Description

Thesis

Tallink is the dominant cruise and ferry operator in the Baltic Sea, with a #1 market share in its 5 routes among Sweden, Finland, Estonia, and Latvia. The company has a market cap of €700 million, trades for 7-10x FCF, and has recently announced a strategic review regarding a potential sale.

History and management

Tallink was established in 1989 during the dying days of communism as a joint venture between Finland and Estonia, with the aim of promoting traffic in the Gulf of Finland. In 1996, a new management team led by Enn Pant (head of the company’s majority shareholder Infortar) took over and raised the funds required for a management buyout. In 2005, Tallink went public to raise capital for the acquisition of the Finnish Silja Line, originally founded in 1957. By 2009, the merged company had completed its fleet revitalization program and began to reduce the leverage it had incurred in the process.

Today, Infortar owns 38% of the company, while private equity firm CVC International (part of The Rohatyn Group since December 2013) owns 24%, the majority of which it acquired in late 2012 for €1.10 per share (slightly above the current price). The free float is 38% and all shareholders hold the same class of shares. The company is listed on the Nasdaq Baltic exchange (TAL1T ET in Estonia) but also has a listing in Germany (which is even less liquid than the former) that I have had to select when posting.

Business background

Tallink generates €950 million each year by transporting 9.5 million passengers and 328,000 ro-ro (roll-on/roll-off) cargo units on routes in the Baltic Sea. The breakdown of sales is 25% tickets, 56% on-board restaurants/shops, 11% cargo, and 8% other (charter of vessels, 5 owned hotels). Tallink owns 14 ships (11 operated for passengers, 2 for cargo, 1 chartered) and is the world’s largest tax-free ferry retail shop and the world’s 13th largest travel tax-free retail shop after Frankfurt Airport (11th) and Taipei Airport (12th). The passenger breakdown is 51% Finnish, 20% Estonian, 12% Swedish, and 17% other (Latvian, Lithuanian, Russian, Chinese).

Tallink operates 6 routes, 5 of which are for passengers and 1 exclusively for cargo. The company’s market shares on the passenger routes have been dominant and stable over time.

Competitive advantage

Tallink faces competition from air travel and other ferry companies. The advantage over air travel is strongest on the company’s route between Tallinn and Helsinki, which is its most profitable route. The journey lasts only 1.5 hours, and 97% of Finns entering Estonia do so via ferry. On routes such as Tallinn to Stockholm, air travel is clearly a more efficient form of transportation. However, the passengers on this route choose to take an overnight cruise for the sake of entertainment (dinner, dancing, shows, etc.) and also to enjoy tax-free purchases that are made on-board. Such tax-free purchases are not permissible on routes between countries in the European Union (EU), but the Åland Islands have a special VAT exclusion that was negotiated when Finland entered the EU. Tallink takes advantage of this by making a brief stop in the Åland Islands during some of its EU to EU routes. For instance, when going from Tallinn to Stockholm, the route is divided into two segments, first from Estonia to the Åland Islands (where the ship docks for 15 minutes) and then from the Åland Islands to Stockholm, thus allowing on-board tax-free purchases throughout the entire journey.

The second form of competition is other cruise and ferry companies. Tallink’s primary competitor is Viking Line (Finland), but Tallink’s superior scale, market share, fleet, and tax regime have created a great advantage in terms of both absolute and relative earnings power each year.

Tallink’s primary competitive advantage is its local economies of scale. Approximately 2/3rd of its costs are fixed and are spread over 9.5 million passengers (though more accurately, the fixed costs should be considered on a per route basis). None of its competitors achieve such scale, which also acts as a barrier to entry for new competitors. Two companies exited the market in 2008 and no company has attempted to replace them. The following is Tallink’s 2016 income statement, simplistically separating the company’s costs into fixed and variable in order to give an idea about the cost structure (although analysis on a per route basis is also necessary).

Another way to view Tallink’s advantage over Viking Line is to consider the Tallinn – Helsinki route, each player’s most important route. Tallink operates 7 trips a day with a passenger capacity of 21,000 while Viking runs 6 trips a day with a passenger capacity of 10,000. In only running 1 fewer ship but offering half the capacity, Viking has a much higher fixed cost per passenger. This is a mature market and does not support more capacity, which was confirmed by Viking’s announcement of a Chinese newbuild in 2020 directed toward a route between Finland and Sweden.

Evidence of Tallink’s advantage is clear when comparing the approximate operating cash flow margins of the two companies (Tallink 12.5% and Viking 6.5%). While Finland has a 20% corporate tax rate, Estonia has a 0% rate – partially contributing to this advantage. Companies in Estonia must pay a 21% tax only when they distribute dividends to shareholders.

Tallink has 2.2 million Club One cardholders, a frequent traveler program that increases loyalty and customer captivity (a trait necessary for the economies of scale advantage to continue in the future).

Track record

Below is a simplified chart showing Tallink’s cash generation since 2010 (following the heavy capex period ending in 2009). The cash flows during this time have served to reduce leverage and pay dividends to shareholders.

Below is a comparison of depreciation to capital expenditure in the period (a stark contrast to the heavy capex period culminating in 2009).

In 2009, Tallink completed its fleet revitalization program. Over the past few years, it has invested in upgrading its older ships, particularly those on the Sweden – Finland routes, which it believes will defer any requirement to replace them for approximately 10 years (an investment between 5-10 years from now would not be surprising, however). At the end of last year, Tallink purchased one new ship for the Tallinn – Helsinki route. This ship cost €230m and is 80% financed at around 3% (CIRR) but replaced a ship that was sold for €91.5m, resulting in a net cost of €138.5m. Management expects a 5 year payback and the investment should partially be considered as growth capex given the increase in passenger capacity and earnings. Management declined the option for a second ship, implying its satisfaction with the current fleet in the Tallinn – Helsinki route. The routes where Tallink is the only operator (Riga – Stockholm & Tallinn – Stockholm) will likely not require or justify any fleet replacement in the near future. It is also important to re-iterate that Tallink’s fleet is a decade younger than the fleet of both Viking Line and other global companies.

Depreciation expense runs around €80m annually, while only €10m is required to keep the ships running each year. Of course, maintenance capex is required to either extend the useful life of the ships or in our calculation to represent the “annual cost” of fleet replacement over time. Over the next ten years, Tallink will most likely purchase 1-2 new ships to replace 1-2 existing ships, at a net cost of €300m (new build cost of €500m, less sales of €200m). As a result, total maintenance capex can be considered to be €40m (€30m + €10m) per year and free cash flow will be materially higher than net income, at least for the next decade.

Valuation

The debt is low-cost, long-term (~60% matures in >5 years and ~40% in 12 years), and backed by the ships. As mentioned above, Tallink only pays taxes when distributing dividends. Thus an approximation of its earnings is EBITDA – normalized maintenance/replacement capex – interest expense, which ranges between €70 – 100m. Relative to the €700m market cap, this is a 10 – 14% earnings yield. The company can grow either by increasing passenger counts, improving on-board spending, or adding capacity. Given the uncertainty of the former two and capital requirement of the latter, it is prudent to consider the earnings yield as an approximation of the annual return in an investment in Tallink. Over time, the value of the firm should shift from the debt to the equity as the large cash flows reduce debt (or pay dividends).

Strategic review

On July 19, the Tallink Supervisory Board announced the start of a strategic review for the company, with Citigroup acting as the financial advisor. The result has not yet been announced and the share price is only 6% higher from the time of the announcement. It is unclear if shares will simply change hands between/among Infortar, the private equity group, and/or a 3rd party, or if the company will in its entirety be sold.

Risks

An investment in Tallink has several risks:

1)  Fuel price increases (In 2014, fuel cost was 14% of sales compared to 8% today. Even if fuel prices double, the company would still generate cash. It could also optimize routes or raise ticket prices, which it has a higher ability to do compared to competitors with lower margins.)

2)  Net debt position (debt must always be monitored)

3)  Continued subpar returns on certain routes (the Tallinn – Helsinki route is much more profitable than the other routes and the long-run economics of the other routes is not entirely clear)

4)  Potential ship accident which damages the company’s reputation

5)  Deterioration of relationship with union (no issues historically) or evolving regulation involving sea industry employee subsidies

6)  Changes to tax-free status of Åland Islands (unlikely given the agreement and the precedent for “duty free” sales globally in airports)

7)  Geopolitical risk affecting Baltic Sea region

Summary

Tallink is a locally dominant cash cow that has a low risk of being disintermediated. The company generates large cash flows relative to its market cap, and its competitive advantage is increasing over time as a result of its cash generation relative to peers. The opportunity exists likely due to exotic geography, low liquidity, and the appearance of low net income (compared to cash flow).

Catalyst

Continued cash generation or sale of the company