Flight Centre: travelling light

Here's an admission: selling Flight Centre has vexed me. In at $30 and out at $60 only 18 months later makes me feel like I need a shower. Well-managed businesses aren't easy to come by, so why have we let this one go?

The simple answer is that the stock is no longer good value. A price-earnings ratio of 23 looks expensive for a retailer whose main division is struggling to grow, particularly when it's also subject to cyclical, structural and one-off event risks.

Let's return to the 2009 financial year to examine the cyclical risks first. As the global financial crisis hit, uncertainty gripped investors, consumers – and travellers. In December 2008, Flight Centre announced that first-half profit would be down about 30% on the previous period as travellers delayed their plans and losses at Liberty, the company's just-acquired US business, blew out.

When Flight Centre released its interim result in February 2009 the market was well and truly spooked. The company reported an operating cash outflow of almost $300m and slashed its interim dividend by 76%. By March 2009 the stock was closing in on $3.00, having fallen an astonishing 90% in 15 months.

The cash outflow proved temporary and a year later the share price had recovered to $20.00. But the global financial crisis revealed that Flight Centre's business was cyclical, seasonal and subject to occasional shocks. In fact, we took advantage of a cyclical issue – fare discounting by airlines – to upgrade the stock in late 2016.

Shock and awe

Any number of cyclical downturns or one-off shocks could hit Flight Centre in future. The housing market or economy generally could weaken, an airline could collapse, or a pandemic could sweep across the globe. War could break out, there could be a terrorist attack, or a volcanic eruption could ground flights.

Flight Centre has faced many shocks already, it's true – with the noteworthy exception of an Australian recession (almost 27 years since the last one, can you believe?). But the more nebulous structural threat of the shift to booking travel online could eventually hit the company. So far the consistent growth of the corporate travel division, as well as cost-cutting internationally, has not only shielded earnings but driven them higher.

The natural segmentation – and vast size – of the travel market has helped too. There'll always be demand for personal advice from time-poor or ‘complicated itinerary' travellers. But ten years hence that market segment might be smaller than it is today.

There's little doubt Flight Centre's main division – Australian leisure – is struggling to achieve growth in the face of online competition. It's potentially worsening too, with total transaction value (TTV) for Australian leisure growing by only about 1% in the first half of 2018 (although the changeover to a new travel distribution system didn't help).

Leisure displeasure

Other management actions suggest leisure travel retailing is challenged. Flight Centre still makes acquisitions, but no longer in the leisure space. And online growth points to the future – the company's discount brands such as BYOjet and Aunt Betty produced 87% TTV growth and an operating profit of $2.5m in the first half.

If anything the structural threats have intensified and yet the share price has doubled. Such is the nature of our topsy-tervy stock market, which is obsessed only with profit growth over the next two years.

While the decision to sell Flight Centre vexed me, the buy recommendations vexed many members. This isn't a criticism; if you're not comfortable with a stock, you're not comfortable. You need to sleep well at night.

Nevertheless, there are a couple of psychological lessons to learn from this Buy recommendation that polarised many. (It's worth reiterating that analysts aren't immune to psychological obstacles – despite believing Flight Centre to be underpriced, I missed buying the stock myself partly because I waited for a slightly cheaper price that never came.)

The first lesson is the reverse of a Buffettism: you pay a very high price for a cheery consensus. Today Flight Centre's price-earnings ratio of 23 reflects just such a favourable outlook, whereas when we recommended it the stock traded on 13 times earnings and a free cash flow yield of 8%.

Negative narrative

Flight Centre's ‘negative narrative' was well known 18 months ago – at that point five profit downgrades, the risk of a sixth, and the not-at-all-new threat of online competition were baked into the price (Intelligent Investor's analysts had been debating the online booking threat for a decade). In 2016 Flight Centre was one of the most shorted stocks on the ASX, and stocks with a well-understood negative narrative are sometimes underpriced.

The second lesson is to beware of confirmation bias, which is the seeking out of information that agrees with preconceptions. Member comments below Flight Centre reviews provided many examples.

One member suggested that Flight Centre's sixth (and final) profit downgrade was confirmation of a mistaken recommendation; another assumed that Webjet's strong profit growth implied Flight Centre was losing market share (when there was no evidence for that particular link). Mental shortcuts must be used with caution.

Confirmation bias was particularly easy to fall victim to because Flight Centre's growth engines – corporate and international – weren't visible in your local high street, whereas the slower-growing Australian stores were ubiquitous. Assuming that other people are the same as you or your peer group – ‘everyone I know books travel online' – can miss other market segments.

Perhaps the best way to describe the disagreement with the Buy recommendation on Flight Centre – and don't get us wrong, dissenting views are important and encouraged – is that it was based on the ‘contrarian consensus'. When significant negativity is already reflected in the share price, it has become part of the consensus view.

Will we upgrade Flight Centre if the price returns to our $35 Buy price? We hope so but, as always, any upgrade will be based on a review of the evidence at the time. It's also possible we've exited too early, as betting against Flight Centre's management has been a mistake in the past.

In the end, though, we must return to the beginning: The stock is now some way from being underpriced based on the evidence before us. SELL.

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