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Higher oil prices have dampened the sweet spot airlines enjoyed last year, but rising airfares and the prospect of capital returns to shareholders have prompted Bank of America Merrill Lynch to reinstate coverage of Qantas with a buy rating on the stock and a target price of $7.75.

It is a far cry from just a few years ago, when the airline’s shares were trading below $1.

“Global airfares are on the rise for the first time since 2011 as cost pressures are passed on to the consumer and capacity is moderated across many markets. Demand to fly continues unabated, with global passenger numbers reaching record highs, translating to an improved yield outlook,” the BAML analysts said in a note.

Qantas’s passenger revenue needed to rise 8 per cent to offset the higher fuel costs and maintain margins. The airline had already achieved this growth in the domestic market, at the expense of a 2 per cent cut in capacity, the analysts noted, while pricing growth in the international market was expected to follow as its competitors were forced to pass on higher costs.

“We expect Qantas’s $400 million per annum transformation benefit combined with revenue growth to offset cost inflation,” the analysts said.

They are forecasting a 2018- 2020 financial year earnings per share compound annual growth rate of 14 per cent.

Central to BAML’s buy rating is the prospect of further capital returns to shareholders.

“Management has committed to paying back excess capital to shareholders if debt is below the upper end of the target range of $5 billion-$6.2bn. Based on our ­financial year 2019-2020 estimates, debt will remain at the lower end of management’s target range, giving us the confidence that capital return will remain a key investment thematic for Qantas,” they said.

The analysts expect Qantas to generate free cash flow in excess of $1bn for the 2019 and 2020 fin­ancial years and they are calling for a 7 per cent increase in dividends per share. They also see a case for a special dividend to be paid.

“Given Qantas’s financial position and forecast $1.6bn free cash flow, we believe the group is in a good position to potentially pay a special dividend in the 2019 financial year,” they wrote. “On our estimates, Qantas has $600m of surplus cashflow in 2019 which could be utilised in part to fund a special dividend. A special dividend in the range of 5c-10c per share would have a funding requirement of $70-$150m.”

Risks included a downturn in the macro environment that would dampen demand for air travel, further fuel price rises, increased competition, and unproductive capex, while the US trade war could also hit the airline.

“While the current US trade war has limited impact on Qantas given its small exposure to freight and strong domestic business focus, it could potentially see a moderation in premium travel demand in Qantas’s international business,” the analysts said.

Qantas shares closed yesterday at $6.37, up 13c.