Resource-Past student assignment Qantas PDF

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Introduction Qantas Airways Limited (ASX: QAN) is founded in 1920 and headquartered in Australia1. Its main business involves passenger and freight air transportation services. Qantas’ business comprises of catering, holidays & travel services, logistics transportation and a frequent flyer loyalty program2. To date, Qantas is widely regarded as one of the strongest airline brands in Australia.

This report aims to provide insights on Qantas’ financial strength by applying corporate

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finance theories and models to analyse its shareholders, risk-return profile, cost of capital and financial statements.

1.0 Shareholders’ Analysis 1.1 Type of Shareholders

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Shareholders choose different stocks to invest in based on their investment philosophies. Figure 1 below illustrates the 9 different types of investment philosophies that an investor might hold. Different investors may subscribe to different philosophies

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due to their age, risk aversion, time horizon of investment and strategy.

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Figure 1: Nine Different Types of Investment Philosophies3

1 “The Men Who Established Qantas,” Qantas Airways Limited, 6th October 2017, https://www.qantas.com/travel/airlines/history-founders/global/en 2 “Qantas Business Summary,” Morningstar DatAnalysis Premium, 15th September 2016, http://datanalysis.morningstar.com.au.dbgw.lis.curtin.edu.au/af/company/bussummary?ASXCode=QAN&xtmlicensee=datpremium

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Aswath Damodaran, “Investment Philosophies” (Lecture, New York University, accessed 4th October 2017), http://www.master272.com/finance/memoire_2014/strategies/docs/damodaran%20invphil.pdf, 217

In Qantas’ case, investors are likely to adopt a passive investment strategy. This is because Qantas’ is a large capitalisation stock that has relatively stable growth, given its reputable brand name. This is evident from the equity screening results shown in Figure 2. The equity screening process sieved out Qantas as one of the stocks under the consumer discretionary industry in ASX that has the lowest price-to-earnings, price-to-sales and price-to-book ratio. It also has a PEG ratio of less than 1. This matches the profile of a passive investor, who is looking to park their money for long

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Figure 2: Equity Screening Criteria & Results4

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period on an undervalued stock.

1.2 Type of Returns: Capital Growth vs Dividends The type of returns that Qantas’ shareholders want depends on the financial objectives of Qantas. According to its Financial Framework and the CEO’s message, Qantas is focusing on three key objectives to enhance long-term shareholder value5. 4

Bloomberg, “Equity Screening Results,” accessed 17th September 2017. “Annual Report 2017”, Qantas Airways Limited, 30th June 2017, http://investor.qantas.com/FormBuilder/_Resource/_module/doLLG5ufYkCyEPjF1tpgyw/file/annualreports/2017AnnualReport.pdf, 3-6. 4

Firstly, Qantas aims to improve its return on invested capital (ROIC). In Qantas’ case, ROIC measures how well Qantas’ size and moat contribute in turning investors’ capital in to profit. Qantas’ has a target ROIC of 10% and has consistently exceeded expectations6. This suggests that Qantas’ is profitable and can deliver positive shareholder returns.

Secondly, Qantas seeks to optimise its capital structure by sustaining positive free cash flow and lowering its debt7. To achieve this, Qantas intents to maintain a strong short-term liquidity position in cash and undrawn facilities. Hence, it is likely that

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retained earnings remain as free cash-flows to maintain financial slack instead of being distributed as dividends.

Lastly, Qantas’ track record of shareholder returns in the past 5 years (FY2012 – FY2017) is mostly made up of capital returns and share buy-backs8. The exception of

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a dividend distribution only occurred since 20169. This is because Qantas is focusing on growing its invested capital. Its strategy is to distribute dividends only when debt

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levels are healthy and surplus capital exists10.

Therefore, it is likely that Qantas’ investors are more interested in capital growth as

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opposed to dividends.

1.3 Marginal Investors

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Marginal investors have three characteristics. They own a lot of stocks, trade frequently and are well-diversified. Figure 3 below illustrates the top 20 largest shareholders in

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Qantas as at 4th August 2017. 18 out of the 20 largest shareholders in Qantas are institutional investors. They command approximately 83% of the total number of issued shares. Hence, they meet the first criteria of owning a substantial number of shares.

6 “Annual Report 2017”, Qantas Airways Limited, 30th June 2017, http://investor.qantas.com/FormBuilder/_Resource/_module/doLLG5ufYkCyEPjF1tpgyw/file/annualreports/2017AnnualReport.pdf, 3 7 Ibid. 8 Ibid. 9 “Qantas Dividend History,” Qantas Airways Limited, accessed 4th October 2017, http://investor.qantas.com/investors/?page=capital-management 10 “Annual Report 2017”, Qantas Airways Limited, 30th June 2017, http://investor.qantas.com/FormBuilder/_Resource/_module/doLLG5ufYkCyEPjF1tpgyw/file/annualreports/2017AnnualReport.pdf, 3

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Figure 3: Top 20 largest shareholders of Qantas Airways Limited11

These institutional investors are mainly nominees accounts that operate as fund managers for their clients. These fund managers are likely to hold numerous well-

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diversified portfolios, making investment decisions in the best interests of a group of

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individual investors. Thus, they meet the second criteria of being well-diversified. Finally, the volume of trade by these institutional investors is high. This is evident from Figure 4, which shows that institutional investors of Qantas have the highest

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percentage change in the number of shares they hold (17.03%).

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Figure 4: Percentage Change in Volume of Shares by Institutions and Insiders12

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Ibid., 107. Bloomberg, “Qantas Ownership Summary,” accessed 17th September 2017.

Therefore, Qantas’ marginal investors are mainly institutional investors that comprises of nominees and banks that hold large number of shares and have high buy and sell out positions. However, there are two shareholders on the list in Figure 3 that may not meet the definition of a marginal investors. For example, the 18th largest shareholder, Alan Joyce Pty Ltd, is a company owned by the current CEO of Qantas Airways Limited, Alan Joseph Joyce. He has both direct and indirect shareholdings of Qantas Airways Limited through the family trust of Alan Joyce Pty Limited13. Being the CEO of Qantas

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since 2008 and the founder of Jetstar Airways (Subsidiary of Qantas), he is considered a company insider14. It is unlikely that Alan Joyce will relinquish the shares he owns and be involved in frequent transactions of Qantas’ shares.

The 20th largest shareholder, Dr Kui Lim Chong and Mrs Jocelyn Elizabeth Chong are

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individual investors without any connections to Qantas’ management. Both investors bought Qantas stocks since FY2015. It is likely that an individual investor might not

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have the technical expertise, like a fund manager, to hold large and well-diversified portfolio. Thus, they are unlikely to be considered as marginal investors.

Since majority of the shareholders are marginal investors, they are influenced by the

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risk-return trade-off. If Qantas’ hurdle rate does not meet that of their marginal investors, they are likely to sell off the shares. Since the Capital Asset Pricing Model’s

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(CAPM) concept revolves around investors requiring compensation for undiversifiable

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risk, it is a fairly accurate measure for Qantas’ cost of capital.

2.0 Risk-Return Analysis To evaluate the risk-return profile of Qantas, it is essential to consider three fundamental elements of the business: (1) Business Risks, (2) Total Shareholder Returns and (3) Review of Qantas’ Projects and Market Reaction.

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“Change of Director’s Interest Notice,” Qantas Airways Limited, 15th September 2017. http://investor.qantas.com/DownloadFile.axd?file=/Report/ComNews/20170915/01896618.pdf, 1-4. 14 “Background of Alan Joseph Joyce,” Bloomberg, accessed 4th October 2017. http://www.bloomberg.com/research/stocks/people/person.asp?personId=24840853&privcapId=874341

2.1 Business Risks The aviation industry is subjected to several inherent risks. In this section, the report will study Qantas’ exposure to three material business risks: Fuel Hikes and Volatility, Cyber Security and Climate Change15. Firstly, Qantas is subjected to fuel price volatility. Fuel price is critical for Qantas because it comprises a significant portion of the airlines’ operating costs. Figure 5 illustrates the relationship between the weekly closing price of Qantas and WTI Brent Oil. The details of the closing prices are shown in Appendix A. Qantas’ stock price is

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negatively correlated with WTI Brent Oil with a correlation coefficient of -0.0618. To make matters worse, industry competition prevents Qantas from mitigating the risk by increasing air fares and seat capacity. Fuel prices has always been a nemesis for the aviation industry and will continue to be the case, given the political instability in

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the Middle East, OPEC’s oligopoly control on oil supply and price inelasticity in demand & supply for oil. Currently, Qantas manages its fuel hikes via hedging, options and

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swaps16. In the long run, Qantas should invest in R&D to improve fuel efficiency to stay competitive in the aviation industry.

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Figure 5: Weekly Closing Prices of Qantas Airways Limited17 & WTI Brent Oil18

15 “Annual Report 2017”, Qantas Airways Limited, 30th June 2017, http://investor.qantas.com/FormBuilder/_Resource/_module/doLLG5ufYkCyEPjF1tpgyw/file/annualreports/2017AnnualReport.pdf, 23. 16 Ibid., 76. 17 “Qantas Historical Stock Prices,” Yahoo Finance, accessed 4th October 2017. https://au.finance.yahoo.com/quote/QAN.AX/history?period1=1467216000&period2=1498752000&interval=1wk&f ilter=history&frequency=1wk 18 “WTI Brent Oil Historical Prices,” AU Investing, accessed 4th October 2017. https://au.investing.com/commodities/crude-oil-historical-data

Secondly, Qantas is susceptible to cyber-attacks. After the tragic disappearance of MH370, concerns regarding cockpit tampering were flared up19. These concerns are only the tip of the iceberg with regards to cyber security issues. Qantas, like many airlines, is worried about the theft of sensitive customer data. With cyber-attacks appearing frequently as headline stories, consumers are becoming increasingly concerned with data protection. For instance, on 28th June 2017, The Australian reported a technical glitch on Qantas’ airline booking system. While many consumers were unsatisfied with outage, a larger emphasis was placed on whether the technical fault was somehow linked to the ransomware attack in Europe and United States20.

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This reflects consumers’ fears towards a cyber-attack on Qantas by hackers or cyberterrorists. With new technological advancements to improve connectivity of flight operations, the opportunity for malicious individuals to exploit these systems increases21. It is imperative that Qantas improves its cybersecurity capabilities to

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prevent any cyber-attacks that may erode consumer confidence.

Lastly, Qantas faces the long-term challenge of tackling climate change. As air travel

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becomes a common mode of mass transportation, long overhaul flights and holiday getaways are becoming more frequent. However, air transportation contributes to climate change in terms of carbon emissions. It is crucial for Qantas to reduce its carbon emissions especially due to carbon taxes imposed on them. For example, when

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the European Union rolled out the Emission Trading Scheme in 2011, Qantas’ profit margin was negatively impacted by approximately AUD5 million22. This price sensitivity

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to carbon tax schemes is due to Qantas’ geographical position. Since Australia is an isolated island from the rest of the world, its airline services consume more fuel to

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complete long overhaul flights. With carbon tax calculated based on fuel consumption and distance, Qantas will end up paying more than its competitors. In addition, Qantas

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Sarah Fox, “Flying Challenges for the future: Aviation preparedness – in the face of cyber-terrorism,” Journal of Transportation Security (2016) 9(3): 191 – 218. DOI: 10.1007/s12198-016-0174-1

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Supratim Adhikari, “Qantas booking headaches not malware related,” The Australian, 28th June 2017. http://www.theaustralian.com.au/business/companies/qantas-booking-headaches-not-malware-related/newsstory/f27bd883eb44cb21c8153cee8a28921a 21 “Cybersecurity & the Airline Industry,” PricewaterhouseCoopers Ltd, 2016. http://www.pwc.com/us/en/industrialproducts/publications/assets/pwc-airline-industry-perspectives-cybersecurity.pdf 22 Steve Creedy, “Qantas braces for $5m hit from ETS in Europe,” The Australian, 28th December 2011. http://www.theaustralian.com.au/business/aviation/qantas-braces-for-5m-hit-from-ets-in-europe/newsstory/279bf396d419faed4643ea6bc3a89e28

cannot pass on the tax burden to consumers due to the intense competition in the aviation industry.

Presently, Qantas participates in the Carbon Offset and Reduction Scheme to push for lower emissions growth23. These efforts are increasingly important as government agencies and consumers are becoming more environmentally conscious.

2.2 Total Shareholder Returns for FY2017 Qantas Airways Limited’s total shareholder returns for FY2017 can be computed as

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the sum of dividend yield and annual capital gain:

𝑇𝑜𝑡𝑎𝑙 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟 𝑅𝑒𝑡𝑢𝑟𝑛𝑠 = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑌𝑖𝑒𝑙𝑑 + 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐺𝑎𝑖𝑛

The initial and final closing price for Qantas was $2.82 (30th June 2016) and $5.72 (30th June 2017) respectively24. Hence, the annual capital gain of Qantas’ shareholders is

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computed as:

𝐹𝑖𝑛𝑎𝑙 𝑆ℎ𝑎𝑟𝑒 𝑃𝑟𝑖𝑐𝑒 − 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑆ℎ𝑎𝑟𝑒 𝑃𝑟𝑖𝑐𝑒 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑆ℎ𝑎𝑟𝑒 𝑃𝑟𝑖𝑐𝑒 5.72 − 2.82 = 2.82

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𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐺𝑎𝑖𝑛 𝑟𝑒𝑎𝑙𝑖𝑠𝑒𝑑 𝑓𝑜𝑟 𝐹𝑌2017 =

= 103%

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In addition, Qantas Annual Report 2017 reported an interim and final dividend of 7 cents per share during the financial year25. Appendix B provides the details of the

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dividends, franking proportions and adjustments for franking credits. After grossing up, the interim and final dividends are 8.5 cents and 10 cents per share

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respectively. Therefore, Qantas’ dividend yield can be computed as: 𝑇𝑜𝑡𝑎𝑙 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑌𝑖𝑒𝑙𝑑 𝑓𝑜𝑟 𝐹𝑌2017 = =

𝐼𝑛𝑡𝑒𝑟𝑖𝑚 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 + 𝐹𝑖𝑛𝑎𝑙 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑆ℎ𝑎𝑟𝑒 𝑃𝑟𝑖𝑐𝑒 0.085 + 0.10 2.82

=6 6.56 .56 .56% % 23

“Offsetting emissions together,” Qantas Airways Limited, accessed 23rd September 2017. https://www.qantas.com/travel/airlines/offsetting-emissions-together/global/en 24 “Qantas Historical Share Prices,” Qantas Airways Limited, accessed 4th October 2017. http://investor.qantas.com/investors/?page=historical-share-price 25 “Qantas Annual Report 2017,” Qantas Airways Limited, 30th June 2017, http://investor.qantas.com/FormBuilder/_Resource/_module/doLLG5ufYkCyEPjF1tpgyw/file/annualreports/2017AnnualReport.pdf, 67

Hence, the total shareholder returns for Qantas during the FY2017 is computed below: 𝑇𝑜𝑡𝑎𝑙 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟 𝑅𝑒𝑡𝑢𝑟𝑛𝑠 = 103% + 6.56%

109.56 .56 .56% % = 109 To measure shareholder returns against market returns, this report will use the All Ordinaries Index (AORD) as the market proxy. The index represents the top 500 largest companies in the Australian equities market26. Appendix C provides the full computation for the total market return. During the period,

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the total market return (𝑅𝑀 ) was 8.60%. This result shows that Qantas is outperforming the market with a positive total shareholder return of about 12 times that of the total market return. These calculations implicitly assume that the stock is purchased on 30th June 2016 and sold on 30th June 2017, clearly representing the period of the annual report.

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2.3 Review of Capital Projects & Market Reaction

The outperformance of Qantas returns to market returns can be attributed to the

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projects that Qantas has been embarking on. One of the key projects that Qantas has engaged in FY2017 was to introduce the new Boeing 787-9 Dreamliner aircraft, which will be taking non-stop flights between Perth and London. Figure 6 below shows the

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Market Sensitive Announcement Chart of Qantas in relation to its share price.

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Figure 6: Market Sensitive Announcement Chart (October 2016 – June 2017)27

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“All Ordinaries Index,” S&P Dow Jones Indices, accessed 4th October 2017. http://au.spindices.com/indices/equity/all-ordinaries 27 “Qantas Market Sensitive Announcement Chart,” DatAnalysis Morningstar, accessed 4th October 2017. http://datanalysis.morningstar.com.au.dbgw.lis.curtin.edu.au/af/company/announcement?ASXCode=QAN&page= 1&resultsperpage=25&xsl_predicate=&xtm-licensee=datpremium#/aSec3

The project’s announcement was made on the 11th Dec 201628. It can be observed that the stock price did not spike right after the announcement. This might be due to the initial outlay of purchasing the new aircrafts. However, during the month of April, the stock price shot up. It is highly likely that this rise corresponds to positive expectations of investors on this project. The reason is because the first ticket sales for the non-stop flights begins in April 201729. However, a large part of the outperformance is due to the Qantas management. The CEO’s decision to engage in the Accelerated Qantas Transformation Program to

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restructure Qantas from its slump in FY2014 was the main cause for the rise in stock price over the years (FY2015 – FY2017)30. Although it was a painful decision to lay off workers and cut down on expenses (e.g. freezing bonuses), it was a wise decision and

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has generated great value for the shareholders.

3.0 Cost of Capital

The company’s cost of capital measures the expected return on the portfolio of all their

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outstanding debt and equity securities. In this section, the report seeks to find the cost of equity, debt and WACC of Qantas.

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3.1 Cost of Equity – Capital Pricing Asset Model (CAPM) The cost of equity is derived by the CAPM equation given below: 𝑅𝐸 = 𝑅𝑓 + 𝛽(𝑅𝑀 − 𝑅𝑓 )

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Where 𝑅𝐸 = cost of equity, 𝑅𝑓 = risk-free rate, 𝛽 = beta of stock (Correlation between

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market & stock) and (𝑅𝑀 − 𝑅𝑓 ) = market risk premium.

The first step in determining 𝑅𝐸 is to find 𝑅𝑓 . To estimate 𝑅𝑓 , the report uses the Australian Government 10-Year Bond Yield as a proxy. Appendix D shows the government bond yields for Australia. The report will assume the...