Market Overreacts to Sabre's Rattle

Sabre SABR is executing well on the factors under its control. In the first quarter, its air booking share grew 140 basis points to 38.3%, the fifth straight quarter of share gains, and the company continues to migrate slow and expensive mainframe functionality to a faster, cheaper, and more reliable open-source platform. However, Sabre is facing new headwinds out of its control as its customers are affected by financial hardship (Jet Airways) and 737 MAX crashes (Lion Air and Ethiopian Airlines). These external events reduce our 2019 sales, EBITDA, and free cash flow projections, but our estimates for the underlying business are unchanged. We view the share price decline after the earnings announcement as an overreaction and continue to expect an earnings acceleration for Sabre starting in 2020 as platform investments and current customer headwinds wane.

In late April, reservation customer Jet Airways announced it was suspending flights due to financial hardship caused by the competitive landscape. We estimate that Jet Airways accounted for about 3% of Sabre’s total 2018 passenger boardings in its airline IT segment, which was 28% of its total sales last year. We are removing this customer from our 10-year forecast. This segment is also seeing a modest headwind from reservation customers Lion Air and Ethiopian Airlines after their 737 MAX crashes. As result, we expect 2019 air solutions revenue to move to a 4% decline from 2% growth prior.

2019 operating profit will be greatly reduced with the accelerated migration to open systems. However, this transition is offset by lower capital expenditures, leading to no change in free cash flow. Also, we see investment waning after 2019, allowing for a return to earnings growth.

Sabre is maintaining its 2019 outlook for its underlying business. However, it is reducing its revenue, EBITDA, and free cash flow guidance by roughly 1%, 3%, and 7%, respectively, to account for the external issues of the aforementioned three reservation platform clients. The reservation platform business is higher margin, leading to a larger negative impact to EBITDA and free cash flow than sales. We have reduced our forecast roughly in line with the company’s updated targets.

Sabre continues to successfully migrate to an updated cloud platform, which will improve reliability and speed of service, supporting its intact network, switching costs, and efficient scale advantages that contribute to its narrow economic moat. We are encouraged that over 90% of Sabre’s processing power is now on open systems (less than 10% on outdated mainframe) and that over 50% of its compute footprint is in the cloud (up 14 percentage points from the end of 2018). While the transition remains a multiyear event, we believe that 2019 represents the heavy lifting year and that earnings growth will resume in 2020.

Powerful Network Advantage We expect Sabre's global distribution system booking share to slightly increase over the next five years but remain in the mid-30s, aided by expansion into new markets and improvements in technology. We see Sabre's IT technology solutions share of passenger boardings reaching above 21% in 2028 from 18% in 2018 as platform investments drive new airline and hospitality wins over the next decade.

Sabre’s global distribution system enjoys a powerful network advantage. As more supplier content (predominantly airline content) is added, more travel agents use the platform, and as more travel agents use the platform, suppliers offer more content. This network advantage is solidified by technology that integrates global distribution system content with back-office operations of agents and IT solutions of suppliers, leading to more accurate information that is also easier to book and service the end customer with. Additionally, the company’s platform reach should expand as Sabre looks to grow in European and Middle Eastern countries where it previously had only minimal penetration, which are also markets that yield higher than the consolidated North American region.

Replicating Sabre’s global distribution system 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--Sabre, Amadeus, and Travelport--control nearly 100% of the global distribution system market, and we think they enjoy efficient scale, which is evident in the limited traction that airlines or travel agents have had in bypassing this distribution platform.

The main risk to Sabre and the global distribution system industry is technology advancements that increase the ease of booking travel directly through supplier websites (disintermediation) or through direct connections between suppliers and online travel agent platforms, which bypass traditional travel agents using the global distribution system platform.