Phil Strano, Senior Investment Manager at Yarra Capital Management, takes a close look at Virgin Australia’s May 2018 bond deal.
There are few industries which have proven more challenging for investors than the airline sector. In just the past 30 years, the US alone has had more than 50 airlines file for bankruptcy, roughly one every seven months. Warren Buffett’s 2007 shareholder letter was direct on the challenge, dryly suggesting that had a far-sighted capitalist been present for the first airplane flight back in 1903 they’d have done future investors a favour by shooting it down.
That said, while the tarmac is littered with potholes from past airline defaults and poor equity returns, there are always exceptions to the rule. In our experience great returns can come from analysing complex situations and dispelling common misperceptions, even in airlines. Domestic operator Virgin Australia (VAH) is a good case in point; this month the airline became Australia’s first ever domestic high-yield single B issuer, printing $A150mn of 5-year non-callable 3-year bonds (5NC3) at a stunning 8.25% yield (560 bps over the 5-year swap rate).
Standard credit analysis of VAH tells only part of this story. Instead, forming an investment decision demands a deeper understanding of the airline industry, which today looks stable and is not dominated by the sustained discounting of recent years.
VAH is a very different business today to the one which landed in Australia in mid-2000 with just two aircraft and one solitary route (Sydney-Brisbane). Through its discount airline Tiger and international offshoot, VAH is now a full-service carrier with significant scale. The substantial capacity added via Jetstar and Tiger means QAN and VAH have virtually eliminated the threat of new entrants, with both companies seemingly content with their current market share (QAN 63% and VAH 37%). A shortage of major airport landing slots has both airlines well entrenched, and the quasi-duopoly ensures they are well placed to set pricing and pass on any fuel cost rises to customers.
For investors, though, the ownership structure of VAH – it is roughly 90% owned by foreign airlines – means the credit looks currently a far more appealing opportunity than the equity, since:
- VAH has very limited ambition to chase domestic growth: a stable market means a new capacity war seems unlikely (i.e. rational behaviour should continue);
- Tiger provides a defensive play against potential new entrants (as noted above);
- Internationally, VAH continues to leverage its networks via Australia’s large and growing outbound travel market; and
- Capital requirements are falling and VAH is appropriately containing credit risk.
While VAH was only a modest-sized issue, at two rating bands below investment grade it offers a compelling risk-adjusted return. With management focused on improving financial performance and deleveraging the business – VAH is forecast to be free cash flow positive in 2019/20 – a credit rating upgrade to BB looks achievable.
For bond investors, the VAH deal illustrates the benefits of maintaining a rigorous and adaptable investment process which can discerningly target higher risk-adjusted returns across multi-sectors. While we do not see the Virgin deal being followed by a plethora of new high-yield names, we remain alert to similar opportunities across our multi-sector universe.