Description

Long TRZ/B at C$18.20

Summary
I believe that at current levels Transat trades at a substantial discount to its intrinsic value and could easily double within 2 years. Transat’s stock is currently out of favor after profit expectations for the next couple of years have come down substantially owing to a temporary and unsustainable situation of excess supply of travel packages in Canada. However, Transat is fundamentally a strong company in a healthy industry trading at 8x trough FCF and 5-6x normal FCF excluding C$8.50 per share in net cash. There are several indications that margins are currently troughing: After management guided the Street lower, margins are already expected to descend to levels last seen in the period following 9-11. The guidance was issued on an exceptional basis in connection with an announcement to buy back 16-18% of the stock, so management had every incentive to be conservative. In addition, since providing that guidance on 10/20/05, fuel and currency have moved in Transat’s favor. Transat will repurchase the stock as part of a Dutch auction tender offer on 12/22/05 at a range of C$17.50-C$20.00. Despite taking out a substantial amount of the outstanding shares, the current stock price is still only at the lower end of the buy back range, implying that close to 18% of the shares will be tendered at the current price. The buy-back should provide a boost to the stock in the short term, but two years out the stock could be at C$34 assuming a conservative 12x normal FCF.

Business
Transat is Canada’s largest and most profitable package tour operator with dominant positions in Canada’s smaller markets such as Quebec and western Canada and a number 2 position in Ontario, Canada’s largest but more competitive market. Package tour operators buy hotel and airline capacity up to 18 months in advance, bundle them into packages and sell them to consumers through travel agents as well as their own channels. The biggest outbound Canadian tourist destinations are the Caribbean, Mexico and Florida in the winter months and Europe in the summer months.

Transat operates its own charter airline, which accounts for roughly 1/3 of Transat’s costs. The company also operates a smaller package tour business in France (21% of ltm sales), which has been loosing money over the last few yrs. The French business is being turned around with the EBITDA loss for the October 05 fiscal year tracking at less than half the previous year’s loss. Management has committed to shutting down the French business should they not be able to return it to profitability by F06.

Transat’s dominance in smaller niche markets outside of Ontario has enabled the company to enjoy better margins than competitors SunQuest and Signature Vacations and probably also better than Air Canada Vacations. SunQuest and Signature are owned by British parents MyTravel and First Choice respectively, which are both public and partially disclose North American results (which are largely comprised of Canadian results). In smaller markets for travel originating from midsize Canadian cities and/or travel to smaller, more exclusive destinations, there are relatively limited passenger volumes. In these markets it is difficult for new entrants to succeed against an entrenched player that can employ larger planes at higher frequencies, enjoys better load factors and has exclusive hotel deals. Given this dynamic, I would expect Transat’s margin advantage to persist.

The package tour industry is characterized by significant negative working capital, as consumers/agents pay for packages prior to trips but tour operators only pay suppliers after they have rendered their services. For Transat, negative working capital has been running at 5-10% of ltm sales. As of JulQ05, working capital was a negative C$189m, tangible invested capital was C$14m and tangible invested capital including off-balance sheet debt (operating leases for the planes) was C$408m (all adjusted for some minor tax-related items).

The package tour industry has a short but pronounced business cycle, as operators typically respond to a profitable year by increasing capacity commitments for the coming seasons until margins plummet due to overcapacity and/or demand shortfalls. Losses then drive out weaker operators and the next cycle begins. The Canadian tour industry has gone through a cyclical trough after 9-11 and during the SARS crisis, followed by a strong 2003/2004 season.

Throughout the cycle, TRZ/B has generated industry leading EBITDA margins, which were 5-6% at the trough in F02 and F03 and 10.2% (adjusted for a benefit from a legal settlement) at the peak in F04. The last peak has attracted additional capacity from the existing players as well as from two small new competitors called Zoom Airlines and Sunwing Vacations. We’re now in the midst of the next trough, with Transat’s guidance implying a 6% EBITDA margin in F05 and less than 6% in F06, en par with margins following 9-11.

There is no reason to believe that margins shouldn’t recover from the F06 trough. Zoom and Sunwing have been aggressive but are now almost certainly loosing money (both are private). Transat and other competitors are now matching their prices and Transat says that their margins are 15 points lower in markets where they compete with Zoom. Both new entrants have little or no advantage leasing and staffing planes, but should suffer from lower market penetration and buying power disadvantages for hotel capacity at the destinations.

The global package tour industry has also faced some secular issues, especially in Europe. The emergence of low cost carriers flying to the Mediterranean in combination with the increased transparency brought by the internet, the trend towards residential tourism (Europeans buying property/timeshares in the Mediterranean), the common currency and shorter weekend trips have all weakened the value proposition offered by the tour operators in Europe. This has led to modest revenue declines and difficult margins despite growth in overall tourism. However, by and large these issues do not apply to Canada as the Caribbean and European destinations are too far from Canada for weekend trips, residential tourism and the low cost carriers, which typically focus on <2h trips. As a consequence, Canada’s tour operators have continued to generate sales growth across the cycle and healthier margins than the Europeans, a trend which I expect to continue.

Fuel and US Dollar exposure
Fuel constituted 7.6% of sales or C$177m over the last 12 months. As of the JulQ05 conference call, 25% of the need for this winter season has been hedged at an equivalent of around US$60/brl for crude, close to the current spot price. Eyeballing the crude charts on Bloomberg, I would estimate the average crude price for the previous winter season to be around $50. It’s hard to be precise about forecasting the fuel effect on profits given some pass-throughs in the form of fuel surcharges to customers, fuel hedges last year, crack spreads, subsequent hedging adjustments etc. Fuel is clearly a head wind currently, but the above numbers should give you a sense of the magnitudes involved. Also, while still up year over year, jet fuel spot prices (JETINYPR on Bloomberg) are actually currently down 16% from when Transat provided guidance on 10/20/05.

Roughly 30% of Transat’s costs, but virtually none of its revenues, are US Dollar based. Therefore, the strength of the Canadian Dollar relative to the US Dollar has been a partial offset to the fuel headwind. For this winter season, Transat has hedged about 70% of its US Dollar need at around C$1.20 / US$1. The Canadian Dollar is currently at C$1.15 / US$1 and was at about C$1.23 / US$1 in the last winter season. As with fuel, it’s hard to calculate the exact benefit from exchange rates, but it’s fair to say that at current rates, the strong Canadian Dollar should continue to provide some offset to surging fuel. Again, the above numbers should provide a sense of magnitude of the exchange rate exposure.

A and B shares
Since Transat owns an airline, the Canadian Government restricts non-Canadian ownership in Transat to 25% of the voting interest. For this reason, Transat instituted a dual share class structure with the class A shares (TRZ/RV/A on Bloomberg) owned by non-Canadians and the Class B (TRZ/B) shares owned by Canadians. Cumulatively, Class A shares are limited to 25% of the vote and the voting rights per share change depending on Transat’s foreign ownership. In practice, you do not need to worry about which share you buy, as the A shares acquired by Canadians automatically convert to B shares and vice versa. The B shares are much more liquid than the A shares.

Valuation and target
With the stock at C$18.20 and 41.5m fully diluted shares, Transat’s market cap is C$755m. Excluding the leases for the planes, most of which are off-balance sheet, there is C$353m in net cash (C$8.51/sh). This ignores C$132m of “cash in trust” from customer deposits, which under Canadian law can’t be used for general corporate purposes. On this basis, EV is at C$402m. The leases amount to a total of C$491m (C$97m in capitalized leases and C$394m in off-balance sheet operating leases), so on an EBITDAR basis, EV is at C$893m.

With OctQ05 EPS guidance at “less than half of OctQ04” (54c), I get an implied F05 EBITDA of about C$115m. Earnings for F06 are guided to be “below F05”. Technically, given the buy back in December and the resulting decline in interest income, earnings would be down in F06 even if EBITDA remains at the F05 level, but lets assume C$110m in EBITDA for F06 to be conservative. Assuming 5% revenue growth and break-even results in France, this would imply a 5.5% EBITDA margin in Canada. Ltm aircraft rent was at C$56m. This would get us to a trough F05 / F06 EBITDA multiple of 3.5x / 3.7x and a trough EBITDAR multiple of 5.2x / 5.4x.

My best estimate of normal EBITDA margins for Canada would be the average over the F02 – F04 cycle, which was 7.2%. On F06 Canada sales (assuming 5% sales growth to C$1922m), this would imply normal EBITDA of C$143m. Thus, Transat trades at 2.8x normal EBITDA and 4.5x normal EBITDAR, assigning no value to the French operations. This is too cheap.

Looking at FCF, the valuation looks just as attractive. With ltm Capex of C$31m and assuming a tax rate of 35%, F06 trough FCF should be C$51m, a 13% yield on EV even without any cash generated by growing the negative working capital in line with sales. Normal FCF (again assuming normal EBITDA of C$143m) would be C$73m, a 18% yield. This cash generation power is not just theoretical. Over the F02 to F04 cycle, Transat has generated C$268m in FCF even excluding the additions to restricted cash. This is equal to an average annual FCF of C$89m or C$2.15/sh on a C$17.50 stock with C$8.51/sh in net cash

Assuming a return to a normal EBITDA margin of 7.2% in Canada in F07 and 5% annual revenue growth, Transat would generate about $144m in FCF by the end of F07 (ignoring the cash in trust, but including other working capital effects). This would bring the total net cash in two years to $497m (ignoring the buy-back). At a modest 12x FCF of $77 in F07, the operating business would add C$929m to the valuation for a total market cap of $1,426m or C$34 per share, almost a double from the current level. This target implies a 6.2x multiple of normal 07 EBITDA and a 6.9x multiple of normal EBITDAR.

Catalyst

Catalysts
On 10/20/05, Transat announced that it would use C$125m of the cash on hand to buy back stock and C$85m for smaller acquisitions. The company later clarified that they will buy back C$125m worth of stock on 12/22/05 in a Dutch auction tender offer at a range of C$17.50-20.00. This represents 18% of the outstanding shares at the low end of the price range. It would appear that there is a good chance that the company will have to offer much more than the low end of the range or the current share price to repurchase this amount of stock. In addition, the buy back will make it harder for investors to ignore the cash.

In the medium term, I expect that a stabilization in margins will help the stock as people start to see through the current down cycle. I am reasonably comfortable that there isn’t a lot of downside to F06 margins from the current guidance, as it already reflects margins at levels equivalent to the period following 9-11. Furthermore, management had every reason to be conservative in guiding the Street. Transat does not usually provide guidance and the recent guidance was given to lower the Street’s expectations to more realistic levels prior to the buy-back. In addition, jet fuel prices have come down 16% since they provided the guidance while the Canadian Dollar has strengthened modestly, both obviously positives.

In the longer term, I expect the stock will continue to appreciate as margins recover cyclically, C$85m in cash earmarked for acquisitions is deployed and adds to earnings and additional cash is generated.