Has Flybe's investment thesis been grounded by cost increases?

Over the past few years I’ve been a Flybe bull. I believed that the company has a sustainable competitive advantage in that it is often the only operator on certain UK flight routes and operates the most cost-effective airplane (Q400) for domestic flights. My thesis (http://www.dangercapital.co.uk/2016/09/flybe-dog-is-value-investors-best-friend.html) was that their load capacity would increase as their routes mature, their revenue would increase, their costs would go down as they reduce their fleet size and their high operational gearing would generate significant profits.

While their recent Q1 trading statement has shown significant increase in load capacity, and their revenue has been growing over the last few years my thesis has proven to be fundamentally wrong.

https://www.investegate.co.uk/flybe-group-plc/rns/results-for-year-ended-31-march-2018/201806190700107882R/

Despite positive progress on the top line it seems that they have been simply unable to control their costs even though they are starting to reduce their fleet size. Q1 costs increased at 16.6% in reported currency and this is on top of the cost increases last year. Some of this increase is due to currency movements so while the management cannot be held solely responsible, things like the unexpected large jump in maintenance costs do suggest a lack of management focus in this area. To get a look at what impact this might have on profitability I model the Q1 figures from the trading statement together with all statements about future periods contained in there.

If the 16.6% increase in costs held for the whole year then the figures would look like:

Note how badly this £78m loss would compare to a broker forecast of £2m loss for the year and more importantly a c£90m market cap. Now this is unduly pessimistic since the company suggests that the rate of increase will moderate significantly later in the year so I have modelled both 10% & 5% cost increases in H2 (keeping 16.6% for H1.) In these cases we still end up with big losses of £56m and £40m respectively. Based on the current forward-looking figures in the Q1 trading statement to hit the current broker forecasts we would have to see zero cost inflation in H2 and only about 5% in Q2. Of course the load factor could increase further and mitigate this to some extent, and simply taking 4xQ1 for white Label & Other Revenue may be too low,  but it seems to me highly unlikely that they can control their costs and generate top line growth sufficient to hit brokers’ estimates given what we know from Q1 trading.

Note that there are additional cash costs on top of any trading losses too. They have an onerous lease provision on the balance sheet which is costs related to historic aircraft purchases that are not competitive on their routes. Although these costs have been taken through the income statement already they represent real cash outflow that will happen in the future. They also have been capitalising costs related to their new IT systems, £4.5m last year.

When I wrote up my initial thesis a couple of years ago the company had sufficient balance sheet strength to trade through the expected short-term weakness as they took action to rationalise their fleet, however I am no longer confident that is the case today. They hold a lot of cash which is customer deposits and they own planes that potentially they could borrow more against so there is probably no immediate solvency concern but with a current ratio of 0.71 I don’t think they have a lot of wriggle room. A big loss this year would seem the mid-case scenario to me. If this is followed by another loss next year as their fuel & currency hedges start to increase, or a Brexit related aviation disruption this would see them at the very least having to raise capital from the market.

Net assets in the past year have fallen from £125 to £93m and I would expect another year of significant losses to further erode this figure. So the argument that Flybe is an asset play and if they cannot run the business profitably someone else will take them over for the planes & routes who can run them profitably starts to carry less and less weight in my opinion. They did receive interest from Stobart Air earlier this year but this was before the full year results & Q1 trading were known and it seems that Stobart Air were not making a cash offer but proposing some kind of non-cash merger so I’m not sure this is indicative that others in the industry see significant undervaluation.

Given all this it is probably unsurprising that I no longer hold shares in Flybe. I will re-assess if and when they can show significantly declining costs and/or after any capital raise.