Loyalty saves the day for Qantas: Graham Witcomb

Qantas flights and income have been slashed, but luckily the company has another source of vital cash to help it navigate the crisis

We expected little from Qantas going into the current crisis and the company has not disappointed. With borders locked, the airline is operating just 5% of domestic capacity and 1% of international. There’s only a trickle of cash coming in and lots going out.

The next few years don’t look much better. There’s the risk that the travel industry is entering a “new normal” of reduced flights, even after the Covid-19 crisis ends. It’s almost too easy to hate the company.

With the crowd so negative and the stock price less than half its December highs, is this an opportunity?

From the outside, Qantas looks like an airline. Its inner workings reveal something quite different. The company made more money selling loyalty points to banks and businesses in 2019 than it did selling international flights to travellers.

Qantas Loyalty has more than 13 million members – every second Australian. A third of Australian credit cards are program partners and two out of three points are earned from day-to-day spending on groceries and the like. That means consumer spending drives the business more than the travel industry, so the division is an important buffer during crises.

Unfortunately, with credit card purchases falling, it’s reasonable to assume Qantas is selling fewer points right now. How the year plays out depends on the success in controlling the spread of the virus and the measures used to contain it.

The more important point is to understand that Loyalty is Qantas’s best business by far. It has a pretax profit margin more than double any other division and requires little capital to operate. In comparison, the airline divisions need endless cash injections to buy planes and infrastructure.

Better yet, Loyalty throws off cash because revenue from merchants arrives when the points are issued, but Qantas only pays for a new waffle maker or flight when points are redeemed.

This means Loyalty generates a “float” much like insurers, allowing Qantas to invest that cash for its own benefit before members pinch it back through redemptions. The float is probably growing, too, because members currently can’t spend points on flights.

The division earned $1.7 billion in revenue in 2019, which has grown around 5% a year over the past five years. Assuming revenue and margins shrink slightly, operating profits in the 2020 financial year would be around $380 million (at time of print).

One way to value this division is to look at comparable sales – a routine loved by real estate agents and art auctioneers. This gives an indication of relative value.

In 2019, Air Canada bought the Aeroplan loyalty program for $C2.9 billion ($3 billion) when the business had around five million members and generated $C1.2 billion of revenue and $C268 million of operating profits. Qantas Loyalty is a third larger, so could be worth $4 billion or so applying the same multiple.

In 2014, Virgin Australia sold a 35% stake in its Velocity program to private equity group Affinity Partners for $336 million, implying a price of $960 million for the entire business. It then bought back that same 35% stake in 2019 for $700 million (a total valuation of $2 billion). Member numbers doubled during that time, so this isn’t as crazy as it looks. Both the initial sale and the repurchase were made on valuations of around four to five times revenue and 13 to 16 times operating profits.

That would put a comparable value for Qantas’s Loyalty division at around $6 billion if it were sold or spun off, although with lower margins and slower growth $4 billion to $5 billion might be more reasonable. At Qantas’s current market capitalisation of $6.4 billion, the Loyalty division accounts for roughly two-thirds of the stock’s value.

Now for the bad news ...

The bad news is that Qantas has a ton of net debt – $5.8 billion at last count, and that number will get bigger as the year goes on.

Adding Qantas’s net debt to its market cap delivers an enterprise value of around $12.4 billion. If we knock off $4.5 billion of that for the Loyalty division, we’re left with $7.9 billion for the remainder. This is where things start to look interesting.

Previous pandemics have had zero long-term effect on traffic growth; passenger numbers have always returned to normal within a year. This time it will probably take longer, but if the travel industry rebounds and we assume Qantas earns similar margins to 2019, the company’s airline business could again be generating $1.1 billion of earnings before interest and tax (EBIT) in the near future, excluding the Loyalty division.

That suggests an enterprise value just seven times EBIT for the airline itself – low by any measure, but especially compared with international competitors like Air New Zealand (14 times 2019 earnings), Air France (17) and large US and Canadian airlines, mostly around 10.

And who’s to say that Qantas won’t come out of the crisis even stronger? The company was already the biggest breadwinner in Australian aviation, taking more than three-quarters of industry profits domestically, despite accounting for just 59% of passengers.

But with Virgin emerging from administration, Qantas has a chance to add to its lead. Every 10% of Virgin’s domestic market share that Qantas claws away would add around $1 billion in revenue, and likely with better margins than before.

There may be other silver linings too: the jet fuel price is well below levels of previous years, reducing a major operating cost; rising unemployment and the Covid crisis give the company more sway when negotiating with unionised labour and monopolistic airports; and the international division – long an anchor on profits and growth – might benefit from route expansions if foreign competitors collapse.

One final unintended consequence could be loosening regulatory oversight. The US Department of Transportation is proposing new definitions for “unfair practices”, which could make it harder for travellers to get compensation from airlines that violate consumer protection rules.

Australia’s Department of Infrastructure knows a Qantas monopoly wouldn’t be good for consumers, so it may seek to loosen the regulatory burden on the industry while most small carriers and Virgin are in trouble and trying to deal with heightened safety protocols.

Risk of a price war

There’s a lot to like about Qantas and a lot could go right in the coming years. The risks, though, offset the potential rewards.

As Virgin emerges from administration, it could trigger a price war as it tries to hold onto market share, which may depress revenue and narrow margins for Qantas’s domestic division (40% of EBIT).

And while the Loyalty division provides a floor to our valuation, its value isn’t lost on management. The odds of a spin-off are low – the recent trend has been for airlines to bring their loyalty divisions in-house, not sell them.

That will be doubly true while Qantas’s airline operations are losing money. Qantas is unlikely to part with its only cash-generating division until it’s gasping for air, and shareholders may never get their hands on it if creditors nab it first.

Huge fixed costs, a capital-intensive business model, a rotten balance sheet and an armada of other risks mean Qantas remains a lousy company by most standards. This is one to watch from the sidelines.

Graham Witcomb is a senior analyst at Intelligent Investor.

Qantas is unlikely to part with its only cashgenerating division until it’s gasping for air