Qantas: Crash Landing

I’ve been recently looking through large cap, consumer exposed companies based in Australia to express my general bearishness on the Australian economy. The core traits that I’m looking for are large debt loads, higher ticket sales items and exposure to middle class spending. While a few companies look interesting, the company that clearly ticks all these boxes and more is QANTAS ($ASX:QAN).

The Macro

I’ll begin by looking at the broader macro picture in Australia, and why I’m significantly bearish on the Australian consumer. For those who aren’t aware, a core feature of our economy is a significant dependance on the housing market with one of the highest household debt to GDP ratios in the world. More importantly unlike places like the US, a large proportion of our mortgage debt is variable rate or short term fixed rate. We have already started seeing these impacts in spending, with goods spending down around 2% ytd when adjusted for inflation, however we almost certainly haven’t seen the worst. According to the RBA (Reserve Bank of Australia) almost 40% of outstanding mortgages are fixed as buyers rushed to fix them at low rates during the pandemic. This amounts to around $350m of mortgages, of which a third will roll over into variable rate within the June and September quarters (with the rest coming over the next year and a half). For the households involved this will lead to an almost doubling of interest payments and a large reduction in spending power on top of the many who are already doing it tough.

Furthermore, I would argue that the likelihood of rate cuts are low with services inflation remaining persistent within Australia. By most metrics, inflation is only just starting to tick over the peak and governor Phillip Low has consistently been fairly hawkish in his rhetoric. The Australian consumer is already doing it tough. ABS data shows consumer spending is down in real terms and corporate insolvencies are rising significantly according to ASIC. Many Australian consumer exposed retailers are releasing profit downgrades such as Baby Bunting, Adairs and Dominoes. Anecdotally, cost of living has become a huge concern all over the income spectrum and many businesses are experiencing down periods. The Australian consumer is struggling, and it’s only going to get worse in the short term. The only question is how to play it?

The Core Thesis

Qantas is Australia’s largest and oldest airline with a fleet size of 124 aircraft. After receiving a $2.3b bailout from the Government during Covid the airline managed to make it through covid and is now trading a bit off all time highs, being a significant beneficiary of the Covid recovery that has seen demand for flights significantly outstrip supply. At a 4 TEV/Run-rate EBIT multiple the shares look cheap if demand keeps up and the company has expressed its confidence by buying back around $500m worth of shares in the past year. However, underneath the hood I believe there are reasons for concern around the short term outlook for the company.

The core of the thesis comes down to the durability of current demand. As outlined above there is reason to believe that the Australian consumer will likely come under significant pressure coming into the second half of 2023. I’m firmly of the opinion that big ticket items such as airline travel (which has remained somewhat resilient so far) will drop off as the Australian middle class hunkers down to preserve their mortgages. While consumers have been under pressure for a while now, this pressure wouldn’t show up in flight data or financials with a combination of data delays (people purchase flights well in advance of when they take them) combined with supercharged reopening demand. The current demand picture is 6 months to a year old and not reflective of recent rate hikes, nor the looming mortgage cliff that hits in the coming months.

The issue for Qantas is that naturally airlines are expanding their capacity to meet the growing demand, Qantas themselves included. Furthermore, Qantas has one of the oldest fleets in Australia and is spending to not only expand their fleet, but replenish their old aircraft too. This renewal is expected to cost between $13-15b over the next 5 years and will see $3.2b in capex for FY2024, a sizable increase from their $600m trailing capex and $800m depreciation cost. I believe that this may be a classic cyclical case of expanding supply at a cyclical peak right as demand drops off.

Part of the reason why this is an issue for Qantas is because of how their revenue is recognised. While cash payments are made when customers book, the revenue isn’t recognised until much later when the traveller actually makes their trip leaving a large unearned revenue liability on their balance sheet. This means that Qantas has already received the cash for the large influx of passengers that they are, and will continue to see over the next year. Qantas will continue to put up strong revenue numbers for at least the next 6 months as that unearned revenue flows through, however this won’t be translating to cash coming into the business. Currently unearned revenues are approximately $2B higher than they have been historically due to high demand and lack of supply forcing people to book aggressively. These pressures will likely subside as airline fleets expand and economic pressures dampen demand. The important thing to note here is that as an airline, Qantas has high fixed costs for and has benefited greatly from operating leverage in the past 6 months. In a slowdown however, moderate decreases in revenue and margins will hit their bottom line hard. 

Additionally, it’s hard to see how margins stay as high as they currently are. Qantas has been accused by both consumers and other airlines of price gouging, a practice that has only been possible due to increased levels of demand. In the last half their operating margins were 15%, almost double historical levels. They have been able to achieve this by neglecting reinvestment in the company as at the same time as customer complaints have increased 70% for the airline due to issues such as lack of staff, flight cancellations and overbooking. In a scenario where their margins revert back to historical levels their EBIT halves, putting them at a much less scary 8 TEV/EBIT multiple without factoring in slowdowns in volume. From there even a small slowdown in volume has the potential to push them back into unprofitability. With competitors such as Rex, Virgin and new entrant Bonza aggressively reinvesting, Qantas is at risk of losing market share as public perception of their quality continues to decrease while competitors undercut their pricing. Qantas thrives off being seen as the premium brand, but what happens as that perception begins to erode?

Bonus

While the macro outlook and finances are the core of the thesis, there’s various other factors that add to the attractiveness of the short. To start, the company is buying back shares aggressively. While share buybacks can be an effective tool for creating shareholder value, they can also destroy it if timed poorly. If my broader thesis is correct then they are just hurting their capital structure and weakening their liquidity position while purchasing overvalued shares.

Australian investors are a picky bunch. Due to our imputation tax credit system, dividends are a huge aspect of Australian investing culture. Between a decrease in profitability and increased capex demand over the next 5 years it’s difficult to see Qantas reinitiating their dividend. While for investors like you and me a company's ability to pay a dividend probably doesn’t heavily impact our decision to invest in it, for many Australian investors it does. If Qantas keeps their dividend shelved we could potentially see an adverse reaction from their investor base.

Another factor is public sentiment, which feels like it is at all time lows for Qantas at the moment. After receiving a huge, free bailout from the Australian tax payer and firing their entire ground staff during Covid Qantas proceeded to repurchase shares this year while gouging prices at the same time as service and customer experience has taken a significant downturn. Anecdotally, I know a staff member who is frustrated by the culture throughout the company, the treatment of workers and the decline in the quality of the workforce throughout the company, especially amongst the outsourced workers. This is supported by their employer rating on Indeed which has fallen drastically in the past 5 years. While the Australian consumer has had no other choice in the past year due to lack of supply, competition has an opportunity to steal serious market share from Qantas in the next few years as customers potentially look for more favourable options. I think there’s even the possibility of regulatory intervention here with many calls for regulators to address the anti-competitive practices of Qantas and Virgin with regards to hoarding airport space.

Finally, in May controversial CEO Alan Joyce announced he would be resigning in November this year. His last few years saw him as a divisive figure both outside and inside the company and he has been described as “leaving a financial mess for the next CEO”. Furthermore, on his way out the door Joyce managed to dump $17m of his $18m Qantas stake into the recent buyback, a nice bit of exit liquidity. This is a lovely show of confidence from the CEO and gives us a little bit of confidence we are investing alongside management. The drama behind the scenes at Qantas seems messy at the moment, a terrible state to be in going into a big rebuild and tough economic times.

Risks and How I’m Playing It

There are two core risks as I see it. The first risk is that consumer spending remains strong, or at least stronger than I expect. Qantas isn’t trading at a crazy valuation so if spending remains fairly robust this short likely won’t work out. This risk should be straightforward to manage by watching the real time data and looking for either confirmations or lack there of for the thesis. The second risk is that the valuation just remains dislocated. This is a big concern in the Australian market as the constant inflow of capital through superannuation seems to keep the Aussie mid to large cap space permanently expensive. My hope for this is that we will see earnings disappointments along with liquidity concerns that I believe will provide a catalyst for selling. Additionally, while it’s not core to my thesis I do see some potential for mortgage related forced selling of stocks as investors prioritise their mortgages above all else.

Currently I’ve gone short the equity for Qantas in modest size (around 3%). This makes it my largest short position, which I’m willing to do due to cheap borrow and a lack of squeeze potential. If I see signs of my thesis being confirmed with no reaction in the business I will likely double my position size and possibly even use options as there are short term catalysts here. If the economy remains strong in 6 months time I will likely close the position. Obviously the upside to this position isn’t as high as many other ideas I have, but it’s uncorrelated with lower risk and is also just an interesting idea to me. For Australian long/short investors looking to hedge Australian economic exposure I think this would be a good way to do that.  As always I appreciate any thoughts or criticism of this idea and hope you’ve enjoyed.