Where next for Qantas?

The Qantas share price has soared 600 per cent since 2014. This has surprised many long-term investors, who view airlines as a bit like the Bermuda Triangle – a place where money is lost and never seen again. So, what’s happened? Are airlines now a great place to invest?

Over the years, airlines have generally produced poor returns on incremental equity. In addition, accounting standards allow large divergences to persist between reported profits and ‘economic’ profits. For those reasons we have chastised those who even entertain purchasing shares in airlines.

You might think we’d be applauded for protecting investors. Qantas shares are trading where they were about 11 years ago and Virgin’s shares are 90 per cent lower than where they were 11 years ago.

Of course, stock markets have short memories and investors instead look to the six-fold jump in Qantas’s shares since January 2014 as reason to think airlines have changed their spots.

One of the inescapable issues for airlines is the need to fund new aircraft to remain fresh, efficient and competitive. The problem is that airline accounting doesn’t do a great job of reflecting the true cost of running the airline and replacing the planes.

The depreciation expense in the profit & loss statement is based on the historical cost of an aircraft that could be more than 15 years old and if the depreciation change were instead replaced with an equally creative ‘provision-for-replacement of aircraft’ charge, the expense on the profit & loss statement would be much larger and the accounting profit could quickly turn into a loss.

Of course, another way to test whether any real money is being made is to look past the reported accounting profits to the cash flows. But in Qantas’s case, the company has also been reporting strong cash flows in recent years.

Back in 2014, the year the company wrote down the value of its international fleet by $2.6 billion, Qantas reported a $2.8 billion headline loss and a $640 million underlying loss; however, the operating cashflow amounted to just over $1 billion. Fast forward to 2017, and while reported profit had grown to $852 million, cash flow from operations grew to $2.7 billion. And since 2014, the share price is up over six-fold.

So, what gives? Have airlines suddenly become high quality businesses that we should hope to own for the long term? Or is there something the strong cash flow isn’t reflecting?

As an aside, Warren Buffett has previously been on the record pointing out that had he been at Kitty Hawke in 1903 when Orville Wright took off for his maiden voyage, he hoped that he would have had the presence of mind, for the benefit of all future capitalists, to have shot him down. This is due to the tremendous aggregate losses airlines have accumulated over decades.

Those losses are a function of being incredibly capital and labour intensive, and there’s the small matter of some competitors having access to much cheaper fuel thanks to ties with royal families or supportive governments.

Yet only back in January, Berkshire Hathaway’s share portfolio, which is arguably managed by Ted Weschler and Todd Combs, owned an US$11 billion stake in United Airlines, Delta Airlines, Southwest and American Airlines (all are lower since the beginning of calendar 2018).

So back to the original question – have airlines become compelling investment opportunities?

We think not and here’s why.

First, while the company’s cash flows look great, they have benefitted in recent years from generally declining oil prices. In July 2008 West Texas Intermediate crude oil traded at US$147/bbl. By February 2016, the oil price had fallen to less than US$26.00/bbl. But since then oil has almost tripled to over US$70/bbl and analysts at UBS now believe Qantas could be hit with a $700 million negative shift in fuel costs from FY2018 levels to the current spot price. And while the impact might be offset by an expected 10 per cent increase in domestic revenue, there’s the small matter of $400 million per annum in cash tax payments starting in FY2019.

In addition to benefitting from cheaper fuel, cash flows have also been boosted by a strategy that has allowed the fleet to age.

The most expensive part of running an airline is replacing old cheap planes with newer and more expensive models. Airlines cannot escape this capital expenditure lest passengers jump to competing airlines with fancier entertainment offerings and more comfortable seats, bars and beds.

You can call it a disciplined approach to capital spending or you could say the board might prefer to see the share price go up now, maximise share price-related incentives for current management and leave the reality of replacing planes to the next guy.  Whichever way you spin it, the investment bank UBS note Qantas’s ‘fleet age’ has increased from 7.7 years in 2015 to a current 10.2 years.  They also note that the fleet is now older than the last peak of 9 years in 2007.

According to the same report, Qantas has introduced just nine new aircraft, or 3.7 per cent of group seat capacity, over the last three years and so a minimum of $1.4 billion per annum will be required to maintain a constant fleet age, with an additional $300 million spend on the non-aircraft asset base making $1.7 billion. That matches depreciation, but depreciation is based on historical costs so it is still probably undercooking how much is needed to keep the fleet fresh, new and competitive.

And that means future cash flows might not look as good as recent numbers suggest – airlines cannot escape having to eventually replace their planes.

As a final comment, it seems Buffett’s airlines investments are not going so well this year.

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