Treasure Chest | May 29 2013
– Domestic pricing pressures to ease
– International alliances to provide benefit
– Currency-based sell-off overdone
By Greg Peel
“We recognise,” said CIMB Securities this morning, “that investing in airlines is not for everyone given the industry’s volatility”. Another way to look at airlines is as stocks you “might wish to date but would not want to marry”.
In other words, airline stocks can throw up terrific shorter term trading opportunities but from the longer term investment point of view, they’ve long been considered by many to be a bet to nothing.
A case in point is the performance of the Qantas ((QAN)) share price in May. It has fallen from $1.90 at the beginning of the month to $1.52 on yesterday’s close, down 20%. The simple driver has been the sharply falling Aussie dollar. The long period of above-parity for the exchange rate has encouraged Australians to take their holidays offshore, which has boosted earnings for Qantas International. Now that the Aussie appears to be correcting, presumably that demand will dry up, and once again the Gold Coast will be popular.
So currency plays a big part in an airline’s performance. So too does the price of jet fuel, which is linked to the price of crude oil, given fuel is an airline’s most substantial running expense. The quandary here is that if the global economy is strong, more passengers will take to the skies, but then the price of oil will also be strong, offsetting the benefit.
Over a period of decades, airline ticket prices have suffered from extreme price deflation. When I was a uni student, I used to catch the train to Queensland. The cost of an air ticket was way beyond my means. Nowadays, a ticket to Queensland can cost about as much as one night at the pub. Air travel is no longer something one saves up for. Competition and aircraft efficiencies have ensured you can fly to Bali for a little more than tuppence.
A point I am yet to hear cited but which I personally feel must have an impact is that of internet technology, and particularly download speeds. Today one can sit in an office in Sydney and “meet” with a client or colleague in Melbourne or London over the net, face to face, as easily as if you were in the very same room. Emergency dash to Hong Kong on the red-eye? Not necessary.
All of the above adds up to airlines not being a great candidate for the longer term investment portfolio. That does not, however, suggest airline stock cannot throw up compelling trading opportunities every now and again. CIMB acknowledges the industry’s “volatility”, and volatility equals trading opportunity.
CIMB feels the big sell-off in Qantas shares this month on the back of the weaker Aussie is overdone. The broker has been forced to reassess its currency forecast input and has also taken note of rival Virgin Australia’s ((VAH)) recent admission that business in the second half FY13 has been tougher than expected, and as a result has reduced Qantas forecast earnings by 47% in FY13 and 17% in FY14. But the broker feels the market is discounting the fact that while a lower Aussie may stymie outbound international travel, it should re-encourage inbound demand.
Unfortunately a lower Aussie increases the cost of US dollar-denominated fuel, albeit the airline does hedge its fuel costs, but fuel prices are actually down 11% since February, CIMB notes. Currency considerations aside, CIMB is expecting “material” earnings growth for Qantas ahead driven by a more favourable domestic operating environment and improvements in the airline’s International business. The Emirates alliance will contribute to upside.
Citi had ceased covering Australian airlines a while back but the broker has now returned to the fold believing FY14 will be a “watershed year” for the industry.
Citi expects current aggression in domestic leisure pricing between Jetstar and Virgin to subside in the next couple of months. Qantas is the one playing aggressor, so it’s in the company’s interest. At the same time, Qantas’ aforementioned international alliances will begin to provide upside. Structural changes to the international network in particular should encourage further share price re-rating back to fair value, says Citi.
Virgin will also benefit from its alliances, Citi acknowledges, and the airline’s acquisition of Tiger offers further advantages. But it will take some time to integrate Tiger and passenger perception of the previously poorly thought of discount carrier will need to be improved. It will be a big call to juggle this integration alongside growing Virgin Australia further into the corporate space and together this leaves “little room for error,” Citi suggests.
Citi has re-initiated coverage on Qantas with a Buy rating and an expected total return over 12 months of 47% to the analysts’ target price of $2.30. Of the two airlines, Citi believes Qantas has the “clearer path” to earnings valuation and upside, and should resume paying dividends in FY14.
Citi has reinitiated coverage on Virgin with a Neutral rating with an expected total return of 3.4% to a target of 45c. Another issue facing Virgin and thus investors is the low free float level of listed shares, Citi notes.
The FNArena database now shows six Buy and two Hold or equivalent ratings on Qantas with a consensus target of $2.03, suggesting around 28% upside. Virgin attracts five Buy and three Hold ratings with a target of 47c for 8% upside.
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