4Q13  was  a  disappointing  quarter  for  the  sector  and  the  outlook  for 2014 will continue to be challenging with no yield recovery in sight. This is  on  carriers  continuing  to  deploy  capacity  aggressively.  We downgrade the sector to NEUTRAL  (from  Overweight)    following recent call  downgrades on MAS and AAX. Our  Top  Pick is Malaysia Airports, as the competitive airfares will stimulate passenger growth ahead.

• A  disappointing  quarter  on  weaker  yields.  4Q13  results  for  the aviation  stocks  under  our  coverage  were  disappointing,  with  numbers weaker than our  and  consensus  estimates. All  booked  a drop in profits on  weaker  yields,  stiffer  competition  and  the  depreciating  MYR,  which bumped  up costs. Although sector earnings were worst off  in FY13, we were  still  impressed  by  AirAsia  (AIRA  MK,  BUY,  FV:  MYR2.66)’s earnings outperformance, where EBITDA only contracted by 2% in FY13 on  cost-cutting  efforts.  However,  overseas  associates’  losses  dragged overall bottomline.
• Yields  suffered  on  MAS’  airfare  dumping.  Malaysian  Airline  System (MAS  MK,  SELL,  FV:  MYR0.20)’s  airfare  dumping  strategy  widely deteriorated  yields  for  the  sector,  dropping  by  10-18%  y-o-y  in  4Q13.The  downside  in  yields  in  Malaysia  were  more  than  what  we  saw  in Thailand, where yields contracted by  5-10% y-o-y. None of the carriers there  undertook  massive  fare  damping  activity,  which  cushioned  the yields downside.
• Currency  hitting  on  USD-denominated costs.    The  weakening  MYR against  the  USD  also  saw  higher  costs  incurred  on  USD-denominated expenses.  With  the  MYR  expected  to  be  persistently  weaker,  this  will give further risk on cost increases, which will more than offset the impact from higher USD-denominated revenue churned.
• Yield outlook challenging,  emphasis on cost cuts.  There appears to be  no  change  MAS’  and  AirAsia  X  (AAX  MK,  SELL,  FV:  MYR0.70)’s FY14  strategy,  ie  continuing  to  expand  their  capacity  aggressively  by 10%  and  48%  respectively.  This  will  put  further  risk  on  yields  moving forward. On the other hand, AIRA is scaling back its aircraft deliveries as it  restructures  its  routes,  bringing  FY14  capacity  growth  down  to  8%. 2014 will continue to be a challenging year for yields, according to most airlines,  and  we  concur.  The way  to  outperform  peers  is  by  a  carrier’s own cost-cutting efforts and we see AIRA scoring highly in this category.
• Downgrade  to  NEUTRAL.  With  two  BUYs  and  two  SELLs,  we downgrade  the  sector  to  NEUTRAL  (from  Overweight).  The  landscape remains  challenging,  with  no  signs  of  yield  recovery  in  sight  to  boost profitability in a significant way.  Malaysia Airports (MAHB MK, BUY, FV: MYR9.80)  is  now  our  Top  Pick  (previously  AIRA),  as  competitive  air fares will continue to stimulate passenger growth  – coupled with KLIA2 –giving boost to earnings and cash flow.

A Disappointing Quarter
Below  ours  and  consensus.  The  overall  sector  earnings  were  worst  off  in  4Q13 despite it being the seasonally strongest quarter of the year. All the companies  under our coverage reported numbers that were weaker than our and consensus estimates. This was attributed to  weaker yields, stiffer competition and the depreciating MYR, which  bumped  up costs.  The  losses  at  MAS  and  AAX  shocked  us  most.  Although sector  earnings  were  worst  off  in  FY13,  we  were  still  impressed  by  AIRA’s outperformance, where EBITDA only contracted by 2% in FY13, thanks to its  costcutting  efforts.  However,  the  sharp  losses  from  its  overseas  associates  dragged overall bottomline.  Not  only airlines  saw  disappointing earnings,  Malaysia  Airports too suffered a drag in its bottomline, as it incurred higher staff costs in preparation for the upcoming opening of KLIA2 which is scheduled for opening on 2 May. 
Yields suffered on MAS’  airfare dumping.  MAS’ air fare dumping strategy widely deteriorated overall yields for the sector, which were down by  10-18% y-o-y in 4Q13 (see figure 2 overleaf). The downside in yields in Malaysia were more than what we witnessed in Thailand, where yields contracted by 5-10% y-o-y. None of the carriers there undertook massive fare damping activity, which, to some degree, cushioned the downside in yields.

We briefly summarise the 4Q13 results below:

Currency  hitting  on  USD-denominated  costs.  The  weakening  MYR  against  the USD also resulted  in higher costs incurred on  USD-denominated expenses such as fuel,  aircraft  maintenance  and  borrowing  costs.  With  the  MYR  expected  to  be persistently weaker, this will give further risk on cost increases, which will more than offset the impact from higher USD-denominated revenue churned  on overseas ticket sales.  Our  analysis  suggests  that  both  AAX  and  MAS  will  be  most  sensitive  to currency fluctuations due to  their  low  earnings base. We estimate  an increase of 5 sen in USD/MYR exchange rate (weaker MYR) will negatively swing earnings lower by 43%/12%.  For AIRA, a 5  sen increase in the USD/MYR conversion will result  in  a 6%  reduction in  earnings.  We are less concerned  on  the USD-denominated debt  to result  in higher interest expenses incurred ,  as most  airlines  have already locked in lower conversion rates than the current prevailing spot exchange rate.

Yield outlook remains  challenging.  2014 will continue to be a challenging year for yields,  according to most airlines and  we concur. There appears to be no change in strategy  for  MAS  and  AAX,  which  will  continue  to  expand  their  FY14  capacities aggressively  by  10%  and  48%  respectively.  This  will  put  further  downside  risk  on yields moving forward,  of which we expect overall yields to drop by  4%  (MAS) and 10%  (AAX).  On the other hand,  AIRA, is scaling back its aircraft deliveries   to only four  additional  aircraft  in  2014  as  the  budget  carrier  restructures  its  routes  in  an attempt to maximise yields. We understand that AIRA  is  scaling back frequencies on crowded routes  like  Kuching and Kota Kinabalu  in order  to launch new routes. This will bring down its capacity growth to 8% in FY14 from 11% last year.

Emphasising on cost cuts.  AIRA’s management has highlighted that it is targeting for a 4% improvement in unit costs (ex-fuel) in FY14, of which 2% improvement in costs have  been realised so far over the first two months of the year. These include initiatives like automation, improved flight operations and renegotiation of engineering contracts. For MAS and AAX, we see improvements coming in from the reduced fuel burn on new aircraft deliveries. The latter will also benefit from the cost-cutting efforts by the  AirAsia  group  as a whole. Further upside to cost improvements will be  from the commencement of KLIA2, which we expect to improve overall fleet efficiencies on lower fuel consumption as the issue of congestion that carriers are facing  currently at the existing Low Cost Carrier Terminal will be eliminated completely.

The  mystery  of  the  missing  MH370.  The  recent  incident  of  the  missing  aircraft, MH370,  en  route to Beijing,  remains a mystery, with hijacking a likely possibility. Our thoughts and prayers are with the passengers and colleagues on board MH370,  as well as their families and loved ones. While this incident will be another blow to MAS’prospects  for  a  turnaround,  we  do  not  expect  this  to  have  severe  implications  in deteriorating demand for air travel in the mid-  to longer-term. We understand that, so far,  flight bookings and load factor have  seen no change in trends  and no signs  of slowing down. The recent tour fair held over the weekend in Kuala Lumpur still saw a good crowd. The implications for MAS in the near term will be a halt in its promotional activities, as its website turns to a “dark site”, ie a “dormant” website that removes all promotional  materials  to  provide  information  and  updates  on  the  ongoing  incident. Dark sites are only activated during a crisis situation and, in this  case, we are unable to predict how long this will persist.

KLIA2  opening  on  track.  According  to  news  reports  over  the  weekend,  IKRAM Premier  Consulting  SB  (IPC),  the  independent  consultant  appointed  by  the Government to assess the  KLIA2  project, said the new terminal is safe for use and can  be  opened  as  scheduled  on  2  May.  The  report  made  by  IPC  also  stated  that small  cracks  found  on  the  apron  and  parking  taxiway  at  the  terminal  should  be repaired. There were no cracks on the terminal runaway, as earlier claimed by some news media. Malaysia Airports will have until 14 April to fix these issues, which is the date  that a  second assessment will be carried out. Should KLIA2 see a one quarter delay  to  its  opening  date,  the  revenue  loss  from  rentals  collected  and  lower passenger  spending  is  estimated  at  MYR48m,  or  1.6%  of  topline.  This  could potentially shave 10% of our FY14 earnings estimates on Malaysia Airports.Downgrade to NEUTRAL  (from  Overweight).  The disappointment in earnings has resulted to fair values being trimmed across the board. This has consequently led to the downgrade in recommendation on MAS and AAX. AIRA stays as a BUY while the recent  share  price  retracement  on  Malaysia  Airports  since  its  private  placement announcement back in Dec    2013  prompts  us to upgrade the counter to BUY  (from Neutral).  With  two  BUYs  and  two  SELLs  in  our  aviation  coverage,  amidst  the challenging outlook of the sector with no yield improvement in sight in the near term, we  therefore  downgrade  our  sector  call  to  NEUTRAL  (from  Overweight).  Malaysia Airports  is  now our Top Pick  (previously AIRA), as competitive air fares will continue to  stimulate  passenger  growth,  coupled  with  KLIA2,  giving  boost  to  earnings  and 
cash flow.

Source: RHB