AirAsia - At a Yield Inflection Point

kiasutrader

Publish date: Thu, 20 Nov 2014, 10:52 AM

9M14 earnings came in better than expected, prompting us to adjust our FY14/FY15/FY16 earnings upwards by 104%/14%/17%. Maintain BUY with a higher MYR3.11 TP (from MYR2.73, a 26.4% upside). Better-than-expected 3Q14 net profit was largely attributed to the lower average jet fuel cost incurred. The upward pricing rationalisation of airfares is expected kick-in on a stronger note next year.

Better than expected. 3Q14 and 9M14 core earnings of MYR82.5m and MYR97m respectively were better than we expected (FY14F: MYR121m) but lower than consensus. The Bloomberg-compiled numbers may not have factored in associates’ actual core losses. Better-than-expected 3Q14 earnings were largely on lower average jet fuel costs, even after conversion (-10% QoQ, -12.5% YoY). The underlying passenger yields drop (ticket sales and surcharges) moderated in 3Q14 and, thanks to the 8.1% YoY increase in per pax ancillary income, overall yields finally inched into positive territory (+0.1% YoY) after five
quarters of YoY decline. Associates contribution remains in losses but were better than expected from its Expedia joint-venture’s (JV) stronger-than-expected profits and Indonesian operations breaking even.

Forecasts. On lower jet fuel price assumptions, capacity growth guidance and less-than-expected total losses from associates, we raise FY14F/FY15F/FY16F earnings by 104%/14%/17% respectively.

Outlook. Yields are at an inflection point. With Malaysian Airline System’s (MAS) (MAS MK, NR) restructuring and the likelihood of its 20-30% capacity cut next year, the upward airfare pricing rationalisation is expected to kick in on a stronger note then. We expect overall yields to inch higher YoY by 4Q14, with an increase of 4% (FY15) and 2% (FY16). We expect earnings growth to be strong in both years on this yield recovery and the lower jet fuel price environment.

Briefing highlights. Off the net incoming five aircraft in FY15 (nine incoming and four selling), its Malaysia operations will only be taking in one net additional aircraft next year with the rest going to Thai AirAsia. The transfer of all sub-leased aircraft to its newly-created leasing house entity is expected to free up a sizeable debt burden too.

Maintain BUY at a higher FV of MYR3.11 at unchanged FY15 P/E of 14x. In line with the average P/E of its regional low cost carrier peers. The stock remains our Top Pick in the aviation sector.

Key Briefing Highlights

Malaysia operations
Yield outlook. The drop in underlying passenger yields (ticket sales and surcharges) has moderated in 3Q14 and, thanks to the increase in per pax ancillary income of 8.1% YoY, overall yields finally inched into positive territory at +0.1% YoY for the first time after five quarters of YoY decline. As expected, associates contribution remains in losses, but came in better than expected due to stronger-than-expected profits rom its Expedia (EXPE US, NR) JV and Indonesia’s operations breaking even.

With MAS restructuring and the likelihood of its 20-30% capacity cut next year, the upward pricing rationalisation of airfares are expected to kick in on a stronger note then. MAS trimmed its domestic capacity by 6.1% YoY in 3Q14. We view this positively in boosting AirAsia’s yields moving forward (see Figure 5). We expect overall yields to inch higher YoY by 4Q14, with an increase of 4% and 2% in FY15/FY16 respectively

Capacity
Six aircraft were grounded in 3Q14, down from eight in the previous quarter. This led to more cost optimisation, given AirAsia’s sustainable load factor of 79-80%. The company will be reactivating three of its grounded aircraft in 4Q14, a quarter where demand is seasonally stronger. Moving into FY15, AirAsia will be taking delivery of nine aircraft. The nine will be offset by the sale of four older aircraft. This will bring the net addition to its fleet at only five, of which one will be allocated to Malaysia and four to be leased to Thailand. In 2016, there will be 18 incoming new aircraft deliveries, of which most are also likely to be leased out to its associates. With its current six grounded aircraft likely to be reactivated for next year, we expect capacity to grow by 7% and 8% in FY15 and FY16 from our earlier estimates of 6%/6% respectively.

Leasing house
AirAsia’s aggressive fleet expansion – to accommodate its associates’ fleets – has created a burden on the company’s balance sheet. Total debt has ballooned to the tune of MYR10bn. The slew of incoming new aircraft deliveries moving forward brings opportunity for the carrier to grow its lease sub-leasing revenue from its associates and, potentially in the longer run, to third parties. With a total of fleet of 172 currently in the AirAsia group – excluding long haul AirAsia X (AAX MK, SELL, TP: MYR0.57) – and with more incoming deliveries ahead, the company is looking to spin off the owned aircraft that it has sub-leased to its associates by transferring them out to a leasing house entity. We estimate that AirAsia will own 18 aircraft in total that will be leased out to its associates by end-FY14 (FY13: 16 aircraft). These 18 could represent as much as MYR3bn in debt to the company’s balance sheet that may potentially be transferred out. We understand that the leasing entity has gotten the approval from the respective authority in Labuan and is expected to begin with the novation of 12 aircraft by the end of this month. According to AirAsia’s 3Q14 earnings presentation slide, management is targeting to have as many as 43 aircraft transferred out to this new leasing house entity by Mar 2015. The rest of the aircraft to be transferred to the leasing house would likely be from AirAsia’s associates, notably Thai AirAsia in our view, noting that Thai AirAsia too has some aircraft parked in its balance sheet. As this leasing house will need to be backed by sufficient capital to take the aircraft into its balance sheet, AirAsia said that there is the possibility of bringing in other leasing investors at the early stage and, eventually, an IPO in the long run. Management guided that the leasing house is expected to rake in earnings of USD30m in net income by FY15 with an EBIT margin of 36%. This could likely be possible, as AirAsia’s large orders from Airbus (AIR FP, NR) entitles it to a substantial discount.

We view this move as positive for AirAsia, as future income statements (except for the associate share of earnings) and balance sheet would truly reflect its Malaysia-based operations, where it is already recording healthy cash flows. However, we have yet to factor this leasing house into our earnings forecast, pending more guidance on its ownership structure from management.

Associates updates
Thai AirAsia. Thai AirAsia booked a higher core net loss in 3Q14 vs 2Q14 as yields and load factor were impacted by the drop in travel due to the political turmoil impacting Thailand. We expect 4Q14 to see a surge in profits on the back of seasonally higher year-end demand. A Krabi hub has recently been introduced as the country’s fourth hub, which ought to see more routes being introduced moving forward. Recently the Krabi-Guangzhou (China) route was launched. Indonesia AirAsia. With the network optimisation being completed by focusing on trunk routes and the termination of its top loss-making routes, Indonesia AirAsia managed to book in a small profit in 3Q14. This was thanks to the significant 18% increase in average air fares, which is a positive surprise as we had earlier expected losses. Management guided that 4Q14 will be profitable, with which we concur. We
have trimmed our losses expectations for FY14, but we now forecast higher losses in FY15 and FY16. This is because we think our earlier projections were too optimistic. Philippines AirAsia. 3Q14 losses by Philippine AirAsia (MYR5.6m for AirAsia’s associate share) are deemed in line with projections. This was a 34.3% YoY reduction vis-à-vis 3Q13, thanks to a combination of higher air fares (+16% YoY). Expectations of possibly booking in earnings in 4Q are highly likely. While we have left our estimates for FY14 losses for Philippines AirAsia unchanged, we now forecast losses in FY15 and FY16 from profits previously as we still see the outlook there continuing to remain challenging on intensifying competition against dominant leader Cebu Air (CEB PM, NR). India AirAsia. India AirAsia recorded an associate loss contribution of MYR7.7m in 3Q14, which was higher by 13.8% QoQ. We expect FY15 losses to be larger due to its full year of operations (vs only 6 months of operations in FY14). There will be four more incoming aircraft by year-end with another two slated for 1Q15. This allows the carrier to build its scale as fast as it can. In the pipeline, five new destinations are ready to be launched in the near term. On a positive note, the reduction of value added tax (VAT) on jet fuel in some states could ease concerns over escalating losses. The reduction quantum in VAT varies from state to state. Expedia JV. The JV with the internet-based travel website company saw a strong jump in earnings in 3Q14, owing to higher transaction activities of tour packages (+56% YoY), which drove up revenue by 35% YoY.