QAN’s trading update was understandably cheery as domestic activity regains altitude. International travel remains a tricky proposition and is retarding a recovery. QAN has charted a new course towards Airbus for its domestic fleet replacement program but did not reveal the total cost which will be substantial.
Domestic activity is where QAN will concentrate its biggest effort over the next 12 months, in our view. State border restrictions appear unlikely to be a threat now that a large majority of the population is vaccinated, and yet travellers are still timid about leaving the country. Even the laggard states like Western Australia will re-open by February and we expect pent-up demand will fill many seats throughout CY22. Christmas domestic bookings for QAN are very busy and as all states re-open, the company is anticipating domestic flying to rush towards 100% of pre-COVID levels by February 2022 from 75% at the end of 2021.
QAN has cleverly manoeuvred its post-COVID domestic business to grab an extra slice of the Australian market. Virgin Australia’s smaller fleet is only partially offset by Rex Aviation’s ambitions to fly more routes and the imminent arrival of Bonza Airlines, a small start-up. QAN has quietly encouraged its 20% associate, Alliance Aviation, to beef up its balance sheet and fleet, and is now wet-leasing a handful of E190 jets to fly QAN routes without a red kangaroo tail in sight. QAN says it expects its domestic market share to settle towards 70% once all state borders are open, but we suspect it has ambitions to permanently increase this. It is a clear opportunity to do so and investors should expect QAN to make the most of it.
We expect all domestic carriers to try to fill seats whatever the price in order to generate cashflow. At this point in the recovery, with airlines well behind every other industry, cashflow is paramount so we think cheap airfares will be a feature of the domestic market in 2022. That cashflow will be important to sustain the return to work of thousands of stood-down airline staff along with every other aspect of the business.
International travel is back but nowhere near pre-COVID levels even if demand suggests it could be. QAN is expecting its international capacity to lift from 30% of pre-COVID levels in 3Q22 to 60% by the end of FY22. That’s a fairly steep trajectory but still well below where it really needs to be and indicates how awkward international travel is at the moment. Until test-free flying and no threat of quarantine (at either end) is restored, travellers will run a risk and a cost for doing so.
With everyone back at work, QAN is absorbing some upfront cost which will leak into 2H22f. With 1H22f activity still badly affected by border lockdowns, QAN is expecting the period to deliver an EBIT loss of $1.1 billion (-$888m in 1H21). Fuel cost for the half year will be about $495 million compared to $309 million for the same period last year giving an indication of the modest rise in activity so far.
The freight business will make a strong contribution and the Loyalty business continues to generate excellent cash flow. These elements will soften the hit from the core flying business.
Fleet renewal
QAN has made a momentous decision on the future of its fleet configuration. The choice of Airbus as its preferred aircraft for its future domestic fleet, including Jetstar, sets a pathway for the group’s dominant domestic business to become even more entrenched with a higher market share.
The aggregation of QAN’s order with Jetstar’s existing order would have helped on the total bill which was undisclosed by QAN. That is unfortunate as the likely total cost is expected to be several billion dollars spread over more than a decade but the implications for the group’s long term cashflow are significant. According to Statista (August 2021), the list price of a brand new A321XLR is around US$55 million, and an A220-100 is US$33 million. No airline pays the list price for large orders like QAN has submitted and a 50% discount is a reasonable assumption. A back of the envelope guestimate for 20x A321XLRs and 20x A220-100s would therefore be roughly US$880 million with a 50% discount. But that is just the firm order that QAN has committed to so far. QAN has purchase rights to a further 94 aircraft over a 10-year period. When stapled to the Jetstar shopping list of over 100 aircraft (in the A320neo family), QAN will have access to a total of 299 aircraft over the next decade for its domestic fleet replacement program. For context, QAN’s entire fleet as at June 2021 was 304 aircraft.
The missing sticker price for the new fleet deal is therefore a key risk that cannot be factored into a valuation equation for QAN.
Fuel efficiency
As an extra observation, the new aircraft will be incrementally more fuel efficient and quieter as you would expect. Fuel efficiency is important not only from an earnings perspective (QAN’s fuel bill has averaged 27.5% of total costs over the last 13 years) but also now that airlines are committing to net zero emissions by 2050 (IATA’s goal). It is worth noting that global fuel efficiency is 80% better than 50 years ago but there is much more the industry can do to reduce emissions. Plenty of attention is being given to SAF (sustainable aviation fuel) which is really just re-cooked old vegetable oils and other discarded bio-materials. There are few facilities producing SAF at the moment and hence it costs more than 4x standard jet fuel. When blended with normal jet fuel, SAF can reduce emissions by about 10%. QAN is already experimenting with SAF and has purchased 10 million litres but will not pass the cost on to customers. QAN has also committed $50 million in seed funding to a local effort to develop SAF.
But even bigger improvements to aircraft fuel efficiency will come from futuristic design elements such as the ‘canard wing’. A canard wing design has the main wings set behind small forewings giving the entire aircraft greater lift which would enable huge fuel savings. Other airframe design ideas might have additional benefits. IATA says geared turbofan engines and design advances will drive 15-25% fuel efficiency improvements over the next 25 years.
Flying is going to look quite different in a few decades, just as QAN’s new domestic fleet is due to retire.
Investment view
Although QAN CEO Alan Joyce described 1H22 as “one of the worst halves of the entire pandemic”, investors should be encouraged by the ramp up in domestic activity and the slow and steady international recovery.
The desire to fly is unquestionable but demand will be tempered by the fear of further lockdowns, quarantines and the general palaver associated with flying – PCR tests, extra costs and queue times, and the potential for mid-trip changes in conditions.
We see FY22 as an interim step towards normality with FY23f more likely to be the year to judge how the business is going. The balance sheet is in relatively good shape, but cash flow will be critical from hereon.
The lack of financial disclosure on the fleet renewal decision is disappointing. Hiding behind commercial confidentiality is a nonsense as the company will have to reveal the details eventually as it is so material. This will be a key risk factor until it is known.
Earnings projections for QAN remain fraught with uncertainty and this is the main reason we retain our Hold recommendation.
