Description

This write-up can be seen as a complement to mip14’s and zzz007’s thesis, which we cannot recommend more highly.

We believe Dart group plc (‘DTG’) is executing according to plan which is de-risking the company’s debt investment in 34 brand new 737-800s fast. We believe the recent sell-off provides an opportunity for investors that are willing to accept headline risk and price volatility (we added to our long-term investment).

We believe the market values Dart Group plc (DTG) by considering that

1. it is an airline

2. has indebted itself through a large new plane order late in the cycle

3. Brexit negotiations have immeasurable uncertainty

We think the market should soon value DTG by recognizing that

1. it is a well-managed, part airline, part package holiday operator (it has rapidly grown to 3rd in the country and is growing this segment fast). This implies

1. Less cyclicality

2. Higher ROIC (even stand-alone from the higher ROIC package holiday segment, which we believe possesses weak increasing returns to scale)

2. Dart will be a net cash company end of  ~FY19 as its latest report confirm strong cash flow generation, partly because of a growing negative working capital (it is at an inflection point where the fast growing package holiday segment revenue now accounts for 60% of absolute revenue, and will generate the bulk of additional ‘float’)

3. For DTG, Brexit negotiations have small downside, as a bilateral agreement of which DTG only needs the basic 3rd freedom to operate its routes (i.e. for routes solely from the UK to the EU) will in all likelihood be reached, some day removing ‘the fear of fear’ (or the fear of looking bad in hindsight for clients, if you will)

Other things to like:

1. ‘Intelligent fanatic’ owner-operator that has demonstrated rather spending time on creating value than communicating his prowess (see previous posts)

2. an idea we’d love to get challenged on: Dart’s fleet possesses optionality for which it is being penalized from an accounting perspective, and is especially useful for this cyclical. We think there are small convexity benefits to owning a combination of brand new and very old planes similar to the barbell strategy in bonds. As part of the brand new planes that got delivered in FY17 (14 out of 34), the company has bought three additional ~15yold 737-800s and has not retired any of its very old planes. Dart still owns a staggering 29 planes with an avg. age of ~29 years, while the avg. age of its 75 plane fleet is 17 years. This indicates confidence for summer. These fully depreciated planes (~options) can be scrapped opportunistically and with little risk, depending on the environment (which we think is currently still favourable given the company’s actions and +40% yoy advance sales). At the risk of sounding promotional - because what is not to dislike about airlines in a time that being a “quality investor” is so popular that it too might ironically prove cyclical (does Berkshire agree?) - the fleet is probably becoming one of the most ‘convex’ fleets in the world, which could prove to be of minor benefit with Brexit uncertainty and late in the cycle.

3. we enjoyed our Jet2 package holiday, and think that Dart creates value

1. for customers: by controlling the end-to-end customer experience better than competitors, e.g. Thomas Cook (e.g. Thomas Cook allows for booking on 3rd party airline websites which can be confusing). Mr. Meeson also seems laser-focused on good customer experience with continuous small incremental innovations

2. for shareholders: DTG cross-sells package holidays by offering info/vouchers in-flight to seat-only customers

Valuation

Assumptions

We model

• no capacity expansion after Stansted/Birmingham this year (cap at 9.7 pax capacity)

• package holiday customers to taper off to 52% of total passengers in FY20 after growing fast from 30% in FY14 to 49% in FY20 (if this segment keeps on growing fast as it did, e.g.  reasonably to 60% of total pax in FY20, changes from working capital allow the business to pay off debt much faster, see second scenario in results)

• load factors to fall to 90% and get back to last year’s 92% in FY20

• fuel efficiency of the fleet should improve ~8% by fiscal year-end 19

• package holiday prices to remain flat at 620 GBP, after being flat as a “price investment” in FY17

• seat-only ticket and ancillary revenue to go down to resp. 85 GBP and 31 GBP (FY17 was at 87 GBP and 33 GBP)

• other operating charges (which spiked to 145M GBP in FY17 to ramp up demand through ads) to come down to 100M GBP p.a. (FY16: 90M GBP)

• as our cases do not have any capacity expansion beyond Stansted/Birmingham, we expect the rental costs of short-term leases to curtail towards zero in FY19 as all new planes are delivered (55M GBP p.a.)

• we use maintenance capex of 1.7 M GBP per plane for the legacy planes, and 0.25 M GBP per brand new plane. The legacy MCX estimate is based on capex spend in years with no new plane investments, and the airline maintenance inflation index

• we believe Dart already spent 430M GBP in new plane capex, leaving ~620M GBP of capex to be spent in FY18 (price paid per end of life 737-800 at 31M GBP)

We think a FYE20 (March ‘20) valuation of 5x EBITDA for the airline business (9X 5yr avg EBITDA for the small distribution business) is reasonable given the deleveraging (that will already be ~locked by Spring 2019 through virtue of advance payments), and Dart steadily becoming a part asset-light package holiday company.

Results

On the latest results

Summary

For us the most informative data point of what is essentially a winter season update, is actually

• the advance sales number of summer (+43%, corroborated by ONS data)

• the strong cash flow generation driven by changes in working capital that are increasingly driven by the growth of the package holiday segment. This segment does not only grow fast on a YoY relative basis, but will also drive increasingly most growth in absolute working capital changes as it has grown to 60% of leisure revenue

The bad: on margins declining last winter

• in line with our expectations, extra costs driving fast new customers growth caused margins to decline for winter. Fast demand growth is needed for the model of operating new planes to make sense (i.e. have enough demand to make new planes part of the fleet run at full capacity throughout the year). Historically, Dart was a very seasonal airline operating with a six-to-one peak-to-trough pax ratio. We noticed a lot of Jet2 ads in London (TV, tube, newspapers) that started in autumn ‘16 which should be expensed and could thus have positive knock-on effects on revenue and margin, when it matters most in summer (see the spike in ‘other operating charges’ on the last page). Also, the new bases in Birmingham and Stansted require hired personnel with a lead time to revenue generation. In short, we believe the updated financials from the last period are quite limited in information value.

• at the expense of margins, extra revenue gives Dart the added benefit of free customer loans to fund plane deliveries

The good

• Strong advance payments (+43%), indicating that a strong summer will probably be realized

• from both the cash flow and balance sheet we back out that Dart (indeed) paid a discount on the planes listing price of 52-55% (34 planes order), which puts this uncertainty to rest

• we think evidence for a strong summer means Dart’s capital structure is de-risking fast as a net cash position should be reached again by end of CY19 in our base case, this makes the valuation attractive

• wrt Ryanair competition in Stansted: we think the new Stansted base should primarily be seen in the light of serving new package holiday customers in the south of the country (see Canaccord research that this local market is underserved, and the ad focus in London). This somewhat mitigates brutal competition.

The scary: on the non-UK ownership limitation amendment

The market seems to have reacted heavily on Dart’s proposal to limit foreign shareholdership as Brexit progresses. We find the market reaction interesting, given that many peers have already discussed publicly the risk of ownership rules that Brexit entails (see the many articles on - and documents by - Easyjet, Ryanair, IAG).

Perhaps others can chime in here as we are no experts.

The context is such that both EU and UK require their airlines to be majority owned by EU or UK nationals. Before Brexit, UK airlines just had to comply with EU regulations. Post Brexit, UK airlines have to ensure that the company is UK controlled (up to interpretation but generally this means >50% voting rights) to maintain its operating license.

The worst case is that non-UK nationals (long-term holders of DTG) could be forced to sell shares at an inopportune moment.

First mitigants

1. DTG noted in its announcement that they believe currently non-UK shareholders make up less than 35% of the shareholder base (the cap proposal). DTG is 40% owned by its founder, Philip Meeson who is a UK national.

2. the company will try its best to avoid activating such clause unless absolutely required.

3. the directors can first deprive certain shareholders of voting rights before having to move to the more draconian forced selling

4. we still don’t know how the Brexit negotiation will play out on this issue – maybe it is favorable maybe, while airlines are preparing for the worst
   
   

In short, there is a good chance we never get to the forced selling part. But the important question is if the company decided to trigger this, how are they going to decide which shareholders should sell, i.e. if there are 40% non-UK shareholders and DTG wants to bring that down to 35%. How do they choose which 5% of the non-UK shareholder base to force sell?

Major mitigant

See here for Ryanair’s rules in the Articles of Association (EasyJet is similar).

1. Dart’s peers use a “LIFO” type rule. In other words, shareholders that cause foreign ownership to exceed the threshold will be forced to sell (first). Also, from the documents it seems like pressuring certain shareholders to force sell shares is a last resort option, after suspending voting rights.

1. I think it is reasonable to assume that Dart will use the same rules, but we will use the comment section for updates once we manage to get in touch with the company

⇒ as value investors, we are not concerned with current / future forced sellers, as long as we are protected from forced selling, which is in all likelihood is the case here (as Dart’s current foreign ownership is below the cap)

Key pieces in the Ryanair doc:

1. “Concerns about the foreign ownership restrictions described above could result in the exclusion of Ryanair from certain stock tracking indices. Any such exclusion may adversely affect the market price of the Ordinary Shares and ADRs”

⇒ this leads us to believe that part of the sell-off might be caused by these actors

2. [..] have regard to the chronological order in which details of Affected Shares have been entered in the Separate Register and, accordingly, treat the most recently registered Affected Shares as Restricted Shares to the extent necessary. [..]

Risks

1. Airline, cycle timing

• Mitigants in recession: LCC, great value package holiday (all-in cost certainty), barbell fleet able to shed 40% of fleet capacity that are airlines of on avg. 29 year old

• Although in FY09, Dart actually grew revenue probably because of the above reasons (richer clients trading down to LCC), we think a recession is the single largest risk, especially if it materializes soon (because of the debt pay-down). If no recession materializes by spring ‘19, Dart will largely have “locked in” a ~ net cash position by ‘20 because of advance payments

2. Headline risk because of Brexit negotiations

• Mitigant: we do not commit 100% of our “risk budget” to this position as we think messy negotiations could lead to a panicky market and great future entry points (see recent market action as an example). The prospect of Brits not being able to fly to the EU for X months makes great headlines.

• we believe the Brexit news volatility is most probably not a permanent loss risk as Dart only needs a timely, but very basic third freedom of the air

• slower negotiations could have a longer overhang on valuation, limiting the upside

3. Key man risk: Philip Meeson is 69 years old

• we believe a major reason for great ROICs in the past has been great management execution

• Longer term: great execution by one intelligent fanatic is perhaps not as scalable as Dart’s fleet grows

Catalyst

Fast deleveraging

Brexit

Label change from "airline" to "package holiday provider"