Valuhunteruk

 

Introduction - Dart Group is, according to its latest annual report, an “aviation services and distribution group”. Under the Jet2.com name it operates a budget airline offering scheduled charter and tour operator flights (it also operates its own tour operator jet2holidays.com) to popular leisure destinations throughout Europe flying from airports in the North of England and Scotland. Under Fowler Welch,  DTG distributes fresh produce and temperature-controlled and ambient product to supermarkets and wholesale markets through the UK.

Before we get into details, it should be highlighted that DTG has been something of a value favourite (I owned some DTG last year) and it has been written up on VIC and SumZero (amongst other places. In addition, the annual report for 2011 was just released so all of the figures in the model are using the numbers for FY10. In the first table, the numbers are mixed so some are from FY11 and some FY10. The main figures such as EV, Revenue are all updated so the valuation ratios are the  latest. However, the estimates are from FY10 as are the growth and margins figures.

According to the final results for 2011 (the LFY), the Distribution arm (Fowler Welch) made 26% of revenues and Aviation made the remainder. The margins on the two businesses are, predictably, quite different with Aviation making 89% of group EBIT.

Operating Metrics - Looking at the table above we see that costs are a big issue for DTG with a lot of variability regardless of movements in revenue. However, looking at cost breakdown in the FY 10 annual report we don’t get a good picture of what is happening. We see fuel costs rose by £5m but these were offset by savings elsewhere, what made the difference was the movement in the vaguely named “Other direct operating costs” which increased some £20m. From the segment breakdown, we can infer that this increase related to the Aviation division. So we have no idea if this is a permanent or temporary move (we don’t get the breakdown in the latest final release) in the company’s costs which is really, for the outside investor, as frustrating as it gets.

(COGS is on the right axis with the other costs on the left axis. MAINT=Maintanence)

Looking at the line items I have from my data we see what the trends have been. Unfortunately, the way the data has been entered isn’t to helpful as the distinction between COGS and OTHER is quite vague (the definition of ADMIN/MAINT is consistent). What is noticeable is the clear trend in staff costs which is particularly impressive considering revenue has doubled in that time.

In the FY11 annual report, we also saw an interesting trend with revenue growth of 25% but operating margins falling by 22bps. If the cost base stayed steady we would see profit growth equal revenue growth. Rather operating profits only grew 19.5% which means costs must have grown rather significantly. Looking at the segment breakdown, most revenue growth came from Jet2 and operating margins improved by 200bps. For distribution,  revenue grew about £20m but operating margins dropped 400bps. So the problems with margins in the last year was led by distribution.

In the FY11 annual report, we don’t get a line breakdown of segment costs but it appears that the most of the £100m increase in the cost base comes from an increase in fuel and admin costs. The fuel costs appear to be part and parcel of the increased sales. Admin costs should be worry as these can’t be cut away easily if revenue growth falls. In addition, we should consider the big capacity expansion  at Fowler Welch we may presume this led to an increase in fixed costs that hasn’t resulted in revenue growth yet. If we don’t see some good revenue growth from distribution in the next interim we may start to get worried.

Another noticeable factor is the growth in NOA. Whilst revenue grew £230m to £434m between 2004 and 2010, NOA only grew from £61m to £64m (although it did reach £91m in 2008). The easiest way to get the bottom of these movements is usually doing a common-size balance sheet.

PPE is one of the biggest investments DTG is making, around 50% of total assets in 2010, and we see that part of this improvement in NOA usage is a big change in PPE turns (revenue/PPE). Over the 2004-2010 period this improved from 3.7x to 6.8x. However, we should ask is this just underinvestment? Detail for capex only goes back four years but we can see that part of the big increase in PPE is explained by light investment in the past three years. This isn’t to say that the company is underinvesting but capex is quite cyclical. In 2011, we see that capex was just under £70m which is roughly the same as the capex in 2007. I couldn’t really work out any noticeable split between the two businesses but, logically, capex would be most lumpy for Fowler Welch with investment in new storage capacity. Either way, I think we can be quite positive as FCF is quite substantial even with the company spending £70m. In the current fiscal year, we should see some very significant free cash flows (the company doesn’t appear to give guidance).

The other major items are accounts receivable and accounts payable. Accounts receivable has grown slightly faster in the past few years which should have worked against the trend in PPE whilst tax liabilities appear to have grown which accounts for the remainder of changes in NOA turns. In addition, revenue growth between 2004-2008 was rapid which resumed in the last fiscal year which obviously has the effect of improving NOA turns.

Overall, the Aviation side appears to be doing pretty well. Fuel costs appear to have been well-hedged (the company usually hedges around 90% of fuel costs) and considering the cutthroat competition in the sector we should feel vaguely positive. The company built a new distribution centre in the last fiscal year so we are maybe seeing lower margins as a result of this (in the past, margins look to have been fairly steady). In terms of capital usage, we can infer the company has been pretty careful. Obviously, the new distribution centre is a big gamble but we can see how the company investments in aviation were pretty good producing some good revenue growth.

Financial Condition - Clearly with cash on hand of near £110m (against the market cap of £120m) the company’s financial condition is solid. The only concern here is that the company doesn’t invest this, doesn’t return to shareholders and this leads to a return on equity far less than the return for shareholders. Indeed, it seems quite likely that the cash is going to be larger than the NOA (I haven’t had time to calculate the NOA from the most recent annual report). Really, there isn’t much more to say but it is something to be concerned about as there isn’t much point in investing in a company that has most of its assets invested in deposits especially now.

Recent Trends/Competitive Position – Getting to grips with the industry in question is usually an important part of getting comfortable with investing in a certain company. With airlines, we are faced with a pretty formidable challenge as the industry is requires quite a bit of specialist knowledge as it is highly regulated and the permutations in terms of business strategy (and destination choice) are quite endless. To my mind, a helpful simplifying comparison is liner shipping. As with liner shipping, we have a mode of transport with a fixed, published schedule and the aim, generally, is to fill capacity as best as you can.

One area where we can see airlines creating some kind of clear competitive advantage is in specialization. An important part of this is focusing on which airports to fly from and fly to. Airlines can cater to certain customers and focus on building solid capacity/brand value in these destinations. Jet2 is clearly focusing on budget holidaymakers travelling from the smaller, regional airports. Its hub is Leeds International and it doesn’t operate out of anywhere in the South of the UK.

A vital measure for the industry is load factor (a measure of capacity utilization which is measured a few ways but, essentially, is equal to passenger km travelled/available km travelled). Most airlines update investors with these figures monthly. For example, we have the figures for IAG (British Airways and Iberia) and here we have the figures for more direct competitors Easyjet and Ryanair. The 12m rolling load factor is particularly useful as this normalizes for the yearly cycle in holidays. To get to revenue, this obviously has to be combined with some kind of price measure like passenger yield (this is usually defined as the ticket revenue + ancillary revenue (drinks etc.) / seats).

As I am no expert I don’t really know what is good so it’s obviously quite difficult to build a view. In addition, figures for load factor are far more consistent than figures for passenger yield with slightly different levels of disclosure with each company. What we get though is a vague idea of where the companies are competing. For example, at Flybe we have a very low load factor of 61.7% but the company has kept revenue growing with a total passenger yield of £76.15. Compare this to Jet2 with a load factor of 85% and a yield of £52.42. Easyjet appears to be quite a close comparison to Jet2 with a load factor of 87% (12m rolling) and a yield of £53.07.

Interestingly, a trend we see at both Easyjet and Dart over the past three years is growth in yield and load factor which we wouldn’t really expect as price increases should lead to lower capacity use. This suggests a fairly positive outlook for the industry although Dart is clearly far smaller than EasyJet. Another encouraging factor is the increase in load factor we have been seeing generally at DTG. In 2009, it was fairly paltry 78% (Ryanair’s is around 82% which considering it caters to business suggest this was a real problem) whereas in 2011 we are at 85% which is really pretty good (the yield was roughly the same in 2007 at £51.86). In addition, the company is now flying from Glasgow which may introduce some new dynamics for the current fiscal year.

Other things we should consider are the profitable cargo business with the Royal Mail (a contract they have had since 1978!) exploiting the “Quick Change” aircrafts (8 in the last AR). The current Chairman and CEO, Philip Meeson (who still owns 39% of the company) also has a notorious reputation as a cost cutter.

The distribution business isn’t as interesting as the margins are really quite tight despite the high sales figures. In addition, the new capacity is going to be a pretty big gamble as the additional capacity is 36% of the old capacity. We really aren’t seeing the effect of this new capacity yet if we look in terms of fleet mileage per annum. Overall, we would say that, as in aviation, capacity is fairly important. The vehicles that Fowler Welch uses are refrigerated so there is a degree of competitive advantage here. However, Fowler Welch is obviously facing supermarkets which may suggest a competitive challenge. I am not sure how true this is as Fowler Welch is operating at the local level and as it will be fairly dominant in the area it operates in and has deep pockets I would say the business is in a fairly good position (although not enough to start earning some decent margins). Again, I would suggest the fall in margins is to do with increase in costs as a result of the new distribution centre which hasn’t had time to produce the sales. I think the company’s position is strong and so margins will normalize.

Historical Valuation – This time I have only included the P/B valuation as the P/E is quite volatile. Another addition here is the inclusion of ROE. Essentially, this difference between the P/B and ROE line is the core of my strategy with a buy “signal” being formed when P/B falls below ROE. P/B is supposed to be determined by ROE, cost of equity and growth (P/B = ROE-G/cost of equity-G). Taking out growth we have ROE/cost of equity. So if a company makes 10% ROE given a 10% cos of equity we would expect the P/B to be around 1x. So what we see with the table above is that scale for ROE on the right is lined up with the P/B so a cost of equity of 10% is assumed. In addition, any growth we get in either ROE or profit essentially comes for free under this model.

I think it’s also appropriate to speculate here about what has been driving valuation. Obviously, with a small stock like DTG this is pretty difficult to say. From the above graph, we would suggest that the company fell out of favour in a massive way through 2008 and hasn’t really recovered. The volcanic ash cloud in early 2010 was another significant event. However, it is difficult to conclude, considering the massive run the company had before 2008, that the current price low valuation is a result of the growth investors becoming disinterested and it taking a while for investors to take notice.

Valuation - Due to the uncertainties of the company’s financial position, it’s a bit difficult to project here so we are going to tread cautiously. We are going to assume in all cases that the company continues to hold a lot of cash and this cash returns nothing (I am using the numbers from the FY10 annual report so this means net debt of £-50m). We are going to assume that a payout ratio of 10% and growth in NOA of 9% in every case. As usual, the focus is going to be around sales growth and margins. With margins, I am going to just assume three constant margins in each case.

• Base Case – Margins of 4% and revenue growth of 5%.
• Worst Case – Margins of 2.5% and revenue growth of 2.5%.
• Best Case – Margins of 5% and revenue growth of 7%.

I think these estimates give a fairly decent picture of the possible outcomes. I think the outlook for margins and revenue growth is particularly favourable with the expansion into Glasgow from Jet2 and the new distribution centre becoming more effective for Fowler Welch. The main uncertainty is the cash balance.

Conclusion – The risk:reward with DTG is really one of the best on offer at the moment. Both Fowler Welch and Jet2 have pretty good prospects. As mentioned already, the trends in load factor have been quite encouraging and the expansion into Glasgow could be profitable. Fowler Welch should benefit from the capacity at the new distribution centre being utilized more effectively. Certainly, free cash flow next year will be pretty significant as the capex in FY11 was heavy. My main concern is really with the cash balance because with net debt at the end of FY11 of some £-90m even if the value of Fowler Welch/Jet2 grows this could be heavily diluted by this big hole earning basically nothing. Even in my worst case scenario, the company is returning 14% on operating assets but even then shareholders could still make a great deal of money if the company returned some of this cash to shareholders. Another possibility is that Jet2 has run out of space to grow within its northern niche. Either way, investing is about managing risk and the opportunities here are really favourable on all counts.

Disclosure – No position at the time of writing.