This article aims to determine the current position of Air New Zealand Limited (AIR) within the industry, examine the major threats and opportunities and analyse its dividend payout policy. Then, the calculated intrinsic value of the share of AIR and its current market price will be compared. It will be supported by an investing recommendation and justification of the key assumptions made in the financial analysis of AIR and the peers.
Current position, threats and opportunities
Air New Zealand is the state-owned airline of New Zealand. The company provides regular/contract passenger and cargo transport services across 30 international and 21 domestic destinations. In terms of financial performance, AIR has been profitable for the last 14 years, distributing dividends for 86% of this period.
AIR has one of the strongest structural positions for an airline globally. With ~80% domestic market share, it built a significant international business across the whole Pacific Rim.
Table 1. Revenue distribution across geographical regions – Air New Zealand (2017)
It softened competitive threats through alliances and revenue sharing JVs (including Cathay Pacific, Singapore Airlines, Air China, United Airlines), lower cost capacity, and its brand positioning among higher yielding New Zealand travellers. Combined, the JVs now account for ~73% of AIR’s international capacity, and ~76% of its long-haul capacity. AIR also has a strong management team, which has executed well both strategically and tactically for an extended period of time.
According to Deloitte, airlines industry is perceived to be highly volatile and risky partially due to three major threats: fuel prices (and currency), demand side shocks and competitive forces (capacity). For AIR, the threats are similar: increasing oil prices, yet forward curve suggests risks to downside; deteriorating domestic consumer confidence, yet business confidence has recovered after the sharp post-election fall; demand shocks or a broader global slowdown. Competitors’ capacity has increased, with Virgin Australia raising the amount of flights across the Tasman region.
Nevertheless, airlines face strong structural growth as demand continues to increase. They improve their positions by consolidation activities, revenue sharing JVs (for which AIR has been a key advocate), better capacity management and new pricing strategies. For example, this March, AIR increased its charges for a range of ancillary services in response to the growing use of the low-cost carrier model. Finally, for AIR there is a capital-intensive opportunity to expand internationally, with the recent example of Chicago entry (Bradley, 2018b). Overall, AIR enjoys a strong growth potential overseas.
Comparison of the market share price and the calculated intrinsic value
The current market price as of May 12, 2018 is NZ$3.38, which is lower than the calculated intrinsic value of NZ$3.83 by 13%. The assumption of the annual growth for FY18-22 is 0.9% with WACC of 5.2%. Overall, the recommendation is to purchase the shares at the current market price as AIR is undervalued. The Graph 1 clearly shows the higher dependence of company’s share from its WACC and the lower dependence on the annual growth.
Graph 1. Sensitivity analysis (Tornado graph) – author’s calculation
Several key assumptions impacted the calculated intrinsic value of the share:
1) Dividend pay-out ratio (DPR): AIR has payed dividends for the last 12 years, having DPR of 1.38 in FY17. Due to increased competition, the company will need more resources and may attract investors with a high DPR. In FY18 it is estimated to be 0.95 (with probability of paying special dividends) with further stable DPR of 0.5 in FY19-22.
2) Operating revenue: AIR is growing its markets progressively and consistently subject to demand. New route to Chicago is expected to attract NZ$70 million to the NZ economy. On the established markets, e.g. the Tasman region, AIR and Virgin Australia hold ~55% market share, struggling to increase the shares. With rising demand, a 4.5% annual revenue growth is expected, which is still lower than in FY15-16 due to increased competition.
3) Operating expenditure (OPEX): scale benefits have been a key driver of cost efficiency improvements in recent years. This should continue along with capacity growth. The OPEX is expected to be 0.72 of the revenue in FY18-19, with further decrease to 0.7 in FY20-22.
4) Deprecation/PPE: there is an estimate of the -0.105, reflecting the delivery of new aircrafts in FY17 and lounge refurbishments.
Air New Zealand Dividend policy
Over the last 5 years AIR has had a high (>50%) yet unstable dividend payout ratio (DPR) due to the following factors: volatility of fuel prices and currency, fleet and lounges reinvestment programmes, macroeconomic factors and competitive forces. The average DPR was at an average of 60% for the period FY13-17, except for one outlier. In FY16 the DPR exceeded 100% to attract more investors and finance the fleet renewal program in FY17.
Discussion of stated pay-out policy
Following the policy, before distributing dividends AIR considers current earnings, the mid-term trading outlook, long-term capital structure (with a debt target of 45-55%), future capital expenditure and other macroeconomic factors. For instance, the significant decrease of dividend payout in FY17 reflected the earnings decrease, the increased competition and investments in the lounge refurbishment program. Therefore, it can be concluded that AIR’s payout ratio matches the current dividend distribution policy.
Other methods of returning capital
In FY13 AIR conducted an on-market share repurchase acquiring 3% of the ordinary shares as a part of recapitalization program. AIR also issued special dividends reflecting strong results of FY14 and selling a stake in Virgin Australia in FY16. Although, dividends have a tax disadvantage, they were issued to keep the target capital structure.
Comparison with peers
Asiana Airlines distributed cash to the shareholders via shares repurchases, while China Airlines and Qantas Airways had an irregular dividend policy combined with the shares repurchases. Singapore Airlines regularly payed out dividends with a high DPR of 65-70% due to zero tax rate on dividend distribution in Singapore. Overall, the peers had a higher average DPR in FY13-15 due to Singapore Airlines’ contribution and lower DPR in FY16-17 due to the record earnings of AIR.
Table 2. Dividend payout ratio – Bloomberg (2018)
|FY 2013||FY 2014||FY 2015||FY 2016||FY 2017|
|12 Months Ending||06/30/2013||06/30/2014||06/30/2015||06/30/2016||06/30/2017|
|AIR NEW ZEALAND||48.6%||84.8%||55.0%||109.1%||61.7%|
|Net annual change||74.4%||-35.1%||98.2%||-43.4%|
|Net annual change||110.8%||-62.3%||-30.3%||26.0%|
Compared to the peers, AIR provides substantially larger dividend yield. Along with the current strong performance, the market is likely to see a risk of this yield decreasing over the next several years due to the increased competition and macroeconomic factors in the region.
Table 3. Dividend yield – Bloomberg (2018)
|12 Months Ending||06/30/2017|
|AIR NEW ZEALAND||9.3%|
|1. China Airlines||2.1%|
|2. Asiana Airlines||n/a|
|3. Qantas Airways||2.4%|
|4. Singapore Airlines||1.9%|
Appropriateness of dividend pay-out policy
Given the data on AIR and the peers, it can be concluded that the dividend payout policy of the company is appropriate as of now. For the last two years, comparing to the peers AIR had a higher DPR and ROE, which could be accounted to the effective management of the retained earnings. Following the policy, AIR reduces the retained earnings as a part of total shareholder equity and, therefore, boosts the ROE.
Table 4. Return on equity – Bloomberg (2018)
|12 Months Ending||06/30/2017|
|AIR NEW ZEALAND||17.2%|
|1. China Airlines||3.9%|
|2. Asiana Airlines||24.3%|
|3. Qantas Airways||25.4%|
|4. Singapore Airlines||4.1%|
In conclusion, given the above analysis I propose a BUY recommendation on Air New Zealand. Nevertheless, there are several risks: debt-to-assets ratio over 35% due to the highly leveraged industry, increased competition, volatile fuel prices and macroeconomic factors. The strong domestic and international position with anticipated increasing customer growth ensure further capacity and revenue growth.
Analysis by Oleg Sennikov.