✨ AirAsia (Part 3) - the Southwest Airlines of ASEAN is on sale at 12x EV/E! (or 2x PE)
A pandemic report card of how AirAsia performed during the past 8 quarters (1Q20-4Q21) - and assessing their past performance to forecast their future performance
AirAsia’s PN17 status has nothing to do with their Merger Deficit - it is exclusively a product of their negative Retained Earnings, which in turn were contributed by their recent Net Losses experienced during the pandemic period. Fortunately, things seem to be turning around for their profit trajectory.
Assuming the full conversion of all RCUIDS issued, total shareholder dilution of 55% will have taken place since FY19 - thus increasing their implied market cap to RM 3.6B; which is benign next to their Enterprise Value of RM 19.1B (i.e. including Net Debt).
If we assume that the pandemic is behind us, AirAsia’s liquidity and going concern risk are essentially zero, owing to advantageous newly restructured lease terms which will reduce annual lease expenses by 20-30% . Pent-up demand is already evident, and their no. of Passengers Carried during 4Q21 was only 20% of 4Q19’s figures - yet their share price still hasn’t budged. (update: Capital A records healthy 1Q load factor of 76%)
We also take a deep-dive into their historical operating KPI performance during pre-pandemic times (FY14-FY19) in an attempt to forecast their future performance - and breakdown the key success factors which led to AirAsia becoming the dominant ASEAN airline. Spoiler: they are phenomenal.
Assuming that things will get better from here pandemic-wise, AirAsia’s current valuation of an EV/E ratio of 12.0x is incredibly attractive - terrible airline business model notwithstanding. Pandemic risk is presently also no longer greater than most other business risks.
“In other words, the Merger Deficit is completely irrelevant to AirAsia’s PN17 status - as there are no real-life implications to this accounting entry whatsoever.”
As most of you might be aware of, investors in secondary markets do not profit from the Net Profits of the companies they own per se - their profit is a function of the price they paid to acquire those profits, i.e. the Earnings Yield (EPS / Share Price). In other words, the earnings yield represents the ROI of an investor in secondary markets - which can be compared to the ROI of a bond paying a particular interest rate (e.g. 3%).
This distinction is important to make, as many market participants get hoodwinked when they see the improving fundamentals of a company - without stopping to think how much they are paying to acquire them. If you pay an excessive amount to acquire a company’s profits, your earnings yield would naturally be low - even if the company’s profits may be phenomenal.
Consequently, the reverse is also true - even a company that sports poor profits can become an attractive investment if the price paid to acquire them is low enough - since this rebalances the earnings yield back up to a reasonable level. For many of the stocks I’ve discussed in the past (e.g. Innature, Do Day Dream, Supermax), this was exactly the opportunity presented to investors. I believe it was Howard Marks who said the following quote:
"We think no asset is so bad that there's not a price at which it's attractive for purchase, and no asset is so good that it can't be overpriced." - Howard Marks
What this means is that a company’s fundamentals should not be considered in isolation when making an investment decision - the price paid is an equally important consideration. And if the price offered is low enough, it can become a significant enough factor that can even sway the tide in favor of an underperforming business.
But what if I told you… that there is currently a business for sale - which not only has high-growth fundamentals, but can be bought today at a normalized EV/E ratio of 12x historical profits? This is AirAsia today - the Southwest Airlines of ASEAN.
A Quick Recap of my AirAsia Part 1 & Part 2 Reports
If you’ve been following my blog, you’ll know that I’m a huge fan of AirAsia at its current prices - for the reasons described above. You can click the above links if you’d like to read my AirAsia Part 1 and Part 2 stock reports in their full glory - but you can also find a quick summary below.
In my AirAsia Part 1 report, I described AirAsia as the Southwest Airlines of ASEAN. Those of you who are familiar with the US Airline industry will know what I mean by this - Southwest was founded by the most legendary cowboy entrepreneur ever, Herb Kelleher. His entrepreneurial legacy resides at the top layer of society with some of modern America’s greatest heroes of business - amongst the likes of Henry Singleton, John Malone, Warren Buffett, Andy Grove and Bill Gates - and is worshipped by all low-cost carrier founders who came after him. If you want to know where Virgin Airlines’ Richard Branson, Ryanair’s Michael O’ Leary and AirAsia’s Tony Fernandes got their brash streak from, look no further than the following old Southwest Airline ads featuring Herb himself:
Aside from being rip-roaringly hilarious, Herb Kelleher (which we shall affectionately refer to as “Herb”) also introduced what was at the time a relatively new concept in the airline industry - a deliberate focus on employee satisfaction. Since low-cost carriers (LCC) operated on a business model which required them to cut corners on price in many respects, the service element became increasingly important - as customers would be bringing their impressions of their first-hand contact with airline staff home with them. Herb would go on to become instrumental in propagating the “service-with-a-smile” business model that has now become the mainstay of the airline industry.
However, what was truly notable about Southwest wasn’t just its service-first approach to the airline business, but its unique take on the sector’s economics. While it may be easy to take for granted all the industry norms of the LCC sector today, it was Southwest who first introduced concepts such as quick turnaround times, staff with overlapping functions, no check-in boarding and no-frills flying. Through an intense focus on consistently driving down unit operating costs, Herb was able to democratize the experience of flying to the middle-class - and his legacy eventually led to Southwest Airlines becoming the 2nd largest airline in the USA today:
In my AirAsia Part 1 report, you’ll also note how the top 4 US Airlines commanded about 66% of total US Airline market share in 2019. This is what typically happens in commoditized industries where economies of scale rules supreme - over successive market cycles the winners will absorb the market share of the losers via mergers & acquisitions, which leads to the TAM of the entire industry being controlled by just 4-5 industry players. You can see this phenomenon happening in many other commoditized industries as well - hypermarkets, banks, insurance, O&G, etc.
The real kicker though is that once the aforementioned industries turn into oligopolies - where the majority of the industry’s TAM is controlled by just a few players - those oligopolistic market leaders start to acquire pricing power, since they can unoficially collude in order to manage the industry’s supply/capacity. For instance, if passenger demand starts to wane, the top 4 US Airlines can collude in an unofficial manner to reduce supply in order to keep ticket prices high - where previously they might have resorted to price wars in order to maintain market share. This is currently the prevailing theory about why Warren Buffett might have acquired all 4 of the biggest US Airlines in 2016 (prior to the pandemic, which he couldn’t have predicted).
The analogy I’m trying to draw here is that as the lowest-cost carrier in ASEAN (with the largest economies of scale today), AirAsia has the potential to eventually become the Southwest of ASEAN in the far future. And when ASEAN eventually turns into the next China in 30 years time (i.e. the low-cost manufacturing hub of the world), it has the potential to become the next Southwest Airlines in this region and benefit from all the advantage that Southwest partakes in today. I’ve discussed all this and more in my AirAsia Part 1 report - just imagine what the profits and earnings multiples might look like for that future industry behemoth.
Understandably though, all that lies in the far future and should not serve as our baseline expectation for AirAsia’s valuations today. Nonetheless, there is still a lot to be excited about AirAsia’s current prospects, which we shall be delving into below. We are going to be covering a lot of ground - and in the interest of brevity, this is perhaps going to be one of the densest article I’ve ever written for this blog. Check your luggage, and remember to fasten your seatbelt - it’s almost time for lift-off.
Note: In order to facilitate easier historical comparisons, we shall be using the names “Capital A” and “AirAsia” interchangeably. AirAsia recently renamed itself to Capital A to better reflect the inclusion of its new Digital ventures.
AirAsia’s Latest Industry Developments
Before we delve into my analysis of AirAsia, it helps to have an understanding of the current business environment that it resides in - as well as how things got to be this way.
Firstly, it should be readily observable that there is already light at the end of the tunnel for the global COVID-19 pandemic, and its implications on the Travel & Aviation sectors. For much of the past two years, international and domestic lockdowns kept the Aviation sector’s planes grounded - with unsurprisingly catastrophic consequences. However, things appear to be looking up for the global industry - with China remaining as the only major global economy still implementing stringent lockdowns. For context, both US and European airlines are currently experiencing huge pent-up demand - with mergers already being explored by Spirit, Frontier and Jetblue (all top 10 US airlines), and ticket prices surging through the roof. The videos below provide an excellent quick primer about the latest developments in the airline sectors of Western economies:
In this regard, we should expect that the Airline sectors in the rest of the world should also gradually follow suit - including in AirAsia’s ASEAN market. In fact, Malaysia Airlines (AirAsia’s largest domestic competitor) recently said in this news article that it is “recording a very encouraging load” - and advises locals to “purchase their flight tickets early to avoid being burdened by costly ticket prices during the Hari Raya Aidilfitri period caused by dynamic pricing strategy”. Unless another COVID-19 variant-of-concern (VOC) pops up, it’s pretty safe to say that the pandemic risk to AirAsia going forward is no longer greater than any of its other business risks.
The other major concern plaguing AirAsia today is the PN17 status that was recently imposed on it. According to Malaysian bourse regulations, PN17 is a regulatory status which indicates that a company is under financial duress - usually implying going concern risk. In AirAsia’s case, it triggered the PN17 status mainly due to its book value entering negative territory - owing to the pandemic environment it had experienced over the past 2 years. As the above news article explains, the airline had technically triggered the PN17 criteria as far back as July 2020 - but was not classified as such thanks to relief measures introduced by local regulators at the time. However, those relief measures ended on 7 January 2022, upon which AirAsia was officially classified as a PN17 company.
Besides that, there has also been market chatter about potential overcapacity streaming into the domestic airline industry - as regional economies reopen and new entrants start taking advantage of cheap hulls for sale to become new competitors. We’ll talk about this in more detail below - but the gist of my take on this is that AirAsia’s current valuation is so low that it can offset any reasonable increase in regional industry supply. Remember, if the price paid is low enough, it rebalances your earnings yield upwards.
One last thing to point out is that the short-haul and long-haul airlines of AirAsia are two separate listed entities - the recently renamed Capital-A is for short-haul flights, while AirAsia X is for long-haul flights. As the economics of the two are vastly different, separating the two businesses was actually a very wise decision. In this report, we will be discussing the former not the latter.
For our first challenge, let’s discuss the prominence of their PN17 status - what it is, why it occurred, and what threat it poses to AirAsia going forward.
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Updated for 1Q22 results (3/6/22): Paid subscribers can download Capital A's 1-page summary sheet & a robust 300-row Excel model of their historical three statements (FY14-FY21) by clicking the links below: