More To Airlines Than Valuation Alone

This story features QANTAS AIRWAYS LIMITED. For more info SHARE ANALYSIS: QAN

– Valuation only one variable for airline stocks
– Moelis suggests a number of other factors are also important
– Stockbroker initiates coverage on both Qantas and Virgin Blue with Hold ratings

By Chris Shaw

For some time both Qantas ((QAN)) and Virgin Blue ((VBA)) have received favourable ratings from either a majority (QAN) or some (VBA) of the equity brokers in the FNArena database, in both cases because of evidence of valuation support relative to existing share price levels.

The database currently shows Qantas is rated Buy seven times and Hold once, while Virgin Blue scores three Buys, three Holds and one Underperform recommendation.

But as stockbroker Moelis points out, a number of recent market shocks such as ash clouds, floods, earthquakes and the potential for industrial action means earnings in the sector remain volatile. This suggests an airline stock being cheap on earnings based multiples should be only one factor driving any investment decision.

Other factors needing consideration according to Moelis include structural issues, the cost structure of the airline, macroeconomic drivers, earnings sensitivity and financial leverage. Moelis suggests structural issues include capacity increases coming at the expense of yields, an inability to pass on increased fuel costs and different regulations for airlines in different countries.

Fuel costs in particular have been an issue in recent years, as having been equal to about 10% of group revenues in 2000, fuel costs for Qantas have risen to about 25% of revenues in 2010. Moelis also notes in 1965 the lowest airfare from Sydney to London and return was equal to about 21 weeks wages, now it equates to around 1.7 weeks average wages. 

Over the same period, petrol prices have increased by 1,386%, while the same airfare has risen by just 44%. This is pressuring margins, as Moelis notes gross margins for Qantas for 2009 and 2010 were around 2%. This compares to an average gross margin of 7% over the past decade.

Moelis also points out airlines don't have the same economies of scale that other capital intensive businesses enjoy, as variable costs represent around 65% of total operating costs. This helps keeping earnings volatility high, the commodity based variables making forecasting earnings in the sector very difficult.

In terms of financial leverage, Moelis notes both Qantas and Virgin Blue utilise operating leases as a way to finance their fleets. If these leases are regarded as another form of financing, Moelis suggests investors need to incorporate these figures into coverage and gearing ratios. 

Looking at the Australian macroeconomic picture, the stockbroker suggests the outlook for the domestic airlines is mixed at best. Consumer sentiment and business confidence are both subdued, which implies some risk to spending on air travel.

With these factors being considered, Moelis has initiated coverage on both Qantas and Virgin Blue with Hold ratings. Respective price targets stand at $2.00 for Qantas and $0.31 for Virgin Blue, which compare to respective consensus targets according to the FNArena database of $2.60 and $0.39.

For Qantas, Moelis suggests the stock is attractive on virtually every valuation metric, the exception being free cash flow multiples. This reflects a current capital expenditure program, which will keep free cash flow in negative territory for the near-term.

Given this and a volatile earnings stream, Moelis doesn't see the stock being cheap on valuation metrics as justification for investment. This is especially the case in the light of limited earnings visibility given current forward rates and Qantas's hedging position.

This means shareholders are not getting the required return on capital to justify the investment risk. This is especially the case as while earnings for Qantas are expected to recover, Moelis suggests any recovery is likely to be fragile. In such an environment a Hold rating is seen as appropriate.

Looking at Virgin Blue, Moelis notes when the company first entered the Australian market its no frills business model delivered a genuine cost advantage. The subsequent advancement of the business model to a New World Carrier has increased complexity and costs, which has impacted on returns.

As well, while the current strategy utilising a virtual network has some merit, Moelis notes it remains untested at the customer level. This, and the leverage in place from operating leases, leads Moelis to suggest it is currently difficult to justify a Buy rating on Virgin Blue, especially without a well defined path to profits in FY12.

Shares in Qantas and Virgin Blue are mixed today, with Qantas trading up 0.5c at $1.82 and Virgin Blue down 0.5c at $0.275 as at 11.30am. Over the past year Qantas has traded in a range of $1.785 to 2.97, while Virgin Blue has traded between $0.265 and $0.48.

The current share prices imply upside to the consensus price targets according to the FNArena database of around 42% for Qantas and about 43% for Virgin Blue. 

 

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