Dart Group has nearly halved - but is it just too soon for airline stocks?

It was only a couple of weeks ago that we looked at Warren Buffett’s 2019 letter to shareholders - a lot has happened between then and now.

In that piece, point two (“Acquisition discipline is key”) remains particularly relevant. Certain high profile Berkshire shareholders have expressed disappointment at the company’s lack of significant acquisitions over the past four years, but that c$130bn cash pile must look a lot more enticing now.

In recent years, Berkshire has been frustrated in its aim to buy good companies at attractive valuations. Given recent dramatic price moves, however, it is worth noting that Berkshire’s response has been to spend around $45m on Delta Air Lines shares. In upping its stake in Delta, Berkshire is living up to that famous mantra: “Be Fearful When Others Are Greedy and Greedy When Others Are Fearful”.

But is this actually the time to be buying airlines? It looks like there is more short term disruption to come. If any contrarians out there are tempted, I would encourage caution and a keen focus on financial health.

Stock market Darwinism: how bad markets can help good operators

Let’s just get this out of the way: airline stocks are particularly risky investments. Low barriers to entry, brutal competition, high fixed cost bases and a weak negotiating position with suppliers are just some of the dangers. That said, you do get big winners as well.

Airline stocks have been clobbered in recent weeks. People are flying less. It is highly likely that most operators will report reduced business for at least a quarter or two. And while those sales might have evaporated, operating costs will be much stickier. This week’s crashing oil price could provide some welcome relief, but not immediately - most airlines work hard to hedge out oil price exposure.

It doesn’t take a genius to see that a market shakeout and possible sector consolidation is on the cards.

Shakeouts never feel good, but in the long term they are a net positive for quality operators. It’s a harsh, Darwinian truth. Good businesses with strong balance sheets can take advantage of market weakness while the competition suffers. This might be done through buying back stock, acquiring competitors at knockdown rates, or just investing for future growth at a time when others are fighting twice as hard to keep the lights on.

It is in such moments that good businesses can increase the odds of future success. While share prices might decline across the board, intrinsic values can be enhanced.

I think we were beginning to see something like this reflected in the rising share price of Dart (LON:DTG) following Thomas Cook’s collapse. Recent fears have reset a lot of that progress, however.

Focusing on financial safety

Net cash position

In such markets, when investors are laser-focused on downside risks and an underlying current of panic hangs in the air, possibly the most important rule is to stick to strong balance sheets. Indebted companies can usually roll over their debts. Every now and then, however, they must refinance in exceptional market conditions that prove disastrous for equity holders…

The risks are multiplied when you find a low-margin company with high fixed costs and debt on its balance sheet. This combination of financial characteristics can be fatal. Comparing Dart to some other airlines (including Berkshire’s Delta) shows that Dart is the only airline to currently have a net cash position.

Cash generation and liquidity

Dart Group stacks up well on a free cash flow basis:

Meanwhile, its liquidity measures are strong versus this peer group:

Relative valuation

As well as having a net cash position and superior cash generation and liquidity measures, Dart Group is also attractively valued on an EV/EBITDAR basis.

Conclusion - too soon to bet on airlines?

First Coronavirus, then a breakdown in OPEC+ relations… Exogenous shocks to the global economy operate, apparently, like London buses: you wait for a decade and then two come along at once.

Investors will be far more focused on margins of safety and balance sheet health in the months ahead, and rightly so.

With cyclical, operationally geared stocks such as airline companies, leverage that looked manageable can quickly become unsustainable. Flight disruption is more likely to deteriorate than improve over the next few months, in my view. Demand for air travel to and from Europe has already fallen rapidly.

The International Air Transport Association (IATA) has updated its financial analysis of Coronavirus on the global air transport industry, revising estimates of 2020 global revenue losses for passenger business of between $63bn and $113bn, up from $29.3bn.

Given such headwinds, having a cash pile to soak up operating expenses could make all the difference.

Dart Group appears to be financially safe and modestly valued compared to peers. A stronger balance sheet will be vital in the months ahead. The best will be able to take advantage of market conditions. The weak will suffer.

Dart Group looks reasonably well positioned to pick up the pieces in the UK and Europe. However H1 growth was unspectacular and costs have been increasing in tandem with its expansion push. Given prevailing conditions, perhaps those lukewarm H1 figures should be viewed in a more critical light.

Back in November, I wrote that Dart Group “has a significant opportunity to gain market share” but added that “this is one investment that should be monitored closely for developing risks”. Evidently, risks have developed and must now be considered.

I don’t see any great need to rush back into airline stocks right now. The chances are we will get a wave of tough airline trading updates and revised broker EPS estimates over the next couple of months.

I’ll be watching Dart Group from the sidelines to see how it fares in this tricky time. If it wins out as an eventual survivor and consolidator, it could guarantee growth for years to come. It’s worth noting that, while Coronavirus disruption is bad news for airlines, a sharply lower oil price (if sustained) should be a very good thing.

On another note, I think hotels and restaurants are another danger area in terms of fixed operating costs and variable demand. Some will be seeing pretty painful year-on-year like-for-like trading figures right now - I think minus double digit LfLs at least, particularly for those with exposure to travel hubs.

Michael recently flagged Restaurant Group as a stock to avoid and I would second that. Cheap stocks can always get cheaper.

It’s easy to find the risky parts of the market right now. Given the recent, extreme market moves, I’d be interested to know where others do see opportunities.