AirAsia  is  making  a  comeback  in  the  Japan  market,  this  time  via  a  JV partnership  in  which  the  carrier  will  likely  get  a  free  hand  in  operating the  new  airline. AirAsia’s first attempt failed largely  due  to  differences with its previous JV partner. The Japan market holds huge potential as the  penetration  of  its domestic  low  cost  carrier  segment  is a mere  5%. Maintain BUY, with our MYR2.78 FV unchanged.   
 
A second chance. AirAsia announced yesterday that it will be setting up a  new  low  cost  airline,  AirAsia  Japan  (AAJ),  which  will  be  a  JV partnership  comprising  several  Japanese  investors.  AirAsia  is  to  hold  a 49%  majority  stake,  while  the  remainder  will  be  held  by  its  Japanese partners.  The  initial  investment  will  be  JPY1bn  (MYR31.5m),  with AirAsia’s  49%  share  being  approximately  MYR15m.  Being  the  only shareholder  with  expertise  in operating  the  proposed  airline  means  that AirAsia would get a free hand in running it. This is the low cost carrier’s second attempt, after its first – in 2012-2013 – failed. We understand that Nagoya  is  likely  to  be  AAJ’s  hub,  possibly  with  an  initial  fleet  of  six aircraft. The new airline is to commence operation by mid-2015.  

Why  Japan  again?  Japan  offers  great  potential  as  the  country’s domestic  low  cost  travel  segment  is  underserved,  with  a  penetration  of only 5% vs South Korea’s 31%. Furthermore, domestic passenger yield in  Japan  can  be  lucrative  due  to  the country’s high  per  capita  income and  cost  structure.  As  a  leading  low  cost  carrier  with  a  low  cost  base, AirAsia  stands  to  enjoy  enormous  benefits  from  the  high  yield  to  be reaped  in  Japan’s passenger  market,  which  may  boost  profitability  (by maximizing  its  revenue  base).  Having  a  free  hand  and  with  minimal influence from its JV partners, the low cost carrier  may even be able to control costs more efficiently. However, due to startup costs, we estimate that  the  carrier  may  have  to  bear  losses  in  its  first  year  of  operation. Pending  further  developments  and  more  details  on  the  proposed venture, we have not factored this new development into our forecasts. A conservative  loss  estimate  may  be  MYR40m  per  annum  (6.2%  of  the group’s FY15 earnings), which hits EPS by MYR0.014.

Maintain BUY.  Our unchanged FV of MYR2.78 is premised on a target FY15 P/E of 12x. The stock offers a decent dividend yield of 4%, and is currently  priced  at  an  attractive  10x  FY15  P/E  vs  its  Asian  low  cost carrier peers’ 13.6x.

A  second  chance.  AirAsia’s  new  low  cost  airline,  AAJ  will  be  a  JV  partnership comprising several Japanese investors. AirAsia will hold the majority 49% stake - the maximum  shareholding  allowed  for  a  foreign  entity  in  a  local  carrier.  The  remaining stake will be held by Octave (unlisted) with 19%, Rakuten (4755  JP, NR) with 18%, 
Noevir (4928 JP, NR) at 9%, and Alpen (3028 JP, NR), 5%. The initial investment will be  JPY1bn  (MYR31.5m),  where AirAsia’s 49% share will come  to  about  MYR15m. AirAsia will be the only shareholder with airline operation expertise. The JV, however, has yet to obtain regulatory approval, but getting the nod, we think, would not be an issue.  

AAJ  will  mark  AirAsia’s  second  attempt  at  the  Japan  market.  Its  first  attempt encountered difficulties arising from differences with its previous partner, full service carrier ANA (9202 JP, NR). As that JV airline posted losses totaling MYR217.5m over six  quarters of  operation,  AirAsia  exited  the  Japan  market  last  year by  relinquishing 
its  stake  in  that  airline  to  its  JV  partner,  selling  its  49%  stake  to  ANA  (All  Nippon Airways) for MYR80.4m.  

Second  attempt  may  be  successful.  We  understand  from  management  that Nagoya  is  likely  to  be  made  a  hub  for  AAJ,  which  may  start  with  a  fleet  six  aircraft initially. Previously, AAJ hubbed at Narita airport in Tokyo, which was a much  more competitive market.  The new airline is due to commence operations by the summer of  2015  (July-August  2015).  Information  from  a  Google  search  shows  that  Nagoya has  potential,  as  it  is  the  point  from  which  domestic  airlines  fly  to  18  domestic destinations,  compared  with  Tokyo’s  49.  This  suggests  that  competition  is  less severe.  Domestic  flights  from  Nagoya  are  dominated  by  ANA.  Against  the  LCCs, whose  fares  are  typically  30%  cheaper,  AAJ  would  be  competing  head-on  with JetStar and Skymark on only five routes. AirAsia has yet to announce the routes, but upon commencement of operation, AAJ will serve the Japanese domestic market and the North-East Asian countries of South Korea, Taiwan and China.

Why Japan again? 

1)  Low  penetration  rate.  Japan  offers  great  potential  for  the  low  cost  airline business as its domestic penetration is a mere 5%, according to an analysis by the Sydney-based Centre For Aviation (CAPA) last year. This is far lower than South Korea’s penetration of 31% and Malaysia’s 57%. Competition in the low cost carrier space will be mostly against Skymark and Jetstar Japan, given  their  fleet  of  32  and  18  aircraft  respectively.  The  passenger  growth rate  of  low  cost  carriers  such  as  Peach  and  JetStar  Japan  has  been  very encouraging,  as  these  airlines  are  tapping  new  demand  for  passenger growth with their cheaper airfares. 

2)  Tapping a high-yield market. Domestic passenger yields in Japan can be lucrative due to that country’s high per capita income and cost structure. For instance, Peach (a low cost carrier owned by ANA) commands a passenger 
yield  of  JPY8.5/RPK  (revenue  passenger  kilometer)  that  is  equivalent  to 26.9 sen/RPK – which is 32.5% higher than AirAsia’s yield of 20.3 sen/RPK (as  of  1Q14).  The  discount  in  yields  relative  to  full  service  carriers’  can  be 
rather  substantial,  ie  of  at  least  30%,  thus  making  low  cost  air  travel  a cheaper option.

3)  Getting a free hand. With AirAsia likely to have a free hand to operate with minimal influence from its JV partners, the new low cost carrier may be able to control its costs more efficiently.  As a leading low cost carrier with a low cost base, AirAsia may benefit enormously from the high yield environment of  the  Japanese  passenger  market,  which  may  boost  its  profitability  (by maximizing revenue base). However, we expect AAJ to incur start-up losses in its first two years of operation. That said, having set foot in Japan before, the  group may  need  to  put  in  less  effort  to  promote  its  brand  name  as  the AirAsia brand is already prominent there.  

4)  A more meaningful partnership. With Rakuten as one of its key partners, AirAsia may be able to leverage on a potential distribution network. Rakuten has  major  businesses  in  Internet  services  (e-commerce,  travel),  financial 
services (bank, credit card, securities), telecommunications and professional sports. Noevir, its other partner with a 9% stake in the JV, will also be able to  provide  competitive  aircraft  leasing  rates,  since  it  also  owns  an  aircraft 
leasing business. 

Extensive bullet train network could hamper route expansion. Japan’s domestic airline  industry  has  been  facing  hurdles  to  route  expansion  domestically  given  the country’s extensive network of bullet trains, as consumers find it cheaper (especially when one has an unlimited travel pass for a certain period) and travelling by train is a more  reliable  mode  of  transport.  As  such,  route  offerings  would  be  critical  for domestic carriers in ensuring that they do not overlap with bullet train routes.

Pilot  shortage.  Due  to  Japan’s  ageing  population,  there  is  currently  a  severe shortage  of  pilots  as  the  proportion  of  ageing  pilots  nearing  the  age  limit  for employment  grows.  We  note  that  both  Peach  and  Vanilla  Sky  recently  cancelled flights  as  they  were  unable  to  meet  the  required  number  of  pilots.  Peach  said  in  a 
statement  that  it  cancelled  more  than  2,000  flights  between  May  and  October  this year,  while  Vanilla  Sky  had  to  cancel  up  to  1,545  flights  in  June.  To  temporarily address this situation, the Japanese Transport Ministry last week mooted the idea of raising the age limit for pilots, which currently stands at 64.  
 
Forecasts.  Peach,  owned  by  ANA,  reportedly  made  its  first  profit  in  FY13  of JPY1.04bn  (USD10.2m)  after  three  years  of  operation.  It  reported  a  loss  of JPY1.29bn in FY12. The improvement in earnings was on the back of a strong load factor  of  83.7%,  with  a  total  of  3m  passengers  carried  as  it  achieved  economies  of scale.  

Factoring in startup costs, we estimate that the AAJ may suffer losses in its first two years of operations before turning profitable. Pending further developments and more details  on  the  venture,  we  have  yet  to  factor  this  into  our  forecasts.  A  conservative loss estimate may be MYR40m per annum (6.2% of FY15 earnings), which works out 
to a hit to EPS of MYR0.014.

Maintain BUY.  AirAsia remains as our Top Pick in the aviation sector, with our FV of MYR2.78  unchanged,  and  premised  on  a  target  FY15  P/E  of  12x.  At  the  current price, AirAsia offers an attractive FY15 dividend yield of 4%, and a fetching valuation of only 10x FY15 P/E vs 13.6x of its Asian low cost carrier peers. 2014 may still be a challenging  year  for  the  aviation  sector,  with  concerns  centered  on  whether  yields may  recover,  with  the  restructuring  of  MAS  as  the  wild  card  to  the  overall  sector outlook.

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Source: RHB