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Morningstar | Qantas FVE Lifted to AUD 5.00 per Share on Stronger Margins and Lower Long-Term Fuel Price

Fiscal 2018 was another stellar result for no-moat-rated Qantas, with underlying profit before tax up 15% to AUD 1.6 billion, despite a 25% jump in the jet fuel price. The key earnings drivers were strong ticket revenue across Qantas Domestic, Qantas International, and Jetstar, which each increased revenue by 5%-8%. EBIT margins were also solid, expanding by 60 basis points at the group level to 10.5%, reflecting ongoing transformation benefits. While this performance was consistent with our expectations, we are becoming increasingly confident in the company’s ability to extract cost efficiencies and increase prices, offsetting operating cost inflation and the growing fuel bill, ultimately helping to sustain margins. The balance sheet is also strengthening, which has allowed the company to return around AUD 3 billion of surplus capital to shareholders since October 2015, through a combination of dividends, share buybacks, and capital returns. The board declared a final dividend of AUD 0.10 per share (fully franked), up from AUD 0.07 in the prior corresponding period. As the company has exhausted its accumulated tax losses, we expect future dividends to be fully franked.

We increase our fair value for Qantas by 20% to AUD 5.00 per share. This follows a revision of our cost base assumptions, including oil, which we expect to peak during fiscal 2019 and commence falling thereafter, along with transformation benefits, which we expect will meet the company’s AUD 400 million fiscal 2019 target. We also anticipate stronger yields, particularly in the domestic market (which increased by approximately 8% in fiscal 2018), where the company should be able to pass most of the cost pressure onto consumers.

Despite some near-term fuel pressure, we have lifted our average EBIT margin forecast to 10% on average during the next five years, from our prior expectation of around 9%. Our revenue assumptions are broadly unchanged, and we forecast that revenue should continue growing at a low- to mid-single-digit pace on average, reflecting modest annual capacity additions, ongoing utilisation improvement, and stronger yields. Despite increasing our fair value estimate, the shares are expensive at the current price. The industry is highly cyclical, and we believe the company is currently operating at peak cycle margins. Over the long term, we expect the falling fuel price and excess returns on capital will attract additional competition into the market, particularly on the international routes, which will cap EBIT margins at around 10% in the long term, partially eroding the benefits of the cost-cutting program.

We expect the company’s operating margin to fall by around 1% to 9.7% during fiscal 2019, mainly reflecting the higher fuel costs, although EPS should grow at a modest single-digit pace. Management indicated the company’s fuel bill is likely to jump by over 20% to almost AUD 4 billion during fiscal 2018, despite hedging and improving fuel economy. This projection assumes an average Australian dollar/U.S. dollar exchange rate of AUD 0.73 and a jet fuel price of USD 85.80 per barrel. In the domestic market, where Qantas clearly dominates and has moderate levels of pricing power, we believe most of the burden will be passed through to consumers and mitigated through improving capacity management. Internationally, however, we expect the company to struggle to pass through the higher costs, given the more intense competitive environment and ongoing mid-single-digit competitor capacity addition. Regardless, we forecast oil prices to taper off from fiscal 2020 onwards (driven by additional shale production coming on line), stabilising at our midcycle forecast of USD 60 per barrel. Given the strong correlation between yield and fuel price, we expect the average ticket price to decline slightly from 2020 onwards. This is a consequence of the additional competition attracted to the market by lower fuel prices.

The company will take a very measured approach to capacity management in fiscal 2018. Management guided to flat group domestic capacity and a modest 1% increase in international capacity (compared with the 4% expected growth in international market capacity), and we expect this pace to be maintained. This conservative approach to capacity management should support improving utilisation, which in turn should help offset some of the higher fuel price. During fiscal 2018, the company pulled back Qantas Domestic capacity by over 2%, which supported higher utilisation and higher unit revenue, both of which lifted the segments operating margin by 140 basis points to 13%. The domestic market benefited from an improving resources sector, although our long-term outlook for the mining sector and Western Australia is fairly bearish.

Strong free cash flow helped improve the balance sheet considerably during the period. Net debt now stands at AUD 4.9 billion (down over AUD 300 million), which is below management’s AUD 5.1 billion-AUD 6.3 billion target range. This represents less than 1 times EBITDA, which is considerably lower than historical levels. While this surplus capital provides the flexibility to continue reinvesting in the fleet and in cost-cutting, we believe the company is highly likely to continue returning surplus capital to shareholders. Based on our earnings projections, we believe the company can comfortably increase its dividend payout ratio from the current 30% to at least 40% within the next few years without putting any stress on the balance sheet. Management also flagged an on-market share buyback of up to AUD 332 million.