Oz Airlines Flying Too High

This story features QANTAS AIRWAYS LIMITED, and other companies. For more info SHARE ANALYSIS: QAN

– Consumer sentiment slump hits airlines
– Market over-optimistic of earnings rebound
– Travel service companies taking off

By Greg Peel

The latest data from the Australian Bureau of Statistics showed short-term international departures from Australia in May were down 4.5% on April, seasonally adjusted, and the annual growth rate to May fell to 6.6% from April’s 7.0%.

Goldman Sachs points to the sharp, budget-related fall in consumer sentiment in May and subsequent failure to rebound in June as an argument to support lower travel demand. This has created a challenge for Australian airlines, as has ongoing aircraft capacity growth from Middle Eastern and South East Asian carriers servicing Australia.

Bell Potter nevertheless points out that there is on average a three-month lag from when a booking is made to when a passenger departs, hence the weaker departure numbers evident in May reflect bookings made earlier in the year or even late last year. This would suggest departure numbers are destined to fall further from here, assuming weak consumer sentiment in May-June translates into lower bookings for three months hence.

Bell Potter suggests this weakness should ultimately prove transitory, however, as history suggests consumers tend to adjust their expenditure patterns quickly after such sentiment shocks.

We note that Westpac’s July consumer sentiment survey, released yesterday, does not suggest evidence of any meaningful return to consumer spending in the short term. The 1.9% increase in July takes sentiment only to 2% above the May level, which represented a 7% fall from April. Sentiment is sitting 14% below its level of last November, when people were actually excited about an Abbott government, and 10% below the 2013 average.

While consumer sentiment provides a guide to holiday travel, Morgan Stanley can see little growth in corporate travel ahead either, be it international or domestic. Australian corporates, and indeed corporates across the world, remain very heavily focused on cost reductions as a means of supporting earnings in a challenging environment while continuing to deleverage in the wake of the GFC. On the domestic front, the peak in mining construction also means a peak in FIFO construction workers, and as mining companies join the cost-cutting spree, a peak in FIFO mine workers. There will continue to be less F going on, and less so again as the big LNG projects begin to reach completion over the next few years.

This writer has never heard mention of this in airline analysis but I have long assumed one of the biggest additional threats to airline ticket sales is the internet. Specifically, the exponential improvement in face to face communication afforded by faster and broader broadband. Time zones notwithstanding, corporate meetings can be held with offshore executives or clients on screen as if they were in the room, undermining the need to fly half way around the world to achieve the same result. Even family members can catch up cheaply on platforms such as Skype, also undermining the need for expensive air travel.

I would therefore suggest that when one lists downside risks to Australian airline and travel-related stocks, the NBN should be included.

A glance at one-year chart indicates Qantas ((QAN)) has rebounded out of the depths of its annus horribilis, which culminated late in 2013 with the infamous grounding episode. The market has assumed things could not possibly get worse, and a subsequent end to the internecine race between Qantas and Virgin Australia ((VAH)) to increase capacity has provided support to this assumption. But Morgan Stanley believes the market is too optimistic, citing the aforementioned cost-reduction and resource sector headwinds.

Indeed on Morgan Stanley’s analysis, 12-month forward multiples for Qantas and Virgin are 20-30% “expensive”.

Within the sector, Virgin continues to take market share away from Qantas, the broker notes. Forward booking numbers suggest this trend is ongoing. While this should suggest a preference for Virgin over Qantas, all else being equal, Morgan Stanley wonders just what it is costing Virgin to facilitate these market share gains. The company is thin on capital and is not expected to reach breakeven on free cash flow until FY17. Virgin’s share register is tight, so there is some price support inherent, but the broker will not rule out another capital raising being required.

Morgan Stanley is not prepared to wait until the upcoming earnings result season to assess if its assumptions prove correct (QAN August 28; VAH August 29). The broker has downgraded Qantas to Underweight, and is maintaining its existing Underweight rating on Virgin.

Deutsche Bank maintains Hold ratings on both stocks, while noting domestic passenger growth has lagged its long-term average since December 2012. Yet forward fares for domestic travel are trending upward in July and into August.

The broker suspects that having called a truce in the capacity war, the airlines also see price wars as destructive and would rather keep ticket prices more stable while shifting volatility onto load factors. That said, Qantas still enjoys an average 30% price premium over Virgin in economy class and 20% in business.

The challenge now for the airlines, within an otherwise challenging environment, is getting these price increases to “stick” with passengers.

The Australian travel sector as a whole does not consist exclusively of two airlines but includes travel agents, corporate travel managers and travel insurers. These businesses do not care who you fly — Qantas, Virgin, Emirates or Aeroflot — just so long as you fly. Hence they are removed from any Qantas/Virgin woes but very much beholden to Australian consumer and business sentiment, the ups and downs of which have been discussed already in this article.

They are also beholden to market share, in their domestic markets and vis-a-vis global online peers. Morgan Stanley notes the locals are winning share from their offshore counterparts and are also more exposed to high growth in domestic small and medium enterprises. Agents are also benefitting from market fragmentation, the broker suggests, which is ongoing as Australian passengers turn more towards overseas carriers for international routes and low-cost carriers for domestic routes.

To that end, Morgan Stanley retains Overweight ratings on travel agent Flight Centre ((FLT)) and corporate travel solutions manager Corporate Travel Management ((CTD)).

Corporate Travel Management remains Bell Potter’s preferred stock in the sector as the broker is increasingly confident the company will deliver material earnings growth in FY15, driven by domestic market share gains and the incremental impact of recent acquisitions. The broker is nevertheless bullish on international holiday travel in general, given its expectation for a rebound in consumer sentiment, as noted above.

To that end, Bell’s top picks also include Flight Centre and travel insurer Cover-More ((CVO)).

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