Dart Group Memo – 25th Nov 2017

Dart Group (DTG) released its latest 1H FY18 results on 16th Nov 2017. Operating results were very satisfactory. The total number of passenger sector flown for the period between Mar-Sep 2017 increased by 41% while the ticket yield decreased by 17% from GBP 92 to GBP 76. With the competitive pricing, load factor remained at an impressive 93.2%. Consequently, leisure travel revenue grew 36%. Operating profit grew 22% which led to a continued margin compression of 12.3% as compared to 13.5% in 1H FY17.

Advanced sales grew by 38% from GBP 519m to GBP 713m which is indicating a strong growth for the Winter of 2017/2018. The growth in Winter programme corresponds to Jet2’s capacity expansion as the company grows its aircraft fleet. Strong free cash flow generation with impact from working capital is largely neutral. Capex spend is expected to be much higher in 2H 17 with aircraft delivery.

All things considered, this is a very impressive operation performance by the Dart Group management. The share price rallied strongly upon the release of the set of performance. The market seemed to value DTG very differently over a 5-month period. However, the intrinsic value of DTG most definitely did not change as much as that implied by the share price. I added to my position after Mr Market taking a dim view of the company’s prospect after results release in July 2017. I am glad that Mr Market has changed his view since then.

Post the recent share price rally, DTG is the biggest position in my portfolio by far (~30%). Naturally, I am re-evaluating the appropriate sizing for DTG. To arrive at what is the optimal position size, one would need to understand 1) the expected upside and 2) the downside risks.

DTG can generate further upside by 1) growing its free cash flow; 2) pay down of debt 3) expansion of valuation of multiple. While I do believe that the current multiple on DTG is on the conservative side, I typically do not count on multiple expansion for value creation. As such I would focus on future earnings growth and value creation to equity holder through debt repayment. DTG can generate further earnings growth by:

  1. Volume growth – this can be achieved either through 1) expanding to new airport and 2) adding new routes to existing airports

  1. Pricing growth – this can be achieved either through 1) increasing prices and 2) improving revenue mix by getting customers to purchase higher valued products

  1. Cost efficiency – given that the mix of aircraft is skewing towards new planes, one would expect some degree of operational efficiencies

  1. Operating leverage – as DTG continue to grow in its bases, it should be able to spread fixed cost over larger revenue and achieve some margin expansion. This is especially true at newer bases

DTG might be able to expand to new bases to generate further growth, but it would not be prudent to anchor an investment on such an aggressive assumption. I am happy to be wrong here. So in this analysis, I assume that future volume growth is only coming from adding new routes to existing bases. In the short term, DTG is likely to enjoy high single-digit volume growth due to the collapse of Monarch. In the longer term, DTG is unlikely to grow its volume above the market as competition in the airline/holiday industry is intense. Similarly, on the pricing side, I suspect pricing growth is very limited due to competition. But DTG does get some insulation from pure price competition because they are focused on holiday destinations and are currently very profitable while being very price competitive. Putting the two together, DTG’s organic revenue growth over the next five years is unlikely to exceed 10% while the risk of a cyclical downturn is more severe at current valuation.

By replacing older aircrafts with modern aircrafts, DTG should be able to realise cost savings through fuel efficiency and lower maintenance cost. But the impact of this should be fully incorporated by 2019. It is difficult to estimate this precisely, but I am not expecting a more than 1% of EBIT margin improvement. On the other hand, the risk of a higher fuel price weighs down on the cost savings from the new planes. Operational leverage might kick in with further growth, but this is difficult to quantify.

Putting the above together, I estimate that Jet2 will run at around 11-12m pax capacity with 91% load factor. Assuming a conservative pricing environment, I get GBP 2.4bn revenue in 2019. With an 11.5% EBITDA margin and no working capital benefit, I get ~ GBP 200m operating cash flow. The question of what is the right maintenance capex is a difficult one. I assume that with newer aircrafts in the fleet, the run-rate maintenance capex is close to GBP 60m. Deducting the maintenance capex, the FCF would be ~GBP 150m; implying a close to 15% free cash flow yield on GBP 1bn market cap. Assume that all FCF is used for debt repayment, equity value should increase while the FCF yield would decrease assuming that FCF doesn’t increase too much over time. In today’s world, 15% FCF is still a very attractive rate. Nonetheless, the upside on DTG is probably around 30-50% without any multiple expansion. Given that, I have investment opportunities with similar downside risk but 100% upside. It no longer makes sense to allocate such a large size to DTG.

However, Jet2 is still the best-valued package holiday business where it strikes a great balance between customer service, experience and price. The company is managed by an excellent management team and a well-aligned owner operator. Jet2’s position as value for money package holiday operator should prove to be most robust in a recessionary environment.

At this point, I believe 15% position size is probably the right one for DTG. I am retaining a large position size because I am very keen to partner alongside a competent and well-align management at a reasonable if not cheap valuation. However, I will be selling down more DTG shares.



Why is successful investing so hard?

I am fascinated with the notion that investing is “simple but not easy”. The principles of investing look deceitfully simple, buy low and sell high, while the execution of these principles can be hellishly hard. And the execution is hard because the process of learning and improving from the mistakes in investing does not work in the same way as it does with other activities such as sports.

First, unlike most sports activities, investing lacks an immediate feedback loop where the outcome of an investment decision is presented at once and mistakes analysed. One must, sometimes, wait for years before knowing the outcome of an investment decision which meant useful learnings and improvements potentially come on the back of a string of mistakes. It is the equivalent of trying to improve baseball batting skills but only knows the result of each bat one year later.

Second, the quality of the feedback is very weak as the investment outcomes do not always reflect the strength of the investment decision, i.e. one can be right for the wrong reasons or wrong for the right reasons. The inability to determine the precise causes for a particular investment outcome is very dangerous as one can put huge confidence in the wrong lessons learnt. It is analogous to practising basketball shots in the dark. One would have to rely solely on the sound of the basketball hitting the rim to determine how much more or less strength to apply for the next time. The lack of information for shot calibration impedes the basketball player’s rate of improvement.

Third, most lessons in investing have nuances and contexts such that they can only be applied to certain conditions and environments. In another word, these lessons are seldom generalised. The trick here is to balance between following the broad prescriptions of investment lessons but also able to recognise the exceptions to the rule. For example, a shrewd investor would rightfully conclude that based on historical precedents to avoid heavy-indebted companies is a wise thing to do. However, John Malone’s TCI supported by its steady cash flow is heavily indebted, but it turned out to be a great investment.

Fortunately, we stand on the shoulders of giants today. We can study the life of great investors and learn from their success and mistakes. We can observe the rise and fall of companies to find patterns. However, there is no better way to learn and grow as an investor than to work alongside like-minded and very accomplished investors.


Loyalty program series: Blue Chip Stamps case study

Loyalty program operators are similar to insurance operations in the sense that they issue a claim “stamps” or “air miles” in exchange for cash upfront “float” (industry term “billings”). This cash or “float” can then be invested while the clients slowly (or never, see breakage) redeem their points or miles (industry term “redemptions”).

Earning streams

Ordered by increasing amount of uncertainty, money is earned through

  1. taking a margins on a mile billed minus a mile redeemed
  2. selling customer habit analytics to companies
  3. breakage: this can be a significant ~20-50% of billings, with ~100% pre-tax margin
  4. investment income and capital gains from investing the float (other people’s money)
  5. point devaluations: this comes at the expense of the loyalty program’s reputation if done visibly, but remains largely unregulated. Companies should take an example from central banks and slowly but steadily devalue (as in “the optimal inflation target is 2% p.a.”)

Float from customers and the government (other people’s money²)

From day one the “billings” cash comes in with most of the revenue still unrecognized (except for a conservative breakage estimate), and offsetting “deferred liabilities” on the balance sheet. This means that almost no cash taxes are paid upfront.

In other words, this business uses other people’s money (clients) to earn extra money on the investment side, while deferring the cash taxes due on real loyalty earnings far into the future (after accounting for real breakage and devaluations down the road).

Powerful psychological biases working in favor of loyalty operator

I think there are some powerful psychological biases working in a loyalty card issuer’s advantage:

  • small amount of miles in every purchase “feels” like it was earned for free, or an “extra” (this is far from the truth, as loyalty programs get paid cash on day one for these points and an alternative to miles is cash back credit cards)
    • people do not value things they got for free as much as things they “worked” for
      • Result n1.: neglect of points that leads to slow devaluation of redemption liability and breakage
  • because the points are not expressed in usual fiat money terms, and they feel for free, the urge to buy unnecessary goods is bigger (perfume, hotel upgrades etc), this is similar to buying presents for friends.
    • see Dan Ariely’s The Perfect Gift : something you always wanted but never wanted to feel the pain of paying for
    • these products have a knack of carrying higher profit margins
    • the loyalty company will use its purchasing power pool to negotiate hefty discounts from retail cost on these high-margin products
      • Result n2.: sales mix is typically profitable for redemption partners (perfume, seat or hotel upgrades) and loyalty partner will take a nice piece of those economics

Case study from the past: Buffett & Munger’s investment in Blue Chip Stamps

I now want to present a very interesting case study from the past, Buffett and Munger’s purchase of loyalty program Blue Chip Stamps (’70s business).


The main takeaway is that Blue Chip Stamps’ revenue (~’gross billings’) declined heftily in 10 years, while the float more or less kept up. Why?

  • part of the declining revenue cumulatively adds to the float, while
  • the redemption frequency drops as the program loses mindshare and people forget/delay spending points


In other words, permanently declining loyalty programs can still be valuable vehicles to compound investments in, using other people’s money.

Case study today: Aimia

Today, Aimia is trading at ~1.5 x current cash flow, with gross assets (excl. loyalty card liabilities) worth about 2x current share price because of the uncertainty surrounding the major partner Air Canada “AC” that is leaving in 2020 (10% of accumulation but 50% of redemption).

Aimia’s loyalty card “Aeroplan” is one of the biggest in Canada.

Network effects of being big

There is many-sided network effects involved.

What makes the program valuable?

  • # of Accumulation Partners (partners that pay upfront cash “billings” to Aimia for offering clients miles)
  • # of Redemption Partners (partners that allow to redeem miles with products, getting paid by Aimia)
  • # of Clients

Each category interacts, e.g. more redemption and accumulation partners makes the program more valuable for clients, more redemption partners and clients makes the program more valuable for accumulation partners, etc.

Lastly, it’s all about “the big data” nowadays. More # of each category makes Aeroplan’s data analytics more valuable because the number of interactions (data) increases faster than the individual amounts.


Case study investment case


  • Aeroplan’s cash flow remains stable until 2020 and
  • post-2020 cash flows minus its real liabilities are worth at least 0, this is an attractive investment (worth ~10$ per share).

It seems unlikely that management would not be able to manage its way through a “run on the bank” redemption before the 2020 expiry of AC by delaying customer redemptions through two control mechanisms that induce clients to delay and forget:

  1. “gating” (offering limited redemption options ‘temporarily’, e.g. only flights on wednesday and sunday)
  2. devaluing points faster: this has the effect that more people will have insufficient miles to redeem products they deem valuable, hence delay and forget

Given the network effects and switching hassle for customers, I do not believe Aeroplan is going away abruptly as the market seems to think (maybe slowly, but then again Blue Chip Stamps is an interesting case).

Disclaimer: no position*

*Not yet comfortable in the industry.

Comments are welcome.


How Margin of Safety made me take more risk

In my previous contribution An exception to the no genuine value-add to society filter, I discussed a recent personal deviation from value investing.

This time I will expand on how reading Margin of Safety for a second time made me realize my personal context warrants more risk taking than generally advised in investment literature.

An imperative in investing is diversification. A portfolio of eight equal-sized stocks might be called risky “concentrated investing”.

Again, it is the context that is of great importance. For a wealthy investor holding close to 100% of net worth in stocks, I fully agree (the books are generally written by or for these types anyway). However, for investors that are invested across asset classes and/or benefit from large cash flows from relatively uncorrelated sources, the riskiness of this strategy is mitigated (e.g. an endowment with cash flows from forests, farms and real estate, or an individual that has a job and/or private business).

Seth Klarman highlights the advantage of having liquidity from high cash yielding positions in a downturn in his seminal book Margin of Safety:

The third reason long-term-oriented investors are interested in short-term price
fluctuations is that Mr. Market can create very attractive opportunities to buy and sell. If you hold cash, you are able to take advantage of such opportunities. If you are fully invested when the market declines, your portfolio will likely drop in value, depriving you of the benefits arising from the opportunity to buy in at lower levels. This creates an opportunity cost, the necessity to forego future opportunities that arise. If what you hold is illiquid or unmarketable, the opportunity cost increases further; the illiquidity precludes your switching to better bargains.


Maintaining moderate cash balances or owning securities that periodically throw off appreciable cash is likely to reduce the number of foregone opportunities. Investors can manage portfolio cash flow (defined as the cash flowing into a portfolio minus outflows) by giving preference to some kinds of investments over others. Portfolio cash flow is greater for securities of shorter duration (weighted average life) than those of longer duration. Portfolio cash flow is also enhanced by investments with catalysts for the partial or complete realization of underlying value (discussed at greater length in chapter 10). Equity investments in ongoing businesses typically throw off only minimal cash through the payment of dividends. The securities of companies in bankruptcy and liquidation, by contrast, can return considerable liquidity to a portfolio within a few years of purchase. Risk-arbitrage investments typically have very short lives, usually turning back into cash, liquid securities, or both in a matter of weeks or months. An added attraction of investing in risk-arbitrage situations, bankruptcies, and liquidations is that not only is one’s initial investment returned to cash, one’s profits are as well.

–  Margin of Safety, chapter “At the root of a value-investment philosophy” paragraph “The Relevance of temporary price fluctuations”

It was only after investing on my own and reading this book a second time that I realized that my personal situation is similar to an investor with high cash flows from sources with relatively low correlation to the price of equity markets. Indeed, I derive significant cash flow from a job (rest assured that my employer is not an asset manager. Indeed, AM typically have a revenue ‘beta’ of ~2 to the stock market).

These sources of liquidity are not often discussed in investment books, but once I came to the above realization (in my 7th out of 10 years of investing!) I was embarrassed with my own lack of independent thinking. 

Today I hold a lower cash balance in general as my “replenishment rate” is high. However, I do believe that having no cash is only “optimal” in theory. In practice, a small amount of cash can have the huge benefit of getting psychologically undamaged through a market correction, allowing oneself to rationally grasp the opportunities at hand.

Last year I started asking this:

What is the threshold of cash level that would actually make me happy when the market crashes? 

What is yours?

My answer is 20% (taking into account my moderately high replenishment rate and the fact that I am a young investor, not an older disinvestor). Note that this is a theoretical question, as a certain M. Tyson said: Everybody has a plan until they get punched in the face. Likewise, the level that will truly feel good is probably a bit higher. Lastly, remember what Warren Buffett says about plummeting markets:

A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves.


But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the “hamburgers” they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.


‘[S]mile when you read a headline that says ‘Investors lose as market falls.’ Edit it in your mind to ‘Disinvestors lose as market falls— as investors gain.’ Though writers often forget this truism, there is a buyer for every seller and what hurts one necessarily helps the other.”

– Buffett in ’97 BRK chairman letter

Oddly, most newspapers and books are written for disinvestors (older and wealthier participants). We can guess to the reasons why:

  • in part because this audience has the most money to spend on content
  • on the other hand most is probably explained by the insurmountable instinct for many to focus on short-term nominal gains

In the last market correction (Feb ’16) I actually felt content, but that probably meant that my cash level was too high in practice (i.e. 30%). Today it is at 10%.



Kahneman’s on what’d most improve our world understanding

Some gold from Cialdini’s new book Pre-Suasion, para. “What is salient is important”:

[Kahneman] was once asked to specify the one scientific concept that, if appreciated properly, would most improve everyone’s understanding of the world. Although in response he provided a full five-hundred-word essay describing what he called “the focusing illusion,” his answer is neatly summarized in the essay’s title: “Nothing in life is as important as you think it is while you are thinking about it.”

What is salient is indeed important, Cialdini:

As the tenth anniversary of the terrorist attacks of September 11, 2001, approached, 9/11-related media stories peaked in the days immediately surrounding the anniversary date and then dropped off rapidly in the weeks thereafter. Surveys conducted during those times asked citizens to nominate two “especially important” events from the past seventy years. Two weeks prior to the anniversary, before the media blitz began in earnest, about 30 percent of respondents named 9/11. But as the anniversary drew closer, and the media treatment intensified, survey respondents started identifying 9/11 in increasing numbers—to a high of 65 percent. Two weeks later, though, after reportage had died down to earlier levels, once again only about 30 percent of the participants placed it among their two especially important events of the past seventy years. Clearly, the amount of news coverage can make a big difference in the perceived significance of an issue among observers as they are exposed to the coverage

Kahneman’s most important thing is worth repeating for investors:

Nothing in life is as important as you think it is while you are thinking about it.



An exception to the “no genuine value-add to society” filter

TC and MC (the blog authors) discussed investing in Philly Shipyard (PHLY on Oslo Börse) a while back, and one counter-argument for not investing was that this company would not exist without the force and subsidies of the Jones Act. As such this company could not be labelled as a genuine value-add for society or customers.

Many value investors have mentioned they do not (generally) invest in companies that do not genuinely add value to their value chain or society. Usual suspects are cigarettes, gambling, time-share rentals etc. In different ways, these companies prey on humanity’s weaknesses (respectively addiction and ignorance). Another close to home company I like to use is Edenred (rearview mirror high and stable ROIC ‘great’ company that through regulation in France and Belgium enjoys operating in an oligopoly for a product that is fiscally advantaged but ultimately destroying value for society in TC’s humble opinion).

In different ways, these companies prey on humanity’s weaknesses.

However, I will explain why I have come to believe this rule is not (as) applicable to investments like Philly Shipyard ASA.

The great danger of investing in the above businesses is that they optically look like great companies from a rear-view mirror perspective (and near future perspective, with high and stable ROIC). Indeed, human weaknesses are time-invariant, or favorable (but questionable) regulations create a stable subsidized high ROIC, and these companies are generally valued as ‘quality’ by the market.

If the valuation multiples reflect quality this also means the investment only works out if the company is still flourishing 10 years from now (unless one is relying on future greater fools).  The problem is that investors are very bad at predicting the future more than five years out. Once public opinion turns against these companies’ (the timing is highly uncertain), the valuation can tank towards liquidation value. I think I sketched an investment that has unknowable (immeasurable) uncertainty to the downside. 

Value investors should prefer the inverse type of uncertainty. I believe immeasurable uncertainty vs risk is not often enough discussed, which is why I recommend having a quick read through The Dhandho Investor.

Why I made an exception and invested in Philly Shipyard

We have been following Philly Shipyard since Nov. ’16. Philly traded comfortably below liquidation value, and we found there was clarity that the Jones Act would not be repealed in the medium term (see also Trump’s slogan). Philly’s management seemed to have cared well for shareholder value in the past, and even a repeal of the Jones’ act could have accelerated the  (liquidation) value realisation, locking a small profit or loss. In other words, the Jones Act regulation was not a large risk factor by virtue of the valuation. The upside was that there was a decent ~ >50% chance that this company could soon be valued on a going concern basis once a new shipbuilding contract would get signed (in that case it would be worth 2.5X – 4X).


Clearly it is always important to assess a company’s true value-add to stakeholders. However, I hope to have made a convincing argument that this factor’s weight in decision making is dependent on the context (“great company” / “cigar butt” valuation?). In case of cigar butt valuation, this factor is not on top of my checklist. 

It is only through thinking about real-world case studies that I have found the courage to deviate from value investing dogma. Honestly, this is dramatic, as I only have one remaining personal example of a deviation worth sharing (in a next contribution). 


Summary of French Bollore documentary

For those that understand French, I very much recommend this excellent documentary on Vincent Bolloré. I found it to be quite unbiased, surprisingly.

Disclosure: long a bit of BOL (main thesis being that a full simplification is a catalyst for the unlocking of the NAV which is at ~2X the share price by virtue of the economic share count which stands at around 50% of the total share count, after accounting for the circular ownership loops. The timing is very unclear, but in the meantime NAV is compounded at a decent rate. The author did a very similar exercise as the highly recommended Muddy Waters analysis that came out just months after)

For everyone else, I have summarized the documentary:

  • in France, Vincent Bolloré has the nickname “two-faced smiling killer”
  • Bolloré has a smartphone app counting down the moment he steps down. I think this shows he is obsessed by providing the “right” company to his family successor (whatever that is, importantly it could include a simpler structure)
  • when Bolloré started at the family company after his Rothschild banking experience, he managed to negotiate a 25% wage cut in his family’s rolling paper factory legacy business when the factories faced cyclical headwinds. This is almost unheard of in France and it shows his influencing skills.
  • the name Bolloré in Africa is very famous. Bolloré uses his abundance of smarts, political connections (including personal friends Sarkozy, Hollande* and Macron), capital and synergies from the media business to gain profitable contracts in many African countries

I didn’t build my empire from one franc by being a passive investor, it’s not in my genes, I am an activist. – Vincent Bolloré at the Havas board meeting.

*Although Sarkozy is one of Vincent’s personal friends, the documentary shows an example where a Hollande visit to Africa allegedly helped Bolloré win a bid for a Cameroon port concession.