As you know, I am a measured contrarian. The biggest money you make is buying the nadir of pessimism and selling/shorting the peak of euphoria. Of course, this isn’t a perfect science and is more about mass psychology, consensus analyst views, investor positioning, media/social commentary and momentum assessment.
In terms of contrarian buying opportunities, the key is to the pick the turn. Waiting for the knife to stick in the deep value floor is the key, then picking up that still vibrating knife.
The Qantas story
That brings me to QANTAS (QAN), where the stock has rallied 42% from its December 2013 low and 33% from its post-interim results lows in March 2014. I think that clearly shows you Qantas has found a deep value floor at $1.00 and the knife has finally stuck.
What interests me the most about Qantas is who has been buying the shares. Two deep value US funds now own over 25% of Qantas combined and the question then becomes what do they see that just about nobody else domestically sees?
They obviously see deep value in their modeling, but I suspect they see the US examples of how United Continental (UAL) and American Airlines (AAL) have traded out of bankruptcy protection/major loss making periods to be very strong performers on Wall St. The United Continental and American Airlines examples are relevant to Qantas, except I would suggest Qantas is two years behind the two big American carriers, which used bankruptcy protection/near death corporate experiences to accelerate the sustainable cost out program. Below is a chart of UAL, AAL, and QAN (blue line) on a common performance base over the last year.
Yes, I can hear you all saying “airlines are terrible companies” and “Warren Buffett says never buy an airline”, but Warren never said “never trade an airline stock”. Airline equities are GREAT trading stocks. They will probably never be truly investment grade, but they are GREAT trading stocks for multi-year periods. The US example shows you the alpha that can be generated when they turn and that is why I remain focused on Qantas as a trading idea.
To me, Qantas has all the attributes of other Australian deep value turnaround situations we have made money in. It has a great brand, arguably one of the most recognisable in the world. It operates in a domestic duopoly, while Australians will always have some form of home bias towards its international offering. The Frequent Flyer/loyalty business locks in customers. The group should and will be more profitable (note well – Qantas group top line revenue has been very stable for many years).
Earlier this week QAN announced they were ending the domestic capacity war with Virgin (VAH). This is another crucial step in the road to re-rating/ higher profitability. In fact, it’s arguably the most important step in the process to date. Similarly, Virgin confirmed they had reduced domestic capacity for the third straight month.
Australia is the land of cozy duopolies. In my time, I can never remember a more futile battle in an Australian duopoly than what QAN/VAH have done over the last few years. It was possibly the dumbest thing I have ever seen in a domestic duopoly. There was no winner, both sets of shareholders were major losers, but now we are finally seeing economic rationality prevail and that is a major development in the domestic aviation market.
Market share means absolutely nothing unless it’s profitable. What’s wrong with having a highly profitable 51% share of a cozy duopoly? Nothing, and Qantas stepping back from defending the 65% market share line in the sand, in my view, confirms that shareholders can look forward to better returns from the group. If anything, Qantas and Virgin should reduce domestic capacity and put up premium ticket prices. There’s an idea, none of us will be catching the Greyhound Bus to Melbourne no matter what you charge!
Just to remind you what Qantas domestic should earn, in the 1H of FY13 underlying EBIT was $218m versus the $57m reported at the February FY14 interim.
So domestic industry structure is getting no worse and should improve in terms of rational competition. Yields and load factors should rise. This is a good backdrop for Qantas to then focus on itself and make the necessary adjustments to its overall business model.
The CEO view
I have to say I did like Alan Joyce’s recent presentation at the Macquarie Group Conference. It was all focused on micro not macro, exactly like BHP Billiton now does. Focus on what you can control, run the business as hard as you can, drive better returns, be consistent in your message, then the share price will take care of itself.
I like the line “moving at pace” and I think the key forecast in the scorecard is “positive free cash flow from FY15 onwards”. Well, FY15 is a month away and estimates are QAN could generate $1 billion of free cash post capex in FY15 that sees them retire the equivalent debt load.
The momentum in the core airline is heading the right way. Fleet age is falling sharply, fuel efficiency is rising, fleet complexity is falling, maintenance costs are falling, full time employee numbers are dropping sharply, and it’s fair to say Qantas is now controlling its controllables. Better yields and load factors will follow.
Financial services play
But this is where I will now get a little controversial. Is Qantas a financial services company where you get an airline thrown in for free?
My view is that the US value funds which are moving up the Qantas register have focused on the stand alone value of the Qantas Frequent Flyer business and worked back from there to an assessment of what they are paying for the Qantas airline.
Yes, I realise Frequent Flyer needs the airline and the airline needs the Frequent Flyer business, but this is a valuation debate and I feel either the Qantas Frequent Flyer business is undervalued in the current Qantas share price, or the airline is, as it cycles earnings lows, or both.
Qantas Frequent Flyers/Loyalty is a high growth, high ROE, financial services company. It would arguably trade on 10x EBIT. In FY14, Qantas Frequent Flyer made $146 million of EBIT and will be on line to generate $300 million of EBIT this financial year. To my way of thinking, the stand alone listed value of that business is $3 billion.
Is $3 billion an outrageous valuation for a debt free financial services business with 9.8 million customers? It works out at $306 per customer versus CBA’s current market cap per customer of $23,000, and Qantas Frequent Flyer isn’t risking its capital lending to customers. (Unfair comparison, but you can see my point).
The current market cap of Qantas is $2.6 billion. The enterprise value is closer to $6 billion when you add on net group debt (and subtract cash), but that net debt is coming down. By the end of FY15, the Qantas balance sheet should show $2.4 billion of cash and $4.3 billion of total debt obligations. EBITDA should be over $2 billion, meaning debt to EBITDA ratio headroom increases. Qantas is not going broke, far from it.
I think the Qantas Frequent Flyer valuation underpins the Qantas share price at these levels and the airline business is effectively a call option. If I am right and international losses move to break even, the domestic business returns to appropriate duopoly profitability, and Frequent Flyer keeps growing, then value will be added to the Qantas share price for the airline business. It may be as simple as Qantas’ reduction in group debt being replaced by equity value growth in the enterprise value of circa $6 billion.
So, I maintain my view that Qantas is a “trading buy” after this week’s developments. Sure, it’s not for ‘widows and orphans’ (no dividends for the foreseeable future), but I can see a clear scenario where the stock trades up to $2.00 in the years ahead, generating significant portfolio alpha. Remember, it was around $2.00 in April 2013, so it’s not like I am making a monster call here in a trading stock. It’s also worth noting the two big US investors have tightened the Qantas register (top six shareholders own 52%) and the open short position is 58.2 million shares.
Go Australia, Charlie.
100% of Charlie Aitken’s fees for writing for the Switzer Super Report are donated to The Sydney Children’s Hospital Foundation.
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