7905AFE Corporate Finance Learning Case Study

QANTAS

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 2

Appendix ............................................................................................................................................... 28 Qantas Historical Share Price Performance .................................................................................. 28 Qantas Historical Stock Trade Volumes ........................................................................................ 28 Bibliography .......................................................................................................................................... 29

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. Qantas 2. JetStar Qantas also has number of subsidiary businesses which operate under the Qantas Group banner and these include: 1. 2. 3. 4. 5. 6. 7. Q Catering Qantas Freight Qantas Frequent Flyer QantasLink Qantas Holidays Express Ground Handling 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.

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 business improvement 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 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 dont indicate a short to medium term recovery. Qantas is a heavily levered firm with a current debt equity ratio of 1.27; this coupled with inadequate 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 to invest 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 spiralling operational 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 amongst analysts that this is likely to continue.

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 both Qantas 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 Base Pay Short Term Incentive Long Term Incentive Performance Share Plan Other Total 2,109 2,163 1,134 n/a 171 5,577

FY 2011 $000 2,045 2,049 542 125 247 5,008

FY 2010 $000 1,842 964 49 n/a 69 2,924

FY 2009 $000 1,825 1,253 529 n/a 57 3,664

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

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 Deferred shares held in trust Rights granted Total 375,014

FY 2011

FY 2010

FY 2009

1,753,863 2,336,863 1,170,863 383,750

2,759,000 1,455,070 626,350

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)

Board of Directors The below table represents the members of the Qantas Group board and important information as at 30 June 2012: Director Leigh Clifford (Chairman) Peter Cosgrove Patricia Cross Year of Appointment 2007 2005 2004 Inside Director No No No Other Directorships Barclays Bank plc Cardno Limited National Australia Bank Wesfarmers Ltd Rio Tinto Limited Rio Tinto plc DuluxGroup Limited PanAust Limited Gary Hounsell 2005 No NuFarm Limited Orica Limited Mitchell Communication Group Limited William Meaney 2012 No No No 80,000 CEO of other Stock Holdings organisations 30 June 2012 No No No 251,622 34,565 30,474 at

Richard Goodmanson

2008

No

No

20,000

Corinne Namblard

2011

No

Codan Limited Treasury Wines Estates Limited

No

Paul Rayner

2008

No

Boral Limited Centrica plc BHP Billiton plc

No

71,622

John Schubert

2000

No

BHP Billiton Limited Commonwealth Bank of Australia Kathmandu Holdings Pty Ltd

No

103,103

James Strong

2006

No

Woolworths Limited IAG Finance (NZ) Limited Insurance Australia Group Limited Brookfield Funds Management Limited

No

30,670

Barbara Ward

2008

No

Brookfield Capital Management Limited Lion Nathan Limited

No

47,597

Alan Joyce

2008

Yes

No

2,531,188

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

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 JP Morgan Nominees (Australia) HSBC Custody (Australia) Limited Nominees

Commonly Known Name JP Morgan HSBC Bank National (NAB) Citibank Australia Bank

Percentage 30 June 2011 28.88% 19.09% 13.41% 11.11%

Ownership

at

National Nominees Limited Citicorp Nominees Pty Limited

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 Share Price (close 02/10/12) Total number of shares on market Average 3 month traded volume (daily)

Approx $2.7 Billion $1.22 Approx 2.21 Billion 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 Citi CLSA Commonwealth Bank Credit Suisse Deutsche Bank Goldman Sachs JBWere JP Morgan Macquarie Merrill Lynch Moelis & Company Morgan Stanley Nomura RBS UBS Analyst Shavarsh Bedrossian Robert Bruce Matthew Crowe Anthony Moulder Cameron McDonald Andrew Gibson Scott Carroll Russell Shaw Matt Spence Simon Fitzgerald Scott Kelly David Fraser Mark Williams 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 continually improving 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 Aviation fuel and carbon emissions Environment Electricity Water Waste Customer Domestic on-time performance Occupational health & safety People Absenteeism Diversity National export revenue Community Economic Domestic traveller expenditure Economic output Underlying profit before tax

Social

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 Adjusted R Square Standard Error Observations Intercept of regression Slope of regression (95% accurate) Estimated range of risk 0.530636092 0.520432528 0.082458379 48 -0.011353944 1.793914271 1.293187899 To 2.294640644

Average Commonwealth bond rate for regression period (Reserve 4.93% Bank of Australia, 2012) Jensens intercept Market Risk Firm Specific Risk Annualised annual excess returns
Table 8: Regression output FY09 FY12

0.0278% 52.04% 47.96% 0.33%

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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 Qantas JetStar Qantas FF Qantas Freight Other business Corporate Eliminations
Table 9: Qantas beta analysis

Group

Revenue FY12 ($M)

Weightings

Divisional Business Beta

Levered Divisional Beta 3

Average Debt Unlevered (asset) Levered Equity Ratio FY09 Business Beta Business Beta FY12 4

Passenger 12,494

79.45%

0.82

1.42

Freight

784

5%

0.05

0.09

1.045

1.03

1.79

Other

2,446

15.55%

0.16

0.28

1 2

Similar divisions were grouped together for ease of calculation and representation of analysis results. The aggregated group revenue was used to establish divisional or group weightings. 3 A company tax rate of 30% was used in all calculations. 4 An 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 Investment 56
Table 10: Qantas required rate of return

17.46%

Default Risk & Cost of Debt The below table represents Qantas current Standard and Poors credit rating and associated data: Rating Type Foreign Long Term Foreign Short Term Local Long Term Local Short Term Rating BBBA-3 BBBA-3 Date of Rating 07-Sep-2012 07-Sep-2012 07-Sep-2012 07-Sep-2012 Default Spread 2.5% 1.65% 2.5% 1.65% Interest Rate7 7.43% 6.58% 7.43% 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 Weightings 8 Cost Market Value 11 56% 7.43% 9 $1.512B Equity 54% 17.46% $1.188B Capital n/a 38.90% 10 n/a

Table 12: Qantas capital structure

5 6

Long run market risk premium of 7% has been used. Risk free rate of 4.93% used which is representative of 5 year average Commonwealth bond rate for FY09-12. 7 Risk free rate of 4.93% was used in interest calculation which is spread plus the risk free rate. 8 Debt 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 this coupled 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 current operating 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 by common 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 Net Debt including off balance sheet debt Equity (Excluding Hedge Reserves) Cash Reserves Gearing Ratio
Table 13: Qantas debt position at 30 June 2012

$M 7,544 5,848 3,398 56:44

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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 Debt Levels ($M) Equity ($M) Gearing Ratio 7,544 5,848 56:44 FY 2011 6,970 6,071 53:47 FY 2010 6,170 5,896 51:59 FY 2009 5,696 5,794 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 Free Cash Flows ($M) (472) FY 2011 (696) FY 2010 (294) FY 2009 (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 Cash Flows ($M) % Change 15,752 6% FY 2011 14,894 8% FY 2010 13,772 (7%) FY 2009 14,382 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 Interim dividend Full Year Dividend Special Dividend Statutory Profit After Tax ($M) 0 cents 0 cents 0 cents (244) FY 2011 0 cents 0 cents 0 cents 249 FY 2010 0 cents 0 cents 0 cents 116 FY 2009 6 cents 17 cents 0 cents 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 year period 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 and a levered beta of 1.79 which coincidently is the same beta obtained in the regression analysis. 22

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 debt is 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. 23

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 reduce the firms debt. 2. The high cost of servicing the debt is reliant on revenues remaining at or around current levels 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 further downgrade 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 to delay 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 24

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
The board consists of experienced individuals with shareholders interests as it main 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. Qantas has a high beta which means it is considered a risky firm to invest in; this high 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 to achieve. Qantas has a deteriorating credit rating thats forcing an increase in cost to new debt. Cost of capital is prohibitively high. Earnings have declined over recent years with a statutory loss of $244 million achieved 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 awareness o Good reputation amongst travellers o Best safety record in the airline industry 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. 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 medium term it is likely a share buyback scheme would be preferred by the management and board as opposed to a dividend payment.

Corporate Governance

Risk & Return

Earnings Flow

&

Cash

Financing Sources

Dividend Policy

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 dont indicate a short to medium term recovery. Qantas is a heavily levered firm with a current debt equity ratio of 1.27; this coupled with inadequate 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 to invest 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 spiralling operational 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 amongst analysts 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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