A blinkered view of airlines may mean missing the flight to value
Investors have had good reason to avoid airline stocks over the years. Capital-hungry aviation companies, with their high fixed costs, produced lousy shareholder returns. Think Qantas Airways until 2014, Virgin Australia Holdings and most international airlines.
Airline stocks have many risks: hard-to-predict fuel costs, combative industrial relations settings, and high sensitivity to unfavourable currency movements. Then there’s the weather, regulatory risk and the threat of terrorism and plane crashes. 
For the most part, airlines are not businesses with superior competitive advantages, pricing power or high rates of return. But taking a blinkered view of airline stocks, or any sector for that matter, is a sure-fire way to miss value when investors stop paying attention. 
Qantas is an example. When it traded near $1 in early 2014, some commentators called for CEO Alan Joyce to resign and the airline’s many critics were quick to highlight its faults, even though management was implementing one of corporate Australia’s impressive turnaround strategies.
Aided by a tumbling oil price, Qantas hit a 52-week high of $4.22 this year and analysts lauded its progress. Qantas in April disclosed softening domestic demand and heavily discounted its domestic and international routes. Its stock slipped to $3.
Chart 1: Qantas AirwaysSource: The Bull 
Uncertainty around the federal election, waning consumer demand and lower patronage on resource sector routes weighed on Qantas’s revenue per available seat kilometre (RASK). It sensibly responded by reducing planned capacity additions for the rest of FY16.
The market’s reaction was understandable. A patchy economy, reflected in lower-than-expected inflation figures and the latest interest rate cut, suggested faster deterioration in air travel demand as consumers and businesses sat tight. 
Qantas’s April traffic statistics, released last week, showed a bounce back. The negative RASK trend in the previous release was arrested, with improving trends in May and June. Qantas’s quick response to weakening demand paid off. 
It’s too soon to say that Qantas has fixed the problem, but the sharp fall in traffic in the March quarter may have been an aberration; more because of Qantas’s capacity increases, an earlier-than-usual Easter and other one-off events, than a sustained trend. 
Still, prospective investors should watch Qantas’s RASK closely. After-tax net profit is highly sensitive to passenger volumes and yields, and analysts busily downgraded earnings forecasts when Qantas signalled weakening demand and a cutback in planned capacity growth. 
The market was not convinced by Qantas’s improvement in its latest traffic numbers, judging by continued selling in its shares. Rising oil prices have also led to Qantas shedding almost 25 per cent in the past six weeks in a rising sharemarket.
That selling momentum could continue in the next few months as the federal election weighs on consumer confidence and analysts look for signs that the recent improvement in Qantas’s passenger yields were not a one-off. It would not surprise if Qantas tested support around the $2.50 mark.
Portfolio investors should put Qantas on their watchlists in anticipation of better value in the second half of 2016. Another interest rate cut and a lower Australian dollar should support domestic travel demand, and Qantas is doing a good job of proactively managing its capacity and passenger yields.
Seven of 10 broking firms that cover Qantas have a buy recommendation, one a hold and two a sell. A median share price target of $4.46 suggests Qantas is undervalued at the current price of $3.08. Broker forecasts range from $2.70 to $5.15; even at the lowest valuation forecast, Qantas is only marginally overvalued. 
On some valuation metrics, Qantas is one of the world’s cheapest large-cap airline stocks. Its enterprise value/EBITDA (earnings before interest, tax, depreciation and amortisation) of 3.56 times, based on Capital IQ data, is well below its historic average and compares favourably with other leading global airline stocks.
Long term, Qantas’s frequent flyer program (Australia’s de-facto currency, according to some wags) is arguably its most valuable competitive advantage. Qantas made the right decision to keep its frequent flyer program rather than sell it through a demerger a few years ago, despite several overseas airlines (and Virgin Australia) fully or partially selling their points programs, and a mooted $2.5-billion price tag on the Qantas loyalty scheme.
The frequent flyer program gives the airline a touchpoint with almost one in two Australians. It is could be worth more than the airline itself one day, given the value of data mining in the digital economy. It’s no stretch to think of Qantas partly as a technology company as it uses its loyalty program to become the hub in an even larger network of retailers and customers. 
Although its fundamentals look attractive, Qantas was always due for a pullback or correction after quadrupling in two years. It is rapidly approaching value territory again, but the headwinds for domestic airline demand are unlikely to abate quickly. That could create an opportunity in the next few months.
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Tony Featherstone is a former managing editor of BRW and Shares magazines. The column does not imply any stock recommendations. Readers should do further research of their own or talk to their financial adviser before acting on themes in this article. All prices and analysis at June 1, 2016.