Renowned value investor Warren Buffett described airline stocks as a “deathtrap for investors”. Many long term shareholders of Qantas Airways Limited (QAN) would agree. In the past ten years the QAN share price has fallen over 60 per cent, while the ASX 200 has increased over 50 per cent.
Figure: Qantas share price versus ASX200
Source: Google Finance
QAN operates in a challenging environment due to economic volatility, uncertain exchange rates, high fuel prices and intense competition.
In fiscal 2013, QAN recovered from a statutory loss of $244 million in fiscal 2012 to a statutory profit of $5 million. A positive result in contrast to competitor Virgin Australia Holdings (VAH) which recorded a full year loss of $98.1 million.
However, hopes of a sustained recovery were dampened at QAN’s recent AGM. Management said the airline continues to face a challenging operating environment and indicated fiscal 2014 would be worse than fiscal 2013.
QAN noted consumer confidence remains low at the leisure end of the market and the rise in business confidence following the election has failed to translate into any discernible increase in demand.
QAN expects group yields to decline in first half of fiscal 2014 by two to three per cent versus the previous corresponding period, as a result of weak underlying demand and competitive pressure domestically and internationally.
The pressure on yields is due to oversupply on key routes at the same time as weak demand. The September domestic passenger numbers from Sydney Airport highlight the weakness in demand for domestic air travel. This is a particular concern given stated seat capacity increases from QAN and VAH of 1.5 per cent to 2.5 per cent and three to four per cent respectively in fiscal 2014.
Figure: Sydney Airport Traffic Performance
Source: Sydney Airport Holdings Limited
QAN has drawn a ‘line in the sand’ with respect to retaining 65 per cent of the domestic market share, however this may be to the detriment of yields as VAH increases capacity at a faster rate.
Increased capacity on QAN’s Asian routes due to retaliatory behaviour from foreign carriers Singapore Airlines and Cathay - in response to the Jetstar Asia expansion - has increased pressure on yields and loads.
QAN faces strong competitive pressures domestically and internationally. VAH is a formidable competitor with the investment backing of international airlines Singapore Airlines, Air New Zealand and Etihad. VAH is challenging both the domestic business travel and leisure segments. In May VAH bought a majority stake (60 per cent) in Tiger Australia which competes against QAN’s budget airline Jetstar.
QAN noted its partnership with Emirates was off to an encouraging start and will be a key driver in helping QAN International to break even by FY15. However, strong competitor growth into Australia, in particular competition from Asian low cost carriers Singapore Air owned Scoot and Malaysian owned AirAsia, will challenge growth in the International business.
In first half fiscal 2014 group fuel costs will be $160 million higher versus the previous corresponding period - a record for any half year. A lower Australian dollar adds an additional headwind to the already high fuel costs.
We use an adopted normalised return on equity (NROE) of 7.5 per cent and required return (RR) of 17.6 per cent to derive a fiscal 2014 valuation of $0.48. This very large discount of NROE to RR means QAN’s intrinsic value is at a similar discount to forecast equity per share on 30 June 2014 of $2.63.
QAN is a low quality business trading significantly above valuation and not worthy of investment consideration. We expect strong headwinds will continue through FY14 as QAN battles a challenging operating environment due to a volatile economy, uncertain exchange rates, high fuel prices and intense competition.
Figure: QAN Price vs. Value Chart
Amelia Bott is an Equities Analyst at StocksInValue, a joint venture between Clime Investment Management, a value fund manager, and Eureka Report. StocksInValue provides valuations and quality ratings of 400 ASX-listed companies and equities research, insights and macro strategy. For an obligation free, FREE trial please visit www.stocksinvalue.com.au or call 1300 136 225.