Description

Flight Centre (“FLT”) is 57% off of its lows due largely to investor optimism on FY2020 (June YE) targets set by a management team that has consistently overpromised and under-delivered. Even if the targets end up being hit, there is not much incremental upside from the current price. I believe it is a good time to be short.

Business Overview:

Hearing this on its own will probably make you want to short the company. It is an Australian bricks & mortar travel agency. As in, customers walk into one of their stores, there is a travel agent physically present (note: not a robot, a person), and that agent books flights and hotels for the customer. The customer then walks down the street to get their typewriter repaired, their film developed, and to rent a VHS at Blockbuster, I can only assume. In any case, A$19B worth of people still used them last year, so there are still some Luddites out there.

In all seriousness, they do provide a valuable service for some types of transactions (e.g.  complex itineraries, foreign language countries) and it therefore makes sense that the brand has gotten significantly more traction and generates higher margins in Australia vs. other countries it operates in. However, it should be clear that the use cases for physical travel agents diminishes every day as OTA capabilities increase and travelers get more comfortable with those platforms.

From a geographic perspective, 52% of transactions (but 80% of EBIT) come from Australia, where they have ~1,550 sales teams (note: most sales teams have their own storefront location). They also have meaningful footprints in US/Mexico, UK, Canada, and New Zealand, as well as a few other countries.

Roughly 1/3 of their transaction volume is corporate and ~5% is online – both of these offerings have lower commission rates than the core leisure business. Corporate business is ~85% airfare and leisure business is 55% airfare - the remainder is land spend (largely hotels).

The general model is to earn a ~12-13% revenue margin on the aggregate travel they sell (higher for hotels, lower for airfare) – this comes from a combination of regular commissions as well as “overrides” which are essentially volume bonuses that kick in depending on the aggregate volumes sold for a given client. ~55% of revenues are paid out to employees (most of them sales employees), ~30% goes towards other expense (sales & marketing, rent, IT, etc.) and the remaining 15% drops down to EBITDA. In addition to travel commissions, they operate some tour companies as well as some other miscellaneous businesses, but these do not really move the needle.

Thesis Overview:

1. FLT has run up ~57% since March based largely on mgmt’s initiation of long-term (FY 2020) targets with no clear path to achievement and a history of overpromising & under-delivering

2. FY 2018 consensus estimates at risk given reticence to provide guidance in August on FY17 call

3. Beneficiary of technical buying over the last few months from short covering

4. Proxy bet on weakening Australian consumer/housing/economy

5. OTA threat is structural and will only get worse over time – online OTAs have a lower cost structure and as they gain share will get higher relative commission levels from overrides, allowing them to discount and feed the flywheel

6. Close to fully valued even if everything works out according to plan

7. Lot of room to fall if optimism subsides given near-record trading multiples

1. FLT has run up ~57% since March based largely on mgmt’s initiation of long-term (FY 2020) targets with no clear path to achievement and a history of overpromising & under-delivering

FLT traded around the $30/sh mark last November when they gave disappointing FY17 guidance of $320-355M PBT (vs. $360M estimate at the time) and continued around that level as guidance was revised even lower in February, to $320-355M. However, since April, the stock has run up dramatically, essentially on two events:

1. FY17 came in better than revised guidance (but on the low side of original expectations) @ $330M

2. Mgmt outlined an aggressive set of targets to grow transactions by 7% p.a. through to 2020 and to get back to a 2% pre-tax margin on transactions, in-line with 2015 levels and above the 1.58% generated in FY17

On these two events, the stock almost inexplicably rallied up to $50/sh and has since fallen back a bit. If mgmt were likely to achieve their 2020 targets, then some optimism would be warranted – the targets reflect EPS levels that are almost 50% higher than the 2017 result. However, such optimism is not warranted. Management has consistently over-promised and under-delivered over the last 3 years, resulting in earnings revisions which look like this:

Note that this was during a 2014/2015 period that saw a large weakening of the AUD which should have positively impacted their results due to the translation of foreign businesses.

Furthermore, it’s not like management has some grand detailed plan to achieve these results. I think DB summed up mgmt’s plan well – they are now going to “constrain cost expansion, while maintaining top line growth”. Brilliant! Why didn’t I think of that?! Managing a business seems easy.

In reality, judging by commentary on the call these targets seem more aspirational and goal-like rather than something they have a clear line of sight onto. The levers they can pull here are limited and historically they have not proven they can pull more than a few at the same time:

• Lever #1: Growth in sales teams

• Lever #2: Growth in sales team productivity (transaction volume, or TTV, per team)

• Lever #3: Revenue margin (commission rate they get from airlines & hotel)

• Lever #4: Employee cost %

• Lever #5: Other costs / team

Their targets require them to execute on all of these – they will need to generate organic TTV growth that is ~100bps better than that achieved in the last 3 years while driving down costs. Historically they have relied heavily on lever #1, growing their sales staff by ~5% p.a. – however, this level of growth is not conducive to productivity gains. It is only when they turned down growth on sales staff that they were able to achieve any productivity gains (i.e. by getting rid of lower-performing locations & staff) – see chart below. Furthermore, mgmt has admitted they cannot pull lever #3 at all – areas they are leaning on for much of their TTV growth like online and corporate are inherently lower revenue margin – they expect this metric to continue to contract. On lever #4, they have not historically generated any savings here and I don’t see why this would change. On lever #5, many of the investments they are making to drive growth in TTV (e.g. online) are coming from increased spending on communication/IT and capex which will continue to flow into D&A over the coming years.

Essentially, mgmt needs to pull ~4 of these 5 levers at the same time to hit their targets and historical evidence is that they only have 2 arms…

2. FY 2018 consensus estimates at risk given reticence to provide guidance in August on FY17 call

I also believe FY18 guidance (likely to be provided in November) is at risk.

• Historically, mgmt has guided the next year out in August on their FY results call – in general it has been close to where consensus already has them

• Last year, mgmt failed to give guidance in August for the first time, indicating that it was “too early” – they subsequently gave it in November and it was meaningfully (6%) lower than expectations as of August – I believe they knew results were going to be weak and gave themselves a few more months to see if the outlook improved

• This August they again failed to give guidance, also indicating that it was “too early” – to me this suggests that sell-side expectations for 5% y/y growth vs. declines in each of the last 3 years may be too aggressive

• Sell-side appears to derive some comfort from mgmt’s comments that they have gotten some momentum in H2 and would be “disappointed” with their results if they didn’t get profit growth in FY18 – let’s look at what management has said about their outlook in the last two years:

• June 2015: “And we’re looking at a PBT target of about $380-395M. I think that’s about 4-8% growth. And yeah, we’ll be disappointed if we don’t get that.” (end result: achieved $352M)

• June 2016: “Just going on to guidance, we can’t provide really meaningful guidance right at this stage. We certainly will be disappointed if we don’t improve on this 2016’s results. But after six or seven weeks, it’s impossible to give any accurate guidance except that, as I say, we will be disappointed, if we don’t get to last year’s results.” (3 months later: guidance initiated below last year; end result: achieved low end of that range)

• Bottom-line – mgmt is used to disappointing investors (and themselves) and I think there is reason to believe they could again in November. After the FY17 call consensus took their FY18 PBT estimates up 4% from $349M to $364M and are now reflecting 10.5% growth off of 2017 numbers. Meanwhile all mgmt has committed to is being disappointed if they don’t get a result that is 10% below consensus – not super confidence-inspiring

3. Beneficiary of technical buying over the last few months from short covering

FLT is a company that has attracted a healthy short interest at times. I believe the unwinding of ~40% of this short volume from 12.4M shares in late June to 7.3M currently has been a source of technical buying, generating squeeze-y price action. The net covering of 5.1M shares has represented ~17% of all shares traded during this time period. Once this short covering stops (or reverses), the stock will lose its technical bid and should contribute to a decline in the stock price.

4. Proxy bet on weakening Australian consumer/housing/economy

I’m not going to go into too much detail on this. Suffice to say that when you have an economy that hasn’t had a recession in 30 years, your first one is probably going to be super super ugly. And international leisure travel really doesn’t do too well in the midst of a recession. The unwinding of their insane housing bubble won’t help either (shown next to US for comparison):

5. OTA threat is structural and will only get worse over time – online OTAs have a lower cost structure and as they gain share will get higher relative commission levels from overrides, allowing them to discount and feed the flywheel

Given they do not need to spend on physical locations or human travel agents, OTAs have a competitive advantage vs. B&M travel agencies. This advantage also has self-feeding “flywheel” like effects, meaning that the OTA threat is structural and will continue to get worse.

Lower cost base → ability to spend aggressively on advertising → share gains → leverage fixed cost → lower cost base (repeat)

Share gains → More attractive for clients → Higher “override” payments → ability to spend more on advertising → share gains (repeat)

To date FLT has surprisingly been able to keep up in its core Australian market and has maintained its overall market share. However, I believe they have only maintained share by taking share from smaller B&M travel agencies and through aggressive expansion of their store base (Australian sales teams are up 26% in the last 5 years). As of today, they are more or less the only B&M travel agent of scale in Australia – however I believe this will be an instance of having won the B&M travel agent battle but eventually losing the overall war to OTAs.

6. Close to fully valued even if everything works out according to plan

The run-up in the stock price provides a good margin of safety here. If mgmt somehow manages to hit their 2020 targets (7% transaction growth, 2% PBT margins on transactions) – this should get them to $3.40 of EPS in FY2020. Historically, FLT has traded in-line with the broader ASX which is currently at 15.8x forward EPS. Maybe the successful turnaround will allow them to trade at a slight premium to that. So if we assume FLT trades somewhere between 15.8x to 17x 2020 EPS that gives us a $54-58/sh PT in 2 years, plus ~$4 in dividends, or a 14-18% IRR over 2 years.

In reality I think the plan is a long shot – if they can achieve some, but not all of the goals (still a bullish case IMO and say, grow at 6% and get to 180bps margins, they can get to $2.98/sh in EPS by 2020 – at 15.8x EPS plus divs that gets us to a 7% IRR over 2 years.

7. Lot of room to fall if optimism subsides given near-record trading multiples

If optimism subsides, there is a lot of room for this to decline. At almost 18x earnings vs. a trading range of 12-16x over most of the last 3 years, we could see ~20-25% downside just from multiple contraction, and probably another 5-10% from earnings estimates coming off. In a recession case all bets are off given the cyclicality of the business – the stock return in CY2008 was (76%) and it dropped further from there…

Catalyst

Future results not meeting the glide path to 2020 that sell-side assumes

FY18 guidance to be given in November