RECOMMENDATION
Campos, Lanuza, & Co. Inc. (CLCI)
A member of the Philippine Stock Exchange
Cebu Air Inc.
26 OCTOBER 2010
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Going full throttle with LCC model
HIGHLIGHTS
‰ Fastest growing domestic airline with focused business model.
Cebu Air Inc. (CAI), which operates the Cebu Pacific airline, has more
than tripled its market share of the Philippine passenger air travel
market since 2004 thanks to its transformation to a low-cost-carrier
(LCC);
PERFORMANCE
‰ Strong cashflow generation. The LCC model has enabled Cebu
Pacific to boost operational cashflows amid high demand growth for air
travel in the Philippines and Asia and supported by a low-cost structure
and efficient operations. We estimate that cashflows are sufficient to
support expansion plans without being forced to tap the debt markets;
‰ Opportunity provided by regional economic growth. The projected
high GDP growth in emerging markets will sustain growth in air travel
demand as well as Philippine tourism. The continued deployment of
OFWs in the region will also assure a growing and regular market for
Cebu Pacific;
PRICE CHART – Jet Fuel Index
‰ Fuel cost is the main risk. Like all airlines, jet fuel accounts for a
major portion of operating costs. If they rapidly rise again, air travel
demand may decline enough to create a loss similar to 2008. Net profit
is also vulnerable to the eventual expiration of the company’s ITH.
‰ Initiate with buy rating. We begin coverage of Cebu Pacific with a
BUY rating and a FMV of P148/sh. Our valuation is based on a DCF
model using assumptions from and validated by P/E multiples of
comparable regional LCC peers.
FORECAST SUMMARY
DISCLAIMER
The following analyst, strategist,
or research associate owns
securities in a company that he or
she covers or recommends in this
report: None
This report has been prepared by:
CAMPOS, LANUZA, & CO., INC. EQUITY RESEARCH
Unit 2002-B 20th floor, East Tower
Philippine Stock Exchange Center
Exchange Road, Ortigas Centre
Pasig City 1605
Analyst: Jomar Lacson
Telephone Nos.
(632) – 634-6881 to 87;
(632) – 636-1167
E-mail:
research@camposlanuza.com
Market Navigator
26 October 2010
Investment Highlights
Rapid growth running on LCC model
Cebu Air Inc. (CAI) operates Cebu
Pacific Airlines (CPA), which is
currently the fastest growing domestic
airline in the Philippines today. The
airline has increased its share of the
passenger market from 4.2% in 2006
to 14.0% in 1Q10. The speed by
which Cebu Pacific has increased
market share has been due to
company’s shift to a low-cost-carrier
(LCC) model from the full-service
airline model.
Philippines airline industry market share
The LCC model in a nutshell
In an LCC model, airlines follow a
cost-leadership strategy. Introduced
by Southwest Airlines of the US, this
Source: CEB, Civil Aeronautics Board, CLCI strategy is characterized by pricing
that can be aggressively low and supported by a very low cost structure and high operational
efficiency, thus, enabling the LCC to be very competitive and profitable.
To be cost competitive, LCCs adapt several different cost-reduction strategies such as a no-frills
service, which partially means that in-flight catering may be limited to inexpensive snacks and
beverages or none at all. To improve on fuel-consumption, LCCs utilize newer planes, limit the
allowable baggage weight, and increase the number of seats of the aircraft by changing
configuration.
This is why Cebu Pacific has retired some of its older DC-9 and Boeing-757 aircraft in favor of the
Airbus 319/320s. For the A319s, the seat configuration was increased to 156 seats from the
standard 134 seats. Having only one aircraft supplier also helps the company reduce training
costs of pilots.
But apart from cost-reduction, the other key ingredient to an LCC model is operational efficiency.
Airlines have significant fixed-costs such as leasing, cargo-handling, repairs and maintenance,
and staff costs. Whether an aircraft is flying or not, these costs are incurred by the airline.
Given high-fixed costs, LCCs strategy is to maximise asset turnover or utilization. This means
each aircraft has to be almost constantly flying and ground time minimized. Cebu Pacific has an
average aircraft utilisation rate of 11.6 block hours as of Jun10, which is nearly competitive with
other regional LCCs that have around 12.0 block hours. Full-service airlines operate their aircraft
with an average of 8.0 block hours.
Some North American and European LCCs go to the extent of choosing airports since terminal
fees could be substantial. This is partially the reason why some regional LCCs operate from Clark
instead of terminals in Metro Manila. For Cebu Pacific, the airline operates from Terminal 3 of the
Ninoy Aquino International Airport (NAIA) but this is subject to regular contract updates with the
government.
Distribution costs are also an area of operational efficiency. Like other LCCs, Cebu Pacific relies
heavily on its online website to book seats. But apart from online booking, customers can also
secure seats via Cebu Pacific’s direct sales and third party vendors.
Page 2 of 7
Market Navigator
The dominant player on home
ground…Although it is a second in the
overall Philippine aviation passenger
market, the LCC model has enabled
Cebu Pacific to capture market
leadership in the domestic passenger
market. As of Jun10, Cebu Pacific
cornered 48.7% of the domestic
passengers from only 32% in 2004.
Unintentionally, Cebu Pacific has
benefited from recent problems of its
main competitor. Philippine Airlines
(PAL.PM – P5.19) has been saddled
with labor issues involving both pilots
and flight attendants’ unions that have
impaired its air travel service capacity.
26 October 2010
Domestic passenger market breakdown 2009
Source: CEB, CAB, CLCI …that is shifting fight to Asia. Although domestically Cebu Pacific is a market leader, its shift
towards other regional markets has intensified its rivalry with other existing LCC operators in Asia
such as AirAsia of Malaysia (AIRA.MK – MYR2.59), Tiger Airways (TGR.SP – SGD1.84), and
Jetstar among others. Some of these LCCs have been in the regional aviation market longer
than Cebu Pacific. Like its LCC peers in East and Southeast Asia, we expect Cebu Pacific to
capture some market share in a rapidly growing air travel market. Asian economies continue to
growth amidst rising capital inflows from North America and Europe that are driven by continued
quantitative easing policies.
Profitable and operational cashflow positive
With the exception of 2008, Cebu
Pacific has been reporting net profit
Projected operational cashflows and ancillary
since 2004. Like all airlines, the
company
is
susceptible
to
fluctuations in jet fuel prices. But on a
normalized basis, Cebu Pacific
appears to be able to generate stable
operational cashflows provided that
asset turnover is maximized.
By our estimates, operational
cashflow can support planned capital
expenditures over the next fiveyears. Capex is expected to reach its
peak in 2012-2013, when Cebu
Pacific takes delivery of around 11
Source: CEB, CLCI
A320s. The airline also has options
to purchase seven A320s from 2015-1017 but these will expire in Dec12. For 2010, capex is
expected to be around P7.9bn.
Ancillary revenue is a hidden upside. We also have noticed that ancillary revenues have risen
significantly since the shift to the LCC model. Ancillary revenues correspond to excess baggage
charges, which have increased by 72.5% CAGR since 2004. Cebu Pacific may have
unconsciously tapped on the penchant of Philippine air travelers to exceed the 15.0kg LCC
baggage limit. In general, return trips from major shopping destinations will generate more
baggage than the trips going to these destinations.
Page 3 of 7
Market Navigator
The key to Cebu Pacific’s strong
operational cashflow is the LCC model,
which has allowed the company to
maintain a cost/ASK that is comparable
to regional peers. The company
maintains the youngest fleet in the
Philippines and has an average age that
is comparable to regional LCC peers.
Combined with problems at Philippine
Airlines (PAL.PM – P5.19), Cebu Pacific
will likely benefit from its strong brand
recognition in the domestic aviation
market. However, when it comes to the
regional market, Cebu Pacific may find
stiffer competition as far as brand
recognition is concerned.
26 October 2010
Comparable regional LCCs 2009 Cost/ASK
Source: Company Annual Reports, CLCI
LCC peers have an advantage in the Asian air travel market because they have stronger brand
recognition than Cebu Pacific. We believe even PAL, being the first airline in Asia with operations
starting in the 1940s, has a brand advantage relative to Cebu Pacific when it comes to the regional
aviation market.
As it builds brand in the region, Cebu Pacific will have to rely on the Philippine air travel passenger
market for patronage of its regional flights in the meantime. This domestic patronage will enable
the airline to stabilize their yields/RPK, which measures the pricing power of Cebu Pacific. Based
on our estimates, yield/RPK for Cebu Pacific should improve over the next 12-24 months as the
airline supports demand that PAL cannot accommodate. The only potential problem will be
intensified competition, which we discuss in a succeeding section
OUTLOOK
A growing market for air travel. The introduction of the LCC model has also made domestic air
travel in the Philippines very affordable. In Cebu Pacific’s case, one-way airfare from ManilaCebu is around P1,400 as against boat fares of around P2,000-4,000. A quick check on the
promos of Cebu Pacific, PAL, and ZestAir for a Manila-Cebu flight is around P1,146 one-way.
The average air fare of Cebu Pacific in 2009 is P2,227.50 as against P2,385 in 2007 or roughly
2.4% of per capita GNP in 2009.
The improvement in the affordability of domestic travel has spawned a 19.4% five-year CAGR in
domestic air travel in the Philippines. As Cebu Pacific flies more international flights, RPKs will be
driven by four key economic factors: 1) rising GDP growth for the Philippines and Asia in general;
2) expansion of the Philippine tourism market; 3) growth in Overseas Filipino Workers (OFW)
deployment; and 4) expansion of ASEAN trade. Based on the International Air Transport
Association (IATA) outlook for 2010, business passengers have been driving the recovery in
global air travel, which suggests that economic growth in the region can benefit from an
accelerated integration of the ASEAN market.
Cebu Pacific has been able to benefit from the increase in demand, which so far has outpaced
the growth in capacity as measured by ASK. Load factor as of Jun10 was at 85%, which is a
substantial improvement from the 65% load factor in 2005. The airline has achieved a 24.6%
CAGR in ASK since 2004 and is expected to further increase its capacity with the purchase of
additional A320s.
Page 4 of 7
Market Navigator
26 October 2010
Key Investment Risks
Jet fuel is the Achilles heel of
airlines. Like any other airline, Cebu
Pacific is susceptible to the price
volatility of jet fuel. Over the past three
years, jet fuel accounted for an
average of 40.4% of total expenses of
the airline. When jet fuel prices peaked
in 2008, Cebu Pacific suffered a
P2.6bn loss.
Jet fuel Price Index
Although the price of jet fuel has
declined
to
an
average
of
US$69.97/bbl in 2009, they have
started to recover in 2010. As of 15
Source: Bloomberg, CLCI
Oct10, the Mean of Platts Singapore
(MOP) price of jet fuel was at US$95.80/bbl, which is 14.6% higher y/y and 9.4% higher than the
1H10 average of US$87.52/bbl.
To mitigate the fuel price risk, Cebu Pacific hedges its fuel requirements with derivative contracts
and purchases in advance. When fuel prices were rising rapidly 2008, many airlines imposed fuel
surcharges on top of their airfares. Cebu Pacific has stopped imposing a fuel surcharge since then
and instead charges an “all-in” fare. At the end of the day, however, if crude oil and fuel prices rise,
profit margins for the industry will get squeezed.
Competition is not likely to be idle for long. Although PAL has been hit by its perennial labor
problem, this does not mean that it is out of the picture. The main problem of PAL, in our view, is
that it lacks strategic focus. It initiated its counter-strategy to Cebu Pacific’s LCC by creating PAL
Express and pushing Air Philippines towards the low-cost market. Despite this, the management of
resources is still centralized at PAL’s level, which may limit the efficient allocation of capital.
This lack of focus can be a temporary situation only. If PAL secures a strategic partner, such as
the purported interest coming from San Miguel Corporation (SMC.PM – P74.50) or the First Pacific
Group, this could unify the different business models of PAL and improve its competitiveness
again.
We have also noticed that ZestAir has begun offering significantly discounted fares that compete
with Cebu Pacific. Although we believe its cost/ASK is much higher than Cebu Pacific, as a small
player, ZestAir may be after a specific niche of the low-cost passenger market that it can carve out
with good marketing and effective pricing.
Taxes will cut on earnings growth. Cebu Pacific currently has an income tax holiday (ITH) on
some of its aircraft. Based on its 2008 registration with the Board of Investments (BOI) as an air
transport services provider, Cebu Pacific will enjoy a four-year ITH from Jan10 on 13 aircraft that it
has acquired. We have assumed a gradual increase in the effective tax rate to reflect corporate
income tax on aircraft not covered by the existing ITH. The impact will be a capped growth in net
profit despite rising EBIT levels.
Company is deleveraging. The company appears to be slowly deleveraging its balance sheet.
From a peak of 4.8x in 2008, net debt to equity is estimated to decline to 0.4x by end-2010 and
eventually be net cash by 2014. As we mentioned, operating cashflow is estimated to be sufficient
to support capital expenditures. However, to maintain a high level of ROE and eventual dividend
payout, we believe, the company may secure additional vendor financing for planned new aircraft
purchases.
Industry event risks. Cebu Pacific also carried systemic risks related to its industry. Air disasters
involving Airbus A319/320s may result in the suspension and/or investigation of its fleets
operations. Global or regional pandemics such as the Avian flu or terrorist attacks on airlines could
result in a severe reduction in air travel demand. Lastly, the company could suffer from the same
labor problems of PAL if unions achieve in establishing a foothold in the airline.
Page 5 of 7
Market Navigator
26 October 2010
Investment Summary and Valuation
Take-off with a buy rating. We initiate coverage of Cebu Pacific with a BUY rating and a
target price of P148/sh. The company is one of the fastest growing airlines in the region and is
a direct beneficiary of rising incomes in Asia. Although the expiration of its income tax holiday is
something to watch out for, operating profit for Cebu Pacific is expected to grow significantly
with its fleet expansion. Operating and cost efficiency ratios are close enough to the levels of its
best-of-peers to merit an optimistic outlook for earnings.
The key risk to our forecasts is the impact of jet fuel price volatility on cashflow and earnings.
Cebu Pacific enjoys a home court advantage which will enable to pass on some of the cost
inflation to its customers temporarily but in a sustained high cost environment, its operational
and cost efficiencies will dictate its competitiveness.
ROE-P/B analysis. Based on
our ROE-P/B analysis, Cebu
Pacific appears to expensive
relative to regional airlines.
However, because the airline
is expected to report an ROE
of 33.4% in 2011, it will still
remain as the most profitable
airline amongst its peers just
as it is expected in 2010.
Regional Airlines ROE-P/B Analysis
Upside with DCF.... Based
on our five-year DCF, we
value
Cebu
Pacific
at
P148/sh, which represents an
upside of 18.4% to the IPO
Source: Bloomberg, CLCI
price of P125/sh. Our DCF
utilises a CAPM assumptions that use the beta of AirAsia, a risk-premium of 5.5%, and a
growth rate of 3.5%.
… validated by peer earnings multiple. If the company is valued at the regional average of
11.2x 2011 earnings, whether it’s LCC or full-service, then the downside risk to the target price
would be P133/sh. However, the average 2011 P/E multiple for regional LCCs, which is the
comparable peer group, is 12.2x. Based on this multiple, our forecast EPS of Cebu Pacific of
P11.87/sh yields a fair value estimate of P144/sh, which we believe validates our DCF estimate
of P148/sh.
Regional Airlines Valuation Multiples
Source: Bloomberg, CLCI
Page 6 of 7
Market Navigator
26 October 2010
FORECASTS AND VALUATION
DISCLAIMER
All the information contained in this report is for information purposes only and is not a solicitation or offer to buy or sell any security. It is based
on information obtained from sources believed to be reliable and does not purport to be a complete description of the market; securities or
developments referred to in this material.
Opinions expressed in this report are subject to change without notice. Campos, Lanuza and Company Inc. (CLCI) does not accept any liability
whatsoever whether direct or indirect that may arise from the use of information contained in this report.
CLCI, its associates, and employees may from time to time seek to establish business or financial relationships with companies covered in their
research reports. As a result, investors should be aware that CLCI and/or such individuals may have one or more conflicts of interests that could
affect the objectivity of this report.