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Morningstar | Higher Fuel Price and Softening Macro Environment Weigh on Air New Zealand’s Earnings

No-moat-rated Air New Zealand has endured a challenging start to fiscal 2019, with profit before tax, or PBT, sliding 34% to NZD 211 million. While disappointing, the result was in line with our expectations, and the firm continues to track towards our NZD 370 million fiscal 2019 forecast, which is a significant drop on the NZD 540 million PBT last year. The company delivered a healthy 7% increase in revenue, although this was more than offset by a 28% jump in fuel cost and higher operating costs. Excluding the impact of the fuel cost, PBT would have increased by 10%.

We maintain our NZD 2.60 per share fair value estimate (AUD 2.50 per share), and at the current price, the shares are fairly valued. The board declared an interim dividend of NZD 11 cents per share (fully imputed for New Zealand tax residents), flat on last year despite the expected fall in earnings. This is in line with our current forecast albeit implies a higher payout ratio.

While we continue to expect demand growth in the domestic market, the pace of growth is slowing due to softer leisure travel within domestic New Zealand and softening inbound tourism. In light of the softer demand, the firm has cut its capacity growth guidance to 4%, the bottom end of previously guided capacity growth of 4% to 6%, lowering near-term revenue growth expectations. We expect the company to adapt to the softening market conditions, and it is presently undertaking a comprehensive review of the network, fleet and cost base, with additional detail to be provided in late March. Notwithstanding, management reaffirmed the recently provided fiscal 2019 full-year guidance of between NZD 340 million and NZD 400 million.

Over the next five years, we project steady low- to mid-single-digit top line growth on average. This assumes Air New Zealand retains its market-leading position in the core domestic market, and adds around 3% per year capacity on average, while utilisation remains strong at around 83%. The Tasman and Pacific Island routes should grow at a slightly faster pace, as the company increases flight frequency following the end of the Virgin Australia alliance.

The softer capacity growth will be partially offset by the falling fuel price. The firm expects average jet fuel costs in the second half of fiscal 2019 of around USD 75 per barrel, and around USD 81 per barrel for the full year on average. While this is lower than the first half, fuel prices can often prove a double-edged sword. As one of the largest operating costs for airlines, competitors will share this advantage, and the lower fuel price will often attract additional competition into the market. This puts pressure on ticket prices--especially on the international routes which remain highly competitive. Air New Zealand appears to be feeling this impact with a 1% decline in unit revenue on the Tasman & Pacific Islands during the first half, while 3% growth on international routes was insufficient to offset the fuel bill.

We continue to forecast a long-term Brent Crude oil price of USD 60 per barrel, which implies a jet fuel price of USD 80, broadly in line with current levels. Despite our forecast for steady fuel prices going forward, we expect the group EBITDA margin to expand by around 2% to just over 20% by fiscal 2023, as the operations are right-sized to meet the softening demand. While the company has generated higher margins in the past (25% in fiscal 2016), this was primarily due to a sharp decline in fuel prices, which attracted additional competition and drove margins down to 20% which is where we see the sweet spot that the company can earn a fair return on capital.

Based on our projections, fiscal 2019 leverage (net debt/adjusted EBITDA) will be approximately 1.53 times, which is slightly above what we view as ideal level. However, we are not alarmed by this as we forecast earnings improving, and capital expenditure requirements moderating over the next few years. Accordingly, leverage should fall towards 1 by fiscal 2021, a more comfortable level and in line with the five-year historic average.