Description

Summary

Dart Group is a UK package holiday business that has been written up six times on VIC in the last decade and has performed exceptionally well, with the stock going from around £0.7/shr to a peak of nearly £20/shr this February. Then Covid struck and the stock dived as low as £1.8/shr before rebounding to £5/shr today. If the business survives, it is likely to be worth multiples of today’s stock price in three years’ time. In this writeup we argue that survival is now highly likely and that with its competitors struggling much more, Dart is likely to exit Covid with significantly enhanced market share. Three pieces of news from last week tipped over the conclusion of our liquidity analysis from being ‘too risky’ to investable in our view: the announcement that the company had secured £300mm in Covid financing from the Bank of England, their biggest competitor TUI reporting results that offered clarity on likely cash outflows, and the EU making a big push to ensure some level of summer tourism.

Situation Overview

Dart Group is a UK based low-cost package holiday and airline business that operates under the Jet2Holidays and Jet2Airlines brands. In both markets, Jet2 has been a low-cost entrant profitably taking share from legacy players like TUI and Thomas Cook who are burdened by expensive cost structures that include brick and mortar stores, labor issues, and ageing fleets.

The company is run by its outstanding founder Philip Meeson, who owns 36% of the stock. Mr. Meeson has exceptional customer focus, high integrity, and focuses on long term value creation when allocating capital. He has done a terrific job of compounding value and over the last decade earnings have compounded at 30% per annum despite modest or no leverage.

Jet2 is now the second largest package holiday player in the UK with around 18% market share. TUI has around 21% share and Thomas Cook ceased trading a few months ago, vacating more room for Dart to grow into.

Then Covid struck, and Dart and TUI’s stock prices have both fallen 75% despite Dart having far more liquidity and being a much better business. The stock has swung wildly from day to day, often on no news.

While the market is (understandably) emotional right now and we must warn that anything can happen given the unprecedented pandemic, we think that the new information provided last week now allows us to say that Dart will survive under the vast majority of scenarios. If this is correct Dart’s intrinsic value is likely to be worth multiples of today’s stock price when travel normalizes in the next three years.

This writeup will focus on Dart’s liquidity today and what is could be worth if it survives.

Liquidity Analysis

Based on the following liquidity analysis we think Dart now has enough liquidity to survive until Easter 2021 even if it earns no at all revenues in the meantime:

This analysis suggests that Dart will reach the end of Sep 2020 with £723mm in liquidity even if it earns no revenues (£1,983mm liquidity – 6 x £210mm cash outflows = £723mm). At that point, it will have another 6-7 months in liquidity (£723mm / £110mm = 6.6 months).

These numbers exclude potential further liquidity such as the fixed cost % reducing over time, rolling over debt (£78mm included in payables), taking debt out against unencumbered aircraft (£250mm), and deposit inflows for winter 20/21 and summer ’21 that the company says are “encouraging”.

Together, this means Dart has liquidity until Easter 2021 even with no revenues in between. The Covid Facility agreed last week was an important moment in our view as it’s the difference between having liquidity until Christmas (still ‘too risky’ and vulnerable to things like a second wave) vs Easter next year and makes this situation investable. Additionally, TUI reporting last week gave us a direct comp for the package holiday business on top of the reports of airlines and gives us comfort that our monthly cash outflow numbers are unlikely to be far off.

Other things to consider:

-   The EU made a big push on May 13 promising a summer tourist season, conducting several press conferences and releasing multiple papers (https://ec.europa.eu/commission/presscorner/detail/en/ip_20_854). These are light on details but the tone was very strong and supported the use of vouchers instead of cash refunds. Tourism is 10% of the EU economy. The UK’s tone has not been as positive and the government announced a fourteen day quarantine for international arrivals. However, this is a first step and we think it is unlikely that the UK will be completely closed for the summer if the EU is open to some extent.

-   If UK tourism reopens to even a small extent this summer, the liquidity scenario is far improved. This is because in addition to leveraging fixed costs, any reopening will substantially reduce cash refunds and lead to deposit inflows. Even a recovery in passenger volumes to 30-50% of their prior peak would lead to deposit inflows of £50-100mm per month. On refunds, travel operators in the UK have to offer cash refunds if the UK Foreign Office advises against all non-essential travel to a destination. This advice came into place for all destinations in mid-March as the UK entered full lockdown and is only used in exceptional circumstances. Clearly Covid is one such circumstance but as the UK exits that full lockdown it is possible/likely that this guidance will moderate also if tourism was to be allowed even slightly.

Valuation

Assuming Dart survives, we think it is worth multiples of today’s stock price in three years’ time. The permanent losses of Covid are substantially less than the liquidity analysis suggests because working capital outflows that hurt liquidity flow back in when things normalize. Dart is also likely to earn profits in years two and three, offsetting these losses.

This is what the economics of the business looked like before Covid: Per the trading update on April 24, pre-exceptional PBT for the year ended March 2019 was £265-270mm, which implies around £300mm in EBIT. Sales and earnings have CAGRed at 25% and 35% respectively over the last five years.

The company today has £1,201mm of leases and aircraft loans + £1,087mm in unearned revenues (estimated above) + £381mm in other current liabilities (estimated above minus £74mm included in leases and aircraft loans) = £2,669mm of debt. Offsetting that is £1,500mm of cash + £288mm in current assets which means net debt = £881mm. EV is then £1,581mm.

Assuming the package holiday market has recovered from Covid in three year’s time, what really matters is Dart’s market share at that point. This sits at 18% today and aside from their ‘normal’ market share growth of around 2pp per year is likely to benefit from Thomas Cook exiting the market (previously 10% share), many small competitors not surviving Covid (~30% share with companies that have less than 2% share each), and potentially even TUI exiting or being restricted (21% share). There are other positives like low oil prices for the airline business next year and Dart and TUI both reporting strong bookings for next summer, suggesting there may be a catchup effect. Finally, Dart’s package holiday model is largely a spread business as they don’t own the hotels and most costs are variable, meaning lower ASPs should be partially offset by lower costs.

There is a wide range of outcomes if the business survives, but here are three examples:

Of the cash outflow caused by Covid, only cash burned from fixed costs (£72mm per month) represents a permanent loss. These are likely to be offset by earnings in years two and t

We don’t want to be too precise on what the right multiple for the business is in three years’ time, the point is this – the stock is likely worth multiples of where it is trading today if Dart survives and given recent news that now appears very likely. As a back of the envelop example: Dart’s trailing P/E has averaged 9x over the last decade and if we use 7-9x because the management may hold even more cash in future that would imply a valuation of £10-£33/shr under our scenarios and be 2-7x the current stock price. For context, the stock was at £20/shr pre-Covid.

Note that comparing to historic EV/EBIT multiples is misleading because Dart has technically had substantial net cash throughout the last decade but our numbers above treat customer deposits and current liabilities as debt so result in a net debt figure (we are being more conservative). If our scenarios above play out, Dart will have a similar level of liabilities to its history so comparing to historic P/Es should be representative.

A few final things to bear in mind:

-   As previous VIC writeups have noted, the founder Philip Meeson is extremely impressive. This business is his life and he is the main difference between this being yet another value destructive travel company vs a nearly 30x return for shareholders over the last decade. However, the management team also includes the CEO Stephen Heapy and CFO Gary Brown who have been there for a decade or so. They are conservative and have high integrity. Aside from being good operators, they have also instilled a culture at the company focused on the customer. This is fairly rare among low-cost providers and enables them to both have the lowest costs and strong customer satisfaction. At the AGM last September they said they were resistant to deploying their cash pile, commenting that this is a cyclical business and they would be the last ones standing in a downturn.

-   Even after receiving state aid, TUI has only four months liquidity remaining using the same assumptions we used for Dart. Perhaps it will receive further aid, but there is a significant chance that TUI exits the UK market or is severely impaired. If you had told us twelve months ago that both Thomas Cook and TUI would exit the market, we would have surely been excited and made Dart our largest investment.

Catalyst

We expect that the stock will recover strongly as Covid eases and things normalize to some extent. We also listed five specific ‘flags’ to look for in an internal email several weeks ago and some of these are now playing out:

-   Dart accessing the Covid Corporate Financing Facility -> This has now happened.

-   UK Foreign Office changing advice on non-essential travel -> No change and UK tone has been negative although EU tone is very positive.

-   Governments making a big push to support refunds in the form of vouchers -> The EU is now doing this but the UK has not make stance clear yet.

-   Ramp up of testing over 60k/day alongside quick adoption of contact tracing app -> Testing is now around 100k/day and the target is 200k/day by the end of May. The NHSX app is on trial was expected to be rolled out in late-May.

Key risks

Clearly, Covid poses the key liquidity risk but we no longer think this risks Dart’s ability to survive. Nevertheless, this is an unprecedented pandemic and there are important ‘known unknowns’ such as the possibility of a second/third wave as well as ‘unknown unknowns’. An investor needs to be aware that the worst-case scenario therefore remains 100% downside. We do think the chance of that is now very low given Dart has liquidity until at least Easter 2021.

There are other risks that are standard to travel companies but at today’s stock price we don’t think those pose much downside for long term shareholders.

One event we would highlight is Brexit (remember that?). The UK has exited the EU and is scheduled to exit the transition period at the end of 2020. It was hoped that the outline of the post-withdrawal relationship would become clearer by the middle of this year, but Covid has changed that and the chances of a ‘no deal’ are rising. ‘No deal’ can be a misleading term as this would likely involve many industry specific deals and we would expect travel to be within that given UK tourist spending is an important contributor to the GDP of several EU economies. But while we do not expect a severe hit to Dart’s economics in the event of a ‘no deal’, it is nevertheless likely that the stock would react poorly for a period before recovering, like it did after the 2016 referendum result.

Appendix

1. Covid Corporate Financing Facility.

See https://www.bankofengland.co.uk/markets/covid-corporate-financing-facility.

Dart announced on May 14 that it had been confirmed as an eligible issuer for the Covid Corporate Financing Facility. This is twelve-month low interest commercial paper purchased by the Bank of England. Dart Group has secured up to £300mm at 60bps above the sterling overnight index swap rate.

2. % Fixed Costs. 

Most airlines have reported in the last few weeks with cost cuts typically coming in around 75% per month for the remainder of the year. There are some airlines reporting smaller cuts, typically due to the terms of accepting state aid.

The most relevant comp is from TUI, which reported results on May 13. The company reported that monthly cash costs were down over 70% and implied that fixed costs for the remainder of the fiscal year ended Sep 2020 would be down nearly 80%. This was split €250-300mm per month + €50mm for payment aggregation and works out at 21% of the 2019 cost base.

For Dart group specifically we estimate costs will be cut down to 20-30% of the cost base:

The company has provided some information on key line items: (1) On accommodation, the majority of hotel deposits are able to be reallocated to future bookings, (2) On fuel, the company is taking a £109mm for the year ending March 2021 due to over-hedging, (3) On staff, 80% of UK employees are furloughed and the remainder are taking a 30% pay cut for six months. Performance bonuses for all staff will not be paid.

3. % Cash Refunds.

The liquidity analysis assumes that cash refunds flow out over six months rather than twelve as most deposits are placed for summer holidays. In general, the US airlines are not a good comp as they are incurring surprisingly small cash outflows compared to European airlines. This is because European countries typically have stricter rules on customers being able to access cash refunds.

TUI acts as the best comp and on May 13 reported that 40-50% of customers are accepting a voucher or rebooking rather than cash refund. Dart commented on April 24 that “encouraging numbers choosing to rebook rather than cancel.” With the EU now pushing to support voucher schemes it is possible that these numbers will improve further, although we have not assumed that in the liquidity analysis.

TUI also guided to low-mid single digit hundred millions in cash refunds per month and that the total number of customer deposits at the end of March was €3.4bn. So if 45% of deposits are not cash refunded that leaves €1.9bn and if this flows out at €300mm per month that suggests a timeline of six months for outflows.

Further, TUI stated that they are already receiving €50mm per month in deposit inflows for Winter 20/21 and Summer ’21. Dart similarly commented on both April 24 and May 13 that the volume and pricing for Summer ’21 was encouraging. Of course, as we get closer to that date and this Winter deposit inflows should increase.

Catalyst

We expect that the stock will recover strongly as Covid eases and things normalize to some extent. We also listed five specific ‘flags’ to look for in an internal email several weeks ago and some of these are now playing out:

-   Dart accessing the Covid Corporate Financing Facility -> This has now happened.

-   UK Foreign Office changing advice on non-essential travel -> No change and UK tone has been negative although EU tone is very positive.

-   Governments making a big push to support refunds in the form of vouchers -> The EU is now doing this but the UK has not make stance clear yet.

-   Ramp up of testing over 60k/day alongside quick adoption of contact tracing app -> Testing is now around 100k/day and the target is 200k/day by the end of May. The NHSX app is on trial was expected to be rolled out in late-May.