Description

Probably the key risk we see to that line of business is that the politicians/public have been shown to be a bit unhappy about the route closures –

think the popular view seems to be that the state has bailed them out and they have responded to that by laying off loads of people and reducing

the quality of the service. Company have said that domestic routes only get reopened if they are profitable and that is that – we’ll see how it pans

out.

The LCC are also obviously a threat to the business, but the company think that a lack of availability to departure and landing slot availability

will impair the ability to really compete hard in the short-term.

The international business is operated out of Narita (largest international airport) and Haneda (second-largest) – they have the highest number

of departure and landing slots at both. Biggest routes by far are transpacific (to the US and Canada – about 35% of ASK at 76.8% load factor)

and SE Asia (about 30% of ASK at 63.7% load factor). It is a much more “efficient” business in terms of load factors (70.4% in 2012 rising to 76.2% i

n 2013) but on the work we have done, we think less lucrative:

The strategy is to add more of the Boeing 787s to this part of the business over time (20% more fuel efficient with fuel being 19.3% of sales in

2012 for the group) which should help. Key risk we really see to this business line is that it is fiercely competitive and new slots are being opened

at the two main airports in the next 2-3 years that will add double digit percentage capacity. Company have said that they expect to get their fair

share of the slots but we wonder what it does to pricing. We see it modestly up (again the increased premium offering offsetting some price

competition) but it is a risk.

In terms of the cost structure – they are at 11.5 unit cost now and they are targeting 11 by 2017. In terms of how exactly they get there – capacity

should be growing at something like 3.5% CAGR out to 2017 (that is all international as the 787s they have on order are deployed) – costs probably

do not need to grow that much annualized – wages we have up 6.1% this year and another 5% in 2014 (staff had a rough time and company guiding

for bigger bonuses) before stabilizing at +2.5%. Fuel we think will be up something like 12% in 14 after a rise of nearly 8% this year (we have the

workings behind this if anybody has a burning desire to pick out holes in the idea), then everything else (maintenance, rent, incidentals and so on) we

think can grow much less.

It’s a little bit of a case of it being a leap of faith going from the excel model to actually seeing it in the P&L, so the jury is out, but all we can really do

is observe they have been quite disciplined so far.

The target when they listed again was to deliver operating profit of 150bn on revenues of 1,220bn – that target has since been upgraded a couple of

times – to 165bn at the Q213 stage, then 186bn ant the Q3 stage, Things seem to be working out pretty well so far – we have them on track to do

about 185bn of EBIT, which should translate to nearly 170bn of net income (tax loss carry forwards mean they will pay little tax for the next 5-7 years):

The better cost structure and better capital discipline should mean that the profitability is translating into quite a bit of cash flow as well:

We actually have EBIT declining, which is obviously a worry (and probably explains the valuation a bit) but we see 100bn+ as a mid-term

FCF that is certainly achievable. That is against a market capitalization of just shy of 800bn. Not bad.

Value

In terms of what it could be worth – on peer multiples it’s one of the most profitable, high return-generating listed airlines and also one of the cheapest:

Asian peers trade at a P/E of double what these guys do for generally lower returns and margins, which gives a sense of the type of upside that is

potentially realizable.

With the usual health warnings applied to even trying to do a DCF on a company in such an unstable industry – we have done it anyway – resulting

upside is over 50%:

In terms of what closes the gap – they have upgraded their guidance a couple of times since the relisting which should hopefully help to build a bit of

confidence in the management team.

Would also highlight that they have targeted an equity ratio of 50% in the medium term – they are accumulating equity fairly prodigiously – it was

44.8% as at the Q313 stage against 35.7% at 2012 y/e – at this rate they are going to hit their target within the next 12-18 months – we wonder

whether special dividends could be on the cards. They upgraded the payout ratio from 15% at the relisting to 20% (DPS will be 180 against share

price 4400) as they said feedback from investors was that they wanted more returns. We wonder if perhaps the company have found religion on

capital allocation and that could be a catalyst.

For us, on our adjusted measures, the ROIC in 2012 was about 21%; it should be in the very high teens again this year; the market valuation is

implying single digits into perpetuity. It is a horrible industry so maybe that is right and they start to try to add loads of capacity again and price

competition really hurts them badly – gut given what they are doing now and what the market is implying – we think it is a risk that we are being

quite well-compensated to assume.   

Catalyst