Can Dart keep climbing?

The business

It also has a distribution and logistics business called Fowler-Welch, which provides its services to food retailers, processors, growers and importers. This business contributes a negligible amount of profit to the company as a whole and so I will limit my discussion to its airline and package holiday business.

Dart history can be traced back to the early 1970s when its planes shipped flowers from Guernsey to the UK mainland. Today the company earns virtually all its profits from airline Jet2.com and Jet2 Holidays. 

The company sums itself up very simply in its annual report: It takes people on holiday. it is the second biggest UK tour operator behind TUI with 3.9m authorised passengers on its ATOL licence. Jet2.com is the UK's third biggest airline.

Jet2.com has a fleet of 100 aircraft (mainly Boeing 737s), which is mainly owned rather than rented. It operates out of nine UK airport bases – Edinburgh, Glasgow, Belfast, Newcastle, Leeds-Bradford, Manchester, East Midlands, Birmingham and Stansted – and flies people to beach resorts in the Mediterranean and the Canary Islands, as well as cities and ski resorts in Europe. Just under half the flights each year are taken by the company’s packaged holiday customers. Ninety-one per cent of its flight-only seats are sold over the internet on its jet2.com website.

Jet2holidays has set itself up as a package holiday business to cater for a wide variety of tastes and budgets. It has contracts with nearly 5,000 hotels, ranging from two to five stars. Forty per cent of its package holiday sales are all-inclusive, which appeal to families on a tight budget and are generally very resilient when the economy turns down. Seventy-five per cent of its sales are made direct with customers (60 per cent over the internet, 15 per cent over the telephone), while 25 per cent are made through independent travel agents.

Owning an airline gives the company the advantage of being fully in control of its seat capacity. It is also trying to grow and differentiate itself from its tour operator competitors by creating new products. These include Jet2Villas, which offers a package of flight, villa and rental car without the hassle of booking them all separately, and Jet 2 City Breaks. It also has a luxury offer called Indulgent Escapes, which is based around stays in selected five-star hotels.

A key part of the company’s strategy is investing in customer service in order to get customers to book with it again in the future. There is a big focus on the quality and location of hotels offered, with the company often paying big deposits to secure dependable and competitive rooms in the most attractive locations (such as those with waterparks nearby).

There has also been investment in value-added services such as resort flight check-in which allows customers to check in for their return flight at their hotel and enjoy the last day of their holiday without the hassle of carrying their bags with them. 

Dart’s ambition is to become the UK’s leading leisure travel business. While it still wants to grow its airline business, it sees the package holiday market as more attractive as the longer time period involved allows it to sell more products and services to customers and therefore earn higher profit margins.

Business performance

Airline and tour operators have not always been happy hunting grounds for long-term investors. Trying to earn steady and rising profits has proved to be almost impossible as getting the right balance between demand for holidays and the supply of them has proved to be tricky. 

Soft demand for holidays can leave tour operators with too many flights and hotel rooms to sell and the price cuts needed to fill them can blow a big hole in a company’s profits. Airlines are often plagued by periods where there are too many planes chasing too few passengers or a rising jet fuel price that can decimate profit margins.

Owning an airline with a packaged holiday business has been a good way to keep planes as full as possible while controlling the supply of seats into key destinations. Dart has proved to be very good at growing these two businesses side by side over the past few years.

The performance of its leisure business has been very good indeed. It has spent huge amounts of money expanding its fleet of aircraft and the destinations they fly to and has achieved stellar growth in its revenues and profits.

Jet2.com and Jet2holidays: Business statistics

Source: Annual reports

Since 2014, the business has doubled its seat capacity and expanded its aircraft fleet from 55 to 100. It has vastly increased its route network and kept its planes very full (evidenced by it high load factor) while doing so. Its revenues and operating profits have followed suit.

Dart does not separately disclose the profits for its airline and travel business and reports them as one combined business. You can see that it is not a high-profit-margin business, which reflects the fact that it has lots of competition. It has been able to grow while keeping profit margins at a consistent level, which is an encouraging sign.

Travel leisure division

Source: Annual reports

The scale and pace of expansion is bound to raise concerns that the company is trying to grow too quickly. It is operating in an asset intensive sector where you need to spend a lot of money to grow. It is also a business with lots of fixed overheads, which gives it significant operational gearing. 

Given that spending money on travel and holidays is quite sensitive to the prevailing economic climate, I think it’s fair to say that Dart Group is a business that comes with a reasonable amount of risk attached to it. Profits go up a lot when times are good – as they appear to be at the moment – but that operational gearing works, sometimes viciously, on the way down as well and can decimate profits in a recession.

Financial analysis points

Dart’s accounts throw up some interesting analysis points. In particular, it is a seasonal business that makes all its profits between March and September. It also benefits from customers paying for their flights and holidays in advance, which throws up some interesting questions as to how investors should view its substantial cash balances.

Before we look at these two issues, let’s see if Dart’s financial performance has the hallmarks of a great business or not.

Dart Group: Key financial performance indicators

Source: Annual reports/Investors Chronicle

For me, Dart is a good business rather than an outstanding one. However, relative to the challenging economics of the industry it operates in, there’s a lot to like about it.

We have already established that Dart’s revenues and profits have grown rapidly in recent years. We can also see from the capex figures that the company has invested heavily – mainly in new aircraft – and that its free cash flow performance took a hit as a result. Capex peaked in 2017 and has now come down significantly. As a result of its strong trading performance and rising profits, its free cash flow (FCF) has soared. Its latest 12-month FCF margin for the year to September was 8.8 per cent, which is approaching a level consistently achieved by good quality companies.

Yet Dart’s return on capital employed (ROCE) is less flattering and is currently a quite modest 10 per cent on an annualised basis, according to my calculations. The revenue and profits growth has come with big increases in the capital invested in the business. In fact, the capital invested has grown a lot faster than profits since 2016. Having said that, there are grounds for thinking that there is some spare capacity within all this extra investment spending that the company can utilise better by continuing to grow. If that proves to be the case then I would expect its ROCE to start moving up again.

As with many companies that rent assets, Dart now puts the associated assets and liabilities on its balance sheet. As the company has tended to own most of its aircraft fleet – which was already on its balance sheet – the impact on its balance sheet has not been too marked.

A seasonal business

One of the most important things to understand is that Dart is a highly seasonal business. Its performance in the key holiday season between March and September will largely determine how much profit it makes for the year as a whole. People still go on holiday between September and March, but Dart – and the industry in general – cannot sell enough holidays to cover all its costs and usually makes a significant loss. Managing the scale of this loss is a very important test of management.

Dart: First-half operating profit and second-half operating losses

Source: Annual reports/Investors Chronicle/SharePad

We can see here that as first-half profits have grown, so have the size of the second-half losses. Based on current analysts’ consensus operating profit forecasts for the year to March 2020, second-half losses are expected to be held at a similar level to last year.

Seasonality is also seen in the company’s operating and trading cash flows. Note that the trading cash flow has remained positive in the second half of the year, unlike operating profit. This is largely due to the non-cash depreciation not being deducted and therefore a significant source of cash flow.

Dart: Operating cash flow and cash working capital (£m)

Source: Annual reports/Investors Chronicle

One of the most striking features of Dart Group’s finances is the significant funding benefit it gets from its customers paying in advance for their holidays. This has provided a significant working capital boost to its cash flows in recent years as cash has been received before it has been earned. These tend to build up in the second half of Dart’s trading year between September and March.

The cash inflows also flatter the company’s cash balance at its March year-end balance sheet date as customer deposits have been received but flights and hotels have not been paid for yet.

It is a nice benefit for a company to have, but investors need to be aware of it and not be fooled into thinking that the company has more cash than it has in reality. 

This is important as there is a tendency among investors to net off cash balances from borrowings when looking at a company’s financial position, its capital invested or its enterprise value (the market value of a company’s assets). As a result they can think a company has less financial risk, higher returns and a cheaper stock market valuation than is the case. In my opinion, they should be prudent and not net the two items off.

Let me explain why I think this by looking at Dart in more detail.

Dart: Cash, borrowings and customer deposits

Source: Annual reports/Investors Chronicle

Dart reports significant cash balances at its balance sheet date and these have been growing, which is positive. Its debt balances have also been growing as it has bought more aircraft for its business. Yet, many investors and analysts will point to its sizeable net cash position – £455m in September 2019 – as a sign of significant financial strength.

The first question here is why would a company with growing and big cash balances need to borrow lots of money? 

The answer is that most of its cash balances are not freely available to it. The company helpfully discloses how much of its cash balance is made up of customer deposits for holidays and these are typically a big chunk of the annual closing balance. There is a small amount of profit margin in these balances, but most of it will have to be used eventually to pay flight and hotel costs.

The rest of the cash is used to finance the day-to-day activities of the business. Dart hedges its foreign exchange and jet fuel costs using derivatives. If exchange rates and fuel costs move in the wrong direction then the company can owe money to the counterparty providing the hedge under what is known as a margin call. Having a pile of cash on hand is very useful in meeting such calls.

The company also uses cash to secure hotel capacity throughout the year.

Interest income and costs should also not be netted off, but they often are when calculating ratios such as interest cover. This measures how many times a company’s operating profit can pay the annual interest bill. For me, the correct way to calculate interest cover is to add any interest income to operating profit and then divide that number by the interest cost.

Dart: Interest cover

Source: Annual reports/Investors Chronicle

We can see that despite having a net cash balance at its balance sheet date, Dart has a significant annual interest bill, which has more than doubled since 2018. Its interest cover is still comfortable at just over five times (6.8 times if interest income and costs are netted off), but I’m not sure shareholders would want it to go much lower than this given the cyclical risk and operational gearing within the business.

Can Dart keep on growing its profits?

The short answer is yes. The uncertainty is by how much and how volatile they will be in the future.

The company clearly has a business model that increasing numbers of customers like and has bold plans to keep on wooing more of them. So far, it seems to be doing a very good job of this.

Jet2holidays currently has an Air Travel Organisers’ Licence (ATOL) for around 3.9m passengers, compared with around 5.7m passengers for market leader Tui (TUI). The bankruptcy of Thomas Cook last year has put around 2.5m passengers up for grabs. It’s likely that a decent chunk of these could end up on Jet2holidays in 2020.

Jet2.com bought up Thomas Cook’s landing slots at Manchester, Birmingham and Stansted and along with its own growth plans could well increase its ATOL capacity to around 4.5m passengers by this summer.

The company is increasing its routes to Greece and Turkey and is significantly expanding its operations at Birmingham airport. This bodes well for the company’s near-term growth prospects.

There are still some potential headwinds in the form of political uncertainty, the buying power of the pound in Europe and fuel costs. Despite these, the company was confident to say back in November last year that forecasts for group profit before tax for the year to March 2020 would be “significantly exceeded”.

Dart forecasts

Source: SharePad

It would not surprise me to see current forecasts beaten again, but after a stellar run Dart shares may pause for breath for a while. At 1,803p, the shares are on a rolling one-year forecast PE of 16.3 times. That may not seem excessive in today’s stock market, but for a business with cyclical risk in an industry that tends to be volatile that looks about right to me.