Qantas shows its resilience despite weak headline FY14 result

Despite a weak FY14 result, with the general media attention focussing on the large headline losses, there were still a number of positives for Qantas’ bondholders to take away from the FY14 results. Of particular note were the better than expected underlying earnings, an increase in group liquidity of $600m to $3.6bn, positive management comments on market conditions, progress on the cost reduction initiatives and confirmation that Qantas Loyalty (Frequent Flyer) will not be sold.

Qantas was also able to generate large positive operating cash flows of $1.1bn in FY14 despite being engaged in a price war with arch rival Virgin Australia. In addition, whilst Virgin has declined to provide any guidance to the market, Qantas has forecast it will return to profitability in 1H15. In a further boost for bond holders, management stated that it was focused on regaining the company’s investment grade credit rating.

Offering high yields to maturity of between 6.5% to 6.9%, we believe the Qantas bonds represent good value for a premium brand with a stated intention to improve its credit position.

Key points

• The FY14 results have been generally well received by the market. Analysts had expected the airline to report an underlying pre-tax loss of around $750 million, so the underlying result is better than expected, however the market had not expected the airline would take such heavy write-downs on its fleet. In particular, profitability is better than expected in 2H14
• As a result of the weak earnings result, credit metrics such as gearing have increased. However, in the results briefing, Qantas management stated its intention to return to investment grade credit metrics over the medium term. In particular, Qantas is targeting an improvement in its Debt / EBITDA ratio to 4.0x by FY 17. The Debt / EBITDA ratio is a key credit metric reflecting the ratio of debt in the business to earnings
• Following the results announcement, the rating agencies have maintained their negative outlook on Qantas, but have chosen not to downgrade its credit rating. While the outlook remains negative, S&P has in particular noted there are early indications that some key drivers are moving in Qantas' favour: revenue yields are expected to improve through more manageable capacity additions in both domestic and international markets, and the improved unit costs provide evidence of progress with Qantas' transformation program

Summary of FY14 Results

• Group revenue down 3% from $15.9bn to $15.3bn
• $646m underlying loss after tax and $2.8bn statutory loss after tax
• The statutory loss includes a non-cash writedown of international fleet of $2.6bn -  bringing the carrying value of the international fleet to be more reflective of the current market value
• Operating cash flow of $1.1bn, leading to a neutral free cash flow result
• EBIT down $806m from $366m in FY13 to an EBIT loss of ($440m) in FY14
  • Qantas Domestic reported underlying EBIT of $30m, down from $365m a year earlier, as a result of the damaging capacity war with Virgin Australia Holdings
  • Qantas International reported an EBIT loss of $497m, compared with a loss of $246m in the prior year
  • The Jetstar Group reported an EBIT loss of $116m, down from a profit of $138m in FY13, but the Australian domestic portion of the business remain profitable
  • Qantas Loyalty division reported EBIT of $286m, up from $260m on the prior year. Qantas Loyalty to be retained within the existing group structure
• EBITDA down 46% from $1.8bn to $982m
• Following the partial repeal of the Qantas Sale Act, the group will establish a new holding structure and corporate entity for Qantas International
• On balance sheet debt ratio up from 36% to 54%. Total gearing ratio (which includes obligations under operating leases) up from 46% to 62%
• Group liquidity is up to $3.6bn, comprising $3bn in cash (up $600m from last year) and ~$600m in undrawn facilities
• No major unsecured debt maturity until April 2016
• Qantas expects a return to underlying profits in 1H15, “subject to factors outside of its control”
• Non-core assets identified and valued, including terminals, land and property holdings – Qantas will continue to assess opportunities to sell, with proceeds to repay debt

Despite the headline losses, Qantas’ FY14 results have been received well by the market, with Qantas flagging a return to profitability in 1H15. However, there continues to be a lot of near term uncertainty in terms of competitive factors, fuel costs and the results of the business transformation. The large fleet writedown is not considered to be a major issue for bondholders at it is a non-cash writedown and relates to operational fleet which will continue to be used by Qantas.

Following the FY14 result, bond yields have moderately fallen by between 10-15 basis points, as highlighted in the chart below.

The high yields on the Qantas bonds reflect the near-term uncertainties and credit pressures associated with the business. However, should the company be able to return to profitability in 1H15 as stated, we should see some of the negative rating pressure come off and a continued reduction in yields and corresponding increase in bond prices. With an improved outlook on profitability, high liquidity levels and managements’ stated intention to return the business back to investment grade credit metrics, we continue to believe that the Qantas bonds represent good value even with the moderate fall in yields following the results announcement.

FIIG has good supply in each of the Qantas 2020, ’21 and ’22 maturing bonds. With the downgrade protection offered in terms of step-up margins, we continue to prefer the Qantas ‘21s and ‘22s. Please contact your FIIG representative if you are interested in investing in Qantas’ bonds.

All prices and yields are a guide only and subject to market availability. FIIG does not make a market in these securities.

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