Is Qantas a buy at the current price?

Among the more obvious victims of the COVID-19 pandemic have been the world’s airlines. In Australia, Virgin Airlines in April became one of the first large businesses to enter administration, and Qantas (ASX:QAN) has scaled back its operations to a tiny fraction of normal capacity and loses money every week while this continues.

More recently, Warren Buffett’s Berkshire Hathaway announced that it had exited positions previously taken in the big four US airlines, stating “the world has changed for airlines” as a result of the coronavirus.

Investors in Virgin equity will not see their capital again, but what of investors in Qantas? QAN shares have recovered somewhat from the lows of March, but still trade at prices less than half of those prevailing when 2020 began just months ago. Does this price represent an opportunity for investors, or does a changed world for airlines mean that investors should consider an exit, even at these depressed levels?

It is canon amongst quality-focused investors that the airline industry has poor economics. High capital costs and a service that is difficult to differentiate have contributed to a long history of poor profitability and, if the world has indeed changed for the worse for airlines then the future would not seem very bright. However, it may be that a generic analysis like this is lacking something, especially when it comes to the facts as they relate to Qantas.

Will COVID-19 create a permanent change for airlines?

Firstly, let’s look at the question of a changed world. There is no argument with the idea that the world has changed for the worse for airlines, but it is important to think about whether this is a permanent change which would have potentially large consequences for value, or a temporary change, which may be relatively benign.

The permanent change argument says that COVID-19 brings long-lasting impacts to airline economics, and if we imagine a world where COVID-19 is not eradicated, and attempts to find an effective vaccine fail, then we might imagine, for example, a world where airlines leave a predetermined fraction of seats empty to facilitate social distancing. Given the importance of load factors to airline profitability, this could lead to grim forecasts for the industry, as fares would need to rise to demand-smothering levels to allow airlines to earn an acceptable margin.

However, even assuming that a vaccine is not found, we think this scenario is selling short the potential of the airline industry and others to find innovative and cost-effective solutions to the problems faced. One obvious example could be the use of testing and screening to ensure that airline passengers are largely free from COVID-19. Passengers could for example be required to test negative for the virus prior to travel, and provide a further test sample on arrival. A vaccine may prove to be out of reach, but being able cost-effectively test for the virus and quickly contain a limited number of cases that get through? That is very achievable.

Given this, we are much inclined to view the “changed world” as largely a temporary state, even in a worst case scenario of no vaccine. While managing COVID-19 risks may add some cost to air travel, it is hard to see that these costs need be prohibitive. Accordingly, the investment question is better directed more at how long the temporary state of disruption may last.

How soon will things return to normal?

Forecasting a timeframe for this is tricky, but there are a few things that we can say with some level of confidence:

• Firstly, for obvious reasons, domestic travel in Australia seems likely to recover more quickly than international, and this is contemplated in the statements from the government about the possible path back to normality, which suggests domestic and trans-Tasman travel returning as early as July.
• Secondly, this would be an important step forward for Qantas given that its domestic business has traditionally been significantly more profitable than its international business, and trans-Tasman flights could represent a worthwhile increment to this.

A widespread resumption of international travel is harder to forecast, but there are some good economic imperatives for a restoration of air travel as soon a practicable. In a country like Australia, air travel plays a crucial role given its ability to quickly, safely and efficiently span the distances that separate our population centres from each other, and from the rest of the world. What may surprise you is that air travel, despite its reputation for poor owner economics, contributes materially to an economy, and particularly an economy that relies to some extent on tourism and leisure. Modern aircraft have fuel efficiency per passenger km better than a modern compact car and, unlike road and rail, air travel covers all of its own infrastructure costs and contributes positively through taxation.

Qantas shares may well prove to be an opportunity

Australia’s tourism industry was suffering before the pandemic, and given the economic imperatives, we anticipate that real efforts will be made to allow a safe, early restoration of international as well as domestic air travel. We think these efforts will succeed as the problems raised, while real, are solvable.

It will certainly take some time to achieve a “full” recovery, but to the extent that air can start to be restored within a reasonable timeframe, the current trading level of Qantas shares may well prove to be an opportunity. In addition, we see some grounds to think that Qantas may emerge from the current turmoil in a stronger position than it went in.

At this point, we should take our hats off to Qantas management. In February 2014 the company began a turnaround program and, over the following years tackled difficult structural issues and built the airline into one of the world’s most profitable. While having a healthy domestic market has certainly helped, hard work also played an important role.

Further, Qantas went into the COVID-19 crisis with a very strong balance sheet and net debt below target levels, and this has allowed it to secure additional debt facilities at attractive rates as the crisis unfolded. Unlike Virgin which quickly fell to the administrators, it looks as though Qantas may emerge from the crisis without having to issue equity at discounted prices.

Competitors

That Virgin has gone into administration is probably a clear positive for Qantas. Over the years Virgin implemented two different corporate strategies – one involved operating as a focused low-cost carrier and generating respectable profits. The other, more recent, strategy involved investing heavily in capacity, taking on Qantas as a full-service carrier, and failing to generate respectable profits. It was thought that Virgin’s largest shareholders (including several international airline competitors) may have placed some value on Virgin’s ability to put financial pressure on Qantas in this way.

In any event, it seems likely that a new owner may prefer a strategy that generates good profits, and that Virgin may return to being a focused, niche operator with capital discipline. This would be a good outcome for Qantas.

It also seems likely that international competitors who entered the crisis in weaker financial positions than Qantas may be constrained in their ability to invest in capacity as the world emerges, ceding share to those carriers that do enjoy relative financial strength. Further, while Qantas benefits from a large, profitable domestic business that should recover relatively quickly, many international competitors do not. We anticipate that as the world returns to some sort of normal, Qantas may gain share both domestically and internationally. It is possible that the world has changed for the worse for airlines, at least to some extent, but it is also possible that it will change for the better where Qantas is concerned.

To sum up, the airline industry continues to be one with challenged economics, and carriers need to be well-managed in order to succeed long term. On the other hand, we believe that Qantas is well-managed, enjoys the benefits of a profitable domestic market, and is well-placed in respect of a changed market environment.

The future is still very difficult to predict, and an investment in Qantas today is clearly not without risk. However, investors who are willing to accommodate some flexibility around their definition of business quality could do well to think about whether the upside from here may outweigh the downside.

ICAO report