AirAsia 2Q17 core profits stronger than headline. Proposed reorganisation is positive step forward

AirAsia (AIRA:MK) Fair Value: M$3.40
AirAsia (AIRA:MK) Rating: Outperform

29 August 2017, Malaysia – AirAsia (AIRA:MK)’s 53% y/y decline in net profit to M$147m in 2Q17 (on a pro-forma basis) masks the marked improvement in its core operating profit. The Proposed Internal Reorganisation of AirAsia Group and backdoor listing of Indonesia AirAsia are positive developments. Here are our key takeaways:

Strong core profitability in 2Q17

At the operating level, AirAsia Group’s financial performance was good in 2Q17. Net operating profit (after taking into account net finance costs) surged 59% y/y on a pro-forma basis in 2Q17 even though fuel prices have risen this year and most competitors’ profits have fallen, mainly driven by the 37% y/y decline in maintenance costs. AirAsia’s net profit shrank 53% y/y on a pro-forma basis mainly because of the M$212m deferred tax charge booked by Indonesia AirAsia after it participated in the Indonesia Tax Amnesty Program which is one-off.  Excluding this adjustment, net profit rose 18% y/y to M$352m on a pro-forma basis and core profit margin fell 3ppts y/y to 15% in 2Q17 based on our estimates which is commendable considering that fuel costs rose 30% y/y.

Results in line with our expectations

1H 2017 net profit of M$724m amounts to 49% of our full year net profit forecast of M$1.5B, we therefore maintain our current earnings estimates.  Note that AirAsia’s share price has risen 13% and outperformed the KLCI by 13% since we initiated research coverage on the stock on 31st May 2017 with Outperform rating and fair value of M$3.40. Our forecasts are 15% above consensus average estimate and we expect the Street to revise up their earnings estimates for AirAsia.

AirAsia (AIRA:MK) Initiation Research Report 2017 – Cost Leadership, Extensive Network & Strong Branding

Proposed Group consolidation is a positive step forward

The Proposed Internal Reorganisation of AirAsia Group, with one holding company directly controlling the 6 airlines (AirAsia Malaysia, Thailand, Indonesia, Philippines, Japan and India) in operation (and possibly another 2 in Vietnam and China) plus the related businesses will help streamline and centralise the business functions and potentially optimise aircraft utilisation. Management expects to reap cost savings of US$45m by the end of 2018.

The reverse takeover of Rimau Multi Putra Patrama (CMPP:IJ) helps to expedite the long overdue listing of Indonesia AirAsia

Indonesia AirAsia has targeted for IPO for numerous years and a backdoor listing expedites this process and will enable Indonesia AirAsia to gain direct and broader access to financing and grow more quickly in the longer term. Management guides that the total gain from the transaction will be around M$230.4m (M$207.5m reversal of impairment that was previously recorded plus M$22.9m forex gain). Our key concern is that Indonesia AirAsia’s target to double its aircraft fleet by 2020 seems too aggressive as it has had a weak financial track record so far and only started to turn profitable in 2016.

Ancillary income per passenger was M$49, up 6% y/y, contributing 20% of total revenue

 This, along with rebound in average fare (+10% y/y to M$177) and higher passenger load factors (+2ppts y/y to 89%), helped to lift AirAsia’s revenue per ASK (RASK) by 11% y/y in 2Q17. Excess baggage fees continue to be the largest contributor at 49% of total ancillary income. Management targets M$60 per passenger.

Chart: AirAsia’s ancillary income contribution (2Q17)

Chart: AirAsia’s ancillary income contribution (2Q17)

Unit cost ex-fuel reduction in 2Q17 is a positive development, following its sharp rise in 1Q17

Unit cost per ASK rose 5% y/y, mainly driven by higher fuel costs but unit cost excluding fuel fell 2% y/y in 2Q17. AirAsia still has the lowest cost structure in the airline industry with unit cost excluding fuel of US$0.0191 which is its biggest competitive advantage.

Well-protected against fuel price volatility for the full year 2017 

AirAsia has already hedged 78% of its 2017 fuel requirements at an average price of US$60/bbl jet kerosene (84% at US$60/bbl for 3Q17 and 79% at US$61/bbl for 4Q17) and 15% at US$61/bbl for 1H18 so far. This will reduce AirAsia’s earnings risk should fuel prices spike up more significantly. The fuel hedges have also been locked in at favourable rates compared to the current and ytd average spot jet fuel price of US$62/bbl and US$61/bbl respectively.

Planned capacity growth will accelerate this year so yields need to be carefully managed

AirAsia Group plans to add 22 aircraft in 2H17, raising its fleet size to 201, implying a 17% y/y increase for the full year. This is a marked increase from its average Group fleet growth of only 4% per year in the past 3 years, mainly driven by its expansion plans in AirAsia India and AirAsia Japan. Excluding these two carriers’ expansion, AirAsia Group’s planned fleet growth is a more moderate 5% y/y in 2017. AirAsia Group’s longer term planned fleet capacity growth is 8%-10% per annum.

International routes are main growth opportunities

AirAsia’s main growth opportunity will be on international routes for its joint venture airlines in India, Indonesia, Philippines and Vietnam as dominant and highly cost competitive domestic low cost carriers are already present in these markets. Low cost carrier market penetration remains relatively low in Japan and China; they therefore offer large untapped domestic and international markets for AirAsia Group. However, the key challenges are the competitive incumbent airlines with strong financial backing, vastly different cultures and regulatory framework. In addition, AirAsia’s management resources may be spread too thinly given its large number of geographically spread-out joint venture airlines.   

Thailand and India more disappointing

Thai AirAsia’s operating profit margins halved to 5% in 2Q17. The 5% y/y decline in average fare is the key disappointment as the number of passengers carried rose 13% y/y. Unit cost ex-fuel also rose 3% y/y. AirAsia India’s losses widened 20% y/y to INR244m in 2Q17 notwithstanding the 89% y/y surge in the number of passengers carried and 2% rise in average fare as unit cost ex-fuel rose 13% y/y. If unit cost continues to escalate resulting in further losses, AirAsia India may require further capital injection to fund its expansion.

Financial leverage has risen q/q

AirAsia’s net debt-equity rose to 1.35x at the end of 2Q17 from 0.93x at the end of 1Q17. AirAsia generated positive free cash flow of M$351m but paid out M$401m dividends in 2Q17. Management still targets to further unlock value in the Group over time. However, this needs to be balanced against the future capital requirements of the newly formed joint venture airlines AirAsia Vietnam, AirAsia China, AirAsia Japan, AirAsia India, as well as AirAsia Indonesia, AirAsia Philippines, AirAsia Thailand and AirAsia Malaysia.

25% of AirAsia’s US dollar borrowings are unhedged

All of AirAsia’s US dollar loans for aircraft have either fixed interest rates or have interest rate swaps in place. AirAsia has also hedged 50% of its USD operating expenditure until Dec 2017. This will help reduce the negative earnings impact on AirAsia should the Malaysian ringgit weaken again and/or interest rates rise. 

Note: Stocks with upside of more than 10% based on our fair value are assigned an Outperform rating. Stocks with downside of more than 10% based on our fair value are assigned an Underperform rating. Stocks with upside or downside of less than 10% based on our fair value are assigned an In-line rating. These are Crucial Perspective’s proprietary rating classifications and by no means serve as investment recommendations.

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