REX is Australia’s largest independent regional airline, established in 2002 from the merger of Hazelton and Kendell. REX is the sole provider in the majority of its routes. Airlines are capital intensive and traditionally offered poor returns for investors. Rex effectively holds monopoly position in 60% of its routes, many too small to be profitably serviced by Qantas, Virgin Blue or Jetstar. The dividend payout-ratio is around 30-40%, at the high end given considerable capital requirements. Freefloat is small and share turnover low. Pilot shortages are a great concern.
Event22-Apr-2008
Pilot numbers continue to improve and are now at 94% of ideal levels. Flight cancellations have reduced. Persistent high oil prices have forced REX to increase it fuel surcharge to $33 from $27. Passenger numbers have remained strong. The pilot academy has suffered some setbacks, with delays to flight training postponing graduation by a month or more. Instructor shortages may cause more delays. Negotiations on a new EBA are underway. Pilot wage increases will impact FY09 earnings.
Business Impact: Good load factors and lower maintenance costs indicate a stronger second half result. Cadet progress is slow and justifies our cautious stance. REX believes it will come close to full year earnings guidance but with risks to the downside we maintain more conservative forecasts.
Event Analysis
REX continues to improve pilot numbers with a net gain of nine pilots since December 31, 2007. Pilot numbers are now at about 94% of ideal levels, up 11% from the low-point in September 2007. Attrition is still high but for now is more than matched by recruitment. Flight cancellations have reduced with stabilising pilot numbers. Cancellations were only 0.2% in March, compared to 1.7% in February and over 2% in October last year. Volatility is to be expected and cancellations for April are tracking higher. REX continues to rate well for cancellations compared to other airlines. Figures for February show REX ahead of Virgin Blue (VBA) at 2.9%, QantasLink at 2.4%, Jetstar at 2.1% and Qantas at 1.8%. High oil prices forced REX to increase its fuel surcharge from $27 to $33 over the past couple of months, passing most of the cost increases through to passengers. At this stage passenger numbers remain strong. Costs for competing carriers and other forms of transport are also affected. REX does not have fuel hedges and is fully exposed to rising prices, but turbo-prop aircraft are more fuel efficient than jets. Fuel accounts for around 19% of REX’s operating expenses compared to more than 32% for VBA. The price of fuel and falling yields were recently identified by VBA as major concerns, and we expect its expansion to slow. VBA has been a substantial recruiter of REX pilots. The pilot academy has suffered some setbacks. The first intake of cadets finished ground school but were unable to begin flight training due to approval delays. These have now been granted and cadets are flying. A shortage of flying instructors may cause more delays. REX remains hopeful that some cadets will graduate in August, as per the previous schedule, but it is likely most will not graduate until September or later. The second intake of cadets has begun. All up there are 39. A third intake begins following graduation of the first. Delays to flight training are a concern as this is a key solution to the pilot shortage. Mangalore Airport has pulled out of the joint venture pilot academy, implying it is unsatisfied with performance. The academy will continue to be based at Mangalore but REX will take full ownership and control. Negotiations with pilots on a new Enterprise Bargaining Agreement are underway. A decision is expected on June 30 and will impact FY09 earnings. Wages will rise but REX is not in a position to match larger airlines. The result is unlikely to satisfy pilot demands and as such attrition will remain high. REX is in a tough position and would rather carry on with low wages and high attrition than increase wages without certainty attrition will slow. In other news, REX and subsidiary Air Link retained 15 expired Air Transport Licenses for regional NSW. The licenses confer monopoly rights on certain routes and run for five years from March 2008. Interestingly, none of the licenses were contested, indicating competing airlines are not willing or able to service these small regional routes. The share price should be supported by the recently introduced buy-back for up to 12m shares, approximately 10% of total equity or 20% of free float. Share purchases by Executive Chairman Lim Kim Hai also signal the shares are undervalued. These are good signs but we remain wary of the considerable risks facing this company. Load factors have been good for the last couple of months and REX believes it will come close to hitting full year earnings guidance. Engineering and maintenance costs have improved from abnormally high levels in 1H08. In an environment of high fuel costs and pilot shortages, risks are to the downside. We leave our forecasts unchanged for now. Forecast FY08 NPAT is 7% below guidance at $22.0m. FY09 NPAT is $20.7m. Our valuation remains $1.40. Hold.
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