Category: Regional Express

Click here to see my original post on Rex.

It was a solid half year result for Rex. No surprises and my views are pretty much the same as my last post. A few points to highlight:

1. The passenger and load factor increases were the main driver of the 60% increase in profit before tax. An illustration of this is the cost comparison between the prior comparable period (pcp). Total cost for 1HY18 only increased by $1.5 million from the pcp, whereas passenger revenue increased by $5.4 million.
2. Based on seven months of operating statistics, it appears that after many many years of decreasing passenger numbers and load factors, there is a recovery underway.
   
3. There is some seasonality in the business, the first half tends to be marginally more than the second half. The split is around 52:48, so I expect the second half results to fall marginally short of the first half.
4. I see the new RPT win in WA being marginal. The Perth to Carnarvon and Monkey Mia route has  combined annual passengers of less than 30,000. Perth to Albany and Esperance has combined passengers of 100,000 pa. These two new routes will still be helpful in defraying some of the fixed cost base at Perth.

In terms of outlook, management has flagged a 20% improvement in the full year result. These guys are pretty conservative so that number probably has a bit of buffer in it. Factors that may further improve the FY18 results include more charter revenue wins from an improving outlook in commodities (coal and copper), depreciation in the USD:AUD exchange rate leading to cheaper spare parts and possibly even fuel cost.

The long wait for this dividend will make it extra sweet for long suffering shareholders. I think the real positive from this dividend is the signal that it sends. Given management’s conservative nature and for them to pay out nearly 87% of FY2017 net profit after tax as dividend (10 cents), they must believe that the fall in passenger numbers has bottomed out.

I also feel like a genius as I have previously forecast FY17 net profit to be between $8-$12 million. Just thought I mention it in case anyone missed it 🙂

Key takeaways

So the key takeaways for me are:

• The increase in passengers pcp from March 2017 onwards. The WA routes started in Feb 2016 so a comparison from March onwards shows the increase in passengers with the same network. With the exception of April, the network has experience passenger growth. The surplus in March and deficit in April are linked to Easter falling in March last year and falling in April this year. So net, passenger are up 6% which is consistent with May to June figures. 
• Load factor has increased from 56% (FY2016) to 58.8% (FY2017). This is a good sign as it corroborates with the above recovery.
• Wage cost increased by 2.5% pcp. I was very pleased to see Rex keep this cost under control. I have been arguing that rising cost is forcing the company to raise ticket price which further drives customers away so this marginal increase in wage cost is very pleasing.
• The other positives are of course the Pel-Air winning FIFO contracts with Iluka Resource and Cobham.  So I expect the charter revenue of $22.9 million to increase in FY18.

Valuation
Investors cheered the dividend and pushed the share price up to a 5 year high. The last time the share price was at this level was in October 2012. The company is currently trading at:

On a price earnings basis, it doesn’t look very cheap. However, it still appears cheap based on the following (also see chart below):

1. Profit before tax (PBT) was significantly higher back in FY2006 to FY2011. FY2012 was an unexceptional year for charter revenue which masked the poor results from RPT operations.
2. Load factors are still depressed compared to FY2006 to FY2011 (back then above 60%).
3. Although passenger numbers appear to be recovering, in reality Rex today has a larger route network than it had 10 years ago; meaning the passengers on the “traditional” network (NSW, VIC and SA) have still not recovered to previous levels.

Based on the March to July passenger data shown above, it appears that passenger numbers on the “traditional” network is starting to recover. This recovery should increase the load factor and given the fixed cost nature of the business, any increase in load factor falls directly to the bottom line.

Therefore, I think there is a good possibility of Rex getting back to previous profitability levels.

 

The results for this half year were much better than pcp but was not unexpected given the full year contribution of the WA routes. An interesting development which management pointed out was that the downturn in the traditional network appears to have bottomed. Although still very early days (we had false starts before), this is great news if the passenger numbers on the traditional network can recover after 9 consecutive years of decline.

My takeaways from the half year are as follows:

• Both the WA and traditional network are performing well. The half year presentation showed that the passengers on the WA routes made up 9.7% of the traditional work which on the surface doesn’t seem surprising given the historical passengers numbers. However, we do know that Rex increased the WA route service by 35% over the previous operator and therefore for the passenger percentage (10%) to remain consistent, passengers on the traditional network must have increased as well. I’ve analysed the comparable monthly passenger data for year to date (YTD) FY17 and FY16.

As shown above, YTD17 passengers are up 12% but more interesting is the strong pcp growth from November to January. Another indicator that passengers are increasing is that the HY load factor has increased by 2% (54.8% to 56.6%).

• Now that Rex has established itself in WA, the natural progression would be to expand operations there to spread the overheads. Like the eastern states, WA has some regulated and unregulated routes which Rex could expand into. The closest competitor to Rex (besides Qantaslink) is Skippers Air which has the rights to some regulated routes. Rex’s entry into WA can’t be good news for a small operator like Skipper and I won’t be surprised if they end up selling to Rex.

• Pel-air have started medivac operations out of Singapore with 2 aircraft. Currently it is likely to contribute immaterially to earnings and therefore no breakdown was provided, however it is a nice toehold into a new market.

• On the cost front, cost have gone up (Flight & port operations  and also salaries) which management have said were due to the new WA routes and medivac operations in Singapore.

Based on the half year result, I forecast net profit after tax to be circa $8 – $12 million with recurring capital expenditure being less than depreciation at the current fleet size. The recent developments are positive and I believe when the dividends are started again, the stock will move higher.

Meh … is what I felt after going through Rex’s results for FY16.

The FY2016 loss of $9.5 million (mainly due to impairments) wasn’t too surprising given what shareholders were told at the half year.  However, the underlying net profit of $3 million was disappointing as they have gone backwards from the half year (which reported an underlying net profit of $3.3 million). The key developments in FY2016 were i) winning the WA routes, ii) the cessation of Pel-Air’s defence towing contract which led to the above impairment and iii) Vietnam Airlines cadet training program tie up with AAPA, all of which were already flagged at the half year.

These were some of the positives takeaways:

• 2^nd half RPT revenue grew by 16.7% despite i) the WA routes only started on 28 February 2016 and contributing four months of revenue to the 2^nd half of the year and ii) RPT on the existing network fell by 0.74%. This means that although the WA routes on a full year basis will increase passenger numbers by circa 9%, its impact on revenue will be larger (due to its fares being higher than the average fares in the traditional network). Rex should experience full year FY17 revenue growth in the teens just from the WA routes.

• Fuel hedge in place which will lower fuel pcp cost from July 16 – Mar 17 by $4.7 million.
• Strong cash flow generation (operating cash flow $28.4 million) enabled management to reduce debt by $5.1 million at the same time increasing cash by $3.5 million. So overall net debt has decreased by $8.6 million.

Now the negatives:

• Annual expenses growth of 4.7% (excl impairments) exceeded revenue growth of 2.2%. Additional mobilisation and set up costs were incurred due to setting up the new WA routes.
• Passenger numbers are still falling in the regional areas of NSW, VIC and SA markets.

• No dividend for FY16 means that the share price is likely to continue to trade around current levels.

No doubt, this is a business where margins are so slim that the difference between one more or less passenger on a flight could be the difference between profit or loss. Cost is a key factor to the sustainability of the airline and the unionised nature of the workforce effectively ensures that wage cost (the biggest cost item) will increase annually. The annual cost increases are a structural problem for Rex.

Let me illustrate, from FY14 – FY16, Rex has nearly doubled the number of routes that it services and its net profits have actually gone from $7.7 million (FY14) to $3 million (normalised FY16). More routes, lower fuel cost and less profit?

Besides rising cost, one undisputed reason is that passenger numbers have fallen, in fact they have fallen by nearly 50% from 2008 (in spite of winning the new routes in Qld), a staggering decline. Management have always blamed weak regional economies, downturn in the mining sector etc as factors which have pulled down passenger numbers. I don’t disagree but I would add that management’s response to rising cost by increasing the fares is turning customers away.  The chart below shows the passenger numbers and average fare over an eight year period.

So what to do? The obvious answer is to slash cost but given management frugality, it would be pretty hard to achieve without shrinking Rex’s operations. And I believe this is exactly what management should do. I believe Rex should re-assess its entire network and only service those routes where it can earn an adequate return on its capital.

Rex is unlike say Airasia who can benefit from network synergies as their route network expands. Airasia’s KL to Sydney and Shanghai to KL routes also attract passengers going from Sydney to Shanghai and vice versa.  Rex enjoys very little network synergies as its customers are either headed to a capital city or going to a regional city from a capital city. There is very little inter-regional city traffic. Therefore, I would argue that there is little benefit of Rex having a large network (other than say sharing of central costs).

Routes that are culled as part of this process may even end up being subsidised by government (given regional politics) which would then make it profitable for Rex to continue the service.

Nonetheless, I’m still holding on to my shares as with the shares trading at 0.45x net tangible book value, the market has very low expectations. At this price it is like a free bet, (low downside but huge upside) but unfortunately the odds for upside isn’t looking great at the moment.

Although the results were disappointing, it isn’t as bad as they first appear to be. Yes, they made a loss but the loss was mainly due to impairment of goodwill and specific assets (one-off items).

The highlights of the half year results are as follows:

• Accounting loss of $11.3 million. Loss mainly due to impairment of $13.4 million from goodwill and fixed assets related to Pel-Air’s defence contract which has ceased. The termination of this contract was previously flagged. The surprise to me was the quantum of the contract, as it was mentioned in the Q&A session that the contract was worth about $2 million in operating profit.
• Revenue and passengers numbers are up marginally from the previous half year. This is primarily due to the commencement of the Queensland regulated routes. Passenger numbers have only increased by 3,655 which is tiny considering the Queensland routes should have added about 19,000 passengers over a 6 month period (reported to have 38,000 annual passengers).  I believe the small increase is due to: 1) falling passengers in the rest of the network offsetting the uplift in Queensland passengers and 2) Queensland routes having lower than expected traffic due to the mining downturn.
• Purchased 2 Saab 340 for the commencement of the WA routes (28 February 2016).  The rights for this route are for 5 years. As noted in my last post, the WA win is a significant for Rex as the two WA routes are reported to have 103,000 annual passenger traffic (10% of current annual passengers).
• AAPA has been certified by the Civil Aviation Authority of Vietnam, this clears the way for the cadet pilot training to commence for Vietnam Air.  It has taken a few years for AAPA to sign up its first customer and hopefully this will provide confidence for other airlines to follow suit.
• Purchased a hanger in Wagga Wagga for aircraft painting and refurbishment. This will provide some cost savings as the work can now be done locally.

Excluding the one-off impairment charges (including loss on fuel swap) result in an underlying profit of $3.3 million (HY15: $3.9 million).  It appears that the loss of the defence contract was offset by the new Queensland routes. On a brighter note, salaries and wages have only marginally increased from HY2015. The EBA negotiations are still on-going and this loss result may help dampen the union’s demands.

So overall disappointing result given that passenger numbers are still weak. However, there are some tailwinds from the new WA route commencing and lower fuel prices.

 

 

 

In my last update for Rex, I noted that I was going to hold my position till I see a trend reversal in passenger numbers.  Recently Rex had their AGM and announced a few interesting developments which I think may reverse the declining passenger numbers, amongst other things.

The important bits worth noting are:

• Rex has been selected as the preferred tenderer for the Perth-Albany and Perth-Esperence regulated routes.

• Fuel hedge will bring additional savings of $4.5 million in FY16

• AAPA reaches agreement to train cadets for Vietnam Airlines commencing FY16

• Pel-Air’s Fast Jet contract with the Australian Defense Force has ceased.

The WA selection of Rex for the above two regulated routes is significant given the passenger traffic on these 2 routes.  To give relative traffic on these routes, the 23 Queensland routes which were awarded to Rex in total have about 38,000 annual passengers.  Perth-Albany and Perth – Eseperence have about 58,000 and 45,000 pax p.a. respectively.  Aggregate of these routes are about 10% of current passengers flown. These 2 inaugural routes may open up further opportunities in WA.

On the downside, Pel-Air’s Fast Jet contract has ceased.  Based on the information released by the AusTender, I estimated that this will result in a revenue loss of approximately $7.5 million p.a. based on disclosure from AusTender.

Based on the results in FY2015 and factoring in the above developments, I estimate that the recurring NPAT over a 12 month period is potentially $12.5 million as shown below:

 

 

 

 

 

 

 

 

 

 

Note that this is not a forecast for FY2016 as the WA routes revenues will only commence in February so will at maximum contribute 5 months of incremental revenue in FY2016 notwithstanding the one-off set up costs for commencement of the routes.  The above analysis is really to show the potential run-rate moving forward.  Obviously things can and will change but $12.5 million is not unreasonable given Rex had achieved NPAT of $14.0 million in FY2013.

As mentioned in my previous post, cash generation is still strong as the depreciation of nearly $16 million is non-cash and the level of debt should come down substantially by the end of FY2016.  I estimate by the end of 2016 barring any major capex spend (excluding the $6.2 million for the new catering facility) the company should be debt free (cash > debt).  My view is that dividends will resume at the latest at the end of calendar 2016, triggered by either a turnaround in passenger numbers (downtrend for continuous 7 years) or when company becomes debt free.

The continuation of dividends would be a catalyst for the stock to move higher.  I’ll wait for the half year results to see how passenger numbers are tracking before changing my stand on Rex.

Regional Express FY2015 results

Rex recently announced its FY2015 results and it was a mixed result with both favourable and unfavourable elements.  Let’s start with the bad news:

• Passenger numbers were down again. YOY it fell another 2.7% and this is the 7^th year of continuous fall in passenger numbers.  I am convinced that the ticket prices are too high as the passenger numbers have fallen in spite of winning so many new routes in Queensland.

• Salaries continuing to grow at a faster pace than revenues. This may be due to the mobilisation cost for new Queensland operations.

• Rex fell to 2^nd spot from 1^st last year on the airline reliability index which measures on-time departures.

There were a few positive developments as well:

• Significant expansion of the routes in financial year with the Queensland routes increasing the route network to 53 destinations from 36 last year. Rex now has the scale to further expand the route network in Queensland.

• Fuel for FY2016 hedged which will bring savings of $4.5 million.

• Cash generation still good. Cash from operations was $23 million, which is very similar to adding back depreciation ($15.8 million) to net profit ($6.7 million)

• Borrowings were paid down and net debt is now $12 million compared to $22 million last year.

• WA will call tenders for the provision of RPT services to various regional towns and Rex may tender, which is a good opportunity to further expand the network.

So what does this mean?

I think Rex’s strategy of increasing ticket prices to offset operating cost escalating is not a sustainable strategy as I’m convinced that the high air fares are driving away passengers. Load factors have decreased from the high 60s in 2008/09 to the mid 50s (2013 onwards).

Having said that Rex still has a dominant position in the regional aviation sector and it’s ability to generate cash flow is excellent.  Capital expenditure is lower than depreciation so free cash flow is higher than the reported net profits.  The Saab 340s will operate for at least another 10 years so I expect capital expenditure levels to be broadly flat.

Rex is still trading at a significant discount to the book value which means the down side is low.  However, for the share price to move up, the market must see some growth and the escalating airfares are not helping the passenger numbers to grow. At the current share price ($0.90), I’m holding my position until I see a reversal of the trend in passenger numbers.

Regional Express Holdings
As a general rule, I stay away from investing in the aviation sector given its tough and volatile business conditions.  But on rare occasions like this one, I bend the rules. Regional Express is Australia’s largest regional airline based in Mascot, NSW.  It was formed by merging the old Hazelton and Kendell businesses, which was sold by the administrators of Ansett in 2001.

Here are 4 key reasons why I like Rex:

• Sole operator in a substantial number of routes it services – monopoly.
• Secured key landing slots at Sydney airport – competitive advantage.
• Good conservative management whose interest is aligned to the other shareholders as majority shareholder is also the executive chairman.
• Currently cheap, low debt levels and running a share buyback program.

RPT routes
Whilst Rex offers charter services, the bulk of its revenue (approximately 80%) comes from regular passenger transportation (RPT); which will be the focus of this analysis.  Rex is the sole operator on a very high number of RPT routes it services; as shown in table below:

 

 

 

In terms of regulated/ licensed routes, nearly all of the Rex’s routes in Queensland are regulated whereas slightly more than half of its New South Wales routes are regulated. Notwithstanding the regulated routes, Rex is still the sole operator of many competitive routes in South Australia, Victoria and New South Wales.

Given that these routes are competitive, it begs the question why haven’t Rex’s main competitor (Qantaslink) stepped into the ring?

The answer lies in the type of aircraft and the annual route patronage of these rural communities.  Rex operates a uniform fleet of Saab 340s, a 36 seater turbo prop aircraft which was mostly purchased off lease for approximately $2 million each whereas Qantaslink operates a variety of aircraft with the 74 seater, $30 million Bombadier Dash 8-Q400 making up the largest portion of the fleet.  Given the low annual patronage of some of these smaller routes (sub 50,000p.a) and the competitive pricing by Rex, the economics simply isn’t attractive enough for a company the size of Qantas.  In NSW, I’ve observed that Qantaslink stays away from unregulated routes where the annual patronage is less than 100,000.

Rex has in excess of 540 weekly slots at Sydney airport of which approximately 45% are for peak periods between 7.30am to 9.00am and 5.30pm to 7.00pm.  Rex is the largest holder of NSW regional slots at Sydney airport.  These slots are vital for regional carriers trying to get passengers in and out during peak hours at Sydney airport.  Without primetime slot ownership, it makes it extremely difficult for a new entrant to compete in New South Wales due to the high volume of business travellers on regional routes. This slot system is currently only practised in Sydney airport to alleviate congestion.

Financials
Summary of the income statement over the past 5 fiscal years is as follows:

Revenue has increased by 11% over the past 5 years in spite of an overall decrease of 15% in passengers over the same period.  This has been achieved to a large extent by fare increases, average fares have increased from $155.90 (2010) to $192.10 (2014), as shown in the chart below.

Costs on the other hand have jumped by 20% over the same period. The main driver of increased cost is salaries and wages (which also happen to be the largest expense item).  The enterprise bargaining agreements (EBAs) currently in place allows for a 2% real growth in wages.  As a result of revenue not keeping up with costs, net profit has decreased.

A summary of its financial position at the end of fiscal year 2014 and half year 2015 is as follows:

The majority of asset value lies in the PPE, specifically aircraft, rotable assets and buildings.   Rex operates a total of 96 aircraft, most of which are owned outright.  Based on its annual report, carrying value for its aircraft and other rotable assets is $214.5 million (FY2014).  A high level sense check below suggests that the risk of a material overstatement of the PPE is low.

The other thing I would like to point out on the balance sheet is a liability called “unearned revenue”.  In reality this is not a really a liability as it is fares paid in advance (common in the airline industry) which are not likely to be refunded.  Although the accounting standards deem this a liability, it is actually more like an asset as the company can earn interest on this float.  Therefore, the net asset on the balance sheet is somewhat understated.

Valuation
The market capitalisation of Rex is approximately $107 million.

Based on FY2014 results, it is currently trading on a price earnings multiple of 13.8x ($107m/$7.7m) and a net tangible asset multiple of 0.57x ($189m/$107m).  This appears to suggest that the company is cheap when looking through the asset lens but not as cheap when looking through an earnings lens.  This is simply because Rex is currently not earning an adequate return on its capital.

The return on equity (ROE) based on the book value of equity (FY2014) is 4% ($7.7m/ $189.1m). As a result, the market has discounted the value of equity (market capitalisation) so that a purchaser buying in at the current share price would get a more reasonable ROE or yield of 7.2% ($7.7m/ $107m).

Generally speaking low growth companies have historically been priced on yields of 8% – 10% (price earnings ratio of 10x – 12x).  Based on this general rule, this suggests that the market is pricing in only marginal growth for Rex. The airline industry is a cyclical business and Rex’s passenger numbers have been falling since the GFC.  The drop in passenger numbers have slowed in FY2014 and at some future point in time will eventually reverse.  Given its high operational leverage (mostly fixed costs), any turnaround (increase in revenue) would mostly flow down to the bottom line.

Given the above, I believe the LTM price earnings ratio of 13.8x is undemanding as:

• Management has disclosed that the decrease in oil price will lead to a $2mil savings for FY2015. Although I am unable to predict with any degree of certainty that oil prices will stay low, some media reports have reported that the world currently has surplus oil production.
• In FY2015, Rex bagged the Queensland Western 1,2 and Gulf routes greatly increasing its exposure to the Queensland market. This win should help slow down or reverse the drop in passengers.
• The reintroduction of the enroute rebate scheme. Although this scheme is less generous than its predecessor, it is certainly better than nothing.
• Savings from leasing charges as Rex currently owns all of the Saab 340s. These savings will kick in when the current bank loans are all fully repaid.

Given the cyclicality of its earnings, it is difficult to predict what earnings will be next year. However, the combination of the above factors has created a “tail wind” behind earnings in FY2015.  Whilst there is of course a possibility of earnings deteriorating further in FY2015, I think there is a higher chance of them being better than FY2014 given this “tail wind”.  Moreover the HY2015 earnings were better than the corresponding HY2014 earnings.

In the long run, I believe Rex will be able to earn an adequate return on equity given its monopoly position on most of its routes. Therefore, the book value of its assets should provide an indication of its intrinsic value (based on the replication method).  Its net tangible book value (HY2015) suggests an intrinsic value of $184.6 million. Compared to the market capitalisation, it implies a margin of safety of 42%, which is pretty good.

Risks
An investment in Rex is of course not without any risks. In my mind the potential downside risk for an investment in Rex are:

• Rex’s fares have reached a point where any further increase will result in a greater fall in passenger numbers,  in which case it would be challenging for revenue to keep pace with growth in costs.

• Regional councils spending to upgrade their airports and passing on cost increases to passengers which will further increase fares and lower passenger numbers.

• Government implementing more stringent new safety or security guidelines which may lead to increase costs for regional airlines.

• In the longer term, the Saab 340s will eventually need to be replaced (in 10 – 15 years time) and large capital expenditure will be required.

Overall, I believe the market has already priced in some of these risks (market believes there will be little or no growth) and that passengers are falling mainly due to a pull back in business and government spending.  So I believe an investment in Rex at current levels (around $1 a share) has limited downside risk but a greater upside potential.  However, this upside will probably take some time to materialise given the downward trend in passenger numbers; but if you wait for conditions to improve then as Buffet says “if you wait for the Robins, spring will be over”.