Up in the Air

YTEUpInTheAirWritten by Michael Kodari.

Australia is a proud nation. We’ve come to believe that having the beloved flying kangaroo soaring across foreign and remote skies is necessary to engender a sense of enduring nationalism. After all Qantas is the spirit of Australia… of course, just like a fickle fair-weather football fan, when it comes to a commitment such as booking a flight to Melbourne none of this really matters. How much are those Tigerair flights to Melbourne again?

History is littered with hundreds of airline bankruptcies. Huge recurring capital requirements like those associated with new aircrafts; uncontrollably volatile fuel costs; currency fluctuations; carbon taxes; and an intensely competitive industry are just some of the toxic ingredients that have hindered airline companies since that famous day at Kitty Hawk in 1903.

Qantas Airways is Australia’s largest airline; the dominant airline in what is a duopoly in the domestic market. Despite this industry position, intense competition from Virgin has led to excess capacity in the domestic market, which has naturally translated into lower airfares. The international operations too face significant challenges from various Asian and Middle Eastern airlines. Many of these airlines are sovereign funded and operate off a lower cost base to that of Qantas.

Industry returns and earnings visibility have historically been poor for airlines. There is no doubt the aviation industry is one of the toughest in the world and that’s before you consider the restrictions that stem from the Qantas Sales Act and the burden imposed by a carbon tax. Brave shareholders for a while now have attempted to ascertain whether they attribute the plight of Qantas down to poor management and company-specific factors, or whether their difficulties are just a symptom of being an airline.

In 2007 Qantas was the target of a takeover attempt by APA (Airline Partners Australia) who made an offer of to pay $11.1 billion for the airline. Around that period Qantas shares rose to $6.06 and the business had a market capitalisation of $12.3 billion. At that pre-GFC stage the business managed to achieve earnings per share of 39.8 cents, had a return on equity of 12.7% and paid a fully franked dividend of 15 cents per share. It’s worth noting that although Qantas wasn’t subject to a carbon tax at that time they were bound by the same Qantas Sales Act that is the topic of such vigorous debate today.

As recently pointed out by James Packer in the media, hindsight suggests that from a purely economic perspective, shareholders previously should’ve accepted the offer and taken the money. Given the bidders stated their intentions to have the airline remain Australian based and owned, the bid never drew the ire of government and was allowed to proceed. Nevertheless the offer was rejected by both the employees and shareholders alike.

Fast forward a few years to 2014 and after having not paid a dividend since 2009 and a succession of poor results including the most recent $252 million first half loss, the share price of Qantas hovers around the $1.15 mark and has a total market capitalisation of $2.504 billion. Perhaps those APA bidders are now breathing a deep sigh of relief.

Such deterioration in Qantas’ position must have shareholders scratching their heads asking themselves, “Where to from here?”

By looking at the raw data it becomes clear that fundamentally Qantas is a shambles and isn’t investment grade. In the year 2000 the business reported earnings of around $500 million, had $3 billion in bank debt and had a respectable return of equity of around 17%. Today the business makes a loss compounded by the fact that bank debt has more than doubled in that time to over $6 billion. Regardless of whether that debt is government guaranteed or not, such a rapid and unsustainable increase would have any creditor reassessing Qantas’ risk profile. Going forward as the strategic aircraft fleet renewal continues, the profitability of the airline stands to remain in its current depressed state given the likelihood that the deprecation charge will continue to rise with the fleet modernisation. ..

Excerpted from an article originally published in the May/Jun 2014 issue of YourTradingEdge magazine. If you are a subscriber to YourTradingEdge magazine, you will receive this article in your May/Jun 2014 issue of YTE. If you are not a subscriber, click here.

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