Virgin Blue Warning Highlights Change In Industry Dynamics

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This story features QANTAS AIRWAYS LIMITED.
For more info SHARE ANALYSIS: QAN
The company is included in ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Chris Shaw

Warren Buffett is well known for his investment prowess and one rule he has long stuck by is to never invest in airline stocks. This was forgotten in the Australian market last year as a privatisation bid for Qantas ((QAN)) almost got across the line but those who didn’t take advantage of the share price at the time are now sitting on an investment worth substantially less.

Virgin Blue ((VBA)) shareholders have a similar tale of woe following Friday’s downgrade to earnings guidance from management, which has prompted some harsh reactions to the news from securities analysts covering the stock. The company has indicated normalised net profit for FY08 is now likely to be somewhere around $140 million, UBS noting this compares to its recently revised forecast of $182 million and market consensus of around $200 million. UBS believes the revised forecast suggests the company will be doing well to simply break-even in the current six months.

To reflect the new guidance brokers have slashed earnings estimates, UBS taking 24% from its FY08 estimate and 36% off its FY09 numbers, while Merrill Lynch has dropped its estimates 27% this year and a whopping 78% next year. Other cuts are also sizable, with JP Morgan lowering its numbers by 40% both this year and in FY09 and ABN Amro dropping its numbers by 40% and 85% respectively.

The downgrade to guidance reflects the combination of higher fuel costs and increased pricing pressure in the Australian market, where competition has intensified of late with Jetstar becoming more aggressive and Tiger Airlines entering as well.

Higher fuel prices mean earnings risk is to the downside, UBS noting it has factored in a 26% increase in fuel costs for the remainder of this year and a 17% rise in FY09 but this is based on an average oil price of US$79 per barrel, which compares to current prices of well over US$100 per barrel.

For Virgin Blue specifically the reduced earnings outlook means cuts to price targets, the FNArena database showing the average price target has fallen to $1.11 from $1.57. The change reflects the impact on earnings, UBS noting its valuation on the stock has dropped to $1.00 from $1.60.

Ratings have followed the price target down and Merrill Lynch has switched from Buy to Sell on the stock on the back of the revised outlook, citing the combination of start-up losses as the group attempts to expand into international routes and the cost of funding its capex requirements as reasons why there is little in the way of positive share price news likely in the medium-term.

UBS and Deutsche Bank also downgraded their ratings, the former to Sell from Neutral and the latter to Hold from Buy, the FNArena database showing the company is now rated as Buy once, Hold three times and Sell twice. It isn’t only Virgin Blue that is impacted by the news though as major shareholder Toll Holdings ((TOL)) is suffering a corresponding earnings impact and Qantas is being found guilty by association.

Revised earnings for Toll have led Credit Suisse to cut its price target to $11.03 from $14.90, Citi to $10.00 from $11.00 and UBS to $10.20 from $11.00, while JP Morgan has lowered its earnings forecasts for FY08 by 16% and ABN Amro by 13%.

Of greater significance than the medium-term earnings impact of a lower contribution from Virgin though is the fact the company will now not be able to sell its stake in the airline until the cycle again picks up and this will impact on its growth strategy.

As UBS points out the fact Virgin Blue is still on the books means earnings will remain volatile and the company won’t have the financial capacity it would have otherwise had to expand into Asia, slowing down its growth outlook. JP Morgan agrees and suggests in the current environment Toll is not a medium-term growth stock even though it is being priced as one in the marketplace.

The broker confirmed this by downgrading its rating to Neutral from Overweight, a move matched by Merrill Lynch and ABN Amro. This leaves Toll as rated as Buy three times and Hold five times with an average price target of $10.51 now, down from $12.41 previously.

For Qantas the brokers have taken the view Virgin Blue’s issues are not simply company specific but are industry wide issues, particularly as Merrill Lynch notes yields across the industry have been in decline for several months. This has prompted some minor cuts to earnings forecasts across the market, though the positive as JP Morgan points out is Qantas’s non-fuel costs are now rising at a slower pace than for Virgin Blue, leaving it in the healthier position of the two.

As well there is the potential for positive news from the relaunch of the Frequent Flyer program, which according to Macquarie is likely to be enough to allow the company to offset the industry-wide earnings pressures. ABN Amro is not so sure and suggests the sweet-spot for the company from an earnings sense is now over, the broker last week cutting its rating to Hold from Buy. Overall the company is rated as Buy five times, Accumulate once, Hold three times and Sell once, with an average price target of $5.10.

Shares in the three companies are mixed in today’s trading, Virgin Blue trading slightly higher after yesterday’s sell-off and as at 11.00am being up 3.5c or 4% at 90.5c, Toll trading down 20c or 2.5% at $7.85 and Qantas changing hands 8c or 2.2% lower at $3.54.

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