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One cheap ASX airline stock ready for take-off

Despite the downturn in consumer confidence and shoppers’ reluctance to spend, it seems the world’s demand for our resources is continuing unabated.

Even with the recent falls in the Australian dollar, the currency once derided as the ‘pacific peso’ still remains well above its long term average. The dollar’s strength makes life difficult for our exporters, and our retailers struggle to get us to part with our hard-earned.

We all know that miners are making money hand over fist – most notably the Big Anglo-Australian, BHP Billiton (ASX: BHP). Importers are also benefitting, and figures from our airlines and travel agencies such as Flight Centre (ASX: FLT) and Webjet (ASX: WEB) show that Australians continue to travel – most notably overseas – in huge numbers, thanks in large part to the improved buying power of our local currency.

Australian Dollar + Travel = Opportunity Amongst Airlines?

With so many Australians travelling and the market in a funk, perhaps it’s time to look for opportunities amongst airline stocks.

I’ll admit to a fair degree of scepticism when looking at airlines. The economics of the business are generally pretty awful – high, regular investment costs, fluctuating (and growing) fuel charges and excess seat capacity characterise the international aviation business. The business is generally so bad, that Warren Buffett was moved to say of Orville Wright’s momentous first flight:

“If a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.”

On a hiding to nothing

Believe it or not, the Australian aviation industry has been much more profitable (or perhaps just less diabolical) than the international average. In fact, based on the figures released by the International Air Transport Association in June this year, the entire global airline industry has lost an aggregate $US23.9 billion in the last nine years. It’s hard to overstate this point – while some airlines have made money and others haven’t, the entire industry is unprofitable!

Australian airlines have the luxury of a relatively protected local market, both in terms of limited regulatory access for international airlines and a domestic market that is really only big enough for two major players. While a few would-be third entrants have tried – and the incumbents have suffered reduced profits for a time – none have been able to successfully challenge the reigning duopoly.

Going where angels fear to tread

With the poor economics and Buffett’s warning ringing in my ears, I had a look at Australia’s two major airlines, Qantas Airways Limited (ASX: QAN) and newly-renamed Virgin Australia (ASX: VBA), as well as regional minnow Regional Express Holdings Limited (ASX: REX), better known these days by the moniker Rex.

Qantas has had a chequered recent history, with earnings per share being as high as almost $0.40 in 2007, and as low as only $0.07 two years later. In the most recently completed financial year, Qantas eked out only 11.6 cents per share in earnings.  In the past few years, Qantas’ return on both assets and shareholders equity has been a good deal less than the average term deposit. It’s hard to justify an investment in the Flying Kangaroo.

Virgin Australia, nee Virgin Blue, hasn’t been so successful either. While Qantas has turned a profit in each of the past 5 years, Virgin Australia has lost money in 2 of those years, in 2009 and 2011. When the company has been profitable, the return has been meagre. While Virgin sported solid returns on equity early in its publicly-listed history, superior results have been hard to come by in the past three or four years.

Pockets of opportunity

It is often the case that specialist players can carve out a profitable niche in a market. Our largest regionally-focused airline, Regional Express, perhaps is just the best of a bad bunch, but may also be a really interesting opportunity. Profitable in each of the last 5 years, Rex also delivers reasonable (and comparatively very impressive) returns on capital and shareholders equity.

Positioned to take advantage of increased mobility – particularly with the growing numbers of so-called ‘fly in fly out’ mine workers – and relatively conservatively financed with a manageable debt load, the business has seen slightly eroding profitability, which is a watch-out for the investors.

Foolish take-away

Qantas and Virgin Australia are likely very well run airlines, but the industry economics are the millstone around management’s neck. However, Rex looks potentially quite attractive. With its share price around two-thirds of book value, Rex trading on a price/earnings ratio of less than 6, and is sporting an 8% fully-franked dividend yield.

As long as management can restrict the slow but steady profit decline (or better yet start to deliver profit growth), the smallest of our trio may well deliver investors a soaring return.

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Scott Phillips is The Motley Fool’s feature columnist. This article has been authorised by Bruce Jackson.

 

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