One of my major contributor my profit this year is Dart Group. Since my initial purchase of Dart Group’s business ownership in Oct 2016, it has both doubled its revenue and net profit while the share price has increased by 4.3x from GBP 3.7 per share to GBP 17 per share due to the most wonderful combination of earnings growth and multiple rerating. I am proud to report that with more than 14m of annual passenger traffic, Dart has overtaken Tui to become the largest package holiday operator in the UK. Better yet, it is also more profitable than its main competitors. Dart enjoys 10-11% operating profit margin while Tui’s margins are half of that.
The initial investment thesis in Dart Group was anchored on 1) demand for package holiday will remain resilient after Brexit, and 2) Dart Group is a good quality business that is misunderstood. I underestimated both factors. UK’s demand for package holiday was more than resilient; it grew at an annualised rate of 5% for the last three years. Dart’s management team did a first-rate job successfully launching a new base in London Stansted, launching new products and constantly improving customer value propositions. I did not foresee the exit of two large competitors in a relatively short period of time. Hence, the timing of purchasing more Dart shares in the first half of 2019 was incredibly lucky. The third-largest package holiday operator, Thomas Cook, declared bankruptcy in September 2019 and since then Dart Group share price soared more than 100%. Thomas Cook roughly represented 20% of total market volume and have ~30% volume overlap with Dart Group. I fully expect Dart Group to capture 20-25% of Thomas Cook’s customer base and enjoy some temporary price increase. Net profit margin in FY2020 could rise above the usual 4-5% range and reach 6-7%. However, the profit boost will be short term in nature. Just like the bankruptcy of Monarch in 2017, the market will respond to supply shortage swiftly which will lead to normalisation of prices and compressing Dart’s profit margin.
In Nov 2017 (link to the 2017 memo), I wrote that “Jet2 will run at around 11-12m pax capacity with 91% load factor” and have “GBP 2.4bn revenue in 2019”. Oh, boy, was I wrong! In 2019, Jet2 actually have 14m passengers and a GBP 3.5bn revenue. Again I credit this excellent growth to Jet2 management team and more specifically Steve Heapy.
Dart Group grew its package holiday business at an annualised rate of 22.8% for the last 11 years. Dart is now ~20% of the total European holiday market in the UK in terms of holiday visits. Narrowing down to the European package holiday segment, Dart’s market share is even higher at 30%. The European holiday market is growing at 5% and the European package holiday market is growing at 8%. I believe Dart can continue to gain market share but at a much slower pace. Or said in another way, there are no more new airports in the UK that Dart could enter to change its growth trajectory materially. For the next 10 years, Dart is extremely likely to grow at a much slower pace versus the previous 10 years. My best guess is that 10% would be very respectable. Again I could be wrong here again….
On the profit margin side, I expect the profit margin to slowly deteriorate due to general cost inflation and limited pricing power. Dart’s value proposition is to provide good value for money holidays to its customers. There is also limited operating leverage in the business without pricing power. One potential source of operating leverage comes from higher Winter revenue. Typically, Dart makes all its money in Summer and must endure losses in the Winter because the Winter volume is not high enough to cover the fixed cost. If Dart could grow its Winter business materially, then there could be some operating leverage. However, the overall UK winter holiday is roughly 2-2.5m visits per year. This pales when compared to the Summer market of 20-30m. The size of Dart’s fixed cost is determined by the peak capacity of 2m passenger per month during the Summer months. Considering the overall Winter holiday market size, it is very unlikely for Dart’s Winter revenue to ever become large enough relative to the fixed cost base that is determined is peak volume during Summer months.
Another possibility for the profit margin to expand is to increase penetration of package holiday relative to the flight-only seats. The cost to serve a flight-only customer and a package holiday customer is roughly the same. Hence if Dart can convert more flight-only customer into a package holiday customer, its profit margin should improve. Currently, 52.8% of total customer choose the package holiday product. I believe that for mature airports such as Leeds, it is not possible to increase the package holiday penetration materially in the future. For newer airports such as Stansted and Birmingham, the package holiday penetration is still quite low. Over the next 5 years, one could see package holiday penetration increasing further to 55% at best.
Combining the slowing revenue growth outlook and compressing profit margin together, earnings likely to grow at less than 10% over the next 5 years. For a company with no pricing power and confined long term grow runway, I am comfortable underwriting a 10-12x terminal multiple on net profit. Correspondingly, the position size has been trimmed back from a 13% position to a 5% position.