Why Qantas Airways Limited is a great company in a very tough space

Credit: Joits

Following Warren Buffett’s investment in the four major American airlines I decided to investigate whether or not it would be worth investing in some airlines on this side of the world. The result was surprising. Qantas Airways Limited (ASX: QAN) is a great turnaround story with management doing a superb job.

Unfortunately, the business operates in a very competitive space with unit margins already beginning to come under pressure. Additionally, the investment required to upgrade the Qantas fleet means that the amount of free cash flow the business is able to produce is limited.

Airlines have been a terrible business for the last hundred years with a record number of corporate bankruptcies and industry pressures that force companies to continually lower prices. An airline seat is essentially a commodity and consumers are extremely price sensitive. Recently, the airlines in the United States have begun a process of rationalization and consolidation, with the four majors taking more than 70 percent market share.

The primary problem for Qantas is that this level of consolidation has still not taken place in Australia. The airline business has continued to be extremely competitive and companies such as Virgin Australia Holdings Ltd (ASX: VAH) are prepared to square off purely on price and “value provided”.  Qantas is also disadvantaged as it continues to compete with airlines that are subsidized by their national governments in a major way. Over the long-run, this structural disadvantage will continue to limit the company’s ability to gain market share outside of Australia and Asia, as economies of scale mean that it makes less sense for them to branch into international markets in the same way that it does for these lower-cost players.

Despite this, Qantas has some remarkable achievements of late. The company has achieved a twenty percent return on capital, improved its operating margins every year and pushed through a number of productivity initiatives to lower their operating costs. Aggressive share buybacks have also lowered the number of shares outstanding by 20 percent and this benefits current shareholders. Management has been extremely disciplined and transparent with its capital allocation plans, working to lower debt, boost share buybacks and pay dividends to shareholders when possible. Labour disputes also seemed to have been mitigated, at least in the short-term. Excellence in leadership has resulted in Qantas earning the second highest profit in its company history.

With lower fuel costs globally, the company has also been benefited by a number of macro-factors which have served as a tailwind to the company’s growth. Fuel prices are likely to stay relatively low for a long-time as it looks that oil is destined to stay below $100 a barrel due to a glut of global supply. Qantas shouldn’t see its fixed costs rise too much in the short-term.

The main problem for the company remains the competitiveness of the industry and the rapid change which competition could bring. This isn’t going away anytime soon. All of the excellent work performed by the leadership team could be immediately undone if industry capacity increases and pressure comes down on seat margins. Qantas will have no choice but to compete on marginal cost. It would therefore be prudent to wait and see industry developments, before investing in the company.

Foolish Takeaway:

Despite excellent management and disciplined management, the airline industry is extremely competitive. It is too risky to invest in Qantas currently, given fierce competition and pressure on unit prices. This could be one for the future though.

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Motley Fool contributor mpinto has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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