On Tuesday, Macquarie Equities Research (MER) released a report on AirAsia, analysing the low-cost airline’s fundamentals and responding to investors’ queries whether the company is on the verge of bankruptcy. In the research report titled “Understanding Ms Complicated”, MER stated that they maintain an “Outperform” rating with a lower target price of RM2.59. Read on excerpt from the report below to find out more…

According to press, AirAsia was the target of short-sellers amid accounting worries, with claims that the airline uses related-party transactions with loss-making associates to boost its earnings and requires US$1.9bn in funding. Yield-to-date (YTD), AirAsia’s share price is down 55% vs FBMKLCI’s -4.5% YTD. In this report, MER re-examines AirAsia’s fundamentals, key drivers, balance sheet position and cash flow strength, and answers the key question that investors may have: “Is AirAsia going bankrupt?” MER maintains an Outperform rating with a lower target price of RM2.59 from RM3.04 as MER inputs the in-house fuel and forex forecasts, while lowering the yield assumption to reflect weaker consumer sentiment in Malaysia. Indonesia AirAsia now contributes negatively to MER’s standard of operations (SOP).
 
Accounting treatment is a sector-wide issue
Across Asia, airlines would need to align themselves with local partners in order to operate under each country’s bilateral flying rights, as majority foreign ownership is not yet allowed. Thus, AirAsia cannot have legal control or legal power over its associates, resulting in equity accounting being applied. Similarly, operating lease income (fixed rate US$ over 5-7 year contracts) received from associates is recognised as revenue, instead of being consolidated. Accumulated unrecognised losses of its associates was a concern raised but according to accounting standards, AirAsia only needs to equity account losses up to its investment amount. Unlike its competitor Singapore Airlines, which has more cash surplus, AirAsia puts minimal investment into its JVs as AirAsia believes its low unit cost and shorter flight range requires less operational cash.
 
Is AirAsia going bankrupt? Or in need of funding?
Learning from others to understand the present. Key similarities that led to Japan Airlines’ “pre-packaged bankruptcy” in 2010 and Malaysia Airlines’ bailout in 2014 were high staff unit costs, low staff productivity, and operating the fuel-inefficient B747 (for JAL) and aging fleet (for MAS). This, however, does not apply to AirAsia, with its flat management and no unions, and operating only the narrow-body A320s (average fleet age of 5.2 years) which are considered to have a stable market price due to liquidity in the secondary market.
 
Cash is king. AirAsia has managed to generate operating cash flows (OCF) of more than RM1bn from 2009 to 2013. MER estimates the US$/RM would need to go up to 5.25 before AirAsia’s OCF is insufficient to service its interests, which could be the first sign of distress. Also, up to 2Q15 AirAsia has entered 10 sale-and-leaseback (SLB) transactions, raising gross proceeds of RM900mn (YTD is 13 SLB transactions). Note that there are no stringent financial covenants imposed on AirAsia that could increase the risk of a cash call.
 
Management’s execution in its associates to regain investor confidence remains key driver of share price
MER’s fair value scenario analysis suggests investors are wary regarding the recoverability of receivables owed by Indonesia AirAsia (IAA) and Philippines AirAsia (PAA). The share price is currently trading at 1x 16E P/BV minus the receivables (RM1.24). Recapitalisation of Indonesia AirAsia (IAA) and Philippines AirAsia (PAA) along with management’s forecast of profitability of IAA and PAA in 3Q15 and 4Q15 respectively would be key catalysts in the near-term. A potential future catalyst is the monetisation of assets, including its leasing business, which could see deleveraging of its balance sheet.

Source: Macquarie Research - 25 Sep 2015