Clear skies ahead for the Flying Kangaroo

Firetrail has owned Qantas since its inception 3.5 years ago, but our holding goes back to our time at Macquarie, when Virgin and Qantas were engaged in a price war, creating an amazing investment opportunity. We materially increased our Qantas position through the depths of COVID last year which presented another excellent opportunity. Qantas is one of the larger holdings in the High Conviction Strategy:

Managed Fund

Firetrail Australian High Conviction Fund

Australian Shares

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Why we are attracted to Qantas

Our bullish medium-term view is based on our belief that the domestic profit pool will be considerably larger in a post-covid environment. Investors willing to bear the short-term pain will be handsomely rewarded on the other side. What Matters for Qantas is:

i) Improved Domestic Market Structure

For the past decade, key competitor Virgin failed to generate appropriate returns on capital. During COVID, Virgin entered administration, but was saved and is now owned by Bain Capital, a private equity firm. Private equity ownership of Virgin bodes extremely well for industry returns and is a positive development for Qantas.

Historically, Virgin’s strategy was flawed. They targeted high-end corporate travel while simultaneously competing aggressively on price. Under new ownership, Virgin has shrunk to a more targeted mid-market offering. The move to mid-market leaves room for Qantas and Jetstar to own the premium and low-cost niches respectively and grow share towards 70%, up from 60% pre-COVID. There is increasing evidence ticket pricing is proving rational under this market structure which is hugely beneficial for Qantas’ bottom line given the fixed cost leverage in the business.

While a lot has been made of Rex’s entry into domestic mainline routes, it remains sub-scale and at this point appears unlikely to destabilise the rationality of the broader domestic market.

We believe Qantas is set up for an extremely high period of domestic profit over the coming years.

ii) Structurally lower Qantas Cost Base

Covid has presented Qantas with a once in a lifetime opportunity to completely restructure its cost base. In FY21, the management team delivered structural cost benefits exceeding $650m, ahead of their own $600m target. By FY23 the cost reduction is expected to approach $1bn. The market is failing to give management credit for this cost out which, when combined with the rational revenue environment discussed above, should see considerable upside to earnings over the medium-term.

iii) Liquidity

While we are confident that Qantas’ earnings will be structurally higher going forward, ongoing lockdowns certainly do cloud the short-term outlook. As such, Qantas’ liquidity position is critical to ensure they can bridge the gap to a more normal earnings environment. There was considerable talk leading into the result that Qantas may tap the market for additional equity. We were pleased to see this did not occur and are comfortable with how the balance sheet has been managed thus far. Qantas has $3.8bn of liquidity, not to mention an unencumbered asset base of over $2.5bn. With most one-off cash drags now in the past, we believe this liquidity should be ample in light of Qantas’ now structurally lower cash burn and against the backdrop of Australia’s accelerating vaccine rollout.

Key points

i) We are all going to be flying sooner than we think!

1. Although those of us currently in lockdown may be feeling down and as though there is no end in sight, Australia’s vaccination trajectory and agreed national reopening framework means seeing family in London or LA by Christmas is looking increasingly realistic. Based on frequent flyer member surveys, Qantas noted international travel intention is 3x higher than pre-covid. It’s time to be optimistic after 18 months of start-stop.

ii) Net debt of $5.9bn

1. Lower than the market’s expectations. It highlighted the strong underlying cash generation from Qantas’ operations over the short periods they were operating more normally.

2. Lower than expected debt also highlighted the favourable working capital moves as Qantas restarts flying, with revenue received in advance contributing a $500m positive swing in the second half.

iii) Domestic yields

1. Domestic yields were solid through the year once adjusting for COVID volatility on load factors.

2. Strong pricing is supportive of our view that domestic market pricing is rational under Virgin’s new ownership structure which is very bullish for medium-term earnings.

EBITDA and EBIT were bang in line with our expectations and marginally ahead of those of the broader market. However, this result was less important in the scheme of Qantas’ earnings recovery and the key number was that net debt which was better than expected.

Surprises

The stronger balance sheet position. Some in the market were likely surprised Qantas did not raise capital but we think today’s result demonstrates a robust liquidity position to weather the current spate of lockdowns.

Where to from here

Our position in Qantas remains the same from here. Nothing today altered our bullish three-year view. We see considerable upside versus today’s $5.04 close price.

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