Flight Centre; The One That Flew Too High

This story features FLIGHT CENTRE TRAVEL GROUP LIMITED. For more info SHARE ANALYSIS: FLT

Flight Centre delivered a welcome surprise, upwardly revising guidance for FY17 towards the top end of its prior range. Nevertheless, brokers consider the valuation is stretched.

-Recent share price rally considered excessive
-Is risk still skewed to the downside?
-Major efficiency initiative under way which could deliver value
 

By Eva Brocklehurst

Flight Centre ((FLT)) delivered a welcome surprise, upwardly revising guidance for FY17 after a string of downgrades in recent years. The company expects pre-tax profit between $325-330m, up 2.5-4.9%, and signals a strong sequential improvement in trading in the second half. This is the first growth in earnings the company will have reported since the first half of FY16.

Morgans considers the upgrade a significant positive and believes the company is now through the worst of what has been a challenging period. The broker asserts the return of earnings growth in the second half is illustrative of cyclical issues rather than the structural threat that many feared.

Although there has been some moderation in airfare deflation, the company has delivered strong volume growth, which Deutsche Bank suggests is indicative of market share gains, given a weaker backdrop. The broker expects the increased focus on costs and productivity should assist margins going forward but acknowledges the stock is not cheap, although the outlook is considered better than it has been for quite some time.

Share Rally Overdone?

Citi observes the supply-demand outlook for airfare pricing has clearly improved and implements double-digit upgrades to its earnings estimates for FY18 and FY19. Still, the broker believes the share price has factored in an optimistic growth profile and/or major cost reductions. Citi downgrades to Sell from Neutral.

Morgan Stanley agrees the recent movement in the share price is over the top. The broker suspects that the main drivers of the better-than-expected FY17 guidance are the recent improvement in Australia's consumer cycle and faster moderation of international deflation. The broker also notes volume growth continues to outpace the market.

Does this announcement justify the sharp upward movement in the share price since March? Morgan Stanley suspects not. Consensus earnings forecasts are likely to move up to the guidance mid point, so up around 6%, which implies that the shares, having risen 50%-plus, have re-rated considerably. The broker believes pressure on the company's model in Australia continues.

As an indication, the price/earnings multiple of 20x on FY17 estimates implies significant earnings growth and would be a considerable reversal of the last three years. Morgan Stanley forecasts earnings to decline in FY18 and retains an Underweight rating.

Growth in the second half was driven by better performances in several of the company's jurisdictions, notably North America and the UK. The company has guided to a record result from the US business and improvements in Canada and is also guiding to local currency growth in the UK business.

While Flight Centre did not provide specific reasons for the strong performance in the US and UK, Macquarie believes it was driven by the small-medium enterprise market which the company has been targeting over recent years. Despite indications the US and the UK are delivering "record results" this year, the broker suspects the weak GBP is a headwind.

Meanwhile, Australasian business improved during the second half because of increased prices for air tickets and robust turnover, despite soft discretionary spending conditions elsewhere, brokers observe. Credit Suisse highlights the resilience of travel volumes and the strong recent retail trade figures as a paradox in a low-wage growth environment.

Australia, the company's most important leisure business, is suffering from high levels of inbound capacity and, in this context, Macquarie considers the stock expensive on an absolute and relative basis, maintaining a view that continued softness in airfares in FY18 and medium-term margin declines, coupled with valuation pressure, mean risk is skewed to the downside.

UBS upgrades its earnings per share estimates for FY17-20 by around 6%. While believing the company is in a strong position to grow earnings in FY18, the broker is cautious on the Australian consumer outlook and suspects this could limit further upside, given Australia makes up over 70% of Flight Centre earnings.

Transformation Program

Credit Suisse believes the share price has now overshot valuation and downgrades to Underperform from Outperform. Despite this, the broker notes there are several avenues to improve value. A major efficiency initiative is under way and the company has a potential for significant reduction to costs from further automation of back-office functions.

Sustainably reducing the cost structure of the store network is less obvious, in the broker's observation, although achieving a -5% reduction in cash costs would add around $4 per share to valuation, all else being equal. The main challenges facing the company centre on gaining the benefits of vertical integration without over-committing on fixed costs, Credit Suisse suspects, and to manage the risks associated with concentration in any particular market.

Morgans is also encouraged by the decision to pursue internal improvements through the business transformation program, yet agrees the recent share price appreciation has largely factored in the benefits of transformation and subsequent earnings recovery.

Until management is able to quantify the level of earnings improvement stemming from its transformation program, the broker believes the stock is fairly valued and retains a Hold rating. The company is expected to provide further detail on the targeted benefits at its FY17 result.

FNArena's database has four Hold ratings and four Sell for Flight Centre. The consensus target is $36.02, suggesting -14.7% downside to the last share price. This compares with $30.93 ahead of the update. Targets range from $28.70 (Macquarie) to $40.00 (Morgans, Citi, Deutsche Bank).

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms