Qantas - fly but don't buy!

Qantas had little trouble maintaining altitude during the last year but the question now is whether there's turbulence ahead. On the available evidence we'd have to say 'yes'. As we mentioned on August 28 (More certain value elsewhere - $2.50), the year was completed with a surprising 20.7% rise in net profit for the year to June 1998 to $304.8m. A final fully-franked 7 cent dividend was paid pushing dividends for the year to 13.5 cent.

This is a very good result achieved amidst difficult conditions. The Asian economic woes hit international services and Qantas had to act quickly to reshuffle aircraft to new routes (South Africa and the US and Paris and Buenos Aires later this year). Meanwhile, its domestic operations performed very strongly, recording a 26.8% increase in EBIT with an improved traffic mix and better yields. 

Operating enhancements

With overall revenue up by only 3.8% to $7.8bn, Qantas had to work on its cost base to deliver such a result. Cost reductions, cost avoidance, productivity improvements and other revenue enhancements totalled a massive $475m for the year. A flow on from the strong result is a 9% fall in the company's gearing ratio to 40%, a real plus given the uncertain outlook facing the airline. On the other hand, EPS only rose by 13.5% due to the dilutory effect of the dividend reinvestment plan and the bonus share plan, although the discount on these has been removed and may help lessen the dilution from here on.

Interestingly, there was a degree of profit smoothing in this result which understates the bottom line by around $40m. Around $45m in redundancy costs and $44m in year 2000 computer systems compliance costs were treated as above the line expenses rather than abnormals - even though redundancy costs had been treated as abnormals in the first half, they were restated as normal operating expenses for the full year. Why would the company want to do this? Perhaps it just wants to be conservative but more than likely it's because it will help next year's result compare favourably with this year. Given that the Qantas' Chairman did warn that this result would be difficult to match in 1998/99, this makes sense.

Tough environment

Although you can make money from airlines from time to time, they're notoriously cyclical businesses. Airlines are capital intensive with large fixed costs and not much control over their operating environment. This can make revenue streams unreliable and goes some way to explaining why only a handful of airlines are consistently profitable.

It also explains why airline stocks tend to trade at a big discount to other industrial stocks and why they don't usually have high dividend payouts. In Qantas' case, the stock has the advantage of an attractive dividend yield although in the long run it's probably not sustainable.

All the Asian airlines and Air New Zealand are facing similar problems. More worryingly, they're coming up with similar solutions - more capacity to Europe and the US to capitalise on weaker domestic currencies. Price wars are already breaking out on European routes and unlike the Asian airlines, Qantas lacks the right size aircraft to fly to secondary European ports. It must also be regretting its decision to hand San Francisco traffic over to United Airlines.

The fact that the Qantas' Chairman signaled 1998 as being the top of the cycle is therefore no surprise. The company has held back some profits for the future but earnings momentum is flattening. Combine this with the region's economic woes and a softening domestic economy, we think that Qantas is the airline to fly but not to buy. When Asia shows signs of turning there's may be a case but until then stronger and more reliable earnings growth can be found in companies like Brambles. TAKE PROFITS/AVOID.