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Flight Centre: Structural Or Cyclical?

Australia | Mar 20 2017

Travel agency Flight Centre has overseen a decline in its earnings trajectory for several years. Brokers review the dominant themes in the outlook.

-Mixed expectations for whether a recovery in airfare pricing is underway
-Could valuation be improved by the closure of 20% of the company's stores?
-Online business development key, but further investment required

 

By Eva Brocklehurst

Is it structural or cyclical? For some time this question has prevailed in the analysis of travel agency Flight Centre ((FLT)) as the company has overseen a decline in its earnings trajectory.

Acknowledging structural issues persist, such as the change from store-front travel agencies to online bookings, Credit Suisse believes that the company's potential for near-term cyclical improvement warrants a more positive view.

Most of the deterioration in FY17 profit expectations is attributed to cyclically low airfares and, therefore, based on a view that prices will improve over the next six to 12 months the broker moved to a Outperform rating in the wake of the company's first half results.

Macquarie acknowledges its forecasts may be too bearish but disputes that the dominant issues are more cyclical than structural. The broker also disagrees with the timing regarding a cyclical upturn and does not expect a recovery in pricing until FY19.

The broker believes the Qantas ((QAN)) international unit is a reasonable proxy in terms of revenue growth and indicative of the direction in which prices are heading and, while not the only carrier engaged with Flight Centre, does reasonably represent the unit revenue performance of those airlines offering tickets for sale through Flight Centre.

Therefore, Macquarie's proprietary capacity data shows growth easing into the first half of FY18 and that the market still needs to absorb the 16% increase in capacity that has occurred over the last two years for Qantas. Accordingly, Macquarie does not expect a recovery in ticket prices until FY19 and transfers this expectation to Flight Centre.

CLSA takes a different tack, observing Flight Centre recognises revenue about three months ahead of the airlines. The company is one of the few in the top 100 with more than 10% of its market capitalisation net cash, the broker asserts, and it has a strong forecast free cash flow yield of 7.5-8.0% for the next two years which, when adjusted for net cash and investments, increases to more than 9%.

The broker, not one of the eight monitored daily on the FNArena database, has a Buy rating and $35 target, and believes the Australian business is structurally sound. Earnings are expected to stabilise in the current year.

CLSA acknowledges it is critical, as the pressure on revenue subsides, that Flight Centre demonstrates positive operating leverage. As the second half is seasonally stronger, the broker is looking for a rebound and believes earnings could show a recovery.

The risk to FY17 earnings may be reduced and there is an easier growth comparable now, with less FX headwinds, but the issues are structural, Morgan Stanley believes, as Flight Centre was once a stock that delivered superior earnings growth year-on-year and is now expected to report its third year of profit declines, despite making accretive acquisitions.

On this basis, the broker envisages ongoing pressure on margins, which will be driven by the continuation of lower airfare yields, growth in low-cost carriers and the headwinds from growing online transaction revenue, which is at a significantly lower margin.

Morgan Stanley is also sceptical regarding capital management, given earnings remain under pressure and the company continues on a path of making small acquisitions. The broker remains Underweight.

Store Closure?

Valuation could be improved, in Macquarie's opinion, by the closing of around 20% of the company's stores. Total transaction value (TTV) per store has not grown since 2013 and since that time around 20% of the current footprint has been added.

For sure, there would be one-off hits to earnings from lease obligations and redundancy costs associated with such closures but, under a scenario where the company invests $100m online and maintains its absolute level of TTV at FY16 levels, the broker's current valuation would increase.

This assumes a continued decline in income margins but enough transaction growth to provide the offset from an earnings perspective.

In particular, Macquarie highlights 18 store locations in the Sydney CBD that are a throwback to when the company wanted to have a store front in every city block, such that workers would come down from their offices and book travel arrangements.

Online Business

Hence, online business development is the nub of the structural problems. The launch of Aunt Betty last year has meant the company has attempted a very late catch-up in the online business and, despite being on track to hit $1bn in TTV this year, this will be achieved, in Macquarie's calculations, with margins of only 7-8%.

The broker's sources suggest that while BYO Jet, acquired in 2016, provided the online engine for the company, further investment is required and success is not guaranteed. Macquarie maintains a Underperform rating.

CLSA also envisages the company screening well for private equity, as its focus on costs and pulling back on international expansions are obvious opportunities. Nevertheless, the broker acknowledges that "insiders” account for 46% of the register and are unlikely to cede control. CLSA believes the stock is cheap on both an absolute and relative basis.

Acquisitions

Macquarie considers a scenario whereby Flight Centre acquires Webjet ((WEB)), given existing assets are not expected to deliver sustained organic growth.

Such an acquisition would would be accretive and Macquarie's base case under this scenario assumes 40% equity funding and $25m in synergies, which would deliver accretion to earnings per share of 2.0%. Were there to be an all-debt structure for the transaction, with the same level of synergies, the accretion would be 13.1%.

FNArena's database shows two Buy ratings, for Hold and two Sell on Flight Centre. The consensus target is $30.74, suggesting 6.6% upside to the last share price. Targets range from $25.00 (Morgan Stanley) to $36.10 (UBS). The dividend yield on FY17 and FY18 forecast is 4.5% and 4.8% respectively.
 

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