A Punter's Review: Flight Centre (ASX:FLT)

The Business

Flight Centre (ASX:FLT) is an Australian company that essentially has four main businesses:

1. Flight Centre Retail / Leisure
   • Flight centre retail outlets
   • Escape Travel
   • Student Flights
   • Intrepid My Adventure
   • Cruiseabout
2. Flight Centre Corporate
3. Wholesale (selling holidays to independent travel agents)
4. Other
   • Bike Retail and Wholesale (Managing Director's son)
   • Healthwise
   • Moneywise

The travel businesses account for over 98% of revenue and profit. Flight centre is predominantly a bricks-and-mortar travel agency and are thus far not competing much in the online space.

About 57% of their travel bookings are made in Australia, the remainder split between the U.S., U.K., Canada, New Zealand, South Africa and some emerging markets.

An overview of Flight Centre's history reveals it obviously has a very solid recipe for successful bricks-and-mortar travel agencies. I would say it's the closest thing to MacDonald's (MCD, Financial) in the travel world; by that I mean they have a blueprint for their businesses that ensures:

• Standardisation and consistency
• Profitability
• Leveraging of their purchasing power (and hence pricing power)

The importance of consistency in service is highlighted in their annual report.

Their continued success recently is particularly impressive as online booking sites like Expedia draw people away from shop fronts.

Economic Moats

The most significant moat is its Australian pricing power. Effectively it's not charging its “customers;” it's actually charging a commission on bookings. Its commanding market position in Australia enables it to secure cheaper flights to then on-sell for a higher margin than competitors. Overseas though it doesn’t enjoy this moat. And it also has some strong wholesale competition that is growing.

It's unlikely that it will be able to leverage this moat in the longer term. The reason is that it needs to grow; the new offshore markets it really has to rely on don't enjoy this purchasing power. So in effect, as it grows, margins will be squeezed. There may be some step changes in other regions if its presence starts giving it pricing power, but that's a blue-sky scenario.

Arguably its brands and successful business systems also provide it with a competitive advantage, but they're fairly weak moats.

Management

Graham "Skroo" Turner is obviously a natural entrepreneur. He’s built a fantastic business which is making the most of opportunities that are present and doing well to fend off challenges. His critics cite the following shortcomings:

• Flight Centre is riddled with related party transactions. The business acquired a bicycle business and installed Turner's son as MD. His wife owns a boutique hotel chain which Flight Centre pushes as one of its preferred destinations. Flight Centre also purchased Top Deck Tours (Skroo’s first business that he still held a share in). It’s quite possible that these examples are actually good for Flight Centre; however it’s also possible that they’re more sentimental.
• He likes getting his way (and is possibly pushing the board around a bit on the above decisions?).

The business has met with considerable challenges over the last 20 years, however, looking at the historical financials, you wouldn’t know it. This is a tribute to management and their ability to evolve the business. Skroo Turner is just over 60 years old and believes he has "another 10 years" left. Such is his capacity, it seems the business is well and truly safe for his remaining tenure. Thereafter is unknown territory. I doubt this is a business that can run itself.

The management remuneration is very well aligned with shareholder interests. Management is highly incentivised to perform (in fact the whole workforce is). Executives have relatively small base salaries. The board, however, does seem to be very well paid, although it is small so the cumulative financial drain on the company is relatively small.

Average tenure is exceptional. Most leaders are sourced within the business and the exec team has something like an average tenure of 20 years with Flight Centre. In terms of maintaining a culture, this is very positive.

Financials

The balance sheet is very healthy, next to no debt. They also have good cash flow. Historically their sales and profit figures are also fantastic.

Return on equity and profit margin is also very healthy. I'm most impressed with the ability of Flight Centre to maintain comparable (or better) margins than the online booking sites. Given their physical presence (staff and leases) I expected margins to be much thinner than their online only competitors.

Interestingly sales growth is pegged at 5%, whereas profit has grown at 20%. The business has managed to really increase margins over the last 10 years but it's questionable whether this is sustainable in the longer term for the following reasons:

• They will need to rely more on offshore markets to continue growth
• Their current margins in offshore businesses are much lower than Australia (about half).
• They are a long way from achieving the buying power they enjoy in Australia in these markets, and hence improving these margins

It seems very likely profit margins will be squeezed and profit growth rates will retract back in line with sales growth.

Risks

The following risks were identified by Skroo Turner in the annual report and I’ll address each of these individually:

• Economic uncertainty, which can adversely affect short-term demand

• Global pandemics, SARS for example, that may cause travellers to temporarily bypass affected areas
• Use of alternative distribution channels that potentially allow suppliers and/or customers to bypass agents
• Reliance on the Australian business to drive overall group results
• Cost control and the need to enhance in-store productivity, given that major expense items (wages, advertising and rent) typically increase while airfare prices typically remain steady or become more affordable in real terms
• Leadership, staff development and recruitment to meet ASX:FLT’s growth needs; and
• Inconsistent customer service

Economic Uncertainty

History doesn’t really seem to support the argument that earnings are going to be significantly affected in a sustained manner. If you look at a ten-year history of Australian consumer confidence and net profit margin for flight center, there’s no real correlation. 2009 was a tough year and profit margin dropped to 6 percent from an average of about 9. It quickly picked up again though which is good to see.

The Australian exchange rate does seem to have more of a relationship to profit margin. This supports the idea that bricks and mortar agents are utilised preferably for overseas bookings and that people are more likely to travel overseas with a high dollar. Again however, quite significant swings in exchange rate don’t seem to have a very large effect on net profit margin (so even when it does hit, it’s not hard).

Global Pandemics

If you’re worried about this one, hedge the risk with an investment in CSL (you’ll probably do really well out of this investment with or without pandemics)! In all seriousness, though, the SARS epidemic did affect them significantly, so it's on their radar. There's not a lot they can do about it except stay strong enough financially to weather it (which they seem to be doing presently).

Alternative Distribution Channels

Expedia (EXPE, Financial) is probably the biggest threat in terms of alternative distribution channels. At present, Expedia have about 2.6 times the Total Ticketing Volume (TTV) and revenue of Flight Centre (but only 1.8 times the earnings). Flight Centre has a significantly higher operating and profit margin. Interestingly both businesses make about the same “commission” on TTV going on the rough numbers below. World air travel growth rates are at about 5-6% (World Bank), so clearly Expedia is picking up competitor’s market share in order to grow, Flight Centre is holding steady.

There’s certainly a trend away from bricks and mortar travel agents. This is noted in research by Roy Morgan on the Australian Market. This seems to be a global trend, for example in the U.K., approximately 80% of overseas holidays are booked online.

Interestingly though, Flight Centre who were losing market share seemed to have recently pegged some back from 8.3% in 2013 to 9.1% in 2014 (note this change may be due to sample error). However the retail travel agent is still relied on more than the internet (at least as late as 2012) for overseas travel advice and the majority who sought advice from the agents, go on to book with them.

There’s a few explanations for why travel agents are maintaining market share. It may be the aging population, a portion of whom are unwilling to embrace technology. In this case Flight Centre probably have some short-term tail winds (baby boomers retiring and taking more holidays) and long term headwinds (as a greater percentage of the population becomes tech-savvy).

The other explanation is that there’s a technical limitation to online bookings, such as the inability to book multi-point, multi-carrier international flights. This is somewhat supported by Roy Morgan’s research, which states the agents are the preference for Australians who are flying overseas. If this technical challenge is solved by Expedia, Booking.com or another competitor then it could pull more market share from Flight Centre.

Alternatively, this preference to use an agent for overseas bookings may also be driven by better information (visas etc) and higher stakes if the booking is stuffed up.

I think this risk may be manageable but is definitely one to watch, and I’d certainly feel more comfortable if Flight Centre were getting more involved with the online space, particularly mobile and tablet apps.

Reliance on Australian Business

This is a real risk. Flight Centre is diversifying; however, the overseas markets are clearly tougher than Australia. Some quick facts to support this:

• Australians booked 37% of all trips with agents in 2014, and overseas trips were the most “agent heavy” type of trip, whereas in 2013 in the U.K., just 15% of overseas trips were booked with agents.
• ASX:FLT's earnings to TTV ratio in Australia is 3.2% whereas offshore it is as low as 0.04% (Canada) and the highest is the U.K. (2.6%). So it seams they are going to have to work harder for the overseas earnings. Possibly some short tailwinds in this area as exchange rates drop, but that could squeeze local earnings also.
• There may be limited opportunity for further growth in the Australian market.

The last point is somewhat debatable, however. According to Roy Morgan Research, the top 10 agents/web sites only accounted for 34.5% of total market share in Australia in 2013. The opportunity for Flight Centre here is to pick up the bookings going to the other 65%. This may be a case of acquiring market share (rather than organically growing it). They are certainly in a commanding position to do this, their next largest "bricks and mortar" rival is Harvey World Travel with 2% of market share.

In isolation this risk is only going to effect growth, not stability, and if the bricks and mortar travel agency market share stabilises, there's still growth opportunities in Australia.

Cost Control

It seems they’re doing a better job of this than the online competitors which is phenomenal considering the physical presence required by Flight Centre. I’m also buoyed by management’s ability, awareness and past performance (margins are pretty consistently healthy).

Leadership

Their strategy is very solid in this area. If the 2014 annual report is to be believed I don’t think you could ask for a better group to be leading the company as a whole. I think they will ensure the middle management is up to the task also. It really sounds like they look after their people.

Inconsistency in Customer Service

Again, I’m very buoyed by management’s awareness and strategy in this area.

Risks Not Considered by Flight Centre

One leadership risk that I think it worth mentioning is that many of the executive team are earning very significant figures from the Business Ownership Scheme (BOS) which essentially gives staff the ability to invest in their own business units. While business is good, these staff won’t be going anywhere as they couldn’t hope to receive similar levels of remuneration elsewhere. However, if business starts faltering (due to outside controls) this incentive disappears and their collar is effectively removed, enabling them to move on. This presents a risk, in tough conditions when they need their best people most, there could be a run of good senior staff and a knock on effect in performance.

Acquisition risk is also something that should be mentioned. They're probably safe in this regard for the short to medium term as they burnt their fingers in 2008 with a U.S. acquisition that didn't pay off and are probably sensible enough to remember this one.

Summary of Risks

I certainly don’t think Flight Centre can tank in the short term. It’s financially stable and has weathered some significant storms easily in recent history with essentially the same management group. The risks noted are manageable, particularly if they continue to evolve as they have historically. The online travel booking space seems to be the biggest threat and this needs to be watched carefully.

The Tough Questions

I like to ask myself these questions before making an investment.

Is this a business I’d be happy to buy now and forget about for 10 years?

Yes, but that’s pretty much the limit due to Skroo Turner’s age. So I’d be reluctant to buy it in five years time and then forget about it for 10 years.

If I had a punch card with only 20 slots on it for capital allocation decisions, is buying this business worthy of one of these slots?

No, not at today’s price. Possibly at $30 a share, so price needs to come off a bit to justify this.

Is there any element of impatience influencing my decision making process? (Don't let “missing out” tempt you).

This is the biggest motivation to buy at the moment. But it’s not worth it at today’s prices. Although they've recently fallen about 20%, there likely better purchases out there (even though the market as a whole is probably just over fair value).

Is this business inside your circle of competence?

Yes, it’s a pretty easy business to understand, they’re an expert sales team (I'd describe them as "the MacDonald’s of travel agents”).

My Valuation and Recommendation

I have a very high level of confidence in this business. To value the business I relied on two DCF models:

• Present value of 15 years worth of future cash flows using the below assumptions, which yielded a value of $34.
• The above earnings in addition to revenue gained by selling the company at the 15-year mark for 5 x PE it would be worth $44 today.

These are long time frames but when you're looking for truly excellent businesses they're probably short time frames (Buffet: "Our favorite holding period is forever"). Taking a long-term view also helps one to carefully consider the risks and galvanizes the research effort. I believe the second scenario is the more realistic given my assumptions (there’s a lot of de-risking in them already). Taking this valuation it’s trading a little below fair value today.

Applying a 150% value-to-price ratio margin of safety would see my buying eagerly at $30. It hasn’t been at these levels in nearly two years so I may not get in. But I'm going to sit on my hands and hope. Over the past 10 years it’s taken a 40% fall (2004-2006) and a 70% fall 2008-2009, so I’m going to be patient and hope the market gets cold feet about something!

DCF Assumptions

• Sales Growth – 5.5% (Historical and also the international growth in flights)
• Profit Margin – Starting at 11% and depreciating down 4.4% at the 15-year mark as the growth relies on offshore markets where pricing power is more difficult. Used diminishing value type calc for this.
• Discount Rate: 4.5% (long term cash deposit rate)

Beware: Flight Centre has a history (especially recently) of exceptional growth in times of adversity which I believe is a testament to management. Having researched the business I have a gut feeling they'll do this again and the share price will soar further. What I've presented here is a "hard but fair" valuation that tries to avoid pricing this potential upside. This approach may have missed the 500% value increase that shareholders have enjoyed since 2009.