CORPORATE FINANCE CORPORATE FINANCE J.D. Han King’s College, UWO.
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Transcript of 7905AFE Corporate Finance Learning Case Study Exemplar #1.pdf
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7905AFE Corporate
Finance Learning CaseStudyQANTAS
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Table of Contents
Executive Summary ................................................................................................................................. 4
Purpose ............................................................................................................................................... 4
Company Overview ............................................................................................................................. 4
Recommendation ................................................................................................................................ 5
Findings ................................................................................................................................................... 6
Corporate Governance........................................................................................................................ 6
Group Chief Executive Officer ......................................................................................................... 6
Board of Directors ........................................................................................................................... 8
Bondholders .................................................................................................................................. 10
Financial Market Considerations .................................................................................................. 10
Societal Constraints ...................................................................................................................... 12
Risk & Return .................................................................................................................................... 13
Historical Risk Parameters (Top down Beta)................................................................................. 13
Divisional Betas (Bottom up Beta) ................................................................................................ 15
Choosing the Appropriate Beta .................................................................................................... 16
Default Risk & Cost of Debt ........................................................................................................... 16
Cost of Capital ............................................................................................................................... 16
Earnings & Cash Flow ........................................................................................................................ 17
Existing Investments ..................................................................................................................... 17
Competitive Strengths .................................................................................................................. 17
Financing Sources ............................................................................................................................. 18
Current Financing .......................................................................................................................... 18
Debt versus Equity ........................................................................................................................ 19
Costs of Debt ................................................................................................................................. 19
Dividend Policy .................................................................................................................................. 21
Dividend Policy .............................................................................................................................. 21
Firm Characteristics ...................................................................................................................... 21
Discussion.............................................................................................................................................. 22
Summary & Recommendation .............................................................................................................. 26
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Appendix ............................................................................................................................................... 28
Qantas Historical Share Price Performance .................................................................................. 28
Qantas Historical Stock Trade Volumes ........................................................................................ 28
Bibliography .......................................................................................................................................... 29
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Executive Summary
Purpose
The purpose of this case study is to undertake a financial analysis of Qantas based on previous
results and future expected results in order to determine if it is a worthwhile investment prospect.
The framework used will analyse various aspects of the Qantas business and present findings and
make recommendations on weather or not current operations are maximising firm value and would
deliver a positive result for a potential investor.
Company Overview
Qantas was founded in the Queensland outback in 1920 and has grown to be Australias largest
domestic and international airline and widely regarded in the aviation industry as the leading long
distance airline. Qantas is one of Australias most recognisable and respected brands despite recent
union activities which forced a complete stoppage of operations across the globe due to an
industrial dispute. Qantas has built a reputation for excellence in safety, operational reliability,
engineering and maintenance and customer service. (AR, 2012, 2011, 2010, 2009)
Qantas main business is the transportation of passengers through the use of two complimentary
airline brands:
1. Qantas2. JetStar
Qantas also has number of subsidiary businesses which operate under the Qantas Group banner and
these include:
1. Q Catering2. Qantas Freight3. Qantas Frequent Flyer4. QantasLink5. Qantas Holidays6. Express Ground Handling7. Qantas Defence Services
The Qantas group has a diversified product offering delivered through a number of iconic brands.
The group employs approximately 35,700 people with 93% of those jobs being housed in Australia.
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The Qantas Group is currently implementing a strategy to build a stronger firm for its people, its
customer and its shareholders and this will be achieved by a series of transformation programs with
the following key themes:
1. Reducing debt and improving the balance sheet by cost savings through businessimprovement programs.
2. Divisional restructure to provide focus for each of its brands with dedicated CEOs.3. Sell off of assets to reduce debt and improve the balance sheet.
Recommendation
The purpose of this case study was to undertake analysis based on recent results and current
business plans to make a recommendation as to Qantas suitability as an investment prospect for
potential investors. Based on the findings of this case study it is the recommendation that this is nota suitable stock for potential investors for the following reasons:
The Qantas stock price has fallen 64% over the past 4 financial years and current signs dontindicate a short to medium term recovery.
Qantas is a heavily levered firm with a current debt equity ratio of 1.27; this coupled withinadequate free cash flows to reduce current debt is extremely concerning. Despite this the
management team are currently implementing a strategy to reduce debt but this case study
has uncovered that free cash flows are insufficient to execute on this plan so asset sales will
be required to delivery this result.
Downgraded credit rating has increased the cost of debt and therefore Qantas ability toinvest in new projects in an attempt to generate new cash flows.
Cost of capital is prohibitively high. Revenues have been stable but without the ability to invest in new projects delivering new
cash flows revenue is unlikely to improve.
Current investments are underperforming and this can likely be attributed to spirallingoperational costs due to increased price of aviation fuel that were not factored into project
estimates. This underperformance is likely to continue.
A dividend has not been paid for the past 3 financial years and it is a common belief amongstanalysts that this is likely to continue.
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Findings
Corporate Governance
Group Chief Executive Officer
The Qantas Group is an Australian Stock Exchange listed company and as such must adhere to strict
corporate governance frameworks.
The Chief Executive officer of the Qantas Group is Alan Joyce. Mr Joyce was appointed as CEO of the
Qantas Group in November of 2008 after previously holding the position of CEO of Jetstar from 2003
to 2008. Prior to that Mr Joyce has held senior leadership positions for the previous 15 years at bothQantas and Ansett as well as Irelands national airline Aer Lingus. Mr Joyce has extensive experience
in both the Australian domestic airline industry as well as the international airline industry and has
management experience across the full breadth of the industry including network planning, schedule
planning, fleet planning, sales, marketing, IT and revenue management.
CEO Remuneration
The below table represent the CEOs statutory remuneration over the past 4 financial years:
FY 2012
$000
FY 2011
$000
FY 2010
$000
FY 2009
$000
Base Pay 2,109 2,045 1,842 1,825
Short Term Incentive 2,163 2,049 964 1,253
Long Term Incentive 1,134 542 49 529
Performance Share Plan n/a 125 n/a n/a
Other 171 247 69 57
Total 5,577 5,008 2,924 3,664
Table 1: CEO Remuneration at 30 June 2012 (AR, 2012, 2011, 2010, 2009)
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CEO Company Equity
The below graph represents the interests in the issued capital of Qantas for Mr Alan Joyce:
Figure 1: CEO Stock Volumes at 30 June 2012 (AR, 2012, 2011, 2010, 2009)
The below table represents the future options and rights awarded to Mr Alan Joyce:
FY 2012 FY 2011 FY 2010 FY 2009
Deferred shares held in trust 375,014 1,753,863 2,336,863 1,170,863
Rights granted 2,759,000 1,455,070 626,350 383,750
Total 3,134,014 3,208,933 2,963,213 1,554,613
Table 2: CEO deferred shares and rights granted at 30 June 2012 (AR, 2012, 2011, 2010, 2009)
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Board of Directors
The below table represents the members of the Qantas Group board and important information as at 30 June 2012:
Director Year of Appointment Inside Director Other DirectorshipsCEO of other
organisations
Stock Holdings at
30 June 2012
Leigh Clifford (Chairman) 2007 No Barclays Bank plc No 251,622
Peter Cosgrove 2005 No Cardno Limited No 34,565
Patricia Cross 2004 No
National Australia Bank
No 30,474
Wesfarmers Ltd
Richard Goodmanson 2008 No
Rio Tinto Limited
No 20,000
Rio Tinto plc
Gary Hounsell 2005 No
DuluxGroup Limited
No 80,000
PanAust Limited
NuFarm Limited
Orica Limited
Mitchell Communication Group Limited
William Meaney 2012 No - No -
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Corinne Namblard 2011 No Codan Limited No -
Paul Rayner 2008 No
Treasury Wines Estates Limited
No 71,622Boral Limited
Centrica plc
John Schubert 2000 No
BHP Billiton plc
No 103,103BHP Billiton Limited
Commonwealth Bank of Australia
James Strong 2006 No
Kathmandu Holdings Pty Ltd
No 30,670
Woolworths Limited
IAG Finance (NZ) Limited
Insurance Australia Group Limited
Barbara Ward 2008 No
Brookfield Funds Management Limited
No 47,597Brookfield Capital Management Limited
Lion Nathan Limited
Alan Joyce 2008 Yes - No 2,531,188
Table 3: Board Member Information at 30 June 2012 (AR, 2012, 2011, 2010, 2009)
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Bondholders
The Qantas Group does not have any publically traded debt and the vast majority of debt both
current and non current is in the form of secured and unsecured bank loans as well as lease and hire
purchase liabilities. These interest bearing liabilities relate to specific financings of aircraft and
engines and are secured by the aircraft to which they relate to.
Financial Market Considerations
The Qantas group is owned by four (4) main institutional investors that own approximately 70% of
the stock. These shareholders are listed below
Shareholder Name Commonly Known NamePercentage Ownership at
30 June 2011
JP Morgan Nominees (Australia) JP Morgan 28.88%
HSBC Custody Nominees
(Australia) LimitedHSBC Bank 19.09%
National Nominees LimitedNational Australia Bank
(NAB) 13.41%
Citicorp Nominees Pty Limited Citibank 11.11%
Table 4: Qantas major shareholders at 30 June 2012 (AR, 2012, 2011, 2010, 2009)
The below table represents key market information for Qantas stock listed on the Australian Stock
Exchange (ASX) as at 2 October 2012:
ASX Market Capitalisation Approx $2.7 Billion
Share Price (close 02/10/12) $1.22
Total number of shares on market Approx 2.21 Billion
Average 3 month traded volume (daily) 9,043,300 (0.43%)
Table 5: Key market information at 02 October 2012 (Yahoo, 2012)
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The following analysts are known to cover the Qantas Group:
Firm Analyst
Citi Shavarsh Bedrossian
CLSA Robert Bruce
Commonwealth Bank Matthew Crowe
Credit Suisse Anthony Moulder
Deutsche Bank Cameron McDonald
Goldman Sachs JBWere Andrew Gibson
JP Morgan Scott Carroll
Macquarie Russell Shaw
Merrill Lynch Matt Spence
Moelis & Company Simon Fitzgerald
Morgan Stanley Scott Kelly
Nomura David Fraser
RBS Mark Williams
UBS Simon Mitchell
Table 6: Analysts following Qantas at 30 June 2012 (AR, 2012, 2011, 2010, 2009)
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Societal Constraints
The Qantas Group operates in an industry that is considered by many as one of the largest polluters
in the world and as such Qantas are mindful of their social responsibility and manage this through
various programs. The Qantas Group strives to operate in a sustainable manner by continuallyimproving its economic, social and financial performance. It does this by focusing on 6 key
sustainability categories as outlined below:
Sustainability Measure
Governance Corporate governance statement
Environment
Aviation fuel and carbon emissions
Electricity
Water
Waste
Social
Customer Domestic on-time performance
People
Occupational health & safety
Absenteeism
Diversity
Community
National export revenue
Domestic traveller expenditure
Economic output
Economic Underlying profit before tax
Table 7: Qantas sustainability model (AR, 2012, 2011, 2010, 2009)
The Qantas group has over many years worked tirelessly on the sustainability model outlined above
and as such have a positive reputation as a good corporate citizen.
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Risk & Return
Historical Risk Parameters (Top down Beta)
The below table represents the summary output of the regression of returns for Qantas against the
ASX 200 for FY2009 FY2012:
Regression Statistics
R Square 0.530636092
Adjusted R Square 0.520432528
Standard Error 0.082458379
Observations 48
Intercept of regression -0.011353944
Slope of regression (95% accurate) 1.793914271
Estimated range of risk 1.293187899 To 2.294640644
Average Commonwealth bond rate for regression period (ReserveBank of Australia, 2012)
4.93%
Jensens intercept 0.0278%
Market Risk 52.04%
Firm Specific Risk 47.96%
Annualised annual excess returns 0.33%
Table 8: Regression output FY09 FY12
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The below graph in a visual representation of the Qantas performance against the ASX 200 for FY09 to FY12:
Figure 2: Qantas performance versus ASX200 FY09 - FY12 (regression)
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Divisional Betas (Bottom up Beta)
The below table represents the bottom up beta analysis conducted on the Qantas group:
Division Group1Revenue
FY12 ($M)Weightings2
Divisional
Business
Beta
Levered
Divisional
Beta3
Average Debt
Equity Ratio FY09
FY124
Unlevered (asset)
Business Beta
Levered
Business Beta
Qantas
Passenger 12,494 79.45% 0.82 1.42
1.045 1.03 1.79
JetStar
Qantas FF
Qantas
FreightFreight 784 5% 0.05 0.09
Other
business
Other 2,446 15.55% 0.16 0.28Corporate
Eliminations
Table 9: Qantas beta analysis
1
Similar divisions were grouped together for ease of calculation and representation of analysis results.2
The aggregated group revenue was used to establish divisional or group weightings.3A company tax rate of 30% was used in all calculations.
4An average debt equity ratio was derived from taking an average of ratios from FY09 to FY12.
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Choosing the Appropriate Beta
It is more appropriate to utilise the bottom up derived beta and the reasoning for this decision is
elaborated further in the discussion section of the report. Below represents the expected return on
equity investment for the Qantas Group:
Expected Return on Equity Investment56 17.46%
Table 10: Qantas required rate of return
Default Risk & Cost of Debt
The below table represents Qantas current Standard and Poors credit rating and associated data:
Rating Type Rating Date of Rating Default Spread Interest Rate7
Foreign Long Term BBB- 07-Sep-2012 2.5% 7.43%
Foreign Short Term A-3 07-Sep-2012 1.65% 6.58%
Local Long Term BBB- 07-Sep-2012 2.5% 7.43%
Local Short Term A-3 07-Sep-2012 1.65% 6.58%
Table 11: Qantas S&P credit rating at 07 September 2012 (Capital IQ, 2012), (New York University, 2012)
Cost of Capital
The below table represents Qantas current cost of capital structure:
Debt Equity Capital
Weightings8 56% 54% n/a
Cost 7.43%9 17.46% 38.90%10
Market Value11
$1.512B $1.188B n/a
Table 12: Qantas capital structure
5Long run market risk premium of 7% has been used.
6Risk free rate of 4.93% used which is representative of 5 year average Commonwealth bond rate for FY09-12.
7Risk free rate of 4.93% was used in interest calculation which is spread plus the risk free rate.
8Debt equity ratio figures used as at 30 June 2012.
9
Foreign long term interest rate used for cost of debt.10 Company tax rate of 30% was used in cost of capital calculation.11
Market capitalisation of $2.7B as at 02 October 2012.
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Earnings & Cash Flow
Existing Investments
A concrete accounting return figure for the firm was unable to be identified so in the absence of this
key metric in order to determine the benefit being extracted as a result of current existing
investments an earnings/share (after tax) metric will be discussed. For the 2012 financial year the
Qantas Group made a 10.8 cent loss/share compared with an 11 cent profit per share the year
before.
Competitive Strengths
Qantas is the largest domestic carrier in Australia and its main competitor is Virgin Australia. Virgin
Australia has over recent years reinvented itself to compete directly with Qantas in the key business
segment of the domestic travel market. Whilst Qantas continues to hold market share over Virgin
Australia it now needs to think of innovative ways to ensure further market share is not lost and gain
back some of its losses. This is going to be difficult for Qantas considering it has existing high levels
of debt, a downgraded credit rating and a high internal rate of return. Qantas has however made
structural changes to its business in order for it to compete better with its competitors in the
differing segments of the market that it operates in by appointing divisional CEOs. The Qantas brand
name is unmistakeable and will always hold a special place in the heart of Australias and thiscoupled with its unrivalled safety record are key strengths that management must exploit in order to
improve performance in the domestic travel market. Reputation and brand identity are hard things
for competitors to imitate in order to achieve a similar competitive advantage and Qantas
management need to use these to their full advantage.
In the international travel market Qantas has many competitors and this division of the business has
been struggling for some time and continually returning operating losses due to a decline in
passenger numbers and increased operating costs, namely aviation fuel. As in the domestic market
Qantas biggest strengths are its brand awareness, reputation and safety record and it needs to
exploit these strengths further in order to turn the results around for this division. The currentoperating model is not sustainable for the Qantas international travel division and as such changes
are already being implemented like the well publicised arrangement done with Emirates to run code
share flights in an attempt to reduce cost for both airlines. Singapore Airlines and Etihad are also
aggressively targeting the Australian international traveller as more and more Australians look to
travel overseas due to a continuing strong Australian dollar. Similarly to the domestic market
reputation, brand identity and good safety record are hard things for competitors to imitate.
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Financing Sources
Current Financing
The Qantas Group is a publically traded company and when it is required to raise equity it does so bycommon stock offerings. In recent times Qantas has only undertaken one capital raising exercise and
this was in February of 2009 where the Group raised $514 million in equity via an institutional
placement as well as a share placement offering to existing stock holders. This capital raising
exercise was completed successfully and was utilised to strengthen the balance sheet of the group
by reducing debt in response to the global financial crisis of 2008. In the recent months in response
to Qantas poor FY12 result it has been rumoured that a capital raising exercise is imminent but this
has been categorically denied by the Group CEO and Chairman of the Board both reiterating the
strong cash reserves as well as the ability to pull other levers in order to combat the challenging
conditions of the airline business are its alternatives.
The Qantas Group is a substantial borrower of money and this is due to the nature of the airline
business and the huge expenses associated with the purchase of new aircraft. The Groups primary
source of debt is in the form of secured and unsecured bank loans. The below table represents the
current debt position of the Qantas Group as at 30 June 2012:
Debt & Gearing Analysis $M
Net Debt including off balance sheet debt 7,544
Equity (Excluding Hedge Reserves) 5,848
Cash Reserves 3,398
Gearing Ratio 56:44
Table 13: Qantas debt position at 30 June 2012
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Debt versus Equity
The Qantas Group for taxation purposes is an Australian company and is therefore subject to the
standard marginal company tax rate of 30%. The group uses depreciation and amortisations as
primary drivers of reducing taxable income and minimising the amount of tax payable.
The below table represents the level of debt versus equity for the Qantas group over recent years:
FY 2012 FY 2011 FY 2010 FY 2009
Debt Levels ($M) 7,544 6,970 6,170 5,696
Equity ($M) 5,848 6,071 5,896 5,794
Gearing Ratio 56:44 53:47 51:59 50:50
Table 14: Qantas debt and equity positions FY09 FY12
The Qantas group does not have high free cash flows to service debt as illustrated in the table
below:
FY 2012 FY 2011 FY 2010 FY 2009
Free Cash Flows ($M) (472) (696) (294) (14)
Table 15: Qantas free cash flows FY09 - FY12
Debt is a necessity for the Qantas group due to the extremely high costs of purchasing new aircraft
and maintaining one of the lowest average age of aircraft fleets in the world. However as illustrated
in the table above Qantas ability to reduce debt has been significantly reduced in recent years but it
is the current strategy of the groups executive team to improve the firms balance sheet and
liquidity levels by actively reducing debt and this has resulted in the delaying of several deliveries of
new aircrafts.
Costs of Debt
The below table represents the cash flows (revenue) of the Qantas Group:
FY 2012 FY 2011 FY 2010 FY 2009
Cash Flows ($M) 15,752 14,894 13,772 14,382
% Change 6% 8% (7%) n/a
Table 16: Qantas cash flows FY09 FY12 (revenue)
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The cash flows of the group are relatively stable which is a positive sign however in recent years debt
has continued to grow and equity has also but not at the same rate. Another concerning point to
note is the lack of free cash flows available to the group to reduce debt.
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Dividend Policy
Dividend Policy
The below table represents the dividends paid by the Qantas Group for the past 4 financial years as
well as the associated full year profit:
FY 2012 FY 2011 FY 2010 FY 2009
Interim dividend 0 cents 0 cents 0 cents 6 cents
Full Year Dividend 0 cents 0 cents 0 cents 17 cents
Special Dividend 0 cents 0 cents 0 cents 0 cents
Statutory Profit After Tax ($M) (244) 249 116 123
Table 17: Qantas dividend payments FY09 - FY12
The above dividend yields align with the capital management strategy that Qantas has employed
over the past few years which has been to strengthen the balance sheet where possible in an
attempt to maintain a high credit rating with the ability to access finance at a reasonable price.
Firm Characteristics
In the past few years Qantas has clearly conveyed its dividend policy to the market by having not
paid a dividend since 2009; this along with its desire to obtain and maintain an investment grade
credit rating it is unlikely that this policy will change. The marginal stockholders of the Qantas Group
are predominately mum and dad investors and considering the fact the Qantas stock is trading at
all time lows it would likely be their preference that a dividend payment be made if at all possible as
opposed to a stock buyback which would be the preference of the firm.
A key component to Qantas capital management strategy is to elevate its credit rating and by doing
this it can provide itself with surety around its future cost of debt as well as firm flexibility. It has
made a recent decision to avoid further immediate debt in order to strengthen its balance sheet in
order to improve its credit rating. Qantas clearly understands it future funding needs and this
centres solely on the purchase of new aircraft, this coupled with a solid understanding of its cost of
debt it makes the planning for future projects to be done with greater certainty not withstanding
further unforeseen increases in operating costs namely aviation fuel and labour costs.
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Discussion
Corporate Governance
After reviewing the corporate governance model implemented by the Qantas Group it would appear
that the chance of a principal agent conflict scenario arising would be low. All but a few of the board
members have significant personal stock holdings which illustrates that the current board will and
do represent and protect the best interests of shareholders. The executive group including the
Group CEO have significant personal stock holdings also which is healthy for shareholder interests as
whilst their primary role is management they also have a personal interest in the overall
performance of the company. The remuneration policy of the Qantas group also provides short term
and long term incentive schemes in the form of stock and options to the executive team which
ensures that share price improvement and shareholder maximisation is also important not only to
stockholders but also the management team.
There is no potential conflict between stockholders and lenders to the firm. The Qantas Group does
not publically trade debt on any debt market and all firm debt is in the form of secured or unsecured
bank loans. As such in the event of liquidation or wind up of the Qantas Group the debt holders
would be serviced first if assets were sold to settle outstanding debt and stockholders would only
receive a payout should the liquidation proceeds received be in excess to outstanding debt levels.
As the Qantas Group is a member of the Australian Stock Exchange (ASX) it is required to comply
with all ASX listing rules. The Qantas Group adhere to ASX guidelines with respect to any price
sensitive information and this is always fully and formally disclosed publically to the market via the
Australian Stock Exchange by the company secretary.
The Qantas Group puts a high value on ensuring it meets is social obligations and the primary way in
which the group makes its efforts visible is through a triple bottom line reporting methodology. The
Qantas Group also has several social programs running as well key society sponsorships that show its
commitment to not only maximising shareholder value but also ensuring it does so in a socially
responsible manner.
Risk & Return
A regression analysis was completed for the Qantas stock price versus the ASX200 for a four yearperiod including FY09 to FY12 and Qantas performance relative the ASX200 was slightly better with
0.33% annualised excess returns in comparison to the index for the period of regression. Qantas has
a high beta which indicates that it is a relatively riskier stock when compared with the risk free
return of Commonwealth bonds however the majority of Qantas risk throughout the regression
period can be attributed to market risk totalling 52.04%; while the firm risk attributable to Qantas is
47.96%. It is not unexpected that market risk would be high considering this period of regression was
when the global economy was in the depths of dealing with the GFC. Qantass estimated beta
obtained by the regression method is 1.79 which is high which equates to it being a high risk stock
with the potential for higher returns.
A bottom up beta was also obtained for Qantas with an unlevered or asset beta of 1.03 obtained anda levered beta of 1.79 which coincidently is the same beta obtained in the regression analysis.
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Normally the beta obtained via the bottom up method is a better estimate but in this case it does
not matter as the same result was obtained. Bottom up betas are traditionally more reliable because
it breaks the business into divisions and assesses the risk associated with each division and how they
contribute to the overall risk profile of the firm. Bottom up betas also take into account the current
mix of business of a firm where regression derived betas look at the historical mix and performance
of the business.
When utilising the beta calculated using the bottom up method an expected return on equity was
derived which was 17.46%. This is basically the breakeven point for any potential projects that
Qantas may take on and is the hurdle rate for projects. Put alternatively the cost of equity for Qantas
is 17.46% which is considered to be quite high.
Standard & Poors ratings agency has just recently downgraded Qantas credit rating and as a result
Qantas cost of debt has risen. Whilst this does not affect existing debt levels it does place strain on
future projects and their ability to achieve the high internal rate of return or hurdle rate required. In
the short term this will not affect Qantas a great deal as it has already shelved key projects in favour
of improving the balance sheet in order to improve its declining credit ratings. So whilst current debtis not affected and if Qantas refrains from borrowing further and focuses on reducing its current
debt levels it will be hoping for an improvement in its credit rating in order to make future projects
more viable and attractive.
Qantas debt levels are beginning to impact its ability to take on new projects to ensure that it
remains a world leader in the passenger airline industry. It is a heavily levered firm with a recent
lowered credit rating which has increased its cost of debt. This coupled with a high internal rate of
return results in an extremely high cost of capital. Due to its current debt level Qantas has no other
options but to stop new projects and improve its balance sheet in order to reduce current debt
levels in order to undertake new projects in the future that will deliver value to the firm and
shareholders.
Earnings & Cash Flow
During FY12 the Qantas group delivered a statutory loss of $244 million which equated to a 10.8c
loss/share. No economic value was added to the firm in the last financial year and current
investments did not meet the required hurdle rates to deliver value to equity holders. The quality of
the existing investments is poor and this can be attributed to the high levels of debt required in
order to execute on these investments. The poor performance of these investments can also be
attributed to dramatic increases in operating costs that were probably not foreseen at the time
current investments were planned and implemented. In the short term Qantas needs to focus on
improving its balance sheet in order to reduce its cost of capital so that it can begin to invest in new
projects again in order to deliver additional competitive advantages.
Although the quality of current investments is poor Qantas still has some key strengths available to it
for exploitation in order to turn its performance around. Qantas has a strong reputation, high level
of brand awareness amongst travellers and an impeccable safety rating that competitors will find
hard to imitate and hence delivering Qantas a key set of competitive advantages. Due to Qantas
recent poor earnings it will need to rely on these current competitive advantages to improve its
balance sheet before it is in a position to invest in new projects that will deliver it additional
competitive advantages and new cash flows.
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Financing Sources
As outlined previously the Qantas group has a simple model for sourcing finance and is
predominately through the use of secured and unsecured bank loans (debt) however in the past it
has used capital raising exercises through the issuance of stock (equity).
Qantas is reliant on debt in order to maintain its fleet as the lowest average age of fleet in the world
due to the costs associated with the purchase of new aircrafts. The use of debt allows the Qantas
Group to hold significant cash reserves on its balance sheet which is attractive to potential investors
because it shows the firm has good levels of liquidity. However the debt carried on the balance sheet
can also be detrimental to the firm and some issues that present themselves as a result of the
Qantas Groups debt are:
1. As outlined before the Qantas Groups free cash flows are not of a sufficient level to reducethe firms debt.
2. The high cost of servicing the debt is reliant on revenues remaining at or around currentlevels and with the overhang of the GFC and the ever rising cost of aviation fuel this could
potential impact top line revenue as the cost of flying increases and consumers continue to
watch their expenditure.
3. Mounting levels of debt without liquidity increasing in line may result in a furtherdowngrade in the firms credit rating which in turn would make the cost of new debt higher
and therefore place even greater strain on the group considering their low free cash flows.
The current strategy of the Qantas executive group and board is to improve the liquidity of the firm
by improving the cash reserves as well as attempting to reduce debt. They have made decisions todelay the delivery of new aircraft that were planned in the next 24 months in an attempt to not
increase current debt levels. The biggest concern with their current strategy is the lack of free cash
flows to reduce current debt levels to improve the balance sheet and there is a possibility the Qantas
Group may indeed undertake a capital raising exercise in order to raise equity and use it to reduce
current debt levels. This strategy also is void of new investment and projects and therefore no new
cash flows are expected.
Dividend Policy
The current dividend policy of the Qantas Group is nonexistent with a dividend not being paid since
2009 and there seems to be no indications that this will change in the immediate future. The
earnings over the past 4 years have not warranted the payment of a dividend. The executive have
adopted a capital management policy centred on guaranteeing the availability of debt at the best
possible price by attempting to improve Qantas credit rating and by also attempting to reduce
current debt levels. This policy however from a shareholders perspective is not maximising firm
value or indeed shareholder value and this coupled with a share price that is well below its book
value the Qantas Group does not present overly attractive to a potential investor. However in saying
that the current strategy being employed by the firm to exploit inherent underlying value in
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conjunction with its improving balance sheet strategy could result in uplift in share price and a
possible return of dividend payments or a share buyback. (Kelly, 2012)
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Summary & Recommendation
Summary
The below table summarises each of the key areas covered as part of the case study:
Area of Interest Summary
Corporate
Governance
The board consists of experienced individuals with shareholders interests as itmain priority.
The remuneration policy eliminates the potential for a principal agent conflict. Qantas is an ASX listed company that adheres to all ASX guidelines. The company is committed to delivering on its corporate social responsibilities
and discloses its actions and results via it triple bottom line reporting
methodology.
Risk & Return
Qantas has a high beta which means it is considered a risky firm to invest in; thishigh level of risk can be attributed almost equally to market and firm specific
risk.
The high internal rate of returns required makes new project viability difficult toachieve.
Qantas has a deteriorating credit rating thats forcing an increase in cost to newdebt.
Cost of capital is prohibitively high.
Earnings & Cash
Flow
Earnings have declined over recent years with a statutory loss of $244 millionachieved last financial year.
Current investments are not delivering the required internal rate of return. Qantas has 3 key competitive advantages and these must be exploited to their
full potential whilst Qantas rectifies its balance sheet issues; these are:
o High level of brand awarenesso Good reputation amongst travellerso Best safety record in the airline industry
Financing Sources
Qantas is a highly levered firm at approximately 56%. Free cash flows are insufficient to reduce current debt levels. New projects have been postponed and cancelled in order to reduce debt and
improve liquidity.
Asset sales are part of short term business plans to reduce debt.
Dividend Policy
No dividends have been paid since FY 2009. Likely to be a continuation of the current no dividend policy as Qantas tries to
reduce debt and improve its balance sheet.
If excess profits are available for dividend payments in the short to mediumterm it is likely a share buyback scheme would be preferred by the management
and board as opposed to a dividend payment.
Table 18: Case study summary
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Recommendation
The purpose of this case study was to undertake analysis based on recent results and current
business plans to make a recommendation as to Qantas suitability as an investment prospect for
potential investors. Based on the findings of this case study it is the recommendation that this is not
a suitable stock for potential investors for the following reasons:
The Qantas stock price has fallen 64% over the past 4 financial years and current signs dontindicate a short to medium term recovery.
Qantas is a heavily levered firm with a current debt equity ratio of 1.27; this coupled withinadequate free cash flows to reduce current debt is extremely concerning. Despite this the
management team are currently implementing a strategy to reduce debt but this case study
has uncovered that free cash flows are insufficient to execute on this plan so asset sales will
be required to delivery this result.
Downgraded credit rating has increased the cost of debt and therefore Qantas ability toinvest in new projects in an attempt to generate new cash flows.
Cost of capital is prohibitively high. Revenues have been stable but without the ability to invest in new projects delivering new
cash flows revenue is unlikely to improve.
Current investments are underperforming and this can likely be attributed to spirallingoperational costs due to increased price of aviation fuel that were not factored into project
estimates. This underperformance is likely to continue.
A dividend has not been paid for the past 3 financial years and it is a common belief amongstanalysts that this is likely to continue.
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Appendix
Qantas Historical Share Price Performance
Figure 3: Qantas stock price (historical) (Australian Stock Exchange, 2012)
Qantas Historical Stock Trade Volumes
Figure 4: Qantas stock traded volumes (historical) (Australian Stock Exchange, 2012)
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