Competition will remain challenging in 2014 but less severe  in our view, as  Malindo has opted to take a more conservative  expansion strategy, which  bodes  well  for  AirAsia  and  MAS.  We  see  value  in  AirAsia  and AirAsia  X  as  their  valuations  are  cheaper  than  those  of  regional  and global peers. Stay OVERWEIGHT on the sector, with Visit Malaysia 2014 and the opening of KLIA2 set to boost passenger arrivals.

• Competition to remain challenging but  less severe. 2014 is expected to  remain  competitive  as  Malindo  continues  to  spread  its  wings. However, we think Malindo will be less aggressive due to its high cost structure.  Its  airfare  discounts  have  narrowed  while  there  have  been capacity cutbacks on some routes. Furthermore, fleet delivery so far (it currently  has  six narrow-bodied aircraft) has been below its initial target of  12  aircraft.  Malindo  has  adopted  a  new  strategy  of  expanding  to regional  routes  such  as  Indonesia,  Bangkok  and  India,  as  opposed  to competing  for  domestic  market  share  amid  the  tough  local  landscape. This bodes well  for the two dominating local carriers, AirAsia (AIRA MK, BUY,  FV:  MYR3.70)  and  Malaysian  Airline  (MAS  MK,  NEUTRAL, MYR0.30),  if they play their cards right in maximis ing yields and loads.Intense  competition  has  resulted  in  airlines  luring  travellers  with  big discounts,  which help  boost  demand for air travel. This will continue to benefit Malaysia Airports (MAHB, BUY, FV: MYR10.13).
• Buoyed by Visit Malaysia Year 2014.  The Government has earmarked 2014 as Visit Malaysia Year. Its efforts to promote the country as a major tourist  attraction  bodes  well  for  airport  operator  MAHB,  as  it  will  be buoyed  by  the  expected  rise  in  foreign  tourist  arrivals.  In  view  of  the carriers’  rising  capacity  and  expectations  that  air  fares  will  remain competitive,  we  conservatively  expect  passenger  traffic  handled  by Malaysia Airports to grow 12% in 2014 (vs 14% forecast in 2013). We see  upside  to  our  passenger  forecasts,  as  growth  will  be  fuelled  by AIRA’s new hubs  in  Penang, Kota Bharu and Kota Kinabalu, which are enjoying strong take-ups.
• Maintain  OVERWEIGHT.  We  see  value  in  AIRA  and  AirAsia  X  (AAX MK, BUY, FV: MYR1.31),  as  their  valuations are relatively cheaper  than those of regional and global peers. AIRA is our Top Pick due to growth at its associates and improving performance  in  its Malaysian  operations as air  fare  discounts  from  Malindo  narrow.  Excluding  the  market  cap  of AIRA’s  listed  entities  and  valuing  its  soon-to-be-listed  (in  2014) Indonesia unit at a 10x FY14 P/E,  we estimate the Malaysian unit’s P/E at  only 6x FY14. Meanwhile, any selldown in MAHB  shares on the  delay of  the  KLIA2  opening  will provide bargain-hunting opportunities. We like MAHB  in  anticipation  of  its  strong  free  cash  flow  generation  upon  the commencement  of  KLIA2  and  potentially  higher  rental  revenue  it  can generate from a bigger airport. We also like AAX’s aggressive capacity expansion,  which  will  promote  economies  of  scale  and  propel  its earnings. We maintain OVERWEIGHT on the sector.

2013 Review To Date

• Competition rose to new heights following Malindo’s entry, thus pressuring yields
• AirAsia’s low-cost model has enabled it to stand strong despite intensifying competition amid a cost-conscious culture
• Malindo has ambitions to be the next major player after AirAsia
• Malaysia Airports benefits the most from rising passenger demand, as low air fares stimulate air travel
• Our OVERWEIGHT call on the sector in 2013 outperformed the benchmark index, with an equal weighting return on our BUY calls of 23% vs the FBM KLCI’s 12%

2013 a year for yield
2013  has  been  a  challenging  year  for  Malaysian  carriers,  as  they  embarked  on aggressive capacity expansion to boost topline and achieve economies of scale amid heightening competition driven by Malindo Air’s debut. This resulted in yields coming under pressure for Malaysian Airlines (MAS, NEUTRAL, FV: MYR0.30) and AirAsia (AIRA, BUY, FV: MYR3.70), dropping 12.7% and 5.3% YTD respectively. Other new foreign carriers commenced flights to/from Kuala  Lumpur,  sparking new competition (albeit  to a lesser extent) in the international  segment as well. Although AirAsia X’s (AAX,  BUY,  FV:  MYR1.31)  yields  were  lower  than  expected  (6.3%  YTD),  we  think this is the result of newly-launched flights priced at promotional rates and not due to competition.

Only the strong will prevail during tough times
With yields coming under pressure, margins took a hit. MAS reported a massive YTD core loss of MYR818m (+24% YTD) as management  opted for a load-active strategy by  lowering  air  fares  significantly  without  meaningfully  cutting  costs.  Its  turnaround attempt  was  a  disappointment  despite  its  load  factor  rising  to  new  highs  and  YTD (9MFY13)  revenue  passenger  kilometre  (RPK)  climbing  28%.  While  we  expected AIRA’s earnings to decline, its results were commendable as it continued to report EBITDA growth (+2.8% YTD). We note  that  the low-cost carrier focused on cutting costs since revenue only inched up 6.7% vs the 11.5% growth in seat capac ity. AIRA has  exercised  prudence  in  its  fleet  delivery,  opting  not  to  compete  head-on  with Malindo’s and MAS’ aggressive fare discounting strategy

New kid on the block turns up the heat on competition 
Malindo,  which  commenced  operation  in  late  March,  has  a  fleet  of  nine  aircraft (including three turboprops) flying to 16 destinations, of which four are overseas. The carrier, which is partly owned by Lion Air of Indonesia (via a JV), is embarking on an aggressive expansion  plan  to increase its Malaysian-flagged fleet under Malindo Air by taking delivery of 100 aircraft over the next decade to compete with AIRA. Lion Air has also set foot in Thailand by establishing Thai Lion Air, thus taking competition up a notch. Thai Lion Air also plans to expand its fleet to 12 aircraft by end-2014, before increasing to 50 aircraft within five years.

MAHB the winner amid tough competition
Intensifying  competition  has  resulted  in  airlines  luring  travellers  with  big  discounts, which  helped  boost  demand  for  air  travel.  This  has  largely  benefited  Malaysia Airports  Holdings  (MAHB,  BUY,  FV:  MYR10.13),  which  reported  a  17.3%  jump  in YTD passenger numbers in October, driven by strong growth in both the domestic (+16.6%) and international (+18.0%) segments. The airport operator’s traffic numbers are  likely  to  outperform  our  FY13  growth  forecast  of  14.0%.  The  inclusion  of  new foreign carriers into KLIA also partly lifted the overall passenger traffic handled by the airport  operator.  As  a  measure  of  how  much  overall  capacity  has  increased,  the October YTD flights handled were 13.3% higher, mostly driven by domestic traffic.

Decent sector performance 
We  are  OVERWEIGHT  on  the  sector.  MAHB,  our  preferred  pick  throughout  2013, has  raked  in  YTD  returns  of  71%.  The  underperformer  was  MAS,  which  we downgraded to SELL  as  its 1QFY13 results fell short of expectations. On an equal weighted  basis,  our  BUYs in the  aviation coverage  recorded a  YTD return of 23%, thanks to  strong  numbers from MAHB and AIRA in 1H,  which  beat  the FBM KLCI’s 12%.

2014 Outlook

• Malindo’s expansion plan is likely to slow down as competition is tougher than it had originally anticipated
• Weakening MYR could increase debt levels, which could in turn translate into higher interest costs
• The effects of Visit Malaysia Year 2014 will spill over to neighbouring countries
• Passenger yields could stay flat in 2014
• KLIA2 will be a significant upgrade in terms of infrastructure in addressing passengers’ comfort needs and this would pave way for low-cost carriers to lure in premium passengers
• Delay to have minimal impact on valuation, and hence any selldown on poor investor sentiment represents an opportunity for investors to accumulate MAHB shares. MAHB stands committed to the existing deadline for KLIA2, targeting for operations to commence by April 2014
• 2014 will be a cost-conscious year for carriers after the aggressive expansion in 2013
• Maintain OVERWEIGHT on sector, with AIRA as our Top Pick

Competition to remain tight but less severe 
We  expect  2014  to  remain  a  challenging  year  as  Malindo  continues  to  spread  its wings.  However,  we  think  Malindo  will  be  less  aggressive  due  to  its  high  cost structure. We notice that its airfare discounts have narrowed while there have been capacity  cutbacks  on  some  of  its  routes.  Furthermore,  its  fleet  delivery  so  far  (it currently has six narrow-bodied aircraft) has been below its initial target of 12 aircraft. Malindo  has  adopted  a  new  strategy  of  expanding  to  regional  routes  such  as Indonesia, Bangkok and India, as opposed to competing for domestic market share given  the  challenges  in  the  local  competitive  landscape.  MAS  appears  to  be aggressive  in  pricing  its  fares  while  AIRA  seems  to  be  chalking  up  encouraging loads, with load factor remaining strong. We believe that Mal indo will take a longer time  to  obtain  regulatory  approval  for  landing  rights  in  international  destinations ,compared with commencing new domestic routes. Hence, the time factor will favour MAS, AIRA and AAX.

Operating expenses, funding costs climb on currency fluctuations 
The  depreciation  of  some  currencies  due  to  the  regional  exodus  of  funds  (on concerns  over the US Fed’s timing  in  tapering its bond-buying)  is expected to boost the revenue of the airlines under our coverage. However, this will be more than offset by  high  jet  fuel  costs.  Long-haul  carriers  like  AAX  and  MAS  will  likely  see  higher yields  and  passenger  demand  from  non-regional  travellers,  whose  stronger currencies may translate into cheaper airfares and vacation cost. However, the risk of a  further  depreciation  in  the  MYR  will  erode  profits  as  jet  fuel  costs,  aircraft maintenance  fees  and  leases  are  typically  paid  in  the  USD.  This  may  offset  the impact of the higher revenue churn. Meanwhile, debt will  increase as local currencies weaken, since  the funding of aircraft purchases  is  mostly in USD terms, which will accordingly result in higher interest expenses. We are of the view that carriers  which are most sensitive to currency risks are those with low earnings bases  such as MAS and AAX.

Buoyed by Visit Malaysia Year 2014
The  Government has earmarked 2014 as  Visit Malaysia  Year.  Its efforts to promote the country as a major tourist attraction  bodes  well for  airport operator  MAHB,  as it will be buoyed by the  expected rise in foreign tourist arrivals. The Government has been promoting the year-long tourism campaign since early 2013 and the calendar is now filled with  events  throughout the 12 months.  We believe  that  the  Visit Malaysia Year  2014  will  not  only  increase  the  inflow  of  tourists,  but  also  create  a  positive spillover  effect  on  neighbouring  countries  such  as  Singapore,  Indonesia  and Thailand. In view of the carriers’ rising capacity and expectations that air fares will continue  to  remain  competitive,  we  expect  passenger  traffic  handled  by  Malaysia Airports  to  grow  by  12%  in  2014  (vs  14%  forecast  in  2013),  which  we  deem conservative. We see an upside to our passenger forecasts, as growth will be fuelled by  AIRA’s new hubs  in  Penang, Kota Bharu and Kota Kinabalu, which are enjoying strong take-ups.

Yield picture for 2014 
Given that MAS and AIRA’s  9MFY13 (YTD)  passenger yields have  dropped 12.7% and  5.3%  respectively,  and  in  tandem  with  our  assumption  that  discounts  from Malindo will continue to narrow next year, we expect passenger yields to stay flat at best in FY14,  before  inching up slightly in FY15. AIRA’s flat yields  next year  could likely  be  offset  by  a  higher  ancillary  take-up  as  it  expands  its  service  offerings  to include  in-flight  duty-free  shopping,  its  “high  flyer”  programme  and  new  “fly-thru” pairings.  Meanwhile,  we  expect  AAX’s  yields  to  be  slightly  higher  as  the  pricing discount relative to full-service carriers for its mature routes narrow.

KLIA2  could  pave  way  for  LCCs  to  tap  into  the  premium  “fussy” passengers
Premium  passengers  who  have  been  hesitant  to  depart  from  the  LCCT  due  to inconvenience and  the  uncomfortable environment  will  likely change their minds  with the  commencement  of  KLIA2,  which  is  expected  to   address  passengers’  comfort. This  could pave  the  way for low-cost carriers  to lure in premium passengers, which will  be  positive  in  providing  upside  to  passenger  yields.  AirAsia  has  taken  this opportunity  by  offering  a  “hi  flyer”  scheme,  tailored  to  the  needs  of  business  and premium  passengers  with  the  option  of  flexibility  on  flight  timing  and  express boarding. We understand that this  extra service  offering has seen a strong  take-up from the business community.

MAHB stands committed to a timely completion
Of  late,  there  have  been  media  reports  highlighting  renewed  concerns  that  KLIA2 may not meet the scheduled completion to commence operations in early April 2014. MAHB  has  acknowledged  that  the  problem  is  centred  on  the  slippage  in  the  work schedule  of  the  KLIA2  terminal  building,  which  is  being  constructed  by  the  UEMC Binapuri  JV.  Problems  arising  from  this  include:  i)  cracks  on  the  surface  near  the apron  (aircraft  parking),  ii)  uneven  airport  taxi  ways,  and  iii)  the  district  cooling system. Without  factoring  any Liquidate and Ascertained Damages (LADs) into our earnings assumptions, we estimate that a 3-month delay would result in EBITDA loss of MYR10m,  as  lower  revenue  earned  from the retail outlets  would be cushioned by reduced  operating  expenses  of  KLIA2,  notably  from  electricity  and  maintenance. Depreciation would be tied  in with the commencement of KLIA2.  We thus estimate the impact on valuation would be minimal, and hence any selldown on  poor investor sentiment  represents  an  opportunity  for  investors  to  accumulate  MAHB  shares. MAHB stands committed  to  the existing deadline for KLIA2, targeting for operations to commence by April 2014.

Cost discipline may be the new order
Jet fuel prices have dropped 3.5% YTD and moving forward, we expect it will likely remain  flat  in  FY14-15.  Hence,  we  do  not  see  higher  jet  fuel  prices  posi ng  a significant threat to earnings. FY14 will be a cost-conscious year for the carriers as they  strive  to  be  profitable.  This  could  see  Malindo  taking  a  more  conservative approach in its future expansion plans. We are also positive on the commencement of  KLIA2 in improving  aircraft turnaround  from  the current congestion  at  the LCCT. AIRA  believes  its  cost  structure  will  continue  to  improve  on  potential  fuel  burn reduction  upon the commencement of KLIA2. Furthermore, the automated baggage handling system  set  to be installed at the new airport is  expected  to lead to lower ground and baggage handling costs.

Maintain OVERWEIGHT on sector 
While the sector’s outperformance was mostly driven by the strong  rally  from MAHB, we  think  AIRA’s  share  price  has  been  overly-punished  despite  its  better-thanexpected 9MFY13 earnings amid intensifying competition. We see value in the  airline as its valuations are relatively cheap compared to its regional and global peers. AIRA is  our  Top  Pick  given  growing  overall  income  from  its  associates  and  improving performance  at  its  Malaysia  operations,  as  air  fare  discounts  from  Malindo  come down. Including the market cap of AirAsia’s listed entities and valuing its soon -to-belisted (in 2014) Indonesia unit at  a 10x FY14 P/E, the Malaysian unit’s P/E is only 6x FY14. Elsewhere, any selldown in MAHB  on  potential  delayed  opening  of  KLIA2 will provide  bargain-hunting  opportunities.  We  like  MAHB  for  its  strong  free  cash  flow generation upon the commencement of KLIA2 and the higher potential rental revenue it  can  generate  from  a  bigger  airport.  We  also  like  AAX’s  aggressive  capacity expansion,  which  will  promote  economies  of  scale  and  accordingly  propel  its earnings.  Meanwhile,  MAS  is  still  a  NEUTRAL  as  we  remain  pessimistic  on  the carrier’s ability to bring down costs. We maintain OVERWEIGHT on the sector.

Source: RHB