The slump in oil prices will benefit the aviation sector. While we do not see  demand  growing  strongly,  sector  earnings  will be underpinned  by yield  recovery,  with  an  additional  positive  impact  from  lower  jet  fuel prices. As such, we upgrade the sector to OVERWEIGHT from Neutral. AirAsia  is  our  Top  Pick  for  the  Malaysian  aviation  sector.  AirAsia  X remains a SELL as losses will continue into FY15.  
 
Yields  at  an  inflection  point  to  recovery.  Soon-to-be  privatised Malaysian  Airline  System  (MAS)  (MAS  MK,  NR)  is  in  the  midst  of  a restructuring  that  will  likely involve  capacity  cuts  on  loss-making routes and frequency reductions.  More importantly, this ought to  put to an end to  its  irrational  pricing  strategy,  the  chief  cause  behind  the sector’s depressed yields. MAS has yet to announce the size of its capacity cuts, but  we  estimate  that  this  could  be  c.10-15%  of  its  available  seat  per kilometres  (ASK)  at  best,  as  its  core  focus  ought  to  be  on  cutting  its workforce (by 30%) and raising ticket prices.   

2015  travel  sentiment  remains  shaky  on  goods  and  services  tax (GST).  We  expect  2015  passenger  growth  to  inch  up  6%  YoY  after recovering  from  the  tragic  MH370  and  MH17  incidents  in  2014.  This year,  we  forecast  for  passenger  growth  of  4.4%  YoY,  less  than  the 18.4% growth recorded in 2013. The recovery in 2015 passenger growth may not reach double-digit levels, though, given the uncertain consumer sentiment. For 2016, we expect a passenger growth of 5%. The weaker MYR  could  also  have  positive  implications  on  inbound  foreign  tourist arrivals that would benefit airlines and airport operators.

Decline  in  oil  prices  a  positive.  While  we  collectively  see  an  overall improvement in earnings across the carriers we cover, we prefer to stick to  those  that  have  scale  in  their  operations  with  proven  cost  efficiency structures. As such, we see AirAsia (AIRA MK, BUY, TP: MYR3.47) as a sound  pick.  Within  our  Malaysian  aviation  coverage,  AirAsia X’s (AAX MK, SELL, TP: MYR0.58) bottomline would be the most sensitive to jet fuel  price  fluctuations.  We  note  that  the  carrier  is  unprofitable  currently and  we  estimate  that  a  1USD/bbl  change  oil  prices  would  have  an inverse  impact  in its  bottomline  by  MYR12.4m  and  MYR13.5m in  FY15 and FY16 respectively. Meanwhile AirAsia’s sensitivity to a 1USD/bbl change would inversely impact earnings by 2.3% in both FY15 and FY16 (or  approximately  MYR18.4m-19.2m).  Carriers  with  strong  balance sheets and cash piles like AirAsia could possibly take the opportunity to take a larger hedging position of its needed fuel intake into 2016.   

Upgrade  to  OVERWEIGHT.  The  slump  in  oil  prices  would  benefit  the aviation  sector.  While  we  do  not  see  demand  growing  strongly,  sector earnings would be underpinned by the yield recovery, with an additional positive impact from lower jet fuel price. As such, we upgrade the sector to  OVERWEIGHT  from  Neutral.  We  prefer  AirAsia  for  its  compelling valuations  and  thrifty  operating  structure  and  the  stock  remains  our sector Top Pick.

2014 An Eventful Year

2014  would  be  deemed  a  washout  year  for  aviation. While  the  industry  anticipated this year to be  challenging – as intensifying competition put pressure on yields and the political conflicts affected Thailand’s capital – this was further compounded by the MH370  and  MH17  tragedies,  which  dampened  overall  air  travel  sentiment. Passenger air traffic has since declined, due mainly to fewer inbound China tourists, which has always been a lucrative target market for Malaysian tourism. The aviation sector  saw  continuous  earnings  downgrades  as  quarterly  earnings  failed  to  meet expectations.  In  2014,  we  also  witnessed  the  privatisation  of  ailing  MAS  as  a necessary  means  for  its  restructuring,  which  could  possibly  lead  to  a  potential  10-15% capacity cut. MAS’ irrational pricing strategy, which was made in an attempt to boost loads – to the extent that it undercut air fares offered by low-cost carriers, has been the core reason behind the overall depressed yields in the Malaysian aviation sector.  Malaysia  Airports  (MAHB  MK,  BUY,  TP:  MYR8.06)  commenced  operating KLIA2  in  May,  but  its  high  operating  costs  disappointed  investors.  The  airport operator also announced the full acquisition of the remaining unowned shares in its Sabiha Gokcen airport associate stake, which also took the market by surprise.

Yield Pick-Up From 4Q Onwards

Soon-to-be  privatised  MAS  is  in  the  midst  of  a  restructuring  that  will  likely  involve capacity cuts from its loss-making routes and frequency reductions. We foresee the airline  likely  cutting  its  Amsterdam  route  and  trimming  down  frequencies  to  North Asia, ASEAN and Australia. More importantly, this would put to an end to the carrier’s irrational pricing strategy, which has been the culprit behind the sector’s depressed yields. MAS has yet to announce the size of its capacity cuts, but we  estimate that this could be to the tune of 10-15% of its ASK at best over  the FY15-16 period, as its core  focus  ought  to  be  on  cutting its  workforce  (by  30%)  and  bumping  up its  ticket pricing. At the same time, we expect the budget carriers’ yields to be positive in 4Q, which will continue through to next year. We expect yields for AirAsia and AirAsia X to grow by 5% and 10% respectively in 2015 vs drops of 4.7% and 13% in FY14.

Demand From 2015 Onwards

2015 travel sentiment could be shaky due to GST 

We expect consumer sentiment to be weak in 2015, on the upcoming implementation of the GST in Apr 2015. We also expect the tax to affect air fares. International routes and routes departing from tax-free zones such as Langkawi will be exempt from the tax, but domestic routes would see tickets being subjected to a 6% GST. Still, we do expect the carriers to absorb part of the taxes.  This could potentially cap the yield upsides for AirAsia and MAS. Passenger service charges  (both  international  and  domestic)  would  factor  in  the  GST,  although  the impact  on  consumers  should  be  fairly  minimal  as  it  will  only  translate  to  a  6% increase  in  the  airport  tax  base.  This  will  range  from  MYR6-65,  depending  on  the airport  that  passengers  depart  from.  Duty-free  goods,  and  aircraft  parking  and landing charges are also understood to be zero-rated. On a  positive note,  Malaysia Airports  may  stand  to  benefit  from  the  GST,  as  this  could  boost  sales  of  duty-free goods.  On  the  cost  front,  airlines  are  expected  to  pay  for  higher  jet  fuel,  when  it comes to local flights. Although  we  note  that  the  flat  growth  in  wages  and  rising  inflationary  pressure  – stemming from the implementation of the GST and rationalisation of subsidies – may weigh on consumer spending, we expect spending trends to gradually normalise over the course of next year. RHB economists project consumption spending to grow at a slower pace (+5.2% YoY) in 2015

We  expect  2015  passenger  growth  to  inch  up  6%  YoY  after  recovering  from  the tragic  MH370  and  MH17  incidents  in  2014.  We  estimate  a  4.4%  YoY  growth  this year,  which  is  comparatively  less  than  the  18.4%  growth  recorded  in  2013.  The recovery  in  2015  passenger  growth  may  not  reach  double-digit  levels  given  the uncertain consumer sentiment. For 2016, we expect a passenger growth of 5%. The weaker MYR could also have positive implications on inbound foreign tourist arrivals that would benefit airlines and airport operators.

Slump In Oil Prices Leads To Earnings Bonuses

Oil price slump a saving grace for carriers

With  the  compounded  negative  news  flow  throughout  2014,  things  took  a  positive turn for the aviation sector as the crude oil price has slumped by 47.5% from its 2014 peak and continues to trend lower (39.8% for jet fuel spot). This would bode well for the aviation sectors’ earnings, which would move towards an inflection point as yields recover. Fuel costs represent a significant chunk of airlines’ operating costs and we believe that this could provide a double whammy in terms of an earnings upside, in addition  to  the  recovery  in  yields.  On  the  flipside,  however,  the  downtrend  in  fuel prices  has  consequently  weakened  the  MYR  against  the  USD,  which  will  put pressure on maintenance and USD-denominated borrowing costs as well as capex. These  are typically transacted in USD. Fortunately, the sharp drop in jet fuel prices has clearly outweighed the negative impact arising from the depreciation of the MYR against  the  greenback.  Our  base  case  assumption  for  jet  fuel  prices  for  2015  and 2016  stands  at  USD100/bbl  and  USD110/bbl  respectively  –  which  were  recently lowered from USD115/bbl and USD123/bbl. Note that we have input a handling cost 
of USD7/barrel on the forecasted spot price as well as a 6% GST charge on fuel for domestic flights.

While  we  collectively  see  an  overall  improvement  in  earnings  across  the  carriers under  our  coverage,  we  prefer  to  stick  to  those  that  have  scale  in  their  operations with  proven  cost  efficiency  structures.  As  such,  we  see  AirAsia  as  a  sound  pick. 

Within  our  Malaysian  aviation  coverage,  AirAsia  X’s  bottomline  will  be  the  most sensitive to jet fuel prices. We note that the carrier is unprofitable currently and we estimate  that  a  1USD/bbl  change  oil  prices  would  have  an  inverse  impact  in  its bottomline by MYR12.4m and MYR13.5m in FY15 and FY16 respectively. Meanwhile AirAsia’s sensitivity  to  a  1USD/bbl  change  would  inversely  impact  earnings  by  2.3-2.3% in both FY15 and FY16 (or approximately MYR18.4m-19.2m).

Assumptions

AirAsia

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 12.8% and 6.3% in FY15 and FY16 respectively.

AirAsia X

AirAsia X’s upcoming aircraft delivery in 2015 will be slated for its associates, Indonesia  AirAsia  X (one  aircraft) and  Thai  AirAsia  X  (two aircraft). We  understand AirAsia  X is  only  expected  to  see  a  net  addition of  only  one  aircraft  in  FY15 for  its Malaysia  operations. We also  assume only  one  aircraft  added  in  for FY16. We  still remain concerned on where AirAsia X will be deploying its aircraft, although there are talks  of  a  possibility  reactivating  its  terminated  London,  UK,  route.  Another mooted destination  is  also  Hawaii,  US.  We  think  these  two  routes  are  unlikely  in  the  near term, unless the carrier optimises its overall cost restructure.  All of AirAsia X’s aircraft deliveries will be on operating lease in view of its weak balance  sheet,  and  this  will  likely  persist  in  FY16.  As  such,  there  will  not  be  any aircraft capex required in the immediate term for the long haul low cost carrier.  

In the meantime, to optimise capacity during the seasonally weaker quarters (2Q and 3Q), AirAsia X will continue to tactically deploy its fleet aggressively on wet leases in FY15. These wet leases could potentially earn as much as USD2m over a 2-3 month period  for  an  aircraft,  with  a  possible  net  margin  of  10%.  As  such,  we  only  expect single digit growth in ASK over the next two years.

Source: RHB