Grounded: keep away from airline stocks

Warren Buffett is not the only one who believes airlines are wealth destruction machines. Australian investors should not be tempted by Qantas or Virgin.

PORTFOLIO POINT: Don’t be tempted to get on board the wealth-destruction machines. A dollar invested in Qantas five years ago would now be worth 39¢; in Virgin Blue it would now be worth less than 24¢.

If you haven’t already heard what the world’s greatest investor Warren Buffett once said about the notoriously treacherous area of airline stocks (and Eureka Report has noted this before), you should hear it again before reading further: “I have a 1800 number now that I call if I get the urge to buy an airline stock. I call at two in the morning and I say; 'My name is Warren I’m an aeroholic.’ And then they talk me down.”

Recent industrial action at Qantas has highlighted the range of issues and risks confronting the aviation industry in Australia. From the destabilising strength of unions, to excessive executive pay, both sides of the argument have been voiced and confrontationally defended by each party. From an investor standpoint, however, it has given rise to the issue of shareholder rights, and the returns they are receiving for the support of their capital.

The Qantas share price was battered in the wake of the ongoing disputes. Virgin Blue’s share price benefited as investors speculated on the positive flow-on effects for Virgin. The question one should ask however is, what is the value of these companies, and am I paying a reasonable price for what I am receiving? Without a view on value, it is difficult to say whether something is “cheap” in an absolute sense.

As a value investor, I find that not only are airlines the sort of businesses investors should seek to avoid, they are currently well overpriced.

Similar to miners, airlines are capital-intensive businesses and tend to retain much of their profits. Where a company is growing and achieving high returns on equity (ROE), it is desirable to see management retain profits and invest in the business. This however is not the case with Qantas and Virgin.

Both Qantas and Virgin have displayed poor ROE on average over the past five years, being only 5.4% for Qantas and 3.6% for Virgin. Even if we were to normalise the return on equity figure, that is, attribute a value to the franking credits received by investors and account for any abnormals, these figures are still relatively poor.

Over the same period, $1 invested in Qantas would now only be worth 39¢ and $1 invested in Virgin Blue would be worth even less at 24¢. These figures are inclusive of dividends received over the period. In comparison, $1 invested in the All Ordinaries Accumulation Index would have remained flat at $1. (As at 31 October 2011)

Virgin Blue displays high net debt to equity at around 98% and while Qantas is lower, it is still towards the higher end of our preferred range for an operating business at close to 42% (As at June 30, 2011). Although net operating cash flows are strong, as mentioned earlier they are often reinvested in the business due to the high capex requirements leaving little for distribution to shareholders.

While some valuation methodologies may suggest airlines to be attractive at current prices in the short term, in the interests of long-term value creation Qantas and Virgin are not on the radar. We currently value Qantas at $1.36 and Virgin Blue at $0.27 (2011-12 forecasts).

Matthew Koroi is an analyst at Clime Group. Clime uses MyClime, its online stock valuation and research service, to determine the value of a stock and assist with their stock selections. For a free two-week trial to MyClime, click here.

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