Points International (PTS.TO): Nice top-line, but where is the leverage?

Points International reported Q4 and FY 2008 earlier today. The revenue line was ahead of its top-line guidance for the year at between $65.0 million and $75.0 million. Actual annual sales performance was $75.6 million, which happens to also fall above my expectations of $75.3 million. The company has a solid $22.8 million balance sheet and no debt. During this recession, Companies with solid balance sheets that exceed guidance are usually viewed positively by the market. As a SaaS provider with over 95% recurring revenue and a first mover lock on its niche, one would expect this listing to fit squarely within the Top 30 Small-Cap Tech Stocks on the TSX.

But wait...

A closer look at bottom-line performance may erode some of the first-look "looks good" sentiment in the market. Despite growing revenues dramatically throughout the year, operating earnings have eroded since the first quarter. EBITDA was negative $0.54 million for Q3, and only $0.04 million for Q4 2008 on record sales $21.7 million. This is incongruous with the intent of the wholesale model (described by the Company as Principal Revenue) when it was first introduced to the market during 2007. Expectations at the time were that real contribution margins would initially triple, and then with the introduction of new higher margin clients, operating earnings would increase from there. Based on its reported earnings, the margins that it receives from the wholesale points business is around 14.8%. It is certainly an improvement over the average of 8% that it was generating in commissions, although it is a far cry from a triple. With over 96% of its revenue now reflected in the wholesale model, there is a lot more clarity in the results. It would appear that PTS is getting the squeeze as a wholesaler. Passengers may be utilizing their loyalty currency with greater frequency, but Points International appears to be bearing the brunt of price discounting risk - possibly passed on by its airline clients.

Personally, I have always been skeptical of the viability of the consumer portal and have never in the past modeled revenues associated with Points.com, or the Global Points Exchange (GPX). Although creating a secondary trading market seems like a reasonable idea with future earnings potential, the airlines need to better understand that the trading fees are incremental revenue streams (found money) with high margins. Earning $1 a hundred times is the same as earning $100 once. However, doing a hundred trades creates a market, whereas 1 trade is not a market. Basically, the high trading fees (however they are justified) appear to be slowing adoption and impairing the liquidity required to make a secondary market viable and profitable. On the beta site there are still only 130 trades posted at any time, up by only 30 posts since July.

There has been a lot of management effort and development costs applied to the GPX project. Airlines are signing up to the program, which also presumably brings many cross-sell opportunities for other PTS solutions if the GPX stalls. There are still a couple more quarters of "wait-and-see" goodwill left in the market, but the wick may burning on this concept.

Looking forward, the guidance for revenue of between $85 million and $95 million during FY 2009 is a modest 12% to 25% forecasted increase in sales. Considering that 95% of its revenue streams are supposed to be recurring, and sales are benefitting from recent launches at British Airways, Northwest Airlines, and Hawaiian Air, there appears to be not much forecasted growth momentum.

Shareholders would likely be satisfied with modest top-line guidance as long as the wholesale model demonstrates the potential for earnings leverage. Otherwise, the much vaunted conversion to the Principal Revenue model may have been a whole lotta whatever.

Earlier this year PTS would have ranked in the lower half of the Top 30 Small-Cap Tech Stocks, but with this 4th quarter profit result, it may have fallen out of the rankings for the time being. With some earnings momentum over the next couple of quarters, it could return to the list.

As a reminder, there are over 300 tech and cleantech small-cap stocks listed on the combined TSX and TSXV exchanges. Being ranked among the top 30 is pretty tough.

Disclosure: I do not own PTS shares, nor do I own any airline shares.