Monday 09 December 2013 by FIIG Research Legacy

Qantas balance sheet strength offers an opportunity

Last week was a tough one for Qantas and its CEO Alan Joyce. Despite the forecast loss and a credit rating downgrade the flying kangaroo maintains a strong balance sheet which provides bond investors comfort and an opportunity

Key points:

  1. Qantas reports expected loss coming half year, S&P downgrades

2      Government sends out mixed signals on support

3      Company balance sheets strength remains the real story

Last week Qantas CEO, Alan Joyce, surprised the market by announcing an expected underlying half year loss of between $250m and $300m, raising the stakes in its claims for government intervention in the ongoing public battle with Virgin Australia. In response to the reported losses and deterioration in the Australian domestic market, the company’s credit rating was downgraded to BB+ (from BBB-) by Standard & Poor’s.

The combined announcements helped drive the company’s share price down  around 20% and spreads on the company’s debt widened as institutions with investment grade mandates became forced sellers of the downgraded paper.

Despite the significant sell down in the company equity, market capitalisation (at the time of writing) was still above $2.16bn.

Mixed messages from the government

Joyce called last week for the government to level the playing field for Qantas as it competes domestically with Virgin. Virgin in turn is majority owned by three government owned airlines – Etihad, Singapore and Air New Zealand, which all enjoy government support, in turn, Joyce contends that Virgin can access cheaper funding than Qantas, putting it at a competitive advantage. A number of options for Australian government support have been bandied about including equity stakes, debt guarantees and removals on ownership restrictions set out in the Qantas Sale Act.

Federal Treasurer Joe Hockey stated he was open to public debate about the concept of a national carrier and what we, Australian taxpayers, are prepared to pay to maintain that concept. Prime Minister Tony Abbott seemed less enthused about direct government support of the business at the time, whilst Shadow Treasurer Chris Bowen has this week described Qantas as ‘too big to fail’.

For his part, Alan Joyce has said he will do whatever it takes; the political pressure has only just begun. With the car industry under significant pressure to survive, would the Prime Minister remain as defiant on Qantas support if it announced the shutting of its maintenance facilities in Australia – to be replaced with Asian based facilities, at a considerable saving to the company?

It is also worth noting that Qantas has been a fundamental partner to Tourism Australia and its campaigns over recent decades, as well as contributing significantly to state tourism body’s campaigns.

Changing fundamentals

Whilst the company noted that the high Australian dollar and jet fuel prices contributed significantly to the loss; S&P noted changing fundamentals to the industry at the time of its downgrade. However, the fundamentals are affecting the whole industry. With slow economies in Europe and the United States, airlines have significant excess capacity with which to compete in fewer markets. Australians, on the back of the high Australian dollar, have remained one of the few bright spots of international travel and this has attracted international airline attention.

In addition to this international pressure, Qantas has faced increasing competition (the company would say unfair competition) at home from Virgin. Despite making a loss last year Virgin has added capacity to its Australian operations. A strong Virgin (market share wise, if not profitability) can help drive passengers through the foreign hubs of its parents to achieve larger domestic goals, more important to the international carrier and their government owners than a short term loss in Virgin’s domestic Australian operations.

Strong balance sheet

Despite the losses and the difficult operating environment the company maintains a very strong balance sheet. At 30 June 2013 Qantas held $2.8bn in cash and equivalents on its balance sheet and had a further $630m in undrawn facilities available to it.

Of the $20.2bn in total assets held on the balance sheet, only $714m are intangibles, the majority of which relates to software. Included in the total assets is $13.8bn in property, plant and equipment, with $7.3bn (net of depreciation) in owned aircraft (and a further $2.9bn in leased aircraft). Total net debt carried on the balance sheet was $3.2bn against $5.7bn in share holders’ equity.

The strength of the Qantas balance sheet should provide investors with considerable comfort over the security of their bonds. The balance sheet is more than capable of sustaining the business through the current difficulties.

With the rating downgrade forcing some selling from investment grade mandated institutions, concentrating on the balance sheet strength of the company may provide investors with the opportunity to add a high yield bond from a company with a $2.2bn market capitalisation.