2014 Outlook: Competition Likely To Be Less Severe

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1 Strategy, 16 December 213 Aviation 214 Outlook: Competition Likely To Be Less Severe Overweight Macro Risks Growth Value Competition will remain challenging in 214 but less severe in our view, as Malindo has opted to take a more conservative expansion strategy, which bodes well for AirAsia and MAS. We see value in AirAsia and AirAsia X as their valuations are cheaper than those of regional and global peers. Stay OVERWEIGHT on the sector, with Visit Malaysia 214 and the opening of KLIA2 set to boost passenger arrivals. Ahmad Maghfur Usman ahmad.maghfur.usman@rhbgroup.com Competition to remain challenging but less severe. 214 is expected to remain competitive as Malindo continues to spread its wings. However, we think Malindo will be less aggressive due to its high cost structure. Its airfare discounts have narrowed while there have been capacity cutbacks on some routes. Furthermore, fleet delivery so far (it currently has six narrow-bodied aircraft) has been below its initial target of 12 aircraft. Malindo has adopted a new strategy of expanding to regional routes such as Indonesia, Bangkok and India, as opposed to competing for domestic market share amid the tough local landscape. This bodes well for the two dominating local carriers, AirAsia (AIRA MK, BUY, FV: MYR3.7) and Malaysian Airline (MAS MK, NEUTRAL, MYR.3), if they play their cards right in maximising yields and loads. Intense competition has resulted in airlines luring travellers with big discounts, which help boost demand for air travel. This will continue to benefit Malaysia Airports (MAHB, BUY, FV: MYR1.13). Buoyed by Visit Malaysia Year 214. The Government has earmarked 214 as Visit Malaysia Year. Its efforts to promote the country as a major tourist attraction bodes well for airport operator MAHB, as it will be buoyed by the expected rise in foreign tourist arrivals. In view of the carriers rising capacity and expectations that air fares will remain competitive, we conservatively expect passenger traffic handled by Malaysia Airports to grow 12% in 214 (vs 14% forecast in 213). We see upside to our passenger forecasts, as growth will be fuelled by AIRA s new hubs in Penang, Kota Bharu and Kota Kinabalu, which are enjoying strong take-ups. Maintain OVERWEIGHT. We see value in AIRA and AirAsia X (AAX MK, BUY, FV: MYR1.31), as their valuations are relatively cheaper than those of regional and global peers. AIRA is our Top Pick due to growth at its associates and improving performance in its Malaysian operations as air fare discounts from Malindo narrow. Excluding the market cap of AIRA s listed entities and valuing its soon-to-be-listed (in 214) Indonesia unit at a 1x FY14 P/E, we estimate the Malaysian unit s P/E at only 6x FY14. Meanwhile, any selldown in MAHB shares on the delay of the KLIA2 opening will provide bargain-hunting opportunities. We like MAHB in anticipation of its strong free cash flow generation upon the commencement of KLIA2 and potentially higher rental revenue it can generate from a bigger airport. We also like AAX s aggressive capacity expansion, which will promote economies of scale and propel its earnings. We maintain OVERWEIGHT on the sector. Jerry Lee jerry.lee@rhbgroup.com P/E (x) P/B (x) Yield (%) Company Name Price Target Dec-14F Dec-14F Dec-14F Rating AirAsia MYR2.37 MYR BUY AirAsia X MYR1.2 MYR BUY Malaysia Airports Holdings MYR9. MYR BUY Malaysian Airline System MYR.31 MYR.3 na NEUTRAL Source: Company data, RHB estimates See important disclosures at the end of this report Powered by EFA TM Platform 1

2 Aviation 16 December Review To Date Competition rose to new heights following Malindo s entry, thus pressuring yields AirAsia s low-cost model has enabled it to stand strong despite intensifying competition amid a cost-conscious culture Malindo has ambitions to be the next major player after AirAsia Malaysia Airports benefits the most from rising passenger demand, as low air fares stimulate air travel Our OVERWEIGHT call on the sector in 213 outperformed the benchmark index, with an equal weighting return on our BUY calls of 23% vs the FBM KLCI s 12% 213 a year for yield 213 has been a challenging year for Malaysian carriers, as they embarked on aggressive capacity expansion to boost topline and achieve economies of scale amid heightening competition driven by Malindo Air s debut. This resulted in yields coming under pressure for Malaysian Airlines (MAS, NEUTRAL, FV: MYR.3) and AirAsia (AIRA, BUY, FV: MYR3.7), dropping 12.7% and 5.3% YTD respectively. Other new foreign carriers commenced flights to/from Kuala Lumpur, sparking new competition (albeit to a lesser extent) in the international segment as well. Although AirAsia X s (AAX, BUY, FV: MYR1.31) yields were lower than expected (6.3% YTD), we think this is the result of newly-launched flights priced at promotional rates and not due to competition. Only the strong will prevail during tough times With yields coming under pressure, margins took a hit. MAS reported a massive YTD core loss of MYR818m (+24% YTD) as management opted for a load-active strategy by lowering air fares significantly without meaningfully cutting costs. Its turnaround attempt was a disappointment despite its load factor rising to new highs and YTD (9MFY13) revenue passenger kilometre (RPK) climbing 28%. While we expected AIRA s earnings to decline, its results were commendable as it continued to report EBITDA growth (+2.8% YTD). We note that the low-cost carrier focused on cutting costs since revenue only inched up 6.7% vs the 11.5% growth in seat capacity. AIRA has exercised prudence in its fleet delivery, opting not to compete head-on with Malindo s and MAS aggressive fare discounting strategy. New kid on the block turns up the heat on competition Malindo, which commenced operation in late March, has a fleet of nine aircraft (including three turboprops) flying to 16 destinations, of which four are overseas. The carrier, which is partly owned by Lion Air of Indonesia (via a JV), is embarking on an aggressive expansion plan to increase its Malaysian-flagged fleet under Malindo Air by taking delivery of 1 aircraft over the next decade to compete with AIRA. Lion Air has also set foot in Thailand by establishing Thai Lion Air, thus taking competition up a notch. Thai Lion Air also plans to expand its fleet to 12 aircraft by end-214, before increasing to 5 aircraft within five years. MAHB the winner amid tough competition Intensifying competition has resulted in airlines luring travellers with big discounts, which helped boost demand for air travel. This has largely benefited Malaysia Airports Holdings (MAHB, BUY, FV: MYR1.13), which reported a 17.3% jump in YTD passenger numbers in October, driven by strong growth in both the domestic (+16.6%) and international (+18.%) segments. The airport operator s traffic numbers are likely to outperform our FY13 growth forecast of 14.%. The inclusion of new foreign carriers into KLIA also partly lifted the overall passenger traffic handled by the airport operator. As a measure of how much overall capacity has increased, the October YTD flights handled were 13.3% higher, mostly driven by domestic traffic. Decent sector performance We are OVERWEIGHT on the sector. MAHB, our preferred pick throughout 213, has raked in YTD returns of 71%. The underperformer was MAS, which we downgraded to SELL as its 1QFY13 results fell short of expectations. On an equal weighted basis, our BUYs in the aviation coverage recorded a YTD return of 23%, thanks to strong numbers from MAHB and AIRA in 1H, which beat the FBM KLCI s 12%. See important disclosures at the end of this report 2

3 Aviation 16 December Outlook Malindo s expansion plan is likely to slow down as competition is tougher than it had originally anticipated Competition to remain tight but less severe We expect 214 to remain a challenging year as Malindo continues to spread its wings. However, we think Malindo will be less aggressive due to its high cost structure. We notice that its airfare discounts have narrowed while there have been capacity cutbacks on some of its routes. Furthermore, its fleet delivery so far (it currently has six narrow-bodied aircraft) has been below its initial target of 12 aircraft. Malindo has adopted a new strategy of expanding to regional routes such as Indonesia, Bangkok and India, as opposed to competing for domestic market share given the challenges in the local competitive landscape. MAS appears to be aggressive in pricing its fares while AIRA seems to be chalking up encouraging loads, with load factor remaining strong. We believe that Malindo will take a longer time to obtain regulatory approval for landing rights in international destinations, compared with commencing new domestic routes. Hence, the time factor will favour MAS, AIRA and AAX. Weakening MYR could increase debt levels, which could in turn translate into higher interest costs The effects of Visit Malaysia Year 214 will spill over to neighbouring countries Passenger yields could stay flat in 214 Operating expenses, funding costs climb on currency fluctuations The depreciation of some currencies due to the regional exodus of funds (on concerns over the US Fed s timing in tapering its bond-buying) is expected to boost the revenue of the airlines under our coverage. However, this will be more than offset by high jet fuel costs. Long-haul carriers like AAX and MAS will likely see higher yields and passenger demand from non-regional travellers, whose stronger currencies may translate into cheaper airfares and vacation cost. However, the risk of a further depreciation in the MYR will erode profits as jet fuel costs, aircraft maintenance fees and leases are typically paid in the USD. This may offset the impact of the higher revenue churn. Meanwhile, debt will increase as local currencies weaken, since the funding of aircraft purchases is mostly in USD terms, which will accordingly result in higher interest expenses. We are of the view that carriers which are most sensitive to currency risks are those with low earnings bases such as MAS and AAX. Buoyed by Visit Malaysia Year 214 The Government has earmarked 214 as Visit Malaysia Year. Its efforts to promote the country as a major tourist attraction bodes well for airport operator MAHB, as it will be buoyed by the expected rise in foreign tourist arrivals. The Government has been promoting the year-long tourism campaign since early 213 and the calendar is now filled with events throughout the 12 months. We believe that the Visit Malaysia Year 214 will not only increase the inflow of tourists, but also create a positive spillover effect on neighbouring countries such as Singapore, Indonesia and Thailand. In view of the carriers rising capacity and expectations that air fares will continue to remain competitive, we expect passenger traffic handled by Malaysia Airports to grow by 12% in 214 (vs 14% forecast in 213), which we deem conservative. We see an upside to our passenger forecasts, as growth will be fuelled by AIRA s new hubs in Penang, Kota Bharu and Kota Kinabalu, which are enjoying strong take-ups. Yield picture for 214 Given that MAS and AIRA s 9MFY13 (YTD) passenger yields have dropped 12.7% and 5.3% respectively, and in tandem with our assumption that discounts from Malindo will continue to narrow next year, we expect passenger yields to stay flat at best in FY14, before inching up slightly in FY15. AIRA s flat yields next year could likely be offset by a higher ancillary take-up as it expands its service offerings to include in-flight duty-free shopping, its high flyer programme and new fly-thru pairings. Meanwhile, we expect AAX s yields to be slightly higher as the pricing discount relative to full-service carriers for its mature routes narrow. See important disclosures at the end of this report 3

4 Aviation 16 December 213 KLIA2 will be a significant upgrade in terms of infrastructure in addressing passengers comfort needs and this would pave way for low-cost carriers to lure in premium passengers Delay to have minimal impact on valuation, and hence any selldown on poor investor sentiment represents an opportunity for investors to accumulate MAHB shares. MAHB stands committed to the existing deadline for KLIA2, targeting for operations to commence by April will be a cost-conscious year for carriers after the aggressive expansion in 213 KLIA2 could pave way for LCCs to tap into the premium fussy passengers Premium passengers who have been hesitant to depart from the LCCT due to inconvenience and the uncomfortable environment will likely change their minds with the commencement of KLIA2, which is expected to address passengers comfort. This could pave the way for low-cost carriers to lure in premium passengers, which will be positive in providing upside to passenger yields. AirAsia has taken this opportunity by offering a hi flyer scheme, tailored to the needs of business and premium passengers with the option of flexibility on flight timing and express boarding. We understand that this extra service offering has seen a strong take-up from the business community. MAHB stands committed to a timely completion Of late, there have been media reports highlighting renewed concerns that KLIA2 may not meet the scheduled completion to commence operations in early April 214. MAHB has acknowledged that the problem is centred on the slippage in the work schedule of the KLIA2 terminal building, which is being constructed by the UEMC Binapuri JV. Problems arising from this include: i) cracks on the surface near the apron (aircraft parking), ii) uneven airport taxi ways, and iii) the district cooling system. Without factoring any Liquidate and Ascertained Damages (LADs) into our earnings assumptions, we estimate that a 3-month delay would result in EBITDA loss of MYR1m, as lower revenue earned from the retail outlets would be cushioned by reduced operating expenses of KLIA2, notably from electricity and maintenance. Depreciation would be tied in with the commencement of KLIA2. We thus estimate the impact on valuation would be minimal, and hence any selldown on poor investor sentiment represents an opportunity for investors to accumulate MAHB shares. MAHB stands committed to the existing deadline for KLIA2, targeting for operations to commence by April 214. Cost discipline may be the new order Jet fuel prices have dropped 3.5% YTD and moving forward, we expect it will likely remain flat in FY Hence, we do not see higher jet fuel prices posing a significant threat to earnings. FY14 will be a cost-conscious year for the carriers as they strive to be profitable. This could see Malindo taking a more conservative approach in its future expansion plans. We are also positive on the commencement of KLIA2 in improving aircraft turnaround from the current congestion at the LCCT. AIRA believes its cost structure will continue to improve on potential fuel burn reduction upon the commencement of KLIA2. Furthermore, the automated baggage handling system set to be installed at the new airport is expected to lead to lower ground and baggage handling costs. Maintain OVERWEIGHT on sector, with AIRA as our Top Pick Maintain OVERWEIGHT on sector While the sector s outperformance was mostly driven by the strong rally from MAHB, we think AIRA s share price has been overly-punished despite its better-thanexpected 9MFY13 earnings amid intensifying competition. We see value in the airline as its valuations are relatively cheap compared to its regional and global peers. AIRA is our Top Pick given growing overall income from its associates and improving performance at its Malaysia operations, as air fare discounts from Malindo come down. Including the market cap of AirAsia s listed entities and valuing its soon-to-belisted (in 214) Indonesia unit at a 1x FY14 P/E, the Malaysian unit s P/E is only 6x FY14. Elsewhere, any selldown in MAHB on potential delayed opening of KLIA2 will provide bargain-hunting opportunities. We like MAHB for its strong free cash flow generation upon the commencement of KLIA2 and the higher potential rental revenue it can generate from a bigger airport. We also like AAX s aggressive capacity expansion, which will promote economies of scale and accordingly propel its earnings. Meanwhile, MAS is still a NEUTRAL as we remain pessimistic on the carrier s ability to bring down costs. We maintain OVERWEIGHT on the sector. See important disclosures at the end of this report 4

5 1Q-29 2Q-29 3Q-29 4Q-29 1Q-21 2Q-21 3Q-21 4Q-21 1Q-211 2Q-211 3Q-211 4Q-211 1Q-212 2Q-212 3Q-212 4Q-212 1Q-213 2Q-213 3Q-213 Aviation 16 December 213 Figure 1: Passenger movement y-o-y % chg Passenger 8,, 7,, 6,, 5,, 4,, 3,, 2,, 1,, Figure 2: Aircraft movement y-o-y % chg Aircraft 7, 6, 5, 4, 3, 2, 1, International Passenger Movement (RHS) International Aircraft Movement (RHS) Domestic Passenger Movement (RHS) Domestic Aircraft Movement (RHS) y-o-y (total domestic and international) chg (LHS) y-o-y (total domestic and international) chg (LHS) Source: RHB estimates Source: RHB estimates Figure 3: Yield trend sen/seat km Figure 4: Revenue passenger kilometre trend (m) , 12, 1, 8, 6, 4, 2, - 7, 6, 5, 4, 3, 2, 1, - Malaysia Airlines (LHS) AirAsia (RHS) MAS (LHS) AirAsia (RHS) Source: RHB estimates, Company Data Source: RHB estimates, Company Data See important disclosures at the end of this report 5

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