Travelport's Investments Support a Narrow Moat

We see

Travelport Worldwide TVPT as undervalued, trading at around 10 times the midpoint of management's 2017 adjusted earnings guidance of $1.29-$1.37 per share, and we believe long-term investors should have the stock on their radar.

We expect Travelport's global distribution system revenue share to remain stable at around 30%, aided driven by the firm's leading position in fast-growing areas (payment, hotel, air merchandising, mobile, international traffic) that is fostered by a leading technology platform. The company is not focused on providing IT services like inventory and reservation management, which are more capital intensive than the distribution business but also offer higher margins and growth opportunities in addition to switching cost barriers.

Travelport was the first GDS company to move from the legacy green screen technology to more innovative technologies; this has allowed it to offer superior content (airline merchandising) and services (hotel content, payment, mobile) on its platform. Travelport will have to continue to innovate, as it has commented that its technology lead over key peers is around a year, according to its customers.

Travelport's distribution platform enjoys a network advantage, as increased supplier content encourages more travel agents to use the platform; as more travel agents use the platform, suppliers offer more content. The firm aims to solidify this network advantage with continued development of its leading technology and product offerings.

Replicating the company's GDS platform would entail aggregating and connecting content from several hundred airlines to a platform that is also connected to travel agents, which requires significant costs and time. As a result of these barriers, three operators--Travelport, Amadeus AMS , and Sabre SABR --control 98% of the GDS market, and we see them enjoying efficient scale.

One key risk to Travelport and the industry is disintermediation--customers booking directly on airline websites. Although carriers have had success here, we expect this headwind to ease in the next several years. Other key risks are incentives paid out to travel agents and online travel bookings growth, both of which we expect to continue.

Network Effect Drives the Moat
Travelport has a narrow moat predominantly driven by a network effect in its core global distribution system business (95% of 2016 revenue) that hosts content from most all global airlines, which pay Travelport a booking fee. This scale of content attracts use by both traditional and online travel agents, who receive incentive fees from Travelport to book on its GDS; this in turn encourages airlines to provide more inventory to the platform.

The company's network effect is supported by challenges in bypassing the GDS platform when connecting to indirect channels. While airlines have had some success generating bookings to direct channels (their own websites), their success in evading GDS when connecting to indirect channels has been very limited. All airlines connect to traditional travel agents and travel management companies through a GDS, and most all airlines also use this distribution channel to link to online travel agencies. Only a few U.S. airlines have bypassed GDS by connecting their content directly with an online travel agency channel, as it is costly and time-consuming for online travel agencies to aggregate carrier content and it is inefficient for traditional travel agents and travel management companies to book using online travel agency platforms that don't have the aggregated content or back-office integration that GDS has. As a result, all airlines continue to use the GDS distribution channel to access demand from traditional travel agents and travel management companies and most online travel agencies.

Supporting the network effect, we point to the lack of success airlines have had charging a GDS surcharge in order to reduce dependence on this channel. Lufthansa is trying to reduce its dependence on GDS by instituting a surcharge for flights booked through the GDS channel. While we understand the rationale to increase direct traffic to reduce costs and increase customer interaction, we think the venture will prove unsuccessful. First, this surcharge makes the airline's flights relatively more expensive than competitors on GDS, and bookings through GDS represent the majority of bookings for Lufthansa. Additionally, agents prefer an aggregated platform versus going to numerous individual airline websites. In 2004, Northwest Airlines attempted to add a GDS surcharge only to reverse itself 10 days later after criticism from GDS companies and travel agents, who said they would shift bookings to other carriers.

We think Travelport's innovative technology offers some support to its network advantage. Travelport was the first GDS company to move from the legacy green screen technology to more innovative technologies, which has formed an early technology advantage that allows differentiated product to be offered and easily booked and paid for through travel agents' back-office operations, thereby supporting its overall network advantage. Among the three core GDS operators, Travelport held 24% booking share in 2016, down from a high 20s share in 2012 due mainly to Orbitz moving from a sole-source to dual-source relationship. Driven by technology and a strong product offering (payments, hotel, merchandising, mobile, advertising, and rail), the company's GDS revenue share of the core three players was around 30% in 2016 versus roughly 32% and 38% for Sabre and Amadeus, respectively, by our calculations.

We believe the core distribution business holds efficient scale advantage. For starters, Travelport, Amadeus, and Sabre combined control 98% of the GDS market, and we don't believe a new entrant would be able to profitably compete away this share. All airlines use the GDS distribution channel and are becoming increasingly connected to these platforms through ancillary offerings and back-office technology integration that makes information more accurate and accessible. Additionally, all travel agents source airline content through a GDS and are also increasingly connected to the platform through back-office technology integration that makes planning, booking, and servicing clients easier. As such, replicating an existing GDS would require large costs to aggregate content and then efficiently integrate that content with travel agents and suppliers for what we believe amounts to a midteens return on invested capital at full scale. These costs are recurring, as each year Travelocity spends a mid-single-digit percent of revenue on capital expenditures ($106 million in 2015) related to improving its travel commerce platform.

Our narrow moat rating is further supported by returns on invested capital that we expect to average in the high teens the next several years, comfortably above the company's 7.9% cost of capital.

Cyclical Industry Is Among the Risks
The travel industry is cyclical and affected by changes in economic growth. In a downturn, consumers have less income and therefore look to cut back on discretionary expenses like leisure travel. Travelport is not immune here, although its fees are based on volume rather than airline, car, or hotel prices, which can soften cyclical headwinds. To illustrate this we can point to 2009, when U.S. airline fares were down 10% while U.S. passenger miles were down 5%, according to the Bureau of Transportation. In 2009, Amadeus' distribution revenue was down 4.9%.

Airlines continue to look for ways to migrate bookings directly to their websites, as costs are often lower than indirect distribution platforms like Travelport's global distribution system and also allow for more control of the customer relationship.

Airlines may also look to bypass a GDS network by connecting their content directly to online travel agencies in order to save on booking fees. These cases to date have proved rare, as the costs and time to integrate are meaningful.

Global distribution platforms that Travelport provides may need to continually invest to remain relevant in the increasingly complex travel transaction environment.