EUR 21.76 For Business Accounts Only

2018 outlook improving; Upgrade to OW from N

Hike 12M TP by 25% to AED1.56/share. We revise upward our 2017-20 EPS estimates by 45% to reflect lower opex over prudent spending and higher profits from JVs. We see a 15% y-o-y drop in fuel cost/ASK¹ in 2017 (vs. our previous -5% y-o-y forecast), and assume no growth onwards, accounting for potential further reductions. Meanwhile, IATA points to slowest ASK growth rate in 2018, since 2002. Despite being a seasonally weak quarter, we see 4Q17 as a good entry point, as we expect AED92mn in profits (vs. losses of AED38mn in 4Q16), along with a 7% dividend yield, to act as catalysts. The stock trades on a 2018e P/E of 8.3x, 33% below industry peers, while our valuation places the stock at a c20% discount.

Bull oil prices positive on the medium-run. Air Arabia’s 2018 fuel hedge position (40% at USD54/bbl) is near consensus (USD58/bbl, benchmark for remaining 60%). If oil prices sustain at higher levels throughout 2018, Air Arabia should continue to book hedge gains (AED53mn gains in 1Q17 or 10% of direct costs) and this presents scope for upside to our EBITDA estimates. This, in turn, would steer demand for travel in MENA countries (IATA estimates 7% y-o-y in 2018, and we forecast 4%). We soften our yield growth estimates for 2018 to c3% y-o-y from 5% y-o-y, based on IATA’s estimate. In 2019-20, Air Arabia is hedged at USD67/bbl and USD69/bbl (consensus for oil prices is at USD62/bbl) which could imply a reversal of hedge effect on profitability.

We favour an operating lease model. Air Arabia expects to add 3 aircraft (finance leased) in 3Q18, to cater for its peak quarter, as well as 6 by 2020e (operating lease). We favour the latter model; there is scope for higher dividends through higher FCFE, with neutral impact on EPS (lease costs offset by lower interest expenses). 2H17 expansions (2 aircraft) directed at the JV hub in Morocco (total 8), along with stability of Egypt operations (1 aircraft), should support our 5% p.a. growth estimate of Air Arabia’s JV profits (5% of net income), starting 2018.

Alliances to support slowdown in capacity additions. We think the Emirates & Flydubai alliance aimed to merge duplicated routes, would leave room for other airlines to grow frequencies and support overall yields in the GCC. Qatar’s impact on Air Arabia is negligent (Ë‚1% of RPK), as capacity is deployed elsewhere.