Brian Gaynor 's Opinion

Brian Gaynor is a Weekend Herald columnist.

Brian Gaynor: Power company might fly better than Air NZ

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Air New Zealand has been a good investment, but falling earnings forecasts could affect the Government's plans to sell some of its shares in the airline. Photo / Supplied
Air New Zealand has been a good investment, but falling earnings forecasts could affect the Government's plans to sell some of its shares in the airline. Photo / Supplied

It is now official: Mighty River Power will be the first initial public offering under the Government's "mixed ownership model" strategy.

The share sale is expected to occur in the third quarter of next year, although this will be subject to market conditions.

The Treasury believes there will be substantial interest from retail investors. This optimism is based on a survey by investment bank Deutsche Bank and investment advisers Craig Investment Partners.

Cynics would argue that these two organisations have a strong incentive to reach this conclusion because they would want to be involved in any IPO.

Recent evidence suggests that New Zealand investors are cautious and reluctant equity investors, particularly on a long-term basis.

Just over 225,000 participated in the Contact Energy IPO, but the company now has only 78,200 shareholders.

Auckland International Airport had 67,000 shareholders but only 50,700 remain on the registry even though the company has been an excellent investment.

The challenge is to keep New Zealanders on the share registry as well as getting them interested in share offerings.

Although Mighty River Power will be the first IPO, the sale of Crown shares in Air New Zealand may occur earlier because it doesn't require a prospectus.

This would be a test of the public's appetite for equities because Air New Zealand's profitability is under pressure even though it has a strong board and an impressive management team.

The Crown owns 804.2 million Air New Zealand shares or 73.4 per cent of the company. It could sell up to 245 million shares, now worth about $220 million, and maintain its minimum 51 per cent stake.

The latest International Air Transport Association forecasts, issued on December 7, illustrate the difficulties the industry faces.

IATA expects the industry to report net earnings of US$6.9 billion ($9 billion) this year, compared with US$15.8 billion last year, and it has cut its forecast for next year from US$4.9 billion to US$3.5 billion.

The main factors affecting this year's figure are:

* The industry has a net profit/revenue margin of only 1.2 per cent and is vulnerable to any downturn in global economic activity.

* European carriers face the most challenging position. The environment in North America is much more benign, and Asia-Pacific airlines have a more positive operating environment even though Japan has not fully recovered from the March earthquake and tsunami.

* Consequently, IATA has upgraded its 2011 net earnings forecast for Asia-Pacific by US$800 million to US$3.3 billion or 48 per cent of the world total.

* World-wide passenger growth of 6.1 per cent is forecast this year, but this will be offset by a worse-than-expected cargo performance.

* Oil prices are expected to rise. Oil is extremely important, as it is expected to cost the industry US$178 billion, or 30 per cent of its total expenses, this year.

IATA has the following comments on next year's prospects:

* The European crisis is a threat, and if it evolves into a full-scale banking crisis world airlines could have losses of more than US$8 billion instead of IATA's current forecast of US$3.5 billion in net earnings.

* World economic growth forecasts for next year have been revised down to 2.1 per cent, and the airline industry's profit has turned into loss whenever global GDP growth falls below 2 per cent.

* Total fuel costs are forecast to increase from US$178 billion this year to US$198 billion next year.

* Industry revenue is forecast to grow 3.7 per cent but costs will go up by 4.5 per cent.

The good news is that IATA has a more positive view on the Asia-Pacific region, mainly because of China. It expects the region to produce net earnings of US$2.1 billion or 64 per cent of the world total.

Recent analyst reports reflect this change in outlook. One analyst had the headline "Earnings Recovery Remains Intact" on an Air New Zealand research report at the beginning of November but his late November report was headed "Earning Recovery Losing Speed".

The median analysts' June 2012 year net profit forecast for Air New Zealand has plunged from $156 million in early October to $96 million. The carrier's June 2013 median forecast has fallen from $165 million to $141 million.

Analysts have also taken the knife to Qantas. The median June 2012 year forecast has fallen from A$470 million to A$327 million over the past few months and the June 2013 year median from A$651 million to A$487 million.

But one of the features of the listed Australasian carriers - Air New Zealand, Qantas and Virgin Blue - is that most broker analysts have a buy recommendation on all three stocks. They say the airlines face further profit risks, but believe their share prices are close to the bottom.

The three companies accept that trading conditions will remain difficult and they are not standing still. Air New Zealand has acquired a 19.99 per cent interest in Virgin Blue, Australia's second largest airline, and the two companies have formed a trans-tasman alliance.

Media reports this week that Air New Zealand may withdraw from the London route cannot be discounted because the European economic downturn will affect fares to and from the region.

Qantas is expected to report lower earnings this year, partly because of compensation payments made to passengers affected by industrial stoppages. The cost of these stoppages was nearly A$200 million.

But the company is in a strong financial position with cash reserves of more than A$3.3 billion, similar to its sharemarket value of A$3.4 billion.

Virgin Blue has several attractive features including its alliance with Air New Zealand, the recently approved alliance with Singapore Airlines, and reduced competition from Tiger Australia.

As well, it is attracting corporate customers from Qantas, partly because of the industrial problems.

The big issue facing the Key Administration is whether it reduces its shareholding now or waits until the European economic crisis abates and the outlook for airlines improves.

Air New Zealand has come a long, long way since the Government sold all its shares in April 1989 to a consortium consisting of Brierley Investments (65 per cent), Qantas (20 per cent), Japan Airlines (7.5 per cent) and American Airlines (7.5 per cent).

As part of the sale agreement Brierley sold 30 per cent to the New Zealand public at $2.40 a share a few months later. This gave the company a sharemarket value of $672 million compared with today's $965 million.

The IPO process was incredibly shoddy, the company had a weak Brierley-dominated board and the IPO document left a lot to be desired, particularly as far as disclosure was concerned.

The issue price was pitched at a 4 per cent discount to net tangible asset backing (NTA) per share - $2.40 to $2.50 - but the company now trades at a 34 per cent to NTA, 88c to $1.33.

The problem is earnings, an issue all airlines face. Air New Zealand had net earnings of $101 million for the March 1990 year, its first report as a listed entity. Its earning for this year and next will be lower than this.

The Key Government must decide whether to sell shares in Air New Zealand before the Mighty River Power IPO.

Based on the airline outlook the Mighty River Power IPO is probably the best option if the Government wants to attract widespread support for its "mixed ownership model".

* Disclosure of interest: Brian Gaynor is an executive director of Milford Asset Management which holds Air New Zealand shares on behalf of clients. bgaynor@milfordasset.com

- NZ Herald

Brian Gaynor

Brian Gaynor is a Weekend Herald columnist.

Brian Gaynor has written a weekly investment column for the Weekend Herald since April 1997. He has a particular particular passion for the NZX and its regulation. He has experienced - and suffered through - the non-regulated period prior to the establishment of the Securities Commission in 1978 and the Commission’s weak stewardship until it was replaced by the Financial Markets Authority (FMA) in 2011. He is also a Portfolio Manager at Milford Asset Management.

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