Oram: Don't put Air NZ on the sale block

ROD ORAM
Last updated 07:00 05/05/2013
Air NZ
Air New Zealand – buy its tickets and its bonds, not its shares.

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Even before Mighty River Power starts trading next Friday, the market is already musing over the next SOE the government will offer investors.

Air New Zealand is the only candidate, if the government wants to maximise its returns. It would have to sell Meridian Energy and Genesis Energy at steep discounts, given the three deep and unresolved factors hanging over electricity generation.

Any one of the three - closure of the Tiwai Point smelter, the Labour/Greens plans to reform the generation market or a water rights settlement - would seriously shake up the sector. All three together would only compound the cut in generators' value.

Solid Energy, the remaining SOE on the government's list, is well and truly last. Its strategy, finances and operational performance ended up such a mess under this government's watch it will take three years at least to restore the company to bare saleability.

Superficially, Air New Zealand would be an easy and attractive float. It is already partially listed; investors, analysts and the public are very familiar with it; and its profits and share price are rising.

But the reality is radically different. Worldwide, airlines are a nightmare for investors. Always have been, always will be. Air New Zealand is no exception.

The problem is the industry itself, as IATA, the airlines' global association, described in its extensive 2011 analysis "Vision 2050 - Shaping Aviation's Future". The report is available at http://bit.ly/13LjFo5

Aviation is profitable for all the players except airlines, IATA concluded. Aircraft and engine makers, fuel suppliers, airports, air traffic control organisations and a plethora of other providers have made money from the tenfold growth of aviation in the past 40 years. But airlines haven't.

Airlines suffer from a very volatile business model: their capital and operating costs are high, their competition intense and their operational leverage extreme. Very small changes in passenger load factors, fare yields, fuel costs and exchange rates have dramatic impacts on profits - good and bad. Airlines are extreme boom-bust businesses.

"Over the past 40 years the net post-tax profit of the airline industry worldwide has averaged a paltry 0.1 per cent of revenues," IATA said. From 40 years of revenues totalling US$12,000 billion, they eked out US$19b of profits.

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"There is today over US$500b of investors' capital tied up in the airline industry. In a ‘normal' industry investors would earn at least the cost of capital, implying a return of US$40b a year. In fact, over the past decade investors have seen their capital earn US$20b a year less than it would have invested elsewhere. Even at the top of the last cycle over US$9b of investor value was destroyed." On average through the 2002-2009 worldwide aviation business cycle, airlines destroyed US$19b of shareholder capital each year, IATA said.

A few airlines buck these vicious conditions. But, as IATA, pointed out, "excluding small airlines, there were less than 15 that managed to produce an average ebit [earnings before interest and tax] margin in excess of 8 per cent". There is no pattern to this select group. Each has its unique set of conditions. Emirates and Ryanair are the two best known. IATA said Emirates benefits from a highly favourable tax regime, deep-pocketed owners, an excellent hub location, a young fleet of efficient aircraft and a fuel price break in its oil-producing home country.

The other standout is Ryanair. But it thrives on subsidies from the out-of-the-way airports it serves, a massive low-cost expansion of its Boeing 737 fleet during the aircraft makers' slump post 9/11 and its brilliant targeting of ultra budget-conscious recreational travellers.

The IATA report also revealed the truth about two industry icons widely seen as models of success: "Singapore Airlines has not generated economic profits in the 2000s;" neither has Southwest Airlines in the US.

Air New Zealand is particularly exposed to these economics because it generates a very heavy proportion of its passenger revenue kilometres on very long, very thin routes, that is ones with small passenger volumes by international standards. For example, 12 extra passengers on an Air NZ 747 at the average fare yield doubles the profit from the flight.

Under such pressures, Air NZ went bust in 2001. Its difficulties were exacerbated by dysfunctional ownership among its major shareholders. Brierley Investments tangled first with American Airlines then with Singapore Airlines.

Broadening Air New Zealand's stockmarket ownership, even with a 10 per cent cap on each investing entity, runs the risk of attracting hostile airlines with unhelpful agendas to harass Air NZ.

The Clark government recapitalised Air New Zealand with $1b of equity, knowing we as a tiny nation at the very end of world routes need a very strong national carrier to ensure adequate international air service.

Over the 12 years since, Air NZ has developed into an admirable airline. Its industry accolades are testament to its innovation, efficiency, creativity and service.

And it has done so in a very distinctive Kiwi way. It delivers a delightful, relaxed and different experience to passengers right from the moment they book online. This has paid off for tourism in particular and national brand building in general.

But all these achievements have not generated adequate or sustainable profits. Its revenues were lower last year than in 2008; likewise, its profits were only $94m versus $304m in 2008; and its cash flow from operations were $472m versus $743m; its return on equity 4.2 per cent versus 13.8 per cent.

As a result, its share price was 86c at the end of its 2012 financial year, below the $1 the government paid to recapitalise it in 2001, compared with $1.09 at the end of the 2008 financial year.

This past week, Air NZ's shares traded at around $1.50, for a price earnings/ratio of 12.5 and a gross dividend yield of 5.6 per cent. It's hard to see the upside from that.

Worse, Air NZ won't get any new capital out of the float. The sole beneficiary is the government.

Actually, Air NZ says it doesn't need more capital. It has $1b of cash on its balance sheet and ample access to aircraft leasing and other more efficient and stable sources of finance than a dividend hungry stockmarket.

In fact, Air NZ has been buying back its shares, which has pumped up their value ahead of the float.

Air NZ absolutely deserves our support. But be smart. Buy its tickets and its bonds, not its shares. As Warren Buffett, the world's greatest ever stockmarket investor, said of his losses on US airlines: "The money that has been made since the dawn of aviation by all of this country's airline companies was zero. Absolutely zero."

- Sunday Star Times

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