Wednesday, May 23, 2012

Mailbag: Transat A.T.

The idea that airlines make for lousy investments has been broached a number of times on this site. But what about a tour operator that trades for far less than its cash balance? Transat AT (TRZ) will be of interest to many value investors, thanks to its $190 million market cap versus its cash balance of $640 million. In addition, the company has more than $75 million (after write-downs) in ABCP! Furthermore, the company is generally profitable and free cash flow positive (though last year was an exception).

Transat calls itself a tour operator instead of an airline because it has vertically integrated beyond being a pure airline. It offers packages (hotels, activities etc.) to tourists, handles logistics (e.g. baggage) for many other airlines at a number of airports and operates a number of travel agencies. And yet I'm not sure it can escape the fundamental risks that make airlines such poor investments.

First of all, when a particular vacation route is profitable, nothing stops a competitor from expanding capacity and driving down the returns of the incumbent. And when a route is unprofitable, price wars for marginal revenue can be devastating.

Second, to a large extent the company's costs are out of its control. On revenues of $3.5 billion, Transat paid a lofty $450 million last year just for fuel. Furthermore, the company has almost $800 million worth of operating leases due over the next few years; if these are capitalized and considered debt (which they should be), the company's net cash position cited above all but disappears.

Occasionally, pre-paying customers have been left in the lurch when airlines have gone bankrupt. As a result, regulations require that companies keep a certain amount of deferred revenue in trust accounts. So even though the company has $640 million in cash on the balance sheet, $425 million of that is reserved and held in trust! As an investor, don't expect this cash to ever be released unless the airline is willing to shrink. On a related note, good luck finding an airline operator that isn't obsessed with growth! Transat continues to add cities and routes to its network this year.

Finally, the way Transat's tour operations provide value to customers in the form of cheaper vacation prices is by buying hotel rooms and airline seats (if it needs those of another airline) in bulk and at a discount in advance. As such, they have to anticipate market conditions and make commitments some 6 to 9 months before the vacation season begins. Note only does this require somewhat accurate demand forecasting which can obviously go wrong, but it also exposes the company to the risk that an event (e.g. a recession or terrorist attack or flu scare) will destroy demand. Since costs are fixed to such a large extent, such an event could cause a liquidity crisis, or even bankruptcy. Obviously, these types of events won't happen often, but the investor must recognize that he bears this risk.

Nevertheless, Transat still trades for substantially lower than the replacement value of its net assets. I'd even go so far as to say that an investor would probably do quite well purchasing Transat at its current price. The problem, however, is that downside risk is not adequately protected for black swan or even mildly-gray swan type events, thanks to the long lead times, fixed costs, and exposure to costs that are out of its control. Despite the risks, however, some value investors may be interested. What do you think?

Disclosure: No position


Anonymous said...

Thnaks Saj for your extensive analysis of Transat. You make a lot of the points that I also considered when I purchased Transat, but at a few of them I look slightly different.

1. When I looked at the balance sheet, I eliminated both the asset and the liability associated with customer’s prepaid vacations. This shrinks the cash hoard to just the amount free to Transat. As it is still well in excess of the MV of TRZ I noted cash as a positive.
2. The risk you see emanating from TRZ’s fungible inventory of hotel rooms is not unlike the inventory of many other retailers: If clients don’t book the room that TRZ had prebooked for June 1-7 (for instance), it won’t be any good after that date. Similarly, clothing stores buy clothing items in the hope that it matches what will be in fashion next season. If not, or if sales are slower due to economic conditions or other factors, they can just as well gift their inventory to Goodwill at the end of the season. Grocery stores have fresh fruits and vegetables that have a very certain expiry.
3. I agree that operating leases are similar to debt. However, operating leases are paid out of Operating Cash Flow, whereas debt is paid out of the financing section of the cash flow statement. If we capitalize the leases we should also increase CF from Ops by the amount the lease payments represent principal reductions. This would add substantially to TRZ`s already positive FCF.
4. TRZ is cash flow positive at a time when its competition (Thomas Cook and Air Canada in particular) is struggling to stay out of bankruptcy. These two companies are also deeply indebted. I look upon TRZ as the lowest cost competitor and the only one with a strong balance sheet. Does this represent a structural advantage (moat)? I wish I knew.
5. Fuel has become a very major part of their cost structure. Can this be reversed? Will fuel stay as expensive as it is? If it does, can Transat (over time) increase prices enough to take care of this cost? If it doesn’t, or if price increases can ultimately take care of the fuel expense problem, Transat can be very profitable and even more cash flow positive than it is now.

Saj Karsan said...

Hi Anon,

In principle I agree with most of what you said. I would only caution that lead times are much longer in this industry than in grocery, which increases risk IMO. I also wouldn't put much stock in this company having a moat, just looking at its numbers and considering the industry, with low switching costs and price being the main factor for customers.