AirAsia IPO: sky's the limit?

Expectations running high despite record oil prices.

Asia's first budget airline, AirAsia Berhad is expected to begin roadshows for a $225 million to $270 million IPO next Monday following two weeks of pre-marketing. At first glance, timing of the Malaysian share sale could hardly seem worse with record oil prices taking a steep toll on global airline stocks.

European budget airline stocks such as Easyjet and Ryanair, for example, have seen their share prices collapse, with the former down 57% year-to-date and the latter 44%. Comparable US stocks have fared little better, though the grandaddy of the industry, Southwest Airlines, is down a more modest 14% thanks to a far-sighted hedging policy towards jet fuel, typically an airline's second biggest cost component.

Yet AirAsia's deal is expected to be a great success and one of its three lead underwriters - Credit Suisse First Boston, ECM Libra and RHB Sakura - is already said to have confidently hard underwritten a substantial portion of the deal right up at the top end of the pre-marketed range.

Based on a 2005 profit forecast of M$153 million ($40.1 million) the deal is being marketed at roughly 19 to 22.5 times 2005 earnings. At the top end of this range, the deal would be priced at a roughly 20% discount to the syndicate's upper fair value estimates for the company of $1.13 billion.

The company is issuing 30% of its enlarged share capital of which 25% will be primary shares and 5% secondary. A total of 700.5 million shares are being sold, of which 140 million (20%) will be placed with retail investors and 560 million with institutions. About 70% of the institutional tranche is expected to be allocated to international investors.

Pricing is scheduled towards the end of the week beginning October 25 pending regulatory sign-offs allowing the leads to begin a nine-day global roadshow on Monday.

In the absence of any direct comparables in Asia, specialists say the company regards Southwest Airlines as its main benchmark. The US carrier is currently trading at 19 to 20 times 2005 earnings, which means AirAsia could potentially price at a premium to a much larger and more established comparable.

The world's first budget airline has been profitable every year since it was founded in 1967. Since listing in 1977, Southwest has also seen it market capitalization grow to $10.9 billion. AirAsia will have a market capitalization of up to $903 million based on the pre-marketed range.

But specialists argue that short-haul budget airlines typically command a valuation premium to comparables during the early stages of their growth profile and that the sector always trades at a premium to long-haul national carriers.

In Europe, London-listed Easyjet is currently trading around 23 times forward earnings versus 27 times at the time of its IPO in 2000. Analysts believe the stock may continue to fall following a recent series of EPS downgrades that now make it look expensive relative to other carriers such as Ryanair. Europe's largest budget carrier is currently trading at around 15 times 2005 earnings, down from 30 times at its January peak.

The other comparable some fund managers may look at is Australia's Virgin Blue, although specialists point out that its plans for trans-Pacific flights hardly make it a short-haul budget carrier. It is currently trading at eight to nine times forward earnings.

AirAsia has enjoyed an impressive growth profile since it launched its first flight in January 2002 with just two aircraft. At the end of FY03 (June) it had made income of M$18.8 million, which jumped 160% to M$49 million in 2004 and is forecast to grow another 200% to M$153 million in 2005 and about 50% to M$226 million in 2006.

The company's supporters believe the deal will be attractive to those investors who believe the bad news is already priced into the sector, who like Asian consumer plays and are impressed with the pioneer's short but successful trackrecord.

Non syndicate specialists who know the company say its biggest selling point is its dynamic CEO and founder Tony Fernandes. The native Malaysian has long been compared to England's Richard Branson and indeed once worked for the Virgin group before going on to run Warner Music for South East Asia.

As one commentator puts it, "This deal will blow out of the door. Fernandes has incredible charisma and built up a phenomenally well-run company. His tie-up with Shin Corp in Thailand also shows he's a deal maker par excellence."

Like Branson, Fernandes has had to battle a national carrier, which tried to drive it out of business through a price war in 2002, not to mention hostility from both the Malaysian and Singaporean governments towards the granting of landing rights and licenses.

"You have to remember that AirAsia started off as the pariah no-one wanted to fund and is now viewed as a national champion," the specialist adds. "This is no small achievement for an Indian businessman in a country where the Bumiputras still hold sway. The Malaysian people will flock to this IPO."

And Fernandes' success has forced many of the region's carriers to jump into the budget sector with a host of competing airlines set up this year. AirAsia will now have to contend with Nok Air in Thailand (a joint venture between Thai Airways and Siam Commercial Bank), ValuAir in Singapore (owned by a former Singapore Airlines executive), Tiger Airways (a joint venture between Singapore Airlines and Temasek) and Jetstar (a joint venture between Quantas and Temasek).

The competition posed by these new rivals will constitute one of investors' main risk factors for the IPO. However, Fernandes and his team are likely to argue that national carriers forced into the sector as a defensive move will never have the passion and energy to develop the market in the way AirAsia has.

He is also likely to argue that operators of national carriers do not necessarily have the right mindset to run budget carriers where the emphasis is always on containing costs rather than improving services. The essence of the company's business model is to fly routes of less than four hours duration and ensure a speedy turn-around time to maximise the number of flights on each route per day.

At 25 minutes the company enjoys the fastest turnaround time of any Asian carrier and claims that its cost of 2.5 cents per average seat per kilometre is the lowest in the global airline industry.

Observers say Fernandes' cost cutting skills are legendary. "He even called a meeting where the engineers were told to inform the pilots that the tyres would last longer if they landed the planes more gently," says one. "All the staff have CRT monitors rather than flat screen computers and there are white boards announcing flight changes and times rather than electronic screens."

Even the company's main hangar at Kuala Lumpur airport is cost competitive. "Tony is most proud of this one," says the specialist. "Having been quoted a very high price by a contractor that had worked for MAS, he eventually used a builder who was working on his house at the time and reckoned he could do it for M$2.5 million. The new hangar may have a corrugated metal roof, but it has been fully hurricane tested."

Over the longer-term specialists say one of investors' main concerns will be whether Fernandes sticks to this business model, or tries to emulate Richard Branson who turned Virgin from a discount airline to a second national carrier competing with British Airways.

Over the short-term the main risk is fuel prices. Fernandes has said the company is fully hedged in 2005 and almost fully hedged in 2006. He has also said the company will still be profitable at $60 per barrel. What he has not yet said is what level the company struck its hedges at.

Analysts comment that a large number of global carriers did not ramp up their hedging activities quickly enough and have now got caught by escalating oil prices. Likewise, AirAsia's competitors are entering a market where they face the difficult choice of hedging at unpalatably high prices, or not hedging and risking oil prices climbing even higher.

This is one of the main reasons why Southwest Airlines has continued to hold its share price, with the company reporting that 80% of its 2004 and 2005 fuel needs were locked in at prices averaging $25 a barrel, half their current level in the spot market.

"Right from the start, Fernades has always been keen to completely mitigate risk," one specialist explains. "His attitude is fully hedge and then build a profitable balance sheet on the basis of those price points."

The focus now lies in expanding the company's network of 19 aircraft and routes out of its three hubs in Kuala Lumpur, Bangkok (through Thai AirAsia) and Senai on the Singaporean border. So far the company has not eaten into the market share of national carriers, but expanded the overall market by targeting the vast swathes of Asians that have not previously been able to afford air travel.

It is, for example, estimated that only 6% of Malaysians had travelled by air pre AirAsia. The company has expanded the domestic market from nine to 13 million passengers.

Its tie-up with Shin Corp - owned by the family of Thai prime minister Thaksin Shinawatra - has been described as a masterstroke, since Fernandes has management control and a northern hub to fly to India (potentially), Macau (first flights started in June) and China (first flights scheduled for December).

The company is also rumoured to be on the verge of striking up a similar but smaller JV in Indonesia.

Pre-deal, TuneAir (a Fernandes-owned vehicle) owned 65% of the company and this is likely to fall to 45% post deal. Most of the secondary shares are being sold by some of the company's private equity investors.

In June 2003, three groups - Bahrain's IDB Infrastructure, Saudi Arabia's Crescent Ventures and Germany's Deucalion Capital - paid $26 million for an equivalent 26% stake.

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