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Game of chicken – Qantas

The biggest game of chicken is playing out right now. It’s uncertain who blinks first. But there is much steely-eyed glaring because at stake is Australia’s tourism industry which ranks in the top 5 of our GDP producers.

The three way stare off is between Virgin Airlines, Qantas and the Federal Government. Virgin which is in trading suspense and almost certainly in a spiral dive in voluntary administration wants the Feds to pony up a $1.4 billion funding life jacket. Qantas pugnacious CEO Alan Joyce reckons he wants what Virgin may get, but to the tune of almost $4 billion, to keep the playing field level.

And the Feds are saying they really don’t want Australian taxpayers to end up as equity holders in a propped up listed aviation company. Especially one where the 5 major shareholders control 90% of the equity, and all but one, Richard Branson, is backing away from tipping in capital.

If Virgin goes under it will have far reaching impacts on Australian tourism. With no competition Qantas will set new higher pricing benchmarks. And that will impact on both in bound and domestic travel. A case of cough up or stay at home.

So where is the opportunity in this? If the scenario plays out Qantas comes out of Covid in reasonable financial shape and Virgin goes to the knackers, then Qantas shareholders will certainly be at the front of the plane.

Easier to stop than to re-start is the case for Qantas at the moment. The airline can weather a lengthy period of travel restrictions. But what does the business look like when restrictions are lifted?

A three month grounding will cost the group $2.1bn. Six month grounding is only marginally more expensive adding up to around $1.70 a share. Qantas was trading this week around the $3.50 level having fallen from a pre Covid high of almost $8.00. Unlike Virgin, Qantas balance sheet is in good nick. Cash stands at around $4 billion, and if unencumbered aircraft were refinanced, this could increase to $6 billion.

Joyce and the Qantas board are aiming at a substantial reduction in the airlines’ gearing in the next 18 months. And lagged increase in working capital and the deferral of discretionary capex will help achieve this.

So, the reality dear investors, is that once the skies are open for business again aviation recovery may take longer than first expected. It’s highly likely Qantas will report losses in the first 12 months after restrictions are lifted, as it begins to build capacity. Don’t expect dividends as this occurs. And there is time to wait to pick the stock buying opportunity.

But take a major competitor, Virgin, out of the picture and things start to look a whole lot different.

Pre-covid demand could take a couple of years to rebuild. In this scenario Qantas will have a significant pricing advantage. And a scenario may well be Qantas returning to breakeven and possibly profits quicker than expected. The share price will move ahead of those expectations.

Qantas has a strong balance sheet relative to peers and it does appear the share price is pricing in an overly pessimistic outcome on the longer-term value of the business. Once the flying kangaroo gets back in the air, Qantas has 2/3 of capacity in a highly profitable domestic market assuming a duopoly. If not, Qantas will be the major beneficiary of that travel demand and price accordingly.

Looking forward to FY23 and the crystal ball is a little hazy. Qantas looks like it is trading on a relatively low single digit multiple price earnings multiple, of around 7 times which could justify less risk adverse investors taking a swing at the stock. But, remember, there will be turbulence in the share price and it will be a multi-year journey till the share price gets back to its previous highs.

The price downside is dependent largely on how long travel isolation remains in force. But I do think the worst market fears are behind Qantas. And, not withstanding a deep and lasting recession, it is possible to see the Qantas share price climb over time to around $5.00 a share.

Legendary value investor Warren Buffet long held the view owning aviation stocks was a death trap for investors. But he has changed his view. And Qantas at these prices arguably is more of a value buy than a value trap.

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