The sky is the limit. The airline industry has long been touted as a death trap for value investors in spite of all the hype, until the Oracle of Omaha himself emerged, only to prophesize about his positive vision for the US airline industry’s future a while ago in 2016.
In one of Buffett’s Berkshire Hathaway Securities Exchange Commission filing on 14 November, it was disclosed that the company had acquired an estimated US$1.3 billion worth of airline stocks during its third quarter; signaling a 180-degree turnaround endorsement by this era’s best-known value investor.
The revelation was a reversal in opinion by the oracle, Warren Buffett, who has long been known to be an irrevocable anti-advocate for investing in airliners. Even as recent as 2013, Buffett at Berkshire Hathaway’s annual shareholder meeting, had dismissed airline stocks, stating that “investors have poured their money into airlines and airline manufacturers for 100 years with terrible results”.
What led the change of heart for Buffett, and can local investors draw any parallels from this to our local airline industry? Has the environment for Singapore Airlines (SIA) transformed in similar measures for investors to consider?
How The US Airline Industry Has Transformed
Least to Buffett, his misadventure with US Airways (US Air) back in 1989 was not about the company itself, but the entire US airline industry as a whole. Back then, Buffett had almost lost all US$358 million in US Air’s preferred stocks when Southwest Airlines showed up in the industry with a cost-per-passenger-seat (per km) of US$0.08, a third lower than US Air.
Characteristic to the industry, consumers perceive passenger seats in any airliner as almost-perfect substitutes. Due to the highly-fragmented structure in the past, pricing became the natural mean of competition which ultimately led to ‘kamikaze-like’ pricing tactics and prolonged low profitability in the US airline industry.
But the old times have gone and Buffett recognizes that. The US airline industry has since gone through a phase of consolidation with several mergers occurring in the past two decades. Now, only four major US major airlines remain and the industry structure has transformed to one that is more concentrated and oligopolistic in nature. Furthermore, less known to retail investors, the four major airlines share links of common ownership by institutional investors who stands to benefit more from cooperation than competition.
How The Paradigm Has Shifted For SIA
Unlike in the US, Singapore does not warrant a domestic airline market due to our size and, owing to our geographical location, SIA used to operate in a highly diverse and fragmented ASEAN landscape.
In the 90s, SIA managed to provide relatively lower cost-per-seat at higher service quality compared to other national carriers in the ASEAN region. Offering a more extensive network through a gold-standard international airport, flying with SIA and transiting through the Changi Airport seemed like a differentiated way of travel.
But times have moved on and it seems that our aviation landscape has become somewhat less compelling.
In the heydays of premium boom, SIA had been able to dismiss the threat of budget carriers. However, with the proliferation of budget carriers in the region, SIA is eventually forced to adopt a broader strategy of embracing both premium and budget markets.
The move to launch Scoot and buy over Tigerair – both budget carriers – was that of necessity to defend its market share, as well as for competing in the budget airline market.
In the premium service sector, SIA is also finding it difficult to differentiate itself as a cost-leader, especially amongst its lower-priced rivals from the gulf-region. In particular, the cost-per-passenger-seat (per km) for the world’s largest and still fastest growing airline, Emirates, was only about AE$1.32 for FY15/16; which is only about $0.05, based on the exchange rate at the time of the book closure at 31 March 2016. On the other hand, SIA’s passenger unit cost-per-km was about $0.09 during the same period.
Adding another whammy, new hubs are being developed elsewhere such as Hong Kong, Bangkok, Dubai and amongst numerous others. The growing number of other new air hubs will cumulatively bring stronger competition to Changi International Airport.
SIA, which relies heavily on Changi Airport as its hinterland to feed passenger traffic, will face the prospect where more travelers may choose to fly past Singapore in the future.
Ailing Recent Financial Performance
Testaments to the challenges surrounding SIA, its recent core operating results have also been somewhat worrisome.
In the latest financial result 2Q16/17, the company’s total revenue was down 5.1 percent at $3.7 billion, while net income (attributable to shareholders) fell nearly 70 percent to $64.9 million when compared to the preceding year. Furthermore, net margin for the period has been stretched thin at only 1.8 percent.
Operationally, the fall in revenue was culminated by a drop in both the passenger load and revenue per pax (per km) in the parent airline by about 3.3 percent and 4.6 percent respectively. Consequently, the resulting passenger yield (per km) for 1H16/17 was 2.9 percent lower compared to the previous year.
Despite maintaining a good net cash position, SIA levered free cash flow for 1H16/17 was an outlay of $956.6 million. SIA has reported four consecutive quarters of negative free cash flow and its cash position has dwindled to $3.3 billion as of 30 September 2016. This was a decline of $1.6 billion from its cash position of $4.9 billion a year ago.
We should make note that SIA has spent $458 million in 4Q15/16 to take over the remaining shares of Tigerair and reduced its debt from $1.4 billion to $1.2 billion in the latest quarter. However, the decline of its cash position over the past year was also partially due to the decline in cash generated from its operations. SIA registered $419.2 million cash flow from operations in 2Q16/17, down from $614.6 million a year ago. As a result, its net cash position has also shrunk from $3.5 billion to $2.1 billion.
Falling Passenger Yields
Too Risky To Bet On Now
For the past five years, shares of SIA have traded between a low of 17.9 times to as high as 75.2 times price-to-earnings (P/E). Currently at about $9.80, SIA is trading at 14.1 times trailing twelve-months (TTM) P/E, the lowest level in five years.
At the current valuation, SIA is also trading at 0.9 times price-to-book (P/B); lower than its historical five-year average of one time. Meanwhile, the TTM dividend yield is about 4.5 percent.
While the valuation appears rather attractive at first glance, it is also important that investors have some intuition of the future prospect of SIA before investing their money. Given that the environment SIA is operating in would become increasingly competitive and coupled with its poor financial performance of recent, we think the low valuation may not be unwarranted. Sharing our sentiments, analysts on the street rated SIA with an average target price of $9.95. Based on the target price, investors are only seeing just 1.5 percent potential upside.