Buy recommendation on Qantas bonds confirmed

Last week Standard and Poors announced the upgrade of Qantas’ credit rating and its long awaited return to Investment Grade. This is a significant achievement given the overall slowdown of the Australian economy and is something which has been years in planning. As stated in our previous research notes, following weak FY14 results Qantas’ management launched a thorough, all-encompassing transformation program which aimed to streamline the company and strengthen its position to face the challenges (high fuel prices, overcapacity, intense competition from low-cost airlines and Virgin) that caused the collapse of its profit. This program included a significant number of employees being made redundant, negotiating new labour agreements, right-sizing its fleet and network (in other words reducing capacity), improving productivity of existing assets, deferring growth, aligning capital expenditure with financial performance and simplifying the groups organisation. Measures taken by Qantas CEO Alan Joyce and his team were quite drastic and necessary in order to put the company in better shape to face the challenging environment for airline globally. The industry has arguably one of the highest level of bankruptcies historically and where it is notoriously difficult to make a consistent returns through economic cycles. It was our opinion that the airline had demonstrated a willingness for structural change in order to meet long term goals. This was reflective in our BUY recommendations on the different Qantas securities since the beginning of our coverage (February 2015) and complemented by a better operating environment where fuel prices had reduced and consumer confidence was improving. The strong Full year 2015 results (published at the end of August) showed the true benefits of the measures taken. As a result the rating agencies increased the rating on the company’s senior unsecured debt which caused a sudden increase in investor demand and a rise in the bond prices. This upgrade is an acknowledgement of the improvements achieved by the company and and its commitment to a more conservative but also forward-looking and pre-emptive financial policy.  Qantas is now committed to target investment grade credit metrics through the cycle including Funds from Operations (FFO) to Net Debt higher than 45% and Gross Debt to EBITDA lower than 4 times. While the company has begun to return capital to shareholders, it has not committed to regular dividends and will only distribute surplus capital once it exceeds its optimal capital structure. Aside from the re-rating , its recent operational statistics on passenger traffic seems to reinforce our current opinion.  As can be seen below Qantas has seen a an increase in growth of passengers carried. Overall, the transformation is only partially complete and when combined with the low oil price (which seems to be happy around $40 a barrel) and the low level of the Aussie dollar. Qantas should continue to reap the benefits over coming years. As a result, we are now confident to lower Qantas risk level from High to Upper Medium but maintain our BUY recommendations on the Qantas 6.50% 2020, Qantas 7.50% 2021 and Qantas 7.75% 2022. These bonds are also available to retail investors on the stock exchange in the form of an Exchange Traded Bond units from the Australian Corporate Bond Company.