Can Virgin Australia Turn Around?

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

-Load factor key to FY14 turnaround
-Domestic bookings improving
-Cash liquidity a concern
 

By Eva Brocklehurst

Virgin Australia ((VAH)) has made a last minute downgrade to FY13 guidance, now expecting a net loss. Results are expected on August 30. Brokers are still hopeful that FY14 will turn around, and industry statistics suggest, at the very least, the domestic market is stabilising. Still, a downgrade is a downgrade and a sign that Virgin Australia is struggling in a competitive market.

UBS is in line with FY13 guidance, for a net loss of $100m (guidance $95-110m). The profit guidance includes, as yet undisclosed, mark-to-market gains on fuel hedging and, depending on how much of this is deemed as below the line, this could result in a large underlying pre-tax loss. UBS has reduced future earnings estimates by 20%. FY14 is now expected to show a pre-tax profit of $80m. The downgrade wipes 10% off book value for UBS but of greater concern is cash liquidity. This is likely to fall to $250m, representing a slim 6% of forward revenue. Too low in the the broker's view. Downgrade to Neutral from Buy is the call.

Management has flagged a number of initiatives to unlock further liquidity such as securitising latent equity in the fleet. This is likely to take some time and heighten the sensitivity to earnings shocks. Of note, 67% of the share register is owned by strategic investors and this could provide investors with some capital protection as well as act as a source of equity if needed. Unit revenue is expected to expand at a greater pace than costs in FY14 and this should help turn things round. Costs contributing to the downgrade were transition to the Sabre booking system, transaction expenses relating to Skywest and Tiger and asset impairments. JP Morgan suspects many of these cost should have been known earlier.

CIMB thinks, while FY14 should be better for the industry as a whole, if management doesn't improve the load factor, the likelihood of another downgrade will increase. The broker thinks Virgin Australia dug a hole by chasing yield in the second half at the expense of maintaining a healthy load factor. This needs to be addressed to generate a profit in FY14. CIMB does expect the domestic load factor to improve to 77.5% from 75% and this should drive a pre-tax profit of $31m.

In the end, revenue quality needs to improve as well and, underpinning this, signs of stalbilsation in the domestic market. Virgin Australia has signalled a 6% rise in forward bookings and strong feed from alliances. Nevertheless, a deterioration in operating profits in such a relatively short time frame and pressure on costs as Australian dollar hedges roll off worries JP Morgan. The broker had expected a FY13 net loss around $2.4m.The risks are seen weighted to the downside now and the stock was downgraded to Underweight from Neutral.

Despite this setback, Credit Suisse believes the company still offers investors a structural growth profile in the Australian regional, leisure and corporate market. Trunk sectors are where Jetstar ((QAN)) is competing the most aggressively against Virgin Australia and likely where much of the load factor and yield weakness is concentrated. Credit Suisse maintains an Outperform rating. The broker is encouraged by the positive comments from management regarding further load factor improvement in July, the rise in forward domestic bookings and more normal FY14 capacity growth. That being said, should earnings continue to disappoint, the market's patience is expected to be sorely tested. Credit Suisse expects debt serving levels to return to more normal levels but, should planned transformation benefits not materialise, an equity raising could be on the cards.

Citi was the third broker on the FNArena database to downgrade the stock in the wake of the news – to Sell from Neutral. The increase in domestic yields is a positive but Citi thinks this is mainly driven by benefits of the new global distribution system. The broker believes Virgin Australia is still missing late, and high yielding, bookings, and this needs to be addressed. Citi is cautious on any recovery in FY14, given lack of visibility on the earnings profile and higher fuel costs. The best that can be said is that FY14 is dependent on a more rational domestic market and this is being seen. Nevertheless, for Citi, value exists elsewhere in the sector.

Challenges abound. These include improvements to the financial position of Skywest and coordinating the joint strategy with Tiger Air as well as the RASK (revenue per available seat kilometre) performance of the Virgin brand. Citi suspects, while the support of strategic shareholders indicates limited downside to the share price, the stock is unlikely to outperform the market. That's even in the event of a takeover, which the broker considers likely.

So what's the verdict? Take your pick. On the database there are three Buy ratings, two Hold and three Sell. The consensus target price is 45c, signaling 10.6% upside to the last share price. The range of targets is 35c to 56c.
 

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