·         Low-Cost Advantage: The Company is able to offer such cheap prices on its flights because of its low-cost structure.

o    Flybe has among the lowest personnel costs in the industry. On average, its pilot wages are 25% lower than its peers including Easy Jet, RyanAir, BA etc. Similarly, flight attendants and maintenance personnel are 15% below the competitors’ average.

o    The second contributor to the Company’s low cost position is due to its fleet. Flybe flies turboprops Q400 and E175 which need 70% load factors and only 40,000 minimum annual passengers per route to be profitable vs. the A319/A320/B737s airplanes that require 89% load factors and 100,000-120,000 annual passengers per route to break-even.

·         Improving Top Line Drivers: The main revenue drivers for an airline include capacity, load factors, pricing per passenger and number of flights per day. While the management has led with lower prices to stimulate demand, it has seen an improvement in its other drivers.

o    While passenger yield (i.e. average ticket price) have not grown much, even slightly declined, load factors have increased from the mid-60s% to the mid-70s% and currently are among the highest for European regional airlines. This is a c.3x increase in load factors for every 1% of price cut – indicating significant price elasticity.

o    Furthermore, after a turnaround process of culling unprofitable routes, the Company started in the last couple of quarters to grow capacity. Available seats increased 15% in the more recent period which was the first YoY increase since the arrival of the new management. Additional growth of 20+% is expected in the coming 2-3 years.

o    Lastly, the average number of flights per plane per day has been gradually increasing from c. 5.5 in 2010 to 6.3 in 2014 – leading to greater fleet utilization.

o    While costs have ticked up a bit during the early phase of the turnaround process, most of this increase is due to one-off factors such as employee bonus accruals, severance costs, increased regulatory accruals etc. In the last two quarters we have started to see signs of cost reductions.

§  Furthermore, fuel consumption is 75-80% hedged one year forward and therefore Flybe is not benefiting from the current low oil prices. The latter will become a tailwind in 2016 and thereafter.

·         White Label Growth Opportunity: The Company is exploring opportunities for growth as a white label service provider. Many legacy airlines do not have the requisite fleet to fly on smaller routes, as Flybe does, and therefore they are looking to partner with regional players. 

o    This provides a win-win situation for both parties, with the legacy airlines responsible for driving traffic and revenues while the white-label provider offering aircraft, staff and efficient cost execution.

o    While operating margins are typically lower in such arrangements (3-5% implied by the former Finnair JV), profits are more secure under this arrangement and the Company has identified a number of potential partners to help generate a stream of white-label earnings.

·         Turnaround Process shows Early Success: The new management team that has come in the last couple of years starting a deep restructuring effort.

o    The Company achieved its first profitable quarter during the summer months of 2015. This was driven by strong top line and cost reductions. The Company should finish the fiscal year in the “green” from its core operations– again a first.

o    Historically the Company’s fleet consisted of larger, costlier aircraft and operated on routes with very low profitability at minimal utilization rates.

o    The new CEO, Saad Hammad, came in 2013, replaced 40 of the top 50 managers, reduced personnel by nearly 40% and divested of unprofitable aircraft swapping them for smaller, more efficient turboprops.

o    An unprofitable JV with Finnair was unwound expeditiously with relatively limited impact to the cash flow and the balance sheet.

o    He significantly strengthened the Company’s analytical toolset leading to greater revenue optimization and yield management with software and statistical models used by the likes of EasyJet and RyanAir. Previously, Flybe used minimal, if any at all, pricing analytics resulting in inefficient revenue generation.

o    Furthermore, a large equity capital raise completed in 2014 improved the balance sheet returning it to a solid net cash position. The improved credit profile of the Company led to lower restricted cash requirements further increasing flexibility.

o    Lastly, the new management team has initiated a large marketing campaign to reintroduce the brand both online and offline. It also focused on improving customer service. Flybe currently generates the top 4 web-hits in its sector behind BA, EasyJet and Ryanair

·         Strong Management Team with Aligned Incentives: The new management team assembled by Saad Hammad has strong and relevant experience in the airline sector with a large contingent of former EasyJet employees.

o    Saad Hammad, the current Flybe CEO, was a COO at EasyJet for several years before taking a turnaround management role for the private equity firm Gore Group. He spent a number of months studying successful regional airline companies’ business models before taking the assignment at Flybe.

§  According to some sources he was one of the drivers behind the significant growth EasyJet experienced during the second half of the last decade.

§  His incentive package is aligned with shareholders, he will receive a one-time payout, equivalent to 3-4% of the delta between the market cap when he joined (stock price of 91p which is about the current price), and the market cap in mid-2016 (his three-year anniversary) as well as equity and bonuses based on achieving operational performance metrics.

§  Management has been active buyer of the Company’s stock in the open market over the summer

o    The CFO, Philip de Klerk, came from SAB Miller and also has a similar incentive package with options, effectively, priced at above market levels (+c.50%) and expiring in 2017. He also has huge incentives to get the price up and make a lot of money.

·         Solid Balance Sheet: The equity raise completed in 2014 was one of the first steps in the turnaround process. It recapitalized the balance sheet and provided sufficient funding to complete the restructuring effort even under challenging financial conditions. In addition, the financing drew a list of new well-respected investors including, Aberforth (20% stake), Soros (8%), Artemis (6%) and T Rowe Price (5%).

o    The Company has about 40-50% of its current market cap in net cash. Even in our bear case, the Company will be able to sustain its operating for another 3-4 years without having to raise additional capital.

o    As of the end of FY 2014, the Company’s had £194mm (90p / share) of NAV vs a current market cap of £190mm (90p / share).

o    However, the company has approximately £260mm in off-balance sheet liabilities (aircraft lease obligations, rental and equipment) and about £2.5mm in underfunded defined benefit pensions’ liabilities.

o    The Company’s CapEx requirements have been curtailed under the management and under our base case assumptions Flybe will generate substantial cash flows.

Risk Factors

Execution Risk. Flybe is in the midst of a turnaround and an expansion strategy. It may not be successful in executing all its plans as it relates to White Label Services, capacity expansion and ticket price increases.

Flybe has a highly concentrated route portfolio. Close analysis of Flybe’s investor materials suggest that the company’s top 10-20 routes are very important to the health of the business. Any competition on these routes, or any outside pressure that makes them less profitable, will have a meaningful impact on the company. 

Flybe’s fleet is increasingly concentrated in a single aircraft type. Flybe has chosen to make the Bombardier Q400 the centre of its fleet.  The company is therefore at risk of a technical issue affecting this aircraft type either resulting in the grounding of the fleet or a loss of customer confidence in the safety of the aircraft. 

Flybe is subject to regulation, and industry specific taxation, which may have a negative impact on the business.  Governments may increase Air Passenger Duty – a charge that disproportionately affects regional air travel.  Governments may attempt to regulate the cost of air fares on routes they deem to be important to regional well-being. The Company has initiated discussion with the government to have such duty reduced but the outcome of these discussions is still uncertain.

Flybe is exposed to competition from other forms of travel in general.  Changes in the cost or other characteristics of road, rail, or sea travel may help these modes of transport attract customers who would otherwise have flown with Flybe. Flybe will be negatively affected if governments choose to regulate train services. Political parties in the UK are campaigning for the renationalisation of the railway system.  This, or any other increased regulation of train services would likely entail price controls on train tickets, which would likely reduce the relative attractiveness of flying.

Flybe is exposed to competition from other airlines.  There are few barriers to entry on most of the routes that Flybe operates.  Many regional airports that are currently served only by Flybe are likely to welcome the additional passengers that a second airline on the route would promise to attract, as well as the additional landing fees additional flights would bring.  Flybe’s costs are lower than those of its competitors and that provides protections.

Flybe is exposed to rising oil prices.  Although Flybe hedges close to 80% of its fuel costs, a sustained increase in the price of oil will increase Flybe’s costs.  A significant change in the value of sterling against the dollar may materially increase Flybe’s effective fuel costs.  In a rising fuel cost environment Flybe may find it necessary to raise ticket prices, which may adversely affect demand for their services.

Any safety or security related incident at Flybe or at any other airline could discourage passengers from flying. Although Flybe’s services are faster, and often cheaper, than other travel alternatives, passengers are likely to be willing to take alternatives if there is any nervousness about flying.

Key Drivers, Valuation and Sentiment

Flybe went public in 2010 offering an exit opportunity for the controlling shareholder Walker Steel Group. Due to its relatively young corporate history, the Company has limited historical financials beyond its IPO date. Therefore our analysis is based on a 5-year period of financial and operating metrics.

There are a few important drivers that determine an airline’s profitability. On the top line, the key drivers are passenger yield (i.e. ticket price), load factor (i.e. plane occupancy) and capacity (i.e.  number of available seats). On the cost side the key factors are labor costs, fuel expenses, ownership charges (rental + depreciation expense), maintenance / regulatory and SG&A.  Below are a couple of snapshots as to how these metrics have oscillated on a 12-month rolling basis.

The following chart [EXHIBIT 2 below] shows the 5-year rolling evolution in total available seats, total number of passengers and load factors.  The black vertical line in the middle indicates the date when the new management arrived at Flybe highlighting the impact of their efforts. The chart suggests that, the new CEO was focused on reducing capacity, by eliminating unprofitable routes and increasing load factors. As a result, despite the lower number of available seats, the number of passengers has remained relatively constant as more travelers have boarded each flight. The benefit of having more passengers per flight is two-fold: 1) more revenues are generated and 2) the large fixed cost component is spread over a wider customer base. The operating leverage and profitability increase, following higher load factors, is quite potent. Furthermore, we have observed a positive correlation between higher load factors and higher prices which provides an incremental benefit.  The chart also shows that as the load factors have stabilized in the mid-70s, the management has started to grow capacity. 

One of the key levers that the management team has employed to achieve higher load factors was reducing prices in order to drive higher demand. The blue line in the chart below suggests that revenues per passengers (i.e. ticket prices) have been on the decline since the new CEO arrived. However, due to the higher load factors revenues per seat have been on the rise, as the planes fly fuller with a greater number of seats occupied by paying passengers. The chart below [EXHIBIT 3] shows that due to attractive pricing and high load factors, the revenue per seat has shot up to a record in the last couple of quarter, indicating an inflection point.

 However, despite the improved revenue generation (red line above), costs per seats (green line) rose for the majority of the last two years. Hence, the passenger travel business did not achieved profitability on a rolling 12-month basis in the second year of the turnaround. This explains why the current stock price reached the lows during the spring of 2015. However, profitability improved significantly in the last couple of quarters with costs declining (as one of charges dissipated) and revenues per seat increased.

If we track profitability per seat on a quarterly basis we can see that the revenues and costs have come to a break-even stance three times in the last five years in early 2011, mid-2013 and in mid-2014 (see black arrows below in EXHIBIT 4). Immediately prior to those break-even periods, the stock price higher than current level. Conversely, when the spreads have widened, the stock has plummeted to yearly lows. Therefore, the ability to prove that the management can operate this airline profitably is key to stock market outperformance. They have done so in the last couple of quarters and the stock has rebounded from the bottom.

We feel confident that the new CEO and his team will manage to improve profitability. Although there are not many publicly traded direct comparables, we have studied a broader universe of peers, EasyJet, RyanAir, BA (IAG) and they have seen increasing profitability per seat in recent years suggesting that industry conditions are favorable. We have observed that, with the exception of the financial crisis, the three Flybe peers from the UK have seen positive Revenue – Cost spreads.  Furthermore, our research shows that for most airlines this profitability spread has been improving over the last few years. This suggest that the current environment favors

A second reason behind our confidence reaching profitability is our belief that there is room to improve yields going forward. The management has been lowering prices to increase load factors and open new routes. Load factors are already among the highest among European regional airlines and as new routes mature, pricing should stabilize and start to gradually increase.

Third, costs have risen in recent quarters due to one-off items such as bonus accruals, regulatory charge provisions, restructuring charges, severance provisions etc. We estimate that about 3-5% of the current costs are due to such one-off expenses. The last couple of quarters have shown that these costs are starting to dissipate.

The management is looking for incremental cost reduction opportunities. In addition 75-80% of the Company’s fuel needs have been hedged at nearly $100 Brent prices thus preventing it from benefiting from cheaper oil. Flybe will start hedging its 2016 fuel consumption this summer and therefore its expense base will see a tailwind next year from that, perhaps in the magnitude of 4-5% in relation to total costs.

Fourth, as highlighted, the CEO has an incentive package which will pay him a cash bonus equivalent to 3-4% (sliding scale) of the market cap above a certain level (adjusted for equity issuance) before June 2016. If the stock price returns to its recent mid-2014 peak, the CEO pay-out will be quite substantial, equivalent to nearly 20x his annual compensation. We believe that this award provides strong incentives for the CEO to execute well and increase profitability.

We have made a range of assumptions for the key business model drivers, the details of which are provided later on in this case study. Our forecasts are more conservative than the consensus as well as those of some buy-side investors. In our base case we assume that the spread between the revenue per seat and cost per seat improves from £1.25 in FY 2016 to +£4.16 in FY 2020. In our bear case we assume that the spread does not close and stay at the high end of historical negative spread i.e. around -£4-5 per seat. In our bull case, which is closer to what consensus and some bullish buy-side investors arrive at, we get to spreads starting at +£3 in FY 2016 rising to +£9 in 2020. We also assume some small contribution from the white label and MRO business in all cases.

We have approached our valuation using the most commonly adopted metric for the sector Adj. EV / EBITDAR, which normalizes the aircraft ownership profile across the various players. Here is a historical chart for a select group of regional, LCC and legacy airlines. The range has varied from 4.5x-5x in the lows of the crisis to a 7.5x-8x on the top end [SEE EXHIBIT 5 below]. The period 2010-2011 was particularly depressed as many legacy airlines were in a restructuring.

We have approached the valuation in a similar conservative fashion as we did with the build-out of our forecasts. We have used 5x EV/EBITDAR, i.e. trough multiples for our three cases. As a result we get to 1-year target prices of £1.50 and £4.25 in our base and bull case, respectively, vs a current price of c. £0.90 i.e. significant upside. In our bear case we think that the stock price is likely to decline substantially perhaps by 50-75%. The downside is somewhat protected by an NAV (accounting based valuation) of 90p / share (£194mm), however that does not factor in the c. £270mm of off-balance sheet future lease obligations. Over a 3 year period we believe that Flybe will be worth over 300p, i.e. over 200% net return.

Conclusion

We think that Flybe represents a very appealing investment opportunity at the current market prices. It has a competitive moat due to its limited competition, low cost base, large scale, strong balance sheet and an experienced, well-incentivized management team. We have high conviction that the management should be able to close the gap between its revenues and expenses given its substantial incentives to do so.