Recently Qantas has been making headlines as it is expected to report losses of
up to $300m for the six months to December 2013. Making matters worse,
Standard & Poor’s announced it would downgrade Qantas’s credit rating to junk
bond status (downgraded from BBB- to BB+). Standard & Poor’s provides
credit ratings on companies who issue debt (borrow money). When a company
receives a bad credit rating it makes it more difficult for a company to borrow
money as less investors are willing to lend their funds. It also means
that when the company does borrow money, the interest rate the company has to
pay becomes higher. Standard & Poor’s have now put Qantas into the
non-investment (‘junk’) grade , which it describes as “[facing] major ongoing
uncertainties and exposure to adverse business, financial, or economic
conditions, which could lead to the obligor’s inadequate capacity to meet its
Pairing Qantas’s downgrade with concurrent talks of partial nationalisation
presents a dim future for the company. You don’t need fundamental analysis
of financial statements to know that Qantas is currently not in a strong
position and likely a poor investment choice. However, the purpose of this
article is to show that this is not a new story for Qantas. Fundamental
analysis of Qantas shows that this story has been told in the company’s
financial statements for a number of years.
Here are some links to recent news articles:
Qantas to cut 1000 jobs, warns of up to $300m loss
S&P downgrades Qantas to junk
Hockey in plan to buy back 10pc of Qantas
Summary of Concerns
Qantas Airways is a business that requires continual capital investment to stay
competitive. It needs to purchase new aircraft to replace old, retired aircraft.
This capital investment is required just to maintain the business without
growth. It is a huge burden on its small profit levels. Qantas has a
trend of borrowing money to fund this capital expenditure. In doing so, it
has amassed a mountain of debt that, in my opinion, it is unlikely to ever pay
Warren Buffett provides these words of wisdom regarding managing this kind of
“Should you find yourself in a chronically leaking boat, energy devoted to
changing vessels is likely to be more productive than energy devoted to patching
Poor Profitability Measures
One of the most obvious, and simplest, methods of identifying Qantas Airways as
a company of poor financial strength is by examining some simple profitability
measures. The profitability measures in Figure 1 show that Qantas Airways has
averaged a return on equity of less than 1% and a return on assets of 0.25%.
These returns are lower than bank interest. While a small profit is better
than a loss, when investing you have to weigh up the risks against the potential
returns. Qantas’s consistently substandard profits (particularly return on
equity) is a warning sign of bad investment.
Figure 1. Simple Profitability Measures
Highly Capital Intensive
Qantas Airways Limited is primarily a passage and air freight transportation
business. Obviously, this kind of business requires expensive aircrafts;
these expensive aircraft eventually wear out and require replacement.
Aircraft are assets which can be found on the company’s balance sheet statement
under the heading ‘Property Plant and Equipment’. As these assets wear out,
Qantas is allowed to depreciate the cost of these assets over its useful life.
In June 2013, Qantas reported $13.8 Bn of property plant and equipment on
their balance sheet (net of depreciation). Without these assets, Qantas
cannot operate. As these assets wear out, Qantas needs to be in a position
to replace these assets. Figure 2 shows that if Qantas needed to replace
these assets without borrowing any money or issuing new shares, it would take
them at least 10 years assuming they could maintain their profit levels, paid no
dividends, and did not expand their business.
When investing in capital intensive businesses, it is easy to overlook the fact
that the physical assets that produce cash flow (in this case, mainly aircraft)
require replacement. In the case of Qantas, the fact that it
will require at least 10 years to replace their fleet assuming
no growth and no dividends is a
worrisome signal about the financial position of the company, particularly when
considering Qantas’s future.
Figure 2. Years to pay for accumulated property plant and equipment
Large Interest Expense
Qantas Airways has a trend of borrowing money to fund the capital expenditure of
property plant and equipment. The interest coverage ratio shows how easily
a company can pay interest on outstanding debt. The interest coverage
ratio is calculated by dividing the earnings before tax by the total interest
expense. It can be thought of as the number of times the current level of
earnings can pay for the interest bill. The bigger the number, the easier
it is for a company to pay its interest bill. As figure 3 shows, over
the last five years Qantas has averaged an interest coverage ratio of only 1.3.
This indicates that the vast majority of earnings made by Qantas are consumed in
paying their interest expense – not a good sign.
As Qantas only generates a very small amount of profit, it will likely be
improbable that they will ever be able to pay back their debt. As of the year
ending June 2013, Qantas had reported a debt level of just over $6 Bn and a Net
Income of $5m. The ratio of Debt divided by Net Income can be seen in
figure 3. It shows a ratio of 1,216! That is to say that for every
dollar Qantas earned in 2013, it owes $1,216. This indicates that it would be
very unlikely for Qantas to repay their debt with that level of profit.
Figure 3. Debt levels
As the story of Qantas Airways continues to unfold, it is likely to be a
disappointing story for the national carrier. However, some simple
fundamental analysis any time over the past five years should have avoided this
being a disappointing story for your portfolio.
Perhaps this Christmas is a good time to cash in all those Qantas frequent flier
Not surprisingly, the author of this article does not hold shares in Qantas.