City Insider: Flybe's model works - but can it up those margins?

City Insider: Flybe's model works - but can it up those margins?

City Insider - FT journalist David Stevenson on the travel industry

Over the last few weeks I’ve been spending an inordinate amount of time staring at satellite images of volcanos in Iceland. Not out of any particular scientific curiosity, but rather out of barely concealed panic that another dust cloud could ruin my travel plans in May and June. 

Obviously I’m not alone – the entire aviation industry has probably been watching just as closely. Luckily, barring a few near misses, my travel plans have remained intact, which has allowed me to witness up front one of the most interesting business models in travel today.

I am almost certainly the archetypal Flybe business customer. My spring has involved flying to key cities around the UK and Europe via regional airlines. My local hub is Southampton, where Flybe is very much the dominant player – and it’s this regional airport that perfectly demonstrates the power of the carrier's strategic model.

The key to understanding airports like Southampton is that there is in fact lots of business beyond the M25 – and some of it even makes a profit. There are in fact lots of companies that don’t want their staff to fly into and out of London for quick hops to places like Edinburgh or Paris. That core non-hub, regional market is complemented by a large number of what one might call serious travellers – VFR/second home travellers in the parlance - who collectively account for about a quarter of all Flybe passengers (alongside the core 45% segment that comprises business travellers).

Combine these two groups up and you have the lion’s share of the 60-to-65% load factor that travels on an average Flybe flight.

This is a market I’d always been rather cautious about from an investment perspective. In the slightly curious world of the City, only two business models have been successfully punted in aviation. The classic is that of the hub national carrier operating out of a place like Heathrow – think what was once British Airways. Then about two decades ago the low-cost model stormed into town, proving so successful that it squeezed the traditional charter model out of the major airports (witness Monarch’s decision to focus on lower-cost scheduled flights).

Flybe was always regarded as a bit different. Obviously there is demand for regional point-to-point travel, but would it produce enough load factor to make running the smaller aircraft profitable? Having travelled with Flybe over the last few months, my impression is a definitive yes, but with one big proviso: business and VFR travellers might be the bedrock of the airline's revenues but it’s also obvious that mainstream leisure travellers are the icing on the cake that probably powers profits.

And therein hangs the crux of the Flybe investment story. Its business travel market at regional airports has rebounded strongly in the last few months but  the weak consumer economy has impacted heavily on its leisure business. Let’s be honest here – although Flybe is good value, it’s still not as cheap as its bigger competitors. In an ideal world that shouldn’t matter, but there are only so many businesspeople you can get to fly on a mid-afternoon flight from Southampton to Edinburgh.

The obvious solution would be to kill the non-peak flights that cost lots of money, but that would get in the way of Flybe’s laudable aim to have lots and lots of daily departures to key regional airports - i.e. proper choice. So it needs to fill those off-peak flights with leisure travellers.

All these worries about business strategy would amount to nothing if Flybe was churning out lots of cash profits to keep investors happy, as Ryanair is currently attempting to do. But Flybe is still in stock market terms a relatively new creature with an unproven track record. The recent trading statement in May confirmed that its core profitability is running at about £22m per annum, but that profit will be completely wiped out by a longish list of exceptionals that includes a hairy-looking FX and oil hedge loss that totals just under £7m.

Not unnaturally, the City of London has taken rather badly to these numbers, marking the shares down from their IPO level in December at 340p to its current 177p. A 50% fall in the value of a leading IPO just six months after its listing isn’t a new story. Yet most of the IPO victims have been private equity deals foisted on an increasingly suspicious stockmarket. Flybe was, and probably still is, the genuine article – a growth stock, led by a good management team, with a decent strategy that’s very close to generating strong cash earnings on a regular and sustained basis. To the City that makes a 50% fall in value cause for concern, and investors are beginning to ask what comes next.

With the shares currently trading at around 175p I have to say that everything is still to play for. I’d actually suggest that at this price, the current market capitalisation of £134m looks more than reasonable, as long as the business is actually capable of generating annual cash profits of between £20m and £25m.

A price-to-earnings ratio of around six times earnings could easily sustain a management buy-in at some point in the future, or even a private equity deal. But the big question is whether that level of earnings is actually sustainable in 2012 and beyond. We're all familiar with the long list of knowable unknowables that could hit the aviation sector at any point – if Flybe is going to prove that regional point to point business travel is a cash monster, it needs to be quick about it.

We need to see at least a few steady years of solid growth in margins, at which point Flybe will begin to look like great value at the current share price. And I think that the model is sustainable – my flights were on time, not bad value compared to the train, and the customer service was excellent (staff actually seemed like they enjoyed working at an airport). My only concern is that there were just too many empty seats at the back.

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