Despite  the  positive  18%  y-o-y  growth  in  the  number  of  passengers handled by MAHB, the recent 1QFY14 earnings results turned  out to be another disappointment. Attention is  now  focused on    what is seen as the  wild  card  for  the  sector,  MAS,  for  which  we  see  bankruptcy  as highly  unlikely.  The  outlook  remains  challenging  but  yields  have bottomed. NEUTRAL stance stays, with AirAsia as our Top Pick.

• Another disappointing quarter. Despite the positive 18% y-o-y  growth in  total  passengers  handled  by  Malaysia  Airports,  1QFY14  earnings again  disappointed,  with  two  carriers  –  AirAsia  (AIRA  MK;  BUY,  FV: MYR2.78)  and  MAS  (MAS  MK,  NEUTRAL,  FV:  MYR0.19)  –  reporting numbers  that  were  below  our  and  consensus’  expectations.  Overall sector losses – significantly weighed down by MAS’ larger-than-expected losses  –  were  higher by 85% q-o-q  at MYR296m in 1QFY14, reversing the core net profit of MYR96.8m achieved in 1QFY13.
• Passenger  yields  still  under  pressure  but  show  signs  of  having bottomed.  Yields remained under pressure during the quarter, declining by  10%/12%/23%  y-o-y  for  MAS/AirAsia/AirAsia  X  respectively.  While the overall  sector’s  yields were lower y-o-y and seasonally q-o-q, we are seeing signs of yields bottoming. Not only is this evident in Malaysia, but also  regionally.  However,  we  cannot  solely  attribute  this  to  higher demand, since that there has been a recent scale back in frequencies as some  carriers  underwent  route  rationalization  to  optimize  their  aircraft deployment on higher yielding routes. We have witnessed  a q-o-q uptick of 1.4% q-o-q on AirAsia’s  yields so far,  despite  1Q  being a seasonally weaker quarter.
• The  wildcard  -  will  MAS  collapse?  We  think  that  a  bankruptcy  is unlikely for MAS as Khazanah Nasional has  publicly said that it will look into restructuring the carrier.  Our ideal assessment is a combination of downsizing  MAS’  workforce  and  cutting  capacity.  We  estimate  that  by trimming its workforce by 19% and reducing capacity by 1 0%, the carrier may be able to trim its losses to MYR349m (from MYR767m) in FY15F. Any capacity cut  would potentially be positive for  its  competitors,  as this will boost yields as more capacity is pulled out from the sector. However, this ultimately depends  on how much capacity MAS  would be cutting. In contrast,  such  a  move  may  be  negative  for  Malaysia  Airports  (MAHB MK; BUY, FV: MYR9.80).
• 2014  to  remain  challenging.  Maintain  NEUTRAL.  2014  will  still  be challenging  for  the  aviation  sector,  with  concerns  centered  on  whether yields would recover, with the restructuring of MAS as a wild card  for the overall sector. We remain NEUTRAL on the sector,  with AirAsia  as our top pick,  with our MYR2.78  FV  unchanged at a target FY15 P/E of 12x. We also have a BUY on Malaysia Airports but advise  investors to  only accummulate aggressively on share price weakness. 

Round-up 1QFY14 Results 
Another  disappointing  quarter.  Despite  the  positive  growth  of  18%  y-o-y  in  total number  of  passengers  handled  by  Malaysia  Airports,  the  recent  1QFY14  earnings results  again disappointed, with two  carriers, AirAsia (AIRA MK; BUY, FV: MYR2.78) and MAS (MAS MK, NEUTRAL, FV: MYR0.19),  reporting numbers that were below our and consensus  estimates. The remaining two  –  AirAsia X (AAX MK; NEUTRAL, MYR0.70)  and  Malaysia  Airports  (MAHB  MK;  BUY,  MYR9.80)  –  reported  numbers that were within our estimates.  The overall sector losses - which were weighed down heavily  by  MAS’  larger-than-expected  losses  –  were  greater  by  85%  q-o-q  at MYR296m, vs the core net profit of MYR96.8m achieved in 1QFY13.

This  was  despite  the  positive  growth  seen  at  carriers’  toplines.  The  disappointing results were attributed to the decline in passenger yields, as measured by ticket sales revenue per passenger collected for every kilometer, and also unit costs, which were also still inching higher.

Changes  to  forecasts.  For  the  four  companies  under  our  coverage,  we  trim  ourFY14 earnings  forecasts  for AirAsia  by 53% while  raising  MAS’ estimated  losses by 23%. Our earnings estimates for AirAsia X and Malaysia Airports are unchanged.

Passenger  yields  still  under  pressure,  but  show  signs  of  bottoming.  Yields remained  under  pressure  during  the  quarter,  down  10%/12%/23%  y-o-y  for MAS/AirAsia/  AirAsia  X  respectively.  When  comparing  y-o-y,  note that  the  drop  in yields  was  also  partly  distorted  by  the  higher  base  in  1QFY13,  as  Malindo  –  the newcomer  in  the  Malaysian  aviation  space  –  had  yet  to  commence  operations. Malindo only started operations at end-March 2013.  

While  sector  yields  were  lower y-o-y and  seasonally  q-o-q, we are seeing signs of yields bottoming. Not only is this evident in Malaysia but also regionally. However, we cannot  solely  attribute  this  to  higher  demand,  noting  that  there  has  been  a  recent scale back in frequencies as some carriers undertook route rationalization to optimize aircraft deployment on  higher yielding routes.  Furthermore, we think MAS has come to  its  senses  by  raising  its  air  fares,  notably  on  the  mid  to  long  haul  route,  and realigning its airfares to those of full service offerings.    Nonetheless, stiff competition remains  prevalent  on  its  domestic  operation  and  to  some  degree,  routes  within Asean,  as  MAS  is  still  pricing  its  airfares  close  to  –  and  sometimes  lower  than  –prices  offered  by  AirAsia.  Over  the  past  few  quarters  since  last  year,  MAS’  yields have  declined  sharply  as a result  of  its aggressive promotion  pricing, which sparked off a price war against the low cost carriers.

We have witnessed  a q-o-q uptick of 1.4% q-o-q on AirAsia’s  yields so far despite it being a  seasonally  weaker  quarter.  While  we  are  more confident  that  AirAsia  may potentially  see  a  faster  pick-up  in  yield  recovery  this  year,  we  do  not  foresee  the same happening for MAS.  For a full-service carrier, airfares in this segment can be rather sticky in nature. Moreover, MAS is facing a tough challenge in ramping up its yields  now  that  its  competing  low-cost  carriers  are  operating  out  of  KLIA2,  which offers  significantly  more  convenience  and  comfort  for  budget  travelers.  As  such, MAS’  premium  passengers  may  be  tempted  to  fly  on  AirAsia,  given  the  latter’s cheaper airfares.

Deferring aircraft deliveries. Among the three carriers in Malaysia, only AirAsia  will be deferring the delivery  of aircraft.  The low cost carrier will see a net addition to  its Malaysian fleet of only four aircraft, which is estimated to see FY14 capacity growing by  9%  y-o-y.  AirAsia  is  opting  for  the  brand  new  A320  NEO  aircraft  (due  to  be launched  only  by  2016),  which  are  more  fuel efficient.  As such,  it  will  be  deferring some  of  its  existing  320  CEOs  so  that  it  can  switch  to  the  A320  NEOs  once  the model  comes into production in 2016.  The number of aircraft deferred  totals  29 for the period 2015-2018.

Outlook ahead
The wildcard  -  will MAS collapse?  We think that a bankruptcy is unlikely for MAS as Khazanah has  publicly said that it will look  into restructuring the carrier, as going through one would be a painful process across all stakeholders.  We believe the best case for MAS is to maintain its listed status and undergo a restructuring exercise to boost yields and improve productivity, while trimming its sizeable workforce. Our ideal assessment is a combination of downsizing of MAS’ workforce and cutting capacity. We estimate that by downsizing its workforce by 19% and reducing capacity by 10%, the carrier may be able to trim its losses to MYR349m (from MYR767m) in FY15F.For more detail on MAS, please read our report issued last week by clicking here. MAS unlikely to make significant capacity cuts. Since 2010, MAS has trimmed its network by 27% by cutting  its  loss-making routes. Hence, any form of capacity cuts going  forward  may  be  in  relation  to  frequencies,  ie  by  allocating  more  capacity  on higher-yielding routes where competition is less prevalent. Note that MAS has made great strides in boosting aircraft utilisation  –  the average utilisation rate of its widebody  fleet  as  increased  to  14  from  13  hours,  while  that  for  its  narrow-body  fleet improved  to  11  hours  from  nine.  We  don’t  see  MAS  cutting  its  capacity  on  a  big scale,  as  this  would  require  a  significant  downsizing  of  its  workforce  to  optimize productivity levels. One likely option for the carrier in the near term is  by deferring its aircraft  deliveries,  especially  during  current  times  when  cash  is  really  tight  for  the carrier.

May  be  positive  for  MAS’  competitors…  Any  capacity  cut  will  be  potentially positive for competitors as this will boost yields as more capacity  is  pulled out from the sector. However, we think a  10% capacity reduction would not be beneficial in a big  way  to  its competitors,  as  the  benefit  to  MAS  outweighs  it,  noting  the  reduced losses from its loss-making and low-yielding routes.

… but not for  MAHB.  A reduction in capacity will not augur well for MAHB  as this essentially means lower number of passengers handled at the KLIA main terminal,where  airport  tax  is  much  higher  compared  to  KLIA2.  Although  this  could  see competitors seeing a spillover of passengers, the risk for MAHB is the lower airport tax collected from  spillover  passengerss  who may  likely  be  departing out  of KLIA2instead.  KLIA2  is  where  most  of  MAS’  competitors  are  operating  from.  While  this would not hurt our traffic projections for MAHB, the risk is in the lower average airport tax  collected,  of  which  a  10%  shift  in  MAS  passengers  to  KLIA2  from  KLIA  could dilute  the  blended  airport  tax  collected  by  3%  from  our  FY15  estimated  blended airport tax collected per passenger of MYR23. This would represent a drop in its total FY15f revenue (-1%, or MYR29.6m), and for net profit (down by 7.6%). This is a very small amount and should not be a cause for a major concern, provided there is not a significant capacity cut for MAS.  In the near term, ascertaining the operational costs of KLIA2 remains a major concern for investors of MAHB, as operating it may dent  its profitability, given its larger infrastructure.

2014  will  still  be  a  challenging  year;  Maintain  NEUTRAL.  2014  will  still  be  a challenging  year  for the aviation sector,  with concerns centered  on whether a yield recovery  can  be  seen  with  the  restructuring  of  MAS  as  a  wild  card  to  the  overall sector outlook. We remain NEUTRAL on the sector, with AirAsia as our top pick, with our FV of MYR2.78 and target FY15 P/E of 12x unchanged. We also have a BUY on Malaysia  Airports  but  advise  only  to  accumulate  aggressively  on  share  price weakness,  due to concerns over KLIA2’s operational costs  that are making  investors nervous. At the current price, AirAsia  offers an attractive FY15 dividend yield of 4.8% at  an  attractive  valuation of only 10.3x FY15 P/E vs  its  Asian low cost carrier peers’ FY15  P/E  of  13.2x.  We  also  like  the  carrier’s  cost  discipline,  where  its  Malaysia operations remains strong despite the challenging times. However, we caution that its India operations could set  back its  earnings, and for this  we have factored in  losses of  MYR60m/MYR80m/MYR30m  for  FY14/FY15/FY16  respectively,  given  the challenging landscape there.

Source: RHB