Description

Dart Group:

We believe that Dart Group presents an excellent opportunity to potentially achieve base case returns of ~80% over the next two years.  Dart is trading at ~7.4x our calendar year 2016 earnings (~6.5x after backing out a conservative view of excess cash).1

We believe it is rare to buy a fast-growing, high ROIC business at this multiple.  We also believe this opportunity is safe given no debt, a very large cash balance, minimal lease leverage, flexible capacity, a long history with positive net income in every year, and a heavily discounted valuation.  The opportunity exists for the following reasons:

• Underappreciated “Holidays” business: Dart Group has a rapidly growing “Holidays” business whose profitability has been obscured by the historically much larger airlines business.  We believe this business has significant operating leverage and provides very attractive returns on capital and will soon comprise nearly half of profitability.  We believe this fee-based business deserves a premium to an “airline multiple”
• Capital Return Potential: Dart has accumulated significant excess cash on its balance sheet.  In addition, Dart is generating far more cash than is needed to fund growth (a position they have not been in historically).  We believe this will lead to capital return
• Lower oil prices: Dart’s fleet is set to benefit disproportionately from lower oil prices.  Fuel prices represent ~7x EBIT in Dart’s Airline business and there are reasons to believe Dart will be able to keep a disproportionate amount of fuel economics vis a vis other airlines
• Earnings estimates far too low: Earnings estimates do not appear to incorporate Holidays’ growth, uplift from lower oil prices, the impact of a weaker euro, and a restoration of normal yields / load factors after a highly competitive summer of 2014.  We believe low earnings expectations reflect interactions with a highly conservative management team, led by owner-operator Phillip Meeson (40% holder).  Historically, earnings expectations have consistently been far too low and we will map out why we believe this year (and next) should be no different

1 We will refer to earnings on a calendar year basis.  Dart’s Fiscal Year ends March 31st.  As such calendar year 2016 earnings refer to our FY 2017 (3/31/17) estimates

Business Overview:

A.) Leisure Airline (56% of CY 2016E Earnings): Dart is a leisure airline carrier that flies under the Jet2 banner.  Jet2’s home turf is the Northern UK and they fly passengers to various destinations across Europe and the Mediterranean.  Flights are concentrated during the summer season (the most common time to take a holiday)

•  Cost conscious: Dart’s management team is extremely focused on costs.  Market participants (and financial results) tell us that purchasing undervalued aircraft has been one of their core competencies.  They are also smart about running at low maintenance costs, savvy when it comes to the fix vs. scrap decision, and flights are a “no frills experience “ (but better flight experience than Ryanair)
• Royal Mail contract: Dart generates significant revenue from long-term contracts to deliver mail at night.  To do this, seats are pulled out at night and the planes are filled with mail crates (increasing fleet utilization)
• Regional focus: Dart focuses on the Northern UK, where they are able to achieve regional economies of scale in a market less competitive than the South.  We have heard there is also regional pride towards Jet2
• Float: Dart generates significantly more float from deferred revenues (vs. other airlines) given that vacations tend to be purchased further in advance than other trips (cheap financing, reduces capital intensity)
• Intelligent fleet management: Dart’s fleet is comprised primarily of older aircraft (15+ years old) that are almost entirely owned (minimal leases) with no debt against the aircraft.  Most airlines buy more fuel efficient new aircraft, and the increased purchase price results in higher lease and/or debt service cost.  The new aircraft strategy can be more profitable to the extent the aircraft are heavily utilized (frequent flights that are mostly full) as the fuel savings make up for the higher capital costs.

Dart’s leisure focus is highly seasonal, which results in a large portion of their fleet sitting idle during the winter.  Consequently, Dart has historically made the intelligent decision to buy old aircraft with minimal capital costs and to instead focus on load factors rather than flight frequency.  The lower capital cost of the aircraft allows Dart to fly the aircraft less frequently, which means their flights are generally scheduled at very convenient flying times which results in higher load factors.  The strategy is clearly working as Dart has historically generated ROICs much higher than peers, and the founder has effectively grown from 1 aircraft to 58 aircraft by re-deploying cash flows at high returns.

One very powerful benefit of Dart’s fleet management strategy is that it makes them incredibly flexible.  Given that aircraft do not have a fixed lease or interest component associated with them, Dart is able to reduce capacity to respond to market conditions by parking aircraft without burning cash.  This has been one of the key drivers of their consistent profitability historically (2009 was a new record for the company in profitability because they massively reduced capacity to offset declining demand).

We also want to reiterate that the fleet is old on purpose.  When we originally looked at Dart, we saw the old fleet and thought there might be a large amount of capex to replace the fleet given its age.  What we did not realize at first was that this was not a young fleet that had aged and would be replaced with new expensive planes at some point.  Rather, the company consistently purchases aircraft that are 15-20 years old and uses them until the end of their useful lives

This business model has generated historic returns on invested capital in excess of 20%, which we think speaks well to Phillip Meeson’s model.  Further, mgmt. has grown the business quite prudently.  Since 2010, load factors have improved by 11 points while increasing capacity by ~65%.

B.) Holidays Segment (40% of CY 2016E Earnings): The Holidays segment sells vacation packages that include flight, hotel, car transportation, and activities (Jet2 is the airline on all packages).  Bookings are 50% internet-driven, 30% telephone driven, and 20% travel agent referral

•  Aggregators less influential in the UK: The budget airlines have effectively blocked the aggregators from selling their seats.  Instead, Ryanair and EasyJet have formed partnerships with Booking.com to offer hotel reservations directly from their own websites.  As such, customers typically go directly to the Ryanair site (if focused on cost) or the Jet2 website (if focused on the best holidays packages)
  •  Our industry research suggests that many Northern UK travelers prefer to travel through a tour operator (who manages foreign country, language, and currency issues).  There are obviously customers who prefer to set up travel on their own, but this is not Dart’s target demographic
•  Rapid growth: The Holidays business was started from scratch ~7 years ago and has become the 3rd largest tour operator in the UK through purely organic growth.  Growth in this segment is very valuable given limited incremental capital (50%+ ROICs).  The Holidays business grew 140%, 114%, 103%, and 29% in each of CY 2010, 2011, 2012, and 2013.  Management expects trends to continue going forward, and we believe Holidays revenue growth will come in at ~25% in CY 2014.  In CY 2013, Holidays customers comprised ~30% of Leisure Airline passengers.  With Holidays growing faster than capacity, this proportion is set to increase.  Management believes that over half of passengers will ultimately buy Holidays packages once the business is fully ramped.  If Holidays customers reach 50% of total passengers, this implies a doubling of Holidays customers assuming normal capacity growth over the next few years.

Dart has been able to grow by taking share from legacy players Thomas Cook and Tui Travel.  Competitors have poor cost structures, pension issues, and a limited online presence (brick and mortar focus).  Dart’s holidays business has been able to capture the mass market through technology (while competitors focus on the high end).  Dart has also developed a portfolio of exclusive hotel relationships and therefore they do not pay fees for access to hotel portfolios like other airlines

•   Significant operating leverage: Dart’s doubling of Holidays customers has the added benefit of very significant operating leverage.  Margins were -1% in CY 2010 and reached 2.9% in CY 2013, as the business continues to gain scale.  The full extent of operating leverage has not been felt as management has said they are ramping spending ahead of future growth.  We believe margins of 4%+ are reasonable (likely conservative, perhaps substantially so) in the long-run.  If customers double, margins expand from 2.9% to 4.0%, and prices increase normally, Holidays profitability would increase 225% (from ~£14mm to £46mm).   It should also be noted that this is actually a very high margin fee-based business (60%+), but the accounting requires the gross balances of the client transaction to show up on Dart’s financials.  We believe the combination of margin expansion and rapid growth deserves a premium multiple, although we do not give Dart credit for it in our valuation
•  Strong synergies with Leisure Airline: Since Ryanair and EasyJet do not have holidays businesses, Dart is somewhat more insulated from “seat-only” competition (target demographic is looking for a packaged holiday).  The holidays business has also helped to push passengers to specific flights with lower load factors by showing these flights first or offering discounts, which has improved both load factors and yields    
•  Stabilizing force: Holidays’ cash flows have less volatility than airline earnings (limited fuel exposure, no fleet capacity management) and they increase the profitability per passenger, which increases economic margins.  This element also contributes to our view that the Holidays business makes the consolidated business worthy of a higher-than-typical multiple

C.) Distribution Segment (4% of CY 2016E Earnings): Fowler-Welch Coolchain is a chilled and ambient food distribution business serving grocery and convenience stores across the Northern UK.  The business owns ~1mm square ft of warehouse space and 450 trucks.  Profits have been stagnant in this business over the last couple of years (in the ~£4mm of EBIT range), although management believes the business should earn meaningfully more than £4mm over time (we do not give them credit for this).  There is likely more upside than downside to this business and it could potentially be divested in the future.

Valuation:

We believe that Dart is trading at ~15.4x, ~10.3x, and ~7.4x CY 2014, 2015, and 2016 earnings respectively.  These numbers are ~13.6x, ~9.1x, and ~6.5x on an excess cash adjusted basis.  You can find our operating earnings bridge below.  We would also point out that last year’s earnings (which we use as our base) are likely too low, as both euros and dollars were purchased 1yr forward at multi-year high; both jet fuel costs ($) and hotel prices(€) were abnormally high last year.  We conservatively do not adjust for this in our operating earnings bridge.  In the next section (“Event Path”), we explain the events that will lead to these results.    

We believe an earnings-based valuation metric is the most appropriate way to value Dart given that:

•  Differences in leased vs. owned fleets and differences in required cash balances make EV / EBITDA and EV / EBITDAR difficult
•  Our analysis of maintenance capex shows D&A is a very good proxy
•  Historical earnings have been stable enough to allow for the use of an earnings-based valuation

Implied Returns:

We believe excess cash will grow from £73mm currently to £198mm at the end of the 2 year period (taking a conservative view of what is excess).  At that point, we believe the company will be earning £103.2mm pre-tax (£82.5mm after UK corporate taxes of 20%).

We assume a 10-12x earnings multiple for Dart Group, which seems fairly conservative given that Ryanair and Easyjet trade at 16x and 12x, respectively.  Furthermore, we could argue that Dart deserves a premium multiple as almost half of its earnings comes from a more stable, less capital intensive, faster growing holidays business (Ryanair and Easyjet do not have meaningful holidays operations).  If we assume the mid-point of our 10-12x range, the business value two years out would be £908mm.  Adding the £198mm of excess cash gets us to £1.106bn of value, 83% higher than today (~35% IRR).

Event Path:

Conservative Guidance Creates Initial Opportunity:

Dart hit then-highs of 300p in April of 2014, after which European airlines began to underperform as Ryanair and Lufthansa warned on capacity and pricing.  This industry weakness caused Dart to move lower into the ~250p context.  Sell-side analysts took down expectations significantly (to ~£30mm of EBIT for CY 2014).  The stock fell into the ~200p context as management warned that “demand for leisure travel [was] less buoyant” and “market pricing weak.”

Dart’s management has a history of being very conservative when guiding street analyst to earnings expectations.  Since the reduction in consensus estimates, Dart has posted excellent results.  The stock first legged up after posting higher summer results (despite their earlier warning that results would be much weaker).  Management attributed improved performance to an uptick in leisure demand after England was knocked out of the World Cup (nobody wanted to fly while England was still in).  This caused analyst expectations to move higher and the stock re-rated into the ~280p context with EBIT expectations raised to ~£40mm.  However, consensus remained too low.  When giving their March trading update, management raised guidance to “in line with last year” (~£50mm of EBIT), which led the stock to re-rate into the ~360p context.

The increase in expectations from £30mm to £50mm (66% increase) resulted in the stock price appreciating ~80%.  We would expect the increase in expectations from the current £50mm to our ~£100mm expectation (~100% increase) in 2 years will result in a similarly sized move in the stock price.

The sell-side conservatism (which we believe is due to interactions with a very conservative mgmt team) is similar to what we have seen over the last several years.  On average, year-forward estimates have been ~25% conservative (and nearly ~40% conservative if we exclude FY 2012).  Management holds no earnings calls, holds no investor days, and attends no conferences.  History suggests this is an under-promise, over-deliver management team.  The company will release full year earnings on July 16th, at which point we would expect another increase in earnings expectations.  Dart gives updates on business performance 5 times in a given year.  We would not expect a massive increase in expectations at any one update, but would rather expect consistent meaningful increases over time.

Earnings Uplift in Calendar Year 2015:

A number of factors will drive similar outperformance relative to consensus expectations (~£53mm of EBIT) this year.  We outline them below:

1.   Demand / yield rebound: We expect load factors and yields to bounce back after weakness last year.  Alongside the expiration of a Royal Mail contract (~£7mm of EBIT), this was one of two key factors in explaining why earnings were flat yoy (camouflaging continued excellent performance in Holidays)

•  Return to rational competitive dynamic – yields were significantly impacted by aggressive pricing from competitor Monarch (which was running out of cash).  Since that time, Monarch was sold to turnaround PE firm Greybull and all indications suggest pricing rationality has returned to Jet2’s market. Improved pricing is set to fall directly to the bottom line.  Monarch is also pulling capacity out of overlapping routes, which should benefit Dart (especially as demand has improved).  Higher load factors will also flow to the bottom line at attractive rates
•  UK economic rebound – commentary from a number of competitors suggests UK travel demand for this summer is set to be very strong.  Canaccord Genuity (one of the two firms that covers Dart) highlighted Thomas Cook’s positive comments on the UK near the end of March, which has helped the stock to move higher

Early evidence is very supportive of this part of our thesis.  Management disclosed that summer capacity is more than 50% booked in early March, over a month earlier than when they announced hitting the 50% level the previous year.  Early bookings help loads (for obvious reasons) but more importantly help yields (pricing), as Dart can price the remaining seats more aggressively.

2.   Continued Holidays growth: The market has consistently underestimated the value of Dart’s holidays business.  Importantly, mgmt. chose to stop separating Leisure Airlines and Holidays, concealing the underlying growth in Holidays.  However, Holidays is set to grow rapidly again in 2015:

•  Increase in leisure passengers purchasing a holiday package: Dart management expects the percentage of leisure passengers who choose to purchase a holiday to continue increasing.  Today, that percentage is just ~30%+ of passengers but run-rate should be 50%+.
•  Increase in operating margins: We expect operating margins to progress to a level of 4.0% or higher (vs. 2.9% in CY 2013).  Moving from a low margin base, the impact is meaningful

Earnings Uplift in Calendar Year 2016:

Calendar year 2016 should see Holidays continue to grow rapidly (for the same reason it will grow rapidly in 2015).  However, 2016 will also see Dart benefit from lower fuel prices and a weaker euro.  Dart (and the broader industry in Europe) hedges the vast majority of fuel costs about a year in advance, so the impact of lower fuel prices will be felt in summer 2016.  We discuss our method for thinking about lower oil prices below:

Fuel price tailwind: We believe Dart may benefit significantly from lower oil prices.  As mentioned previously, Dart has the oldest fleet amongst its peers.  While Ryanair has been buying new planes, Phillip Meeson has been bargain-hunting amongst old planes for years.  Lower oil prices have caused valuations for older planes to take a significant step up and Dart is likely to see this flow through its P&L.  We estimate that fuel is 20% lower yoy for Dart and its peer group (jet fuel down 37%, but dollar strengthening and the upward shape of the curve are offsets).  We use the following operating assumptions in thinking through lower fuel:

•  Ryanair as market price setter – We believe Ryanair is most likely to be the price setter for the market, given its historic cost and price leadership.  The CEO has publicly commented that he plans to pass most oil savings through to customers and we assume that 75% of the benefit will flow through.  Looking at the historic cost of fuel relative to revenue, we believe this means yields could be pressured by ~6% in Summer of 2016 (much more conservative than consensus forecasts; if yields hold in better - as believed by consensus numbers - this is all upside for Dart)
•  Pricing resiliency – We assume that Dart’s yields fall at 75% of the Ryanair price decline given insulation from Holidays.  All else constant, we assume revenue in Leisure Airlines is down 4.5%, which we believe is conservative
•  Dart fuel costs decline – In calendar year 2013 (FY 2014), fuel costs were 714% of EBIT and 34.6% of revenue.  If fuel costs were to decline 20% while revenue declined by 4.5%, we estimate incremental positive EBIT of £15.6mm.  This analysis ignores that capacity is likely to grow in 2016 (there have been many recent announcements about Dart adding capacity to existing routes for 2016).  Dart seems capable of adding this capacity to 2016 routes as it is largely replacing Monarch capacity that was removed during Monarch’s restructuring under new ownership, but with the benefit of rational pricing 

We would note that Dart has not yet received any benefit from lower fuel prices since it typically hedges ~12 month in advance.  Therefore, our ~50% earnings growth estimate for CY 2015 has no fuel benefit.  As such, the important oil price is the 1yr forward that Dart will enter into this summer (this is what will flow through Calendar Year 2016 P&L).

Release of Cash:

While we do not have a precise date in mind, we believe management is likely to increase the amount of capital it returns to shareholders.  Dart is currently paying a small dividend (~0.75%).

We believe the lack of large capital return historically was attributable to one key factor: alternative uses of capital were very high ROIC.  When Phillip Meeson could buy planes at 20% ROICs and build out a Holidays business at 50% ROICs, returning capital would have been unwise.  Historically, most of the cash flow generated could be re-deployed into growing the airline (we believe this is still the case today).  However, the rapid growth of the holidays segment over the last few years has resulted in significant incremental cash flow.  This cash flow is not required to continue growing the holidays business, and therefore cash is now piling up at a rate far quicker than it can be deployed.  The company has not been in a significant excess cash position before, and we believe that a great capital allocator like Phillip Meeson is going to return it to shareholders or find a productive use for it.

If you had hundreds of millions of pounds tied up in Dart (a very significant portion of your net worth), you’d probably pay yourself a fat special dividend.  We think there will come a time where Phillip Meeson will do the same.

How much cash? Given that we think a special dividend is increasingly likely, the important question is how big of a dividend?  Our understanding is that the tightest point of the year from a cash requirement standpoint is right around fiscal year end (3/31).  At that point in the year, our diligence suggests CAA regulations require Dart to hold minimum liquidity equal to 6% of forward revenues. We would expect next fiscal year’s revenue to be ~£1.45bn, implying a need to hold £87mm of liquidity.  We conservatively assume that Dart would want to hold 75% more than this minimum to be prepared against all eventualities, implying a very comfortable level of liquidity for the business of ~£152mm (remember that we are conservatively starting at the tightest point during the year).

We do not get the 3/31/15 balance sheet until next month, so we start by building up from the 3/31/14 cash balances.  The company had £264mm of cash, of which £141mm was posted to credit card counterparties and therefore restricted.  The remaining £123mm of unrestricted cash would then be added to the £50mm undrawn revolver (which qualifies as liquidity) to get to total liquidity of £173mm at 3/31/14.  We expect £50mm of cash generation during the LTM 3/31/15 period, implying total current liquidity of £223mm.  Compared to our very comfortable level of liquidity of £152mm, this implies £73mm of excess cash (~12% of the market cap).  The market values Dart on a P/E basis, and we believe the company is getting minimal credit for this excess cash.  Furthermore, we would expect excess cash to grow meaningfully with cash generation significantly outstripping growth capital requirements over the next few years.

In addition, there is upside to reduced posting requirements to the credit card companies as Dart continues to grow in size and reputation.  Management has confirmed that their posting requirements have continued to decline over time (last year total credit card postings declined despite credit card balances growing meaningfully).  Furthermore, the company can release meaningful cash by increasing the use of LCs to post rather than using on-balance sheet liquidity.  The company recently issued a new LC facility collateralized by a small fraction of the fleet.  We believe the company may increase the size and use of LCs, thereby freeing up cash.  We believe these two factors may serve to free up a significant portion of the £141mm of restricted cash.  Furthermore, we believe Dart could return significant cash simply by increasing the size of its revolver to meet CAA requirements (a ~£600mm market cap company with de minimus term debt can certainly carry a revolver larger than £50mm).  As a result of all of these factors, we believe that our calculation of excess cash is very conservative.

Strategic Transaction:

Sale of Distribution Business: We suspect that a strategic buyer of Dart’s distribution business could realize significant scale efficiencies.  We understand that this business operates completely independently of the airline (no real synergies).  The stability of the business historically helped in obtaining financing, but that is no longer the case.  This could be another source of capital return.

Sale of the Entire Group: We do not have any expectation that the business will be sold.  However, the returns could potentially be phenomenal for three reasons.  First, a significant portion of Dart’s cash is posted to credit card counterparties.  A larger airline would not be required to post as much; therefore, a transaction would free up considerable cash.  Second, airlines have a significant amount of fixed network costs that could be eliminated if acquired by an airline with much more scale.  Finally, Dart’s enormously successful Holidays business could generate significantly more revenues to a potential acquirer as it could be scaled over the acquirer’s larger network.

Other Potential Catalysts:

LSE Listing: The company should eventually outgrow the AIM market (Dart is one of the largest companies).  A move to the LSE market would increase Dart’s profile among investors as well as result in increased liquidity.

Increased Research Coverage: Despite a market cap nearing ~$1bn, the only firms covering Dart are two small cap specialists that cover hundreds of names.  Consequently, publishing tends to be sparse (generally only 1 page earnings summaries twice a year).  As Dart continues to grow, it should become too large to ignore for other research analysts.

Key Risks:

European Airline Cyclical Downturn: Industry yield pressure is always a risk for airlines, and significant capacity has been added to the European airline space.  Fortunately, that capacity has primarily been added to routes where Jet2 does not fly (i.e. Gatwick to Germany / Eastern Europe).  We do model a fairly conservative view of yield declines, and we believe Dart has some advantages to reduce a potential blow to yields (the holidays business reduces price sensitivity of passengers and Dart’s unique model allows it to flex capacity much more easily than others).

Competitive Threat: The penetration of large LCC players in Europe has always been a risk to Dart.  We believe the concerns are misplaced.  Jet2 focuses on leisure travel packages while Ryanair owns the lowest cost end of the market and is trying to move more towards business travelers.  Jet2 thrives in its small niche in the Northern UK, which is not the type of large, growing market that Ryanair tends to target (i.e. recent actions in Germany and Eastern Europe).  More importantly, this increasing competitive pressure has been present for the last several years and Dart continues to win.

Passenger Liability: Passengers in the UK can pursue compensation for flight delays under certain circumstances.  We believe the historic liability for paying out passengers is not material and the on-going impact should have a very small impact on operating earnings.

Conclusion:

Dart Group remains a very cheap stock at ~6.5x cash-adjusted Calendar Year 2016 earnings.  This multiple is far too low for a business that has earned excellent returns on invested capital, avoided losing money despite a variety of difficult environments, and has a long growth trajectory, both in the airline and the holidays business.

The event path is also very attractive.  Management guidance continues to be exceptionally conservative, and as the stock performance over the last year has shown, the stock moves very closely with guidance.

We believe this is a high-conviction way to earn attractive returns over the next 2 years and believe IRRs could be 30%+.

Disclaimers:

The views expressed herein are for informational purposes only, and are not intended to be, and should not be, relied upon as an investment recommendation in connection with any investment decision for any purpose or for legal, accounting or tax advice.  This information does not constitute an offer to sell, or the solicitation of an offer to buy, any security.  The author makes no representation as to the accuracy or correctness of the information contained herein and expressly disclaims any liability to any person from relying on such information.  The information and views contained herein are provided as of the date this summary was posted and present the views of an investment firm that currently holds a long position in the company’s securities.  The author has no obligation to update any of the information provided herein.  The author reserves the right, in light of, among other factors, its ongoing evaluation of the company’s financial condition, business, operations and prospects, the market price of the company’s stock, conditions in the securities markets generally, general economic and industry conditions, its business objectives and other relevant factors, at any time, to decide to purchase, sell, or engage in any other transaction involving, the company’s securities as it deems appropriate.   Past performance is neither indicative nor a guarantee of future results.  There can be no assurance that an investment in the company will be profitable or that the assumptions regarding future events and situations will materialize or prove correct.  

Catalyst

Repeated Earnings Expectation Increases (Earnings Results)

Capital Return 

Uplisting to LSE