Still some turbulence ahead for Qantas shares
07/07/2018 | Author: Roger Montgomery
Over the years, airlines have generally produced poor returns: for this alone I have long chastised those who even entertain the idea of purchasing shares in airlines.
Yet Qantas always has its fans. Earlier this week there was another new buy call on Qantas as Bank of America Merrill Lynch recommended the stock on the back of higher airfares and the prospect of capital returns.
What about the wonderful Qantas turnaround, some might ask: actually, Qantas shares are trading where they were about 11 years ago and Virgin’s shares are 90 per cent lower than where they were 11 years ago.
In addition, accounting standards allow big differences between reported profits and “economic” profits in the sector.
Of course, stockmarkets have short memories and investors instead look to the six-fold jump in Qantas’s shares since January 2014 as reason to think airlines have changed their spots.
One of the inescapable issues for airlines is the need to fund new aircraft to remain fresh, efficient and competitive. The problem is that airline accounting doesn’t do a great job of reflecting the true cost of running the airline and replacing the planes.
The depreciation expense in the profit-and-loss statement is based on the historical cost of an aircraft that could be more than 15 years old and if the depreciation change were instead replaced with an equally creative “provision-for-replacement of aircraft” charge, the expense on the profit-and-loss statement would be much larger and the accounting profit could quickly turn into a loss.
Another way to test whether any real money is being made is to look past the reported accounting profits to the cash flows.
In Qantas’s case, the company has also been reporting strong cash flows in recent years.
In 2014, the year the company wrote down the value of its international fleet by $2.6 billion, Qantas reported a $2.8bn headline loss and a $640 million underlying loss. However, the operating cash flow amounted to just over $1bn.
Fast forward to 2017 and while reported profit had grown to $852m, cash flow from operations grew to $2.7bn. And since 2014, the share price is up over six-fold.
So, what gives? Have airlines suddenly become high-quality businesses that we should hope to own for the long term? Or is there something the strong cash flow isn’t reflecting?
As an aside, Warren Buffett has previously been on the record pointing out that had he been at Kitty Hawk in 1903 when Orville Wright took off for his maiden voyage, he hoped that he would have had the presence of mind, for the benefit of all future capitalists, to have shot him down. This is due to the tremendous aggregate losses airlines have accumulated over decades.
Those losses are a function of airlines being incredibly capital and labour-intensive, and there’s the small matter of some competitors having access to cheaper fuel thanks to ties to royal families or supportive governments.
Yet only back in January, Buffett’s flagship investment company Berkshire Hathaway had airlines: the share portfolio, led by Ted Weschler and Todd Combs, owned a $US11bn stake in United Airlines, Delta Airlines, Southwest and American Airlines. All are lower since the start of the year.
So back to the original question; have airlines become compelling investment opportunities?
No. Here’s why.
First, while the company’s cash flows look great, they have benefited in recent years from generally declining oil prices.
In July 2008, West Texas Intermediate crude oil traded at $US147 a barrel. By February 2016, the oil price had fallen to less than $US26. But since then oil has almost tripled to over $US70 and analysts at UBS now believe Qantas could be hit with a $700m negative shift in fuel costs from FY18 levels to the current spot price.
And while the impact might be offset by an expected 10 per cent increase in domestic revenue, there’s the matter of $400m a year in cash tax payments starting in the 2019 financial year.
In addition to benefiting from cheaper fuel, cash flows have also been boosted by a strategy that has allowed the fleet to age.
As I said earlier, the most expensive part of running an airline is replacing old, cheap planes with newer and more expensive models. Airlines cannot escape this capital expenditure lest passengers jump to competing airlines with fancier entertainment offerings and more comfortable seats, bars and beds.
You can call it a disciplined approach to capital spending or you could say the board might prefer to see the share price go up now, maximise share price-related incentives for current management and leave the reality of replacing planes to the next CEO.
On that matter, having served as CEO for almost a decade, it’s time to wonder whether Alan Joyce will stick around through the next potentially more challenging period, or perhaps leave that job to Alison Webster, who runs Qantas International.
Whichever way you spin it, investment bank UBS notes Qantas’s “fleet age has increased from 7.7 years in 2015 to a current 10.2 years”. They also note that the fleet is now older than the last peak of nine years in 2007.
According to the same report, Qantas has introduced just nine new aircraft or 3.7 per cent of group seat capacity over the last three years and so a minimum of $1.4bn a year will be required to maintain a constant fleet age, with an additional $300m spend on the non-aircraft asset base making $1.7bn.
That matches depreciation, but depreciation is based on historical costs so it is still probably undercooking how much is needed to keep the fleet fresh, new and competitive.
And that means future cash flows might not look as good as recent numbers suggest. You cannot escape being an airline, you will have to eventually replace planes and keep in mind even Buffett’s airline investments are not going so well this year.
Roger Montgomery is founder and chief investment officer of the Montgomery Fund.