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AirAsia's new lease of life risks an erosion of income: Gadfly

Monday, November 28, 2016 - 09:34

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How do airlines make money? You might be tempted to answer, "by selling plane tickets". But it's rarely as simple as that. Take AirAsia Bhd, the Malaysian budget carrier that reported third-quarter results Thursday.

[SYDNEY] How do airlines make money?

You might be tempted to answer, "by selling plane tickets". But it's rarely as simple as that. Take AirAsia Bhd, the Malaysian budget carrier that reported third-quarter results Thursday.

It's become so dominant in South-east Asia that rivals have started ganging up on it. Yet you have to go back as far as Dec 2010 if you want to find a quarter when seat sales covered operating expenses. Costs have exceeded ticket revenue by an aggregate RM4.94 billion (S$1.57 billion) since then.

Perhaps it's all those outrageous baggage and other random fees where AirAsia's making its money? Not really. Adding in such charges certainly improves the picture, but still leaves the company posting losses in all but three quarters of the past five years.

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In fact, AirAsia only breaks even when you factor in passengers' spending on in-flight meals, duty-free, reserved seats, cancellations and other sundries. If you're looking to see where the serious money is made, you're better off regarding the entire enterprise not as an airline per se, but as an unusual segment of the aircraft-leasing business.

The way this works is relatively simple. AirAsia is the single largest airline customer of Airbus Group SE, with 575 planes ordered. Some 401 of them have yet to be delivered - the second-biggest outstanding request after India's InterGlobe Aviation Ltd, or Indigo - giving AirAsia huge bargaining power in negotiating prices and tailoring aircraft to meet its requirements.

All that makes for a rather neat source of additional revenue. Aircraft lessors such as General Electric Co's GECAS and BOC Aviation Ltd typically can't get the discounts that airlines can screw out of the big manufacturers, so whenever AirAsia feels it's got too many planes on its own balance sheet, it can sell them to a lessor, lease them back, and book the premium over its own purchase price as income.

Net out AirAsia's expenses on such operating leases against its income from selling its order book over the past few years, and you'll notice that even after all those charges for in-flight trays of Hainanese chicken rice, the company as a whole typically makes more money from selling and leasing aircraft than it does from flying them.

That makes plans by Group CEO Tony Fernandes to sell this golden goose rather unsettling. The unit could be separated as soon as December, he said earlier this year, and may fetch as much as US$1 billion.

There would be some definite benefits. Investors have often looked askance at AirAsia's leasing business, particularly because many of its sale-and-leasebacks have been not to lessors but to its own affiliates in Indonesia, Thailand, the Philippines and India.

AirAsia's stock shed more than half its value in less than three months last year after GMT Research issued a report criticising the accounting used in such deals, though it has since more than recovered what was lost and has more than doubled this year.

Putting the leasing unit at arm's length will both help Mr Fernandes pay down debt, and remove the shadow GMT's report cast. While AirAsia's return on equity of 26 per cent is close to its low-cost peers Ryanair Holdings Plc and Southwest Airlines Co, on 29 per cent and 30 per cent respectively, its blended forward 12-month price-earnings ratio of 6.88 is barely half their 12.48 times and 12.90 times valuations.

Leasing also looks a lot less attractive when considered in relation to the amount of capital that gets tied up in the business - a situation that will only worsen as international accounting standards for operating leases change.

Still, any sale won't come without risks. Investors who've become accustomed to the comfortable cushion provided by all those lease earnings will find the business has less to fall back on if times grow leaner.

AirAsia's profits have been relying more heavily on ancillary and baggage revenues in recent quarters in preparation for this change. The RM642 million of operating income from non-leasing businesses over the past three quarters is a larger sum than the RM614 million posted in the previous three years, showing the airline can run perfectly well without lease income. But that ultimately means driving up costs to customers, which will weaken AirAsia's ability to undercut its rivals.

In addition, the leverage AirAsia has had over Airbus will diminish. With an arm's-length leasing business, it'll just become one of half-a-dozen smaller customers again.

Being lean and transparent is all very well, but sometimes it's better to be powerful.

BLOOMBERG

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