Japan Airlines 9201 JP
February 28, 2013 - 2:31pm EST by
darthtrader
2013 2014
Price: 4,400.00 EPS $930.00 $876.00
Shares Out. (in M): 181 P/E 4.7x 5.0x
Market Cap (in $M): 8,600 P/FCF 5.3x 6.6x
Net Debt (in $M): 960 EBIT 1,050 960
TEV ($): 9,560 TEV/EBIT 4.0x 3.9x

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  • Airline
  • Japan
  • Bankruptcy

Description

We will try to keep this short and sweet – the idea we are proposing is long Japan Airlines.

 

Quick History

They are one of the big two carriers in Japan (along with All Nippon Airlines) – they went through a fairly spectacular bankruptcy in recent years, and

re-emerged onto the market in Q312 (Bloomberg ticker 9201 JP). The reasons for the bankruptcy are manifold, but the quick explanation would be too

much capacity, too much capex, not enough profit, and too much debt –disaster eventually unfolded. From 1998-2009, the operating margin average

was about 1% and it never went above 4%- at the net level they lost about 192bn yen over this time period. We think the key reason for such a

poor level of profitability was overcapacity – a report claims that over the 90’s, domestic capacity rose, on average, about 6% per annum – to keep

the load factor high, prices were reduced by around 3% per year. The high level of capacity of course implies a lot of investment, and indeed that

was the case with Japan Airlines – a tremendous amount of investment was made in unprofitable capacity additions, hence the free cash flow

performance was even worse than the profitability:

 

  1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
EBIT 40,182 32,856 44,887 78,639 -11,925 10,589 -67,645 56,149 -26,834 22,917 90,014 -50,885
Interest -103,769 3,434 -17,965 -46,979 -21,467 -6,508 -14,503 -11,483 -19,606 29,138 -60,181 -8,129
Tax Paid -5,509 -5,301 -5,894 -9,787 -10,520 -6,991 -9,060 -9,535 -9,762 -7,085 -6,654 -5,961
D&A 94,416 97,130 90,410 91,834 89,748 118,187 119,388 124,713 125,126 117,561 116,580 118,043
Working Capital 12,098 -9,414 -4,638 -30,464 -13,442 36,727 -2,220 -8,664 -15,673 1,968 13,899 4,230
Other 55,039 -36,978 -19,474 45,855 -7,805 3,409 50,385 -5,905 47,733 -36,751 3,673 -25,543
Cash From Operations 92,457 81,727 87,326 129,098 24,589 155,413 76,345 145,275 100,984 127,748 157,331 31,755
Capex -142,292 -129,739 -81,151 -80,271 -102,839 -195,575 -151,585 -121,960 -146,972 -153,251 -174,831 -167,856
Free Cash Flow (JPYm) -49,835 -48,012 6,175 48,827 -78,250 -40,162 -75,240 23,315 -45,988 -25,503 -17,500 -136,101
Capex/Depreciation 1.51 1.34 0.90 0.87 1.15 1.65 1.27 0.98 1.17 1.30 1.50 1.42

 

So negative cumulative free cash flow of 440bn yen from 1998 to 2009 (and this is not even accounting for most of the 90’s, when the capital

discipline was even worse). The yields did start to pick up a little towards the middle of the 00’s, but by then it was too late – much of the damage

had been done and the lack of capital discipline (capex was still well above depreciation as the yields picked up) caused the balance sheet to

collapse under its own weight:

 

  1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
                       
ST Debt 79,593 46,479 30,443 56,627 23,035 10,782 11,611 6,562 4,810 3,084 2,911
Current Portion LT Debt 136,530 181,667 142,293 150,796 198,188 144,718 127,974 145,323 182,530 158,335 180,426
LT Debt 1,066,660 980,818 839,821 886,178 1,094,285 1,170,156 1,178,932 1,084,521 838,827 753,645 618,192
Capital Leases 0 0 0 0 0 0 0 0 0 0 0
Pensions 0 0 102,677 104,405 143,670 163,128 149,665 139,753 129,061 95,485 94,911
Gross Debt 1,282,783 1,208,964 1,115,234 1,198,006 1,459,178 1,488,784 1,468,182 1,376,159 1,155,228 1,010,549 896,440
Cash & Equivalents 244,022 237,651 121,489 133,880 147,766 144,431 253,239 179,884 212,167 363,772 173,087
Net Debt 1,038,761 971,313 993,745 1,064,126 1,311,412 1,344,353 1,214,943 1,196,275 943,061 646,777 723,353
EBITDA 129,986 135,297 170,473 77,823 128,776 51,743 180,862 98,292 140,478 206,594 67,158
Net Debt/EBITDA 8.0 7.2 5.8 13.7 10.2 26.0 6.7 12.2 6.7 3.1 10.8
EBIT 32,856 44,887 78,639 -11,925 10,589 -67,645 56,149 -26,834 22,917 90,014 -50,885
Net Debt/EBIT 31.6 21.6 12.6 -89.2 123.8 neg 21.6 -44.6 41.2 7.2 neg
Equity 233,725 261,491 267,654 228,657 254,256 159,273 193,746 245,103 331,883 471,068 196,767
Debt/Equity 5.5 4.6 4.2 5.2 5.7 9.3 7.6 5.6 3.5 2.1 4.6
Total Assets 1,955,622 1,911,177 1,801,855 1,836,371 2,172,284 2,113,418 2,161,654 2,143,280 2,091,233 2,122,780 1,750,674
Equity/Assets 12.0% 13.7% 14.9% 12.5% 11.7% 7.5% 9.0% 11.4% 15.9% 22.2% 11.2%

The inevitable happened and the company filed for bankruptcy. Over the course of the bankruptcy, a few important changes occurred to the business:

 

  • Streamlined their fleet and their network
  • Non-core assets sold
  • Reduced wages, salaries and headcount
  • Debt and pension obligations were restructured
  • Organizational structure was reformed
  • New mid-term strategies were announced

 

Fleet & Network

Total number of aircraft (excluding cargo) reduced from 225 in March 2009 to 169 as of March 2012, while the number of models in the fleet fell from

seven to five; average age fell from 11.7 years to 9 years, so it is a more efficient fleet with lower maintenance and fuel costs.

 

The number of domestic routes they service directly was reduced from 153 to 112, while the number of international routes fell from 67 to 47, with the

focus being on high-yielding routes where they have strong market shares.

 

Wages, Salaries, Headcount

Headcount was reduced from 48,000 to 30,875, salary cuts of 20% – result has been that the wage cost as a percentage of revenue has fallen from

a high of 26.4% in 2004 (and 19.1% in 2007 for a somewhat more recent example) to 17.7% in 2012.

 

Debt, Pension Obligations

The titanic debt load was reorganized, with a partial debt waiver (unsecured debt took an 87.5% haircut) resulting in a 583.7bn gain, but the key point

being that net debt (our definition) fell from 723.3bn by y/e 2009 to 88.9bn as they exited 2012.

 

Organizational Structure

Official line is that they’re now focused on “divisional profitability”, with each of about six mini-divisions responsible for their P&L and the results tracked

on a monthly basis against targets for that month and future months. There have also been cost cutting measures mentioned (looking at airport and

facility costs, better response to systematic event risks, more asset sales). Obviously talk is cheap, but we’d not that over the course of 2012 they were

able to report operating margins of 6.7%, 25.8%, 17.9% and 14.6%, respectively.

 

Mid-Term Strategies

Together with the measures above, some financial targets were announced to keep the company on the straight and narrow and ensure focus is

maintained – these include:

  • 10% margin target in the medium-term
  • 50% equity ratio targeted
  • 15% dividend payout ratio announced (since raised to 20%)
  • JPY 11 unit cost target (currently about 11.5  vs. 13.8 pre-bankruptcy and 12.5 for peer ANA)

 

Japan Airlines Now

Company now derives about 40% of revenues from domestic passengers, 32% from international and 28% from incidentals.

 

The domestic market is dominated by Japan Airlines and ANA (85% combined market share with JA controlling 37%) – the two key airports are Haneda

(67% of domestic traffic) and Itami – they hold 41% of the domestic departure and landing slots at Handa, 49% at Itami. Not sure how much of a moat

that is for the business really as the load factors are pretty low (63%) and there is increasing talk of LCC attacking them – they actually own part of a

LCC JV called JetStar to help to address the threat.

 

From the work we have done, we believe the domestic market continues to be pretty lucrative for them, and we see some increasing price competition

from the LCCs (should be partially offset by a better premium offering) and limited volume growth (company have said they do not see themselves

adding much capacity). We think that the “yield” (measured by revenues divided by ASK) continues to be pretty high (certainly above the 11.5 unit cost)

and forecast some compression:

 

    2011 2012 2013 2014 2015 2016 2017
Domestic              
  Passenger Revenues 530,857 481,111 486,879 489,636 473,678 446,462 420,784
  Revenue Passengers Carried 33,342,308 28,965,514          
  RPK (1000) 25,399,869 22,264,394 23,129,302 23,495,776 23,312,539 23,129,302 22,946,065
  ASK (1000) 41,072,805 35,523,214 36,647,367 36,647,367 36,647,367 36,647,367 36,647,367
  Load Factor 61.8% 62.7% 63.1% 64.1% 63.6% 63.1% 62.6%
  Revenue Per Customer              
  Average Distance Travelled              
  Revenue Per Kilometre Traveled 20.9 21.6 21.1 20.8 20.3 19.3 18.3
  Revenue Per Kilometre Available 12.9 13.5 13.3 13.4 12.9 12.2 11.5
                 
  Domestic              
  Change in Pricing   3.4% -2.6% -1.0% -2.5% -5.0% -5.0%
  Capacity Added   -13.5% 3.2% 0.0% 0.0% 0.0% 0.0%
  Change in Load Factor   0.8% 0.4% 1.0% -0.5% -0.5% -0.5%

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:

 

    2011 2012 2013 2014 2015 2016 2017
International              
  Passenger Revenues 418,406 385,289 404,306 417,190 435,461 472,164 502,370
  Revenue Passengers Carried 8,284,144 6,844,772          
  RPK (1000) 38,036,925 30,313,789 34,078,929 36,252,749 37,098,347 39,436,308 41,136,253
  ASK (1000) 51,702,984 43,036,984 44,749,804 46,987,295 48,396,913 51,784,697 54,373,932
  Load Factor 73.6% 70.4% 76.2% 77.2% 76.7% 76.2% 75.7%
  Revenue Per Customer              
  Average Distance Travelled              
  Revenue Per Kilometre Traveled 11.0 12.7 11.9 11.5 11.7 12.0 12.2
  Revenue Per Kilometre Available 8.1 9.0 9.0 8.9 9.0 9.1 9.2
                 
  International              
  Change in Pricing   15.5% -6.7% -3.0% 2.0% 2.0% 2.0%
  Capacity Added   -16.8% 4.0% 5.0% 3.0% 7.0% 5.0%
  Change in Load Factor   -3.1% 5.7% 1.0% -0.5% -0.5% -0.5%

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.   

I do not hold a position of employment, directorship, or consultancy with the issuer.
Neither I nor others I advise hold a material investment in the issuer's securities.

Catalyst

Investor community gains confidence in the management team
 
Target equity ratio reached and dividend potentially upped
 
Valuation discount to peers continues to narrow
 
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