Flight Centre disappointed the market with an earnings downgrade in June but the resulting share price fall brought the stock into value on a 2014-15 basis.
Pre-tax profit guidance was trimmed from $370-385 million to $370-380 million due to weak trading conditions in the Australian leisure market and disappointing results in Canada. The softening of guidance is consistent with downgrades by other Australian discretionary retailers in the weak post-budget consumer environment.
The new guidance range represents 8-11% growth (previously 8-12%) on the record $343.1 million FY13 pretax result. Record results are still expected in Australia, the UK and the US. Flight Centre remains financially strong with corporate cash of $402m on 31 December, ahead of the stated policy of maintaining three months operating cash flow (approximately $100-120 million), while debt remains negligible at around $43 million.
Flight Centre has an extensive network of stores, strong brand equity across its portfolio of brands and online capability, all of which provide competitive advantages. Its powerful customer network supports its negotiating strength with suppliers. Economies of scale derive from the ability to leverage costs across the large revenue base.
Flight Centre aims to benefit from increasing scale in its overseas operations, both through organic and acquisitive growth. Growth has been internally funded with no need for debt. However, the international growth strategy has had varying success. We are yet to see earnings sustainability offshore and firm evidence the growth opportunity exists. The US continues to make losses. Australia remains notably more profitable than the international businesses. 41% of total transaction value (TTV) is international, however only 19% of group EBIT is from offshore.
Figure 1. EBIT and TTV by country
Source: Flight Centre
The main competitive threat is online agents with lower cost structures, especially increasing 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 just became more powerful with its agreed takeover bid for Wotif.com (WTF). Increased penetration of direct-to-supplier online booking platforms from accommodation providers and airlines may also challenge Flight Centre’s market share and margins.
The barriers to entry for online travel sites are low, however it would take time to replicate the brand awareness, scale and purchasing power Flight Centre has domestically. And despite the structural shift towards online bookings, many customers prefer to consult travel agents in store. Travel agents are more suitable for complicated international flights which require personalised service and expert advice. Further, many corporates prefer to outsource their staff travel management to avoid the administrative and time burden of online bookings. Corporate business provides around 35% of group revenue.
Less reliance on travel agents and a shift towards direct-to-supplier bookings should increase as websites improve, internet penetration increases and the younger, more ‘tech-savvy’ demographic ages and their discretionary income expands. Flight Centre’s success will depend on its ability to adapt to these 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. Flight Centre says “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 middle man, a dealer for someone else’s product”. As part of the strategic shift, Flight Centre changed its name to Flight Centre Travel Group to better reflect the diversity of its offering as it grows beyond the mainstream leisure sector.
Flight Centre's growth has been supported by the increase in Australians travelling overseas, a trend driven by a strong Australian dollar and more affordable airfares. In the year ended June 2013, there were a record 30.5 million crossings of Australia's international borders. This represents 1,329 crossings per 1,000 persons of the Australian population. Ten years ago (2002-03) there were 16.6 million border crossings, representing 845 crossings per 1,000 persons of the Australian population.
Figure 2. International movements
At the first-half result Flight Centre commented the lower Australian dollar through the half had not affected Australian outbound travel. ABS data shows Australian outbound travel growth actually accelerated during the period as our local currency dropped. However, the impact of a lower currency is likely to have a lagged affect, given bookings are generally done several months ahead. A sustained downturn in the Australian dollar would reduce demand for international flights, which generate higher margins for Flight Centre.
Figure 3. Currency versus outbound departure growth
Source: Flight Centre
The increasing affordability of international travel has supported Flight Centre’s growth. At Flight Centre's June trading update, management commented: “International and domestic airfare prices remain highly affordable and cheap flights are a key factor in stimulating demand and a leisure travel rebound.”
Flight Centre is a cyclical business reliant on favourable macroeconomic conditions including consumer confidence, interest rates, and exchange rates. A recovery in interest rates would reduce discretionary income and spending on travel.
Since 2000, earnings and dividends per share have grown at a compound annual growth rate (CAGR) of 12% and 13% respectively. Though Flight Centre’s sales have been reasonably defensive through the cycle, the June trading update highlights the company is not immune to weak consumer sentiment. And performance can be volatile given the cyclical nature of earnings and fixed cost leverage from the large store network. This was evident in the sharp downturn in earnings during the GFC.
We adopt a forecast sustainable normalised return on equity of 30% (green below) which is below consensus (orange) and the three-year average of 34%. 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. The market has built in a more optimistic outlook than we assume. We adopt a low required return of 12% (red) to reflect large market capitalisation and strong financial health. We derive an equity multiple of 3.75x and FY15 valuation of $47.21.
Figure 5. Adopted valuation metrics and future value
We recommend a 15% margin of safety to value before investment. This implies a $40.15 buy price.
By David Walker, Senior Analyst StocksInValue, with insights from Stephen Wood of Clime Asset Management.