Flight Centre deal grounded again

The Australian travel operator fails in its second attempt to strike a deal with Pacific Equity Partners following a global squeeze on leveraged finance.
Australian travel operator Flight Centre has failed in its latest attempt to change its ownership structure with the help of private equity. Yesterday, the companyÆs directors announced that they were abandoning a proposed joint venture with Pacific Equity Partners (PEP) because the cost of the transaction and the tax considerations were too high.

The company also said that an independent expertÆs report concluded that PEP had undervalued the business and that the transaction was ôneither fair nor reasonableö.

However, equity analysts say the details surrounding the termination of the proposed joint venture are vague and that the results of the expertÆs report are a red herring. They reckon that the recent volatility in the global credit markets would have made it difficult to finance the leveraged vehicle, and that PEP probably got cold feet.

Under the joint venture proposal, Flight Centre, which has a market capitalisation of A$1.8 billion ($1.5 billion), was to transfer its operational and business assets into a new vehicle called JV BidCo. PEP would buy a 30% stake in the vehicle for A$195 million and then debt financing worth A$960 million would be raised, allowing Flight Centre to buy out minority shareholders.

ôOur view was that the proposed leveraged structure was complicated and risky,ö says a small-cap analyst based in Brisbane. Others echo this sentiment. ôThe deal was really the work of an overactive corporate banker trying to mimic the big deals done in the media sector,ö says a small-cap fund manager, referring to similar spin-off joint ventures signed between PBL and private equity firm CVC in October last year, and Seven Media Group and KKR in November. ôThe idea of owning shares in a new-fangled debt-laden vehicle wasnÆt appealing to us,ö says the fund manager, who doesnÆt own Flight Centre shares. ôIf we want exposure to a retail/wholesale travel business we would rather buy the real thing.ö

Flight Centre chose the JV BidCo route after a straight-forward management buy-out, also backed by PEP, was voted down by minority shareholders in February this year. At the time, the directors of Flight Centre, who currently own 58% of the companyÆs shares, were surprised by the rebuttal and promised that operations would return to ôbusiness as usualö. But by June, the directors announced that they had signed a new JV proposal with PEP.

Shareholders responded positively to the new transaction. Before the market correction at the end of last week, Flight CentreÆs shares were trading at A$19.50 each, up from A$15 per share when the first MBO deal was abandoned in February. Though last ThursdayÆs high is still well below the A$28.40 price that the shares achieved in 2002.

Yesterday Flight CentreÆs shares slipped A$1.15 or 6% to A$18.12 following news that the second PEP deal had failed. At one point during the day, they were 10% down on MondayÆs close.

ôOur share price target for Flight Centre is A$17.20 which represents a price-to-earnings ratio of 16 times fiscal 2007 earnings,ö says the small-cap analyst. ôWe think this is appropriate considering its current operating state and its limited growth prospects.ö

The analyst says he is surprised by the valuation given in the independent expertÆs report prepared by Ernst & Young. The report, released yesterday, values Flight Centre at between A$20.04 and A$21.05 per share on a diluted basis. ôWe arenÆt as optimistic as the independent expert,ö says the analyst. ôTheir valuation implies a P/E ratio of around 19x which is high.ö

Ernst & Young was commissioned to conduct the report by Flight CentreÆs directors. The firm concluded that the JV BidCo transaction was neither fair nor reasonable based on its analysis of the companyÆs performance. It says that, based on its assessment of the equity value of the joint venture, PEPÆs 30% economic interest represents a ôsignificant increase in value compared to PEPÆs original investment of A$195 million.ö

The report also concluded that the transaction costs associated with the deal were significant, estimating them to be between A$68.5 million and A$86 million.

Sources say the reasons given for yesterdayÆs termination of the deal with PEP are dubious. ôWe feel that a lot of the issues behind the decision not to proceed would have been thrashed out when the deal was put together, so we think that laying the blame on the findings in the expertÆs report is a bit of a smokescreen,ö says a source. ôIt is more likely that the cost of funding the vehicle just became untenable.ö

PEP has had a good run in AustraliaÆs private equity market. The firm was established in 1998 and currently has A$2 billion in equity funds under management. In February 2006, it raised the largest single fund in the country with its A$1.2 billion Fund III. In March this year it acquired New Zealand snack food company GriffinÆs Foods from Danone Asia, and in May it bought vacuum cleaner specialist Godfreys, in conjunction with CCMP Capital Asia.

Last year, PEP and another local firm Archer Capital, were involved in one of the quickest turnarounds in the industryÆs history. The pair netted a return of 105% on the public sale of earthmoving equipment company Emeco just 20 months after buying the business.

The on-again off-again deal with Flight Centre has proved to be a time-consuming and difficult transaction for PEP. The firm has also invested a lot of time in the bid for retailer Coles. Up until June this year, it was part of a consortium backing WesfarmersÆ A$20 billion bid for the company, but pulled out at the last minute, requiring Wesfarmers to go it alone.

Flight CentreÆs directors have said they are now investigating alternative capital management strategies for the company.

Flight Centre was advised on the JV BidCo deal by ABN AMRO Morgans Corporate, while PEP was advised by Caliburn Partnership.
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