Can Kenya Airways Stocks Take Off Again?

I remember around early 2000 local popular Sunday Newspaper ran a story in its pullout, Lifestyle magazine, on how people who had managed to get in the National Airlines shares (Kenya Airways) had grown incredibly wealthier from the investment. Some of them had got into the share when it very cheap and managed to register super-normal profits in paper form, since I do not recall any of them saying they had liquidated though they probably did later. At that time the general perception towards the airline industry was that it was a very lucrative investment and that there was, no way one could not turn a profit if made long-term investments in the business. The share managed to rally sharply to above a 100 shilling a share (barely above a dollar at current rates) before peaking and plummeting to present value of around 7 shilling a share (account for dilution through rights issues as it raised money to fund expansion). From a very remarkable growth and promising future great profits, about slightly over a decade after, the airline is now staring at insolvency and has been actively looking for additional debt financing aside from most recent extended KSh. 4 Billion. This year it reported half year losses of about KSh. 10 billion and it is reasonable (considering financials & managing director press release statements (funding wages through additional debt)) to expect second half losses much larger than first half losses enough to more than wipe out its previous total equity.

What is ailing the business? There is a high possibility there is two sides to it, an industry with historically very low margins (net profits made against sales made) and an airline that has lagged its peers in terms of efficiency and competitiveness.

Airline Business

Ordinarily, you would expect if an investment is high risk, it should offer high returns to compensate for the risk but this is hardly the case in airline businesses. Airlines earn the lowest return on capital yet face the second highest volatility of returns and risk (among businesses surrounding airline businesses). According to a 2013 IATA report, airlines have earned the lowest returns on invested capital among all industries over the last 30-40 years. Warren Buffett famously remarked during one of his lectures, in response to a student’s question, that he had a special line he calls when he is about to make an investment in an airline business so that they talk him out of the idea. Obviously, it was for a reason, he had burnt his fingers while buying into an airline because it was an attractive security (on valuation) only to learn through loss of his investment that it was a bad business.

This is not to say that no airlines consistently deliver value to investors, there are but very few of them manage to achieve this. In most instances returns are usually, just enough for servicing debts but hardly leave anything for those who buy shares in the business and risk capital while there were alternative high return investments.

National airlines

National airlines serve national interests as primary before profits. This is because they help in for instance marketing economy and enabling trade, that is why governments are usually very willing to bail them out. Very few of them are generating profits, Zimbabwe and South Africa airlines were earlier on in the year insolvent and have been getting assistance from their governments.

Kenya Airways

Most other network airlines around the world have been facing stiff competition from low cost carriers (airlines that target cost sensitive clients) who not only are low cost but also on average record higher return on investments. But in the local context, there is only one low cost carrier which is a subsidiary of Kenya Airways but which also appears (from impression created) to be struggling to break even.

Kenya Airways has found itself falling deeper and deeper into debt, initially due to its ambitious expansion plans and now because of inability to break even. Debt isn’t necessarily an evil, in fact it is recognized for its usefulness in economies compared to re-investing internally generated profits since it tends to make the company that uses debt more efficient so that it can be able to finance cost of the debt (in form of interest). What happens when a business that is struggling to break even, is inefficient and has most of its financing in form of debt? It means it very easily falls into a debt trap that inevitably leads to insolvency.

The business is very low margin (estimated at around sh256 a seat-IATA $2.56), it has to operate efficiently otherwise it would not be able to generate profits. It does not take much of government tax, demand stock or rise in costs to eliminate profits. This also makes it questionable how it will fare in a high interest rate environment unless again its debt was guaranteed by the government.

The problem with airlines where the government is big shareholder, it is quite easy to hide internal inefficiencies through the problems inherent in airline industries outside their control. Contacts within the airline have been highlighting low employee morale (later denied during recent senate probe). There have also been alleged cases of lost baggage especially on the West Africa flights. Due to information asymmetry issues (management knows better), it is difficult to determine what exactly is going on and as to whether rumors that have been swirling around are true. Something that is quite for sure is that even if debts were restructured, operating a network airline (not sure about LCC) without superior customer service and improved efficiencies will make it an unsustainable business model.

My take would be that most of the issues raised are addressed and accompanying measures such as requiring more efficient suppliers/external service provides, subsidized airport charges be effected.

Maybe low fuel costs will help improve profitability and new routes especially to the US, but it will be no mean feat to turn around a company facing serious debt overhang problem denominated in a foreign currency while the domestic currency is depreciating but will be watching commentating from the sidelines how it fares. In the meantime, my view is that it is still a too high-risk investment even for a contrarian although it is highly probable government will try to rescue it.

 

NSE IPO ANALYSIS

The Nairobi Securities exchange has issued an IPO seeking to raise funds for expansion and also to reduce its debt. 34% ownership has been offered to the public in the much awaited IPO. The stock offering has a book value of Ksh. 4.00.

What is interesting about the counter is that investors will not trade it based only on its performance as a company but also on the country’s economic outlook: like trading stock index futures. We should thus keep that in mind. On the same note, we should also remember that even when there is a sell off the company still makes money based on the transaction levies. However, positive news is obviously better as income sources are diversified due to new listings and introduction of new instruments etc.

SWOT ANALYSIS

Strengths

a)      Kenya is the region’s largest economy. It will thus attract majority of investment in the region.

b)      Demutualization will improve the image of the exchange

c)       Foreign market pegged indices

d)      Low correlation with developed markets thus may be used as a hedge and diversification

Weakness

a)      Heavy dependence on foreign investors

b)      Low liquidity and depth thus discourage frequent trading e.g. intraday trading

c)       Limited number of tradable instruments. Currently only shares and bonds.

d)      Delays in implementation of changes and improvements

e)      Only buy side transaction (cannot short sell)

Opportunities

a)      Including derivatives into the markets e.g. REITS, Options, Futures etc.

b)      Large potential customer base in local retail customers

c)       Further automation and better technology

d)      Number of companies with ability to list thus potential income

e)      Growth in revenue streams e.g. data vending

Threats

a)      Political risks

b)      Macro-economic exposure e.g. inflation, currency risk etc

c)       Competition from other exchanges

d)      Foreign capital outflow

e)      Capital gains tax

Financial Results

The prospectus has results from 2009. In 2013 there is an entry that is one off and may not be recurring which is the recovery of debts that amounted to kshs. 115,574,000.

PAT = 184,636,900

The NSE is the second demutualized exchange in the continent so comparable data was somewhat limited for the time being. I however used the exchanges of various emerging markets namely: Johannesburg Stock exchange, Mexican exchange, and Malaysia exchange.

NSE JSE BURSA MALYSIA BOLSAA MEXICO
PE Ratio 10.05 15.36 25.65 22.69
Price/Book 2.375 3.86 5.56 3.16
Price/NAV 1.36
Dividend Yield 3.53 3.85 3.9
Profit Margin 29.29% 27% 40.56% 36.6%
Earnings Yield 9.95% 6.51% 3.90% 4.41%

Source: Prospectus, Bloomberg.com

The company’s retention ratio was at 81% for 2013. This is calculated based on the given in the statement.

Assuming a current growth rate of 10% in Profit after tax and constant retention ratio then this is a possible projection.

YEAR 2013 2014 2015 2016 2017 2018 2019
PAT 183636900 202000590 222200649 244420714 268862785 295749063 325323970
DIV 34891011 38380112 42218123 46439935 51083929 56192322 61811554
Retained prof 148745889 163620477 179982525 197980778 217778856 239556742 263512416
EPS 0.944 1.038 1.142 1.256 1.381 1.520 1.672

 

The prospects of the exchange are bright if the opportunities aforementioned are seized and developments made. The PE ratio and the Price/NAV show that the counter is cheap relative to other counters in the NSE. There is good room for growth and this will be heavily bolstered by an improving economy and fate of blue chip companies listed. It is evident that the company is on its exponential phase. Indeed CAGR on profits is 300% since 2009. This is may not be sustainable over the long term as earnings growth stabilizes. None the less, this is a very good stock to hold over the long term.

 

Alphonce M. Iregi

alphoncemwangi@gmail.com

ANALYSING THE NSE STOCK MARKET

Fundamental analysis and technical analysis are the two major ways of analyzing financial markets.
Fundamental analysis
Using fundamental analysis as a trading tool entails observing the trend of various macroeconomic indicators such as growth in output, interest rates, inflation, and unemployment. One combines all this information to assess current and future performance of financial assets. Traders employing fundamental analysis need to continually keep abreast of news and announcements that can indicate potential changes to the economic, social, and political environment.
The most important rule in fundamental analysis is that prices move primarily based on supply and demand. A financial asset trends upward because there is demand for it, regardless of the type of demand e.g. hedging or speculation. Asset movements are based on the need for that asset. Securities’ values decrease when there is excess supply. Supply and demand should be the real determinants for predicting future movements.

Technical analysis
In technical analysis, historical price patterns are used to predict future movements. The assertion of technical analysis is that all current market information is already reflected in the price of assets; therefore, studying price action is all that is required to make informed trading decisions. In addition, technical analysis works under the assumption that history tends to repeat itself. The primary tool in technical analysis is charts. Charts are used to identify trends and patterns in order to find profit opportunities. The most basic concept of technical analysis is that markets have a tendency to trend. Being able to identify trends in their earliest stage of development is the key to technical analysis.
Technical analysis tools such as Fibonacci retracement levels, moving averages, oscillators, volume indicators and candlestick charts provide further information on the level of emotional extremes of buyers and sellers. This enables one to know where levels of greed and fear are the strongest.
In summary
Before implementing successful trading strategies, it is important to understand what drives the movements in financial markets. The best strategies tend to be the ones that combine both fundamental and technical analysis. Too often perfect technical formations have failed because of major fundamental events, the same occurs with fundamentals.