My feelings about FLT valuation

@hcosah

In answer to your question...

I have framed my opinion on FLT's value, in terms of an effective earnings yield, as follows:

yield = e / EV

Here e is an effective cash and debt adjusted earnings after tax (~ 0.7 x EBIT ) and EV is the effective total price paid by an investor today, including the effect of any debt or cash I expect to be held by the business in the near future (by the time it comes out of 'hibernation').

EV = MC + Cr + D - C + Crf

Here MC is the current market cap (pre CR) with the price at $11 per share (roughly where it currently stands), Cr is the proportionate amount that investors will contribute in the entitlement for those that are participating (Cr = 0 to those not participating), D is any debt I expect on the books at the end of the hibernation period (which will be a function of current drawn debt and whether or not FLT utilises its pre-existing and now extended borrowing headroom, which has been extended to a total of $300m), C is any cash from the CR that may be left over if the hibernation period is modest, Crf is any future capital raising that may be required should it be required (this clearly is largely contingent on the duration of the hibernation period) . D, C & Crf need to be adjusted down by the dilution that will occur after the CR. For those not participating, the dilution will be much greater (they will own a smaller share of any debt and cash). For those participating the dilution will be 20%, whilst it will be 49% to those not participating.

I have guesstimated a future e under a few scenarios, based on the time it takes to get to some kind of normality, and taking into account that FLT will have closed down a large part of its operations. I have also a assumed it takes a while after the hibernation period for the 'new Flight Centre' to break even. As such, I have brought this e to the present, by applying a discount factor. My previous comments about dilution also apply to the e (ie if your denominator is smaller, because you haven't participated in the CR, [reduced your 'ownership' of debt and don't have to dip in to your pocket for the CR], then the penalty is that you also make your e smaller).

Being mindful of the fact that long, indulgent posts often confuse more than enlighten, I am going to be as brief and succinct here as possible. As such I will not go into the details of my assumptions (hibernation period, new normal TTV, new normal operating margins etc), especially as my guess is as good as anybodies. I don't think anyone will be surprised when I say that much depends on the duration of the 'hibernation' period. If this goes too long things get much worse very quickly. Further capital will likely be required, regaining margins will likely be more difficult etc.

Assuming that hibernation falls within a reasonable band (say ending 5 to 7 months from now), then no further capital should be required, and profitability may return fairly soon. In this case I guesstimate a possible effective yield in the range 6% to 8% for those participating in the CR (5% to 7% for those not participating). Whilst this does not seem all that enticing, I feel it under sells the business. For instance, I strongly suspect that FLT will win very substantial margin share from weaker competitors. As such, a return to profitability could herald the beginning of a period of substantial growth. This earnings yield is equivalent to a PE in the range 12 to 17 (14 for the mid point), (or 14 to 19 for those not participating in the CR). It should also be noted that I am not attaching any value to a strong rebound due to any pent up demand. Finally, I am ignoring any advance bookings of very attractively priced holiday offerings, which lets face it, suppliers will be desperately throwing at FLT.

On the other hand, if the hibernation extends for many more months and depends on a vaccine, then things get bad quickly. Not only will further capital be required, but FLT will start to permanently lose staff and permanently lose ground to low cost (online) competitors. I see this as unlikely, as I believe humanity will adapt before it comes to that. But, I believe it is a material risk. Though even here all hope will probably not be lost, for two reasons. Firstly, FLT already has a very developed OTA component. It may mean that FLT has to relinquish most of its shops (at substantial cost unfortunately) and focus on a few 'hyper stores'. It's even possible that this hybrid (omni?) model will continue to provide competitive advantages - at a reduced cost to FLT. The other reason is FLT's corporate travel component, which now makes up a very large part of the business. This will be stickier and less dependent on 'shops'.

Of course, it is also possible that travel returns much more rapidly than is currently expected. There are a lot of smart people with a lot of resources, that are highly incentivised to make this happen. If so, then I expect FLT to have enough cash to pay down its existing debt (if it chooses to), and it may even rebound with rapidly improving margins (after having culled its most unprofitable shops). If this happens then I can see effective yields above 11% for those participating in the CR (close to 10% for those not). I think this would be a very attractive yield for a high a ROE business which will then have a substantial growth runway (in recovering its former glory).

So, all on all I believe the current price of $11 probably offers something a little better than fair value, for both those choosing to participate in the CR, and also for those not participating. I actually don't see a lot of intrinsic value in participation. From my perspective, this is because the return on incremental capital here is probably not all that attractive. This is all about keeping the business alive. This is probably why those participating in the placement (as distinct from the entitlement) demanded a larger share of the pie. As such, all shareholders benefit from the CR , whether they choose to participate or not.

So to the final issue: should I participate in the CR? If I want to increase my stake in FLT, then participation is absolutely the best way to do it.Whilst my sense is there is investment merit in where FLT currently stands (with substantial probability of surprising on the upside), given the risks, I don't see it as compelling. That is to say, for me it's not a high conviction gambit. That's not necessarily a criticism. High conviction opportunities have become highly sought after, and in my mind, over priced (even now). For me, it just means that the risks need to be controlled by limiting exposure (say 5% of portfolio instead of 15%).

All of that said, CR does provide a substantial short-term arbitrage opportunity (for those not seeking to increase their stake). I acknowledge that this depends on the market continuing to rate FLT at substantially above $7.2, on an ex rights basis, for the required duration. As such, it is a speculation. So we will each have to make of that what we will.

Finally, I should say that the current landscape is highly fluid and has many moving parts. I suspect it's unpredictable - which probably makes my valuation exercise little more than a speculation. As such, each passing week will change FLT's (and all travel company's) fortunes - and prospective value. On the other hand, whilst I don't know where FLT will be in 3 years, I do know it is one of the strongest players in the sector, and is run by savvy, experienced, shareholder aligned and incentivised management. That alone gives me reason to suspect that 3 years from now I will look back and see this as a rare opportunity to invest in travel companies, and kick myself that I did not have more in FLT.

Who would have thought my FLT holdings would become a biotech gambit?