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Morningstar | Air New Zealand Pulls Back Capacity and Reviews Cost Base to Mitigate Softening Demand. See Updated Analyst Note from 28 Mar 2019

No-moat-rated Air New Zealand is undertaking several initiatives to adjust its operations to reflect the more subdued growth outlook, which for the most part align with our current expectations. These initiatives include pulling back capacity growth to meet the market, deferring major aircraft deliveries and the associated capital expenditure, while adjusting the operating cost base to better reflect the softer demand. As we are confident the airline is nimble enough to adapt to the changing environment, we expect earnings growth to resume from fiscal 2020 onwards. Management also reaffirmed the recently provided fiscal 2019 full-year guidance of pretax profit between NZD 340 million and NZD 400 million. Accordingly, we maintain our AUD 370 million fiscal 2019 pretax profit forecast, and our NZD 2.60 (AUD 2.50) per share fair value estimate. At the current price, the shares trade broadly in line with our valuation.

As part of the ongoing focus on network and route optimisation, the company has decided to pull back network capacity to reflect the slower demand growth environment. The company will now add between 3% and 5% capacity per year on average, over the next three years, down from the prior projection of 5%-7% on average. The revised outlook is consistent with our unchanged 4% forecast on average for the next three years, albeit significantly below the three-year historic average of 6% annual capacity growth. The company plans to utilise its network growth to stimulate tourism to, from, and within New Zealand, by expanding into new markets, adding new destinations and increasing frequency including new direct services between Auckland and Seoul from late November 2019.

Our near-term capital expenditure forecasts fall slightly, although this mainly reflects a change in timing, and over the next five years our cumulative capital expenditure forecast is broadly unchanged. Management is pushing back timing of several fleet orders, and approximately NZD 750 million of aircraft capital expenditure will be deferred to ensure the capacity growth reflects the slower demand environment. The delivery of three A321NEOs (which will operate in the domestic network) will be deferred by one year, while the delivery of two A320NEOs (designed for trans-Tasman services) will be deferred by two years. Meanwhile, the two long-haul aircrafts which are part of the widebody fleet program intended to refresh the B777-200 fleet will be delayed by four years, all of which will decrease the level of capital expenditure expected in the next three years by an estimated 11% on average.

Air New Zealand intends to improve its operating cost base to reflect the lower revenue growth environment. The firm will embark on a two-year cost reduction program which aims to deliver more than NZD 60 million in annualised savings via the following initiatives: (1) removal of inefficiencies incurred in 2019 to mitigate network disruption related to the Rolls-Royce engine issues; (2) reduction of overheads by 5% through increased efficiency and automation, and (3) a targeted review of the operating cost base. These initiatives will help offset the impact of softer revenue growth and help the group EBITDA margin to increase by around 300 basis points to 20% by fiscal 2021 and remain at this level over the longer term.

Despite reviewing the operating cost base, the firm will continue to invest in and improve the customer travel experience, with several enhancement initiatives scheduled to happen in the next two years. These initiatives include free Wi-Fi on all enabled international aircrafts, upgrading nine lounges across the network, developing a more spacious economy product on the long-haul fleet, and progressively introducing a business premier experience on the long-haul fleet. While we don’t expect a major increase in average revenue per passenger kilometre, we believe these initiatives will help stabilise ticket prices. This is despite our expectation for lower fuel prices which would typically drag on ticket prices. Additionally, this should support strong load factors at around 82% for the foreseeable future.