Wednesday 08 November 2017
Flying in the Jetstream: We think Qantas is still compelling
Wednesday 08 November 2017
Over the past 3 years Qantas’ share price has risen 360% - the top performer in the ASX100 over this time period (to 30 September 2017). Despite this, we still believe that Qantas is a compelling investment proposition due to the significant changes that have occurred to competitive dynamics in the industry over the last 3 years. The Australian domestic airline market has now become a healthy duopoly of two competitors, Qantas and Virgin. To understand Qantas, we also need to understand Virgin.
What matters: Airline Capacity versus Demand
For all the companies that we analyse, including Qantas, we focus our research on the 2-3 things that matter for each company. This ensures a targeted effort that drives the best research outcome. For Qantas the research is focussed on airline capacity versus demand, cost reduction programs, and fuel pricing.
In many ways, airlines can be analysed similarly to commodity supply and demand analysis. If there are too many planes flying on a particular route, airlines will struggle to fill seats on those planes, which affects revenue and profitability. Conversely if supply of seats is more closely matched to demand on a particular route, airlines gain pricing power as well as leveraging fixed cost base. The profitability of Qantas (and other airlines) is closely tied to this supply/demand balance. Each incremental passenger carried on a plane has a high level of profitability.
We can look at the largest domestic airline industry in the world – the United States - to see this correlation in action over the past 15 years (see chart below). Load factor is a measure of capacity utilisation – the proportion of seats on planes which are filled by paying customers.
Source: US Bureau of Transportation Statistics
The domestic industry has changed….for the better
“Investors have poured their money into airlines ... for 100 years with terrible results. ... It's been a death trap for investors” – Warren Buffett, 2013
That quote was from 2013, Berkshire Hathaway is now a $9bn shareholder of US airline stocks – the largest shareholder of listed airlines globally, so we are not alone in identifying these changing industry dynamics!
The increasing profitability of airlines in the US is a direct result of increased industry consolidation – leading to more rational pricing outcomes. The bankruptcies of the late 2000s led to the industry consolidating from 10 major players to 4 in the US. We can compare this structure to Qantas’ largest profit pool of the domestic Australian market. Qantas owns Jetstar, and Virgin owns Tiger – between them these two companies are close to 99% of the domestic market capacity. A better market than the US, you would think? But in reality profit margins have and do continue to lag behind that of the US airlines.
Despite only two players in the Australian industry – until 2014 Virgin had been expanding capacity rapidly. Overall capacity in the Australian domestic market increased nearly 70% between 2004 and 2014. This capacity expansion was driven primarily by Virgin. It grew from just two planes in 2002 to a 35% share of capacity in 2014.
However since 2014 we have seen zero industry capacity growth!
This is due to two key factors:
- Virgin now has “critical mass” in the domestic market. At 35% market share Virgin’s route offering is not dissimilar to Qantas – the main difference being the frequency of flights. It is now a valid competitor of Qantas.
- Virgin Shareholders are unwilling to contribute cash for further expansion. Capacity expansion ahead of demand was a proposition that required significant shareholder funds. Virgin shareholders have now expressed that they would like to see returns on their investments- i.e. profit!
These changes have been critical to the health of the Australian airline industry. As can be seen in the chart below we have been seeing load factors increase. Demand is catching up to supply. And with this we have also seen ticket price rises also. For every 1% rise in ticket price for Qantas, profitability increases by 8%.
Source: Australian Bureau of Infrastructure, Transport and Regional Economics (BITRE)
Journey beginning not ending
Despite the higher share price and profitability, we still believe there is further runway to go for Qantas. Virgin’s domestic business is still not at a sustainable level of profitability and has a large debt burden to reduce. We forecast pricing and load factors to increase further from what we have seen to date, based on what we have seen in the United States.
Load factors in Australia still remain in the high 70’s versus the mid 80’s for US airlines. Profit margins for Qantas are in the low teens versus high teens in the US. And finally Qantas’ forward valuation multiples remain lower than that of its US peers.
Still ascending to cruising altitude
Qantas has been a stock that has flown high, but in 2017 this stock remains a key investment opportunity. Our focus is on the structure of the domestic industry as a critical part of our investment thesis and we continue to see further opportunity for profit improvement and valuation upside.
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