Qantas Quandary

Given the current state of the Australian stock market, most investment decisions that were made 18 months to 2 years ago look pretty poor in hindsight. As such it's generally unfair to single any one fund manager or individual out, because pretty much everyone is in the same boat and has lost a lot of their client's (or indeed their own) money in this crisis.

However, as with every rule there are exceptions, and I would argue that the decision taken in 2007 by Balanced Equity Management and UBS Global Asset Management to scuttle the private equity buy-out of Qantas for $5.45 per share is one worthy of more scrutiny.

There are many arguments to be made as to why the private equity deal led by the now defunct Allco Group should not have been allowed to happen. The private equity model relies heavily on pumping a lot of debt into a company, stripping out costs then refloating the business in a few years time at a substantial profit - a model that in the current environment of low debt availability is not viable, particularly with a business like Qantas which is highly capital intensive. Questions abound as to what would happen with issues like maintenance, timely replacement of planes and safety were Qantas to be taken private and be run in this sort of business structure. There is also the question of the national interest, in that the government permit should arguably not permit an iconic brand like Qantas to be taken over and potentially run into the ground by a posse of deal-hungry bankers. Quite possibly, given the woes that have befallen the debt and equity markets, had the deal gone ahead, Qantas might now be itself be insolvent as the burden of its debt costs increased and banks sought to recover what they could from the company's carcass.

One must, however, query the relevance of these qualitative factors to a fund manager whose role is generally to secure the best return on their client's money and who must make the decision whether or not accepting the Allco offer was in the best interest of their investors. Some fund managers such as Australian Ethical Investment have briefs which go beyond the mere making of money, but given the nature of their organisations it would be surprising if Balanced and UBS had similar provisions in their mandates. Assuming therefore that their brief was limited to maximising monetary gain, were they acting in their investors best interests in rejecting the Allco bid - even in the face of fairly strident urging from the groups own Chair, the highly respected businessperson Margaret Jackson? I would say the answer is an unequivocal "no".

The reasons for saying this are rooted in the nature of Qantas as a company and the global airline industry as a whole. Relative to other industrial companies, airlines have a high degree of operational risk. The prospect of major mishap is an obvious one, but more insidious to the bottom line are factors such as fuel cost spikes, higher levels of union activity due to the number of staff they employ, virulent disease outbreaks such as SARS, increasing airport charges due to global airport privatisation and a high degree of leverage to economic downturns such as the current one due to falling levels of business and tourist travel. At the same time, they are operating in a highly capital intensive industry as planes need to be turned over regularly to meet international safety standards. In a market where capital is scarce, this is probably the greatest risk of all right now and helps explains this month's announcement of a substantial share issue to raise further equity.

You would ordinarily think a company facing this level of operational risk would be able to maintain high profit margins in order to compensate itself for taking on those risks. However this is simply not true of Qantas and airlines in general. While commercial air travel has grown at roughly double GDP pretty much since its inception, the industry is highly competitive in nature and the real cost of airfares has gone steadily backwards for at least the last 15 years. Airlines of course take measures to try and cut costs, improve efficiency and protect their margins - any long-suffering domestic Australian traveller will be able to attest to these - but the fact remains that an airline like Qantas will almost never generate a double digit margin on its revenue. This is a very thin buffer to have considering the risks that the business is exposed to, and if anything goes wrong, the impact on the bottom line can be catastrophic.

Despite all this (and I am speaking from a shareholder perspective here rather than a customer perspective), and especially when compared to overseas airlines, Qantas is very well run and profitable. Almost all of its American peers are in bankruptcy protection, while numerous Australian competitors have come and gone over the years, unable to make sustained go of it in what is a fairly brutal industry.

As a result of the risks which it has to face, Qantas's earnings per share performance has over the long-term been highly variable. Back in June 2003, after the fallout from SARS and the residual hiccups from the dotcom crisis, it reported a profit of 20 cents per share. Since then, it has enjoyed relatively favourable conditions and has reported EPS of 35.5 in 2003-4, 36.8 in 2004-5, 24.9 in 2005-6 and 34 in 2006-7. In 2007-8, just after the Allco bid was rejected, all the planets seemed to align for the company and EPS was a whopping 50.2 cents and with the shares trading for a few months above the Allco bid price. However since then some of the endemic risks that plague the industry (crippling oil prices; economic downturn; fresh competition) have come home to roost and it looks like returning to a 2003 level of profitability in 2008-9. This is before you take into account the dilution in EPS likely as a result of the recent capital raising it has undertaken.

So, how does one properly value a company like this? Typically, market players look at the long term profit growth prospects of a company and apply a multiple to its earnings (called a price to earnings, or PE ratio) to derive a fair price for the stock. There is one hard and fast rule to this valuation exercise but generally as a rule of thumb, a PE at or below 10 suggests negative earnings prospects for the company, while a PE in the high teens suggests strong earnings growth prospects. Given Qantas's long-term earning profile, and without this being a reflection on management at all, it is hard to argue that Qantas should ever trade on a multiple of more than 10 times its long term sustainable EPS, which would seem to be around 34-37 cents per share.

From this you derive a price in the order of $3.40 - $3.70, not too far away from where the shares have traded in a normalised market over the past 10 years. This is a long way below the Allco offer of $5.45 a share, which on current earnings expectation for 2008-9 would be a whopping 27 times earnings.

You have to seriously question in this context what logic Balanced and UBS used in order to form their view that the offer was undervalued - in Andrew Sisson's stated estimation, by as much as $1 per share. Did they think the nature of the airline industry or Qantas's position in it was suddenly about to change dramatically for the better? Did they think that the trend of constantly declining real airfare costs was going to reverse? Did they think despite constant protestations from management and the anecdotal experience of air travellers that Qantas has plenty of room to cut costs? Or, most naively and in spite of the lessons of history, did they think the stock market was going to go up forever?

None of their detailed reasoning was revealed publicly despite their constant complaints in the press about Qantas not being forthcoming with information. To this day we are left in the dark as to their logic, and with Qantas shares now hovering at around one-third of the Allco bid price, I am tipping they won't be volunteering this information any time soon as their assumptions are going to look fairly silly in hindsight. Nonetheless, their clients and their fellow shareholders in Qantas are entitled to an explanation, as they have been pretty badly let down.

I would certainly like one on behalf of my mother, who holds a substantial amount of shares in the company. I would encourage all other shareholders and clients of these fund managers to do the same.