AirAsia: Now Everyone Can Fly

Just to be clear, I'm bullish

  • In this article, we’ll try to unpack how much cash runway AirAsia has remaining, and what their possible next moves might be.

  • All else being equal, the company appears to have 5-8 months of cash remaining before considering any equity funding. However, the share price is so depressed that even the estimated 44% shareholder dilution needed to raise the budgeted RM 1.5 bil will still result in a post-dilution normalized PE ratio of only 6.2x.

  • In my view AirAsia is dramatically undervalued, assuming they survive the pandemic. However given the large uncertainty involved, a small position is recommended.


Background: Current Business Landscape

In September 2020, I came up with an bullish investment thesis on AirAsia. I highly recommend that you at least skim through those slides first, as the below analysis is a follow-up to that. You can read the thesis in its entirety here: https://valueinvesting.substack.com/p/airasia-buy-or-die

Since then, life has turned upside down for AirAsia; and then turned upside down again. As expected, the pandemic environment has not been a pleasant one for airlines globally. In November 2020, the first covid vaccines were announced by Pfizer, Moderna and AstraZeneca, which have since been distributed across most of the developed world and to a lesser extent the developing world. Airline executives globally breathed a collective sigh of relief.

And then just as things were starting to look brighter again, a new wave swept across the world after the original covid strain ravaged India, and gave birth to the variant-of-concern now known as the ‘delta’ variant. Cases suddenly spiked across the world as the one-two punch of the variant’s mutations made it 3x more transmissible, with Malaysia (AirAsia’s HQ) being no exception - at one point, new local daily COVID cases per million people exceeded even India’s.

Prior to this, Malaysia’s new daily cases had actually been stabilizing somewhat, and domestic inter-state border restrictions had been lifted which allowed flying. Domestic tourism was in fact seeing somewhat of a boom, as pent-up demand and the lack of international tourist destinations drove a near-recovery in domestic travel volumes. However, new local cases suddenly and unexpectedly started spiking into the stratosphere in April, and by end-May the government had reinstituted harsh nationwide lockdowns again.

Obviously, this was not good news for AirAsia. Many investors of the airline felt that its survival was predicated on domestic flights providing much-needed cash flow - and if covid could flare up so unpredictably and lockdowns re-implemented without warning, what did their future look like? With only about 15% of the local population having received their first dose of vaccination as of today (compared to the USA’s 50%), the inside of the crystal ball into AirAsia’s future prospects resembled a raging snowstorm.

However, it wasn’t all bad news for AirAsia. In February, a prominent Hong Kong businessman by the name of Stanley Choi appeared as a substantial shareholder, acquiring nearly 9% of its shares by early March through a private placement. In addition, AirAsia’s CEO Tony Fernandes revealed in a recent podcast that the status of a syndicated bank loan of RM 1.0 bil (USD 240 mil) which had been in the works since mid-2020 would be getting an update “very soon”.

So what do I think about AirAsia’s share price today, which has risen by nearly 40% since my last writeup? As Buffett once said, “In the business world, the rearview mirror is always clearer than the windshield”. So let’s grab that divine squeegee and try flexing our prophetic muscles, shall we?


Overview of AirAsia's Current Liquidity/Cash Flow Situation

As expected, the immediate concern that most investors analyzing AirAsia’s financial statements would have is their liquidity position - especially with respect to debt serviceability and operational expenses.

Most airline analysts are familiar with the relentless industry norms of the airline sector - high debt loads, high capital intensity, razor-thin margins and price elastic customers. This high-fixed cost & low-variable cost business model with fungible & perishable inventory is well-known to be the bane of industry participants, as competitors will readily slash gross margins to the bone in order to squeeze that last dollar out of the proverbial rock when it’s time for the plane to leave the tarmac. Indeed, the Oracle of Omaha himself once decried the airline industry as a “death trap for investors”.

However, as we can see above, AirAsia doesn’t have a lot of debt on its balance sheet. This is because the airline switched from an airplane ownership model to a leasing model in 2018, for the various ‘usual suspect’ reasons. This timely shift coincided with a change in the ‘IFRS 16 - Leases’ accounting standards in 2019, which are expressed as Lease Liabilities and Right-of-Use (ROU) Assets line items on its balance sheet.

This explains why AirAsia has in excess of RM 12 bil of Lease Liabilities on its balance sheet as of FY20 (as seen above). As far as AirAsia is concerned, the accounting standards change in 2019 required that Operating Lease amounts be treated similarly to Finance Leases - which basically meant that companies could no longer hide long-term rental commitments from the balance sheet value of capital assets. This change was deemed necessary because companies like Amazon were renewing their Operating Leases into perpetuity when they were in substance acquiring Finance Leases - in effect, borrowing from the owner of the Lease asset to finance the asset’s acquisition. While this was not necessarily the case at AirAsia, a layman would simply observe Debt values being exchanged for Lease values on the balance sheet.

Hence in order to determine AirAsia’s FY20 Liquidity, the logical first step would be to start with the changes in their Lease Liabilities carrying values.


Sources of Cash Inflows: Lease Liabilities and Borrowings

The first thing that would catch your eye in the above table is the absolute lack of YoY change in Lease Liabilities amounts (‘-24‘, or -0.2%) from FY19 to FY20. This is striking for several reasons.

In light of the pandemic, airplane lessors have stepped in to serve as a stopgap of sorts in the aviation industry supply chain - by granting lease forbearance to their airline lessees (e.g. lease payment deferrals or complete lease restructuring). This was the case for AirAsia as well, with industry news portals reporting that the airline had been granted USD 435 mil (RM 1.8 bil) of lease deferrals over the course of FY20.

However, what we’re interested in finding out isn’t the value of lease deferrals per se, but rather their impact on AirAsia’s cash flows over FY20. Specifically, how much did lease referrals contribute to AirAsia’s liquidity in FY20? And by extension, how much will they contribute to liquidity in FY21? Since accounting standards don’t require the company to disclose the exact amount of lease deferrals AirAsia received over FY20, we’re going to have to do some sleuthing to find out.

To do that, we first need to understand how lease accounting works. The basic premise of lease accounting follows the concept of ‘amortized cost’, where the steps involved in calculating the lease balances from one year to the next are as follows:

  1. Start with last year’s Lease Liabilities carrying amounts

  2. Dr Lease Interest Expense // Cr Lease Liabilities - when lease interest is incurred

  3. Dr Lease Liabilities // Cr Cash - when lease repayments are made

As such, we should be able to net off Lease Interest amounts from Lease Repayment amounts in order to arrive at the YoY net reduction in the amount of Lease Liabilities. As we can see above, the Net Lease Reduction difference of (-302) is not too far off from the actual YoY change of (-24), relative to Lease Liabilities carrying values of RM 12,435 mil. And since these are just estimates, the lack of precision (2% difference vs carrying values) shouldn’t be too much of a concern.

Now I’m sure there will be auditors among you who will complain about the possibility of Lease Modification accounting resulting from the lease payment deferrals, which may distort the logical flow of the accounting described above. In a lease modification, accounting standards normally require that the company derecognize the old lease and treat the modified lease as a brand new lease for accounting purposes. This could of course potentially throw off the scent in our hunt for the cash flow impact of lease deferrals, as we can’t easily identify the accounting value of the newly modified lease in the absence of such disclosures.

However, Covid-19-Related Rent Concessions (Amendment to MFRS 16) issued in May 2020 specifically exempts accounting for lease modifications, with regards to lease amounts affected by the pandemic until June 2021. The regulators recently extended that exemption to June 2022. Hence, there should be no change in the accounting treatment of lease modifications that AirAsia received over FY20 and FY21.

As such, we can estimate that there was a Net Lease Reduction of roughly RM 302 million from FY19 to FY20 (578 - 880 = -302). If we compare this amount to the Net Lease Reduction of RM 1,585 mil in FY19, we can fairly assume that there was approximately RM 1,283 mil of forbearance provided by AirAsia’s airplane lessors. This could take the form of either deferrals of lease repayments, or lease restructuring to allow more generous lease terms.

Similarly, we can see that there was an YoY increase in Total Borrowings of RM 860 mil. This is pretty straightforward, no explanation necessary.

Hence, if we add the Net Lease Reduction of RM 1,283 mil to the Total Borrowings of RM 860 mil, we get roughly RM 2.1 bil of liquidity inflow from Leases and Debt. That’s the figure we’re going to be using in the estimation of FY21’s cash outflow below.

As an aside, I understand that these are super rough estimates of FY20 cash flow, with rounding errors potentially in the hundreds of millions. However, we’re not trying to be super precise in our estimates, as at the end of the day there still needs to be a sufficiently large Margin of Safety to inform our investment decision - preferably in the order of about 50%. Hence, there is no need for us to nail down precise amounts at this juncture.

Sources of Cash Outflows: Operating Cash Expenses

Next, we’re going to have to figure out how much cash flowed out of the company in FY20. This one is relatively simple compared to estimating cash inflows from leases above.

The first item to consider is Operating Cash Flows (OCF) of -RM 2,168. For convenience, I’ve highlighted the more significant line items in the discovery of AirAsia’s FY20 cash outflows. Our friend from above, Interest expense - Lease liabilities of RM 578 mil, makes an appearance again; and we can see that FY20’s OCF was -RM 2,168 mil as mentioned above.

However, I’d like to draw your attention to the line item Amounts due from/to subsidiaries, associates, joint ventures and related parties of -RM 1,017 mil. In contrast to the OCF before working capital amount of -RM 1,292 mil, these amounts weren’t in substance actually spent on cash operating expenses. They more closely resembled working capital in nature, as these were amounts that were simply temporarily extended to intra-group companies and were meant to be repaid sometime in the future, i.e. representing timing differences of cash flows rather than accounting profit/loss.

We can also find out where these cash flows went to. In Note 37 of the FY20 Annual Report, we can see that AirAsia has various subsidiaries, associates and joint ventures strewn across the ASEAN archipelago - as well as in India and Japan. In all likelihood, it would be fair to assume that most of the -RM 1,017 mil as stated above went towards funding these intra-group companies. Which means that they are more likely than not going to be repaid to the parent company in the future, making them more akin to working capital in nature. (I know that AirAsia has announced they would be shutting down their India and Japan operations, but let’s discuss this later)

Hence, it would be appropriate to assume that these Intercompany Cash Flow amounts of -RM 1,017 do not represent normalized cash expenses, but rather temporary lifelines extended to their foreign subsidiaries or joint ventures. However, for the purpose of estimating their FY21 cash outflows, these amounts do represent true mandatory cash outflows - hence we shall be including them in the estimation.

By adding up selected significant line items in the Cash Flow Statement, we arrive at the YoY change in Net Cash Flows of -RM 2,092. This estimate somehow magically tallies with the actual net decrease in cash for FY20, so it’s probably a reliable approximation.

So what is the underlying reality of this Net decrease in cash amount of -RM 2,092 mil? Well, it’s basically an estimate of AirAsia’s actual net cash expenses over FY20. Since these are all just estimates anyway, we’re not going to get into the weeds and nitpick on whether it’s actually precisely accurate or not. Just understand that AirAsia had a net cash outflow of roughly RM 2.1 bil in FY20. By pure coincidence, this ties nicely with the aforementioned cash inflow generated from borrowings and lease deferrals - which might explain how AirAsia survived FY20 intact.

However, it would be dangerous as an investor to automatically assume that AirAsia’s lessors will in FY21 continue to extend the same level of generosity as last year in terms of lease forbearance. There is a distinct possibility that they may not grant AirAsia any lease forbearance at all - if only because they are unable to anymore. Hence to err on the side of conservativeness, we shall deduct the previously estimated lease forbearance amount of RM 1,283 mil to arrive at a steady-state assumption of FY21 cash outflows - in the worst-case scenario where no lease forbearance is granted. This brings our steady-state cash outflow assumption for FY21 to RM -3,375 mil.


Estimating AirAsia’s Cash Runway (Number of Months Remaining)

At this point, we have calculated that AirAsia has an estimated FY21 cash outflow of RM -2,092 mil if they receive the same level of lease forbearance as in FY20; and a worst-case estimated FY21 cash outflow of RM -3,375 mil should lessors decide not to extend any further lease forbearance. For simplicity’s sake, we’re just going to round these figures up to -RM 2.1 bil and -RM 3.4 bil respectively.

As of 21Q1, the company has a cash balance of RM 448 mil. This includes funds raised from the aforementioned private placement with Stanley Choi of RM 336 mil. As mentioned above, they’re also in the middle of securing a syndicated bank loan of RM 1.0 bil - which is supposedly about to get a status update very soon.

Hence, the sum of the cash balance and the pending loan amounts will be roughly RM 1,448 mil, or RM 1.4 bil rounded-down. That implies about 8 months of cash runway in the optimistic scenario (where the same level of lease forbearance as FY20 is extended in FY21); or only 5 months of cash runway in the worst-case scenario (where no lease forbearance is extended in FY21). That means that they are likely to run out of cash by either February 2022 or December 2021, ceteris paribus.


If AirAsia Survives COVID, What's the Implied PE Ratio? (post-dilution)

However, bear in mind that the above estimates of cash runway assume that AirAsia does not issue any equity. Obviously if push comes to shove, they would rather dilute shareholders than go through actual bankruptcy; and in theory they could keep diluting shareholders into perpetuity to survive. Hence, going concern risk is actually not very high. What shareholders should be more worried about instead is dilution risk.

If you’ve read my earlier analysis, you’ll remember that AirAsia already made plans to issue equity to the tune of RM 1.0 - RM 1.5 bil since September 2020 - in the form of both the aforementioned private placement as well as a yet unexplored rights issue. This equity raising plan was reaffirmed in the same recent podcast where Tony discussed the pending update on the syndicated bank loan.

Hence, let’s assume that AirAsia raises equity funding equivalent to the fully budgeted amount of RM 1.5 bil - at the latest closing price of RM 0.90. This should give them enough cash runway to last until slightly beyond June 2022. In such a scenario, how much dilution is expected to occur?

As we can see above, at the latest share price of RM 0.90, the company would have to issue 1.666 bil new shares in order to raise the requisite RM 1.5 bil. That would increase the implied number of shares post-dilution to about 5.5 bil - which implies that shareholders would face an equity dilution of about 44% from today.

This would imply that a new shareholder who acquires AirAsia shares at RM 0.90 today would actually have an implied entry price of RM 1.29 (RM 0.90 x 144%) - for an implied post-dilution market cap of RM 4,932 mil.

Next, to arrive at an assessment of AirAsia’s valuation in a normalized scenario (i.e. post-covid), we shall use pre-covid earnings as a benchmark for normalized earnings. By averaging the past 10 years of Net Profit, we arrive at a 10-yr Average Net Profit of RM 799 mil. Let’s just round that up to RM 800 mil.

Furthermore, it bears mentioning that AirAsia’s FY16-18 earnings were significantly higher than the other years of the past decade - and some explanation is in order. FY10’s earnings were distorted by a one-off unrealized foreign exchange gain from borrowings, while FY19’s earnings were reduced by several abnormal charges relating to the switch from an airplane ownership model to a leasing model. FY11-15’s depressed earnings could mainly be attributed to teething issues faced by the fledging airline during the Great ASEAN LCC wars of the early-2010’s.

Hence, if we assume that the FY16-18 earnings better reflect post-covid normalized earnings going forward, the 3-yr Average Net Profit would be RM 1,628 mil.

Hence, there are two valuation scenarios. If we use the aforementioned 10-yr average earnings of RM 800 mil as a benchmark of future normalized earnings going forward - at an implied post-dilution market cap of RM 4,932 mil, the implied PE ratio would be 6.2x.

Whereas if we were to use the aforementioned 3-yr average earnings of RM 1,628 mil as a benchmark of future normalized earnings going forward - at an implied post-dilution market cap of RM 4,932 mil, the implied PE ratio would be only 3.0x.

Now I don’t know about you, but for a company with the growth potential as described in my earlier analysis, that sounds mighty cheap to me (i.e. high Margin of Safety). I’ll just repost the relevant slides here again, for your convenience:

For this level of potential growth, I’m just going to come right out and say it: I’d be willing to pay 15x normalized earnings for their shares. Which means the potential upside is easily in excess of 200%. Let’s take another look at their pre-covid share price history:

At the beginning of FY20, their share price was RM 1.69. Hence if we assume that they can get through the pandemic, it’s not unreasonable to assume their share price could double to RM 1.80, from the latest closing price of RM 0.90 today.

And that could be just the beginning.


Summary

Hence, the entire thesis for buying AirAsia’s shares today boils down to: Can They Survive the Pandemic? If they can, this could perhaps be the steal of the century.

However, the prudent investor must bear in mind that bankruptcy risk for this incredible business is non-zero - and this risk has clearly been priced-in. Should another variant-of-concern unexpectedly decimate the world in the same way that the ‘delta’ variant has, and domestic lockdowns get extended beyond June 2022, the company might have to resort to diluting shareholders way beyond expectations.

Therefore, the only logical way to approach an investment in AirAsia today is through a high risk : high reward, double-or-nothing kind of paradigm - which implies taking a small position that you are comfortable losing entirely should things go south. I discussed this in the following slide of my earlier analysis:

I think it bears repeating: DO NOT BACK UP THE TRUCK ON THIS INVESTMENT! Only put in a small amount that you can stomach losing entirely - e.g. 1% or 5% of your portfolio.


Miscellaneous

In closing, I would just like add some commentary on three major investment-related events in AirAsia’s pre-covid history.

The first is allegations of accounting shenanigans levied on AirAsia by Hong Kong research firm GMT Research in 2015 - which sent their shares tumbling by -50%. I have actually read this report myself, and would like to comment on it. The lynchpin of the report’s allegations rested on AirAsia’s complex web of associates in its corporate structure, which hid the possible existence of a quasi-pyramid scheme where airplanes leased to associates could have obfuscated actual cash-on-cash return.

However, what I have concluded in my own (admittedly cursory) research is that AirAsia’s associate structure was not a significant cause for concern in 2015. This was because the associate structure was probably effected to take advantage of the then-newly introduced ASEAN Open Skies Policy, which is a single aviation market that granted all ASEAN airlines 3rd, 4th and 5th freedoms of the air within all ASEAN airspace.

In addition, it also allows ASEAN airlines to establish a base of operations in each other’s countries without having to apply for a domestic airline license, by partnering with an existing domestic airline - through a joint venture agreement. This, in my opinion, might be why AirAsia possessed such a complex web of associates in 2015.

If I had to guess, the above allegations might also be what contributed to the airline’s decision to switch from an airplane ownership model to a leasing model in 2018. Granted, I have the benefit of a few years of hindsight over GMT Research, so I can imagine why this might have been overlooked by them at the time.

Secondly, there were again allegations of bribery in an Airbus-related scandal in February 2020. I’m going to be utterly honest in that I have not spent a single minute looking into this, so feel free to draw your own conclusions about this.

Thirdly, AirAsia has since announced that they would be exiting their India and Japan ventures. I actually see this as a plus, as India’s airline industry is notorious for having an abnormally harsh business environment. For instance, fuel costs as a % of OPEX are supposedly about 50% higher than the global average. With regards to Japan, I haven’t really looked into it yet, but from what little I understand it’s a pretty competitive market for LCCs. Hence, I’m not too concerned with these developments.

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Resources:

  1. AirAsia’s financial information: https://www.malaysiastock.biz/Corporate-Infomation.aspx?securityCode=5099

  2. AirAsia’s Investor Relations website: https://ir.airasia.com/home_ir.html

  3. Primers on Indian airline industry operating environment (i.e. why AirAsia withdrew from India):


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