3 reasons the "flying kangaroo" is more than a recovery play

Keen to get away for that long-awaited trip to South America? You aren’t alone. Credit card company American Express recently reported a 44% increase in travel bookings versus the same period in 2019, just before the pandemic struck.

This uptick has long been regarded as the primary reason why travel companies such as Qantas (ASX: QAN) and Webjet (ASX: WEB) have rallied since 2020. The share price of Australia’s flagship airline is up more than 10% since the end of last year and a staggering 130% since March 2020.

A key point to acknowledge is that while Qantas is an international carrier, its domestic Australian business comprises around 80% of EBIT. 

“As the dominant domestic airline, we’re confident Qantas will not only survive but emerge in a stronger competitive position,” says Firetrail analyst Sean Drennan during a recent interview.

So, it’s true that the ongoing lockdown of the Western Australian border and continuing Coronavirus infections down the nation’s east coast is bad news for local airlines.

But there is a silver lining and many reasons why Qantas is one of the largest holdings of the Firetrail Australian High Conviction Fund, as Drennan explains.

Investors constantly “look through” the headlines. But the extent of this phenomenon has surprised even many highly experienced professional investors over the last couple of years. This is also why the Omicron variant knocked the market so hard over the Christmas break

Above all, though, Drennan emphasises that all global airlines face the same challenges. And he believes Qantas is better placed than many to emerge in a better position than when COVID struck.

In the following interview, Drennan details three reasons why he singles out Qantas as possibly the number #1 Australian company beneficiary post-pandemic.

Edited transcript

Eliza Clarke: Welcome back to the Firetrail analyst series for 2022. My name is Eliza Clarke and I'm an Investment Specialist with Firetrail. It was La Niña that was forecast to dampen Christmas holiday plans, but instead, we had the Omicron variant spreading across the country and causing flights and holidays to be cancelled once again. It wasn't quite the rebound the travel sector had hoped for. Joining me today is Sean Drennan, analyst in the Firetrail High Conviction Fund to dig into what matters for Qantas. Sean, thanks for joining me.

Sean Drennan: Thanks for having me.

Eliza Clarke: Now, Qantas is one of the key portfolio positions for Firetrail. How is all this Omicron news impacting them at the moment?

Sean Drennan: Well, COVID has not only dominated the headlines but it's also dominated the stock market's perception of Qantas, which has copped an absolute battering through the pandemic. In the short term, there is no denying that a closed WA border and surging infections along the East Coast are bad for Qantas, but we believe therein lies the opportunity.

There are several factors that are currently being overlooked that make Qantas extremely compelling for investors willing to look through the headlines. While Qantas is accruing losses, cash is still coming in the door as people book flights in advance for future travel. Management also just raised $800 million through the sale of excess land. All up, this gives Qantas about $4 billion in available liquidity to withstand the turbulence. Now, the key point here is that Qantas balance sheet remains resilient. While the current situation is clearly very difficult, every airline worldwide faces similar challenges.

Sean Drennan: As the dominant domestic airline, we are confident that Qantas will not only survive the pandemic but emerge in a much stronger competitive position. As we turn to the coming months, we're expecting a very rapid ramp-up in capacity because one thing is clear, people want to travel. Now we've all got an anecdote to support this, but one recent data point we found particularly interesting came out of American Express. In the first two weeks of January, they saw a 44% increase in travel bookings compared with 2019. That's 44% up on pre-pandemic levels. There is a huge amount of pent-up demand. And as the COVID noise subsides, we expect Qantas to be one of the biggest beneficiaries in the Australian equity market.

Eliza Clarke: Alright, that's the update on the short-term there, Sean, but at Firetrail, we invest with a medium-term horizon. What are the key factors that matter for Qantas if we look beyond the noise?

Sean Drennan: Our investment thesis for Qantas is based on three key factors and the leading one is right under our nose but is being completely overlooked by the equity market. It's the competition, Virgin. We believe Virgin will be the single biggest driver of Qantas operating performance and share price over the next three years. And this is why. While a lot has been made on the recovery of international travel and getting back to pre-pandemic levels, international travel does not drive Qantas profits. Rather, pre-pandemic, 80% of the airline's earnings were derived inside Australian borders from its domestic flying operations and incredibly valuable loyalty programme.

Sean Drennan: So, when we think about what matters for Qantas, it's all about the domestic market structure. Australia's domestic aviation market is almost entirely controlled by two players, Qantas and Virgin. Before COVID, Virgin was majority-owned by a syndicate of foreign airlines. Each had its own agenda, and this drove a muddled confused strategy whereby profitability was not prioritised and market share was. But in 2020, when Virgin collapsed, it was taken over by Bain Capital, a private equity firm. 

This changes everything. Private equity cares about one thing, and one thing only, making money. Bain's first move was to shrink Virgin's fleet, simplifying the business and focusing on a middle-market strategy. As demand recovers, we expect their second move will be to gradually raise prices.

Eliza Clarke: Hold on. So does that mean those cheap $69 fares might not be around much longer?

Sean Drennan: No, they'll still be around, but as the market gets more rational, looking towards the end of the year, we're expecting to see a lot fewer deals floating around. Now, consumers might find this very disappointing, but it's good for Virgin and it's even better for Qantas because when Virgin raises prices, so too will Qantas. And there's one more bit of good news for Qantas shareholders. With Virgin's smaller fleet and simpler operating model, Qantas and Jetstar are perfectly positioned to scoop up more market share in their respective premium and low-cost segments of the market. When we tie all of this together, it means one thing for Qantas, more revenue. What's more, you're getting this stronger business at a 30% cheaper earnings multiple than what you had to pay before the pandemic.

Eliza Clarke: Interesting. That seems to be an area the market hasn't fully priced in. Now you mentioned there were two other factors that matter for Qantas, could you give us a quick update on those?

Sean Drennan: Firstly, there's the cost story. This is relatively well understood by the market.

Basically, CEO Alan Joyce and his team have not wasted this crisis. Through an extensive restructuring, they've sought to strip a billion dollars of cost out of the business. When combined with our revenue forecasts, this bodes very favourably for earnings over the next three years. It'll also be extremely helpful in offsetting the industry-wide challenge of a higher oil price. The final piece of the puzzle that matters for Qantas is the balance sheet.

As we've discussed, we're very comfortable with Qantas balance sheet position and its ability to withstand the pandemic. But what the market hasn't necessarily picked up on is just how quickly Qantas will return to a dividend-paying position as cash flow and earnings recover into FY23. We believe that once the market begins to see through the short-term and gains confidence in this trajectory, Qantas shareholders will be very handsomely rewarded.

Eliza Clarke: Now every company has to be thinking to the future, thinking about their sustainability, how is Qantas positioning itself for the energy transition?

Sean Drennan: Aviation is a very carbon-intensive sector, but fortunately, Qantas has positioned itself as a global leader in reducing emissions. Qantas recently started using biofuels derived from vegetable oils on its flights from London to Australia. These can emit up to 70% to 80% less than traditional jet fuels and are a big part of Qantas plan to get to net-zero by 2050.

While the current fleet is capped in terms of how much sustainable aviation fuel it can use, much like your car can only use so much ethanol, as technology improves, Qantas has committed to renewing the fleet with better, more environmentally friendly technologies. Now, this is great for the environment, but it's also very exciting for shareholders. Jet fuel is one of Qantas largest and most volatile expenses, but as the sustainable aviation fuel market scales, we're expecting that these renewable alternatives will come at lower and lower cost. This is good for the planet and good for profits.

Eliza Clarke: You've mentioned before that international is only a small part of the Qantas investment case and earnings, but the recent news about the reopening of the Australian border is pretty exciting. I'm sure you're as excited as I am to be going overseas soon, where's the first place you'll be jetting off to?

Sean Drennan: I am indeed. Like many of us, I’ve had a lot of trips cancelled or delayed due to COVID, and I've got a pretty big bank of annual leave stored up that I've got to spend. The first place on my post-COVID bucket list has to be backpacking through South America, which I've booked in for later in the year.

Eliza Clarke: Flying Qantas, of course! Thanks, Sean, for joining us today to give us an insight into what matters for Qantas. And thank you for joining us for the Firetrail analyst series.

Want to learn more about the Firetrail Australian High Conviction Fund?

The Firetrail Australian High Conviction Fund is a concentrated portfolio (approximately 25 companies) of Firetrail's most compelling equity ideas. The strategy is built on fundamental, deep dive research guided by the philosophy that ‘every company has a price’.

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