Thursday, June 23, 2011

MAS Growing pains (MIB)

Malaysian Airline System
Hold (unchanged)
Share price: RM1.44
Target price: RM1.65 (from RM1.80

Growing pains
Lowering expectations. Reported RM246m 1Q11 net loss was within our RM263m loss forecast, but significantly underperformed consensus which was expecting a profit. We revisited MAS’ fundamentals and are lowering our earnings expectations, forecasting a loss this year. MAS is struggling to cope with the challenging aviation market which is being hit by high fuel prices and weak yield environment. We shift valuation methodology to P/B from PER. We now value MAS at RM1.65/share, in line with its long-term average 1.8x P/B. Maintain Hold.

What now? 2011 is a write-off, our previous bullish call was one year too early. We revise our jet fuel price assumption up by USD10/bbl to USD120/bbl (adds RM480m to cost) and yield growth is toned down to half at 3% growth (lowers revenue by RM454m). In its current form, MAS is unable to navigate the turbulent market; its costs are too high and product quality is below par. This is being rectified with the fleet rejuvenation exercise but it is not moving fast enough to save MAS from making a loss in 2011. We also lower our 2012-13 net profit forecasts by 20-30% for the higher jet fuel price assumption.

Our view differs. Management asserts that MAS is on-track to achieve the operating profit target of RM300-600m in 2011. We are less optimistic and forecast an operating loss of RM264m. We think 2Q11 will be just as challenging due to the high fuel price volatility and industry overcapacity that is negatively impacting on yields. Things will look much better and profitable in 2H, which is seasonally stronger and as MAS extracts the cost benefits of new aircraft inducted into its fleet.

MAS joins Oneworld alliance. MAS has begin its induction process to the Oneworld alliance, it will take around 12-18 months. This is positive as MAS is the sole representative in Southeast Asia and we expect it to enjoy passenger throughput from other members flying into the region.

Do not underestimate privatization. Since MAS’ stock performance has been disappointing and considering potential headwinds ahead, its parent Khazanah may consider privatizing MAS as the stock is trading at its lowest historical price and valued at only 1.4x book. At the current share price, Khazanah needs to pay < RM1.5b for the remaining shares it does not own. If it teams up with EPF, like their partnership for the privatisation of PLUS, it will cost just RM962m.

Revisiting fundamentals
Previous quarter uninspiring. Overall, 1Q11 revenue rose 8.0% YoY, driven by a combination of 3.8% higher volume and 4.0% higher yields. However, this was not sufficient to offset the 7.3% rise in unit cost. Jet fuel prices have soared by 35% YoY to USD115/bbl in 1Q11. This significant cost rise has cause the core net loss to increase to RM351m, as compared to a loss RM93.5m the same period last year.

Slow in adapting. It appears that MAS has been slow to adapt to the changing market dynamics. The industry dynamics deteriorated in 1Q11 due to the MENA uprising and soaring fuel prices; there should be careful capacity deployment in these times. MAS on the other hand added 11% in capacity. Management concurred that it was an oversight and the capacity growth will be moderated in 2H.

We were one year too early. We concede that our bullish call on MAS (since 24 Sep 2010) was wrong. The aviation up-cycle story turned swiftly with the uprising in MENA and Japanese disasters. The supplydemand dynamics deteriorated and the yield environment turned weak. Only airlines with efficient cost base and with industry leading products can prosper through this, and unfortunately MAS did not. MAS will need to lower its cost by a further 3%-4% to be in a strong position – a level we believe it will achieve by 4Q 2011.

Weakest in the region. The table above depicts the summary of financial results of selected airlines in the region. MAS was the clear underperformer with EBITDAR and EBITDAR margin erosion, and produced the biggest net loss.

Passenger underperformed. The table below shows the operating performances for passenger business of selected airlines in the region. MAS was the underperformer in terms of yield growth. Management has mentioned that this was due to significant capacity addition of +11% and the rapid currency appreciation of MYR against major currencies. We however note that Garuda added +40% and it still achieved yield and load factor growth. MAS’ route revenue team has perhaps lagged in responding to the changing conditions of the market.

Cargo worst off. The table below shows the operating performances for cargo business of selected airlines in the region. MAS again underperformed in terms of yield and load factor. The local electronics and electrical industry was undergoing a severe downturn due to the supply chain issues from the Japanese disasters.

• Why was MAS so weak?
Low yields and high cost, an uncanny equation. MAS’ poor performance stemmed from its lowest yields and highest cost position against its peers. Most of the root causes were legacy in nature, having inherited the oldest fleet and the ill effect of substantially under-invested in the business in the past.

Paltry yields. MAS’ yields were substantially lower than the peer group. Based on our regression, it was 15% lower than where it should be. We think the reasons are: (1) unattractive product offering relative to its competitors which inhibits MAS’ ability to charge higher fares; (2) poor yield management; and (3) competing unnecessarily with AirAsia on many overlapping routes.

Unattractive unit cost. We estimate MAS’ unit cost was 3% higher than where it should be. Its old fleet is primarily responsible as they are inefficient, consumes significant fuel and has high maintenance cost.

Can MAS turn itself into a winner?
Definitely, but time is of the essence. MAS is making the right approach to rejuvenate its fleet; it currently has the oldest fleet age in the region and more crucially it has many obsolete aircraft (B737-400, first generation A330). We expect the fleet age to fall rapidly in 2012-13 as MAS inducts 14-16 new aircraft. This will greatly enhance
operational efficiency and reduce cost substantially.

A successful airline is all about having an efficient cost structure that can withstand the ups and downs of the aviation cycle. MAS is still in the fragile stage whereby it will suffer badly whenever the market turns – as was the case in 1Q11. It needs to reduce unit cost by a further 5%-10% from the current level to permanently be in the winner’s circle.

• Cost – the road to sustainability
Unit cost lower in 1Q11, but more is needed. MAS has managed to contain its unit cost when others rose, and unit cost excluding fuel improved by an impressive 6.2%. Management affirms that the unit cost ex-fuel will continue to decline as MAS reaps the benefit of new aircraft inducted into the fleet (it has received 6 aircraft, and expect 3 more by year end).

Assuming constant fuel price, MAS should be able to reduce unit cost by a further 4%-5% by the end of 2011, we estimate. This should theoretically make MAS more competitive, but we expect Thai and Garuda to enjoy lower unit cost as well because they are also inducting new aircraft into their fleet. We itemise in the table below where we think cost savings will stem from:-

• Yields – the road to redemption
Product enhancement vs. yield management. MAS is upgrading its new fleets with best in class products. We had the good fortune to sit in MAS’ latest A330-300 aircraft and we vouch for its high-class and superb quality. We think this should make customers willing to pay higher fares, eventually. We also believe when MAS has a young and
trendy fleet, it is no longer handicapped against its peers and instances where MAS lags the peer group will be an issue of the past.

Choose your competitors wisely. We are of the view that MAS is competing unnecessarily with AirAsia which is partially responsible for the significant 15% yield deficit against the peers. The table below shows the fare for a return flight for Kuala Lumpur to Bangkok between AirAsia and MAS. These quotations are obtained from both companies’ website, for the same day of travel with all value-add item cost summed to obtain a like-for-like comparison. The net result is parity, MAS costs RM505 and AirAsia RM502.

Whilst this is good news for consumers, it is abysmal for investors. It is poor financial logic for a full service carrier – with a much higher cost and value proposition, to be charging the same fare with a competing LCC. The management stated that this strategy is to maintain market share and manage the weak travel periods. It has however been
proven many times that market share does not translate to bottom line. The wiser solution is perhaps to reduce flight frequency or downsize the aircraft during the weak periods, we think.

• Capacity redeployment between Firefly & MAS domestic We noticed that MAS domestic has seen a steep decline in passenger carried and load factor in the past 3 months. We think this is a secular trend change partly due to the induction of East Malaysia services by Firefly that commenced in January. April statistics appears to show an
improvement, but we think this is a once-off event as many Europeans linked travel was paralysed in April last year due to volcanic ash clouds.

Domestic market is not big enough for everyone. We have raised this concern before in our previous report (Firefly graduates to jet engines: 9 Nov 2010). The domestic market is mature; it is growing at 10-year CAGR of 4.8%, which is in-line with GDP growth.

Therefore, to neutralise Firefly’s aggressive fleet expansion growth plans (6-7 aircraft p.a.), MAS domestic needs to relook at its own capacity deployment plan. We think capacity cuts as much as 10%- 25% are required. By right sizing the demand-supply fundamentals, MAS should be able to enhance yields, reduce cost and become sustainably profitable.

Recent positive developments on MAS
MAS joins Oneworld alliance. This process has started, and will consume roughly 12-18 months to be fully inducted into the alliance. The financial impact will only be felt in 2013, the earliest. Benefits of joining the alliance are:- (1) seamless expansion of route network to 950 destinations across 150 countries; (2) passenger flow through from
other alliance members onto MAS network; and (3) frequent flyer points are redeemable among alliance members.

MAS is the sole Oneworld representative in Southeast Asia and it can leverage its strong route network in Southeast Asia, Indian and the Kangaroo routes. We expect passenger throughput from other alliance members flying into the region (e.g. British Airways and Qantas to Singapore and Bangkok) to feed into MAS network. We believe this will also boost strong demand from business class passengers whom previously were swayed to the other alliance hubs of Singapore and Hong Kong.

Exercise options to purchase additional 10 B737-800 aircraft. MAS has recently announced that it has exercised its options to purchase an additional 10 Boeing 737-800 aircraft. The delivery date is not firmed up yet, but the early indications are from 2015 and beyond. This brings the total order to 45 aircraft.

Do not underestimate privatization
It makes sense. We think the privatization of MAS is not an outlandish idea as the market is not paying much optimism; the analyst community is an overwhelming “Sell” call with an average target price of RM1.44, which is just 1.45x above its book value. To make things worse, even the journalist community is very sarcastic in its reviews. Sentiments are at an all time low, and this is the best time for value driven buyout.

Shareholders might be warm to the idea. The principle shareholders of MAS are Khazanah (69%) and EPF (11%). Both have acquired MAS at a substantially higher price. At the current share price, the privatization of MAS will cost just RM962m, if Khazanah and EPF team up again, like in the case for PLUS’ privatization. There are merits;
privatization provides a shelter away from further downside volatility in the share price, while the Company reshapes itself up for a re-listing in the future years.

Relisting can extract more value. Assuming MAS is a private owned company seeking a re-listing, it can extract better valuation by (1) fixing its operations to be sustainably profitable – we think this can be achieved by 2012; (2) wait for the next aviation up-cycle; and (3) float pieces of the group as standalone companies. For example, MAS can public list Firefly first as there is a strong appetite for LCC. This can be repeated for MAS Engineering, MasKargo and its terminal services.

Benefits of breaking up MAS. SIA has done this years ago (SIA Engineering, Tiger Airways, SATS), and it is proven that the spun off entities command a higher valuation than the parent – refer table below. Secondly, the management can dilute down the employee unions’ influence. MAS currently has 42 unions, which is cumbersome and consumes management time.

Fair value of buyout at RM1.65 to RM1.80? The graph overleaf charts MAS P/Book for the past 12 years. After smoothening out the datas; we discovered that the mid range P/B is between 1.8-2.0x. This implies a value of RM1.65-1.80/share based on 2011 book, which represents a premium of 14%-24% of the current price.

Source/转贴/Extract/: Maybank Investment Bank
Publish date:23/06/11

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