Indonesia travel taking off, it is open skies for Garuda Indonesia (PSEOY:OTC US)
By Marc Djandji, CFA
A. COMPANY INTRODUCTION: Garuda, background
Garuda Indonesia (GIAA:IJ; PSEOY:OTC US; YGD:GR) is the national flag carrier of Indonesia, with the largest seat capacity among Indonesia’s premium carriers. GIAAis the only listed play in Indonesia’s air travel market.
After being state-owned for more than half a century, Garuda recently made attempts to modernise and move into the ranks of world-class airlines. The company was listed on the Indonesia stock exchange in February 2011 with 28 percent of its shares sold to the public at 750Rp per share.
Indonesia’s air travel market is relatively immature and is experiencing one of the highest growth rates in the world. Two carriers dominate the domestic market:Garuda offering full service and Lion Group targeting budget passengers.
B. The case for GIAA
Aside from its cheap valuation, Garuda is particularly interesting because the company has such a robust fundamental backdrop.
Our (high-conviction) call on GIAA is based on the view that the Company is facing a very positive outlook compared to many of its global peers:
• Garuda is the dominant player in what is by far the largest aviation market in Southeast Asia. The industry’s outlook looks particularly robust given Indonesia’s underlying demographics:based on forecasts by McKinsey & Co, an additional 90 million people will have entered Indonesia’s consumer class by 2030, more than any other country other thanChinaand India.
• The stock has also been sold off quite aggressively, but we believe this has less to do with the Company’s underlying earnings outlookand more to do with the stock’s leverage and the broader decline in the Jakarta Composite. YTD the stock has declined 26%, versus a 5% rise in the JCI, which has left to the stock trading at a record low on most valuation metrics.
• We have conviction that the Company’s earnings profile will remain relatively buoyant going forward:there islittle signs that domestic passenger growth is slowing. It is expected that both the half and full-year fundamentalsshould reflect gains in the context of the rapidly growing Indonesiantravel market.
• Profitability should also improve through product/fleet renewal, network optimisation (improving connectivity between routes) and cost savings stemming from a younger average fleet age, which is below all regional full-service peers.
• Theoil price scenario for GIAA is gradually improving. Jet fuel prices rose in the first quarter of 2013, which isthe primary reason for the loss recordedin Q1 and subsequent downward share price movement.However, a closer look at the result showed that all key operational metrics continues to move in the right direction.
• GIAAcould be set to post a significant margin rebound as they begin to cycle several quarters of very high jet fuel prices last year.As with all airlines, oil pricesare a key sensitivity to earnings (39.5% ofGIAA’s total cost base). With the directional movement of oil prices trending down, this could be highly supportive of margin expansion.
C. A look at the fundamentals
• Asia will be the centre of growth for global aviation over the next decade; this much is generally agreed by most commentators. It isalso broadly accepted that, along with China and India, the Indonesian aviation industry will be at forefront of this development.
• The International Air Transport Association forecasts Indonesia will to become the 5th largest market globally by 2030after China, the US, EU and India.
• Indonesia’s economy provides a compelling macroeconomic environment, positioned to continue its mid-to-high singledigit growth trajectory.The rise in disposable incomes and the rapidgrowth in Indonesia’s middle class willbe key drivers of growth.
• Indonesian archipelago geography, together with the expansion of airports throughout the country and an underdeveloped road and rail network are thecatalysts for rapid aviation development.
• Passenger traffic in Indonesia has grown 16%-20% in each of the last four years,with the domestic market roughly doubling over that time.
• Garuda controls around half of the full-service air travel market in Indonesia (40% of total air travel capacity). The Company has a near monopolyamong public sector and business clients;these are strong earnings drivers given the profitability at this end of the market.
• Competition has been particularlyaggressive in recent periods,however this is primarily at the budget end of the market.
• In the full-service travel sector, GIAAmanagement has generally done a good job at staying ahead of competitors, investingheavily in new planes, branding and improving product lines. Gurada has grewits market position in both the 2011 and 2012 financial yearsas well as in Q1 this year.
Strong earnings outlook
The key to GIAA’s earnings outlook lies in its operational leverage
• In 2012, reported top line grew just by 12%, but net profit growth grew by 73%.GIAA can simply hold its market share and ride the uplift in Indonesia’s demographics and be capable of comfortably exceeding mid-teen average YOY growth.
• There is room for further earnings upside as cost control measures and products improvement are put in place.
• The recent code-share agreement with Etihad and membership in Skyteam Alliance from 2014 should greatly improve Gaudi’sinternational network and brand image.
1. Cash flow
• Free cash flow is likely to remain negative into the foreseeable future and the extent of the capital expenditure outlay will ultimately place a degree of pressure on the balance sheet.
• The company’s gearing metrics seem low enough to mitigate the risk of raising capital in the near-term.GIAA’s debt-equity was 43% at the end of Q1 (up from 14% at the end of Q4 2012due to a pre-payment for new aircrafts) and interest cover around 14x.
• GIAA is one of the few domestic names which is negatively leveraged to a fall in the IDR, which flows on to higher local currency denominated input costs (primarily jet fuel).
• The IDR has followed a steadily downward two-year trend. There is potential for ongoing USD strength to further erode margins in domestic currency terms, particularlyshould we see the end to US bond purchasing.
The key risk facing the Company isthe competitive pressures stemming from domestic capacity expansion.
• Since Lion Air commenced operations in Indonesia in 2000, there are 8 now brandsoperating on keyroutes.However, demandis projected to continue to grow ahead of capacity into the medium-term.
• Competition has largely been focused on the budget travel end of the market (evidenced by the recent bankruptcy of # no. 4 airline, Batavia Air). Indonesia’s smaller carriers are far more vulnerableand this is unlikely to change materially in the near-term.
• Garuda’s loyal following among corporate and government passengers provides a degreeof insulation from competition at the premium end.
• Despite attempts by Lion and more recently Sriwijaya to capture market share, Garuda’s balance sheet, brand strength, its partnerships with local travel agents and network model have thus far offered successful barriersofentry to premium segments.
• Garuda is also expanding aggressively into the low cost market segment. The group’s budget brand Citilink has particularly ambitious growth plan to support a projected 19 million annual passengers by 2015, compared with just 1.6 million in 2011. This subsidiary is yet to break-even, but has thus far been successful in capturing market share (Citilink carried 2.9 million passengers last year, +76% on the pcp).
WHEN TO BUY AND SELL
• GIAA has historically tended to tradesomewhere in the range of ~1.5x -2.6x book value since listing in early 2011. GIAA’s listed emerging market peers have broadly traded in a similar range.
• The stock is trading at the lowest level in its listed history, at a little over 1.2x BV. The metrics on which the stock is currently trading are likely to put of a floor under the share price.
• An improvement in broader market sentiment could movethe stock to return to the lower end of its typical valuation range i.e. to around the Rp600 level. Beyond that, it is reasonable to suggest that GIAA could trend back up towards its listing price of Rp750 or even higher on a 12-month horizon, an upside of around 53% compared to its current levels.
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