Why Qantas Shares (ASX: QAN) Will Continue to Fly High

This article was originally published at MF & Co. Asset Management.

The skies are clearing for Australia’s flagship carrier Qantas Airways (ASX: QAN) as it continues to stand out from regional rivals. The Australian aviation icon has impressive cash generation, and record pre-tax profit and Qantas shares have risen more than 30 percent over the last 12 months.

However, the volatile fuel price and domestic opportunities could mean there is turbulence ahead for the Qantas stock.

About Qantas Airways Shares (ASX: QAN)

Qantas Airways operates its airline business across dual brands – Qantas and Jetstar. Both of the brands are the core of group’s portfolio strength.

Australian domestic airlines have a high level of concentration as it is dominated by two major companies: Qantas and Virgin Australia Holdings Limited (ASX: VAH).

With a market cap of $10.8 billion, Qantas towers over Virgin, which has a market cap of $1.98 billion.

Globally, Qantas Airways competes with Emirates Airlines, Cathay Pacific Airways (HK: 293) and Singapore Airlines Ltd (SI: SIAL) on Asian and European routes.

Profits Up Due to Strong International Margin and Customer Services

Qantas shares has a strong brand presence and extensive route networks across both flagship and low-cost carriers. With the highest international passengers, the airline has strong international margins and constantly outperforms its peers.

Slow capacity growth is easing competition for Qantas Airways on international routes, while the price war in the aviation industry prompts the focus on cutting costs to match Asian and Middle Eastern airline operators.

Figure1: International Passengers by Major Airlines in 2017

Qantas Shares (ASX QAN)

Qantas Shares (ASX QAN)

Source: https://bitre.gov.au/publications/ongoing/files/International_airline_activity_FY2017.pdf

In the domestic market, Qantas shares has a high chance of winning the fight for market share in the long-term. Additionally, a reputation of exceptional customer service continues to win over customers, and the Qantas Frequent Flyer loyalty program worked to increase revenue by 3.5%, to $1.5bn, with underlying EBIT up 7%.

Fleet Renewal is An Inevitable Hurdle for Qantas

As other international competitors continue to invest in new aircraft that are safer, more fuel-efficient and provide enhanced levels of passenger comfort, Qantas needs to keep up with its competitors.

Given Qantas’s older fleet and large international exposure, it is inevitable that there should be an increase in aircraft investment in the future. According to S&P Global ratings, shareholder returns of Qantas may need to be reduced to pay for the fleet renewal.

The oligopoly of aircraft suppliers (including ) continues to weaken the bargaining power of airline companies, resulting in high purchase prices.

Despite the substantial fixed costs on fleets, high capital intensity featured within the aviation industry could benefit major players like Qantas for building high barriers to entry.

Soaring Passenger Growth Could Partly Offset Rising Costs

Pressure on yields remains as competitors mount significant capacity in key markets with aggressive pricing.

Recent volatile fuel prices have exacerbated the challenging market conditions. If the increase of prices continues, Qantas could mitigate 50% of rising crude oil costs in 2018, which is lower than 80% in 2017.

Trends in fuel prices and investment in new aircraft pose potential risks to the future earnings for Qantas unless the increasing demand makes up costs.

IATA recently increased its expected forecast for the 2018 aviation industry net profit to $38.4 billion due to strong demand, increased efficiency and reduced interest payments. The demand for air cargo is strong, and passenger numbers are projected to rise to 4.3 billion in 2018. Qantas has benefited from the strong growth trend in 2017 and 2018, with international capacity expected to increase by 3% in spite of the domestic earnings squeeze.

Sizable Margin and ROIC For Qantas While Trade at A Discount

Qantas shares currently is trading at 11.42 times the forecasted earnings, far cheaper than its domestic and international competitors.

Moreover, ASX QAN shares has a sizeable margin advantage over its main competitors with a profit margin of 6.53% mainly due to cost-cutting initiatives.

The net free cash flow of $772 million in FY17 is 2.7 times higher than FY16, which indicates there is room for ASX QAN shares to cut prices and remain profitable.

Return on invested capital (ROIC) as Qantas’ primary financial measure is 18.93% in FY17, surpassing Singapore Airways at 4.11% and Virgin at 1.09%.

While the Qantas stock Price-to-Book ratio (P/B) is two times higher than its competitors, the discrepancy of ROIC and P/B may be partly due to Qantas’ rising fleet age. As D/E ratio of 136.67% is reasonable amongst peers, the above average ROIC of Qantas stock was generated from its capacity to increase profit without a massive debt burden.

  Qantas (ASX QAN) Singapore Airlines (SI SIAL) Cathy Pacific (HK 293) Virgin Australia (ASX VAH)
P/E 11.42 22.02 111.90
Profit Margin 6.53% 2.42% -1.29% 0.34%
ROIC 18.93% 10.30% -2.16% 7.32%
D/E (gearing) 136.67% 78.57% 208.20% 154.61%
P/B 3.06 0.91 0.86 1.29

Qantas Stock Will Deliver Solid Performance Amid Industry Challenges

Qantas stock has stabilised its yields amid challenges including volatile oil prices, government subsidisation of competitors, and large fixed costs. The strong international margin for the airline offsets the turbulence in the domestic market and outpaced aviation industry. Together with Qantas’ balanced capital structure, its returns will be sustainable over the long run.

Henry Fung is a Partner Managing Director and co-founder of MF & Co. Asset Management. He is a highly experienced equities, derivatives and financial markets professional with over 12 years of experience. Henry specialises in building trading algorithms & systems, quantitative & qualitative analytics across macroeconomic, fundamental and technical disciplines and currently runs the MFAM VPAC AU/US models portfolios.  The management Partners and Adviser team have decades of experience between them, with experience from major Investment Banks and Brokers. Their Advisers are highly experienced, having dealt with some of the wealthiest clients in Australia.

Categories: Australian Stocks, Featured

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