Flight Centre (ASX: FLT) is a high quality business that continues to deliver record performance despite challenging economic conditions and increasing competition from international online travel services.
Though Flight Centre's sales have been reasonably defensive through the cycle, the June trading update highlights it is not immune to weak consumer sentiment, which has plagued Australian retailers post the May budget.
In early June, Flight Centre trimmed its fiscal 2014 profit before tax guidance from $370-385 million to $370-380m, due to weak trading conditions in the Australian leisure market and disappointing results from the Canadian operations. This is in contrast to Flight Centre's history of upgrading guidance throughout the year.
The new guidance range represents 8-11 per cent growth (previously 8-12 per cent) on the record $343m profit before tax achieved in fiscal 2013. Record results are still expected in Australia, the UK and USA.
The majority of Flight Centre's revenues and profits are derived from its Australian business. Flight Centre has an extensive store network, strong brand equity, economies of scale and online capability, which provide a competitive advantage in the domestic travel market. Its powerful customer network supports its ability to negotiate with suppliers and deliver best prices for its customers.
With the Australian business maturing, Flight Centre aims to benefit from increasing scale in its overseas operations, both through organic and acquisitive growth. Flight Centre's international growth strategy has had varying success. We are yet to see earnings sustainability offshore and firm evidence the growth opportunity exists. The Australia business remains notably more profitable than its international businesses. As per its last result, 41 per cent of total transactional volume was international, however only 19 per cent of group earnings before interest and tax was from offshore.
Flight Centre's main competitive threat is online agents who have lower cost structures. Flight Centre is facing increased aggregator competition from well-funded international players. The online travel market is increasingly globalised and is now dominated by Priceline Group and Expedia.com, which are associated with eight out of the top ten global online booking websites. Expedia, through its potential acquisition of Wotif, is increasing its foothold into the Australian market and an emerging threat to its core business.
Increased penetration of direct-to-supplier online booking platforms from accommodation providers and airlines, may also challenge Flight Centre's market share and margins.
Despite the structural shift towards online bookings, many customers, in particular the older demographic, prefer to consult travel agents in store. Further, many corporates prefer to outsource their staff travel management to avoid the administrative and time burden of online bookings. FLT’s network of bricks and mortar stores and corporate travel services provide a more defensive earnings stream than online only peers.
Less reliance on travel agents and a shift towards direct-to-supplier bookings should increase as websites improve, internet penetration increases, and the younger demographic ages and their discretionary income expands. Flight Centre's success will depend on its ability to adapt to shifting consumer and technology trends.
To navigate these emerging challenges Flight Centre aims to transform the company from a travel agent to a travel retailer, with a focus on promoting its unique brands and specialised services. It explains: “being a world-class retailer means we are the brand/business people identify with and go to. It is very different to being an agent, a middleman, a dealer for someone else’s product”.
Despite its competitive strengths, Flight Centre is a cyclical business reliant on airfare prices and favourable macroeconomic conditions, which include consumer confidence, unemployment, interest rates, and exchange rates.
We adopt a forecast sustainable return on equity (green below) of 30 per cent which is below consensus (orange) and the three year average of 34 per cent. In our view current performance should not be extrapolated into the future given the cyclical nature of earnings and competitive and economic challenges facing the business. We adopt a low required return (red) of 12 per cent to derive a fiscal 2015 valuation of $47.21.
Figure 1. Adopted metrics and Future Value
Flight Centre's domestic business is maturing and its ability to execute its international growth strategy and adapt its business model to structural challenges will determine the business’s long-term sustainability.
By Amelia Bott of StocksInValue, with insights from Stephen Wood of Clime Asset Management. StocksInValue provides valuations and quality ratings of 400 ASX-listed companies and equities research, insights and macro strategy. For a no obligation FREE trial, please visit StocksInValue.com.au or call 1300 136 225.