AIR - Air NZ.

[Beagle]

Hope you not calling 3 bucks again.

Goes ex the 10 cent divvy next week, (not sure if its Wednesday or Thursday under the new T +2 settlement system) so I expect it will temporarily drop by a commensurate amount.

Folks will be aware that official company dividend reinvestment scheme remains suspended but I suspect many loyal shareholders will be planning their own scheme

[777]

Osaka it is....

http://www.nzherald.co.nz/business/n...ectid=11599190


Well a restart anyway.

[Beagle]

Good that they're wringing some more mileage out of those old 767 workhorses. While fuel is cheap it makes sense to keep them flying IMO.

[Balance]

Update from one broker - valuation of $3.20.

Forecasts show peak earnings this year and declining next two years after that.

Dividend however to grow year on year - 22.5cps in 2018. So gross yield of 10.9%.

Report accepts however that situation is very fluid out there and many factors, both positive and negative, will come into play in the next 3 years.

Who really knows is kinda the essence of the summary!

[Beagle]

Update from one broker - valuation of $3.20.

Forecasts show peak earnings this year and declining next two years after that.

Report accepts however that situation is very fluid out there and many factors, both positive and negative, will come into play in the next 3 years.

Who really knows is kinda the essence of the summary!

In other words they have no more visibility than AIR's management are providing them with which is basically what I have been asserting and really undermines their DCF valuation models. Obviously they are adjusting their forecast for more competition in Fy17 as is everyone else. In my opinion one is better to simply compare current year PE of AIR, (I use 64 cps after tax incl of VAH earnings) and base my forward earnings on the theoretical ex divvy price (2.86-.10) = 2.76) FY16 PE is thus 2.76/.64 = 4.3 by my calculations. Compare with other airlines and adjust for how they're growing and factors specific to each airline. $3.20 looks very conservative to me and the stock is currently seriously under-priced in my opinion and trading cum the 10 cps fully imputed dividend due very shortly.
I think a fully imputed special dividend this year of 10 cps in addition to a final of a similar amount is an absolute certainty in September so dividend hounds will be well fed.

[Hoop]

AIR has announced huge profits and forecast to keep doing so for 2016, so why has Mr Market been so pessimistic?...Why is Mr Market ignoring the Fundamental reality?

Answer: Because it is a cyclical Stock and Mr Market sees signs pointing to the cycle reaching it's top level..

In the meantime before a cyclical reaches it's cyclic top it can go through bull market corrections...many cyclical sector indexes around the world are well off their highs at the moment due to the current global economy turning to show current weakness..AIR is not immune...Cyclical sectors are economically sensitive and therefore make good leading indicators to the varying state of the Global economy...

So how do we know whether the cyclical sector is going through another bull market correction or has in fact topped out of its cycle.... How can one invest in cyclical stocks without getting their buy/sell trigger fingers burnt off?
Cyclicals are known as notorious portfolio killers...they are volatile beasts and can make fast and huge (+300%) capital gains and equally they can do the opposite just as quick as well...

Cyclicals are hard to analyse because we investors do not know when the cycles tops or bottoms actually occur..
Long term TA and charting helps (sort of) as it outlines the frequency of the cycle oscillation but as Cyclicals are volatile, a sudden daily drop can be unforeseen..
Usually the usual FA methods don't help either, unfortunately the reason why Cyclicals are notorious portfolio killers are because the price quickly drops while the fundamentals are still great and the Fundee holds on dismissing Mr Markets actions as totally irrational..

There are some good Authors around which touch on the subject of valuing cyclical stocks...One is the University textbook Valuation Measuring and Managing the value of Companies published by McKinsey & Company. Their authors are their consultants in their respected fields...I have the older 5th Edition the 6th Edition is out...On page 755 Chapter 35 Valuing Cyclical Companies They research the data and behaviour of Management (CEO's) of Cyclical stocks...

One amazing find is the management is one major factor causing a company to be cyclical in nature...Quote: "......
Still, based on conversations with these executives, we believe that
the herding behavior is caused by three factors: First, it is easier to invest when
prices are high, because that is when cash is available. Second, it is easier to
get approval from boards of directors to invest when profits are high. Finally,
executives are concerned about their rivals growing faster than themselves
(investments are a way to maintain market share).
This behavior also sends confusing signals to the stock market. Expanding
when prices are high tells the financial market that the future looks great (often
just before the cycle turns down).
.....How could managers exploit their superior knowledge of the cycle? The
most obvious action would be to time capital spending better. Companies could
also pursue financial strategies, such as issuing shares at the peak of the cycle or
repurchasing shares at the cycle’s trough. The most aggressive managers could
take this one step further by adopting a trading approach, making acquisitions
at the bottom of the cycle and selling assets at the top. Exhibit 35.7 shows the
results of a simulation of optimal cycle timing. The typical company’s returns
on investment could increase substantially.
Can companies really behave this way and invest against the cycle? It is
actually very difficult for a company to take the contrarian view. The CEO must
convince the board and the company’s bankers to expand when the industry
outlook is gloomy and competitors are retrenching. In addition, the CEO has
to hold back while competitors build at the top of the cycle. Breaking out of
the cycle may be possible, but it is the rare CEO who can do it.

So Mr Market doesn't see AIR management doing the contrarian view (brown bold)..it seeing the continuing behavioural over and over again and history shows this behaviour causes that cyclical trend.

All valuating methods of Cyclicals have their flaws ...so the Simple way to value cyclicals in mho is just as good or bad as the more complicated rest....The easy concept is to draw one cycle oscillation and draw a the mean horizontal line through the oscilation...Often Investment commentators say use 10 years of data that is using the simplier of simple version rather than trying to estimate the length of the current cycle (Oscillation) which in reality often varies ..
They also say using ROIC can be better ..

Valuation: (see below)..To KISS I will use a rough back of the envelop valuation example using Full Year Basic EPS results over a 10 year period which as you can see contains two cyclical top periods and one and a bit (2006) cyclical low periods..therefore this 10year valuation will have some bias to the high side..

2006....9.6
2007...21.6
2008...20.7
2009....2.0
2010....7.6
2011....7.6
2012....6.5
2013...16.6
2014...23.8
2015...29.9
Average ......14.6 EPS

I not sure what the NZX50 PE Ratio is at the moment The CAPE is around 17.. So for analysis I will take the optimistic view because it's closer to Market sentiment as most market investors would view AIR results as excellent and using forward earnings would see even more rosier results (NOTE:...Fundees should never do Forward EPS with Cyclicals..but they always do) therefore Market investors would view AIR as positive atm....Being more optimistic than pessimistic with the NZX market I will use PE Ratio at 20..using 20 could be wrong but it is also simpler for me to use mathematically for this example

So.....14.6 EPS X PE 20 = $2.92

Hmmm..very close to Mr Market optimistic value

Now if the Global economy continues to weaken Mr Market may value AIR back to sentiment neutral NZX50 PE Average at say 17 = $2.48

If a global recession evolves and the NZX50 enters into a bear market cycle at the depths of that bear market the PE Ratio will be <10 at say 8 with the current EPS average the valuation will be = $1.16 ........The sader news is that as AIR is cyclical the EPS is sensitive to recessions and therefore the 10 year Avage EPS will be lower so it could be less than the $1.16...

Ever wondered why Cyclicals can trail a sharemarket recovery back from Bear to Bull Market...All to do with Mathematics..

Cyclicals are scary..eh?

[sharp]

AIR has announced huge profits and forecast to keep doing so for 2016, so why has Mr Market been so pessimistic?...Why is Mr Market ignoring the Fundamental reality?

Answer: Because it is a cyclical Stock and Mr Market sees signs pointing to the cycle reaching it's top level..

In the meantime before a cyclical reaches it's cyclic top it can go through bull market corrections...many cyclical sector indexes around the world are well off their highs at the moment due to the current global economy turning to show current weakness..AIR is not immune...Cyclical sectors are economically sensitive and therefore make good leading indicators to the varying state of the Global economy...

So how do we know whether the cyclical sector is going through another bull market correction or has in fact topped out of its cycle.... How can one invest in cyclical stocks without getting their buy/sell trigger fingers burnt off?
Cyclicals are known as notorious portfolio killers...they are volatile beasts and can make fast and huge (+300%) capital gains and equally they can do the opposite just as quick as well...

Cyclicals are hard to analyse because we investors do not know when the cycles tops or bottoms actually occur..
Long term TA and charting helps (sort of) as it outlines the frequency of the cycle oscillation but as Cyclicals are volatile, a sudden daily drop can be unforeseen..
Usually the usual FA methods don't help either, unfortunately the reason why Cyclicals are notorious portfolio killers are because the price quickly drops while the fundamentals are still great and the Fundee holds on dismissing Mr Markets actions as totally irrational..

There are some good Authors around which touch on the subject of valuing cyclical stocks...One is the University textbook Valuation Measuring and Managing the value of Companies published by McKinsey & Company. Their authors are their consultants in their respected fields...I have the older 5th Edition the 6th Edition is out...On page 755 Chapter 35 Valuing Cyclical Companies They research the data and behaviour of Management (CEO's) of Cyclical stocks...

One amazing find is the management is one major factor causing a company to be cyclical in nature...Quote: "......
Still, based on conversations with these executives, we believe that
the herding behavior is caused by three factors: First, it is easier to invest when
prices are high, because that is when cash is available. Second, it is easier to
get approval from boards of directors to invest when profits are high. Finally,
executives are concerned about their rivals growing faster than themselves
(investments are a way to maintain market share).
This behavior also sends confusing signals to the stock market. Expanding
when prices are high tells the financial market that the future looks great (often
just before the cycle turns down).
.....How could managers exploit their superior knowledge of the cycle? The
most obvious action would be to time capital spending better. Companies could
also pursue financial strategies, such as issuing shares at the peak of the cycle or
repurchasing shares at the cycle’s trough. The most aggressive managers could
take this one step further by adopting a trading approach, making acquisitions
at the bottom of the cycle and selling assets at the top. Exhibit 35.7 shows the
results of a simulation of optimal cycle timing. The typical company’s returns
on investment could increase substantially.
Can companies really behave this way and invest against the cycle? It is
actually very difficult for a company to take the contrarian view. The CEO must
convince the board and the company’s bankers to expand when the industry
outlook is gloomy and competitors are retrenching. In addition, the CEO has
to hold back while competitors build at the top of the cycle. Breaking out of
the cycle may be possible, but it is the rare CEO who can do it.

So Mr Market doesn't see AIR management doing the contrarian view (brown bold)..it seeing the continuing behavioural over and over again and history shows this behaviour causes that cyclical trend.

All valuating of Cyclicals has flaws so the Simple way to value cyclicals in mho is just as good or bad as the rest....is to draw a cycle and take the mean...Often Investment commentators say use 10 years of data that is the simplier of simple as to try and fiqure out the length of a cycle (Oscillation) can vary..
They also say ROIC can be better ..but to KISS as an back of the envelop rough Valuation example I will use Full year Basic EPS over a 10 year period which as you can see with the EPS figures contains two cyclical top periods and one and a bit (2006) cyclical low periods..so using the 10year valuation maybe be a little bias to the high side..

2006....9.6
2007...21.6
2008...20.7
2009....2.0
2010....7.6
2011....7.6
2012....6.5
2013...16.6
2014...23.8
2015...29.9
Average ......14.6 EPS

I not sure what the NZX50 PE Ratio is at the moment The CAPE is around 17.. So for analsis I will take the optimistic view because it's closer to Market reality as most market investors see excellent results and forward earnings as even more rosier(Fundees should never do Forward EPS with Cyclicals) therefore Market investors would view AIR as positive atm....Being more optimistic than pessimistic with the NZX market I will use PE Ratio at 20..using 20 could be wrong but it is also simpler for me to use mathematically for this example

So.....14.6 EPS X PE 20 = $2.92

Hmmm..very close to Mr Market optimistic value

Now if the Global economy continues to weaken Mr Market may value AIR back to sentiment neutral NZX50 PE Average at say 17 = $2.48

If a global recession evolves and the NZX50 enters into a bear market cycle at the depths of that bear market the PE Ratio will be <10 at say 8 with the current EPS average the valuation will be = $1.16 ........The sader news is that as AIR is cyclical the EPS is sensitive to recessions and therefore the 10 year Avage EPS will be lower so it could be less than the $1.16...

Cyclicals are scary..eh?

Meh.

As long as AIR NZ pays good dividends and makes solid profits and does not overextend itself - I could not care less about the bumpy ride.

[Beagle]

If we are to assume intrinsic growth in AIR and accrued earnings aren't in fact happening, (not a hypothesis I concur with), but I will humour you Hoop and tweak your earnings data to include the full earnings cycle, (trough to peak) which regardless of any text book theories you may have read seems to make more common sense to any other approach, surely... then I would make the following observations :-

The period you've covered includes the GFC, arguably the greatest recession since the great depression of 1929. But be that as it may, lets leave your data period to include the full GFC and only tweak it slightly.

If we're going to take an average EPS that includes the full cycle then I would have thought you'd at least include the current year's earnings since we're most of the way through FY16 and management are confident of profits in excess of $800m, consensus analyst estimate 57 cps. So clipping off FY2006 which I note was pre GFC and including FY16 consensus EPS analyst estimate we get average EPS across the cycle of 19.3 cps and on an current market PE of 17 this gives us fair value of $3.28.

But seeing as the market is always looking forward if we include consensus FY17 earnings as well (54 cps) and exclude earnings to 30 June 2007, (still pre GFC so the ten year average still includes the full GFC period and includes what is arguably the top of the cycle FY16 and FY17) then we get average EPS right across the business cycle including all of the GFC and all of the current projected earnings for the peak years of FY16 and FY17 of 22.6 cps. Applying an average market PE of 17 gives fair value of $3.84

My contention is if you're going to take a ten year average as being representative of the full market cycle, (and try and make the weak case that there's no underlying growth in AIR's earnings over time) then the very least one must do is to include the peak years of the business cycle, (irrespective of any theoretical approach that suggests only historical earnings data is valid). Clearly to not do so is to
mask the real value by skewed data and an unreasonable and unrepresentative choice of underlying data that doesn't truly represent the average of the full business cycle earnings.

My contention is that AIR is growing organically over time and a 10 year average PE is therefore an inappropriate measure to value AIR but for those that insist on this approach the value would appear to lie somewhere between $3.28 and $3.84. I think that the selection of the full peak cycle earnings to include FY17 earnings is a significantly more reasonable and representative approach to average earnings so fair value using this approach is $3.84. This assumes there is no underlying earnings growth in AIR shares and no benefit to AIR shareholders of accrued and undistributed earnings over the last decade which doesn't make common sense to me so the real value is north of $3.84.

To illustrate how invalid your historical earnings approach is I would warmly invite you to run the same analysis on QAN's last ten years historical earnings, (including their recent year loss of $2,800m) and report back on their valuation using your approach compared to the current SP. Go on, you know you want too...

Worth noting too that although management are articulating a plan of record growth along with fleet modernisation and simplification they're doing this contemporaneously with the payment of good level's of dividends which is in stark contrast to most of the other airlines in the world. Further, the attachment of full dividend imputation credits is unique to AIR making dividend payments ostensibly tax free in shareholders hands.

[Hoop]

If we are to assume intrinsic growth in AIR and accrued earnings aren't in fact happening, (not a hypothesis I concur with), but I will humour you Hoop and tweak your earnings data to include the full earnings cycle, (trough to peak) which regardless of any text book theories you may have read seems to make more common sense to any other approach, surely... then I would make the following observations :-

The period you've covered includes the GFC, arguably the greatest recession since the great depression of 1929..I can add the lesser recession 2001-2003 figures if you like

If we're going to take an average EPS that includes the full cycle then I would have thought you'd at least include the current year's earnings since we're most of the way through FY16 and management are confident of profits in excess of $800m, consensus analyst estimate 57 cps. So clipping off FY2006 which I note was pre GFC and including FY16 consensus EPS analyst estimate we get average EPS across the cycle of 19.3 cps and on an current market PE of 17 this gives us fair value of $3.28. No No No..Pay attention Roger...You do not forward analyse cyclicals..How many times do I have to write that....When it happens then you can do that not before, always assume Mr Market has already factored in this publicly media announced news hence Air is above NZX50 market (e.g PE Ratio 20)...If you think Mr Market has not then.. you use the same EPS figures but alter the Market sentiment e.g PE Ratio up from 20 to 23 but Its you word against Mr Market ...but Yes agree in principle so when it happens (FY result announcement) with the proviso that Market sentiment hasn't changed by then when looking forward into the near future ..further out after the next 2016 FY result out thus keeping up the same market sentiment (example: PE ratio at 20)

But seeing as the market is always looking forward if we include consensus FY17 earnings as well (54 cps) and exclude earnings to 30 June 2007, (still pre GFC so the ten year average still includes the full GFC period and includes what is arguably the top of the cycle FY16 and FY17) then we get average EPS right across the business cycle including all of the GFC and all of the current projected earnings for the peak years of FY16 and FY17 of 22.6 cps. Applying an average market PE of 17 gives fair value of $3.84 ..Yes agree that can happen if the Global economy keeps growing especially the consumer disposable part of the economy...however looking at the other side of the coin if NZX50 is in the middle of a bear market cycle then Market sentiment may be negative say PE Ratio 13....22.6 x 13 = $2.93...but I doubt that price as AIR's EPS is sensitve to economic factors if the Market is in the middle of a bear then one could assume the economy has already topped out and consumers decrease their disposable spending habits..

My contention is if you're going to take a ten year average as being representative of the full market cycle, (and try and make the weak case that there's no underlying growth in AIR's earnings over time) then the very least one must do is to include the peak years of the business cycle, (irrespective of any theoretical approach that suggests only historical earnings data is valid). Clearly to not do so is to
mask the real value by skewed data and an unreasonable and unrepresentative choice of underlying data that doesn't truly represent the average of the full business cycle earnings.
pay attention!!!..already added one top cycle 2007-2008 and another in progress now.. if anything I haven't compensated enough with a nearly full bottom cycle before 2006 giving a complete 2 oscillating cycles...remember Roger I'm using a quick rough example to illustrate the Valuation Method but I think nearly 2 cycle average is better represented than 1

My contention is that AIR is growing organically over time and a 10 year average PE is therefore an inappropriate measure to value AIR but for those that insist on this approach the value would appear to lie somewhere between $3.28 and $3.84.
Maybe AIR has Secular growth as most cyclicals aren't pure..some have long term down-sloping cycles negative Secular growth some cycles has the opposite....and to add complexity some have varying amount of both over the decades...

AIR's secular nature is uncertain because investors when there has been a long growth period all think that a cyclical is not cyclical anymore (and start using Forward earnings and other FA techniques again) or some more experienced investors wary of cyclicals may think after an abnormal growth period assume that a cyclic has developed some form of secular growth (secular up trending cycle)..Hence the long term share price high volatility (a cyclical's signature)

Personally...I can't form an accurate opinion as secular analysis needs long term NZ company data history spanning back many decades which is hard to come by and before the NZ market was regulated it was a land where cowboy's came to town shooting up the sheriff...there was a lot of creative accounting going on back then....However AIR went bust so history sees it as a cyclical with negative secular growth...Is it different this time??..maybe but with all the competition entering into NZ airspace I wouldn't be all surprised if AIR overall is now starting to losing market share again (negative secular growth)....

Roger ..cyclical stocks are very hard to analyse..just when you think you have a handle on it something comes out of the blue and knocks down the cycle prematurely, your investing hard work, and wounds your portfolio...e.g GFC or 9/11..That's why many investors stay well clear of them...

.................................

[mikeybycrikey]

Regardless of the specifics of the future profits for Air NZ and how to calculate the appropriate average profit and PE over the entire cycle, it is pretty clear that with the reduced price of oil, competition and therefore risk have increased.

I will accept that the profit for FY 16 is likely to be around 57 cps as suggested by Roger, helped along by the 30cps HY16 result.

However I wouldn't be so sure about the FY17 result. 54cps is possible but not a certainty by any means.

It was really brought home to me how much competition AIR faces with the sight of four Emirates A380s sitting at Auckland Airport the other day. Good publicity shot for the TV news but also a great way of portraying the extent of the competition. Thee are a lot of seats on those planes.

If I were travelling to Europe, the non-stop flight Auckland-Dubai would look pretty appealing.

AIR may be well run and tourism may be growing, but AIR need to be performing exceptionally well to capitalise on that growth and keep their existing market share. Emirates and Chinese airlines are going to be working hard to fill seats into AKL, along with American(?) starting to fly here later in the year. Running empty planes is expensive!

I would also caution against expecting the good times to continue for too long. The profit margin of 57 cps is roughly 14%. This is exceptionally high for an airline and I would expect over the full cycle it would be about half of that, maybe less.

Airlines are risky. Airlines in a low oil climate are even riskier. Caution ahead. I'm hoping for the good returns to continue but I'm certainly wary.