A new perspective on Flight Centre: Part 1

Here's a fact – Flight Centre's managing director Graham Turner didn't get on the BRW rich list by being an idiot. Yet, on the surface, Flight Centre's online strategy might appear idiotic.

In a world where travel purchasing is inexorably moving online, and five years after the company promised a 'clicks and mortar' strategy to provide 'world's best practice in retail, phone and web sales', it's impossible to book even the simplest international flight on the company's website. There's no shortage of stories of frustrated online customers taking their valuable business elsewhere.

No one-trick pony

Here's another fact – Turner has built two multi-billion dollar businesses in his lifetime. The first was Flight Centre's traditional 'leisure' business, which currently sells some $7bn of travel each year. The second, corporate travel business FCm Travel Solutions, has undergone breathtaking growth over the past five years essentially from scratch, and now turns over an estimated $4bn.

Could it be that management has made a very deliberate choice to give up online market share in the leisure business in order to maximise immediate cash flow that can be diverted into the rapidly growing and profitable corporate business? Crazy? Perhaps. Or crazy like a fox? These are the issues we will be exploring in this detailed, two-part analysis.

Firstly, though, let's look at some key numbers we use to assess the progress of this business. Total transaction value (TTV) is the total amount spent by Flight Centre's customers. Revenue is the amount the company keeps after sending off the bulk of the money to airlines, hotels and cruise companies.

From these numbers, we calculate a crucial ratio. Gross revenue to TTV is a percentage measure of the reward Flight Centre receives from travel providers for being the middleman. As suggested in our 2005 special report Looking under Flight Centre's fuselage (download PDF here), it's the growth in overall TTV, and the gross revenue to TTV ratio that are key to assessing whether the travel agent is 'going the way of the dinosaur'.

On average, doing well...

On that front, all appears well. Flight Centre's TTV has grown from $5.9bn in the year to 30 June 2004 to $11.2bn, a compound annual growth rate of 13.7%. After deducting $2bn or so of TTV acquired in the late-2007 Liberty acquisition, the mostly-organic TTV growth rate was about 9% per annum. It's a good result, especially considering 2009 was buffeted by the global economic slump.

Importantly, this volume continues to be rewarded with ample commissions from travel providers. Over the past decade, from each $1,000 spent in a Flight Centre outlet, the company kept $130 for its own expenses and profits and sent $870 forward to travel providers. Chart one shows recent margins are in line with the company's historical experience. If Flight Centre's business model is under threat, it's not immediately apparent in the headline numbers.

But the consistency of these numbers belies the significant shift in Flight Centre's business and industry over the past five years; changes that will likely continue over the next decade and beyond.

But only one division running hard...

Today, it makes sense to think of Flight Centre as two separate businesses: leisure travel and corporate travel. There's also a wholesale operation, but with the exception of less than $1bn of TTV generated through GoGo – which services 12,000 independent travel agents in the US – it should be thought of as a way to add margin to sales generated from leisure and corporate, rather than an independent operation; the quintessential vertically integrated business.

There's a lot to be said about the growth in the corporate business, and we'll save most of it for the second instalment of this review. But it's important to note here that corporate has been the driving force behind organic TTV growth over the past few years. Flight Centre has had a corporate business for more than 15 years, but its importance took off dramatically with the rebranding to FCm Travel Solutions in mid-2004.

Management only sporadically and informally reports the split between corporate and leisure, rather than breaking the numbers out in the accounts. But we know that by 31 December 2005, in less than 18 months, the FCm network had expanded to 30 countries and made up 33% of the company's TTV. By the end of that financial year (30 June 2006), the proportion had risen to 40%.

Over the course of the 2009 financial year, we understand that corporate travel produced 35% of TTV. But apparent regression is mere deception, because the company acquired more than $2bn of non-corporate TTV with the Liberty acquisition in late 2007.

In a recent interview, Turner said that corporate travel now made up 'nearly 40%' of the business, so corporate travel continued its growth over the course of the year. If the growth continues it should prove a tremendously valuable operation for shareholders.

While another division struggles

The leisure business – the focus of this review – hasn't been so spectacular of late; Flight Centre's TTV jumped by about $3.4bn from 2006 to 2009. About $2bn or so came from the acquisition of Liberty Travel in late 2007. Of the organic growth, we estimate that more than $1bn came from growth in corporate TTV. Based on those rough estimates, organic growth in the leisure business over the past three or four years appears to be lower than general economic growth.

Of course, 2009 has been affected by the economic slump. But even allowing for this, the results indicate that the past few years have seen strong corporate growth and minimal organic leisure growth.

While leisure TTV growth has been uninspiring, something impressive has been happening to the revenue to TTV margin in this part of the business. Corporate travel has variable margins, but we estimate the revenue to TTV margin is in the 6-10% range – it's generally a lower commission, lower cost business. With corporate travel growing in importance, and overall margins holding steady around 13%, average leisure margins seem to be on the rise.

Flight Centre receives different compensation for selling different products. Compensation arrives as a combination of front-end reward and back-end (often referred to as 'override') payments; these are bonuses for reaching agreed sales targets. Traditionally, the split between front-end and back-end compensation has been about 3:1. The agreements between Flight Centre and the travel providers vary and are confidential, but table 2 gives an idea of the revenue to TTV ratio for the various travel products.

We understand that for the whole Flight Centre business, air tickets make up about two-thirds of TTV while the remainder comes from 'land' products (including hotels). The latter have grown in importance over the past few years and are responsible for much of the apparent growth in leisure margins. At a recent results presentation, management confirmed that 77% of leisure customers buying an air ticket also buy a land product, so cross selling is a crucial part of the business.

As anticipated in our 2005 analysis, the loss of low-margin and no-margin business has helped boost overall margins. A further explanation for margin expansion can be found in the successful program to source more product through the company's internal wholesale operation, Infinity Holidays. Management has previously suggested that this adds about 0.5% to the revenue to TTV margin.

While increasing margins are a plus, the lack of growth in retail TTV concerns us. According to Tourism Australia, between calendar 2005 and 2008 the number of Australians who departed temporarily for an international holiday or to visit friends or relatives rose about 26% to 4.7m. That number will contract in 2009, and growth is likely to be more subdued in the US, UK and other important markets for Flight Centre.

But the relatively flat leisure TTV levels at Flight Centre over a similar period lead one to an unavoidable conclusion; more and more leisure travellers are choosing to book somewhere else.

Internet threat

'The internet' is the answer to the question of 'where?'. Consumers will come to different conclusions over whether to book travel online or through a travel agent nowadays (there's an interesting discussion on this matter in this Bristlemouth blog piece). Many travellers currently choose to book simple domestic trips online and international travel through an agent. But we don't need to get too involved in that debate here. The point is that the web has delivered new avenues for consumers and travel providers to interact, and an increasing number of customers are finding those avenues compelling. Others are likely to follow.

Prior to the internet, travel agents controlled the market for purchasing travel. Flight Centre's main competitors were other chains – such as Harvey World Travel and Jetset – and numerous independent agents. Having grown the fastest through the 1980s and 1990s, Flight Centre took a first mover advantage and was able to source great deals from travel providers, while its bulk provided scale advantages on the cost side.

The company chose to pass on much of those savings to consumers, undercutting the competition and stimulating demand – much like the virtuous cycle seen at Woolworths grocery and Bunnings Warehouse. This gave Flight Centre a dominant market share in Australia, rapid growth and decent margins.

New world order

Today, instead of being amongst the cheapest of the few ways for an airline or hotel chain to reach its customers, Flight Centre is now among the most expensive of myriad options. And instead of bringing in explosive annual growth in ticket sales, its sales have stagnated (in leisure, at least). In general management jargon, these are 'forces driving change' and both factors will reduce the company's bargaining power with travel providers.

The chief threat to Flight Centre comes from direct distribution. Now, consumers can easily go online and book directly with Qantas, Singapore Airlines or Hilton in a way that was quite difficult not that long ago. This saves the travel provider from paying the sort of commissions shown in table 2 above, so it's no wonder they've eagerly supported this channel.

There's also the emergence of online services such as Webjet, Expedia and Zuji for flights (mainly), and Wotif for accommodation. These provide a useful aggregation role for consumers, helping them locate the cheapest travel options without visiting multiple direct websites. They can achieve reasonable profitability on a combination of low commissions and fees charged directly to customers. The competition is getting tougher, Expedia and Zuji recently abolished fees on all flights booked in Australia, following the lead of the US market. These two businesses now rely on a low commission from airlines, plus extra profits gleaned by cross-selling higher margin items to those customers.

The fee cutting highlights a trend that will keep working against Flight Centre. Because of a high technology spend, a greater percentage of the expenses of both internet middlemen and direct distribution are fixed in nature. As travel spending grows, the competition between online providers is likely to intensify rather than show up in rapidly rising net profit margins.

Over the years, airlines have cut the commissions they're prepared to pay to both online and offline travel agents. If airlines keep trying to cut commissions (and try they will), online travel agents should still be able to eke out a living in a growing market, whereas traditional agents with their higher variable cost structure might have trouble covering those costs.

Plan A

Of course, none of this was completely unexpected when we wrote our 2005 special report – the competition was always going to get tougher. What we didn't anticipate, however, was just how irrelevant online sales would be for Flight Centre come today.

In 2005, we said there 'must surely be a market for a one-stop internet site' and that with its 'strong brand name, Flight Centre is better placed than anyone to be number one in this area'. We believed the company had a good chance of being the largest internet middleman, at least in the Australian market. There was ample evidence to suggest that the company would aggressively defend its lead.

In 2004 announcements, the company touted its 'dominant position online', despite 'poor transactional ability'. And it promised to throw resources into deserving that lead position. It lauded a 'new web-based booking service (which) takes Flight Centre to the forefront'. Various announcements referred to its 'consolidated ecom business', 'clicks and mortar' strategy, and desire to focus on world's best practice in retail, phone and web sales.

In a trade publication article from 2005, we found a quote from the company's global head of marketing, Colin Bowman, who committed the company to an online multi-channel distribution strategy, even though 'it may take revenue away from consultants (agents)'. We thought that commitment was crucial.

Management opts for plan B

Five years on, the company's strategy has clearly changed. In the Business Spectator interview referred to earlier, Turner said that internet bookings are 'an accessory to our model' and that 'it won't become that important to us'. The company has (clearly willingly) handed the baton of leading domestic online middleman over to Webjet. And, astoundingly, customers are still unable to book an international flight online at flightcentre.com.au – the best you can get is a 'prices from' estimate and have someone return your interest via phone or email, an unacceptably slow and personal approach for many modern consumers.

This must be a deliberate strategy. Flight Centre has chosen not to promote a strategy that will take revenue away from its stores, potentially damaging relationships with its staff in the process. There's no other explanation as to why customers are able to book low-margin domestic travel on Flight Centre's website (which are an unrewarding hassle for staff), but not higher margin international flights, even of the simple point-to-point variety.

So far, this strategy hasn't been crippling; not maximising TTV is at least partly being compensated by higher margins. But it seems a terrible waste to let potential online customers slip away without a fight.

Each year, web-based competition will get better at organising more complex travel, and a growing percentage of the population will convert to booking online, from which many will never return. At some stage, this may threaten Flight Centre's higher margin sales. The internet provides a great medium for getting rid of the middleman, and just because Flight Centre isn't prepared to pick around the edges of its own moat doesn't mean its competition won't.

Arguments with airlines

We see this increased competition resulting in travel providers, particularly airlines, acting on their long-held desire to eliminate the profits of the middleman. A few years back, Qantas took a dig at cutting international flight commissions, but evidently moved too soon. This year, Singapore Airlines has chosen to go into battle with Flight Centre and other travel agents in the Asian region over commissions.

Over the past few years, Flight Centre has moved to increase the level of front-end commission at the expense of at-risk back-end revenues. Traditionally, the 13% revenue to TTV margins had come from roughly 10% front end payments and 3% back end. The push to reweight compensation in favour of fixed commission is partly a reflection of a tough economic environment but also of the fact that sales growth is harder to achieve given Flight Centre's large size.

Our take on the widely-reported stoush is that Flight Centre wanted greater up front commissions and Singapore Airlines said no. Flight Centre then took Singapore Airlines off its panel of preferred airlines and its agents won't actively encourage the promotion of the airline.

Since then, it's been reported that Flight Centre's sales of Singapore Airlines tickets is down 70% and other airlines have filled the void. This is an aggressive strategy from both companies, and one that's come with fighting words from Flight Centre's management on internal documents that have since leaked. For Flight Centre, it's probably the right strategy for the times, and there's a good chance Singapore Airlines will return to the negotiating table next year.

The threats will continue

Our concern is that some time down the track, one of these important legacy airlines will construct a business model that doesn't involve significant commissions to travel agents. With continued erosion of the travel agents' share of the total market, that becomes increasingly likely. And any deterioration in this situation (from Flight Centre's perspective) is unlikely to happen in a linear fashion.

If one airline can live without the largest travel agent chains, others will have a commercial imperative to follow. Just as Flight Centre is using its upper hand today, airlines will respond in kind if the power shifts (although most of the savings will end up in the consumer's pocket). The risk of a significant change in the compensation structure of the industry is growing each year.

The loss of airline commissions would hurt, and there'd also be a knock on effect if customers chose to book elsewhere. Lose the air sales and you might lose the chance to sell 77% of them a land product as well. Then there's the similar threat stemming from online competition in the land business, both direct and through internet sites such as Wotif and HotelClub.

Flight Centre is certainly not taking this threat lying down. It's moving aggressively into niche markets where it believes it retains an edge. For example, in 2002 Flight Centre acquired the single retail outlet of Cruiseabout, a travel agent focused on cruise packages. By mid last year, there were still only two outlets. But now there are 12, with plans for more. Cruising sales are high margin for the retailer (revenue to TTV margins of 20% and more), and it's a space that seems more naturally suited to face-to-face sales. Flight Centre estimates that the cruise market in Australia alone generates $1bn of TTV, and the company thinks it might capture 30% of the market with 60 stores.

Similar niche travel opportunities are being pursued, such as the joint venture with Intrepid Travel. It's also exploring opportunities in employment agencies and bike retailing, which are currently insignificant and we hope aren't expensive distractions. But the key defence against the changing landscape has been Flight Centre's push into the corporate travel market, with a focus on the higher margin small and medium enterprise (SME) market.

Flight Centre's Manhattan Project

Our view in 2005 was that the company would face the internet onslaught head on. That didn't happen. One conclusion you could draw is that management is being bone-headed and can't see the threat in front of it. Like Fairfax before it, perhaps Flight Centre is hoping, in vain, to permanently maintain profits that new technology is eroding.

Our suspicion is that something else is happening. Instead of taking the internet onslaught head on, which would require big changes, an immediate sacrifice of profits, as well as settling for lower margins in the longer run, management has opted for a flanking manoeuver.

The corporate SME travel market is one that has, in the past, been somewhat neglected. After spending time looking at how the leisure market has progressed in recent years, it's somewhat surprising that in the corporate market it's Flight Centre's relatively personalised approach that's been key to its explosive growth. This side of the business offers significant growth opportunities which, when combined with the existing leisure business might provide the company with negotiating clout for years yet.

Management is focusing its growth on an area where service is as important as price. But corporate travel is a matter for next issue. Building a new business to replace a foundering one is a strategy that often tempts and often fails. In this case, though, the process is already well underway, and the signs look promising. Next issue, we'll take a closer look at the corporate side of the business and assess whether it offers enough potential to offset the threats to the leisure business. HOLD.