Solving the Flight Centre enigma (Part 1)

My previous article on iSentia delves into the importance of discerning between a moat business with the ability to reinvest within its moat at high ROICs versus a moat business that has no further opportunities to do so.

In this article I will show you how powerful moat reinvestment at high ROIC can be, specifically how it has allowed Flight Centre to not only survive but thrive against seemingly unsurmountable secular headwinds.

Flight Centre is a 33 year old incumbent bricks-and-mortar travel retailer. Like all bricks-and-mortar travel agents, it has faced ever increasing online competition over the better part of the last 2 decades. No matter how you look at it, the undeniable fact is that the proportion of Australians booking through traditional travel agents is declining:

And the travel services sector as a whole is growing at below GDP….

Against this backdrop and with its traditional travel agency peers around the world all seemingly in decline – Flight Centre has not only survived but thrived, delivering extraordinary financial outcomes for its shareholders.

Over the past 5 years, Flight Centre has grown its earnings organically (save for a few niche acquisitions) from $247m to $392m, its NTA from $395m to $884m (22% CAGR!) while paying out $586m in cash dividends. Viewing these financial numbers in isolation, you would have assumed Flight Centre was the disruptor and not the disrupted!

Inverting Peter Lynch’s heuristic

For me, this is an example where the inverse of Peter Lynch’s heuristic – “If you like the store, chances are you’ll love the stock.” – does not hold true. I personally believe Flight Centre offers an extraordinarily poor customer value proposition – yet no one can argue that Flight Centre as a company has delivered extraordinary financial outcomes for its shareholders.

When we see such an apparent incongruence, we must eliminate our personal biases as consumers (note my personal bias in adopting the Bezos doctrine of “your margin is my opportunity” when it comes to dealing with travel agents) and look into the competitive landscape and the underlying economics of the business for that special sauce.

Flight Centre’s special sauce comes from its ability to leverage its extraordinary competitive positioning in the Australian market (where it derives close to 75% of its profitability) into a tremendous compounding machine where it is able to redeploy its cashflow at very high ROICs through the rapid expansion of its store network.

Flight Centre’s dominance in bricks-and-mortar travel retailing

Flight Centre is arguably more dominant in its market than the Big Four Banks or Coles / Woolworths in their respective markets. It currently has no close competitor in the bricks-and-mortar travel retailing market.

In fact, its nearest competitor Helloworld has seen its own store network (mix of franchises, associates and affiliates) decrease from c.1,900 five years ago to c.1,500 today.

Tussles between a company and the competition regulator are typically indicative of a company’s strong competitive fundamentals. Flight Centre is in such a tussle with the ACCC over allegation that it had pressured the airlines against offering cheaper fares on their own websites than it made available to Flight Centre – constituting price fixing. This is currently ongoing as the high court has just granted ACCC leave to appeal but regardless of the outcome it shows the amount of clout Flight Centre has over its suppliers.

The extract from a press release below (after Flight Centre terminated Singapore Airline’s contract as a preferred supplier) gives us a taste of the aggression in which Flight Centre went after Singapore Airline when contract negotiations did not go its way:

Managing director Graham Turner said FLT’s decision was based on unattractive contract offerings that would have led to uncompetitive customer offerings.

As a non-preferred airline, he anticipated SIA would lose more than half the business FLT previously expected to generate for it during the 2009/10 financial year.

During 2008/09, FLT’s 1000 Australian leisure and corporate travel outlets generated more than $300million in revenue for SIA.

There is a simple and very important point here, and that is, as the single largest travel distribution channel in Australia and an extremely aggressive one, no competitor can hope to make more commission revenue on a flight ticket at a given price point than Flight Centre.

This in turn creates a virtuous cycle where Flight Centre’s scale gives it ever increasing bargaining power which ensures that it continues to widen its moat against competitors. And given it is widely recognised as a sector in decline – no financier will invest real capital to challenge Flight Centre in the bricks-and-mortar space.

Flight Centre can reinvests into its moat at very high ROIC

There is strong correlation between Flight Centre’s revenue growth and its store number growth.

How has Flight Centre been able to expand its store network so rapidly within an industry growing at 2.2% p.a. while its own addressable market (brick-and-mortar) is in undeniable decline?

The key here is that when rolling out its new stores Flight Centre actually competes with other bricks-and-mortar specialty retailers – not online competitors – for each square meter of new retail space available. Hence it merely needs to ensure that it can extract more profitability from each square meter of physical retail space compared to other specialty bricks-and-mortar retailers.

We can see below Flight Centre generate substantially higher gross profits for every dollar of rental expense compared to other speciality retailers in Australia:

(Note the numbers above include FLT’s corporate business – but given the magnitude of the differential, I believe the takeout would still hold true if we were able to back out the corporate business numbers.)

If we continue to work our way down past the gross profits line, we can see Flight Centre’s structural advantages against other specialty retailers deepening further:

• Low capex requirements (i.e. just desks, shelves and computers)
• Nil physical inventory (i.e. perhaps some brochures)
• Cash received upfront (i.e. negative working capital)
• Staff costs closely aligned to revenue (Flight Centre sales staff are paid a low fixed wage, and are subject to stringent commission budgets to meet their “cost of seat” – ensuring that every staff pays for themselves at minimum)

We can therefore deduce that ROIC generated from each additional Flight Centre store would be significantly higher than what comparable specialty retailers can generate given the same retail floorspace. In other words, as one of the most efficient user of retail space in Australia, Flight Centre has an unbeatable set of economics at the store unit level.

With the steady demise of its bricks-and-mortar competitors providing a wide open runway, Flight Centre has hence been able to grow its number of stores rapidly from 1,069 at the turn of the decade to 1,568 today – translating directly into revenue growth.

In my next article, we will look into why I believe Flight Centre has a superior set of economics compared to its online counterparts and how its aversion to making meaningful forays into the online world is actually a very well calculated capital allocation decision.

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.