A new perspective on Flight Centre: Part 3

In this series, we’ve dissected Flight Centre’s two main businesses. Part one focused on the significant headwinds facing the company’s traditional leisure operation and we posited that management might be deliberately milking the business and reinvesting the proceeds in its rapidly growing corporate travel business, the subject of part two.

We also made the case that the leisure business is unlikely to grow much in the coming years, in contrast to the corporate business that will keep moving ahead. To wrap up our three-part analysis, we’ll try to piece together how these two trends are likely to combine, to gauge what Flight Centre might look like in five years’ time.

What better way to do this than with some financial forecasts? You might find the going a little tiring over the next thousand words if you have an aversion to numbers, but it’s the most useful way to illuminate the effects of changes sweeping the company, and there’s a bright light at the end of the tunnel. Our journey then concludes with a relatively simple roadmap to measure Flight Centre’s progress.

Educated guesswork

Let’s start with our ‘best guess’ for how the business might progress over the next five years, and follow with a scenario analysis to discover how Flight Centre’s prospects might change along with key variables.

In the fullness of time, forecasts rarely prove accurate. In this case, we’re using incomplete information to make estimates of numerous important internal factors. For example, we’re trying to estimate the profit margin on corporate travel sales when the company doesn’t even tell shareholders the total amount of corporate travel sold. There’s a lot of educated guesswork involved.

And then there’s external influences, such as the global economic tide. Though reality isn’t likely to neatly fit our model over the coming years, the point of the exercise isn’t to accurately predict the future; it’s to consider what possible futures might exist and to gauge whether the odds are stacked towards a pleasant outcome for shareholders.

In Table 1, we’ve published our ‘best guess’ estimate based on our analysis from the past month’s research. Let’s roll down the table line by line and discuss the key assumptions, starting with the company’s leisure business.

We’ve opted for zero growth in Total Transaction Value (TTV) over the coming five years; we’re looking specifically at (the lack of) organic growth, rather than acquired TTV. Flight Centre could possibly make more acquisitions in the leisure business, but this would require more capital (debt or new shares) and that would create further dilution as we move down the table.

That’s debatable

Intelligent bystanders could (and probably will) argue that this estimate is too bullish or too bearish, depending on their viewpoint. But our best guess is that the trend evident over the past few years – almost flat organic TTV – is likely to continue. And if the economic recovery continues at this pace for a while yet, then perhaps there’s scope for some organic TTV growth, a matter we’ll come back to.

For the next line, the Revenue-to-TTV ratio, we’ve opted for 16%. We made the claim in part one that this ratio has been on the rise lately for the leisure business, but we’re not banking on further margin expansion over the next five years. Rising margins have been caused by the migration of low-margin bookings to online alternatives, and that trend should continue, but an offsetting force might become apparent if travel providers push for lower margins generally.

The next line, Revenue, is a function of the assumptions in the prior two lines. Next comes the ratio measuring Earnings before interest, tax and amortisation (EBITA) to revenue. We estimate this figure was 8% in 2008/09, provided we ignore one-off writedowns and (hopefully) temporary operating losses at Liberty.

You’ll notice that over the next two years the ratio moves up to 11%. This isn’t an optimistic assumption, but rather reflects a mild rebound from current depressed levels. Between 1995 and 2004, this ratio ranged between 15-20%. We’ve opted for a lower number to account for some of the headwinds a bricks and mortar travel agent faces. From this ratio, we arrive at an EBITA estimate for the leisure operation.

While not technically the ‘bottom line’ profit, EBITA is the most useful measure of Flight Centre’s – or in this case, its leisure division’s – operating profit. It’s an accounting figure representing how many dollars have been generated to pay the tax office, bankers and, most importantly for us, shareholders. In contrast with profit after tax, EBITA ignores how the company is financed and is particularly useful in assessing the performance of the underlying business.

Corporate Travel

Unlike the leisure business, we’re expecting good growth in TTV from the corporate operation. We’ve opted for a growth rate of 12%, which is probably conservative given the recent growth rates from this division, and the depressed nature of business in the base year 2008/09.

In fact, our best estimate would include a few significant rebound years of 20-25% growth, if not starting this year, then next. As highlighted last issue, significant new client wins are being hidden by existing clients ‘downtrading’, and this is likely to result in a year or two of very fast growth when business conditions pick up. But we’ll be conservative and assume straight line TTV growth of 12%.

Last issue we estimated that Flight Centre’s corporate revenue-to-TTV ratio would be towards to top of the industry’s 5-8% average; our best guess is 7%. We’ve estimated the EBITA to revenue ratio at 12% for 2008/09, a depressed number for corporate travel but one that reflects the company’s depressed overall EBITA-to-revenue ratio of 8.8% last year. The ratio then heads up to 20% over the next few years; as explained last issue, ‘evidence suggests that corporate operates at a significantly higher EBITA-to-revenue ratio than leisure travel’. It could be that 20% is conservative – if our claim that corporate and leisure are ‘similarly profitable’ holds true, this ratio is possibly closer to 25%.

Putting it all together

The next five or so lines include the estimate for TTV, Revenue and EBITA for the whole company, obtained by adding the estimates for the two divisions. Here’s where we get a glimpse of how the combination of a languishing business and a rapidly growing business might look.

The Revenue-to-TTV ratio trends downwards over the five-year forecast, which makes intuitive sense considering the increasing importance of corporate travel to Flight Centre. The EBITA-to-revenue ratio is heading in the other direction, reflecting a forecast improvement from depressed conditions in 2008/09 and the increasing importance of the corporate travel business.

Let’s now briefly consider how the company will fund the growth in its corporate division. Net interest has traditionally been a source of profit for Flight Centre, rather than a cost, because of its significant cash ‘float’ from customers paying in advance. Last year, the company received $12m more in interest from its deposits than it paid in interest on its loans.

But the corporate business is likely to prove more capital-intensive than leisure, for reasons detailed last issue. So the forecast assumes Net interest runs down to zero over the next five years. That’s the equivalent of the company progressively borrowing $150m at 8% to fund organic growth in the corporate business, which should prove ample.

Whether we account for the increased capital requirements here or in terms of the number of shares outstanding – equity is the other form of financing available to the company – won’t make a great difference to the final forecast. But it is important to count it somewhere.

Totting it all up, Profit before tax rises to $225m by the 2014 financial year, from $138m in 2009. After deducting tax and dividing by the number of shares outstanding, our earnings per share forecast increases to $1.57 by 2014.

Though that’s a price to earnings ratio (PER) of 10 based on today’s share price, it’s also misleading. More usefully, it implies earnings per share growth of 10% per annum. So if investors are prepared to pay a PER of 15 for this business come 2014, today’s buyer is looking at average annual capital gains of 8%. In addition, shareholders might expect an average dividend yield of 3-4%, for a total return of 11-12% per year – a decent result.

A different route

But this is just one guess from a wide array of potential futures, so let’s now consider a few alternatives, beginning with a much more difficult future. For our ‘tough future’ estimate, we’ve changed three key variables from our ‘best guess’ estimate. Firstly, we assume that online competition intensifies to the point that Flight Centre’s leisure business not only stops growing, but that TTV goes backwards at a rate of 5% per year. Due to this competition, we’ve also assumed the Revenue-to-TTV ratio shrinks by 1% each year to 11% by 2014, rather than 16% in our ‘best guess’.

Lastly, we assume corporate growth hits a wall and TTV remains at 2009 levels; we’ve also left the shrinking net interest figure from our ‘best guess’ estimate. In this case, the $150m borrowed doesn’t reflect money invested in the growth of corporate, but rather cash needed to close unprofitable retail stores and fund severance pay.

In Table 2, we’ve highlighted how this change might effect earnings per share. You can see the full range of assumptions behind the numbers in a spreadsheet available on our website. EPS might still be in excess of 80 cents per share, but it would be hard to pay a low enough multiple for a stock in that sort of decline. If Flight Centre faced a future of significantly declining leisure TTV and no corporate growth, the reality is likely to be uglier than these numbers imply, and we’d very likely regret our current Hold recommendation.

Free upgrade

Of course, this is not the future we expect. And even our ‘best guess’ leaves room for pleasant surprises, so let’s consider a more ‘bullish’ case. Assuming our caution on the leisure business proves somewhat unwarranted, we’ll allow for 5% growth in organic TTV from that division. For the corporate business, we’ll include two big rebound years for TTV, 20% growth in 2010 and 25% in 2011, before returning to 12% growth for the remaining three years. Under this scenario, we’ll also increase the corporate EBITA-to-revenue ratio to 25% in the latter years, which brings the EBITA-to-TTV ratio for the corporate business in line with the leisure business.

Though this is a ‘bullish’ scenario, we need to be realistic and have therefore increased the Net interest expense to allow for an extra $100m in required capital by 2014. Table 3 shows what might eventuate, with EPS of $2.10 by 2014 (workings are available in this spreadsheet). Following the bullish-but-not-impossible theme, if in 2014 investors put the stock on a multiple of 18 times earnings, today’s buyer would be looking at capital gains in the vicinity of 19% per year and a further 4-5% in average dividends.

One of the great pitfalls of financial modelling is that once you create the numbers, you start to believe them. Rather than get bogged down in our own creation, now’s a good time to take a step back.

The point of these three examples is to show that the range of potential outcomes for Flight Centre is wide. The examples are also useful in showing what the company needs to achieve for it to be a successful investment for shareholders.

Flight Centre today looks vastly different from what we envisaged at the time of our 2005 report, which is why we’ve undertaken this detailed three-part analysis. Shareholders should be aware that the business model is no longer about rolling out new retail stores to replicate past success. The growth engine now is corporate, so the focus will be on growth in corporate sales staff and new account wins.

A simple measuring stick

But the number one indicator of whether Flight Centre will remain successful is growth in overall TTV. It’s absolutely essential that the company is able to grow overall TTV, as this is what gives it bargaining power with airlines and hotels. It really doesn’t matter whether that growth comes from leisure or corporate, although we’ve laid out the case as to where it will ultimately come from.

We can also envisage a scenario, perhaps a decade down the road, where Flight Centre’s TTV exceeds $20bn, versus $11bn in 2009. If that transpires, we’re confident the company will receive adequate compensation from travel providers and the margins in our ‘best guess’ estimate are achievable. If corporate doesn’t continue to grow, though, total TTV is likely to stagnate and we’ll likely look back on this Hold recommendation with regret.

That makes a useful roadmap to follow. If TTV continues growing then the plan is likely to be on track. If growth doesn’t eventuate this year and, in particular, in 2011 and beyond, it’ll force a rethink.

The next most important factor is the Revenue-to-TTV ratio. We expect to see a high ratio over the coming years, although it will unavoidably fall as corporate becomes more important to the company’s future. That’s perfectly fine. What we don’t wish to see is further unexpected deterioration, which would likely indicate a worsening bargaining position with travel providers. If TTV continues rising and the Revenue-to-TTV ratio holds up reasonably well, everything else that matters to shareholders is likely to fall into place.

Metamorphosis

The central thesis of this three part series hasn’t revolved around spreadsheets and mental gymnastics. Numbers are outputs, not inputs. The key story is how Graham Turner and his management team are quietly shifting the fundamental focus of this business away from leisure travel and towards corporate, as a way of dealing with the threat posed by the internet. The speed with which this appears to be progressing says something about this management team’s unique business building skills.

The question we’ve tried to answer is whether this is sufficient to offset the abruptly changing dynamics of the travel industry. Though the initial signs are encouraging, shareholders won’t be able to declare victory for at least a few years yet.

It was only a few months ago that this stock was priced for collapse. Back then, very little needed to go right for shareholders to do well. With the stock up 375% from the low in March, however, today’s shareholders are clearly betting against a disastrous future.

If the stock keeps moving up, it’ll soon reach a point where shareholders become reliant on a rosy future in order to achieve a reasonable outcome. While we are impressed with the company’s transformation, there are considerable risks to its growth plans. As such, we’re likely to sell down, or completely part company, with this long-held stock if such a situation eventuates. We’re not willing to risk our chips if the bullish scenario becomes fully ‘priced in’ and the attached recommendation guide shows our current thoughts on valuation.

We’re mindful that this three-part detailed analysis has demanded a significant investment of your time and attention. Hopefully, this has paid off with a deeper understanding of the fundamental ways in which Flight Centre and its industry have changed over the past five years. We’ll keep you up to date as the situation progresses and our recommendation remains HOLD.

Note: In the special reports section of our website, you can download a spreadsheet with the numbers behind our ‘best guess’, ‘tough future’ and ‘bullish’ estimates. There’s also a ‘Choose your own adventure’ tab, where you can input your own assumptions.