jazeera airways A Change of Fortune Key Data 12-Month Fair Value: KD Recommendation: Buy-Risk Level: 5** Reason for Report: Resuming Coverage

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1 jazeera airways A Change of Fortune June 05, 2011 Key Data Fair Value per share (KD) Closing Price (KD) * week High / Low (KD) 0.194/0.097 YTD / 12-month return 50%/41% P/E (TTM) 15.0 Shares Outstanding (Millions) 220 Market Cap (KD Millions) 41 Free Float 49% Reuters / Bloomberg Code JAZK.KW/JAZEERA KK *Price as of close on June 02, Sources: Zawya and NBK Capital key metrics 2010A 2011F 2012F 2013F EPS EPS Growth n.a. n.a. 0.1% 8.9% P/E n.a Dividend Yield 0.0% 0.0% 0.0% 2.8% EV/EBITDA n.a Revenue (Millions) Revenue Growth -7.7% 14.7% 3.4% 5.9% EBITDA (Millions) EBITDA Growth n.a 103.3% 9.1% 7.6% EBITDA Margin 16.6% 29.4% 31.0% 31.5% Sources: Zawya and NBK Capital forecasts KD Millions 2Q2010A 1Q2011A 2Q2011F 3Q2011F Revenue EBITDA (0.3) Source: NBK Capital rebased performance Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 MSCI Kuwait Sources: MSCI, Bloomberg, and NBK Capital Jazeera Highlights 12-Month Fair Value: KD Recommendation: Buy-Risk Level: 5** Reason for Report: Resuming Coverage A successful turn-around. We feel that Jazeera Airways new strategy has merits, and we think that this could become one of the most exciting turn-around stories in the Middle East and North Africa (MENA) region. Jazeera Airways has made a series of tough decisions over the past four quarters, but we believe that this change has led to a more efficient utilization of assets. Under the new structure, Jazeera Airways has been able to record three successive profitable quarters driven by core operations. High fuel prices may be a short-term obstacle, but Jazeera Airways seems capable of passing a major portion of the cost increase on to passengers by adding fuel surcharges. According to management, Jazeera Airways operates in a late-booking environment, which allows the airline to adjust prices by adding fuel charges. This strategy worked in 1Q2011, and we anticipate the airline will repeat this success in 2Q2011, as Jazeera Airways has shown its ability to raise prices in the past three quarters. The balance sheet is improving, and we see the successful completion of the rights issue as a major catalyst for the stock. The net debt-to-equity ratio has been on the decline for the last three quarters and currently stands at 7.2x. Contingent liabilities (mostly an order with Airbus) have disappeared, with a major portion of the cost of the four aircraft remaining on order already paid for. We feel that the successful completion of the rights issue will decrease the net debt-to-equity ratio to sustainable levels and reduce finance charges. The share price has been on a major rally following the announcement of the 1Q2011 results. Though the share price has rallied from KD to KD 0.186, we feel that there is some more upside left for the stock. We have formulated a new set of forecasts for Jazeera Airways based on the airline s strategy of preserving yields and following a cautious approach for capacity growth. Our fair value for Jazeera Airways, based on a combination of discounted cash flow (DCF) and a peer group valuation method, is KD 0.260, and we have an Buy recommendation with an upside potential of 40%. Analyst Samir Murad, CFA T E. samir.murad@nbkcapital.com ** Please refer to page 8 for recommendations and risk ratings. nbkcapital. com

2 The turn-around plan results in an operating platform that takes the Jazeera Airways Group back to profitability Losses sustained in FY2009 and 1Q2010 wiped out 47% of equity Jazeera Airways ended FY2009 with a loss of KD 8.2 million and 1Q2010 with another loss of KD 4.5 million. Combined, the losses sustained in FY2009 and 1Q2010 wiped out 47% of the company s equity base. Such losses made it clear that if Jazeera Airways wanted to continue operating as a going concern, the company needed to make drastic changes to its business strategy. Figure 1 Turn-around Plan PHASE 1 PHASE 2 PHASE 3 Resize Capacity Profit Before Growth Revise Fleet Plan Market overcapacity Reduce aircraft from 11 to 6 Redeploy excess capacity 3rd-party leasing contracts Cut loss-making routes Increase yield Reduce airline overhead Turn airline profitable Revise fleet order to accommodate market and changes in the overall business environment Source: Jazeera Airways Jazeera Airways had to make some tough decisions while implementing the turn-around plan Jazeera Airways introduced the turn-around plan in 2Q2010 that has led to a positive transformation in operations. The airline made a series of tough decisions that allowed the company to record three profitable quarters the first time in the airline s history. Below we point out the three stages of the turn-around plan: Stage 1: Resize Capacity Issues Overcapacity in the market 51% of seats offered by all carriers on destinations operated by Jazeera Airways were flown empty in Internal overcapacity Jazeera Airways was operating 11 aircraft in its fleet. Following the company s exit from Dubai, the fleet proved to be too large for the Kuwaiti market alone. Corrective Measures Integrate vertically Jazeera Airways acquired Sahaab Leasing, which provided a platform to re-allocate excess capacity to the international markets. Resize capacity Jazeera Airways reduced the number of aircraft the airline operated to six from 11. As a result, the workforce was reduced by a third. Redeploy excess aircraft Through Sahaab Leasing, the group was able to lease four aircraft to Virgin America and one aircraft to Sri Lankan Airlines. This action provided the group with a stable revenue stream. Stage 2: Profit before Growth Issues Loss-making routes Due to overcapacity in the market, Jazeera Airways was forced to sell deeply discounted tickets on certain routes. This had a direct impact on the airline s profitability, especially during the low season. nbkcapital. com 2

3 Corrective Measures Revamp the network Jazeera Airways optimized the network plan to focus on short routes (two hours), which led to a significant improvement in yield. Terminate loss-making routes Jazeera Airways stopped offering its services on routes that were loss making, such as the Indian Subcontinent. Create flexible capacity The reduced capacity allowed Jazeera Airways to redeploy capacity throughout the year according to market opportunities. Stage 3: Revise Fleet Plan Issues Large order with Airbus Jazeera Airways had an order with Airbus for 29 A320s. Following the restructuring of the group, this order was obviously too large and presented a large future burden. Corrective Measures The cancellation of 25 aircraft on order is a step in the right direction Cancel the order Jazeera Airways was able to successfully negotiate the cancellation of 25 aircraft the airline had on order with Airbus. This meant that Jazeera Airways has just four aircraft on order to be delivered between 2012 and This significantly lowered future cash outflows for the airline and provided the group with the ability to respond to market dynamics. Turn-around plan bears fruit almost immediately Average Yield Shoots Up The average yield for Jazeera Airways has been on the rise following the actions taken as part of the turn-around plan. Figure 2 highlights the progression of the quarterly yield for the airline since 1Q2009. The improvement in the yield was coupled with an improvement in the load factor. Jazeera Airways registered an improvement in the load factor from 59% in 2H2010 to 66% in 2H2010 and from 37% in 1Q2010 to 64% in 1Q2011. Figure 2 Quarterly Yields In the past three quarters, Jazeera Airways has shown a strong rebound in yields KD Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 Sources: Jazeera Airways and NBK Capital nbkcapital. com 3

4 Three Consecutive Profitable Quarters It did not take long for the turn-around plan implemented in 2Q2010 to bear fruit, as Jazeera Airways returned to profitability in 3Q2010. The airline recorded a net income of KD 2.4 million (foreign exchange [FX] gains and restructuring costs were removed) and an operating profit of KD 3.6 million in 3Q2010. The fact that Jazeera Airways was able to continue posting profits in 4Q2010 and 1Q2011 reflects that the turn-around plan has improved profitability all year round not just in periods of peak demand. Figure 3 Quarterly Profitability Jazeera Airways has been profitable ever since the implementation of the turnaround plan in 2Q KD ('000) 1Q 2Q 3Q 4Q 1Q Operating Profit (2,708) (1,614) 3,600 2,728 1,908 Net Income (4,499) (4,722) 4,413 2,003 1,028 Sources: Jazeera Airways and NBK Capital Strategy Moving Forward Abandon low-fare pricing policy No longer competing on price only Though Jazeera Airways will retain several aspects of its low-cost strategy, the airline is moving away from the pricing policy of undercutting all competition. The airline no longer aims to differentiate itself on price but rather on product offering. Management has informed us that the difference in prices between Jazeera Airways fares and that of the competition is now less than 5%. We feel that such a strategy could enhance Jazeera Airways operating margins given that 93% of the airline s traffic is based on origin and destination (O&D) travel. All-inclusive fares Jazeera Airways changed its product offering to include free meals on board for all passenger classes and increased the baggage allowance to 40 kg. Customers no longer have to purchase food on the plane and are allowed an extra 20 kg for baggage. Management believes that the revised product adds more value for customers, which, coupled with other features (such as the 94% on-time performance), makes Jazeera Airways the airline of choice. Maintain a young fleet A young fleet provides a major competitive advantage Jazeera Airways plans to keep operating a young fleet, which leads to lower maintenance costs and helps preserve the airline s high on-time performance record. Management informed us that aging aircraft will be retired (or leased out to other airlines) and be replaced with other aircraft on order. We see this as an essential strategy for the airline to maintain a major competitive advantage over Kuwait Airways, Jazeera Airways main rival. Seek and add only routes with strong demand potential Jazeera Airways will be very careful to add new destinations to its network in order not to negatively impact profitability. Jazeera Airways recently announced the addition of Cairo to the network, which we believe will bolster the airline s profitability. Cairo is the second largest destination out of Kuwait, second only to Dubai. However, unlike Dubai traffic, which is highly influenced by transit passengers, Cairo is mostly an O&D market. In addition, currently only two other airlines operate on this route. nbkcapital. com 4

5 Pursue vertical integration Jazeera Airways is aiming to grow through vertical integration. The acquisition of Sahaab Leasing represents the first step in this process. Another step will be for Jazeera Airways to operate its own terminal, which will help diversify revenue sources. Such an expansion will further enhance the customer experience and improve the airline s efficiency. Fuel puts pressure on profitability, but Jazeera Airways appears to be capable of dealing with it High fuel prices will pressure profitability in 2Q2011 Fuel prices have been on the rise in 2011, despite showing some signs of a correction in the past few days. Based on the latest market prices, it looks like 2Q2011 will have a high fuel bill. Jazeera Airways has not hedged for fuel in 2011, but management appears to be confident in the airline s ability to pass this cost increase on to customers. According to management, Jazeera Airways operates in a late-booking environment, which allows the airline to adjust prices by adding fuel charges. This strategy worked in 1Q2011, and we anticipate the airline will repeat this success in 2Q2011, as Jazeera Airways has shown its ability to raise prices in the past three quarters. Figure 4 Jet Fuel Prices Jet fuel prices have been on a rise in 2011 Dollar per Gallon Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Source: EIA Contingent liabilities gone, net debt-to-equity improves but awaits the rights issue Balance sheet improves and we see the successful completion of the rights issue as a major catalyst for the stock Jazeera Airways balance sheet has seen significant improvement since FY2009. The net debt-to-equity ratio has been on a decline for the last three quarters and currently stands at 7.2x. Contingent liabilities (the order with Airbus) have disappeared, with the majority of the cost of the four aircraft remaining on order already paid for. We feel that the successful completion of the rights issue will bring down the net debt-to-equity ratio to sustainable levels and reduce finance charges. The rights issue will most likely be used to complete the payment for the acquisition nbkcapital. com 5

6 of Sahaab Leasing, which currently amounts to KD 26.4 million on the balance to be paid by December Figure 5 Net Debt-to-Equity The net debt-to-equity for Jazeera Airways has been on the decline since 3Q Q2010 2Q2010 3Q2010 4Q2010 1Q2010 Sources: Jazeera Airways and NBK Capital Valuation We are impressed with the success that Jazeera Airways was able to achieve after implementing the turn-around plan in 2Q2011. We feel that Jazeera Airways new strategy has merits, and we think that this could become one of the most exciting turn-around stories in the MENA region. We have formulated a new set of forecasts for Jazeera Airways that are based on the airline s strategy of preserving yields and following a cautious approach for capacity growth. Our fair value for Jazeera Airways, based on a combination of discounted cash flow (DCF) and a peer group valuation method, is KD 0.260, and we have a Buy recommendation with an upside potential of 40%. Figure 6 Valuation Valuation Method Weight Value (KD) Our fair value for Jazeera Airways is KD Discounted cash flow 70% Peer Group - PE % Weighted average Source: NBK Capital nbkcapital. com 6

7 Figure 7 DCF Valuation Figures in KD Millions* Forecast Fiscal Year Ends December Net Operating Profit after Tax Add: Depreciation and Amortization Gross Cash Flow (Incr.)Decr. in Working Capital (Incr.)Decr. in Operating Fixed Assets (7.3) (7.4) (15.0) (2.6) (2.6) Free Cash Flow from Operations Terminal Value Value of Operations in 12 Months Add: Excess Cash 6.3 Add: Value of Long-Term Investments - Add: Value of Other Long-Term Assets 0.7 Less: Total Debt (113.1) Less: Minority Interest (0.0) Value of Equity in 12 Months 58.7 Per Share Value in KD Source: NBK Capital Figure 8 DCF Sensitivity Cost of Equity* Growth -0.50% -0.25% Base Case +0.25% +0.5% -1.0% KD KD KD KD KD % KD KD KD KD KD Base Case KD KD KD KD KD % KD KD KD KD KD % KD KD KD KD KD Source: NBK Capital nbkcapital. com 7

8 Financial Statements Balance Sheet (KD Thousands) Fiscal Year Ends December ASSETS Cash 3,312 7,909 7,216 4,905 5,716 7,142 8,313 Total Receivables, Net 1,932 1,639 1,952 2,018 2,138 2,375 2,565 Total Inventory Other Current Assets 12, Total Current Assets 18,284 9,748 9,376 7,141 8,079 9,753 11,122 Other 28, Goodwill - 3,443 3,443 3,443 3,443 3,443 3,443 Property/Plant/Equipment 26, , , , , , ,135 TOTAL ASSETS 73, , , , , , ,393 LIABILITIES & EQUITY Historical Forecast Accounts Payable 13,759 14,323 15,616 16,147 17,102 19,004 20,521 Short Term Debt 13,709 20,331 17,345 16,355 15,651 15,729 14,262 Other Current Liabilities 8,781 8,711 9,760 10,092 10,689 11,877 12,825 Total Current Liabilities 36,249 43,365 42,722 42,594 43,442 46,610 47,608 Long-Term Debt 13, ,870 98,288 92,680 88,687 89,133 80,818 Other Liabilities, Total 4,195 7,518 7,769 8,029 8,300 8,582 8,874 Total Liabilities 54, , , , , , ,301 Total Equity 19,521 15,436 19,707 23,982 28,638 33,967 37,092 TOTAL LIABILITIES AND EQUITY 73, , , , , , ,393 Income Statement (KD Thousands) Historical Forecast Fiscal Year Ends December Total Revenue 46,093 42,563 48,801 50,459 53,445 59,386 64,127 Operating Costs Excluding Depreciation (51,238) (35,496) (34,438) (34,795) (36,592) (39,946) (42,679) Depreciation (1,963) (5,060) (5,307) (6,275) (6,525) (7,424) (7,834) Operating Income (7,108) 2,006 9,056 9,390 10,327 12,016 13,615 Interest Expense (1,727) (4,832) (5,088) (4,914) (5,452) (5,217) (5,243) Other Net Income Before Taxes (8,204) (2,805) 4,497 4,476 4,876 6,800 8,372 Provision for Income Taxes - - (225) (201) (219) (306) (377) Net Income (8,204) (2,805) 4,272 4,274 4,656 6,494 7,995 Cash Flow Statement (KD Thousands) Fiscal Year Ends December Cash from Operating Activities 10,557 7,586 15,931 16,030 17,813 21,742 23,102 Cash from Investing Activities (6,151) (11,170) (224) (7,049) (7,098) (14,694) (2,272) Cash from Financing Activities (5,010) 7,969 (16,401) (11,291) (9,904) (5,622) (19,659) Foreign Exchange Effects Net Change in Cash (566) 4,597 (693) (2,310) 810 1,427 1,171 Sources: Company financials and NBK Capital Historical Forecast nbkcapital. com 8

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11 KUWAIT DUBAI ISTANBUL CAIRO