Tuesday, August 6, 2013

Dart Group: Looking back & looking forward

When I looked at Dart Group last year it was undervalued: it could have easily generated unencumbered cash sufficient to pay off its liabilities to its creditors and to cash out its shareholders at the value of its market capitalization. In other words, it was a pretty good cigar butt at least and maybe more – one didn’t have to think too much beyond that. 

Since then, as everyone knows, the share price has almost quadrupled. A nice trade that I missed out on because I was thumb-sucking over the 10p that I’d have to pay for the airline (I valued Fowler Welch at ~60p and I wanted Jet2 for free).

At the current market cap, however, more scrutiny is required. Jet2 is a low cost airline. Or rather, Jet2 competes with low cost carriers. Now, in that particular market, what matters is unit cost: people will fly with you if you’re cheap and they won’t if you’re not.
 Jet2's route map. 50% of its traffic is to Spain.

To date, competition has been muted: Ryanair and Easyjet have been busy frying other fish. So Jet2 has been filling its planes, earning profits on ancillaries, and funding its growth via 0% interest bearing loans from its customers in the form of deferred income. This has added up to a high ROIC.

But a high ROIC is not evidence of competitive advantage. Sometimes a high ROIC is built 
into the nature of the sector (every advertising company and recruitment consultant has a high ROIC) and sometimes it is a function of the fact that the competition hasn’t come for you yet.

So, as I say, what matters in price competition is unit cost. And unit costs in the airline business are denominated in “cost per available seat kilometer” (CASK) in Europe, and “cost per available seat mile” (CASM) in the United States. 

This is how Jet2’s CASK compares with the two low cost carriers that are most likely to compete with it in the future:

Consider now that Jet2’s loss of the one quarter of the Royal Mail business will raise its CASK further. Consider also that Ryanair and Easyjet fly much shorter routes than Jet2 does (it costs a great deal more per kilometer to fly short routes than long ones).

Suddenly, there’s cause for concern: if Ryanair, say, decides that it wants to fly holidaymakers from Bradford to Alicante, it can price the flight much lower than Jet2, Jet2's bookings will fall, deferred income will fall, cost per passenger will go up, Jet2 ticket prices will have to go up,  and the negative spiral will be firmly  in place. 

What was a high ROIC operation frolicking in a Jacuzzi of cash can very quickly become a low ROIC business suffering from liquidity problems as the legacy airlines have long since discovered.

A note on the figures:
1. I have taken average stage length of each airline from a source I know to have been reliable:

2. Royal Mail flights are 10% of Jet2's departures and Royal Mail flights have numbered 16 per weeknight, implying that total annual departures for Jet2 = 16 x 5 x 52 x 10 = 41,600 flights per year.   

3. We know the composition of Jet2's fleet (and Ryanair's and easyjet's) so that we can use the maximum seat configuration to arrive at a figure for average number of seats per departure.

4. Together, these give us available seat kilometers (average stage length x annual departures x average number of seats per departure).

5. Short flights are more expensive per kilometer than long flights; they are more taxing on passenger, luggage, and aircraft handling, airport fees, etc. In order to adjust for this, industry convention uses the following formula: a multiplier  -- (average stage length of airline X/ average stage length of all airlines)^(1/2) -- is applied to the CASK of each competing airline to arrive at a cost per equivalent seat mile. If one wants to know how the cost structures of Jet2 and Ryanair would compare on the same route, the cost per equivalent seat mile is what one wants to know.

6. Applying the cost per equivalent seat mile to the distance between two airports (Leeds-Bradford ("Bradford") and Alicante results in a cost figure that can be used to compare the cost structure of two airlines. Small differences (10% or less) don't matter too much but large differences matter a great deal. In this case, it appears that Ryanair could price the flight at a 10% mark up and still charge half Jet2's fare.

7. That may explain why Jet2 is so keen to generate revenues from ancillaries: the more it earns from in-flight extras, the more competitive it can make its ticket prices. One can see that tickets are already priced at below cost. Can such a strategy survive the future attentions of Ryanair or easyjet? Each person must judge that for him/herself but I, for one, doubt it.

This post was corrected, amended & extended on August 21st

Disclosure: No position in Dart Group


  1. Hi Red. I'm just looking at Ryanair's route map and comparing it to Dart's. There's already a lot of overlap, and Dart says price competition is intense from all its bases. I'm puzzled by your figures, and wondering if Jet2.com customers are prepared to pay more for flights because of the level of service (Ryanair's being next to zero). Jet2 makes a big deal about family friendly schedules for example.

    1. Hi Richard,

      I've adjusted the figures above. I think that Jet2's strategy of subsidizing ticket prices by means of on-board retail sales has narrowed the ticket price gap so that it is not yet the most attractive target for Ryanair's attentions.

      Nevertheless, Ryanair's revenue per unit is lower than Jet2'c cost per unit even though Ryanair earns 11% margins. So it's not, I think, a matter of if but a matter of when.

  2. Hi Red, thanks for an interesting article and analysis, a few thoughts:

    1. I make operating cost for DTG airline to be £529.5m per accounts?

    2. RYA and EZJ are both schedule only LCC, whereas DTG also charters its aircraft - I calculate charter/cargo revenues at around £100m year on year. I would deduct this from the operating cost of £529.5 to show the net operating cost to be considered for pricing power purposes when competing against pure LCC.

    3. The cost advantage of pure LCCs is true but they need their aircraft in the air 24/7, so certain routes/schedules that may work for DTG won't work for RYA and EZJ - there is space to go for as long as you are careful on route and schedule planning. The cost advantage of pure LCCs is not new and if you look back RYA moved into LBA but DTG continued to grow, and the growth isn't all down to the holiday business its about picking off routes you can be profitable and maximising efficiency/load factors.

    4. The loss of 25% of the Royal Mail cargo business will effect the net operating cost calculated under point 2, but this can be compensated by increasing number of routes operated by existing aircraft - I'd be surprised if they stand still to this.

    5. Management have navigated some pretty tough waters and there is nothing significantly new in above - I wouldn't discount their ability to deliver again.

    Personally, although I don't think the EZJ and RYA models are all dominating, it is a different model and bolt on holiday business just adds to that. I think there are a lot of opportunities that would enable DTG to co-exist (allegiant/southwest) quite happily as long as they are smart and my guess is that they are.

  3. Hi,

    I have deliberately co-mingled the Jet2 and package holiday business in the following way: Dart minus Fowler Welch = Jet2.

    Why? Because the business of the holiday, charter, and scheduled carrier businesses is the same: to translate aircraft into revenues. If there were a better mix (e.g. all scheduled, no charter) Dart would have done it by now. Charters exist to use the planes in the off peak periods. That is, charters reduce the average cost of the airline segment.

    The Royal Mail contract is what allows use of Dart's planes when people can't fly. The chances of Dart being able to pick up new 16 flights a day without adding new planes is close to zero.

    In other words, Jet 2's business model is premised on the Royal Mail contract. (That and cross-subsidization from on-board retail revenue account are the twin legs of what makes Dart work). You'll notice that Royal Mail has been there from the beginning; it made the whole enterprise possible.

    I know that "we'll make up for it via growth" is Phil Meeson's standard line but growth doesn't keep your asset turns (aircraft usage) steady.

    Picking profitable routes, being smart etc: I think that will work for a little while. At the current valuation, however, one needs to be confident that it will work for more than a decade into the future. That's a long time.

    In the end, the only thing that will matter -- as every legacy airline trying to break even on the tourist trade has found -- is cost. Can ye get me to Lanzarote & back for under a 100 quid?

    I don't have a dog in this hunt, btw, but I think the risk/price balance has tilted toward the unfavorable on this one.

    re: Southwest. It is barely a low cost airline at this point. It has kept its CASM numbers respectable (though not good) by acquisition. It is certainly not as competitive as Ryanair.

    Allegiant is quite different to Jet2: it is almost entirely an ad-hoc package holiday / charter business and it's the sort of business model that can only really work in very large countries -- by acreage and population. One needs a large number of isolated towns and new customer groups to keep the offer fresh.

  4. OK thanks Red - in which case I think you definitely would want to exclude accommodation costs which are about £113m as they don't relate to flying the fleet and are not included in net ticket yield or revenue per pax, and I would also deduct the charter revenues from the op costs to determine the extent they can compete on price.

    To be fair to Mr Meeson & Co they have done pretty well during the past 5 years in growing and running the airline.

    On the rest I am not sure I agree with you but heck the future will tell I guess ;)!

    All the best

  5. Alright, I will look at the numbers again. Thanks for the comments, btw.

  6. likewise, always enjoy your blog.