Description

AirAsia is a successful Asian short-haul low-cost carrier that is trading at a large discount to local as well as European and US peers, despite having a greater long-term growth potential than most and the dominant competitive position in its region. Importantly the company is also operated by high quality people and ~32% owned by CEO Tony Fernandes and his long-term business partner Chairman Kamarudin Meranun. The duo acquired the airline in 2001 and built it into what it is today.

The main points of the thesis are the following

- Short haul LCC model works well and is a relatively decent business at scale

- AirAsia operates in a region that offers an attractive long-term growth potential

- The company is very well run and well positioned to capture future growth

- The current price offers a generously low entry valuation

Some background and facts on the company

Once current leadership took over in 2001, they wasted no time to implement a rigorous LCC business model and AirAsia began its rapid expansion starting from 2 aircraft. First in Malaysia, but relatively quickly also in other ASEAN countries and soon the company started to live up to its name. Today, AirAsia operates slightly over 200 aircraft and carried over 65m passengers last year. In total they have carried over 450m since 2001. AirAsia flies over 325 routes to around 135 different destinations in over 25 countries, with close to 5’000 flights on average a week. Roughly a third of these routes are solely operated by AirAsia, with many destinations/cities in the region first connected by them.

The route network is best in class in ASEAN with attractive slot positions in many of the more congested airports in the region. AirAsia is also the only Airline that has operating licenses in all the big ASEAN countries (in terms of air travel) except Vietnam where they are currently setting up a company. The company also has the best-established brand in the region and ranked as the world’s best low-cost Airline by customers for the 9th consecutive year in a row now. Even more important, Air Asia also holds the lead in terms of cost, with the lowest operating costs (CASK-ex fuel basis) in the region, and until now, also the lowest globally.

Short-haul LCC model

Brief intro for those who are unfamiliar with the model, likely few but anyway; In short, an LCC basically strips out all unnecessary costs, avoids complexities and maximizes aircraft utilization (also to lower costs), with the single goal to get you from point A to point B as cheap as possible. Everything else is considered a luxury and either not available as a service at all or only for additional dollars. Most of the gained cost advantage is shared with customers in the form of lower airfares and part is kept by shareholders. LCCs tend to have the best operating margins. The model works so well because the product/service is undifferentiated enough, that the price becomes a major/the main factor in the customers purchasing decision.  

After being pioneered by Southwest more than 40 years ago, the short-haul LCC model still continuous to gain share around the world and successfully displaces the less efficient FSC model for journeys of up to 4 hours. The much lower prices that the LCCs can offer, are getting the majority of people on their routes to happily tradeoff the full-service experience for a simple well-functioning no frills service for a much lower price – at least that’s true for short flights.   

True low-cost operators only operate a single aircraft type, a single seat class, have no free food or drinks, no free seating choice, offer no refunds, no fancy lounges at airports, fly to many secondary airport destinations, generally have no arrangements with other connecting airlines, use a lean distribution channel without agent commissions, have the shortest possible turnaround times, and the highest possible aircraft utilization. Air Asia applies the LCC playbook very well and achieves very low operating costs.

The airline with the best/much lower cost structure in a region, has a leg up on its competition and the business is much more attractive and resilient as a result. It is quite similar to other commodity industries where differentiation doesn’t really work - it pays huge dividends to have the lowest operating costs and to be able to take share and to remain profitable through cycles.As a result, the short-haul LCC model is basically the only home to the few success stories the airline industry has to show and the only model that handsomely rewarded shareholders over the long-term in an otherwise, to be polite, unattractive industry. Success stories like Ryanair, EasyJet and more recently Wizz Air in Europe, or an early Southwest Airline as well as recently Spirit in the US, are all good examples apart from AirAsia.

To sustainably achieve high returns on capital with the model, an LCC needs at least one of the two following circumstances. Either a large sustainable cost advantage against competitors or a consolidated market with very few competitors if the comps have comparable operating costs. What we have seen historically, is LCCs with huge cost advantages taking share from FSCs all around the world, with the US leading the trend, followed by Europe and then everywhere else. But at the same time, there is also industry consolidation - at least in the short haul space, and it makes sense, given that it is easy for an LCC to enter a market full of FSCs and to take share from them, but much, much harder to do so once there are established dominant LCCs. As a result, once the LCC model has displaced the FSCs up to their respective addressable market share in a region, it is becoming much harder to enter the market for a new LCC and the market in that region should end up with only a few dominant LCCs. This gives us confidence that the returns for well-run dominant LCCs should remain attractive, when the market has matured for LCCs.

Strong growth coming in AirAsia’s core market ASEAN as well as in China and India

AirAsia operations in a region that will likely see strong real growth in air travel for the next one to two decades. The airlines core market ASEAN is home to close to 650m people, around double the size of the US population and more than the population of the EU with 510m. However, given the economic development, much less flight activity per person takes place. The following graphic isn’t super current, but accurate enough to quickly show where each country in the region stands in terms of size and economic development overall.

Besides its growth potential, the region has additional benefits. 1) It is a fantastic travel destination loved by millions of tourists from all around the world 2) it is not a single connected landmass, so flying is a necessity if you want fast travel. 3) With its proximity to the equator the region is attractive all year around, even though there is weather seasonality. Obvious things to dislike are the current regulation with fully open skies lacking and the foreign ownership restrictions in the airline industry.  

The surrounding giants China and India each have a population of more than 1,3b people and should experience strong long-term growth in domestic air traffic and additional tourist flowing into the ASEAN region. AirAsia has a 49% owned associate in India (max foreign ownership currently allowed), and is in the setup phase of an associate airline in China for domestic flights. However, even without an associate operating in China, AirAsia generates around 20% of its revenue with flights back and forth between China and various ASEAN destinations. AirAsia’s current Indian associate is still small, with only 14 aircraft at year end 2017, but the company is scaling quickly (targeting 21 aircraft at year end 2018) and plans to add up to 70 aircraft to its fleet in the next 4-5 years.

Some numbers in terms of current market size. India currently has ~0.1 aircraft seats per capita, China has ~0.4, Thailand has ~0.65, Indonesia ~0.45, Vietnam ~0.40 and Malaysia ~1 (Malaysia has a lot more fly through traffic) whereas the US has 2,75 aircraft seats per capita.   

AirAsia’s biggest long-term growth potential lies in successfully establishing a descent domestic presence in India and China and integrating Indian and Chinese destinations into its existing ASEAN network. The biggest potential in ASEAN itself apart from growth, is deregulation. The adoption of fully open skies (Link) with 9th degree of freedom (Link) together with the stopping of foreign ownership restrictions for airlines. Currently ASEAN has adopted 3th and 4th degree of freedom under open sky standards. Which means that if you have an airline license in one country (A) you are allowed to fly to and back to any country (B) from your country (A) without capacity constraints and a specific bilateral agreement between the two countries A & B. AirAsia is currently persuading regional ASEAN countries to extend open skies to level 5 which would enable an airline to fly routes linking 3 countries. So, going from your home base (A) where you have a license, to country (B) and further to country (C) and back again. AirAsia as the only airline in ASEAN with operations in all relevant ASEAN countries would benefit the most from deregulation. Therefore, it is pushing hard for it. To run a true ASEAN airline at the current state, you must set up companies in each country, which means you end up with quite a bit of duplicative costs and it is more burdensome to move your assets and labor around to serve your markets best. There are also obstacles like, pilots requiring additional licenses/training to fly in other ASEAN countries. So, it will benefit AirAsia a lot when the day comes that ASEAN moves to 9th degree freedom, similar to the EU did many years ago. Day is far ahead, but a push upward in the degrees of freedom and also ownership levels above 50% for foreigners don’t seem to be out of reach in the next 5 years.

AirAsia is very well run and well positioned for continued future growth

The company currently holds the global top spot in terms of operating costs with its 100% owned Malaysian operation and quite a decent cost structure overall with its AOCs. The low-cost structure is a very important part of the investment thesis and also a testimony for how well the company is run overall. Their cost structure would certainly be higher in the EU or US, but a global comparison is not that important anyway. It’s all about local competition. Luckily AirAsia compares favorably in that regard. Apart from that, lower costs are helpful to increase demand in general and certainly stimulating in a low-income region like ASEAN.

I don’t want to go into very detail how AirAsia is able to achieve this cost structure, but I’ll name a few reasons.

Cheap highly utilized assets

One obvious big cost block for an airline that can make a huge difference and does in AirAsia’s case, is the cost of its fleet of aircraft. AirAsia gets much better prices than most airlines and was likely able to negotiate one of the best deals with Airbus given the size of its order. With close to 600 aircraft ordered, and more than 400 aircraft yet to be delivered AirAsia is Airbus single largest airline customer in the narrow body market. Certainly, also helpful to pricing, were early commitments to the new generation NEOs back in 2011. They were also the first Airline to receive sharklets and the first Asian airline to receive the new LEAP engines (Link). Another cost saver in this area is high aircraft utilization and AirAsia does very well on that metric. Last year it achieved an aircraft utilization of 13,05 hours/day on average. Additionally, in terms of cost per seat, AirAsia’s new planes are usually equipped with an additional row of seats/maximum number of seats. The A320Neos will have the maximum of 186 instead of 180 seats and the A321Neos will have the maximum of 240 seats. Here is also a video of their chief pilot talking about some small stuff, like taxing with one engine only, getting rid of books for pilots, designing landing take off routes that save fuel, or filling water tanks depending on flights, load factor etc.     

People and Culture

Culture is of course another very important one. All the small things add up, and AirAsia gets that. They are a very entrepreneurial company and live a true LCC culture. The two main figures Tony and Kamarudin are down to earth, very approachable and run a flat hierarchical structure. Nearly everyone I met struck me as driven, humble and friendly. Tony is a great leader, he has his puts and takes, but overall, he seems like a great, very motivational leader for a people’s business like an airline. He (or someone for him) recently wrote a book that is certainly a worthwhile read for anyone who is considering investing in AirAsia. Tony and Kamarudin also had a few failures along the way. We think they have learned their lessons and are therefore better leaders and businessmen today. Prior to starting AirAsia, Tony was working at Time Warner Music and more than 15 years later, there are still people like Tassapon Bijleveld head of AirAsia Thailand or others from the Time Warner days, working for him now. In general, the overall workforce is very young and driven. AirAsia is considered a huge success story in Malaysia and people are generally proud to be working for the company. There is also kind of a building and dreaming big culture at work, that helps attracting and retaining talent.

Technological leadership

AirAsia embraces a lot of new technologies to drive down cost or gain efficiencies and  is way ahead of its local peers in that area. Couple of examples are; the company started migrating services to Amazon Web Services 6 years ago (Link), they use Facebook workplaces (Link) to communicate more efficiently, they will have their HR on Workday in the next 3 months and they are using Salesforce to improve and be better on the customer front. They also work on a couple of procurement and maintenance cost saving initiatives with Palantir as well as with Google to improve data collection, visualization and to gain better real-time and predictive insights via ML. To stay up to date for all their new digital initiatives, they are setting up a small office San Francisco.

Less related to costs, but also relevant in this regard, are the customer facing applications. Like every airline, they are trying to push ancillary income up. With over 100m users in 2017, AirAsia’s app has good traction. They are collecting data in a way to be able to start pushing some personalization. They recently started an E-payment initiative to become paperless in the cabin with their own product and to offer things like decent FX conversion with a plan to take it further outside the aircraft. Sometime during 2018 their whole fleet will become Wi-Fi enabled. They currently charge around US$4.5 for 10MB apart from the free onboard entertainment stuff and some free chat plans for loyalty members, but they are planning on offering it free of charge longer term. They also have an e-commerce shop with the goal to sell customers more stuff without carrying it on their plane. Which means you can get the stuff you bought online VAT-free at the airport or delivered to your home address including VAT. Of course, they also have offerings for hotels, car hire, adventure trips, enable Uber bookings in advance, make it easy to buy food in advance etc. Additionally, they are quite advanced in terms of airport automation, even applying facial recognition at the boarding gate (Link) and pushing the advanced T4 Singapore Airport model (Link)

Similar to Ryanair fantasizing about become the Amazon of travel (Link), AirAsia throws around statements like becoming the Alibaba of the travel. We consider it mostly PR talk with success far from the bold statements, but at least they are pushing in that direction and a brand reputation for cheapness should help to get some success. The worst case is likely that there is not much revenue to be gained, but their ambitions kept them on their toes technologically and ahead of their competition. In a world where we are all becoming more and more spoiled by modern super customer friendly companies, it will help to keep their brand relevant and liked. Some related numbers:      

Dense route network

AirAsia has built up a strong cross-country network in the region, and has a nice base for further development. The competitors are generally more domestically oriented LCCs and lack a network like AirAsia’s. Apart from the LCCs in the region, each country has one FSC legacy airline, but they can’t be considered serious competition. The LCCs on the other hand should be. There are some decent LCCs. The private Lion Group is dominant in Indonesia with domestic flights and has some share in Malaysia and Thailand (but both aren’t doing that well), Cebu Pacific is leading domestic travel in the Philippines with 55% market share and Indigo is way ahead in India, with domestic market share of close to 40%. AirAsia is building a domestic operation in each country and at the same time is connecting it internationally with its larger network. In markets like Indonesia where they are weak domestically (less than 5% share) they are strong internationally with close to 30% share. There is already a lot of fly through traffic taking place in KL and Singapore. Their separate long-haul operation also feeds guests into their network. From all the airlines in the region, AirAsia’s network is best suited to bring in Chinese and Indian tourists.

Well established brand

AirAsia has a well-known brand and is liked by customers. They have won the world’s best low-cost airline award 9 times in a row. Their cabin stuff is super friendly and I guess their appearance helps as well. If you haven’t flown with them, try it the next time when you are traveling in the region.

Apart from having friendly staff, it really helps your brand if you are able offer a well-received service cheaper than your competition over a long time. It also helps if you enable some of your customers to travel by plane for the first time in their lives - something that is not uncommon in the region and in AirAsia’s history. Another plus is to have an outspoken CEO who can generate a lot of free/cheap publicity for your company. Tony Fernandes is different than Michael O’Leary or Stelios Haji-Ioannou but each of them played and apart from Stelios still is, playing their public persona as marketing tool very well. Even though the previous owners already choose the airlines name, it certainly was a smart choice. Just like the message “Now everyone can fly” is. Quick example of how well established they are in Malaysia today; Malaysia’s Prime Minister recently visited them in their HQ, to basically get some positive publicity prior to the upcoming elections. Tony gave him a roaring thank-you speech, made him the father of low cost travel and the media was all over it. The official news was that he visited AirAsia for the grand opening of their new HQ in KL. However, it already opened in the fall of 2016… AirAsia is also quite successful on the social media front and has over 40 million fans on Line and Facebook.

Aircraft fleet

AirAsia continues to have ambitious growth plans. With a capacity expansion of currently around 30 aircraft a year, consisting of A320Neos and A321Neos starting next year, they will grow their fleet at over >10% a year for the next couple of years. Considering the general growth in the region and the flexibility AirAsia has in deploying those planes across its broad network, the plan doesn’t seem to be too ambitious. In fact, depending on the success of their associate operation in China they might need to order additional aircraft.

AirAsia ended last year with a fleet of 205 aircraft (A320s with CFMs). Of those, a total of 85 aircraft were owned by AirAsia Malaysia, of which 10 were leased internally to other associates. An additional 25 were owned by AirAsia Thailand and an additional 29 were owned by Asian Aviation Capital (AirAsia’s internal leasing arm) which was primarily leasing planes to AirAsia’s associates. So, a total of 139 owned aircraft (114 on group level, 25 on an associate level) and an additional 66 leased aircraft (16 on a group level, and 50 on an associate level).

Sale-leaseback transaction

Going forward a few things will change, AirAsia recently announced a deal (Link) to sell 80 aircraft (+ 4 aircraft which are going to be delivered from now until Q3 2018). The buyer is a group coordinated by leasing company BBAM. They also entered into a future sale and leaseback transaction on close to 50 aircraft of their future deliveries. Additionally, also included are 50 of AirAsia’s aircraft options, with deliveries starting from 2020 and running till 2025. With the deal, AirAsia effectively agreed to sale-leaseback transactions on around a third of their outstanding orderbook. Following the transaction, AirAsia Malaysia will continue to own around 40% of its aircraft instead of 80%. All aircraft that were previously owned on a group level but leased to associates are sold. The Thai associate will own around 33% of its fleet on its corporate level and the associate in Indonesia about 22% of its fleet.   

The transaction amounts to an EV of US$2’846m with an equity portion of US$1’185m consisting primarily of cash. US$50m is an 10% equity piece in Fly Leasing and another US$50m will be invested in the fund (Incline) that gets a chunk of the aircraft. They will likely pay out around 75% of the cash proceeds in dividends and pay down debt with the rest. The transaction will make the company net debt free prior to taking leases into account. We would prefer them to buy back shares with the proceeds but the founders already own 32,5% and would trigger a mandatory takeover by crossing the 33% threshold (Link). At least there is no dividend withholding tax in Malaysia (Link).

Apart from the balance sheet impact and a one-time gain of close to US$250m (RM0,29 per share) the transaction will have slightly negative impact on future earnings and also increase their cash-costs. The impact from the sale and lease back of 37 aircraft for MAA is a net negative US$22m or RM88m a year to the group. The other part of the transaction doesn’t increase the group’s costs, but eliminates rental revenue from aircraft that were previously leased to the associates and (3 aircraft) to external airlines. The net impact should be on the order of US$25m or RM100m after considering depreciation and interest costs savings. The associates themselves should see no impact. The total impact including the positive effect from the paydown of additional debt should be a negative RM140m.

Valuation – AirAsia valued @ 10 x earnings

We estimate the current pretax earnings of the core business without the associates to be around RM1.4b post the sale. There were a couple one-offs in last year’s earnings (sale of AACE, remeasurement gains from the consolidation of IAA and PAA, a sale-lease back transaction) and the associates on aggregate were a drag on earnings (negative one-off in IAA and startup losses in AAJ and AAI).

Last year’s earnings without adjustments:

Valuation with non-core assets, but without associates – AirAsia @ 7 x earnings

The market value of AirAsia is currently RM13’3650m. Taking out the non-core assets and the cash that will be used for special dividends gets the valuation down to RM 9,6b. The Expedia equity partnership will likely be sold relatively soon. AirAsia X will likely be kept for the long-term. Tune Protect, we don’t know. Their general thinking is that they are now going to sell all the non-core stuff that doesn’t really get appreciated in the AirAsia Group and pay out all the proceeds to shareholders.

By taking AirAsia’s non-core assets into account, but without assigning any value to the associates, AirAsia price gets down to 7 x pretax earnings.

Tax Incentives in Malaysia

The official tax rate in Malaysia is 24% but AirAsia is hardly a taxes payer. Malaysia grants various tax incentives, one being an investment tax allowances for capital spending (Link & Link). AirAsia falls into the category of companies being able to charge 100% of capex to EBT for 5 years (at least that is the category I believe they fall in). Which means they won’t pay meaningful/any taxes as long as they buy a couple of aircraft a year. Given their current order book, it would need a tax change for their core business to be subject to taxes for the next decade. So make the valuation 7 x after tax earnings.

Valuation with non-core assets, and value of associates – AirAsia @ 4 x earnings

Assigning no value to the associates, is of course way too pessimistic. AirAsia Thailand is listed (here is a brief overview) and the 55% interest in the business is valued at around RM6b. The company is the longest established associate and continuously profitable. AirAsia is currently pushing capacity into AAT quite aggressively which pressures yields in the market. They are gaining market share as a result (which is great) but earnings are currently a bit depressed (which doesn’t matter much). Last year AAT was the only profitable airline (of the listed ones) in the country. One can either take the RM2,7b face value – which equates to 17x last year’s earnings or 14 x earnings 2016 which better reflect earnings power, or tweak around. For this exercise here, I leave it at the not unreasonable RM2,7b.

The other associates have value as well, but I don’t really value them in detail here. Indonesia was recently backdoor listed on the Indonesian stock exchange (current value RM1,1b) and there is a plan to list the other 2 remain ones as well sometime late 2018, early 2019. Tony can be bullish with his dates, but it doesn’t really matter to a longer-term owner anyway. In the following table we have all 3 associates at RM1b each. Taken together the 3 associates operate a similar amount of aircraft compared to AA Thailand, but they are less established and less profitable, or still loss making in the case of India (surprisingly broke even in Q4 2017). To pinpoint the valuation of those 3 now and here, doesn’t make much sense to us, the real value of them will emerge over time.

Considering all of AirAsia holdings, the valueation of the core business goes down to 4 x earnings.

A couple more things to say. The company is working on consolidating and owning more than 49% of the ASEAN associates. There is a bit of traction and some country regulators are already warming for the idea, according to the AirAsia. The push is the long-term main part of the initiative AirAsia One.  Shorter term initiatives are primarily cost saving in nature. They identified around RM175m at the start of 2017 (Slide 8) and announced a reorganization of legal, finance, communications on the last earnings calls. Instead of 5 departments, they are moving to only one each. The heads will be, but they departments won’t all be at their Malaysian HQ. Part will move to Thailand, part to Indonesia. There will be some savings made as well, and they are preparing the group to be one united entity. They are also taking more control of the associates – management realized how much could be saved, and that regulators would allow it. There is also a new group structure and they will shift their listing to HK some time prior to 2020.

We think AirAsia will do well over the next 5 years. The associates should all enter the face of sustainable earnings growth and AirAsia might already own more than 49% in some of their ASEAN associates - it will certainly manage them more tightly. Given the low valuation the stock could do very well.

Risks and negatives to think about.

Short-term risks are obviously a rising oil price, or a falling in the ringgit. We don’t think about oil too much, but because of that, we might make terrible mistakes in timing. However, given a reasonable holding period it shouldn’t matter too much. I personally think there is enough cheap oil available to comfortably buy an airline and that the existence of US shale oil has decreased the risk of extreme oil price volatility on the upside.

The ASEAN region seems politically and economically stable enough to us, but it’s not home and less developed - bad things can happen easier. AirAsia is diversified across countries, but as of today, one must get comfortable with Malaysia - overtime this dependence/risk will likely more and more ease.

The one risk we dislike the most is bad capital allocation. We think the chances are small and generally we are very comfortable with management, but we didn’t like the way Tony and Kamarudin increased their investment back in 2016. The created dilution from the transaction wasn’t necessary, they should have bought their stake in the open market. Given the size of their stake now chances of bad acting are lower and risk of a take under privatization seems remote, but then again not too remote not to mention it. If you become a fellow shareholder take to them and reduce the risk further.

Overcapacity and excess competition can obviously happen from time to time, but the 1-2 LCC + 1 FSC market structure and real growth seem to create an environment that should lead to reasonable competition.   

Catalyst

earnings growth, suprises

special dividends

Expedia partnership sale

long-term:

1) deregulation

2) Lisitng in HK, potentially NYSE