Is AirAsia in trouble?

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Hong Kong-based boutique analyst GMT Research has come up with a damning indictment against AirAsia, effectively accusing the airline of manufacturing profits by abusing its associates. Is that really true? KINIBIZ takes a deep, hard look.

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If one were to believe GMT Research totally, AirAsia is in very deep trouble, its accounts are in tatters, and it is making profits by abusing its associate companies to which it leases aircraft.

Probably no other research house has made such a damning indictment against AirAsia as GMT in all its years of being a listed company since 2004. Just consider this summary written by GMT’s Gillem Tulloch: “Don’t be fooled by AirAsia’s fancy marketing; we think it’s close to default. We estimate that it has managed to inflate profits by 39% over the past five years through related-party transactions with associates.”

“Today, these associates have not only stopped paying their bills but require AirAsia’s financial support. The company is basically creating profits and flattering its operating cash flow by abusing its associates. Real profits have collapsed and AirAsia now needs a recapitalisation that will dilute existing shareholders by more than 100%.

“We see at least 42% downside with fair value less than MYR1.23 per share. Sell or Short. AirAsia may be a new dog, so to speak, but it’s playing a very old trick,” he said.

But almost all other analysts disagree with this analysis – they are far more bullish, with 16 out of 17 “buys” on AirAsia. Just take a look at the Bloomberg list of consensus estimates, courtesy of GMT, for AirAsia which paints a pretty picture for AirAsia.

Many of the other analysts stated that they are aware of AirAsia’s accounting policies and they disagree with it. Some of them have resorted to cash flow analysis, which basically levels out all accounting policies and focuses on just cash in and cash out. Based on that, they swear that AirAsia is a cash-generating machine.

Surely both Tulloch and the others can’t both be right. In situations such as these, the truth is probably somewhere in between.

In the previous article, KINIBIZ established that GMT and Tulloch were likely wrong with at least one part of their analysis – that AirAsia was deliberately cooking the accounts. AirAsia strenuously denied that saying it has board papers to show that it has pushed for consolidation of accounts with associates previously, but it is its auditors who have been balking.

Looking through GMT’s reports, which were made available to KINIBIZ yesterday, whether GMT turns out to be right and AirAsia wrong are dependent on how well two key associates perform.

The problem now is that these associates, namely Indonesia AirAsia (IAA) and AirAsia Philippines (AAP) are struggling to stay current on their debts to AirAsia. GMT believes that because AirAsia does not consolidate its accounts, investors are not getting a true picture of the airline’s financial health, which according to it, is ailing.

“We think it (AirAsia) is close to default. We estimate that it has managed to inflate profits by 39% over the past five years through related-party transactions with associates. Today, these associates have not only stopped paying their bills but require AirAsia’s financial support.

“The company is basically creating profits and flattering its operating cash flow by abusing its associates. Real profits have collapsed and AirAsia now needs a recapitalisation that will dilute existing shareholders by more than 100%,” said Tulloch. Tulloch estimates recapitalisation at RM7 billion.

Both AirAsia founder and group chief executive officer (CEO) Tony Fernandes and the chairman of the airline group’s audit committee VU Kumar have said that AirAsia wants to consolidate.

However, it cannot do so because the differing aviation rules in the individual countries it operates in do not allow it to have legal power over the associates.

Because of the absence of legal power, AirAsia’s auditor PricewaterhouseCoopers say that under accounting standard MFRS 10 (Consolidated Financial Statements Accounting Standard), AirAsia cannot consolidate its associates accounts. Rather AirAsia is forced to used the equity accounting measures which are permitted by the regulators.

There are several important differences between consolidating, normally done for subsidiaries or companies controlled by the parent, and equity accounting normally done for equity stakes between 20% and 50% with no controlling power. Under equity accounting, AirAsia takes a share of the profit and loss into its accounts in proportion to its stake in the associate company. In this case it would be 49% from IAA and 40% for AAP.

However, when the losses being recorded by the associates surpass the amount that was originally invested by the parent company, the latter stops recognising the losses. This is the case for both IAA and AAP, and 49%-owned AirAsia India.

When accounts are consolidated, inter-party transactions are eliminated, which does not happen under the equity accounting method. The whole of the profit is taken into the accounts, as well as all balance sheet items such as debt, capital, assets, etc.

Further on intercompany elimination of transactions, both revenue as well as costs will be eliminated. Also, the full profit of profitable associates such as the Thai operations will be taken into the accounts, all of which mitigate the adverse effects when the associates are consolidated into group accounts.

Some of these are likely the factors which GMT takes issue with, as it believes AirAsia is not presenting a true picture of its financial situation. The research house will get its wish when the airline releases its second quarter for financial year 2015 (2Q15) results, as the latter has promised to also present a set of pro forma consolidated accounts.

Meantime, GMT has published its own adjusted net profit for 1Q15 in a rebuttal to AirAsia’s assertions over the GMT report.

But it does not seem to be quite fair in terms of the adjustments made. For instance, foreign-exchange losses on loans, which are a huge RM350 million, are included and these are not even realised. Most likely operating profit, which includes extraneous factors, is a far better reflection of profit.

How much do the associates owe AirAsia?

Currently, the total loans to related parties amount to RM2.86 billion as at end-March 2015, which equates to RM1.03 per share or 61% of shareholder equity. One of GMT’s main concerns is what happens if there is a need for AirAsia to write off this entire amount and the impact it will have on shareholder value.

This was a key issue put forward in the report and was the likely trigger for AirAsia’s share price falling 10% to close at RM1.82 on June 11, the day after the report was published.

However, other analysts who cover the airline have said that this is not a new issue and the potential impact of such a writedown had been discussed in investment circles for some time. Maybank Research aviation analyst Mohshin Aziz said: “Nothing new, nor anything groundbreaking that I and the rest of the analyst community have not raised already.”

He opined that in the improbable worst-case scenario where the associates’ debts have to be fully written off by AirAsia, shareholders equity would be slashed to RM1.8 billion or a book value of 65 sen per share.

Net gearing will go up to 6.1 times from the current 2.5 times it is at currently, which will also be higher than the 4.4 times seen during the global financial crisis in 2008. If this happened, it would potentially trigger debt covenants and impede future borrowings, said Mohshin.

According to figures detailed in his report, Mohshin said the airline’s one-year price-to-book value range is from one time to 2.6 times. If it is pegged to its long-term mean of 1.61 times, this translates into a fair value of RM1.58 per share (based on financial year 2015 or FY15) book value equity per share.

Nonetheless, Mohshin said he sees AirAsia’s fair value as being closer to one standard deviation above its mean of 1.97 times and this translates into a fair value of RM1.93 per share.

He is maintaining his earnings forecasts and his “buy” call on AirAsia at a target price of RM2.45. The target price is pegged to a nine-time FY15 price-earnings ratio at a 30% discount to the global low-cost carrier peer average.

And added he was confident that AirAsia’s Malaysian operations would continue to perform well, on the back of better supply and demand balance as restructuring at Malaysia Airlines will provide significant benefits.

Dealing with the associates debt

The crux of the matter, however, boils down to how well the associates do as this will determine if they are able to make good on their substantial debt payments to AirAsia. Currently, the associates are not able to meet their payments without eating their way through all of their working capital.

To deal with this the airline is planning a US$300 million (RM1.13 billion) bond issuance for IAA and AAP over the next three months. It will use the capital raised from the issuance to pare down the two associates’ debts by about half, said Fernandes.

The remainder of the debt will be paid through their cash flow. Fernandes also said that AirAsia may choose to recapitalise some of the debt pre-initial public offering (IPO) to maintain its current shareholding levels in the two.

The question is whether the two associates are attractive enough to pull in the investors for both the bond issue and the eventual IPO. Fernandes said he believes that the bond issue will be well received and that IAA and AAP will continue to improve and head towards profitability.

“We have two very good companies in Malaysia and Thailand. And we have been looking at how we are going to turn around Indonesia. Indonesia has always been (a case of) you turn it around and something happens. Last time we turned it around, the rupiah depreciated and then we fixed it and QZ8501 (crash) happened.

“So again, in the second and third quarter, we should get back to where we should be. It (the crash) did not affect anything, except we cut advertising. But the plan was to always raise capital in these two companies. We are doing this first through our local shareholders, which are putting in money. And then a bond issue, leading finally to an IPO (for both in 2017).

“Both IAA and AAP are turning around very nicely. And third and fourth quarter look very strong and we are looking at being profitable,” he said

When asked about the Filipino market, Fernandes said the country is “probably one of the best in Southeast Asia right now. The economy is good and the government is strong. I keep saying, even though we are being attacked on it, it is our jewel”.

“Remember six years ago, people attacked us on AirAsia in Thailand. Now it is doing so well. The Philippines will be one of those countries. The potential for tourism is huge; it only does two million tourists where Malaysia does 24 million tourists, so the upside is huge,” he added.

Meanwhile, an AirAsia investor presentation following the release of its 1Q15 financials also outlined a positive outlook for the associate companies. The graphic expresses AirAsia’s position with respect to its operations, taken from the the presentation. It basically shows a picture of far better operations going forward compared to Tulloch’s assessment.

The contrasting views can be summarised by Fernandes and Tulloch’s statements.

Tulloch in a rebuttal to Fernandes who spoke against the former’s report, calling it garbage, said: “AirAsia’s historical guidance has not exactly been accurate. In fact, management’s foresight has always been over-optimistic with consensus expectations missing full-year numbers by an average of 44% over the past four years. The sell side hasn’t managed to get within 20% of reported numbers.”

Meantime, this is what Fernandes said: “No point in me talking, just let me do it. Then we will see who is right. I think our record speaks for itself… I think the main message is, despite everything that is happening we are going to have a record year in profits,”

In a nutshell, the question of who will be right will rest crucially on the performance of AirAsia’s associates. Thailand is making profits. If IAA, AAP, and India follow suit, then Fernandes will be right.

If the associates don’t turn around and if their profits remain depressed and the operations are discontinued, Tulloch will have his day and AirAsia will have to write off massive amounts.

But looking at the way in which the figures are moving towards positive territory for the associates, the bets are likely to be on Fernandes and AirAsia, rather than Tulloch and GMT.

That, however, makes no difference to Tulloch. His report has achieved more than what he had set out to do at his own admission; with the AirAsia share price dropping 24% from RM2.02 on June 10, when the report was released, to RM1.53 on June 17 before recovering to RM1.61 yesterday, it is still down 20%. That wiped out some RM1.2 billion from the market capitalisation.

If Tulloch and his clients had followed his recommendations to sell or short AirAsia, they would have made a tidy sum of money. Which raises other questions in this episode.

Yesterday: Did AirAsia engage in accounting shenanigans?

Tomorrow: The perfect setting for a storm of selling

— By Stephanie Jacob & P Gunasegaram