Market Cap (£) = 87m
Shares Outstanding = 142.2m
Price = £0.60
Sector = Aviation & Distribution Logistics
Country = United Kingdom
Cheap on Many Metrics
Price/Sales = 0.16
Price/Earnings = 5x
FCF Yield = 33%
Div Yield = 2%
Div Cover = 10x
“The easiest way to become a millionaire is to start off a billionaire and go into the airline business.” – Richard Branson
Dart Group is primarily an airline (80% of profits) and therefore comes with the stigma associated with that sector. It is capital intensive and economically sensitive with high fixed costs and cyclical demand. It is a horrible industry plagued with excess capacity.
The sensible bit of advice from Mr Branson at the top has been widely followed by prudent investors who shun the sector or the brave investors who “borrow but don’t own” the stocks. I believe this has presented us with a compelling opportunity. DTG is a profitable business at a huge discount to the value of its assets if you closed up shop and liquidated everything today.
If the business remains profitable then at some point the market will be forced to recognise the inherent value of the assets and the earnings power in the business. One analyst puts a sum of the parts at 250p but applies a 40% discount to this for his price target due to management owning 40% and “limited investor exposure”. It seems odd to me to apply a discount because you know a management team is aligned with you as a shareholder and because investors won’t look below a certain market cap.
If we exclude the CEO’s 40% holding, management holdings and the 20% and 7% respectively Schroder and JO Hambro have owned for at least the last 2 years, there is a free float of only about £25m. Not worth the time of sell side analysts looking for commissions or buy side analysts at the big fund houses. It’s way below the radar.
How about we term it a growing, well diversified, asset backed, owner-operated, consistently profitable business and see if we can get comfortable with it?
Peel Hunt describes DTG as “a cocktail of entrepreneurial flair and conservatism”. I would describe it as unknown, unloved and misunderstood. The problem is that this business doesn’t have a “normal” strategy, its building a diversified, integrated leisure and services business which cannot easily be compared with peers.
Current trading conditions for Jet2 will be challenging of course, there are Europe wide macro concerns and the consumer sentiment is on its knees. Jet 2 is experiencing weak demand whilst it tries to expand across the UK regions. Capacity increased 26% over the summer of 2011 as it expanded into Glasgow airport. Fowler Welch is continuing to grow too into its new built capacity but its having to do soon tighter margins. The aviation business is the larger of the two, contributing circa 80% of earnings but I believe the less cyclical Fowler Welch is going to increasingly balance out the earnings of its bigger sister company.
It has not always been this way, in March 2007 this company had net debt of £44.5m as of September 2011, I calculate free net cash of £10.3m or 7.2p per share. There is actually net cash of £107.4m or 75p per share, but most of this is restricted as deferred revenue.
Jet2 runs an airline from its hubs in the Northern parts of the UK. This segment has other complementary parts of the business including chartering and a contract with the Royal Mail for overnight deliveries.
Jet2 has unusually high utilization rates for the airline industry because of its unique business model. Eight of the DTG aircraft are “quick change” which means they can be converted in an hour from day time passenger aircraft to night time cargo planes to fulfil their Royal Mail contract. This demonstrates operational flexibility and efficiency and furthermore de-risks the business a little because the Royal Mail business is considerably less cyclical/discretionary.
Jet2 benefits from a negative working capital cycle – customers pay for flights/holidays before they take them. This means that DTG gets the use of the cash for the interim period between payment and providing the service. This materially strengthens its balance sheet and enhances its flexibility. Operationally this means the business is getting paid for its working capital (interest on the float) rather than borrowing from banks and paying interest to fund working capital.
Because they operate freight, passenger and charter aircraft there is an element of flexibility where they can move capacity from one use to the other to meet demand (or lack thereof).
Of the 38 planes DTG operates they own 30 outright and 4 are leased. By owning the planes the company brings significant assets onto its balance sheet and limits capex on lease payments or finance. This lowers its sensitivity to demand and improves its free cash flow.
Because Jet2 is consistently profitable it has had the fortitude to strengthen and broaden its geographic footprint whilst many competitors were fighting fires during the downturn
Revenues for Jet2 = Capacity x Load Factor (bums on seats) x Revenue per Passenger
In 2011 Jet2 flew 3.4m passengers. The average net ticket yield in 2011 was £52 and the additional retail revenue per passenger was £25. See how this compares to peers below. The additional retail revenue per passenger is from items like premium seating, priority boarding and in-flight retailing.
Jet2 attempts to differentiate itself from the other budget operators by allowing larger baggage allowances, scheduling flights at sociable hours, awarding loyalty points and by using allocated seating like a mainstream airline. This earns brownie points with families who don’t have to struggle to ensure they are all sitting together.
The expansion across the north of England offers substantial opportunity; the move into Glasgow as of H1 2011 was co-incidental with the collapse of budget carrier Fly Globespan which accounted for between 5-10% of Glasgow Airport’s traffic.
The Aviation division’s fleet is slightly older than the industry average according to Collins Stewart. This is apparently totally acceptable because the lower number of flights DTG puts each plane through limits stresses on the airframes although the overall age is worth bearing in mind. At later stages in the plane life the depreciation charge should tail off in sterling amounts too – a 5 year old plane loses less value over 12 months than a brand new plane does.
In addition to this are the stable fixed margins that come from the charter and freight businesses which represent about 20% of division revenues or £80m per annum. The largest part of this is the Royal Mail contract.
Jet2 Holidays is a business founded in 2007 which directly sources holiday and hotel packages for customers. It provides the potential to increase customer wallet share, increase load factor on planes and further encroach into the decimated travel agent industry and hoover up market share. It provides a natural pathway to expand routes and operating bases for the Jet2 business. See the chart below from Peel Hunt…
Jet2 Holidays could really be a growth driver for the business as it picks up momentum. The business sold over 100,000 holidays in 2011 and evidence would suggest that engineering a successful family holiday will engender repeat business and brand loyalty.
Jet2 has in place a 40 person IT department which facilitates dynamic, real time pricing of flights and they have the discretion to bundle offers to customers whilst booking – this is used to improve yield from customers. I would suggest that this is a particularly large cost sitting within the group as it stands and as the airline and Jet2 Holidays “grows into it” there is maybe room for improving margins here.
“Balance Sheet Investment”
DTG is what I would describe as a “balance sheet investment”; I have a theory investors, and particularly the sell side, become infatuated with the income statement and in particular earnings growth. Lip service is paid to “strong balance sheets” but people don’t really look to see “What assets am I buying here?” It’s like buying a property for the rental yield but not checking the structural integrity of the building.
The margin of safety in this investment comes from the net assets on the balance sheet. The largest asset is the 30 aircraft which had a book value of £180.2m as of 31 March 2011. Let’s be conservative and cut that in half to imagine a liquidation scenario, you still get £90m or 63p per share.
Dart has no “nasties” hiding on the balance sheet that I could see, for example there is no pension deficit like British Airways infamous £3bn shortfall.
Fowler Welch Coolchain (FWC)
Fowler Welch is a UK leading logistics provider distributing fresh and chilled produce to supermarkets and wholesalers. Retailers pay FWC to deliver goods in a time critical and careful fashion – this is an important value add service. It has been operating for 30 years and was purchased by Dart Group in 1994. They operate from 1.1m square feet of warehouse space across 14 distribution hubs (13 in the UK, 1 in Holland). 500,000 square feet of that space coming online in H1 2011 in their Manchester distribution centre called “The Hub”. I believe this business offers a non-cyclical compliment to the Jet2 business.
The distribution business has what I consider to be some high quality contracts. Tesco, Asda and Morrisons are supermarket customers. Mars, Unilever and Kerry Foods are perishable clients. FWC is embedded in the supply chain. There are 400 trucks within the logistics business which are all on short leases. This increases the cash outflows but it also keeps the vehicles new and allows them to flex the size of the fleet depending on demand.
The business is winning and keeping contracts – for example it had Tesco for the North East and has recently won the provision of warehousing and delivery for the South West.
Margins have suffered in the distribution business over the last year or so because of the disruption and capex that has resulted from bringing “The Hub” in Manchester online. One off & duplicate costs were quoted at £2m which in theory makes this a £5m profit business. Going forward, after the major capex, this should be a relatively stable margin business.
CEO Phillip Meeson has demonstrated an ability to take steps to stop wastage or inefficiencies; after a review the Felixstowe operation was deemed surplus to requirements and shuttered this year. They have leased a new unit in Devon to attempt to expand the business further in the region; this seems to me to be a prudent and cautious approach rather than investing a few million in rolling it out without guaranteed customers.
FWC is a natural consolidator in what is still a relatively fragmented industry. Highly professional, high tech, large scale operators like FWC are primed to take market share from smaller operators as supply chains rationalise and the big retailers and food producers want to rely on just one contractor. This should help protect or even expand margins.
Apparently management have expressed that they would be willing to listen to offers for the distribution business but it has been suggested that perhaps they would expect something close to the total current market cap for that part of the business. This doesn’t seem totally unreasonable if we say we agree with the numbers in the graphic above – the distribution business could make 4-5% margins on £140m revenue = £6m profit. That would be a 14x multiple on the growing business without considering the freehold assets which Peel Hunt estimate are worth £27m. This would make sense since The Hub is about half of the floor space and cost £15m.
As mentioned above Jet2 benefits from a negative working capital cycle which makes them very cash rich – they get paid to hold customer money. They also have a very high cash conversion rate due to their ownership of the aircraft fleet. Each year they take a sizeable depreciation hit on the income statement but that is a “non cash charge” and isn’t money leaving the business.
DTG has remained consistently profitable and at current valuations I think investors will make money so long as it doesn’t post losses. However, if you take the average of the last 5 years the average is £18m of profit and that includes the breakeven in 2008. That means we’re looking at something close to 5x through the cycle earnings, and those earnings are growing! As I have suggested, the addition of the extra business line of Jet2 Holidays and the expansion of FWC means that earnings volatility will hopefully be lessened going forward.
It is also of comfort that the Aviation group has never had a year where both volumes and yields have declined simultaneously – they have the flexibility to give on one to maintain the other.
Currently the company has cash of £107m on the balance sheet. Interest income for the 6 months to Sept 2011 was only £0.2m. If we ever return to a “normal” interest rate environment a float of this size could earn £3m in interest easily – that’s 2p a share.
A further comment on the £80-100m of this that is “restricted cash”; it is important to remember that this restricted cash isn’t going to have to be “given back” at any stage its merely prepayment for future services rendered. Restricted cash comes from “flights not yet flown” and the standard £30 deposit on Jet2 Holidays taken 6-8 weeks before travel. When the services are provided, which does admittedly cost money, the “restricted cash” immediately becomes unrestricted free cash flow. That money is not going to leave the business, some of it is merely used in the service provision process. It is not “owed” to anyone bar the small amount that might be given as refunds.
The strategic asset of this large float also helps lower financing costs if the business needs cash for any Capex.
The Founder and CEO of Dart Group is Phillip Meeson who owns 40% of the stock (£35m). After a career as a pilot in the RAF he made his first business moves in the used car industry before moving to Jersey to start what subsequently became Dart as a flower import business. This is the career path of an entrepreneur and visionary. There is also “key man risk” in a venture like this.
Management have earned our trust having navigated through the crisis in 2008 by reducing capacity and operating with discipline within Jet2.com to weather the storm. Their willingness to show restraint and large insider ownership gives me great comfort that our interests are aligned. That they managed to grow the business through the crisis is testament to their quality.
Since coming to the market Dart Group has never sought equity finance from its shareholders and management take long term value creation perspective over a short term earnings focus.
Meeson took a salary of £400k in 2010 so he is not excessively remunerated given he created the company. I would suggest that this will focus his mind even more on the share price and perhaps on the dividends he might wish to receive on his stake. He describes himself as a workaholic who is happily divorced. From what I can establish from a Google search, at least half of his net worth post divorce if not considerably more is tied up Dart Group equities. As a 64 year old man I think he has got to be considering realising the value he has built up within the group in the coming year or so.
Investment Case Summary
Freehold Property £27m
Aircraft worth £100-200m
Unrestricted Free Net Cash £10m
= at least £137m of Assets/142m shares = 96p per share
Distribution Profits in FY 2011 (on a trough due to capex?) of £3m
Aviation Profits in FY 2011 of £23m
= £26m EBT/142m shares = 18p per share of earnings before tax
For the Aviation business it is interesting to note that EasyJet trades around its NAV and that RyanAir, presumably as a consistently profitable industry leader, trades at a 60-70% premium to NAV.
So we think that at 60p DTG trades at a 37.5% discount to our conservative NAV above. Historically the average back to 2007 is 19% with a low point of 70% at the market lows. As I pointed out earlier however, this business used to be indebted and in 2008 it barely broke even. Now it’s net cash, robust, in control of its own destiny and management are a little more savvy for their experiences in the last downturn. A with these characteristics does not deserve the discount this punitive.
Strengths of Dart Group Relative to Peers
Focus on the Tier 2 cities in the UK, avoids the competitive London market. The regional airports do not offer a large enough prize to justify an aggressive move by a larger competitor. Even in this event Dart has the balance sheet to respond aggressively to defend itself, this company would not be easy to force out of business.
The eight quick change aircraft offer a defensive revenue stream and keeps the utilization high. I believe this is a fairly unique trait to DTG.
The robustness of the business is keeping it alive as the competition falls by the wayside. Fly Globespan, XL and Sky Europe have disappeared from the airline industry, British Airways was forced to merge with Iberia. In the travel business, Goldtrail and Kiss Flights have gone bust and Thomas Cook and Tui Travel or on life support requiring write-downs and rights issues.
Risks to the Thesis
As with any airline there is a risk if the oil price gets very high. Jet2 have a hedging policy but sustained high prices will still be very detrimental to profits.
UK economy – since close to 100% of sales come from the UK there is sensitivity to the weak consumer and tepid growth outlook. There is the possibility that their budget/value offering means that what they lose in sales at the bottom they may gain in mid range consumers trading down but in a serious downturn, discretionary spending gets mothballed.
Charles Stanley estimate £19m (4%) of revenue comes from credit card fees – this matter is currently under review by the Office of Fair Trading. It seems likely however, given this an industry wide practice that any ban on this practice would be passed on by all airlines to customers through higher fees or other charges. It is however worth bearing in mind.