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The Fundamentals of Qantas Airways

By  | December 9, 2013

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 financial commitments”.

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 back.

 

Warren Buffett provides these words of wisdom regarding managing this kind of investment.

“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 leaks.”

 

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

Qantas QAN Profitability

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

Conclusion

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 points…

 

Disclosure

Not surprisingly, the author of this article does not hold shares in Qantas.

  

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