Dart Group (DTG) released its latest 1H FY18 results on 16th Nov 2017. Operating results were very satisfactory. The total number of passenger sector flown for the period between Mar-Sep 2017 increased by 41% while the ticket yield decreased by 17% from GBP 92 to GBP 76. With the competitive pricing, load factor remained at an impressive 93.2%. Consequently, leisure travel revenue grew 36%. Operating profit grew 22% which led to a continued margin compression of 12.3% as compared to 13.5% in 1H FY17.

Advanced sales grew by 38% from GBP 519m to GBP 713m which is indicating a strong growth for the Winter of 2017/2018. The growth in Winter programme corresponds to Jet2’s capacity expansion as the company grows its aircraft fleet. Strong free cash flow generation with impact from working capital is largely neutral. Capex spend is expected to be much higher in 2H 17 with aircraft delivery.

All things considered, this is a very impressive operation performance by the Dart Group management. The share price rallied strongly upon the release of the set of performance. The market seemed to value DTG very differently over a 5-month period. However, the intrinsic value of DTG most definitely did not change as much as that implied by the share price. I added to my position after Mr Market taking a dim view of the company’s prospect after results release in July 2017. I am glad that Mr Market has changed his view since then.

Post the recent share price rally, DTG is the biggest position in my portfolio by far (~30%). Naturally, I am re-evaluating the appropriate sizing for DTG. To arrive at what is the optimal position size, one would need to understand 1) the expected upside and 2) the downside risks.

DTG can generate further upside by 1) growing its free cash flow; 2) pay down of debt 3) expansion of valuation of multiple. While I do believe that the current multiple on DTG is on the conservative side, I typically do not count on multiple expansion for value creation. As such I would focus on future earnings growth and value creation to equity holder through debt repayment. DTG can generate further earnings growth by:

  1. Volume growth – this can be achieved either through 1) expanding to new airport and 2) adding new routes to existing airports

  1. Pricing growth – this can be achieved either through 1) increasing prices and 2) improving revenue mix by getting customers to purchase higher valued products

  1. Cost efficiency – given that the mix of aircraft is skewing towards new planes, one would expect some degree of operational efficiencies

  1. Operating leverage – as DTG continue to grow in its bases, it should be able to spread fixed cost over larger revenue and achieve some margin expansion. This is especially true at newer bases

DTG might be able to expand to new bases to generate further growth, but it would not be prudent to anchor an investment on such an aggressive assumption. I am happy to be wrong here. So in this analysis, I assume that future volume growth is only coming from adding new routes to existing bases. In the short term, DTG is likely to enjoy high single-digit volume growth due to the collapse of Monarch. In the longer term, DTG is unlikely to grow its volume above the market as competition in the airline/holiday industry is intense. Similarly, on the pricing side, I suspect pricing growth is very limited due to competition. But DTG does get some insulation from pure price competition because they are focused on holiday destinations and are currently very profitable while being very price competitive. Putting the two together, DTG’s organic revenue growth over the next five years is unlikely to exceed 10% while the risk of a cyclical downturn is more severe at current valuation.

By replacing older aircrafts with modern aircrafts, DTG should be able to realise cost savings through fuel efficiency and lower maintenance cost. But the impact of this should be fully incorporated by 2019. It is difficult to estimate this precisely, but I am not expecting a more than 1% of EBIT margin improvement. On the other hand, the risk of a higher fuel price weighs down on the cost savings from the new planes. Operational leverage might kick in with further growth, but this is difficult to quantify.

Putting the above together, I estimate that Jet2 will run at around 11-12m pax capacity with 91% load factor. Assuming a conservative pricing environment, I get GBP 2.4bn revenue in 2019. With an 11.5% EBITDA margin and no working capital benefit, I get ~ GBP 200m operating cash flow. The question of what is the right maintenance capex is a difficult one. I assume that with newer aircrafts in the fleet, the run-rate maintenance capex is close to GBP 60m. Deducting the maintenance capex, the FCF would be ~GBP 150m; implying a close to 15% free cash flow yield on GBP 1bn market cap. Assume that all FCF is used for debt repayment, equity value should increase while the FCF yield would decrease assuming that FCF doesn’t increase too much over time. In today’s world, 15% FCF is still a very attractive rate. Nonetheless, the upside on DTG is probably around 30-50% without any multiple expansion. Given that, I have investment opportunities with similar downside risk but 100% upside. It no longer makes sense to allocate such a large size to DTG.

However, Jet2 is still the best-valued package holiday business where it strikes a great balance between customer service, experience and price. The company is managed by an excellent management team and a well-aligned owner operator. Jet2’s position as value for money package holiday operator should prove to be most robust in a recessionary environment.

At this point, I believe 15% position size is probably the right one for DTG. I am retaining a large position size because I am very keen to partner alongside a competent and well-align management at a reasonable if not cheap valuation. However, I will be selling down more DTG shares.

MC