Come Fly with Me
And then there was one! My portfolio has but one member left without a detailed post, and it’s certainly not for lack of interesting things to say. On my meandering journey through the stock markets, Dart simply got left until last, in the meantime underperforming both my portfolio and the market quite significantly. As I said when beginning this series, I find stocks that fellow value investors have bought which have then declined fascinating. If I agree with their initial logic and nothing has changed, I’m presented with an attractive opportunity made even more attractive by the fact it’s now cheaper than ever. Dart’s down nearly 20% on the back of weak consumer confidence and spending – but if these trends are cyclical as I believe, the long-term prospects of the business are as rosy as ever.
Unusually, the metric box on the right combines two of the most attractive features of the stocks I’m after; it is both cheap on an earnings basis, trading at 6.2 times last year’s earnings, and on an assets basis – £1 invested in Dart buys you more than £1 worth of tangible assets, and hence your downside is reasonably protected. Perhaps the only disappointment is the weak dividend yield, which as discussed last post is the first sign of management intent I’m looking for. Still, forward earnings are forecast to be even stronger, and it’s that combination of factors that initially drew me to the business.
The metric graph is a little dizzying, and makes long term trends difficult to see, but that comes with the business – Dart operate both a low-cost airline and a distribution business, mostly based in the north of England. Margins are fairly thin in both these segments, and highly sensitive to cost pressures – with Dart having to absorb greater fuel costs, for instance, while being unable to pass costs on to particularly price sensitive consumers. Operating a low-cost operator in a recession only exacerbated that problem!
What we do see, though, is a strong revenue jump in the last year, driven by the aviation side of the business. Broker forecasts see a continuation of that trend, with another 15% hike in revenue next year as the continued expansion of the company’s asset base kicks in – both additional aircraft and a large new distribution centre made up most of last year’s capex. Visibility of revenues in the aviation segment is helped by a large order book – last year comprising £121.4m against £398.7m of end-year revenue. This year the order book is £177.1m – a very promising increase. However, with brokers forecasting a 15% hike in revenue when we’ve seen nearly a 50% increase in the size of forward orders, the statistics piqued my interest. To what level do forward orders correlate to end year revenues?
The graph left below shows end-year revenue vs. start-year order book, and we see a tight fit indeed – historically, revenues have come in at between 3.3 and 3.5 times the order book at the start of the year. That holding so tightly true for the last 4 years is certainly interesting. For comparison, if we take 3.3x order book for this year’s aviation segment revenues, we get a figure of £584m for aviation revenues – if we simply add in a flat distribution segment, we arrive at full-year revenues of £728.6m – over £100m higher than broker forecasts. Certainly a discrepancy! If the historical norm holds true, then, we could see significant upside on the revenue front – and that’s without even considering the growing distribution segment.
The problem is, of course, margins – shown in the graph above middle. They’re not at all stable, and recent management communications seemed decidedly shaky on that front – noting that they ‘hoped’ to meet market expectations, but economic conditions meant they could not past on cost increases. Valuhunteruk has an excellent post on Dart Group and margins, but my summarised views come to more or less the same as his – margins are volatile and unpredictable, but don’t need to do anything spectacular to make Dart look like a cheap company. Short-term they make look depressed, but in the medium term any sort of reversion to old margins would make the company appear very cheap. If we take £750m revenue for 2013, for instance, which seems a good target, Dart earning the 5% margin they seem to float around would leave net profits around £28m. Applying a sceptical market valuation of 10x earnings, that would value the company at £280m – 160% upside from the current price.
‘Finding a valuation undermanding’ is an infuriatingly common City phrase, but I can’t think of anything better to sum up shares trading on multiples like Dart – it really doesn’t have to do much to appear cheap in a few years time, and with growth prospects looking strong as well, it has to fail on most fronts to look expensive. Practically speaking, we’d need to see below forecast revenues (defying the order book), margins once again steeply depressed, and no end in sight for the consumer confidence drought. It’s far from impossible – in fact, one or more of those things may likely happen, but I’d see any one of those factors coming through as a great sign for Dart’s prospects.
Operationally speaking, then, I’m bullish – so it now falls to explain that low price to book value. A great deal of Dart’s assets are tied up in property, plant and equipment (see chart above) – unsurprisingly for an airline, most of this is aircraft and engines. This large fixed asset base is played against only a tiny amount of long-term debt. In Valuhunteruk’s piece mentioned above, he noted the company’s large cash balance and questioned its use- similar to Interior Services, Dart have a sizable amount of ‘trade and other payables’ – in this case, deferred income. Deferred income is an interesting proposition, because it’s not ‘debt’ as such in the sense of other trade and payables – such as owing your suppliers money. It simply arises from taking payment from customers for flights and holidays in advance of providing the actual service.
Hence, the cash on hand is once again basically a free source of working capital. Most business absorb cash flow risk – builders, for instance, build first and sell later. Dart reverse that, and hence have no need for complicated financing arrangements. While the company is growing revenues the churn of customer deposits looks set to continue, and the cash on hand will likely continue to grow – particularly looking at the group’s cash flow statement, which is exactly what we like to see – depreciation may sharply impact headline profits, but cash is still coming through.
Ideally, I would like to see some of this cash returned to shareholders. The dividend is particularly disappointing in relation to the profits – while the stock is on an earnings yield of over 16%, their dividend yield is only 1.6% – covered 10 times over. With no long term debt and a great deal of fixed assets, borrowing would probably be relatively cheap for Dart. While it sounds like anathema for a value investor to advocate debt, the trade off between debt and equity is undeniably logical – and I suspect shareholder returns would probably be significantly boosted if the company were to buyback shares or pay and dividend and use a credit facility for working capital management instead of holding so much dead cash.
Still, I digress. What makes this stock appear cheap is exactly the fact that what I’ve said above hasn’t happened yet, and we’re thus left with a strongly cash-generative business growing revenues and sitting on a solid balance sheet. What they decide to do with their money is of interest to me, but not fundamental to the investment decision – that’s based on the operating position. At a P/E of 6.2, as with many of my investments, I just think the balance of risks are tilted in my favour.