Regional Express

Good things come in small packages…

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:

Rex - table 1




Rex route

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.

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

Rex - table 2

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.

Rex - chart 1

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:

Rex - table 3

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.

Rex - table 4

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.

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.

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”.



Good old checklists…

I believe it is important to have a checklist before making an investment.  Very much like buying a pre-owned vehicle, a used car buying checklist can help us avoid buying a “lemon” by reminding us of specific checks or to be aware of certain faults.  Therefore, given the risk inherent risks in investing, an investment checklist can help improve our chances of successful investing.

Obviously not all investors would have the same checklist, the checklist would depend on the investor’s investing strategy and the types of securities he/ she is looking to purchase.  For myself, my investment strategy is build around minimising risks by purchasing securities which are selling at prices lower than their intrinsic value (commonly called value investing). Considering the breath of the investment universe, I believe a principle based checklist which I believe will have broader use than a prescriptive one.  I have developed a simple checklist over time from learning from the great investors, reading books on investing and personal experience. My checklist, in no particular order is:

  1. Know what I am buying.
    This fundamental principle sounds simple but there are few subtle points.  Do I know enough about the industry and the company’s business activities? Are there any potential technological advancements which have the potential to disrupt the industry? Is it within my circle of competence?  Warren Buffet once remarked: “You have to stick within what I call your circle of competence. You have to know what you understand and what you don’t understand. It’s not terribly important how big the circle is. But it’s terribly important that you know where the perimeter is.”
  2. Am I able to value the security with a reasonable degree of confidence?
    The value of a company is the present value of its future distributions so it is important to be able to predict the company’s future cash flows with some degree of certainty.  So I would be more confident in making forecast for a company like Woolworth (with its stable cash flows) compared to a company such as Fortescue Metals (whose cash flows are very much tied to volatile iron ore prices).
  1. Avoid highly geared securities
    I stay away from companies which are highly leveraged.  Although leverage has the potential to greatly magnify returns, it also increases the risk exponentially and since my core strategy is risk minimisation, I prefer companies with low or no debt.  To assess whether a company is highly geared I look at the ability of the company to service its debt obligations (interest coverage ratio) and the overall quantum of debt in the capital structure (debt to equity ratio).  In general, I like companies to have a interest coverage ratio (EBITDA – capex/ interest) of at least 5x and a net debt to equity ratio not more than 30%.
    Warren Buffet has this great saying on debt “If you’re smart you don’t need it, and if you’re dumb, you got no business using it”.
  1. Avoid companies whose management doesn’t act in the shareholder’s interest
    Sometimes it is hard to identify good management just by reading the annual reports and other public documents.  Compounded with that, the general trend these days is to change top management (CEO) every few years so it is hard to gauge how “good” the incoming CEO is. So I think one solution whether a culture of acting in the shareholder’s best interest exists.  I avoid companies whose management puts its needs before the shareholders needs.  Examples of these are overpaying for acquisitions with little or no strategic benefit, unnecessary risk taking by management (maybe due to misaligned incentive system which rewards management for taking huge risks), constant issuance of shares (placements) which dilutes the shareholder’s interest etc.
    Identifying good management can be challenging but avoiding companies with a culture of bad management is an easier way to avoid the landmines.
  1. Understand why the market is valuing the security at the current price
    This is what Howard Marks calls second level thinking.  In general I believe the market is fairly efficient most of the time; so if I do find an undervalued security, I am coming to a pretty bold and arrogant conclusion.  Basically I ‘m saying I’m right and that the entire market with all of its participants is wrong with regards to the pricing of the security.  To achieve that second level thinking, we must invert and understand why the market is pricing the security as such.  Once I understand the reasons for the market pricing, I am then in a better position to assess whether I think the market has overpriced or underpriced the security and this is  typically related to the probability of some future event occurring.  My default position is that the market is fairly efficient most of the time in pricing securities.
  1. Buy the security when it’s price is lower than it’s value (margin of safety exists).
    The margin of safety concept is a concept articulated by Benjamin Graham as the central concept of investing in his book The Intelligent Investor.  Valuing a business is difficult and precise assessment of its intrinsic value is not possible.  The best we can do is to make an approximation of a company’s intrinsic value (say within a range).  Therefore, we should only invest when there is clear bargain and when a clear margin of safety exists.  The principle is similar to say building a bridge, where the daily maximum load is expected to be 100 tons, engineers would always build the bridge so that it can support a load greater than this, e.g. 130 tons.  I wouldn’t want to cross a bridge where the current load is a 100 tons and whose capacity is also 100 tons!
  2. Diversify
    Investing is about the future and since the future is uncertain; there can be no certainty in investing.  All we can do is to invest in securities which have a greater probability of making a profit than a loss.  We may perform the best analysis and invest in a company with say a 90% chance of success and a 10% chance of failure but the failure scenario can prevail (bad luck) which will cause us to lose money on the investment. However, this does not mean our decision to invest was flawed, it was simply bad luck.  So to avoid bad luck wiping out all of my capital and forcing me out of the game, diversification is important.  The age old adage; don’t put all your eggs in old basket is acutely meaningful in investing.  I diversify by trying to invest in securities which are not highly correlated (different sectors).  Diversify but don’t over-diversify, most fortunes are made by owning a single company (most billionaires tend to have the bulk wealth in one entity) and not by owning all 200 companies in the ASX 200.  How many companies to hold in a portfolio to achieve a satisfactory level of diversification? This is personal choice but for me seven to fifteen securities in my portfolio is a good balance in terms of portfolio concentration, diversification and ability to follow these companies closely.

This is my checklist to buying a security.  All feedback/ comments are much appreciated….


Hedging inflation ….

For my first post (which has been a long time coming!), I thought I touch on the Australian stock market returns. We’ll look at whether returns from the ASX keep up with inflation (inflation adjusted returns – which are not frequently cited) and what portion of returns is made up by dividends. I’ve used the ASX All Ordinaries index as a proxy for stock market returns.

Investment returns can be measured in many ways but the ones I like are CAGR (compounded average growth rate) and IRR (internal rate of return). As these returns are calculated on an annualised basis, it makes relative comparisons a whole lot easier. CAGR is good for measuring returns when the investment transaction is a straight forward buy and sell with no interim transactions during the holding period; whereas the IRR is more flexible as it can accommodate other interim transactions during the holding period such as dividends, rights issue etc.

I have charted the long term returns for the ASX All Ordinaries index over a 79 year period from December 1935 to December 2014 on an inflation adjusted basis (real basis – index based on December 2014 dollars).

ASX long runThe CAGR for the above period on a real basis is 0.9%. Before you say that can’t be right, bear in mind that this is just the returns solely based on the price action. To give a sense of the returns based on a nominal basis (i.e. not adjusted for inflation), the nominal returns over the same period was 5.9%. Although inflation eroded approximately 5% of returns, returns from stock prices alone was able to keep up with inflation and produce a real return of close to 1%.

The next natural question would be what if we included dividends, how much more would it add to the returns? This can easily be done by looking at the All Ordinary accumulation index, which is a total shareholder return index assuming that all dividends are reinvested. However, data only exist for the All Ordinaries Accumulation index from 1979.  The chart below compares the price return and the total return indices on a real basis.

ASX AccumulationAs seen above, dividends make up a large portion of returns, how much you ask? Well without dividends the real returns over the above period were 2.7% (price index), whilst the total return including dividends was 7.0% (accumulation index). Based on the above period, dividends accounted for a whopping 4.3% of the overall returns.

So the takeaways from this analysis are:

  • Solely based on the price action alone, returns from the stock market over a 79 year period to December 2014 was able to produce a 1% real return and over a shorter period (35 years to December 2014), the real return based on movement in stock prices was 2.7%.
  • Dividends (reinvested) make up a significant portion of returns. Over a 35 year period to 2014, dividends (reinvested) made up 4.3% of real returns out of the total returns of 7.0%.
  • This suggests that in the long run the stock market is a good hedge for inflation and don’t forget to reinvest those dividends !