Virgin Australia, Australia's second-largest domestic airline, is unlikely to make significant capital returns to shareholders but the threat of a mop-up by the three airlines holding a combined 73 percent stake provides a floor for the share price, says broker First NZ Capital.
It has initiated coverage on Virgin with a 'neutral' rating and target price of 50 Australian cents per share compared to the current trading price on the ASX of 49 Australian cents.
In a research note, its analysts say Virgin's balance sheet is in weak condition and, in their view, the three airline shareholders - Air New Zealand with a 25.9 percent stake and Singapore Airlines and Etihad - have strategic interests in addition to maximising profits.
Virgin's valuation is expensive compared to Qantas Airways and Air New Zealand, trading at a multiple of six times earnings before interest tax, amortisation and rent/restructuring costs (ebitdar), compared to the global average of 4.6 times.
"We believe the threat of the large airline shareholders acquiring the outstanding shares, places a floor under the Virgin share price," the note said.
The shares along with those of other airlines have risen in the past year due to the slump in oil prices, and have gained 8.8 percent so far this year.
Virgin Australia has signalled a return to profitability this year after reporting an annual underlying pretax loss of A$49 million to the end of June 2015, an improvement of A$162.7 million on the previous period.
First NZ said consensus forecasts from analysts have not materially changed despite crude oil prices plummeting 40 percent. It forecasts underlying profit of A$152 million in 2016 mainly due to lower fuel costs and a relatively benign competitive environment in the Australia domestic market. Its forecast for 2017 underlying profit is 20 percent above consensus at A$263 million and First NZ expects Virgin's Velocity loyalty programme to provide significant growth.
We believe the threat of the large airline shareholders acquiring the outstanding shares, places a floor under the Virgin share price.
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Virgin has 80 percent of debt dominated in US dollars and the falling Australian dollar will increase the debt burden by A$150 million this year. Despite the upside from lower fuel price, that will likely delay the airline hitting the hoped-for net debt to ebitdar ratio of under five times it had hoped to achieve by 2017 in order to improve its B+ credit rating from Standard & Poor's, First NZ said.
The research note says while Virgin is focused on repairing its balance sheet, it has less ability to invest in growth and there will only be low extra capacity into the domestic market, which results in higher pricing and profitability for the dominant airline Qantas.
First NZ also criticised the airline's corporate governance, remuneration structures and disclosures, saying minority shareholders risked inadequate representation because Virgin doesn't have at least 75 percent of the board independent in line with global best practice.
Half of the four independent board members have high external workloads and the board lacks directors with audit or legal experience, it said.
The remuneration structure was also management-friendly, with a high proportion of fixed or short-term incentives and stock awards being replaced with 100 percent cash last year which can lead to less shareholder alignment and lack of 'skin in the game', it said.