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Is this as good as it gets for the ‘flying kangaroo’?

Is this as good as it gets for the ‘flying kangaroo’?

Warren Buffett is no fan of airlines as an investment. He once wrote that “if a far-sighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.”  And I doubt he would change his mind when it comes to investing in Qantas (ASX:QAN). Although on face value the Aussie carrier looks to be going gangbusters, the numbers tell a slightly different story.

Qantas has recently upgraded its profit forecast for the first half of 2023. Its underlying profit is now expected to be between $1.35 and $1.45 billion, which is $150 million higher than the company’s previous guidance.

And of course, the commentariat is wasting no time crowing about the upgrade, which is of course due in no small part to the exceptionally high airfares being charged. 

Qantas has noted, thanks in part to the higher profits, that its net debt will also fall between $2.3 billion and $2.5 billion by December 31, about $900 million more than previously guided.

Is an airline a great business to own?

The question of course is whether an airline is a great business to own. Of course, the shares have been on a tear and so it might be easy to conclude Qantas is a terrific business. Since the lows of $1.10 in late 2013 and early 2014, the shares have surged 438 per cent at the time of writing to $6.28, putting the company on a market value of $12 billion, marginally more than the $11.1 billion offered by private equity in 2007. 

Buying and selling, or ‘trading’ Qantas shares may indeed be lucrative but what about investing for the long-term? Back on 13 October this year (barely a month ago) Qantas’s share price was unchanged from its price in August 1999 – in other words, no capital appreciation in all that time.

And while I’d rather own a business whose value rises over the decades, many long-term investors may point out that Qantas dividends are another valid source of returns. So, let’s examine those and find out whether owning Qantas is a solid investment idea.

A look at the dividends

Since 2002 – two decades ago – Qantas has paid $3.5 billion in dividends. On the surface, it sounds acceptable. One note to make is that no net dividends have been paid between 2010 and 2017 inclusive, nor in 2021 or 2022. 

One should also investigate how these dividends were funded because the total profit generated (according to the balance sheet changes in equity) over the 20-year period is only $1.5 billion, a full $2 billion less than the dividends paid. And if the change from $1.1 billion of retained earnings in 2001, to an accumulated loss of $4 billion in 2022, is anything to go by, the company has lost $5.5 billion over twenty years, and the answer to the question of how dividends have been funded is even more curious.

Of course, one answer to how the dividends were possibly funded is obvious. The company has increased debt over the same period by $2.6 billion and raised a net $971 million in equity. If we can agree accounting profits for airlines are a construct aided by the ineffectiveness of the depreciation charge to accurately account for the real economic cost of running aircraft, which of course become more costly to replace as time passes, then we find the dividends over the last twenty years have been 27 per cent funded by capital raisings and 73 per cent funded by an increase in debt.

On one view therefore, in the absence of generous banks and altruistic shareholders willing to tip more money into the company, there’d be no ability to fund the dividends.

Over 20 years we find a business peddling flat-out to produce a revolving door of cash, raising money from banks and shareholders to fund distributions to those same shareholders. 

This year of course may indeed be one to celebrate.  A very large profit allows the poor long-term economics of owning an airline to be somewhat disguised. History however suggests the good years are relatively few and far between and given the share price is now on a near-term high in anticipation of a great year, investors should probably be more circumspect about the prospects of a generous long-term return from here.

INVEST WITH MONTGOMERY

Roger is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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4 Comments

  1. Anthony of Belfield
    :

    Dear Roger,
    Under the heading “A look at the dividends”, you mentioned that entities fund their dividends from other sources of finance such as debt and external sources.

    Suppose you see an entity funding its dividends from profits then subject to analysis you invest in that stock.

    After you invest, the entity decides to pay its dividends to shareholders out of loans or other external sources instead of out of the entity’s profits.

    Suppose that entity was Qantas in 2002.

    Leaving the shareprice rises in the intervening years aside, would you in 2002 invest in that entity and liquidate the stock when the entity starts to borrow or source funds from outside sources instead of profits?

    Thank you

      • Dear Roger,
        Thank you for the reply.

        In your answer could you elaborate please the other external sources of dividends other than debt please.

        And I ask the question: if an entity has been paying dividends from profits, then suddenly the BOD decide to fund dividends from external means, is it time to liquidate your shares.

        Many thanks and a Holy Christmas to all.

      • The other external source of funding for dividends is fresh equity through various possible capital-raising techniques. Regarding your second question, the short answer is no, not immediately. It depends on the circumstances. Franking credits, for example, have no value to the company and enormous value to some shareholders. A company may have amassed a large amount of undistributed franking credits, and a capital raising seeks to fund the distribution of those franking credits through dividends. ARB did something akin to this in 2015.

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