Airlines dominate public transportation and this trend is expected to continue
A “sell” recommendation on Qantas
In the past few decades, airlines have taken the controlling position as a means for intercity travelling. The following graph shows the projected percentage change in passenger transport by mode and car ownership rate from 2000 to 2050. It is clear that airlines dominate rail and road, becoming the major channel for travelling. As the trend of globalization is unavoidable, I believe that airlines will continue to be the most important travelling channel between cities. Airlines are particularly crucial for countries such as Australia to connect with other countries.
Source: Passenger transport demand – outlook from the World Business Council for Sustainable Development (WBCSD)
While the car ownership rate increases in the countries such as India and China, this does not replace the importance of travelling by air. As the following graph shows, the use of cars decreases as the travelling distance increases. And again, long-distance travels between countries are important for Australia and New Zealand.
Source: the U.S. department of transportation, Federal Highway Administration
While the future is bright, the challenges are also big. There are two major challenges in the airline industry and the first one is competition. Although the whole industry has the competitive advantage over rail and bus in long-distance travel, the competition in the industry is fierce. In Australia, for instance, there are nearly forty airlines (See the following table). The competition can squeeze profit margin. This requires airline companies to have highly effective pricing and unique customer service strategy to keep its competitive advantages.
|Air Link||Dubbo Airport|
|Airlines of Tasmania||Launceston Airport, Cambridge Aerodrome|
|Airnorth||Darwin International Airport|
|Alliance Airlines||Brisbane Airport|
|Cobham Aviation Services Australia||Adelaide Airport|
|Eastern Australia Airlines||Sydney Airport|
|Express Freighters Australia||Sydney Airport|
|Fly Corporate||Brisbane Airport|
|Fly Tiwi||Darwin International Airport|
|Free Spirit Airlines||Essendon Airport|
|Hardy Aviation||Darwin International Airport|
|Hinterland Aviation||Cairns Airport|
|Inland Pacific Air||Townsville Airport|
|JetGo Australia||Brisbane Airport|
|Jetstar Airways||Melbourne Airport|
|King Island Airlines||Moorabbin Airport|
|Maroomba Airlines||Perth Airport|
|Network Aviation||Perth Airport|
|Qantas||Sydney Airport, Melbourne Airport, Brisbane Airport|
|Qantas Freight||Sydney Airport, Melbourne Airport|
|Regional Express Airlines||Sydney Airport, Melbourne Airport|
|SEAIR Pacific||Gold Coast Airport|
|Sharp Airlines||Hamilton Airport|
|Skippers Aviation||Perth Airport|
|Skytraders||Hobart International Airport|
|Sunstate Airlines||Brisbane Airport|
|Tasman Cargo Airlines||Sydney Airport|
|Tigerair Australia||Melbourne Airport|
|Toll Aviation||Bankstown Airport, Brisbane Airport|
|Virgin Australia||Brisbane Airport, Melbourne Airport, Sydney Airport|
|Virgin Australia International Airlines||Sydney Airport|
|Virgin Australia Regional Airlines||Perth Airport|
|West Wing Aviation||Mount Isa Airport|
The second major challenge to airlines is the oil price. A booming economy stimulates businesses and promotes the prosperity of travelling. However, a booming economy also pushes up the oil price, which significantly increases costs for airlines. More importantly, it is not only high oil prices affect airlines, but also the fluctuation of oil price demands airlines to have high-risk management ability. It requires a frequent trading in derivatives, such future, options and forward, in order to manage oil price risk and therefore smooth the revenue. Without an appropriate risk management strategy, the operations of airlines can be fairly risky. For example, pre-2014 oil prices used to be $100. If an airline uses this price to set a long-term contract would suffer a significant loss. As we all know that oil price has dropped significantly since 2015 (See the following graph).
In airline companies, the operating profit is calculated as follows:
RPM = revenue passenger miles = Number of passenger Number of miles/kilometers flown. For cargo or in freight, the Number of the passengers is replaced by the Ton of cargo. World-widely, about one forth airlines is cargo/freight.
Yield = Total revenue / the total number of passenger-miles flown. The measure reflects that the two important elements to consider revenue generation ability of an airline is the passenger number and the distance flown. Yield is different from fares as it changes over time and depends on conditions. Such as ticket refund-ability, advance purchase, passenger loyalty programs, and holiday stay conditions. Yield is, therefore, is a price index, rather than the price itself.
ASM = available seat-miles = Number of seat times the number of miles/kilometers flown. Another relevant factor is loading factor (LF), which is RPM/ASM. In other words, it measures passenger per seats. On the revenue side, when the availability of seats is also considered. The modified measure is passenger revenue per available seat-mile (PRASM).
Unit cost is the total costs (including the salary of employees, airport fees and oil costs) per seat. As we can see here is a trade-off. If an airline wants to increase load factor, it may need to reduce yield to win over competitors. However, it is also known that an increase the load factor over 80% can be counterproductive, as the overall revenue would not increase. Therefore, the yield management ability is very important to profit generation of an airline company. In addition, a quick adjustment to demands is important as well. When demand is high, an airline company can increase both loading factor and yield, so as to maximize the total revenue.
Based on the above knowledge, now let’s have a look at the 1H18 performance of Qantas.
In the first line, underlying PBT (profit before tax) increases from $852 million in 1H17 to $976 million in 1H18. In fact, the first four lines in this table show that all measures of earnings or profits of the firm increase over the last year.
ROIC is Return on Invested Capital, which is higher than WACC (weighted average rate of capital), suggesting the return is higher than the costs. However, it declines compared to the figure of 1H17. However, both revenue and operating cash flow increase over the last year and meanwhile net debt decreases, indicating the firm fundamental is fine.
Now let’s get closer to the concept we mentioned in the above section.
Unit revenue (RASK) equals what we mentioned above of passenger revenue per available seat-mile (PRASM). Total unit cost equals Unit cost that we mentioned above, Ex-fuel unit cost is the cost except for oil or fuel. It can be seen that both unit revenue and cost increase over the last year.
Available Seat Kilometers (ASK) equals available seat-miles (ASM) we stated in the last section. Revenue Seat Kilometer (RPK), as it explained in the footnotes, is the total number of passengers carried multiplied by the number of kilometers flown, which equals RPM in the above section. The loading factor in 1H18, therefore, is 83.52% (64,512 divided by77, 240), which improved from the last year of 81.01% (61,348 divided by 75,732)
As it is disclosed by Qantas, the increased revenue is largely driven by the growth of Asian markets, “offset by the reduction in the domestic market”. This statement is in fact in line with our analysis in Section 2 that one of the biggest challenges for Qantas now is it has to face serious competition inside the Australia domestic market.
Further, it is not bad that firm revenue is driven by Asian markets. However, as we know, the competition of airlines in this region is becoming even more severe, if not less, than Australia domestic airlines. Each country has its own airline companies and they all intend to expand their operations in this region.
In fact, as stated in “Boeing current market outlook: 2017-2036”, while Asian-Pacific will dominant the absolute amount of travelling passenger, the other three regions: Middle East, Africa and Latin America, have higher relative percentage growth rate (see the following graph). Therefore, there is still room for Qantas to grow. However, given the increased competition, strategic move is as at least as important as operations for Qantas. The possible takeovers and acquisitions of small airlines may be a feasible option.
(1) Cash flow discount approach – the basic case
In this section, I value Qantas using the discounted cash flow method. In particular,
Terminal Value = FCF2022 × (1 + g) ÷ (Discount Rate – g)
In the basic case, the discount rate is 8.55% and growth rate is 2.76%.
The fair value of the firm = Present value of next 5 years cash flows + terminal value.
The fair stock price = Total value / Shares Outstanding.
The valuation process is shown as follows.
|Levered FCF (AUD, Millions)||$ 1,348.25||$ 1,229.68||$ 957.83||$ 968.25||$ 978.80||$17,371.59|
Discounted (@ 8.55%)
|$ 1,242.05||$ 1,043.60||$ 748.86||$ 697.38||$ 649.45||$11,526.31|
|Total equity value||$ 15,907.65|
|Number of shares outstanding||$ 1,602.00|
|Fair price||$ 9.93|
(2) Cash flow discount approach – the realistic case
In the conservative case, we assume that shareholders require a rate of return of 15%. This is the level of the American airline industry. This is not unrealistic. Because maybe in the next five years, Qantas need to compete with U.S. airlines, in particular in the Asian-Pacific market. Further, the reported the latest return on invested capital (ROIC) is around 21% (see the table in Section 4), a required return of 15% is in a reasonable range.
|Levered FCF (AUD, Millions)||$ 1,348.25||$ 1,229.68||$ 957.83||$ 968.25||$ 978.80||$ 8,217.44|
Discounted (@ 15%)
|$ 1,172.39||$ 929.81||$ 629.79||$ 553.60||$ 486.64||$ 4,085.52|
|Total equity value||$ 7,857.75|
|Number of shares outstanding||$ 1,602.00|
|Fair price||$ 4.90|
(3) Cash flow discount approach – using the previous annual data
Given that Qantas’ return on invested capital (ROIC) calculated using TTM (Trailing Twelve Months) income statement data is 10.80%. If we expect the firm can carry this rate forward, then the following figure is the value of the firm.
|Levered FCF (AUD, Millions)||$ 1,348.25||$ 1,229.68||$ 957.83||$ 968.25||$ 978.80||$ 12,510.14|
Discounted (@ 10.80%)
|$ 1,216.83||$ 1,001.64||$ 704.16||$ 642.43||$ 586.13||$ 7,491.40|
|Total equity value||$ 11,642.60|
|Number of shares outstanding||$ 1,602.00|
|Fair price||$ 7.27|
(4) Comparable approach
As of today (2018-04-20), Qantas Airways Ltd’s share price is $6.01 and P/E ratio is 11.27x. This figure is higher than the P/E ratio of the airline industry, which is 8.96x. The P/E ratio of Qantas is also higher than Australia listed Air New Zealand, which has a P/E ratio of 10.49x. Qantas has a P/B ratio 2.74x, which is higher than the P/B ratio of 2.19X of Australia listed Air New Zealand. The dividend yield of Qantas is 2.35% with the payout ratio of 29.41%. Comparatively, the dividend yield of Australia listed Air New Zealand is 6.53% with the payout ratio of 73.16%, both higher than those for Qantas. Qantas has a debt to equity ratio of 1.30, which is comparable to Air NZ of 1.28.
(5) Intrinsic value
Qantas has EPS of $0.52 and book value per share of $2.10 (the numbers for Air NZ are $0.23 and $1.38, respectively). Therefore, the Graham number of Qantas is $4.96, which is the intrinsic value. This price is close to the price we obtain from the Cash flow discount approach – the conservative case, where the fair price is 4.90. The current price of $6.01 is higher than its intrinsic value.
Qantas is in an industry with big potential but also huge competition. The relatively strong financial status suggests that Qantas has relatively strong execution ability. The way to further increase its competitive advantage can be through strategic moves, such as to acquire or takeover small airline companies.
The things that investors now need to pay attention, however, are not its operation ability. Qantas has two major issues. First, the oil price is expected to rise, which can negatively affect firm profit. Second, Qantas is overvalued based on the Graham number and the Cash flow discount approach – the conservative case. Based on the above analysis, my recommendation about Qantas is “sell”.