The rise of ultra-discount airlines has significantly altered the landscape.
• I believe Sabre's underlying business remains highly attractive as it has a dominant market share and a limited number of rivals in a high-profit margin service.
• Balance sheet concerns make me cautious, regardless I am moving to a speculative buy as the upside is considerable if management can deliver in 2024.

Sabre ( SABR ) is one of the three major global distribution systems "GDS". These serve as a marketplace and directory for airlines, hotels, cruise operators, passenger railroads, and other such travel businesses. For decades, these firms enjoyed a steady business selling reservations via travel agents and collecting a cut of the transaction.

The rise of online travel agencies, direct-to-consumer ticket sales, and ancillary ticket pricing models have fundamentally shaken up the GDS space, however. Then the pandemic hit, and Sabre found itself in grave danger given its overly levered balance sheet. Indeed, Sabre still finds its share price near all-time lows today:

I previously covered the company in May, assigning it a hold rating given the firm's huge debt load. Since that time, operating results have been a bit ahead of expectations, and conditions in the credit market appear to be moving in a favorable direction. As such, I am moving to a speculative buy outlook today.

Why Sabre Has Plunged: Debt & Business Model Concerns

Before getting into the positives that have led to my more favorable outlook, I want to highlight that Saber remains a speculative stock. That’s due to the challenged balance sheet, which in turn comes about from business transition.

The company is going through a fundamental adjustment to its business model. Up through about 2015, Saber had a stable business with little year-to-year change. Its roots originally came from decades ago when the airline industry had a starkly different model.

People would go buy a plane ticket for, say, $700 with everything baked into that price. However, the rise of ultra-discount airlines has fundamentally changed the way the business runs. Now you might pay $70 for a base ticket but then pay $50 for a checked bag, $30 to pick your seat, $10 to board the plane in the first group, $10 for on-board WiFi, and so on.

The legacy GDS systems like Sabre were not designed with this sort of a la carte pricing model in mind. Rather, they were built for selling individual tickets and specifically for selling more complex ticket routings. A classic GDS use case would be for a ticket involving a change of airlines such as when you’re using an alliance you need to fly with one airline in North America and another airline in Europe. The GDS systems are very well optimized for these complex routings with high base ticket costs. GDS systems thrived with complicated itineraries and the particular demands of corporate travel.

Things have shifted over the past decade, though. Ultra-low-cost carriers have emerged. These are for people who are just looking to buy the cheapest possible ticket from point A to point B, and that’s not what the GDS model was designed for. Airlines have instead pushed for a new distribution content "NDC" model that prioritizes upselling additional services rather than focusing on the functionality around the base airline fee and complex ticketing arrangements.

For quite a few years, the GDS operators, including Sabre, did not rush to the NDC model because the old system was working well.

When an existing model works well and has high profit margins, there’s natural hesitation to disrupt the existing business and try something that could hurt your margins and invite in new competition. Specifically, there have been just three primary GDS systems in the world (excluding China) for many years, and they enjoyed the high margins and stability that come with being dominant players in a small field.

However, between the pandemic, the slump in business travel, and the rise of ultra-discount carriers, the GDS systems had to make a move. They've invested more heavily in new distribution methods. Sabre in particular invested heavily in IT just prior to 2020, which ultimately proved poorly timed. When the pandemic hit, Sabre had already spent all this capital upgrading their system, and they got stuck with interest for paying for those upgrades which in theory should have had reasonably quick returns on investment.

Instead, revenues have been far below expectations since 2020, which is an ugly place to be for a firm with high debt levels. Sabre has been paying mounting interest expenses on its debt, but the IT investments simply haven't had the opportunity to pay off as expected yet.

Unfortunately, we are going into 2024 still with a great deal of uncertainty about what the GDS model looks like going forward. Where are we at in five years when the discount carriers are probably the sizable majority of total airline passenger volumes worldwide? Maybe that won't happen in the U.S. and certain other developed markets, but in most emerging markets the discount carriers are winning the lion's share of new business. So where does that leave the GDS operators? It's not just the transition to the NDC model of charging for tickets, either. Many ultra-low-cost carriers are heavily focused on making customers buy directly from their website or app, cutting out the GDS provider entirely from the equation.

I think if Sabre had a fine balance sheet, we wouldn't be facing this level of existential doubt. To back up that claim, look at Amadeus' stock price versus Sabre over the past five years: (the third GDS, Travelport, is not publicly traded):

Amadeus has held its value, even through the pandemic, though it faces a lot of the same structural questions that Sabre does.

The key difference is that Amadeus is not up against the clock in terms of leverage. Sabre, however, has pressing balance sheet problems and so that’s why it’s in such a weakened position.

Specifically, Sabre is close to breakeven on an operating income basis over the past 12 months. And congratulations are in order there, as the company has been profitable for the past two quarters and should generate a respectable annualized operating income going forward. But Sabre paid out a stunning $415 million in interest over the same time period.

Profitability will have to grow profoundly to manage the interest let alone start returning capital to the equity holders. Prior to the pandemic, Sabre generated about $500-$600 million annually in operating income. If profits return to that level, it can handle the interest expenses, though not with all that much margin of safety.

As the chart below shows, the firm's annual interest expense has roughly doubled since January 2020, meaning that even pre-pandemic levels of operating income would leave a lot less breathing room than the company had previously enjoyed:

Simply put, financing remains the overarching consideration for Sabre stock going forward. That's because the firm's equity is a relatively thin slice of the firm's overall valuation. Here's a five-year chart of Sabre's enterprise value and market cap, respectively:

At the start of the pandemic, Sabre had about $6 billion in market cap and around $3 billion of net debt, adding up to an enterprise value of $9 billion, respectively.

Since that time, Sabre's market cap has fallen by more than 75% to $1.4 billion. However, enterprise value is only down by a third or so to $5.6 billion. And now equity only makes up a thin piece -- about 25% -- of the firm's overall capital structure.

Reasons For Optimism

Sabre needs a couple of years for its operating income to continue its rebound and for its heavy IT investments to finally pay off. 2024 is supposed to bring a lot of cost savings for Sabre, and investors will cheer if and when these do occur. The recent slide in interest rates and expectations for rate cuts in 2024 would also help Sabre when it comes to refinancing debt.

I'm inclined to think this works out and that’s why I’m tempted to buy shares myself.

The market cap is very low here for a company that generates more than $700 million annually in revenues with a 60% gross profit. The core business here is enticing. The competitive dynamic, three companies owning a near monopoly on global travel ticketing distribution systems, is a highly attractive one. Sabre's equity is a small portion of the total enterprise value. So, any sort of positive inflection could easily double the stock price from here.

That said, investors should know that it comes with more risk simply because the equity is such a small piece of the total capital structure. It's not hard to imagine this scenario where you get into a recession or the NDC model takes longer to pay off than expected.

In theory, for example, it's attractive to sell hotel upgrades such as spa access or late check-out through Sabre with these new reservation systems. In practice, this could come with unforeseen drawbacks or potentially lead to new competitive entrants arriving now that the core distribution model has shifted after decades of stasis. And that's to say nothing of airlines, which industry is in a massive state of flux since 2020. If Sabre can manage its debt and the NDC transition works out successfully, the stock should have a tremendous upside from here. However, both of those premises are far from assured at this point, which leaves SABR stock as a highly speculative buy for the time being.

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