Cash is King
Dart Group, the airline, package holiday provider and owner of a nationwide distribution group, posted their preliminary results last week – and it’s fair to say they’ve kept doing what we expected them to, with a pick up in both revenues and profits in a difficult environment. Subdued would be a fair reflection of the profit growth, with margins coming down as revenues rise, but that’s probably to be expected given the climate for discretionary consumer spending. Net profit is flattered a bit by a smaller than average tax bill, but it’s surely a positive that everything’s still going in the right direction.
I was a little surprised to see the stock move only 2% upon the release of the results; at a P/E of less than 5 it’s hardly priced for success or any sort of growth, but the market still obviously has some fundamental misgivings about the business as a whole. I’m still not entirely sure what those are – if I were to hazard an uninformed guess it’d probably be a combination of it being a small cap (and perhaps viewed as more fragile) airline, which is hardly a sector in the ascendancy at the moment, the European woes knocking consumer confidence further, and perhaps their choice of capital structure. Discussions around dividends have gone back and forth around comments and blogs at the moment, and whether it is a wise choice for Dart to pay a larger dividend or not is one question; regardless of the answer, I suspect doing so would benefit the share price. Irrationality? Probably.
Interestingly, in my first piece last year I roughly ‘forecast’ (though I hate using that word) the revenues for the year from the order book – my conclusion being that, should historic trends hold true, the broker forecasts for revenue – at the time £620m – would be too low. I gesticulated towards revenues of more like £730m if one only looks at the order book. As it happens, revenue actually came in somewhere in the middle of those two figures – £683m. Still, that’s over 10% above broker forecasts, so my napkin maths probably did help me treat those estimates with a healthy dose of scepticism!
This time, I’m focusing on one of the more interesting facets of Dart Group’s accounts and structure – its holding of cash, and the flows of cash through the business. There’s something to be said for digging deep when you see an interesting story and, at least in my modest experience in the last year or so, companies with stories like Dart’s are rare. Consider the graphs below, which shows cash flows over the last few years. The left one shows a few of my highlighted ‘inflows’ and the right shows a few of my highlighted ‘outflows’.
The first thing to notice is that capital expenditure over the period is significantly larger than depreciation over the period. Indeed, looking at the accounts in 2007 and now we see a figure of £185.5m for PPE then (mostly aircraft) and £234.9m now – a 27% increase. The asset base of the business has increased and so, if we assume the business is fundamentally the same as it was in 2007, we should attribute most of the drop in margins to the general economic climate. This is a factor that we can expect to be mean-reverting, and hence is a positive story for the business.
The main point of interest I am trying to get across is twofold, though; firstly, the business is flexible. Because its primary assets (its aircraft) are depreciated over a relatively short timespan – short compared to freehold property, at least – depreciation is a major charge in its profit statement. This means that, should the company decide to cease capex, its net cash inflows can be expected to be its profit + the value of depreciation. Depreciation sat at £34.4m this year. Profit sat at £28.9m. The market capitalisation of the business is £100m. Secondly, and more importantly, the financing of the company is positively leveraged by growth – the inverse of most companies. Manufacturers, for instance, take out larger and larger borrowings to finance a larger capacity, which then (at some point in the future) hopefully pays off the debt. Dart are able to almost do it backwards – they currently have £152m of cash and short-term deposits on book, financed from £180m of advanced bookings. This is cash they’ve received from customers for trips at some point in the future. They’re running a small ‘deficit’, if you will – using this as a free source of short term capital, and is one of the ways they maintain their lack of debt. Growth is self-financing.
Does this mean they can afford to pay a dividend? Probably. They probably could get away with taking cash from customers and distributing it to shareholders – but then the company’s fortunes are intrinsically tied to not just current revenue, but future revenue. It’s damning and too harsh to call that sort of structure a ponzi scheme, but I have seen companies who finance all of their working capital with revenue received for work not completed. I don’t like the look of that position as a shareholder – it relies on continuing to find new customers to pay up front so you can afford to complete the work you are contractually obliged to do. In return you don’t pay interest on your financing, and you can run an extremely tight ship, I suppose – but it seems too risky for me.
I like Dart and I have no problem with their balance sheet, then. It seems prudent, they’re continuing to grow, and it’s probably the wrong time to be an airline operator. Their distribution arm sounds like it’s slowly rolling up to critical mass (when profits will hopefully be a little less disappointing) and they seem to offer a product people like. If they really hit a roadblock and find growth elusive, then I might start looking for some of their cash to be returned to shareholders – but for as long as they can use capital productively, and benefit from this virtuous circle of increasing scale, improving competitive position and increasing flexibility with financing, that’s fine by me.