7905AFE Corporate Finance Learning Case Study Exemplar #1.pdf

7/27/2019 7905AFE Corporate Finance Learning Case Study Exemplar #1.pdf

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7905AFE Corporate

Finance Learning CaseStudyQANTAS


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Table of Contents

Executive Summary ................................................................................................................................. 4

Purpose ............................................................................................................................................... 4

Company Overview ............................................................................................................................. 4

Recommendation ................................................................................................................................ 5

Findings ................................................................................................................................................... 6

Corporate Governance........................................................................................................................ 6

Group Chief Executive Officer ......................................................................................................... 6

Board of Directors ........................................................................................................................... 8

Bondholders .................................................................................................................................. 10

Financial Market Considerations .................................................................................................. 10

Societal Constraints ...................................................................................................................... 12

Risk & Return .................................................................................................................................... 13

Historical Risk Parameters (Top down Beta)................................................................................. 13

Divisional Betas (Bottom up Beta) ................................................................................................ 15

Choosing the Appropriate Beta .................................................................................................... 16

Default Risk & Cost of Debt ........................................................................................................... 16

Cost of Capital ............................................................................................................................... 16

Earnings & Cash Flow ........................................................................................................................ 17

Existing Investments ..................................................................................................................... 17

Competitive Strengths .................................................................................................................. 17

Financing Sources ............................................................................................................................. 18

Current Financing .......................................................................................................................... 18

Debt versus Equity ........................................................................................................................ 19

Costs of Debt ................................................................................................................................. 19

Dividend Policy .................................................................................................................................. 21

Dividend Policy .............................................................................................................................. 21

Firm Characteristics ...................................................................................................................... 21

Discussion.............................................................................................................................................. 22

Summary & Recommendation .............................................................................................................. 26


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Appendix ............................................................................................................................................... 28

Qantas Historical Share Price Performance .................................................................................. 28

Qantas Historical Stock Trade Volumes ........................................................................................ 28

Bibliography .......................................................................................................................................... 29


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Executive Summary

Purpose

The purpose of this case study is to undertake a financial analysis of Qantas based on previous

results and future expected results in order to determine if it is a worthwhile investment prospect.

The framework used will analyse various aspects of the Qantas business and present findings and

make recommendations on weather or not current operations are maximising firm value and would

deliver a positive result for a potential investor.

Company Overview

Qantas was founded in the Queensland outback in 1920 and has grown to be Australias largest

domestic and international airline and widely regarded in the aviation industry as the leading long

distance airline. Qantas is one of Australias most recognisable and respected brands despite recent

union activities which forced a complete stoppage of operations across the globe due to an

industrial dispute. Qantas has built a reputation for excellence in safety, operational reliability,

engineering and maintenance and customer service. (AR, 2012, 2011, 2010, 2009)

Qantas main business is the transportation of passengers through the use of two complimentary

airline brands:

1. Qantas2. JetStar

Qantas also has number of subsidiary businesses which operate under the Qantas Group banner and

these include:

1. Q Catering2. Qantas Freight3. Qantas Frequent Flyer4. QantasLink5. Qantas Holidays6. Express Ground Handling7. Qantas Defence Services

The Qantas group has a diversified product offering delivered through a number of iconic brands.

The group employs approximately 35,700 people with 93% of those jobs being housed in Australia.


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The Qantas Group is currently implementing a strategy to build a stronger firm for its people, its

customer and its shareholders and this will be achieved by a series of transformation programs with

the following key themes:

1. Reducing debt and improving the balance sheet by cost savings through businessimprovement programs.

2. Divisional restructure to provide focus for each of its brands with dedicated CEOs.3. Sell off of assets to reduce debt and improve the balance sheet.

Recommendation

The purpose of this case study was to undertake analysis based on recent results and current

business plans to make a recommendation as to Qantas suitability as an investment prospect for

potential investors. Based on the findings of this case study it is the recommendation that this is nota suitable stock for potential investors for the following reasons:

The Qantas stock price has fallen 64% over the past 4 financial years and current signs dontindicate a short to medium term recovery.

Qantas is a heavily levered firm with a current debt equity ratio of 1.27; this coupled withinadequate free cash flows to reduce current debt is extremely concerning. Despite this the

management team are currently implementing a strategy to reduce debt but this case study

has uncovered that free cash flows are insufficient to execute on this plan so asset sales will

be required to delivery this result.

Downgraded credit rating has increased the cost of debt and therefore Qantas ability toinvest in new projects in an attempt to generate new cash flows.

Cost of capital is prohibitively high. Revenues have been stable but without the ability to invest in new projects delivering new

cash flows revenue is unlikely to improve.

Current investments are underperforming and this can likely be attributed to spirallingoperational costs due to increased price of aviation fuel that were not factored into project

estimates. This underperformance is likely to continue.

A dividend has not been paid for the past 3 financial years and it is a common belief amongstanalysts that this is likely to continue.


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Findings

Corporate Governance

Group Chief Executive Officer

The Qantas Group is an Australian Stock Exchange listed company and as such must adhere to strict

corporate governance frameworks.

The Chief Executive officer of the Qantas Group is Alan Joyce. Mr Joyce was appointed as CEO of the

Qantas Group in November of 2008 after previously holding the position of CEO of Jetstar from 2003

to 2008. Prior to that Mr Joyce has held senior leadership positions for the previous 15 years at bothQantas and Ansett as well as Irelands national airline Aer Lingus. Mr Joyce has extensive experience

in both the Australian domestic airline industry as well as the international airline industry and has

management experience across the full breadth of the industry including network planning, schedule

planning, fleet planning, sales, marketing, IT and revenue management.

CEO Remuneration

The below table represent the CEOs statutory remuneration over the past 4 financial years:

FY 2012

$000

FY 2011

$000

FY 2010

$000

FY 2009

$000

Base Pay 2,109 2,045 1,842 1,825

Short Term Incentive 2,163 2,049 964 1,253

Long Term Incentive 1,134 542 49 529

Performance Share Plan n/a 125 n/a n/a

Other 171 247 69 57

Total 5,577 5,008 2,924 3,664

Table 1: CEO Remuneration at 30 June 2012 (AR, 2012, 2011, 2010, 2009)


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CEO Company Equity

The below graph represents the interests in the issued capital of Qantas for Mr Alan Joyce:

Figure 1: CEO Stock Volumes at 30 June 2012 (AR, 2012, 2011, 2010, 2009)

The below table represents the future options and rights awarded to Mr Alan Joyce:

FY 2012 FY 2011 FY 2010 FY 2009

Deferred shares held in trust 375,014 1,753,863 2,336,863 1,170,863

Rights granted 2,759,000 1,455,070 626,350 383,750

Total 3,134,014 3,208,933 2,963,213 1,554,613

Table 2: CEO deferred shares and rights granted at 30 June 2012 (AR, 2012, 2011, 2010, 2009)


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Board of Directors

The below table represents the members of the Qantas Group board and important information as at 30 June 2012:

Director Year of Appointment Inside Director Other DirectorshipsCEO of other

organisations

Stock Holdings at

30 June 2012

Leigh Clifford (Chairman) 2007 No Barclays Bank plc No 251,622

Peter Cosgrove 2005 No Cardno Limited No 34,565

Patricia Cross 2004 No

National Australia Bank

No 30,474

Wesfarmers Ltd

Richard Goodmanson 2008 No

Rio Tinto Limited

No 20,000

Rio Tinto plc

Gary Hounsell 2005 No

DuluxGroup Limited

No 80,000

PanAust Limited

NuFarm Limited

Orica Limited

Mitchell Communication Group Limited

William Meaney 2012 No - No -


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Corinne Namblard 2011 No Codan Limited No -

Paul Rayner 2008 No

Treasury Wines Estates Limited

No 71,622Boral Limited

Centrica plc

John Schubert 2000 No

BHP Billiton plc

No 103,103BHP Billiton Limited

Commonwealth Bank of Australia

James Strong 2006 No

Kathmandu Holdings Pty Ltd

No 30,670

Woolworths Limited

IAG Finance (NZ) Limited

Insurance Australia Group Limited

Barbara Ward 2008 No

Brookfield Funds Management Limited

No 47,597Brookfield Capital Management Limited

Lion Nathan Limited

Alan Joyce 2008 Yes - No 2,531,188

Table 3: Board Member Information at 30 June 2012 (AR, 2012, 2011, 2010, 2009)


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Bondholders

The Qantas Group does not have any publically traded debt and the vast majority of debt both

current and non current is in the form of secured and unsecured bank loans as well as lease and hire

purchase liabilities. These interest bearing liabilities relate to specific financings of aircraft and

engines and are secured by the aircraft to which they relate to.

Financial Market Considerations

The Qantas group is owned by four (4) main institutional investors that own approximately 70% of

the stock. These shareholders are listed below

Shareholder Name Commonly Known NamePercentage Ownership at

30 June 2011

JP Morgan Nominees (Australia) JP Morgan 28.88%

HSBC Custody Nominees

(Australia) LimitedHSBC Bank 19.09%

National Nominees LimitedNational Australia Bank

(NAB) 13.41%

Citicorp Nominees Pty Limited Citibank 11.11%

Table 4: Qantas major shareholders at 30 June 2012 (AR, 2012, 2011, 2010, 2009)

The below table represents key market information for Qantas stock listed on the Australian Stock

Exchange (ASX) as at 2 October 2012:

ASX Market Capitalisation Approx $2.7 Billion

Share Price (close 02/10/12) $1.22

Total number of shares on market Approx 2.21 Billion

Average 3 month traded volume (daily) 9,043,300 (0.43%)

Table 5: Key market information at 02 October 2012 (Yahoo, 2012)


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The following analysts are known to cover the Qantas Group:

Firm Analyst

Citi Shavarsh Bedrossian

CLSA Robert Bruce

Commonwealth Bank Matthew Crowe

Credit Suisse Anthony Moulder

Deutsche Bank Cameron McDonald

Goldman Sachs JBWere Andrew Gibson

JP Morgan Scott Carroll

Macquarie Russell Shaw

Merrill Lynch Matt Spence

Moelis & Company Simon Fitzgerald

Morgan Stanley Scott Kelly

Nomura David Fraser

RBS Mark Williams

UBS Simon Mitchell

Table 6: Analysts following Qantas at 30 June 2012 (AR, 2012, 2011, 2010, 2009)


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Societal Constraints

The Qantas Group operates in an industry that is considered by many as one of the largest polluters

in the world and as such Qantas are mindful of their social responsibility and manage this through

various programs. The Qantas Group strives to operate in a sustainable manner by continuallyimproving its economic, social and financial performance. It does this by focusing on 6 key

sustainability categories as outlined below:

Sustainability Measure

Governance Corporate governance statement

Environment

Aviation fuel and carbon emissions

Electricity

Water

Waste

Social

Customer Domestic on-time performance

People

Occupational health & safety

Absenteeism

Diversity

Community

National export revenue

Domestic traveller expenditure

Economic output

Economic Underlying profit before tax

Table 7: Qantas sustainability model (AR, 2012, 2011, 2010, 2009)

The Qantas group has over many years worked tirelessly on the sustainability model outlined above

and as such have a positive reputation as a good corporate citizen.


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Risk & Return

Historical Risk Parameters (Top down Beta)

The below table represents the summary output of the regression of returns for Qantas against the

ASX 200 for FY2009 FY2012:

Regression Statistics

R Square 0.530636092

Adjusted R Square 0.520432528

Standard Error 0.082458379

Observations 48

Intercept of regression -0.011353944

Slope of regression (95% accurate) 1.793914271

Estimated range of risk 1.293187899 To 2.294640644

Average Commonwealth bond rate for regression period (ReserveBank of Australia, 2012)

4.93%

Jensens intercept 0.0278%

Market Risk 52.04%

Firm Specific Risk 47.96%

Annualised annual excess returns 0.33%

Table 8: Regression output FY09 FY12


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The below graph in a visual representation of the Qantas performance against the ASX 200 for FY09 to FY12:

Figure 2: Qantas performance versus ASX200 FY09 - FY12 (regression)


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Divisional Betas (Bottom up Beta)

The below table represents the bottom up beta analysis conducted on the Qantas group:

Division Group1Revenue

FY12 ($M)Weightings2

Divisional

Business

Beta

Levered

Divisional

Beta3

Average Debt

Equity Ratio FY09

FY124

Unlevered (asset)

Business Beta

Levered

Business Beta

Qantas

Passenger 12,494 79.45% 0.82 1.42

1.045 1.03 1.79

JetStar

Qantas FF

Qantas

FreightFreight 784 5% 0.05 0.09

Other

business

Other 2,446 15.55% 0.16 0.28Corporate

Eliminations

Table 9: Qantas beta analysis

1

Similar divisions were grouped together for ease of calculation and representation of analysis results.2

The aggregated group revenue was used to establish divisional or group weightings.3A company tax rate of 30% was used in all calculations.

4An average debt equity ratio was derived from taking an average of ratios from FY09 to FY12.


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Choosing the Appropriate Beta

It is more appropriate to utilise the bottom up derived beta and the reasoning for this decision is

elaborated further in the discussion section of the report. Below represents the expected return on

equity investment for the Qantas Group:

Expected Return on Equity Investment56 17.46%

Table 10: Qantas required rate of return

Default Risk & Cost of Debt

The below table represents Qantas current Standard and Poors credit rating and associated data:

Rating Type Rating Date of Rating Default Spread Interest Rate7

Foreign Long Term BBB- 07-Sep-2012 2.5% 7.43%

Foreign Short Term A-3 07-Sep-2012 1.65% 6.58%

Local Long Term BBB- 07-Sep-2012 2.5% 7.43%

Local Short Term A-3 07-Sep-2012 1.65% 6.58%

Table 11: Qantas S&P credit rating at 07 September 2012 (Capital IQ, 2012), (New York University, 2012)

Cost of Capital

The below table represents Qantas current cost of capital structure:

Debt Equity Capital

Weightings8 56% 54% n/a

Cost 7.43%9 17.46% 38.90%10

Market Value11

$1.512B $1.188B n/a

Table 12: Qantas capital structure

5Long run market risk premium of 7% has been used.

6Risk free rate of 4.93% used which is representative of 5 year average Commonwealth bond rate for FY09-12.

7Risk free rate of 4.93% was used in interest calculation which is spread plus the risk free rate.

8Debt equity ratio figures used as at 30 June 2012.

9

Foreign long term interest rate used for cost of debt.10 Company tax rate of 30% was used in cost of capital calculation.11

Market capitalisation of $2.7B as at 02 October 2012.


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Earnings & Cash Flow

Existing Investments

A concrete accounting return figure for the firm was unable to be identified so in the absence of this

key metric in order to determine the benefit being extracted as a result of current existing

investments an earnings/share (after tax) metric will be discussed. For the 2012 financial year the

Qantas Group made a 10.8 cent loss/share compared with an 11 cent profit per share the year

before.

Competitive Strengths

Qantas is the largest domestic carrier in Australia and its main competitor is Virgin Australia. Virgin

Australia has over recent years reinvented itself to compete directly with Qantas in the key business

segment of the domestic travel market. Whilst Qantas continues to hold market share over Virgin

Australia it now needs to think of innovative ways to ensure further market share is not lost and gain

back some of its losses. This is going to be difficult for Qantas considering it has existing high levels

of debt, a downgraded credit rating and a high internal rate of return. Qantas has however made

structural changes to its business in order for it to compete better with its competitors in the

differing segments of the market that it operates in by appointing divisional CEOs. The Qantas brand

name is unmistakeable and will always hold a special place in the heart of Australias and thiscoupled with its unrivalled safety record are key strengths that management must exploit in order to

improve performance in the domestic travel market. Reputation and brand identity are hard things

for competitors to imitate in order to achieve a similar competitive advantage and Qantas

management need to use these to their full advantage.

In the international travel market Qantas has many competitors and this division of the business has

been struggling for some time and continually returning operating losses due to a decline in

passenger numbers and increased operating costs, namely aviation fuel. As in the domestic market

Qantas biggest strengths are its brand awareness, reputation and safety record and it needs to

exploit these strengths further in order to turn the results around for this division. The currentoperating model is not sustainable for the Qantas international travel division and as such changes

are already being implemented like the well publicised arrangement done with Emirates to run code

share flights in an attempt to reduce cost for both airlines. Singapore Airlines and Etihad are also

aggressively targeting the Australian international traveller as more and more Australians look to

travel overseas due to a continuing strong Australian dollar. Similarly to the domestic market

reputation, brand identity and good safety record are hard things for competitors to imitate.


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Financing Sources

Current Financing

The Qantas Group is a publically traded company and when it is required to raise equity it does so bycommon stock offerings. In recent times Qantas has only undertaken one capital raising exercise and

this was in February of 2009 where the Group raised $514 million in equity via an institutional

placement as well as a share placement offering to existing stock holders. This capital raising

exercise was completed successfully and was utilised to strengthen the balance sheet of the group

by reducing debt in response to the global financial crisis of 2008. In the recent months in response

to Qantas poor FY12 result it has been rumoured that a capital raising exercise is imminent but this

has been categorically denied by the Group CEO and Chairman of the Board both reiterating the

strong cash reserves as well as the ability to pull other levers in order to combat the challenging

conditions of the airline business are its alternatives.

The Qantas Group is a substantial borrower of money and this is due to the nature of the airline

business and the huge expenses associated with the purchase of new aircraft. The Groups primary

source of debt is in the form of secured and unsecured bank loans. The below table represents the

current debt position of the Qantas Group as at 30 June 2012:

Debt & Gearing Analysis $M

Net Debt including off balance sheet debt 7,544

Equity (Excluding Hedge Reserves) 5,848

Cash Reserves 3,398

Gearing Ratio 56:44

Table 13: Qantas debt position at 30 June 2012


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Debt versus Equity

The Qantas Group for taxation purposes is an Australian company and is therefore subject to the

standard marginal company tax rate of 30%. The group uses depreciation and amortisations as

primary drivers of reducing taxable income and minimising the amount of tax payable.

The below table represents the level of debt versus equity for the Qantas group over recent years:

FY 2012 FY 2011 FY 2010 FY 2009

Debt Levels ($M) 7,544 6,970 6,170 5,696

Equity ($M) 5,848 6,071 5,896 5,794

Gearing Ratio 56:44 53:47 51:59 50:50

Table 14: Qantas debt and equity positions FY09 FY12

The Qantas group does not have high free cash flows to service debt as illustrated in the table

below:

FY 2012 FY 2011 FY 2010 FY 2009

Free Cash Flows ($M) (472) (696) (294) (14)

Table 15: Qantas free cash flows FY09 - FY12

Debt is a necessity for the Qantas group due to the extremely high costs of purchasing new aircraft

and maintaining one of the lowest average age of aircraft fleets in the world. However as illustrated

in the table above Qantas ability to reduce debt has been significantly reduced in recent years but it

is the current strategy of the groups executive team to improve the firms balance sheet and

liquidity levels by actively reducing debt and this has resulted in the delaying of several deliveries of

new aircrafts.

Costs of Debt

The below table represents the cash flows (revenue) of the Qantas Group:

FY 2012 FY 2011 FY 2010 FY 2009

Cash Flows ($M) 15,752 14,894 13,772 14,382

% Change 6% 8% (7%) n/a

Table 16: Qantas cash flows FY09 FY12 (revenue)


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The cash flows of the group are relatively stable which is a positive sign however in recent years debt

has continued to grow and equity has also but not at the same rate. Another concerning point to

note is the lack of free cash flows available to the group to reduce debt.


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Dividend Policy

Dividend Policy

The below table represents the dividends paid by the Qantas Group for the past 4 financial years as

well as the associated full year profit:

FY 2012 FY 2011 FY 2010 FY 2009

Interim dividend 0 cents 0 cents 0 cents 6 cents

Full Year Dividend 0 cents 0 cents 0 cents 17 cents

Special Dividend 0 cents 0 cents 0 cents 0 cents

Statutory Profit After Tax ($M) (244) 249 116 123

Table 17: Qantas dividend payments FY09 - FY12

The above dividend yields align with the capital management strategy that Qantas has employed

over the past few years which has been to strengthen the balance sheet where possible in an

attempt to maintain a high credit rating with the ability to access finance at a reasonable price.

Firm Characteristics

In the past few years Qantas has clearly conveyed its dividend policy to the market by having not

paid a dividend since 2009; this along with its desire to obtain and maintain an investment grade

credit rating it is unlikely that this policy will change. The marginal stockholders of the Qantas Group

are predominately mum and dad investors and considering the fact the Qantas stock is trading at

all time lows it would likely be their preference that a dividend payment be made if at all possible as

opposed to a stock buyback which would be the preference of the firm.

A key component to Qantas capital management strategy is to elevate its credit rating and by doing

this it can provide itself with surety around its future cost of debt as well as firm flexibility. It has

made a recent decision to avoid further immediate debt in order to strengthen its balance sheet in

order to improve its credit rating. Qantas clearly understands it future funding needs and this

centres solely on the purchase of new aircraft, this coupled with a solid understanding of its cost of

debt it makes the planning for future projects to be done with greater certainty not withstanding

further unforeseen increases in operating costs namely aviation fuel and labour costs.


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Discussion

Corporate Governance

After reviewing the corporate governance model implemented by the Qantas Group it would appear

that the chance of a principal agent conflict scenario arising would be low. All but a few of the board

members have significant personal stock holdings which illustrates that the current board will and

do represent and protect the best interests of shareholders. The executive group including the

Group CEO have significant personal stock holdings also which is healthy for shareholder interests as

whilst their primary role is management they also have a personal interest in the overall

performance of the company. The remuneration policy of the Qantas group also provides short term

and long term incentive schemes in the form of stock and options to the executive team which

ensures that share price improvement and shareholder maximisation is also important not only to

stockholders but also the management team.

There is no potential conflict between stockholders and lenders to the firm. The Qantas Group does

not publically trade debt on any debt market and all firm debt is in the form of secured or unsecured

bank loans. As such in the event of liquidation or wind up of the Qantas Group the debt holders

would be serviced first if assets were sold to settle outstanding debt and stockholders would only

receive a payout should the liquidation proceeds received be in excess to outstanding debt levels.

As the Qantas Group is a member of the Australian Stock Exchange (ASX) it is required to comply

with all ASX listing rules. The Qantas Group adhere to ASX guidelines with respect to any price

sensitive information and this is always fully and formally disclosed publically to the market via the

Australian Stock Exchange by the company secretary.

The Qantas Group puts a high value on ensuring it meets is social obligations and the primary way in

which the group makes its efforts visible is through a triple bottom line reporting methodology. The

Qantas Group also has several social programs running as well key society sponsorships that show its

commitment to not only maximising shareholder value but also ensuring it does so in a socially

responsible manner.

Risk & Return

A regression analysis was completed for the Qantas stock price versus the ASX200 for a four yearperiod including FY09 to FY12 and Qantas performance relative the ASX200 was slightly better with

0.33% annualised excess returns in comparison to the index for the period of regression. Qantas has

a high beta which indicates that it is a relatively riskier stock when compared with the risk free

return of Commonwealth bonds however the majority of Qantas risk throughout the regression

period can be attributed to market risk totalling 52.04%; while the firm risk attributable to Qantas is

47.96%. It is not unexpected that market risk would be high considering this period of regression was

when the global economy was in the depths of dealing with the GFC. Qantass estimated beta

obtained by the regression method is 1.79 which is high which equates to it being a high risk stock

with the potential for higher returns.

A bottom up beta was also obtained for Qantas with an unlevered or asset beta of 1.03 obtained anda levered beta of 1.79 which coincidently is the same beta obtained in the regression analysis.


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Normally the beta obtained via the bottom up method is a better estimate but in this case it does

not matter as the same result was obtained. Bottom up betas are traditionally more reliable because

it breaks the business into divisions and assesses the risk associated with each division and how they

contribute to the overall risk profile of the firm. Bottom up betas also take into account the current

mix of business of a firm where regression derived betas look at the historical mix and performance

of the business.

When utilising the beta calculated using the bottom up method an expected return on equity was

derived which was 17.46%. This is basically the breakeven point for any potential projects that

Qantas may take on and is the hurdle rate for projects. Put alternatively the cost of equity for Qantas

is 17.46% which is considered to be quite high.

Standard & Poors ratings agency has just recently downgraded Qantas credit rating and as a result

Qantas cost of debt has risen. Whilst this does not affect existing debt levels it does place strain on

future projects and their ability to achieve the high internal rate of return or hurdle rate required. In

the short term this will not affect Qantas a great deal as it has already shelved key projects in favour

of improving the balance sheet in order to improve its declining credit ratings. So whilst current debtis not affected and if Qantas refrains from borrowing further and focuses on reducing its current

debt levels it will be hoping for an improvement in its credit rating in order to make future projects

more viable and attractive.

Qantas debt levels are beginning to impact its ability to take on new projects to ensure that it

remains a world leader in the passenger airline industry. It is a heavily levered firm with a recent

lowered credit rating which has increased its cost of debt. This coupled with a high internal rate of

return results in an extremely high cost of capital. Due to its current debt level Qantas has no other

options but to stop new projects and improve its balance sheet in order to reduce current debt

levels in order to undertake new projects in the future that will deliver value to the firm and

shareholders.

Earnings & Cash Flow

During FY12 the Qantas group delivered a statutory loss of $244 million which equated to a 10.8c

loss/share. No economic value was added to the firm in the last financial year and current

investments did not meet the required hurdle rates to deliver value to equity holders. The quality of

the existing investments is poor and this can be attributed to the high levels of debt required in

order to execute on these investments. The poor performance of these investments can also be

attributed to dramatic increases in operating costs that were probably not foreseen at the time

current investments were planned and implemented. In the short term Qantas needs to focus on

improving its balance sheet in order to reduce its cost of capital so that it can begin to invest in new

projects again in order to deliver additional competitive advantages.

Although the quality of current investments is poor Qantas still has some key strengths available to it

for exploitation in order to turn its performance around. Qantas has a strong reputation, high level

of brand awareness amongst travellers and an impeccable safety rating that competitors will find

hard to imitate and hence delivering Qantas a key set of competitive advantages. Due to Qantas

recent poor earnings it will need to rely on these current competitive advantages to improve its

balance sheet before it is in a position to invest in new projects that will deliver it additional

competitive advantages and new cash flows.


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Financing Sources

As outlined previously the Qantas group has a simple model for sourcing finance and is

predominately through the use of secured and unsecured bank loans (debt) however in the past it

has used capital raising exercises through the issuance of stock (equity).

Qantas is reliant on debt in order to maintain its fleet as the lowest average age of fleet in the world

due to the costs associated with the purchase of new aircrafts. The use of debt allows the Qantas

Group to hold significant cash reserves on its balance sheet which is attractive to potential investors

because it shows the firm has good levels of liquidity. However the debt carried on the balance sheet

can also be detrimental to the firm and some issues that present themselves as a result of the

Qantas Groups debt are:

1. As outlined before the Qantas Groups free cash flows are not of a sufficient level to reducethe firms debt.

2. The high cost of servicing the debt is reliant on revenues remaining at or around currentlevels and with the overhang of the GFC and the ever rising cost of aviation fuel this could

potential impact top line revenue as the cost of flying increases and consumers continue to

watch their expenditure.

3. Mounting levels of debt without liquidity increasing in line may result in a furtherdowngrade in the firms credit rating which in turn would make the cost of new debt higher

and therefore place even greater strain on the group considering their low free cash flows.

The current strategy of the Qantas executive group and board is to improve the liquidity of the firm

by improving the cash reserves as well as attempting to reduce debt. They have made decisions todelay the delivery of new aircraft that were planned in the next 24 months in an attempt to not

increase current debt levels. The biggest concern with their current strategy is the lack of free cash

flows to reduce current debt levels to improve the balance sheet and there is a possibility the Qantas

Group may indeed undertake a capital raising exercise in order to raise equity and use it to reduce

current debt levels. This strategy also is void of new investment and projects and therefore no new

cash flows are expected.

Dividend Policy

The current dividend policy of the Qantas Group is nonexistent with a dividend not being paid since

2009 and there seems to be no indications that this will change in the immediate future. The

earnings over the past 4 years have not warranted the payment of a dividend. The executive have

adopted a capital management policy centred on guaranteeing the availability of debt at the best

possible price by attempting to improve Qantas credit rating and by also attempting to reduce

current debt levels. This policy however from a shareholders perspective is not maximising firm

value or indeed shareholder value and this coupled with a share price that is well below its book

value the Qantas Group does not present overly attractive to a potential investor. However in saying

that the current strategy being employed by the firm to exploit inherent underlying value in


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conjunction with its improving balance sheet strategy could result in uplift in share price and a

possible return of dividend payments or a share buyback. (Kelly, 2012)


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Summary & Recommendation

Summary

The below table summarises each of the key areas covered as part of the case study:

Area of Interest Summary

Corporate

Governance

The board consists of experienced individuals with shareholders interests as itmain priority.

The remuneration policy eliminates the potential for a principal agent conflict. Qantas is an ASX listed company that adheres to all ASX guidelines. The company is committed to delivering on its corporate social responsibilities

and discloses its actions and results via it triple bottom line reporting

methodology.

Risk & Return

Qantas has a high beta which means it is considered a risky firm to invest in; thishigh level of risk can be attributed almost equally to market and firm specific

risk.

The high internal rate of returns required makes new project viability difficult toachieve.

Qantas has a deteriorating credit rating thats forcing an increase in cost to newdebt.

Cost of capital is prohibitively high.

Earnings & Cash

Flow

Earnings have declined over recent years with a statutory loss of $244 millionachieved last financial year.

Current investments are not delivering the required internal rate of return. Qantas has 3 key competitive advantages and these must be exploited to their

full potential whilst Qantas rectifies its balance sheet issues; these are:

o High level of brand awarenesso Good reputation amongst travellerso Best safety record in the airline industry

Financing Sources

Qantas is a highly levered firm at approximately 56%. Free cash flows are insufficient to reduce current debt levels. New projects have been postponed and cancelled in order to reduce debt and

improve liquidity.

Asset sales are part of short term business plans to reduce debt.

Dividend Policy

No dividends have been paid since FY 2009. Likely to be a continuation of the current no dividend policy as Qantas tries to

reduce debt and improve its balance sheet.

If excess profits are available for dividend payments in the short to mediumterm it is likely a share buyback scheme would be preferred by the management

and board as opposed to a dividend payment.

Table 18: Case study summary


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Recommendation

The purpose of this case study was to undertake analysis based on recent results and current

business plans to make a recommendation as to Qantas suitability as an investment prospect for

potential investors. Based on the findings of this case study it is the recommendation that this is not

a suitable stock for potential investors for the following reasons:

The Qantas stock price has fallen 64% over the past 4 financial years and current signs dontindicate a short to medium term recovery.

Qantas is a heavily levered firm with a current debt equity ratio of 1.27; this coupled withinadequate free cash flows to reduce current debt is extremely concerning. Despite this the

management team are currently implementing a strategy to reduce debt but this case study

has uncovered that free cash flows are insufficient to execute on this plan so asset sales will

be required to delivery this result.

Downgraded credit rating has increased the cost of debt and therefore Qantas ability toinvest in new projects in an attempt to generate new cash flows.

Cost of capital is prohibitively high. Revenues have been stable but without the ability to invest in new projects delivering new

cash flows revenue is unlikely to improve.

Current investments are underperforming and this can likely be attributed to spirallingoperational costs due to increased price of aviation fuel that were not factored into project

estimates. This underperformance is likely to continue.

A dividend has not been paid for the past 3 financial years and it is a common belief amongstanalysts that this is likely to continue.


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Appendix

Qantas Historical Share Price Performance

Figure 3: Qantas stock price (historical) (Australian Stock Exchange, 2012)

Qantas Historical Stock Trade Volumes

Figure 4: Qantas stock traded volumes (historical) (Australian Stock Exchange, 2012)


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Bibliography

AR, Q. (2012, 2011, 2010, 2009). Qantas Annual Reports. Sydney: Qantas.

Australian Stock Exchange. (2012, October 7). Retrieved October 7, 2012, from Australian Stock

Exchange: http://www.asx.com.au/asx/markets/priceLookup.do?by=asxCodes&asxCodes=qan

Capital IQ. (2012, October). Retrieved October 23, 2012, from Capital IQ:

https://www.capitaliq.com/CIQDotNet/CreditRatings/SandPCreditRatings.aspx?companyId=874341

Kelly, R. (2012, October 3). Wall Street Journal. Retrieved October 6, 2012, from Wall Street Journal:

http://blogs.wsj.com/dealjournalaustralia/2012/10/03/qantas-dividend-payout-or-buyback-might-

fly/

New York University. (2012, January). Retrieved October 25, 2012, from New York University:

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ratings.htm

Qantas. (2012). Qantas. Retrieved October 2, 2012, from Qantas: http://www.qantas.com.au

Reserve Bank of Australia. (2012, October). Retrieved October 22, 2012, from Reserve Bank of

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Yahoo. (2012). Yahoo 7. Retrieved October 2, 2012, from Yahoo 7 Finance:

http://au.finance.yahoo.com/q?s=QAN.AX

Documents

7905AFE Corporate Finance Learning Case Study Exemplar #1.pdf