Description

Transat can be bought for 5-6 times 2006 or 2007 free cash flow. The bear case is that fuel cost increases will squeeze operating margins from their record 2004 levels, and thus the market has given Transat the same shabby treatment as an airline. I argue that not only is the fuel issue overblown, but favorable U.S. dollar cost exposure should actually increase margins incrementally, creating significant upside in both earnings and multiple expansion as the market realizes its miscalculation. Additionally, Transat’s $320 million cash hoard (net of customer deposits) provides downside protection, especially considering management’s publicly-stated interest in a large stock buyback.

Brief Intro
All dollar figures in this report are expressed in Canadian dollars unless otherwise specified as that’s how they report. The A shares trade under Bloomberg ticker TRZ/RV/A CN, and the B shares trade under TRZ/B CN. Yahoo Finance ticker is TRZ-RVA.TO and TRZ-B.TO.
Transat is Canada’s largest tour operator. Tour operators purchase hotel rooms, air travel and such wholesale and resale them as retail vacation packages. The business model is an attractive one given that it’s one of the least capital intensive businesses in the world – customers pay upfront, effectively providing a mildly profitable “float”. Counting customer deposits Transat actually has negative invested capital to the tune of $125 million. Excluding deposits they still only have about $30 million of invested capital. With at least $100 million of earnings power, at worst they earn 300% on their invested capital – how’s that for EVA? However, for the same reason it’s a fairly competitive industry with low entry barriers and lots of perfect substitutes for a big ticket item.
The one redeeming competitive aspect of the packaged travel industry is that capacity is always short-run (no more than one season) since the vast majority of air capacity is not owned – and of course hotel capacity is never owned – so we would never see a prolonged Level 3-style capacity glut. This is why I’m confident that the current pricing pressure is short-term.
It is management’s contention that after fat years, tour operators have a tendency to pile into the market like dogs off the leash and that overcapacity generally persists during the following year. Furthermore, we believe that in Ontario management is making a concerted effort to drive the smaller players out of the market by causing them short-term pain. Pricing everywhere else but Ontario is healthy. At any rate, since we’re looking out 2-3 years, I think the market has more than sufficient time to rationalize.

Restructurings
The poor travel market prior to 2004 led management to undertake multiple restructurings. Long story short they’re operating with 800, or 15%, fewer employees than they were at the end of 2001. Additionally, Transat removed two aircraft (net) from their fleet and homogenized the fleet to include only Airbus aircraft. The lease savings, maintenance savings from having a homogenized fleet, and the superior fuel efficiency (5-7% per ASM) of the new planes is saving them $25 million annually ($20 million was realized in 2004). Anyway, all this is already reflected in 2004 results so I won’t prattle needlessly.

Fuel Costs
Jet fuel prices began their meteoric rise in 2003 and have since risen from US$.80/gallon to US$1.60. However, given the Canadian dollar’s rise from 1.50 to 1.20 against the U.S. dollar, fuel prices have risen 60% in Canadian dollars.
My data on Transat’s fuel hedges is sketchy because of management’s reluctance to talk about it, but from the limited information they will divulge it would be reasonable to assume they had 45% of their costs hedged six months before both seasons (i.e. at roughly C$1.10/gallon for the winter season and C$1.00/gallon for the summer season). The other 55% would have been paid at market rates. For 2005 they should only have about 15% of their fuel needs hedged (23-24% of winter needs, 9% of summer needs), so this year should be pretty clean as far as reflecting market fuel prices. So with this in hand we can take an educated guess at average fuel prices as reflected in the income statement:

C$1.15 avg winter price x 56% of revenue in winter + C$1.45 avg summer price x 44% of revenue in summer = ~C$1.30 wtd avg fuel price for 2004

We know that C$ fuel prices are currently 50% higher than the 2004 weighted average. So that said, if 6% of your costs have risen 50%, that should hurt margins by 300 bps. This ignores any potential fuel efficiency gains from the newer fleet.
So yes, fuel price increases will undoubtedly squeeze margins. However, I’ll now contend that Transat’s favorable exposure to the weak U.S. dollar will more than offset their fuel troubles.

U.S. Dollar Costs
30-35% of Transat’s total costs are in U.S. dollars. Since fuel is obviously bought with U.S. dollars, the non-fuel U.S. dollar costs are more like 25% of total costs. These non-fuel costs would include things like hotel rooms, some aircraft maintenance, and aircraft leases.
Management provides a little more clarity on dollar hedges than for fuel hedges. They hedged roughly 65% of their U.S. dollar exposure last year. Presumably they’ll do about the same this year. Their weighted average U.S. dollar cost was about $1.40 in 2004 (blended average of hedged cost and market cost). As I write this the market rate is $1.20.
So we have about 15% deflation for about 25% of Transat’s costs which, all things being equal, should push margins 375 bps in the other direction versus 2004, more than mitigating the fuel price increases. Bear in mind I never rely on any possible favorable effects of fuel surcharges, nor potential price increases. But then this exercise also assumes that all cost savings will accrue to the company, which probably isn’t realistic in a business as competitive as Transat’s.

Other Niceties
Providing further upside to this story a French subsidiary, Look Voyages, lost $25 million (both pre- and after-tax since they’re not accruing tax loss benefits on it anymore) in 2004. Management expects to reduce this loss by half in 2005 and have projected profitability at Look by year-end 2006. The other French subsidiaries are earning about $5 million per year. It’s interesting to note that the French segment almost broke even in the summer season (second half) of 2004. If extrapolated forward, this would imply Look is on track to lose at worst $10 million run-rate, in-line with management expectations, even before the latest restructuring has been implemented. I’ve factored in no upside beyond getting it to breakeven because as I see it, worst case, if they can’t get it profitable they can shut it down. Management has stated unequivocally that Look will be shut down if it is not profitable in 2-3 years. Either way the profitability delta is at least $25 million – more if it ever becomes profitable.
It’s also worth noting that management’s projections of profitability rely almost exclusively on cost cutting, so there are no heroic revenue ramp assumptions built in to achieve profitability.

Stock Buybacks
Because Transat owns an airline, foreign ownership is capped at 25%. The company recently amended its capital structure to create a new variable voting class. In effect the variable voting shares pins the voting power of foreigners at the lesser of actual current foreign ownership or 25%. Foreigners’ share of earnings won’t be diluted in any case. At last count foreign ownership was 24%, so as yet foreigners’ voting power hasn’t been diluted but presumably it will be incrementally. Air Canada and Petro-Canada have enacted similar share structures for reference and neither ACE’s nor Petro-Canada’s variable voting shares trade at a discount to the B shares. Apparently foreign investors can buy either the A or B class shares (but obviously B shares would convert to A shares subsequently), so as I see it there should never be a huge arbitrage available. It should be noted that the overriding reason for amending the capital structure was to allow a sizeable share buyback, so we have tangible evidence that a truly value-creating plan is in the works.

Projections
So the above gives me a little more confidence that current margins are sustainable from a fuel perspective. In a worst case scenario if jet fuel prices continued to rise and the U.S. dollar reversed course, after a while we’d be in trouble without price increases. We have a little wiggle room though considering I’ve taken EBITDA margins down in my projections 70 bps even while we’re confident margins should expand.
Below are some projections based on management’s input and general tea leaf reading, and some historicals adjusted for restructuring charges and cost reductions.

(C$ millions) 2006E 2005E 2004 2003 2002 2001 2000
Gross Revenue 2,400 2,300 2,200 2,097 2,074 2,122 1,923
Growth 5% 5% 5% 1% -2% 10% 18%
EBITDA (1) 170 160 169 100 99 160 128
EBITDA % 7% 7% 7.7% 4.8% 4.8% 7.5% 6.7%
Depreciation 28 30 33 42 43 51 34
Unlev. Pre-Tax 142 130 136 58 56 109 94
Pre-Tax % 6% 6% 6.2% 2.8% 2.7% 5.1% 4.9%
Income Taxes (2) 48 44 46 20 19 37 32
Unlev. Net Income 94 86 90 38 37 72 62
Add: Deprec. 28 30 33 42 43 51 34
Less: Norm. Capex 20 20 20 20 20 20 20
Add: Working Cap. 10 10 72 7.1 129 -69 42
Add: Look Losses 25 12 - - - - -
Unlev. Free CF 137 118 175 67 189 34 118

(1) Adjusted for pre-tax restructuring charges of $11.4 mill, $48 mill, and $117 million in 2004, 2003 and 2001, respectively. Also adjusted for $5 million of fleet cost savings in 2004-2005 and $25 million of fleet cost savings in 2000-2003 – this is purely theoretical and may not reflect reality, but this is mitigated by the fact that they have 15% fewer employees on the payroll, which I don’t adjust for retrospectively.
(2) Assumes 34% tax rate, which was not the case prior to 2004.

Valuation (2-3 years out)

Today Base(3) Best(4) Worst(5)
FCF 137 137 150 75
Mult. 5.5 12 14 8
EV 760 1,640 2,100 600
Cash(1) 320 570 420 320
Debt(2) 30 30 30 30
Equity 1,050 2,200 2,500 890
Shares 42 42 35.7 42
Price 25.00 52.00 70.00 21.00

Upside 45.00
Downside 4.00
Rew/Risk 11.0

(1) Cash is net of deposits.
(2) Note that for 2005 some leases will be reclassified as capital leases from operating leases, which will add about $100 mill of debt while actually decreasing operating income by $3.8 mill. But of course, there will be no cash flow effect. I’ve chosen to ignore the new accounting treatment for simplicity’s sake and treat all leases as operating leases. There’s good narrative in the Q1 press release.
(3) Assumes no buyback or acquisitions, but $250 mill of cash-build between now and then.
(4) Assumes a 15% (~$150 mill) share buyback, plus $250 million of cash-build between now and then for a net cash build of $100 million.
(5) Based on today’s cash levels and no buyback.

Catalyst