Big airline stocks have further to fly
There are many reasons not to buy aviation stocks. Large airlines need huge capital investment, have expensive, depreciating assets and no sustainable competitive advantage. Their return on equity (ROE) has collectively been low and volatile.
Then there’s the vagaries of weather, safety incidents, plane crashes and terrorism fears. Hardly the stuff of dependable, recurring earnings growth that drives ROE higher, expands the airline’s intrinsic value and ultimately rerates the share price.
Some good judges I know avoid airline stocks. But every company has its price and some airlines, notably Qantas Airways, are rapidly improving and still look OK value. Even Warren Buffett, a noted critic of aviation stocks, started buying airlines again last year.
Qantas has delivered a 78% total return (including dividends) over 12 months, making it one of Australia’s great corporate turnarounds. The company was on its knees a few years ago before management orchestrated a defining transformation program.
In contrast, Virgin Australia Holdings continues to disappoint. The one-year total return is minus 15%; over 10 years Virgin has an annualised loss of almost 20%. Virgin, at least, rallied in the past few weeks, prompting speculation of a nascent recovering.
Micro-cap airlines are also recovering. Mining services group, Alliance Aviation Services, has a 47% one-year total return, having soared in the past few months after a period of heavy falls. Alliance is benefiting from a pick-up in resource sector activity and higher aviation demand in remote areas.
Regional Express Holdings (REX) is also benefiting from better resource sector activity. After a difficult few years, the regional airline has delivered a one-year total return of 53%. But the stock had flat return over five years and a slightly negative return over 10.
Across the Tasman, Air New Zealand has soared 93% over one year. The airline’s latest full-year result slightly beat market expectation. Like Qantas, Air New Zealand is in its best shape in years thanks to a good strategy and strong management execution.
Airline bears, for the most part, have missed a mighty rally in the past 12 months. In a sluggish economy, investors expected a more subdued performance from the cylical aviation sector. But they underestimated the turnarounds in Qantas and Air New Zealand.
How high can airline stocks fly?
The question now, is whether the rally can continue. Although recent gains impress, some airlines are still trading well below multi-year highs and have much ground to make up after earlier disappointments this decade. The rally could run further.
I preferred to play the aviation theme through airport stocks rather than airlines. Readers of the Switzer Super Report know Sydney Airport was one of my favourite stocks for years (though it looks fully priced, for now). The boom in in-bound tourism is a mighty tailwind for Sydney Airport and, increasingly, for domestic airlines that benefit from extra travel activity.
Longer term, investors are underestimating four factors with airline stocks. The first is the purchasing power and preferences of Millennials (born between 1983 and 2000). The Millennials are travelling far more than previous generations, much earlier in their life. This demographic change is a key driver for airlines, but analysts don’t seem to be factoring it into valuations.
The second is the potential for disruption through frequent-flyer programs. I wrote favourably about Qantas’s program for this report in 2014, arguing that it had a lot more latent value than the market realised. Analysts who argue airline stocks have no competitive advantage underestimate the power of giant frequent-flyer programs. Who needs Bitcoin when Qantas frequent-flyer points are Australia’s de-facto second currency?
The third factor is the pick in the mining sector. The fluorescent shirts that dominated regional airports at the height of the mining boom, thanks to fly-in, fly-out workers, are starting to return. It’s nothing like boom-time conditions, but there’s enough to suggest regional aviation demand is slowing improving, giving a fillip to airlines.
The final factor is management. For years, investors marked down global airline stocks for poor management. Qantas’s executive team has done a terrific job in a difficult sector that is highly unionised and regulated. Qantas’s ROE averaged about 4% for the five years to 2013. The current ROE is about 26%. A management premium in the valuation is warranted.
When choosing airline stocks, stick to the big players. Speculators might focus on Alliance Aviation; it looks undervalued as mining service conditions improve. But most investors should stick with Qantas and Air New Zealand.
Qantas
The Qantas FY17 result, released last week, slightly beat market expectation. Underlying profit before tax, $1.4 billion, was the second highest in the company’s 97-year history.
A highlight was 6% growth in domestic revenue and 5% in international revenue in the fourth quarter. That suggests Qantas is capitalising on a pick-up in airline demand and benefiting from good capacity management, cost control and plane yields.
A share buyback of up to $373 million suggests Qantas is confident in its outlook and news of direct flights to London and New York is another positive. But the shares fell about 7% on the profit as brokers speculated on weaker domestic travel demand and challenging international travel conditions. I suspect some investors were itching to take profits.
The sell-off is good for prospective investors. At $5.61, Qantas trades on a forecast price-earnings (PE) multiple of 10.7 times FY18 earnings, consensus analyst forecasts show. That is undemanding for a company of its quality and just below the global average for airline stocks of about 11 times. As one the world’s most profitable airlines, Qantas arguably should trade at a small premium to the average multiple for global airlines.
A consensus price target of $6.20, from broking firms that cover Qantas, suggests the stock is undervalued at the current price. I’m expecting Qantas to recover recent losses, and then some, within 12 months. A share price approaching $7, based on rising earnings and a slightly higher valuation multiple, would not surprise. The caveat is oil prices not racing higher.
Chart 1 – Qantas Airways (QAN:ASX)Source: nabtrade (as at 31 August 2017)
Air New Zealand
The prominent airline, dual listed in Australia and NZ, delivered a solid FY17 result that led to some broking firms upgrading recommendations and price targets.
Profit before tax of NZ$527 million was slightly ahead of market expectation. A final 11 cent per share dividend was 10% up on the previous corresponding period.
It was a good result given rising competition in international aviation and one that creates confidence in Air New Zealand’s medium-term prospects. The company said it is “optimistic” about overall market dynamics and expects to improve on 2017 earnings. A higher dividend is perhaps the best sign of management’s confidence.
Air New Zealand ticked plenty of boxes with its operational performance. Costs were well managed, and aircraft utilisation and yield were solid. Rising demand for outbound travel from New Zealand to Bali and Pacific Islands is another tailwind.
Like Qantas, Air New Zealand has an excellent market position, prominent brand and improving customer experience. It also has rising return on invested capital (15.3%). Both tran-Tasman airlines have come through their transformation program better than the market expected.
At NZ$3.55, Air New Zealand trades on a forecast FY18 PE of around 10 times, according to consensus analyst forecasts. Like Qantas, Air New Zealand is valued below the global airline PE average, despite its improving operational performance.
The consensus price target of $3.55, based on the average of six broking firms, suggests Air New Zealand is fully valued at the current price. The stock can do better than the market expects as it uses gains in FY17 as a strong platform for growth in the next few years.
Macquarie Equities has a $3.90 price target and upgraded its recommendation from neutral to buy after Air New Zealand’s FY17 result. That looks about right.
