Fair value: M$3.40
31 May 2017, Malaysia – We initiate coverage on AirAsia (AIRA:MK) with a fair value of M$3.40 and Outperform rating. AirAsia has one of the lowest cost structures globally which is its biggest competitive advantage and positions it well to leverage on Asia’s long-term air traffic growth of 7% per annum which is well-supported by the region’s rising per capita income and low travel penetration rate. It will be challenging for any other carrier to replicate AirAsia’s strong branding, geographical network and fleet size in the near term given its first mover advantage, economies of scale and well-established branding. AirAsia is one of the most profitable airlines in the Asia Pacific region and globally and its balance sheet has strengthened following its share placement in January 2017.
AirAsia’s company disclosure has also improved in the past year. The key risks are foreign exchange losses should the Malaysian ringgit weaken against the US dollar and management resources being spread too thinly across the multiple joint venture airlines, especially with the more recent establishment of AirAsia China, AirAsia Vietnam and AirAsia Japan. Start-up losses from these joint venture airlines could be a drag on earnings in the next 1 to 3 years and we expect most of the joint venture airlines to require further capital injections to fund their future expansion.
Chart: AirAsia Berhad – Crucial Perspective Scorecard (Full marks = 100 points)
Chart: AirAsia Berhad – Financial Summary
KEY POSITIVE DRIVERS for AIRASIA (AIRA:MK)
- One of the most competitive cost structures in the Asia Pacific region and globally which is AirAsia’s biggest competitive advantage. AirAsia Group’s unit cost and unit cost excluding fuel were US$0.0336 and US$0.0229 per ASK respectively in 2016.
Chart: Benchmarking Unit cost per ASK
Chart: Benchmarking Unit cost excluding fuel per ASK
- One of the most profitable carriers in the Asia Pacific region and globally. AirAsia’s net profit and EBITDAR margins rank ahead of other low cost carriers globally as well as major incumbent airline competitors in the region.
Chart: Benchmarking Net profit margin
Chart: Benchmarking EBITDAR margin
- Largest geographical coverage and network among all the Asian low cost carriers. It would be challenging for other carriers to replicate this given AirAsia’s first mover advantage and economies of scale.
- Strongest branding among the low cost carriers in Asia. AirAsia has the most well-established branding among the low cost carriers in Asia which enables it to gain customer traction more easily, particularly on international routes.
Chart: AirAsia: Social media influence
- Dominant market position in Malaysia and Thailand. We expect Malaysia and Thailand to remain AirAsia’s key profit contributors near term, helped by the AirAsia Malaysia’s and AirAsia Thailand’s 49% and 22% system-wide market shares respectively.
Chart: AirAsia Group’s market share (2016)
- We see more international growth opportunities for its newer joint venture airlines. We believe AirAsia’s main growth opportunity will be in 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 – IndiGo (in India), Lion Air (in Indonesia), Cebu Air (in Philippines) and VietJet (in Vietnam).
- Low cost carrier market penetration remains relatively low in Japan, China as well as the broader North Asian region at less than 10%. They therefore offer large and untapped domestic and international markets for AirAsia China and AirAsia Japan to grow. However, AirAsia is likely to face stiff competition in these markets given the strong financial position of the major incumbent airlines in these markets compared to ASEAN ex-Singapore where AirAsia first started.
- Further upside from ancillary income. Management targets to raise AirAsia’s ancillary income per passenger to M$60 in two years. Ancillary income contributed 20% of AirAsia’s total revenue in 1Q17.
- Unlocking of value from its divestment of Asia Aviation Capital. AirAsia could potentially distribute part of the sale proceeds related to AAC as a special dividend to shareholders. Management still targets to further unlock value in the Group over time, including the proposed IPO of AirAsia Indonesia, AirAsia Philippines and Asian Aviation Centre of Excellence (AACE) flight crew training centre. 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.
- Well-protected against fuel price volatility for the full year 2017: AirAsia has already hedged 80% of its 2017 fuel requirements at an average price of US$59/bbl jet kerosene and its full year average effective cost is expected to be around US$62/bbl in 2017. 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$60/bbl and US$63/bbl respectively.
- Reduced exposure to US dollar loans. 35% of AirAsia’s US dollar borrowings are unhedged. All of AirAsia’s US dollar loans have either fixed interest rates or have interest rate swaps in place. This will help reduce the negative earnings impact on AirAsia should the Malaysian ringgit weaken again and/or interest rates rise.
- Our Airlines Demand Supply Analysis expects air travel demand and supply growth to be better matched going forward, from supply growth (+10% y/y in 2016) surpassing demand growth (+9% y/y in 2016) to nearly balanced demand-supply growth of 9% in 2017. This could help ease industry yield pressure in the longer term. As per capita income continues to rise in the region, the Asia Pacific airline sector’s air travel demand is expected to grow 8% per annum in 2018 and 2019 and 7% in 2020 and 2021 based on our forecasts. This will outpace the industry’s capacity growth from 2018 onwards which will help to alleviate significant fare pressure in the industry and improve the Asia Pacific airline sector’s profitability over time. We summarize the airline sector’s demand-supply growth differential in each market in the Asia Pacific region below. For more details, please refer to our previous report: Airlines Demand Supply Analysis in the Asia Pacific
Chart: Asia Pacific Airline Sector Demand-Supply Growth Differential
KEY DOWNSIDE RISKS FOR AIRASIA (AIRA:MK)
- The sharp rise in AirAsia’s unit cost in 1Q17 is a concern. Unit cost per ASK rose 14% y/y while unit cost excluding fuel rose 9% y/y in 1Q17. This was mainly driven by higher pilot salaries, higher user charges, the one-off cost for RedQ and the weaker Malaysian ringgit. Management is targeting to reduce Group costs by US$45m (or M$193m) through various initiatives. AirAsia also expects to reap cost synergies (from joint procurement, shared back-office services) as the Group consolidates its various airlines.
- Capacity growth will accelerate in 2017 which could potentially put pressure on fares. AirAsia Group plans to add 29 aircraft this year, raising its fleet size to 201, implying a 17% y/y increase. 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. However, excluding these two carriers’ expansion, AirAsia Group’s planned fleet growth is a more moderate 5% y/y to 181 aircraft in 2017. AirAsia Group’s longer term planned fleet capacity growth is 8%-10% per annum.
- Foreign exchange losses should the Malaysian ringgit weaken again. AirAsia has more US dollar denominated costs than US dollar denominated revenue as well as US dollar debt (of which 35% are unhedged). There has historically been a negative correlation between AirAsia’s share price and the Malaysian ringgit.
Chart: AirAsia share price versus Malaysian ringgit exchange rate
- A restructured Malaysian Airlines and firefly as well as Malindo’s future expansion could raise competition risk and yield pressure at AirAsia’s hub in Malaysia.
- Traffic diversion to from air to rail when the Singapore-Kuala Lumpur hi-speed rail (which is expected to have a travel time of only 90 minutes which could provide a more convenient travel option for passengers considering the KL airport’s distance from the city centre) is scheduled to be completed in 2026.
- Indonesia, Philippines and Vietnam’s domestic markets could remain challenging for AirAsia Philippines, AirAsia Indonesia and AirAsia Vietnam to gain market share and improve profitability as they are not first movers in these markets and will continue to face stiff competition from dominant low cost carriers Lion Air, Cebu Air and VietJet which have first mover advantage and already gained dominant market shares in Indonesia, Philippines and Vietnam respectively.
- AirAsia Japan and AirAsia China provide large growth opportunities for AirAsia. 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. Predatory pricing from the incumbent airlines in China which have strong government support and deep pockets. More government subsidies and airport incentives would help to develop these start-up airlines.
- Most of AirAsia’s joint venture airlines may require further capital injections to fund their future expansion.
- Airport slot constraints at the major airports in Asia could impede AirAsia’s expansion near term.
- Implementation of IFRS 16 Lease Accounting standard will lift AirAsia’s reported gearing level. AirAsia’s financial position has strengthened with net debt-equity down to 93% at the end of 1Q17 following its recent share placement and improved financial results. AirAsia generated positive free cash flow of M$330m (or M$206m excluding the consolidation-related “acquisition of subsidiaries, net of cash” line item). However, the implementation of IFRS 16 will result in an increase in AirAsia’s reported net debt-equity due to the capitalization of its aircraft operating leases.
- Challenging to estimate deferred tax write-backs and charges which increase the volatility of AirAsia’s reported net profit numbers.
EARNINGS OUTLOOK FOR AIRASIA (AIRA:MK)
We expect AirAsia Berhad to report full year 2017 net profit of M$1.5B, down 28% y/y, mainly driven by higher fuel prices and non-fuel costs, delivering an ROE of 20%. Going forward, we expect AirAsia’s revenue to grow 6% per annum, reaching M$10.5B and achieving a net profit of M$1.1B (+7% y/y) by 2019. We expect AirAsia to continue to generate positive free cash flows averaging M$464m per annum in 2018-2019 which will reduce its net debt-equity position to 0.6x (or 1.0x adjusted net debt-equity after taking into account the capitalization of aircraft operating leases) by the end of 2019 and enable AirAsia to sustain long-term dividends averaging M$0.07 per share per annum, implying an average annual dividend yield of 2.4%.
VALUATIONS FOR AIRASIA (AIRA:MK)
We value AirAsia at M$3.40 which is based on our Gordon growth valuation model assuming 13% ROE, 9% cost of equity and 5% growth. This is well-supported by the M$3.6 fair value implied by our discounted cash flow valuation model, assuming long-term free cash flow of M$462m and WACC of 7% as well as the M$4.0 fair value implied by our sum-of-the-parts valuation model.
Chart: AirAsia Berhad – Gordon growth valuation model
Chart: AirAsia Berhad – Discounted cash flow valuation model
Chart: AirAsia Berhad – Sum-of-the-parts valuation model
CRUCIAL PERSPECTIVE FORECASTS FOR AIRASIA (AIRA:MK)
Chart: AirAsia Berhad – Profit & Loss Statement
Chart: AirAsia Berhad – Balance Sheet
Chart: AirAsia Berhad – Cash Flow Statement
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.
Disclaimer: The contents of this website are strictly for information purposes only. This website does not contain any investment, financial, tax, legal or insurance advice; you should always seek such advice only from professionals who are qualified, licensed and regulated in the respective relevant field. Please read our Terms of Service before accessing or using this website.