Flybe - Time to Strap in?

http://www.flybe.com/


Airline operators have been under pressure recently, not only as a result of the wider market correction, but also as a result of weak sentiment regarding the spread of the Ebola virus. The knock-on effect to Flybe is perhaps odd given that the company is a predominantly domestic carrier, and given that oil prices (a proxy for fuel oil) have fallen sharply over recent months. The key question is whether this opens up an opportunity to buy the sector on a period of weakness. Flybe itself is a smaller player within the sector both in terms of revenue generation and geographic scale. However, with a credible management team involved and a turnaround process seemingly underway, it deserves closer inspection.

Technicals


The technical setup for Flybe is encouraging for a few core reasons. Although the 50-day moving average is below the 200-day moving average, there was a strong bounce off the important 100p level with the percentage bounce nearing 12% within just a few trading sessions. That shows that investors were waiting to buy (or set limit orders) at the round-number 100p level. That bodes well for a continuing bounce off 100p in the short-term, especially given there is no lower-low in place; rather the closing low on the day of backtest was comfortably above 100p. The RSI and MACD indicators are both starting to move towards more bullish areas albeit that has not yet been confirmed, and Flybe will of course be affected by the wider market given its liquidity and market capitalisation. Flybe is a constituent of the FTSE Small Cap Index.

At this stage it is worth pointing out recent director purchases and institutional movements. Central to that was a placing totalling a massive £150m in March this year. The placing was completed at 110p, at a minimal discount of less than 8%; since the share price was towards the top of its trading range at that point, it is a vote of confidence from institutions and bodes well going forward.

Notably, Chairman Laffin and CEO Hammad purchased £250,000 worth of stock each, with other members of senior management and board members contributing a combined ~£147,000k. Separately, the new incoming CFO purchased £98,600 worth of shares at 137p, and that is considerably above the current share price; that is a further vote of confidence in the company.

In terms of institutional activity, many institutions increased their stake or bought in at the time of the placing. Since the placing, Pelham L/S Master fund has increased their stake above 5%, Aberforth funds above 12%, Standard Life above 8% and JP Morgan/BNY Mellon above 5%. A legacy holding from British Airways/IAG was sold down to sub 3%. On the whole, the institutional movements are encouraging. Broker forecasts for Flybe are 160p (Cantor Fitzgerald) and 190p (Liberum Capital).

Operations

When a company is in the process of a turnaround, then it suggests that there have been major problems in the recent past; that has been the case, and Flybe since its IPO has been a woeful performer (up until H2 2013. The company floated in December 2010 at 295p, but within a year it had already crashed to less than a quarter of its float price. The drivers behind that were both internal - the company had excess capacity and was flying numerous loss-making routes - and external - customer spending was declining sparking a series of profit warnings, along with a rising oil price squeezing margins. That all led to sentiment among shareholders crashing and the company trading at very low market capitalisation levels. It wasn't such an obvious basket case either, with hedge fund tycoon George Soros backing the business model and buying over 3% of the company upon float.

How has the turnaround taken place? This process started in early 2013 when the previous management team initiated a strategic review, with cost-cutting a core focus of that. Flybe had simply become too broadly focused hence had little control over its cost base, which was disproportionate to the size of the company, amongst other problems.

To rectify the issue, Saad Hammad was appointed as CEO in July 2013. Looking at the new management is a critical issue when looking at Flybe's investment case. Notably, Hammad was the former Chief Commercial Officer of EasyJet between October 2005 and April 2009; a period over which the share price rose from 292p to as high as 730p. No doubt his track record on that point is worth backing and that can be seen through his re-vitalised branding of Flybe through the use of the colour purple (among other new initiatives).

Alongside that, a board upheaval took place with several managing directors stepping down, as well as the Chief Financial Officer and Chairman. As replacements, Paul Simmons joined as Chief Commercial Officer (previously a former EasyJet director) and Philip de Klerk joined as the new CFO (formerly the Global Head of Financial Planning & Analysis as beverage giant SABMiller). Incoming Chairman Simon Laffin matched the impeccable credentials as former finance director of Safeway (pre-takeover) and as Chairman of Assura Group. There is a clear management-backing play.

Moving on, it's imperative to understand where Flybe sits within the airline industry within Europe. At present the company operates three divisions that have been brought into one business under the new strategy:
1. UK flights and franchising whereby Flybe (or partners) provide flights predominantly within the UK, such as Birmingham to Edinburgh
2. White Label services to overseas operators such as Finnair in Finland (through a Joint Venture). In such schemes Flybe provides crew and maintained & insured aircraft
3. Maintenance, Repair and Overhaul (MRO). Flybe provides coverage for a range of aircraft types such as the Bombardier Q400 and ATR Turboprop

Regarding the first point, unlike EasyJet, IAG and other operators, Flybe has a significant majority of its revenues derived from domestic flight provision. In light of competitive pressures in the European airline market, that provides a point of difference for Flybe, and means that it is unlikely to see those pressures transfer over. In fact, former competitor Little Red (owned by Virgin Atlantic) recently announced plans to exit the UK domestic airline market as it failed to gain traction; load factors were just 35% in January this year, well below the next worst performer that was Eastern Airlines at circa 43.5%. That lack of scope for obvious growth generates some 'natural' barriers to entry that ring-fence Flybe's business from both new and existing operators.

Therefore, Flybe does not really compete with other airlines (the likes of EasyJet aside), rather it competes with road and rail travel. The key points which allow Flybe to benefit are time and cost. The time of travel is much shorter than the cheapest option (which is car travel or rail travel most of the time); however, the lack of a need to concentrate means that rail, coach and plane travel tend to come out on top. In such a situation. The shortened time (thus low opportunity cost) makes Flybe a preferable option in many testable scenarios.

That said, Flybe has a legacy reputation to overcome; there are genuine reasons why it became known as FlyMaybe. A poor historic track record of flight punctuality remains a key issue to overcome when winning back customers. A series of key performance indicators give insight into this. Complaints currently stand at around 2.9 per thousand customers (this remains a point to tackle), whilst on-time departures stand at 84.4%. 

In order to win back customers, a new customer-centric scheme has been launched with new initiatives ranging from a chocolate gift when disembarking to the world's first 60:60 on-time guarantee. In that scheme, if a flight is more than 60 minutes late to its destination (for a reason in Flybe's control), customers can claim a £60 credit towards their next flight if booked within 60 days. Given that many of the flights are for business travellers on a relatively frequent basis, this is a smart way to drive customer retention whilst at the same time trying to re-gather customer confidence.

Alongside this, the £150m net placing from earlier in the year will allow Flybe to pursue a multi-pronged approach to revitalising the business. This involved reducing fleet operating costs by owning aircraft (with secured loans) rather than through full operating leases; the target for this is a 50:50 split, and this involves reducing the proportion of operating leases. IT systems will also be invested in, whilst new UK routes will be opened with less profitable and redundant routes closed.

Whilst the turnaround is gathering momentum, as the company notes in recent announcements, there is much work to be done plus there are a couple of remaining legacy issues to clear, which I will touch upon later on. One of the less successful sides of the business (at present) is the Finnish joint venture where "unacceptable ... losses" continue to be generated. Significant steps have already been made though; some of these are listed below.

-   Flybe launched a series of new routes from London City Airport (LCY), including to Edinburgh, Belfast, Dublin and Exeter. Targeting business custom. 5 aircraft will be deployed with ~500,000 passengers expected per year
-   Joined the Avios travel rewards programme in October, providing customers with a more rewarding incentive scheme. This should help build up Flybe's brand, although it is already fairly strong
-   Five year franchising agreement signed with Stobart Air at London Southend Airport whereby Stobart Air will operate aircraft in Flybe livery
-   Strategic services agreement signed with Bombardier. This sees Bombardier undertake a "major programme of enhancements" to make Flybe's Q400 fleet one of the most operationally efficient regional fleets in the world
-   Awarded the Airbus Military preferred bidder status in July 2014. This allows them to provide MRO services to the RAF sleet of new airlifts
-   One previous legacy issue related to aircraft orders that were still outstanding, despite the lack of need for new capacity. The new management team resolved this in September when they successfully cancelled an order for twenty 88-seat Embraer passenger jets. the remaining four undelivered jets had their delivery dates pushed back until 2018

Commenting on the final point CEO Saad Hammad commented, "We are committed to flying the right aircraft on the right routes. The agreements between Flybe, Republic Airways and Embraer bring more than just an ability to keep to that commitment. With the substitution of twenty E175 future deliveries by young and attractively priced Bombardier Q400s, our core UK branded fleet is now right sized to our capacity growth and aircraft renewal plans at a net cost broadly in line with our expectations. Let us be clear, there is more to do.  But these landmark agreements are a significant step towards resolving all our legacy fleet issues and enable us to implement our strategy of connecting regions more effectively." 

There are a few final points to consider. The first of these is to consider how reliant Flybe is to UK GDP and general economic growth. Bottom line is that it is driven by economic growth, hence the (slowly) improving economic scene is a benefit. However, the real attraction is that Flybe is often cheaper than most other types of travel, plus we revert back to the time benefit of flying. That should make the domestic services relatively income inelastic, or at least partly insulated.

Two less predictable events to keep an eye on are Ebola and Badarbunga, the Icelandic volcano. Whilst Ebola remains a low key event relative to Flybe's operations given the fact that Ebola is not in the UK, it is a potential sentiment shaker (any alleviation of the situation would benefit airlines). Badarbunga is rather more complex an issue and not one that is readily understandable; in short, this risk is reliant on both the volcano erupting and it disrupting UK airspace. These are just points to loosely track (at present), but react quickly to in the event that they grow into more serious issues (from an airline investment point of view).

Financials

As noted in the introduction, the price moves in the oil price recently bode well for airlines given that fuel costs are the single largest faced within the industry; it's even more important given that airlines are operationally geared due to high fixed costs.

As per the chart on the right, the Brent crude price (which is a decent benchmark for fuel oil prices) has collapsed by circa 20% in just a matter of weeks. The reason is that geopolitical supply issues have failed to materialise and supply from the US has proved to be plentiful, meaning that the US has not had to import as much oil. Simply supply and demand dynamics dictate that the oil price should fall, and that fall has been exacerbated by a downside technical breakout. At present, there is little reason to be optimistic about a return to $95/barrel let alone $105/barrel. Nonetheless, a return to $95/barrel would still be a net benefit to Flybe with each circa +/- 5% move translating through to +/- £2m in group profits.

Of course, airlines tend to hedge their exposure to oil prices. So whilst fellow airline EasyJet notes that it stands to benefit from falling fuel prices, the full effect will not be felt. Flybe notes that 68% of its H2 requirements are hedged against, falling to 64% in the following half, so whilst there will be a sizeable benefit, it will not equate to the total extent of the fall. Therefore, it can be considered to be 'nice upside'.

The actual Flybe financial performance shows a static/declining top-line as less profitable routes are phased out, as redundancies are made (over 1100 to date), and as the exceptional costs relating to cost savings filter through. Remarkably, the management has managed to identify £71m of annualised cost savings to strip out, and good progress has been made on that front. £30m of that has already been removed, with £15m nearing full removal and a further £26m around 2/3rds complete. That suggests that the previous cost base for Flybe was extortionate. At the last set of results, group operating costs were brought down to £498.7m (vs. £513.5m) and the per seat operating cost, excluding fuel stood at £44.85 (vs. £46.18 last year).

More importantly, the final results for last year released in June showed a return to profitability of £1.7m, albeit this was adjusted and is fairly small compared to the market capitalisation. Group revenues increased 1% to £620.5m, whilst there was an operating cash flow before restructuring of £7.3m. Other key points include the below.

-   Total cash of £218.4m at the end of March. Net cash totals £116.9m
-   Flybe UK passenger numbers up 6.9% to 7.7 million
-   Load factors continued upwards by 6% to 69.5%
-   Improved UK domestic airline sector share to 28.3%. 55.1% excluding London
-   MRO business performed well generating pre-tax profits of £2.2m on £35.4m revenue
-   Current assets = 1.41x current liabilities or 0.86x total liabilities
-   Excluding intangibles, net assets totalled £188.9m. That includes the net book value of aircraft, which stands at £147m
-   Small pension deficit of £2.5m closed to accrual

The net cash figure is very important as at face value it covers a highly material 48.3% of the market cap. The £116.9m includes £40.5m of restricted cash. Post-period end £2.5m of cash was received from EasyJet and the latest figure is that cash was released such that restricted cash totalled £29.9m. Therefore the pro-forma unrestricted cash figure is £76.4m + £2.5m + £10.6m = £89.5m. The level of restricted cash is likely to be continually decreased towards year end, so it still stands that there is a substantial level of cash on the balance sheet to underpin in.

Brokers are forecasting revenues declining to £592m in 2015 giving pre-tax profits of £19.6m, EPS of 7.06p and a price-earnings ratio (PER) of 15.83. That's not particularly appealing although stripping out a large proportion of the cash, it falls down to values at which Flybe is decent value (not outstanding value given the growth story is not obvious at present). What is interesting is that forecasts for 2016 are £625m in revenues, pre-tax profits of £42.2m, EPS of 18.4p and a subsequent PER of just 6.6. That is even lower (sub-5) should you choose to strip back the cash. As per the table below, this reflects well versus industry peers.


Not all of these are perfect comparisons to Flybe, but they provide useful ballpark comparisons. Note that the PERs and Mcap/Revenues numbers are not adjusted, so companies like IAG and Thomas Cook who have large debt balances will look more favourable than in reality. Similarly, the cash is not stripped out of Flybe's numbers. That lowers the already low Market Cap/Revenues figure and PE ratios. The reality is that, even if Flybe misses the 18.4p in earnings estimated for next year, the PER at this level is sufficiently low to provide an enticing risk-reward profile. The low forecast operating margin also shows the scope there is for future margin expansions beyond the three rounds of cost-cutting already announced. Nonetheless, this theoretically limits downside.

An Interim Management Statement (IMS) that has been released since noted that "Momentum Continues", and that the company was trading in line with management expectations. Despite a sharp drop in total seat capacity, there was a 9.2% improvement in aircraft utilisation and passenger revenue/seat was up 9.5% to £52.79. The load factor also tracked higher to 75.8%, and this bodes well for operational gearing kicking in, in due course.

The big legacy issue I mentioned earlier (which the market may be waiting upon) are a series of grounded E195 aircraft. These are surplus aircraft that are grounded, thereby costing Flybe significant cash per quarter (£6.4m in the last quarter). Importantly, the company has commented that is has capped the maximum exposure for next year at £26m/£27m through mitigation initiatives, and management has stressed that this will be the absolute maximum cost to the company. A longer-term solution to the issues is what remains to be seen, but that will take time.

In the IMS, CEO Hammad said, "Flybe's momentum continues, with an encouraging start to the year. Our focus and discipline is delivering the operational improvement in the underlying business that we demand and which is required to drive our future profitability and shareholder returns. We have launched a number of new routes and products, re-launched our brand and announced a number of exciting strategic developments with new partners. We have achieved a significant amount in the quarter, with substantially more to do in the months ahead. Our plans to address the few remaining legacy issues in the business, especially the grounded E195 aircraft and the loss making scheduled flying business in Finland, are progressing and I look forward to providing further updates in due course."

Off to a Flying Start (...but risks still exist)

The operational and financial turnaround of Flybe from the lows in H2 2013 is admirable and the moves being made by the management team are seemingly reaping rewards with load factors increasing and other key performance indicators on the rise (even if just as a result of stripping back poorly performing routes). Flybe is not so much a growth play at present; rather a recovery play to create a firm base to work off down the line. The strong asset backing combined with the low prospective valuation provides not only room for manoeuvre, but also an attractive risk-reward profile. Much work is still to be done, and next year's results will require a further strong operational performance in order to be hit, but if they are hit then a considerably higher share price would likely be inevitable. Arguably the biggest hurdle to overcome is repairing the brand; that will take time and will likely be difficult whilst cutting and re-working routes. That is still a relatively short-term consideration though. Half-year results are due for release on November 12, and any acceptable resolution to the grounded aircraft issue could provide a useful catalyst for the share price. The general risks of airlines do remain though. Nonetheless, I reckon the risk-reward is attractive, and for that reason I have put a Buy tag on Flybe at 111.75p, targeting 140p as an initial target.

Article Updates (Click to view)

UPDATE (12/11/14) - Flybe released their Interim Results today, which came in below expectations primarily down to exceptional items; they also clarified the impact of the Jet2 vs. Huzar case on the business. Unsurprisingly, the market marked down the share price by around 15%. I doubled up the stake at 105.50p in the short-term to capitalise upon any bounce, whilst running through the figures with a fine toothcomb. I will comment upon the resultant impact of that secondary review of the figures if it alters the investment case and adjust positions as necessary

UPDATE (17/11/14) - Having reviewed the figures I remain relatively comfortable with holding the initial stake barring any sharp market decline. I have moved the second stake from Buy to No Rating at 114.75p to get back to a one slot holding. To capture the circa 2.5% gain on the 111.75p holding, the average price on the 105.50p slot drops by circa 2.5% to 102.90p.

UPDATE(22/01/2015) - As noted in the Q4 portfolio review, I have effected my mental stop loss at just over 104p vs. the 105p support on the intra-day charts. The technical picture may break down from here forward, and see a re-test of 100p. Little momentum has been gained since the previous re-test of 100p, which is disappointing and perhaps reflective of no progress yet announced regarding Project Blackbird.

8 comments:

  1. I prefer my pharma stocks :0). Not one for me but incisive analysis :0). Look at GSK?

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  2. Great review. Thanks

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  3. Thorough look at Flybe. As a regular traveller from Birmingham to Manchester, I will safely say that the price point is the key consideration for me as long as the airlines do not have a track record for regular delays. Problems with Flybe are occasional rather than regular so the discounted price makes up for the odd delay with this new 60.60 idea.

    Richard. K

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  4. Great website and review on Flybe. When I was working in the North about 4 years ago now I used to fly Flybe a few times a year and the services had a real problem with being on time. Fly maybe... Thankfully that seems to be changing and I hope it was my purchase at 98p last year that caused that :)! Management have their heads screwed on thank god so here's hoping this is Thomas Cook round 2!

    Eric

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  5. Hi El1te

    Do you have any views about todays substantial decline in SP after the trading update was released.

    Best wishes,
    Imran.

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    Replies
    1. Hi Imran,

      Today's results were interesting in a few respects, and not positive in many unfortunately. Indeed, whilst I did end up cutting the position pre-results as per the Q4 portfolio review, the same cannot be said about my non-site portfolio.

      The reductions in the top-line were to be expected, although the per-seat revenue reduction is a concern and is perhaps reflective of the cutting of some of the low-capacity routes where premium prices are likely to have been charged previously. That seems to be the case carrying forward too. That said, the pre-tax breakeven result after £15.9m of costs is not an awful place to be in by any standard so the recovery potential remains. However, I reckon its the lack of concrete timescales for Project Blackbird that is causing market worries as future forecasts will start coming under threat by virtue of the max £26m impact (although in reality it's probably closer to £24m once the partial mitigation is accounted for).

      The competition on the flights out of London City is a slight concern given its a new venture and BA may be deemed more reliable by the consumer given that propeller planes have had difficulty under some weather conditions in the past, but that will ultimately just become a fight over pricing. In the short-term BA may win that if they subsidise losses or narrower margins on that route through their profits on other routes.

      The £1m cost provision for the Finland venture won't help 2015 forecasts, although that is an exceptional cost and the fuel costs should come down in calendar year 2016 onwards should they start hedging for that now. Although the proportion of fuel hedged can be criticised (too high), but the policy to do so is hard to argue with so hard to have gripes in that respect. To sum up, recovery play remains intact but legacy issues clearly dragging longer than anticipated and timescales potentially moved back by as much as 12 months.

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  6. Thanks for the quick response El1te. Am I right in thinking you still have a position in Flybe? Would you be tempted to add at the current SP, or would you want a resolution of the Project Blackbird issue before considering investing.

    Regards,
    Imran.

    ReplyDelete
    Replies
    1. The site position was closed last week with my non-site position still open. I tend not to average down (ever) unless I am convinced that the reason for the share price drop is harsh. In this instance I am not convinced and as you say it makes sense to wait for Project Blackbird. At present I am not looking to re-open a portfolio for the site.

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