The global financial turmoil coupled with the rising cost of fuel has dented profits in the global aviation industry. But low-cost airlines in the region are capitalising on robust demand and have ambitious expansion plans. While the outlook may not be very bright now, the fundamentals of these budget airlines make them good investments
While airline stocks may not qualify as the most attractive in this part of the world or even globally, the Middle East's two listed carriers — Air Arabia and Jazeera Airways — have managed to keep investors above ground.
Air Arabia
The first airline to be listed in the Middle East, Air Arabia pioneered the low-fare concept in the region. When it listed on the Dubai Financial Market at Dh1 a share in 2007, Air Arabia's IPO was considered the biggest in UAE history at the time. Air Arabia shares yesetrday traded 1.86 per cent higher at Dh0.603 on the Dubai market.
Commenting on the attractiveness of the stock for investors, Mohammad Kamal, director of equity research at Arqaam Capital, said: "Improvements in fuel costs and a significant overall increase in average fares across the industry have been positive for the company."
He added that from a medium-long-term perspective, the company's prospects hinge on the success of its growth strategy. This in turn is contingent on the success of its secondary hubs in Alexandria and Casablanca, and to a lesser degree, Jordan.
The Sharjah-based budget carrier currently operates out of the two other hubs in Egypt and Morocco, but plans for a Jordan hub succumbed to the Arab Spring.
With a fleet of 30 aircraft, Air Arabia has been successfully expanding its reach in the region and beyond to markets in Europe and Russia. It today flies to 74 destinations from its three hubs.
The carrier declared a net profit of Dh274 million for full year 2011, an 11 per cent decline from Dh309.6 million in 2010. Its shareholders approved the distribution of a six per cent cash dividend for 2011, higher than the earlier proposed 4.5 per cent payout by the company's board of directors. Its first quarter net profit was up 11 per cent to Dh49.2 million compared with the corresponding period last year.
Wild card
However, as fuel prices continue to be a wild card in 2012 with crude oil having hit $125 a barrel in the past couple of months, Air Arabia is expected to struggle to keep its stock afloat, according to Samir Murad, vice-president-research at NBK Capital.
"Stock performance in 2012 will be a bit of a challenge for Air Arabia as it will be feeling pressure from higher fuel prices and increasing competition in the UAE," he said.
He added that it remains to be seen whether Air Arabia will be able to enhance its yield to cover the impact of high fuel prices.
Financial services firm Arqaam Capital set in its March report an Air Arabia target price of Dh0.70 per share, with recommendation to ‘hold'. It stated that fuel costs could "materially deteriorate margins" for the budget carrier. "We believe the market is correctly valuing Air Arabia on the basis of low RoA [return on assets] and RoE [return on equity] relative to peers, on a P/BV [Price to Book Value] basis," the report stated.
The firm also forecast a 10-year 3.7 per cent CAGR (compounded annual growth rate) in RPK (revenue passenger kilometres) for Air Arabia, well below RPK growth for operated routes (6.2 per cent), and said it expects fare growth to move in line with the broader sector, producing a 10-year 7.0 per cent CAGR in revenues.
"Despite regional RPK growth expectations remaining high, we expect Air Arabia to concede a growing portion of its passengers to competitors," the firm said.
The carrier's market share loss is inevitable, according to the Arqaam Capital analysis. Asked about the scope for Air Arabia to achieve more market share in the region, Arqaam Capital's Kamal said that the incoming competition will limit market share gains in the long term as aggressive new entrants into the Mena LCC space aim to capitalise on the fact that passengers passing through Dubai are increasingly unlikely to transit via Sharjah on the basis of fare cost alone.
"We expect competitive pressure to arise from well-established LCCs (low-cost carriers) serving the Indian subcontinent, as well as regional carriers," he said.
He added that Air Arabia's expansion strategy appears contingent on the success of secondary hubs set up across Mena. "If successful, the model will create a regional footprint that capitalises on transit traffic linking Europe, Mena and Asia," Kamal pointed out.
Jazeera Airways
Jazeera Airways reported good financial results for fourth quarter 2011 despite the fact that the headline net income showed a 23 per cent decline from fourth quarter 2010 levels.
The Kuwait Stock Exchange-listed company last month announced a record net profit of 10.6 million Kuwaiti dinars (Dh139.9 million) for full year 2011, with an earnings per share of 0.048 fils, against a net loss of 2.8 million dinars in the previous year.
All in all, the low-cost carrier had a successful 2011. The FY2011 record net income came in with an even more impressive FY2011 EBITDA (earnings before interest, taxes, depreciation and amortisation) margin of 31.2 per cent.
Calling it an exceptionally high figure in the aviation industry, NBK Capital's March report on the airline stated: "From a full year results perspective, 2011 is the first full year following the company's turnaround plan in 2010 and displays a strong return to profitability.
"In 2009, Jazeera Airways was struggling with profitability. In 2010 it worked on a turnaround plan," Murad said, adding that if the company can sustain this profitability it will reflect positively on its share price.
Recommendation
Since the performance of Jazeera Airways was close to the financial services firm's forecasts, it stated that it does not expect to be making major changes to its fair value of 0.450 dinar per share, with recommendation on the stock as ‘hold'.
Asked how attractive the stock is from an investor's perspective, Murad told Gulf News: "I believe that the investor community can look forward to a profitable performance in the future."
2011 was a record-breaking year despite continued over-capacity, the impact of political unrest on travel within the airline's network and increasing fuel costs
Supporting the statement he added that Jazeera Airways is aiming to improve load factors and yield, and continue to operate to the 18 destinations it has in its network in order to enhance profitability. "That is what investors should keep in mind," said Murad. "Jazeera Airways has transformed over the last year into a company with very good financial performance."
Echoing similar thoughts is Raghu Mandagolathur, senior vice-president of research at the Kuwait Financial Centre (or Markaz).
He says: "Under the three-year Strategic Master Plan (STAMP) programme developed by Jazeera in 2011, the airline concentrates on keeping the company as a profit-making entity. Under the plan, Jazeera Airways will keep its 18 destinations while focusing on adding frequencies on profitable routes and increasing load factors."
The carrier has put on hold its expansion plans for the next three years.
Commenting on Jazeera Airways stock performance, Murad said that the share price went up approximately 270 per cent in 2011.
Meanwhile, so far this year, Jazeera Airways' stock has been relatively flat, says Murad. "It could start to go up again if the company proves to investors it can improve its bottom line, i.e., enhance profitability," he said.
According to the NBK Capital analysis, 2012 will see Jazeera Airways facing several challenges in 2012, ranging from the situation in Syria to rising fuel costs.
"In our opinion, the toughest challenge for Jazeera Airways would be for it to beat itself," said Murad.
"The company had a spectacular 2011, and we believe that a major catalyst for the stock would be growth in financial results in 2012. The company has outlined a disciplined growth strategy which we believe is best suited for Jazeera Airways."
Stock watch: Operational efficiency is key
Comparing the stocks of the only two listed airlines in the Middle East, Raghu Mandagolathur, senior vice-president of research at the Kuwait Financial Centre (or Markaz), says that while Air Arabia is purely a low-cost carrier (LLC), Jazeera Airways is not strictly a LCC as it has chosen to adopt some of the complexity of legacy carriers (business class, selling through travel agents, generous baggage allowance, and so on).
"With some of the world's largest airlines operating in the region, differentiation and operational efficiency will be key factors for these two airlines to succeed," he said, adding that "high oil prices could play spoilsport since these airline companies don't have the pricing power to pass on the full increase".
As for the upward potential of the two carriers, Jazeera Airways has delivered better returns than Air Arabia in the last few years, according to Mandagolathur. "While Jazeera Airways was up 267 per cent in 2011, Air Arabia lost 28 per cent," he pointed out. "But YTD (year to date), Air Arabia (+23 per cent) has gained more than Jazeera (+5 per cent). Both companies are still down from their 2008 highs — Air Arabia is down 67 per cent and Jazeera is down 11 per cent."
Mandagolathur said he sees little upside from current prices mainly on account of high oil prices and political unrest — "neither of which seems to be retreating anytime soon".
Jazeera Airways stands to have a better chance to gain market share than Air Arabia, according to Mandagolathur. He explained: "Jazeera already operates with a larger market share on most of its operating routes, giving it the much needed pricing power. Jazeera's smaller focus, absence of large profitable players with Kuwait as a hub should augur well for the company. Completion of the Jazeera Airways Terminal will enable the airline to gain market share due to less congestion and enhanced efficiency."
Meanwhile, with not many fleet additions coming due in the next three years for Jazeera Airways, Mandagolathur says he doesn't expect the airlione to add more routes like Sharjah's Air Arabia. "The only reason which can change this course of action is the continuing political disruption in the region which will reinforce the need to diversify income sources," he said.
Are aviation scrips worth it?
As an old adage goes: "How do you make a small fortune in the airline industry? Start with a large one."
Historically, airline stocks have been a poor investment, as the industry periodically loses all the money it has earned, and on aggregate is near break-even since its founding in 1920, says US-based aviation analyst Ernest S. Arvai, president and CEO of The Arvai Group.
"Aviation stocks in the Gulf region are dominated by state carriers, and with only two stocks listed for low-cost carriers the market does not provide as wide an opportunity for investment as other regions," he said, adding that nonetheless, opportunities for profitable investment exist, as airlines are cyclical with economic activity and typically display seasonal patterns that intelligent investors could take advantage of through trading.
Echoing Arvai's views is NBK Capital's Samir Murad who says: "Sadly, here [in the Middle East] most of the aviation stocks are government-owned."
Meanwhile, rising fuel costs will continue to be a burden for airlines, according to Markaz's Raghu Mandagolathur, especially for the listed low-cost players due to their limited pricing power. "Continuing capacity expansion by big players like Emirates and Etihad Airways will only add to the competitive pressure of smaller entities. At current prices, the stocks are not cheap, considering the external headwinds and uncertainty," he said.
Smart investors need to think through the basics of the model and the market, says Andrew Charlton of Geneva-based Aviation Advocacy. "The very successful airlines in the region are successful on a model that sees the Gulf as an entrepot rather than a huge generator of indigenous traffic. Low-cost carriers, on the other hand, require some other competitive advantage," he said.
