AirAsia Below IPO Price

Imagine building a business from scratch into one with an enviable regional footprint. Now just on soaring oil and jet fuel prices, a global credit crunch, and fears about decelerating economies and consumer spending: the share price is even below its IPO price level.

In a difficult environment, you would think that the low-cost-carrier model would be far superior to a full service carrier. However, that is not the case. In fact many investors are preferring MAS and Singapore Air to Air Asia's prospects over the next 12-24 months! There has to be a dislocation somewhere.

Low-cost carrier Oasis Hong Kong Airlines has been Asia's only casualty so far in 2008, although Adam Air in Indonesia remains grounded after the withdrawal of key investors. Safe to say that you will be tying your hands if you choose to operate a LCC out of HK or Singapore. Being based out of Malaysia and Thailand naturally give Air Asia enormous cost advantages.

In the United States, no fewer than five airlines have filed for bankruptcy in the past two months. Add in Champion Air, which will halt flights on May 31, and December casualty MAXjet Airways, and the picture there appears bleak for all airlines. Delta Air Lines in the US, itself just one year removed from bankruptcy, agreed to merge with Northwest Airlines in a stock deal worth more than US$3 billion. Both operators had recorded losses in the first three months of the year to take the first quarter deficit among major US carriers to US$1.38 billion.

It is not hard to see why the industry is under pressure. By mid-April, oil prices had reached a record US$115 per barrel, and now US$130. The global average price paid at the refinery for aviation jet fuel was US$145.40 a barrel in the week to April 18, a 78% year-on-year rise, reports the International Association of Air Transport (IATA).

IATA has downgraded its outlook for 2008 as it expects stagflation to hit air traffic demand. It cut this year's operating profit target for the industry 42% from US$21 billion in June 2007 to US$12.1 billion. For Asia, the figure drops 80% over the same period, to US$700 million. The squeeze would kill off a few airlines, but at the same time shrink the competition capacity for those who survive. Hence it is very important to look at AirAsia more closely, a survivor or something less than that.

Many of the LCCs out of Asia have failed to survive after just a couple of years. Some did not even come out of their starting blocks. IATA predicts that overall capacity in the Asia-Pacific region will rise by 8.8% this year against demand growth of just 6.4% – in other words, higher growth in seats than passengers.

For LCCs, some of the critical decisions would be:
to manage fuel cost, manage labour cost, to buy or lease planes, and be properly capitalised. Failure will surely follow if a LCC did any of the above poorly. Seat management should not be a big problem as demand is there in Asia.

Oasis was based out of Hong Kong International Airport – its crew costs, overheads, and ground and handling fees were high – where it was competing against some of the industry's biggest players, including Cathay. It also had to base its crews and its staff in Hong Kong and Vancouver overnight. AirAsia has its own LCC terminal, enough said. Virgin Blue and Air Asia X, 48%-owned by Fernandes, can also rely on a passenger feed network to fill up their planes, whereas Oasis was flying solo.

"AirAsia X arrives in Kuala Lumpur and on its doorstep has 75 [AirAsia planes] flying all over south-east Asia, so it has a natural feed, as opposed to Oasis which was landing in Hong Kong and was not going to have a Cathay working with them," says Fernandes. And Oasis would have had to pay market rates for its Boeing 747-400s, while AirAsia has a working relationship with Airbus. Oasis also offered passengers free meals and in-flight entertainment, and assigned 22% of its seating to business class - not exactly a LCC model.

However, the visible failure of Oasis may have contributed to the downgrading of AirAsia over the last 3 months.

Malaysia Airlines, meanwhile, is in acquisition mode and is in a net cash position of about RM4.4 billion (US$1.3 billion) following a rights and loan stock issue last year.

Competition

AirAsia already has a 49% interest in Thai AirAsia and in Indonesia AirAsia, and Fernandes is eyeing further tie-ups in south-east Asia.

All Nippon Airways in Japan has stated its intention to establish a low-cost carrier, either via joint-venture or acquisition, to fend off competition from budget rivals. Indonesia's Lion Air has said that it will buy stakes or create new carriers in Vietnam, the Philippines, Bangladesh and South Korea and is launching an Australian tie-up with Brisbane-based SkyAirWorld this year.

Meanwhile, Singapore-based Tiger Airways wants to become a pan-Asia carrier and is keen to establish regional bases through franchise partners. It has announced a joint-venture with Incheon City Council in South Korea to launch an Incheon-based low-cost carrier this year.

Then there is Jetstar, whose Australian and long-haul carriers are owned by Qantas and whose Singapore arm is part-owned by Qantas and backed by state investment agency Temasek. Both Qantas and Temasek are committed to the advance of the low-cost carrier market.

In South Korea, Asiana Airlines acquired a controlling stake in proposed low-cost operator Air Busan, while Yeongnam Air, JB Airways and up to four more start-ups are reportedly preparing for launch. And three airlines are entering the Vietnamese market: VietJet Air, Airspeed Up and Phu Quoc Air. Qantas has also bought a stake in Pacific Airlines, which will facilitate cross-border joint-venture operations with Jetstar. The Vietnamese government vetoed a planned joint-venture between AirAsia and state-owned ship-builder Vinashin, but Fernandes clearly fancies the market.

In Thailand, Thai Airways and its low-cost affiliate, Nok Air, are squabbling, and the former is threatening to re-explore operating a wholly owned subsidiary, notes Capa. Meanwhile, One-Two-Go, Thailand's second-largest budget carrier by fleet, is suffering from fuel-intensive aircraft and under pressure following a crash in Phuket last year in which more than 80 people died.

Hedging Fuel Cost

Singapore Airlines start hedging today for 18 months in the future. Whatever the date in the future is, they will build up 50% cover and they will do it with fairly traditional hedging mechanisms.Cathay Pacific's method as more convoluted. They have put in place a complex structure of swaps, options and three-way options [selling put, buying call and selling another call with a higher strike price]. And that gives them a degree of protection. They are hedged about 30% for 2008 volumes. The head of commodities at one global investment bank names Qantas, All Nippon Airways and Japan Airlines as committed fuel hedgers. Malaysia Airlines, meanwhile, has a conservative policy of benchmarking its fuel hedging ratio against the average hedge ratio of regional airline peers.

AirAsia takes a more directional bet as part of its hedging policy. In late 2007, AirAsia management sold call options at US$82.60/bbl for 150,000 barrels per month, and the call options will be triggered if West Texas Intermediate [WTI] crude prices average US$90/bbl for the month. If WTI oil prices stay above US$90/bbl during January 2009 to June 2010, the losses for AirAsia are likely to mount between the spot price and US$82.60/bbl. But Fernandes says AirAsia has taken 80% of those calls out with a hedge to the end of 2009. That seems to have gone over the heads of analysts and investors. Let's repeat, 80% of those calls have been taken out and they have a hedge till the end of 2009.

Based on absolute PER, AirAsia is ridiculously cheap. Trading at just 5x 2007 and 6.2x 2008 earnings. More importantly, its net interest cover is at a manageable 2.7x, but that figure cannot and should not go much lower from here. Its ROE is still at a very respectable 23%.

The over-riding fears would be the fuel cost. Can AirAsia still pass on some of the irrational hikes in fuel cost? AirAsia should be raising fuel surcharge by RM8-12 per pax sometime this year. Considering where AirAsia is now, that should not affect demand even with the hike.

You have two major risks: fuel price and leverage. As shown, these are certainly not debilitating. Bearing in mind AirAsia has already come through even more difficult phases: SARs epidemic and the tsunami-follow on effect on air travel. The two major risks are manageable. The more difficult phases saw a sharp downturn in passengers, which is not happening now. Hence balancing all that, the current share price levels would be an opportunity, not a call to join the bear camps. (Reference price RM1.08)