Qantas On Recovery Route, Profits A Bit Longer

This story features QANTAS AIRWAYS LIMITED. For more info SHARE ANALYSIS: QAN

A vaccine, re-opening of domestic borders and a tourism support package are stimulating renewed interest in Qantas. How will this play out for a return to profit?

-Domestic borders re-opening, driving the share price
-Tourism package stimulates a rebounding leisure market
-Little impact on profitability from domestic recovery
 

By Eva Brocklehurst

After a torrid year is Qantas ((QAN)) on a recovery path? Several brokers believe so, as the rolling out of coronavirus vaccines provides hope the restrictions on air travel will finally be lifted.

The majority of Australian adults should have been vaccinated against covid by October and the recent government aviation support package for interstate tourism, worth $1.2bn, may support a faster domestic recovery.

UBS has gauged via its surveys that domestic borders re-opening are the most important driver of the Qantas share price and should provide impetus now as more than 90% of interstate travel is open. Interestingly, in the broker's data, the fuel price was the least important driver with 70% of respondents raking it last despite a 30% increase in the oil price this year.

In 2020 concerns centred on the balance sheet and whether people would be hesitant to fly again, as well as the Virgin Australia administration process, and UBS suggests these issues have now been de-risked. Hence, the two drivers going forward are rational domestic behaviour and Qantas achieving on its cost reduction program, ensuring costs do not return with activity.

Generally, Citi believes stimulus for various sectors during the pandemic has produced some of the best performing trades, noting fiscal support has overshot what is required, manifesting in short-term benefits for various companies.

The tourism package is no different, in that the stimulus should heat up an already rebounding leisure market. The broker has removed the High Risk rating and upgraded Qantas to Buy but tempers its enthusiasm somewhat as a leisure-led recovery is negative for the earnings mix.

Stimulus should mean capacity increases and Citi revises up available seat kilometres (ASK) assumptions but is less optimistic about cost reductions, given the company's track record.

International travel could also re-start at the end of 2021, Macquarie notes. For Qantas there are four main international destinations which traditionally account for more than 70% of ASK and the vaccine roll-out in these places may signal the shape of the recovery.

The broker is monitoring the rolling out of vaccines in the four countries that represent the largest portion of ASK – New Zealand, the US, Singapore and Hong Kong – but retains forecasts for 37/80% of pre-pandemic capacity levels in FY22/23.

Schedules are expected to start showing a step up in capacity late in the June quarter but more so during FY22. Macquarie suspects domestic capacity could overshoot pre-pandemic levels, given border policies, government stimulus and the vaccine roll-out. Regardless, the broker points out, discounted fares may mean there is not a material improvement in earnings.

Return To Profit

Macquarie assesses the balance sheet will start to be repaired in FY22 along with improving capacity and it is important to recognise that Qantas has structurally improved its business, with a higher skew towards a more attractive domestic and loyalty programs and cost reductions that reduce the downside risks associated with international travel.

Hence the broker re-rates the stock, upgrading to Outperform from Neutral. Ord Minnett also upgrades to Buy, believing Qantas is positioned from both a balance sheet and competitive perspective to emerge in a stronger position post the pandemic.

The broker notes costs have been taken out to provide $1bn per annum in savings from FY23 and the market position should be enhanced as Virgin Australia is a much smaller airline post administration. Ord Minnett's base case is Qantas will make $1.6bn in profit before tax in FY24, based on domestic and international ASK being back at pre-pandemic levels and a more profitable loyalty business.

Internationally, there are limited re-opening costs as many of the Qantas aircraft are already in operation. Behaviour internationally is expected to be rational and disciplined as many international competitors have geared up throughout the crisis.

Qantas should emerge from the pandemic with a better industry structure, given the rationalisation in Virgin Australia/Tiger Air, and as a result Morgan Stanley anticipates a return to profit in FY22. Significantly, pre-tax profit is expected to recover to FY19 levels by FY23, although demand is expected to be relatively weaker.

Citi agrees there is only negligible impact on profitability with the domestic recovery and suspects cost-conscious travellers will outweigh the high-fare corporates and this means Jetstar may over index a recovery while the Qantas brand lags.

CLSA suspects it is too early to quantify the financial benefits for Qantas of the government's tourism support package but acknowledges the steps taken to provide incentives for domestic travel.

The broker, not one of the seven stockbrokers monitored daily on the FNArena database, as a Outperform rating and $6.00 target. The database has five Buy ratings and one Sell (Credit Suisse). The consensus target is $5.79, suggesting 9.2% upside to the last share price.

Working Capital

Although ahead of the government stimulus announcement, Credit Suisse remains the outlier with an Underperform rating, noting Qantas has a large negative working capital position.

This shrank comparatively in the first half of FY21 to $6.05bn (from $7.15bn at the end of FY19) because of a -44% decline in unearned ticket revenue that offset a 21% increase in unearned loyalty revenue.

The negative working capital position over the past 15 years has varied between -$5-7bn, or 30-40% of revenue. Customers buy tickets in advance of the flight but the cost of providing the services are incurred at the time of the flight. Hence, Qantas has the benefit of cash in the interim.

Qantas also collect revenue from the sale of loyalty points to banks, retailers and other partners but consumers typically take several years to redeem these points for a flight or other item. Hence the airline effectively obtains free funding from a negative working capital position.

Given the shutdown of travel to and from Australia and a significant reduction in domestic travel over the course of the pandemic the composition of the working capital position changed. Unearned ticket revenue dropped (no one booked seats) and unearned loyalty revenue rose (consumer spending on goods increased with lockdowns).

So is this balance set to change? Credit Suisse points out a higher proportion of unearned ticket revenue relates to international travel, as these customers tend to book further in advance than domestic travellers, particularly in the leisure segment.

As international travel will take longer to recover, the broker forecasts the negative working capital position will increase out to FY24 as a recovery in unearned ticket revenue offsets a decline in unearned loyalty revenue.

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