Emergency conference call. AirAsia held a conference call yesterday to address recent developments within the Group as well as the entry of new low cost carrier Malindo. We highlight the key takeaways below.

Japan unit operationally profitable in first month. This is because the month coincides with the seasonal peak in demand. Nonetheless, we think this is an impressive start, as AirAsia Japan has been aggressive in promotions to create awareness and stimulate demand. It recorded a robust average load factor of 80%. Management is targeting for its Japan associates to break even in the first year, which we reckon is achievable given the high yield and low cost structure.

Batavia Air undergoing due diligence. We note that although the proposed acquisition of Batavia Air has been approved by the Indonesian regulators, management has yet to decided whether to proceed with the proposed acquisition as the acquiree is still undergoing due diligence, which should be completed in the next 2 months.

Malindo a welcome rival. AirAsia says it welcomes competition and is determined to give Malindo a run for its money as the former believes that charging low cost fares for a full-service offering including meals, in-flight entertainment and baggage would not be operationally feasible in the long run. Furthermore, as Malindo is starting an airline at a substantially higher oil price base compared with AirAsia 10 years ago, this would limit its flexibility in cutting air fares coupled by the higher adex costs that it would incur to promote its brand name. Malindo is understood to be reconfiguring its B737-900s to cater for two classes, which will cut its seat capacity from 220 seats originally to 168 economy seats and 12 business class seats, for a combined total of 180 seats, which is similar to AirAsia's. We think this configuration would squeeze leg room in economy class and make flying uncomfortable. Furthermore, with the offer of free baggage possibly encouraging passenger to carry more baggage, Malindo's strategy may also slow down aircraft turnaround and burn more fuel, which will consequently erode its bottom-line.

Yields set back temporarily due to promotion fares. Malindo intends to kick off with 12 aircraft in the first year of operations and a fleet of 100 aircraft within a decade. With the new capacity coming in, AirAsia's overall yield may experience a setback as competition intensifies. However, we reckon that AirAsia's yields will not suffer too much as Malindo's aggressive promotions may give rise to operating losses and would only be short-lived, probably for two quarters. Eventually, Malindo would come to its senses and see the need to start showing a positive bottom line.

This was what had happened with Firefly's loss making jet operations servicing East Malaysia in 1H2011. Firefly was then operating six aircraft. To spur demand and load factor, it undertook an aggressive promotion by offering all-in air fares to KK and from JB and KL for as low as RM9 and RM35 respectively. This move pressured AirAsia's yields, which fell 7%/6.2% y-o-y in 1Q/2QFY11 to 17.8/17.9 sen per RPK from 19.2/19.0 sen per RPK. Note that the yield pressure was not only due to the low fares from Firefly's jet operations but also across its entire turbo prop operation. Had the aggressive price cuts been confined only to Firefly's jet operations, there would have been less pressure on AirAsia's yield. In 3Q2011, as Firefly continued to see red, AirAsia's yields began to normalize to 19 sen/RPK. As of 2QFY12, AirAsia's yields had recovered to  18.7 sen/RPK, which was 5% higher -o-y.

The emergence of a Malindo or even potentially, Firefly's revived jet operations, would only lead to a slight contraction in AirAsia's fares as yields in 2013 revert to the 2011 level of 14.5 sen/RPK (vs our 2012 and 2013 forecast for 14.9 sen/RPK). AirAsia's overall yields combined, however, could be flat y-o-y as it will be offset by its growing ancillary revenue. As our overall yield assumptions have been fairly conservative, we only trim our overall air fare yield by 1% for FY13-FY14 to 14.5 sen per RPK. in 2011 and 2010, AirAsia registered an airfare yield of 14.5 and 15.3 sen per RPK respectively. According to our sensitivity analysis, a 0.1 sen reduction/addition in yield would give rise to an  earnings impact equivalent to RM29.5m (or 3% of total AirAsia's income)

How will load factor be affected?As we have stated before, the bane of low cost travel is that any  aggressive price war actually stimulates demand as it encourages consumers to travel more frequently. As exhibited in 1Q and 2Q last year, despite intensifying competition from Firefly on the East Malaysia routes, load factor actually went up by 6.2 and 4 ppts respectively. And once prices normalized, load factor in the subsequent quarter started to tapers off slightly. However, we think that Malindo's aggressive fleet expansion would only slight hurt load, but given our conservative load factor assumption of 78%, we make no changes in our assumptions for AirAsia.

Downside to earnings. Maintain BUY. Following the 1% and 1.4% cuts in our FY13 and FY14 yield assumptions respectively, we are trimming our earnings by 5% and 7% on the back of 1.3% and 2% reductions in revenue forecast. Our FY12 numbers remain unchanged. We arrive at a new FV of RM3.91, implying a a FY13 PE of 12x, in line with the average for global low cost carriers. We maintain our BUY call on AirAsia, which is trading at 9x FY12 PE. Following the steep selldown, we advise investors to accumulate AirAsia shares.

Source: OSK