3Q12 will be black. We think that MAS will breakeven in 3Q12 on a 9% QoQ drop in unit fuel costs, cost savings from capacity cuts, plus higher load factors and yields as 3Q is traditionally a peak period. This will lift sentiment on the stock as the market takes comfort in the successful implementation of its business turnaround efforts. Maintain BUY, with an unchanged target price of MYR1.20/share based on 2013 adjusted EV/EBITDAR of 6.4x – in line with regional peers.

This is it. MAS exhibited better profits in 2Q12, with a core net loss of MYR160m from losses of MYR357m in 1Q12. This improvement was due to a 10%-12% capacity cut on loss making routes, the disposal of old aircraft and efficiency gains. In 3Q12, we estimate MAS will enjoy cost savings of MYR102m from lower fuel costs (USD120.2/bbl in 3Q12 vs. USD132/bbl in 2Q12), and a MYR66m revenue boost from higher load factor and yields – 3Q is seasonally a peak period.

Sales and marketing much improved. We notice the marketing and promotions effort by MAS has improved with consistent email blast, and frequent eye catching advertisements in the newspapers with attractive offers. It is beginning to resemble an LCC in terms of marketing activity. We think this is the correct approach, as Malaysians are sophisticated offer seekers sensitive to ad campaigns. MAS’ load factors have improved YoY, proof that the efforts are yielding positive results.

Malindo Air is not a threat, provided: 1) MAS completely abandons any plan to re-initiate Firefly’s jet operations, as the budget market is saturated; 2) it cuts capacity further to focus on premium passengers; and 3) it minimises or avoids capacity on routes where AirAsia and Malindo are expected to have a face-off. The key is to focus on premium clientele and not to encroach into the budget segment.

Maintain BUY, 20% upside to be had. Our earnings forecasts and target price are unchanged for now pending the 3Q12 results. MAS reported a net loss of MYR517m in 1H12, and we expect it to break even in 2H12. Our 2013-14 earnings estimates are premised on a fuel price assumption of USD125/bbl, which will be adjusted as required.

Turnaround is near

Business has been sufficiently right-sized. The charts below show MAS’ historical capacity deployment for the domestic and international sectors. It is evident that MAS has significantly downsized its capacity deployment over the years; its domestic capacity in 2012 is forecast to be 20% below the peak in 2005, while capacity at the international segment is 27% below the 2005 peak. With the ongoing route restructuring, 2012 will see the smallest capacity deployed for the past decade. This is a positive development, as MAS now essentially serves its core clientele and has removed excess capacity from the system.

Fuel cost plunged in 3Q12. The chart below maps the fuel cost and load factors achieved in 2012 (note that data for September reflect our estimates). Fuel prices dropped over Jun-Aug 2012, and this should provide significant cost savings for MAS. We estimate that MAS made convincing profits during the July-August period due to the combination of low fuel costs and high load factors. However, fuel prices have reverted to high levels, averaging USD130/bbl in Sep 2012.

Other operational costs are coming down as well. MAS has disposed many old aircraft from its fleet and replaced them with new, more fuel-efficient aircraft. In 3Q12, MAS took into service two Airbus A380 super-jumbo aircraft, which boast unit cost savings of 15%-20% compared to the aircraft it replaces (Boeing 747-400). In addition, MAS has cut 10%-12% of its capacity on loss-making routes, which has helped to plug significant losses. These are structural cost reduction initiatives which make MAS more nimble.

Management affirmed 3Q12 will be positive. Management has stated publicly that 3Q12 will be profitable, continuing the trend started with the small profit of MYR0.6m achieved in Jun 2012. With the base assumptions of a load factor of 75.2% (+1.4ppt QoQ), average fuel cost of USD120.2/bbl (-9.0% QoQ) and a modest yield growth of 2.4% QoQ, we estimate 3Q12 will see a profit of MYR7.9m (versus a loss of MYR160.4m in 2Q12). This is the first quarterly profit since 4Q10. Note that our load factor and yield assumptions are conservative, and there is scope for MAS to deliver higher profits than our forecast.

Malindo Airways

A shift in the equilibrium. Malaysia aviation was surprised on 11 Sep 2012, when the Prime Minister of Malaysia launched the new airline called Malindo Airways (refer to our report Malindo Airways: Enter the Lion, dated 12 Sep 2012). This raises immediate concerns of a more competitive environment and the impact of the new airline on the incumbents.

Malindo Airways is budget-focused. We are of the view that Malindo Airways will not impact MAS significantly because its core clientele is different; MAS focuses on the premium segment whereas Malindo will focus on the budget market. The budget market is extremely sensitive to ticket prices and we think AirAsia has more to lose with the entry of Malindo Airways.

MAS passengers are more than just about price focused. If ticket prices were the primary selection criteria, every passenger would have flown with AirAsia. MAS’ customers are drawn to it for other reasons such as better comfort, the flexibility to change schedules, its frequent flyer programme, food and beverages, business lounge access, business requirements or simply despise using the current LCCT. Malindo Airways is unlikely to outdo MAS on all these factors easily, and therefore we belief MAS’ client base is fairly safe.

In fact, it could be good for MAS. The entry of Malindo Airways has help clear up MAS’ business strategy going forward, in our view. Firstly, the budget market will be extremely challenging and saturated, and therefore there is no reason for MAS to convert Firefly into an LCC. Secondly, MAS only needs to focus exclusively on premium passengers and can consider cutting capacity on non-core flights. Thirdly, we think it is inevitable that a price war between AirAsia and Malindo Airways will ensue, especially on the trunk routes; MAS can proactively reduce its exposure on these “hot routes” and let the other two airlines slug it out.

The enemy of my enemy is my friend, for now. Tactically speaking, AirAsia is currently too strong for MAS as reflected by AirAsia’s commanding domestic market share of >60%, and superior profit margins. For now, MAS is vulnerable and unable to respond fully to AirAsia’s aggression.

However, the entry of Malindo Airways into the fray could potentially compromise AirAsia’s dominant position. We think profit margins will fall with the advent of greater competition, and this will force AirAsia to be on the defensive versus its normal aggressive stance.

Furthermore, Malindo Airways is in the process of hiring staff to spearhead its operations – we think it needs to hire 900-1,100 staff per year to support its growth ambitions. MAS is overstaffed and efforts to downsize by offering employees two years voluntary unpaid leave were not successful. Malindo Airways’ recruitment program might solve this problem to some degree. We also think that MAS’ employee unions will be more willing to comply with management’s initiatives from now on because they realise that MAS is not the only GLC airline in Malaysia anymore. Malindo Airways is technically a GLC as well with the Ministry of Finance owning a 36% stake in NADI, which implies it holds 18% of Malindo Airways.

Source: Maybank Research - 9 Oct 2012