By Paul Rickard

Just why HNA Aviation Group - the largest private operator of airlines in China - decided to invest $159m into Virgin Australia by taking a 13% stake at 30c per share is really not clear.

Partnering with Virgin through a strategic alliance that will look to introduce direct flights between Australia and China (as well as co-operation on code-sharing, frequent flyer programs, lounge access and promotion of tourism and business travel) should be advantageous for both Virgin and HNA, but a strategic alliance doesn’t need to involve an equity investment.

The heavily indebted Virgin will surely welcome the capital injection, although it comes ahead of the completion of a capital structure review that it announced to the market on March 21. And it comes at the same time as Air New Zealand is flogging all or some of its post-dilution holding of 22.5% of Virgin.

Maybe Air New Zealand wanted too high a price. Maybe HNA thought that with the AUD at 0.72 US cents and Virgin shares trading at 12-month lows, this was a bit of steal.

                        Virgin Australia - June 15 to May16

Whatever the reason, they are joining an eclectic mix of shareholders in an airline that is not travelling brilliantly. Once the issue has been completed, their 13% holding will be matched by Air New Zealand with 22.5%, Singapore Airlines with 19.8%, Etihad Airways with 21.0% and Richard Branson’s Virgin Group with around 8.7%. Outside these five shareholders, all other shareholders will speak for just 15% of the company.

While Virgin’s first half underlying profit before tax of $81.5m was up from $10.2m in FY15, the third quarter trading update said that Virgin lost $18.6m and forecast the full financial year outcome of between $30m and $60m underlying profit. This implies that Virgin will lose money in the current quarter, and for the half year, report a loss of between $20m and $50m. And it comes at a time when the industry headwinds seem to be building.

Headwinds and Tailwinds

There is no doubt that the Chinese tourism boom is a significant boon to both Virgin and Qantas. Sydney Airport reports that inbound Chinese tourists in the year to April 30 are up 21.3% on the corresponding period in 2015, and that after locals, Chinese nationals are the second biggest group of passengers travelling through the airport.

And with the Aussie dollar in the low seventies, this is going to continue. Hence the tie ups - Qantas with China Eastern and Virgin with HNA.

However, if you have booked an international air ticket lately at some of the amazingly low prices ($999 return to London or the USA), or seen what Flight Centre had to say with its profit downgrade the other day, you will know that there is no shortage of seat capacity. Prices are low because international capacity is in over-supply.

Lower demand is also impacting, partly in response to the increasing security concerns that passengers have about terrorists and other threats. It is hard to see this headwind going away in the short term.

The other headwind is that the tailwinds which drove such a spectacular increase in profit for Qantas (and to a lesser extent, Virgin) are now over. Oil prices have stopped falling, and if measured in Australian dollars, and more now on the rise. To demonstrate how material this was, Qantas reported that of the $554m improvement in its first half profit compared to the corresponding half in 2015, $448m was due to lower fuel expenses. And revenue, particularly domestic revenue, grew because the local airlines ended the savage market share war and decided to manage capacity.

While both Qantas and Virgin have recently demonstrated greater acumen in managing capacity, the easy profit wins from an end to the local market share war and fall in the oil price are over.

Where do the Brokers stand?

Overall, the broker analysts are neutral on Virgin (seeing potential upside to $0.38 per share), and surprisingly, quite bullish on Qantas. According to FNArena, the consensus target price on Qantas is $4.66 - a whopping 51% premium to yesterday’s close of $4.10.

The brokers note that Qantas is trading on a very attractive earnings multiple of around 5.7 times forecast FY16 earnings and 4.5 times forecast FY17 earnings. Macquarie says that on an enterprise multiple of 2.9 times Qantas is one of, if not the cheapest, airline in the world. Here are the current forecasts as collated by FNArena.

Bottom Line 

I have never been a fan of airlines as an investment proposition. Too much ego with some of the players who get involved, government owned airlines competing on a different agenda to commercial airlines, and uncontrollable exogenous risk. It only takes a single accident and the reputation damage to your airline could be terminal. So, they are on my “avoid” category.

With that caveat out of the way, if I had a burning desire to invest in an airline, then on the basis of the brokers’ analysis and the fact that Qantas is now a long way off its recent high of $4.21, it would be Qantas over Virgin. I am also not sure that I want to be part of a 15% minority shareholder group, particularly when one of the other parties wants out.

That said, I still sense that the headwinds facing the industry are pretty strong. Maybe a speculative buy for Qantas, however long term holders should be considering potential exit points.