Transportation Aeroflot

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1 Brent oil USD/RUB Aeroflot MOEX Transportation Aeroflot Review of 9М217 results 12 January 218 Andrey Kozhokaru Ticker Recommendation Current price RUB/share ( ) Target price 12M, RUB/share AFLT RX Buy 148,3 RUB 19,1 RUB Upside potential 28,2% Ticker Recommendation Current price EUR/share ( ) Target price 12M, EUR/share AETG GF Buy 11,2 EUR 14, EUR Upside potential 25,2% Number of ordinary shares, mn 1111 Average daily turnover for 3M, thous. RUB Free float 45,8% Market capitalization, mn RUB Main shareholders: Russian Federation 51,2% Rostec 3,5% Financial indicators, mn RUB 216A 217F 218F Revenue EBITDA Net income EPS, rubles per share Equity Net debt Valuation 216A 217F 218F EV/Revenue,5,4,3 EV/EBITDA 3,2 3,9 2,9 Net debt/ebitda 1, 1,,5 Net debt/equity 1,9 1,2,5 P/E 4,2 7,5 5,5 P/B 4, 3,4 2,5 ROE 95% 46% 46% ROIC 21% 13% 17% Prices dynamics AFLT MOEX index 1М -14% -1% 3М -24% 3% 12М -11% -4% 52 weeks high, RUB weeks low, RUB Sources: Halyk Finance, Bloomberg Aeroflot MOEX Despite the growth of operating indicators for 9M217, the Group worsened its financial results, which was reflected in the reduction of the Company's capitalization. Main factors that led to the revaluation of Aeroflot shares were a strong growth of operating expenses (+15.4% y/y), restrained by ruble appreciation, a weaker revenue growth (+6.2% y/y) due to the currency appreciation, and no full transfer of growth of costs into ticket prices. However, taking into account one-off events observed in , as well as considering the Company s historical financial performance, the results for 9M217 looks quite competitive. Moreover, recent financial results partly reflect the Group's development strategy aimed at an expansion of transit traffic and a higher presence in the international market, which require the preservation of a professional air crews and investments in the development of the product and Aeroflot brand. We consider the current decline in the price of AFLT shares as excessive, considering the Company's long-term prospects. Taking into account the preservation of the dividend yield and the current price, we recommend to Buy Aeroflot shares with 12M TP of 19 rubles per share. Medium-term investments in the development without improvement of margins. We forecast the EBITDA margin slightly above 1.5% for the period of (13% earlier), and net profit margin of not more than 5% (7% earlier). Despite the fact that expected figures are much lower than the results of 216 (EBITDA margin 15.7%, net profit margin 7.8%), we believe that maintenance of margins at these levels will be able to ensure a steady growth of financial metrics in case of a successful implementation of the Group's strategic plans for operating indicators. We forecast average annual growth of passenger turnover at 12% y/y for the period of In the long term, we expect a convergence of growth rates of revenues and expenses. Fuel prices, FX dynamics and competition as main factors. The revenue in foreign currency covers around % of the Group's foreign currency s expenditures. For 9M217, the negative FX effect on revenues exceeded the positive FX effect on expenses by 7.5bn rubles. In case of a continued appreciation of the ruble, the maintenance of a negative FX effect in future results is possible and vice versa. Aeroflot currently does not hedge fuel prices. Nevertheless, this position makes the Group less competitive in case of an excessive rise of oil prices relative to airlines that hedge fuel costs, it also assumes a more favorable position in the event of a decrease or stabilization of oil prices. The increase in yields of air transportation sector, observed in 216, largely attributed to the decline in the presence of foreign airlines in the Russian market. In 217 foreign airlines quite quickly returned to the market, which caused an excess of supply and resulted in a decrease of profitability. Aeroflot has strong position to successfully compete, but an exacerbation of the latter will steadily lead to a decrease in margins of the industry. Buy recommendation with 12M TP of 19 rubles/share. In our opinion, the Aeroflot Group will continue to demonstrate a stable growth of operating results on the forecasted horizon, which, in the absence of external shocks, should ensure a stabilization of financial indicators. The air transportation market in Russia remains unsaturated, which provides a significant potential for organic growth. Considering the current price and projected dividends at the level of 1 rubles per share, we recommend to Buy AFLT, while decreasing our 12M TP from 24 to 19 rubles per share. Brent oil Sources: Halyk Finance, Bloomberg USD/RUB

2 Aeroflot January 218 Fig 1. Financial results for 9М217, mn RUB excluding margins 9М217 9М216 y/y Total revenue ,2% EBITDA ,9% EBITDA margin 13,2% 2,2% Operating profit ,5% Operating profit margin 1,3% 17,6% Net income % Net income margin 6,7% 11,5% Fig 2. 9M217 revenues by sources, mn RUB 9М217 9М216 y/y Regular flights ,6% Charter flights ,% Cargo flights ,2% Airline agreements revenue ,2% Revenue from partners under the frequent flyer programme ,1% Other revenues ,9% Fig 3. Operating expences for 9M217, mn RUB 9М217 9М216 y/y Aircraft and passenger servicing ,3% Staff costs ,8% Operating lease expenses ,5% Aircraft maintenance ,9% Selling, general and administration expenses ,7% Amortization and customs duties ,8% Other expenses ,4% Aircraft fuel expenses ,7% Total ,4% Fig 4. The Group s debt as of 3 September, 217, mn RUB y/y Loans and borrowings ,4% Finance lease liabilities ,5% Pension liabilities ,1% Total debt ,4% Net debt ,9% Overview of 9М217 financial results For the reporting period, the Group's revenue increased by 6.2% y/y to mn rubles. The revenue from a passenger traffic increased by 7.4% to 3 2mn rubles, of which the revenue from charter flights equaled to mn rubles (+74% y/y), the revenue from regular flights amounted to mn rubles (+4.6% y/y). ). The revenue from freight transportation increased by 37.2% y/y, reaching 11 3mn rubles. Other revenues decreased by 8.1% y/y to mn rubles. The increase in transportation revenues was associated with the growth in operating volumes, a significant part of which was provided by resumption of charter flights to Turkey. Meanwhile, the pressure on revenues from international flights was derived from the appreciation of the ruble. Moreover, the strengthening of the Russian currency decreased other revenues, mainly represented by airline agreements (Trans-Siberian royalties). The Group s operating expenses for 9M217 increased by 15.4% to mn rubles. The main expenditures items that caused the increased growth dynamics, were labor costs in the amount of 6 9mn rubles (+25.8% y/y), selling, general and administrative expenses at the level of mn rubles (+18.7% y/y), and expenses for aviation fuel, which amounted to mn rubles (+21.7% y/y). The main driver of the rise in fuel expenses, in addition to the increase in transportation volumes, was the higher price of oil. The increase in labor costs associated with the adjustment of wages, the increase in the number of employees, and the increase in the reserve for unused vacations. A significant growth in general expenses was due to the development of the IT infrastructure and the increased spending on marketing campaigns. An appreciation of the Russian currency had a restraining effect on some expenditures. Aircraft maintenance expenses decreased by 2.9% y/y to mn rubles, largely due to the FX effect. For 9M217, expenses for an operating lease increased by 1.5% y/y to 47 71mn rubles, due to the rise in the number of operationally leased aircrafts up to 262 (+26 y/y) and an increase in 3 month Libor rate. The EBITDA decreased by 3.9% y/y to 53 36mn rubles, net income decreased by 38% y/y to mn rubles. The EBITDA margin equaled to 13.2% for 9M217 versus 2.2% for 9M216. The Group's operating profit was mn rubles, with the operating margin of 1.3% for 9M217 against mn rubles, with the operating margin of 17.6% for 9M216. For 9M217 the Group's passenger traffic increased by 16.8% y/y, reaching 38 34k, of which k (+26.4% y/y) accounted for international traffic and k (+1% y/y) for domestic routes. Load factor increased to 83.7% (8.4%) on international destinations and decreased to 83.7% (85%) on domestic routes. Overall load factor for 9M217 equaled to 83.7% (82.4%). Finance income for 9M217 decreased by 66.3% yoy to 6 349mn rubles, finance expenses decreased by 14.3% y/y to 6 331mn rubles. For 9M217 the Group recognized the loss on hedging result in the amount of 4 226mn rubles against 1 611mn rubles for 9M216. The Group's finance income decreased due to the decrease in FX gains. The decrease in finance expenses is associated with the decrease in debt and the decrease in interest rates. Over the reporting period, the Group significantly reduced its debt burden. The total debt decreased by 23.4% y/y to mn rubles as of September 3, 217 relative to mn rubles as of December 31, 216. During this period, loans and borrowings decreased by 84.4% to 3 182mn rubles. Finance lease liabilities decreased by 13.5% to mn rubles. The debt reduction is associated with a revaluation of liabilities as a result of FX changes, as well as scheduled and advanced repayments. As of September 3, 217 2

3 Aeroflot January 218 cash and cash equivalents amounted to mn rubles, the amount of undrawn credit lines equaled to 13.4bn rubles. Adjustment of financial model and forecasts A significant growth of oil prices has strengthened negative expectations of market participants for results of Aeroflot in the short term. The Group's financial results are susceptible to a seasonal factor and 4Q is traditionally the weakest one for the Company. We expect that 4Q217 loss may slightly exceed 5bn rubles, which will provide a net income of 22bn rubles for 217. Fig 5. Dividends of Aeroflot for F Dividends, % of net income 26% 25% - - % % EPS, RUB 4,65 6,6-15,44-5,85 34,96 2 Dividends per share, RUB 1,16 2, ,48 9,95 Fig 6. Balances of cash and cash equivalents of Aeroflot for , as of the end of periods, mn RUB F Cash and cash equivalents Sources: Company Data, Halyk Finance Fig 7. Group s fuel consumption indicators for Amount of fuel consumed, thous. tons Available Seat Kilometres, mn ASK Weighted fuel consumption, gr/ask Fig 8. Group s yields on scheduled flights for 213-9M217 4,5 4, 3,5 3, 2,5 2, ,1 24,8 23,5 23,1 22, М217 International yields Domestic yields We forecast dividend payments at % of net income under IFRS for 217. Aeroflot's current dividend policy allows payments at 25% of net income. However, the Company, as well as a number of other state corporations, paid dividends at % of net income for 216, according to the government s directive. Previously, the Ministry of Finance of the Russian Federation reported that the draft of the federal budget for assumes state companies dividends payments at % of a net income, but final decision will be taken separately for each company. Considering that, as of September 3, 217 the Group had 61bn rubles in cash and cash equivalents on its balance, we consider as highly probable that the relevant government directive will be adopted in 2Q218 and Aeroflot dividends for 217 will amount to 1 rubles per share, which at the current price of 148 rubles represents a yield of 6.75%. While modeling the Company s future cash flows, we assumed that from 218 onwards, the Group will direct 25% of its net income for dividend payments. However, there is a probability that actual dividends may exceed this level, in case of stable cash flows of the Group and the need of a supplement of the federal budget of the Russian Federation. In our updated forecasts, we adjusted the Group's operating expenses. We expect growth in labor costs at 12% y/y for the period of (1.5% earlier), taking into account current staff costs. The average price of Brent crude in 216 was 45.13USD, with an average price of 54.48USD in 217, as of December 2. We forecast a much slower growth rate of oil at 4% y/y (previously 8% y/y) for the period provided by the higher base of 217. However, the share of aviation fuel expenses in total operating expenses could reach up to 27% (25%- previous expectations) in the medium term. Despite the direct dependence of a jet fuel consumption on a traffic volume, Aeroflot Group has a modern and a regularly updated fleet that allows to achieve high fuel efficiency. For 9M217 fuel consumption relative to the carrying capacities was 22.8 g/ask (-.4% y/y). Selling and marketing expenses (included in selling, general and administrative expenses) for 9M217 increased by 22.6% y/y to mn rubles. We expect the growth rate of these expenses at 12-13% y/y in the medium term (previously 9-1%) due to necessary investments in advertising campaigns and the positioning of the Aeroflot brand on international markets. We adjusted our forecast of total revenue for 217 to 534bn rubles (-1.7% compared to previous expectations), leaving forecasts for almost unchanged. For 9M217 lower yields pressed the Group s revenue. International yields dropped to 3.81 rubles/rpk (- 9.7% y/y), domestic yields declined to 3.5 rubles/ RPK (-2.6% y/y). The decrease in yields can be explained by the higher shares of revenue of the Group's subsidiaries, which have lower yields, and by the appreciation of the ruble. We expect that yields will remain at current levels, exceeding historical values, with corresponding tariffs adjustments relative to market conditions. We adjusted the financial model by capitalizing operating lease, applying the capitalization factor of 7 (a number that equal to an average number of current operating lease payments to estimate the 3

4 Aeroflot January 218 total amount of the respective liability). According to our estimates, net debt, including operating lease, will amount to 516bn rubles at the end of 217, Net debt/ebitdar will equal to The proposed WACC, taking into account the capitalization of operating lease, is 1%, which, in our opinion, fairly reflects the risk of the issuer's country. Fig 9. 12M TP calculation, mn RUB 217F 218F 219F 22F 221F 222F Revenue EBIT Depreciation Income tax CAPEX Changes in working capital Free cash flows WACC 1,% Free cash flows (PV) Terminal value (PV) Enterprise value (EV) Net debt for Equity value Number of shares, mn М TP, rubles per share 19 Sources : Company data, Halyk Finance Discounting free cash flows of the Company, while considering operating lease as a debt, we derive 12M TP of 19 rubles per share, the recommendation is Buy. Medium-term factors of the business Despite the Football World Cup, which will be held in 218, the Group expects a relatively moderate rate of growth of operating indicators. According to the Company's forecasts, the growth of passenger traffic in 218 will be at 11-12% y/y, the increase in RPK is projected at the growth rate of ASK at 9-1% y/y, load factor is expected to be above 82%. Necessary infrastructure imposes some restrictions on the Group's operating performance. In particular, the capacity of the Aeroflot s main airport - Sheremetyevo, in spite of the ongoing modernization, limits the Company's passenger traffic. Fig 1. Passenger traffic and load factor of the Pobeda airline for 1-3Q ,6% Source: Company data 94,3% 1Q217 2Q217 3Q217 Passenger traffic, thous Load factor, % 96,8% 98,% 97,% 96,% 95,% 94,% 93,% 92,% 91,% 9,% 89,% According to 9M217 results, Pobeda airline had a passenger traffic of 3.3mn (+2.2% y/y), with the outstanding load factor of 94.5% (87.6% for 9M216). The Company demonstrated a significant increase a load factor, with the constant number of aircrafts for 9M217. As of September 3, the Company s fleet consisted of 12 Boeing NG, the delivery of 4 additional aircrafts is planned for 4Q217. According to Company's forecasts, the average annual growth of the passenger traffic will be at 26% y/y for the period of , which correspond to an increase from 4.3mn to 15.7mn. The Pobeda s fleet will have 45 airplanes by the end of 222. Pobeda airline is expected to be the main growth driver of the Group s passenger traffic on the Russian market. Given the high demand for low-cost carriers in Russia, which is evident by superior load factors, Pobeda is capable to realize presented operating forecasts. For 9M217 RASK for Pobeda amounted to 2.64 rubles/ask, with CASK of 1.94 rubles/ask. For the same period, Group's indicators were 3.3 rubles/ask (RASK) and 3.6 rubles/ask (CASK). Pobeda s revenue for 9M217 amounted to 16 2mn rubles, which represents about 4% of Aeroflot's total revenue, while the net income of the Subsidiary amounted to 3 619mn rubles, with a net profit margin of 23% against the net profit margin of the Group at 6.7%. Taking into account the interdependence of the companies, the presented data are of a general-indicative nature. Nevertheless, it is worth noting that a significant part of the forecasted growth on the Russian market will be provided by the Airline with competitive financial metrics. Beginning from January, 219 the new standard - IFRS 16, which will replace the current IAS 17, becomes mandatory for companies reporting under IFRS. The new standard establishes the accounting 4

5 Aeroflot January 218 Fig 11. Structure of the Group s fleet by type of ownership for the period of Owned Operating lease Finance lease Total Fig 12. Projected net debt and assets of the Group as of the end of Net debt Sources: Company data, Halyk Finance Fig 13. Dynamics of financial indicators in , mn RUB Assets Source: Company data х7.9 х Net debt in case of operating lease capitalization Assets in case of operating lease capitalization 212A 213A 214A 215A 216A 217F Operating profit EBITDA EBITDAR Net income rules for leasing operations for a lessor and a lessee. According to the current IAS 17, leasing is classified either as finance or operating, depending on the parameters of the transaction. Under the new IFRS 16 standard, almost all leasing agreements will be regarded as finance lease, except for short-term contracts and transactions for small amounts. The difference between operating and finance lease (for lessee) is that operating lease allows to keep debt off the balance, while reflecting regular payments in the income statement, whereas finance lease requires the recognition of assets received under leasing contracts on the balance sheet and the corresponding recognition of debt obligations. During the finance lease contract, a lessee recognizes the depreciation of a leased asset and related interest payments in the income statement. As a result of the presented difference, in case of finance lease, companies report higher levels of debt and assets, and incur higher expenses in the beginning of the finance lease term, but at the same time have a higher operating cash flows, which could be reduced only by the interest expenses (in case of its respective classification), with a portion of principal payments reflected as a financing cash outflow. Under operating lease agreement, companies report lower debt levels and higher revenues at the beginning of the term and lower operating cash flows during the term. The aviation industry will definitely sense the impact of the introduction of the new standard. Despite the fact that changes technically affect only the form of a representation of activities, without changing the economic nature, many airlines may reconsider strategic plans for the future development of their fleets. As of September 3, out of 314 aircrafts of the Group, 261 were in operating lease (83%). All the expansion of the fleet of the Group in recent years was provided by aircrafts, taken into operating lease. In our most recent forecasts, we proceeded with the assumption that in future the Group will expand its fleet using primarily operating lease. However, given the potential versatility of the effect of the introduction of a new standard on the market conditions of operating and finance leases, including future demand and pricing, it might be necessary to adjust forecasts in case of corresponding changes to Group's plans for the fleet formation. On December 21, 217 Aeroflot s Board of Directors approved the program of bonds issuance for the period of 1 years, with a nominal volume of 24.65bn rubles. In the long run, this program can be used to finance the development of the fleet. According to our estimates, regarding the Group's operating lease as a finance one, Aeroflot s net debt and assets increase by 7.9 and 2.4 times, respectively. In case of the operating lease capitalization, operating expenses decrease and projected for 217 EBITDA increases to mn (56 827mn rubles without capitalization), with an EBITDA margin of 22.7% (1.6% without capitalization). Dynamics of Aeroflot shares and related risks The dynamic of the 38% decrease of Aeroflot's shares from the peak, established in July 217, corresponds to the growth rate of the stock, which increased by several times from the beginning of 216. We attribute a significant reduction in the Group's capitalization on the background of the announced financial results to high expectations, formed after the strong performance in 216. For 9M216 the net positive effect of the exchange rate difference on the operating income was mn rubles ( mn to revenue and 2 63mn to expenses). Moreover, for 9M216 the Group received a one-off profit of mn rubles due to the FX revaluation of returned deposits previously paid for a future aircrafts deliveries. For 9M217 the negative FX effect on the operating income amounted to 7 521mn rubles, the FX effect on the revaluation of returned deposits secured a profit of 2 9mn rubles. Aeroflot definitely worsened its financial results for 9M217, but the deterioration does not look so dramatic with the exclusion of one-off events. Furthermore, 5

6 USD/RUB Brent Aeroflot January 218 Fig 14. Dynamics of Aeroflot shares in Fig 15. Dynamics of USD/RUB and Brent crude oil since 216 Fig 16. Changes of Bloomberg's consensus forecasts for Brent oil price USD/RUB AFLT Brent 1Q218 2Q218 3Q218 4Q218 1Q219 2Q219 As of As of As of Company's forecasted financial indicators for 217 as a whole, exceed results of Despite the fact that the exchange rate of the Russian currency has a historically strong correlation with the price of oil, which grew by 26% since June 217, we have not observed a corresponding strengthening of the ruble in terms of dynamics. The average exchange rate of the ruble for 9M217 strengthened by 17% y/y against USD and EUR, but since June 217, the Russian currency weakened by 4% against USD and by 9% against EUR. Currently, the price of Brent crude oil is at 69USD per barrel. Despite a significant improvement in market expectations for the price of Brent for the medium term, the current quotation vastly exceeds the last consensus forecast. We do not expect previous growth rates of oil to hold in the short term, but we do not exclude some strengthening of the ruble in 218 in case of a favorable macroeconomic environment in Russia. Main risks for the Aeroflot Group in the foreseeable future are a continuing rise in aviation fuel prices, an excessive appreciation of the ruble, an increased competition, and an aggravation of geopolitical tensions. The latter carries the risk of an introduction of sanctions against the Russian Federation as a whole, and state owned companies in particular. A significant increase in the supply provided by foreign airlines could further reduce yields, and the Aeroflot Group, in order to maintain and increase its market share, in addition to restraining tariffs growth, may incur higher marketing and product development expenses, which in the aggregate could provide a serious pressure on margins. Around 6% of the Group's total revenue for 9M217 was represented by revenue from airlines agreements that are royalty payments made by foreign air carriers for flights over the territory of the Russian Federation. The Company stated that these payments are directed to the needs of the aviation industry, such as low tariffs for the air communication with the Far East. A potential cancellation of royalties could be a negative factor, but the main issue will be the necessity of a maintenance of Group's current liabilities related to these payments. Source: Bloomberg 6

7 Aeroflot January 218 Appendix 1. Pro forma financial statements of Aeroflot, mn RUB, except per share data 214A 215A 216A 217F 218F 219F 22F 221F 222F Income statement Revenue O perating costs, excluding staff costs Staff costs Depreciation and amortisation Operating income Finance income/expenses, net O ther non-operating income/expenses, net Income/loss before tax Income tax expense Profit/(loss) for the year N umber of ordinary s hares, mn Earnings per share (EPS) Balance sheet C ash and cash equivalents Short-term investments A ccounts receivable and prepayments Current income tax prepayment A ircraft lease security deposits Expendable spare parts and inventories A s s ets c las s ified as held for s ale Total current assets Deferred tax assets Long-term financial investments A irc raft leas e s ec urity depos its O ther non-current assets Prepayments for aircrafts Property, plant and equipment Total non-current assets Total assets A ccounts payable and accrued liabilities Unearned traffic revenue Deferred revenue related to the frequent flyer programme Provisions for liabilities Loans and borrowings Total current liabilities Long-term loans and borrowings Provisions for liabilities Deferred revenue related to the frequent flyer programme O ther non-current liabilities Total non-current liabilities Total liabilities Share c apital Treasury shares reserve A c c umulated profit on dis pos al of treas ury s hares Investment revaluation reserve Hedge reserve Retained earnings Equity attributable to shareholders of the Company Non-controlling interest Total liabilities and equity Cash flow statement C ash flows from operating activities C ash flows from investing activities C ash flows from financing activities Net change in cash and cash equivalents Cash and cash equivalents at the end of the year Sources : Company data, Halyk Finance Appendix 2. The Company s description. The Aeroflot Group has one of the leading positions on the European market and is the largest aviation holding in the Russian air transportation market. The Group includes Aeroflot (the parent company), Aurora, Pobeda, and Russia airlines. The group has an extensive network of routes on domestic and international destinations. As of December 31, 216, the fleet of the Group consisted of 292 aircrafts that executed regular flights on 326 destinations. The Aeroflot Group intends to increase its passenger traffic up to 7mn people by 225 from 43.4mn in 216, by developing a low-cost segment on the domestic market, and by increasing transit and regular flights abroad. The main shareholder of the Group is the Government of the Russian Federation (51.2% of all shares). Ordinary shares of the Company are traded on the Moscow Stock Exchange and are part of the main Russian stock indices. 7

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