Solving the Flight Centre enigma (Part 2)

In part 1 we looked at how Flight Centre’s superior ROIC at the store unit level enabled it to rapidly expand its store network against the seemingly insurmountable secular shift towards online travel booking.

Now let’s take a look at how Flight Centre’s bricks-and-mortar economics stack up against its online counterparts.

As a starting point, bricks-and-mortar retailing is all about converting foot traffic into profitability. This is analogous to converting click-throughs into profitability in online retailing. Real estate is therefore core to understanding and comparing their respective economics.

Real estate price setting – Bricks & Mortar versus Online

With the exception of certain flagship locations, occupants of bricks-and-mortar real estate pay roughly the same price per square meter for a given locale, regardless of what they’re selling or how much profits they can generate.

Rental price is set simply at the point where it will ensure full occupancy for the owner whether that be a shopping mall or a shopping strip – close where the least profitable marginal user of that space can still generate an economic profit.

In the online world your “real estate” is digital advertising space via the likes of Google and Facebook. It is subject to a highly efficient real time auction process where it is priced at the point close to where the most profitable marginal user of that space can generate an economic profit.

Using Google Adwords to illustrate, the price you pay per click varies greatly between different industries according to profitability:

In fact its granularity is at the level of individual key words:

In other words, if a particular industry segment can generate more profits from a given “click through”, Google will price the clicks dynamically in real time and capture most of the retailer’s excess profitability for itself.

In contrast, bricks-and-mortar real estate price setting is relatively static and inefficient in terms of profit maximisation for the real estate owner.

As a bricks-and-mortar retailer that essentially owns the travel vertical and has the ability to generate higher gross profits per square meter compared to other specialty retailers, Flight Centre benefits significantly from this relative inefficiency and gets to keep the excess profitability it generates from the real estate for itself.

Remember, fixed rental costs can impact your profitability in both directions.

Competition in online travel booking

Online travel industry participants spend billions of dollars on digital advertisement – and this is only increasing. Most of this expenditure gets collected directly by the likes of Google as rent for use of its online real estate.

As an example, Expedia’s direct selling & marketing spend in 2015 was ~US$2.7bn (more than Flight Centre’s total revenue) and it performs “hundreds of billions of predictive calculations to inform marketing decisions driving” – check out these algorithms!:

…armed with technology and content spend of US$528m:

So it’s clear that the online incumbents have already built up their moat and have the capacity to spend big to keep it that way.

To engage in a marketing and technology arms race against these big boys would simply be very poor capital allocation for Flight Centre. Remember, competition is the enemy of profitability.

Instead, Flight Centre has chosen to simply pay lip service to online growth opportunities while continuing to invest into expanding its bricks-and-mortar store network at high rates of ROIC – in a market where it has minimal direct competition and where it can continue to exploit the relative inefficiency of the bricks-and-mortar real estate market to its advantage.

Flight Centre’s dynamic pricing mechanism

Despite the hundreds of millions of dollars of technology spend, there is one very powerful tool at Flight Centre’s disposal that its online peers do not possess – a highly effective dynamic pricing mechanism.

Put simply, why sell a ticket for $1,000 when you can sell it for $1,100?

Every time Flight Centre sales staff generates a quote, it’s using organic intelligence to determine your price elasticity and therefore how much margins to make from you. The technology behind this is basic human incentives (i.e. sales staff on low base salaries needing to meet aggressive commission budgets).

There is also some under-appreciated mathematics here around the fact that Flight Centre’s revenue is technically its gross profit (i.e. commission) – and this gross profit percentage is very low (5%-10% excluding overrides).

So hypothetically, if Flight Centre sold a ticket for $1,000 at 10% commission, Flight Centre’s revenue is $100. However, if it can sell this same ticket for $1,100 (a 10% uplift in pricing) after determining this is an old lady with no computer at home – Flight Centre will have achieved a 100% revenue uplift on the same sale!

Consequently, Flight Centre’s Australian business actually generates more profits out of each raw dollar of sale compared to its online counterparts (i.e. it has a higher EBITDA to Total Transaction Value ratio than both Expedia and Webjet).

The Investment Perspective

Flight Centre is a consumer cyclical with massive operating leverage that overshoots both on the way up and on the way down (exacerbated by P/E compression and expansion at either extremes). Add an aggressive network expansion program and a growing corporate business into the mix, it becomes very difficult to discern between what is structural and what is cyclical.

Whilst I believe Flight Centre is definitely subject to structural headwinds, it will certainly always be overplayed and underplayed by Mr. Market at both extremes of the cycle – and hence the opportunity for investors.

Here’s part 1 if you missed it.

Note: The above blog post constitutes the author’s personal views only and is not to be construed as investment advice. Being obviously passionate about the art of investing, the author may from time to time hold positions in the aforementioned stocks consistent with the views and opinions expressed in this blog post.