‘Under-promising’ Qantas likely to ‘over-deliver’ at full year

In the last two months, the share price of Qantas (ASX: QAN) Australia’s largest airline carrier has seriously unravelled having given up much of the 177% gains made over the previous year.

With Qantas now trading at late-February 2015 levels, the market is clearly concerned that too much of the recent measurable improvement in the underlying business has been attributed to cost cutting – notably cheaper fuel – with insufficient upgrades in its core business to sustain earnings.

The rapid and fairly brutal about-face in the fortunes of Qantas were the result of a trifecta of bad news, none the least of which was the return of the oil price again hitting US$50/barrel after falling below US$30/barrel mid-January.

Then there were revelations by Qantas’s management back in April that it was cutting back on domestic and international flights due to weaker than expected demand. Management is blaming much of the fall in demand frail consumer confidence in the lead up to a federal election.

In knee-jerk response, Brokers quickly downgraded their consensus forecasts for the airline’s full-year earnings by 9%, however they still expect it to deliver an underlying pretax profit of a record $1.6 billion.

It’s understood domestic flights booked for April and May were down between 8% and 15% respectively over the previous 12 months.

Thirdly, attempts to woo travellers with cheaper airfares – in response to cheap international airfares to and from Australia by competitors – has failed to entice travellers, which has forced it to cut capacity.

Ironically, while Qantas is still expected to post a profit after tax of more than $1 billion for the 2016 financial year, it’s currently trading at a whopping 60% discount to intrinsic value. Based on a 2016 price to earnings (P/E) multiple of 5.57 times, the stock does look decidedly cheap.

Admittedly, the stock does look more value-play than value-trap. However, what clearly spooks investors is too much uncertainty over issues the airline has no control over, especially oil prices.

Oil prices may never again be as good as they were in January when they price plunged to US26/barrel, however it’s equally unlikely that oil will stay above US$50/barrel for very long.

With the stock trading at a 42% discount to a high-end 12-month target price of $5.15, it’s easy to see why half of the 10 analysts covering the stock have either a buy or outperform on Qantas.

Admittedly, Qantas does have an investment grade credit rating, but due largely to its net-debt to equity that’s jumped to 77%, and long-term funding surplus of $1,19 billion, Qantas does not have an investment grade balance sheet.

But with the oil price unlikely to kick-up significantly any time soon, and with the exceptional earnings per share (EPS) it’s delivered over the last five years expected to continue; plus good return on equity (ROE) expected to continue improving – the stock does appear have been over-sold.

While EPS is expected to jump from $0.54 in 2016 to $0.64 by 2018, ROE jumped from 19.54% in 2015 to 32.22% in 2016, and is expected to remain above 30% by 2018.

Equally encouraging, having returned $1 billion to shareholders since August 2015, there’s growing speculation that despite the headwinds confronting it, Qantas could return more cash to shareholders within its full-year results in August.

Brokers are forecasting the airline to announce between $500 million and $950 million additional share buybacks in the 2017 financial year, followed by dividends at a 50% payout ratio from the 2018 financial year onwards.

But it’s important to note that Qantas only has enough franking credits for a 9¢ per share dividend at present because of tax losses reported when market conditions were tougher.

Assuming that Qantas can generate an average of $1.4 billion of free cash over the next three financial years after factoring in deliveries of Boeing 787-9 aircraft for Qantas and A320neos ordered by Jetstar, there’s no reason why you should be scared off entering the stock at current levels.

Watch closely for any macroeconomic problems likely to compound existing headwinds, and especially any earnings downgrades by Qantas management ahead of the full year announcement.