Investor Central: Singapore Airlines Limited — Management reply: Will it change its fuel hedging strategy?

SINGAPORE, Jan 26 — On January 13, oil price dropped to US$45 (RM) per barrel after making a high of about US$107 (RM385) in June 2014.

At the same time, Singapore Airlines’ share price has appreciated by more than 6 per cent to S$12.40 (RM32.23).

And why not when fuel cost accounts for about 40 per cent of company’s cost.

However, 65 per cent of its H2 FY15 fuel needs are already hedged as at end H1 FY15, so the effects will be very much muted on its H2 results, says OCBC Research.

It believes SIA will still capture the effects from FY16 onwards.

Hence, it reduced assumption on SIA’s FY16 jet fuel cost from US$112 per barrel to US$100 per barrel, which increase its operating margin from 2.8 per cent to 3.5 per cent.

While lower oil prices should improve SIA’s profitability significantly, OCBC believes there are several factors at work that partly negate the positive impact.

First, SIA has always hedged a large proportion of each year’s jet fuel needs and the resultant hedging losses offset savings from lower jet fuel costs.

Second, yields are likely to be depressed due to overcapacity as it continue to see deliveries of new aircraft due in 2015 for Asia Pacific region.

Third, it is likely to pass on the savings to consumers through lower fuel surcharges in order to remain competitive.

And last, SIA will record in its books a larger share, from 40 per cent to 55 per cent, of Tigerair’s expected losses for the next few quarters.

The House increased SIA’s fair value estimate from S$10.12 to S$10.80 but maintained its HOLD rating.

Deutsche Bank has upgraded SIA from SELL to HOLD and raised its price target from S$8.80 to S$11.30.

The changes follow upward revisions to its earnings estimates to reflect cheaper jet fuel, prices of which have declined to US$64 a barrel from US$122 a barrel in July year.

The analyst now expects the carrier to earn S$436 million in FY15, S$880 million in FY16 and S$994 million in FY17, up from its previous forecasts of S$295 million, S$374 million and S$401 million respectively.

DBS Vickers has provided some interesting reasons for upgrading SIA to BUY with a target price of S$12.90.

It is now assuming jet fuel prices to average US$95 per barrel in FY16 versus US$125 per barrel previously, but cost savings would be partially offset by a stronger US Dollar, which will make fuel more expensive in Singapore Dollar terms, and lower yield assumptions.

It increased FY16 earnings estimates by 30 per cent and expects SIA’s return on equity (ROE) to rebound strongly to 7.3 per cent in FY16 and 9 per cent in FY17.

Also, higher dividends for FY16 are likely given improved profit outlook and strong balance sheet.

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1. Will it change its fuel hedging strategy?

SIA has hedged about two-thirds or 65 per cent of its fuel requirement for the second half of this fiscal year at US$116 per barrel.

CEO Goh Choon Phong, mentioned during Q2 analysts briefing that hedges will mute the effect of lower fuel prices.

On the other hand it will protect earnings from the full effects of a bounce if that were to happen.

The FY13 annual report states that the group manages fuel price risk by using swap, option and collar contracts and hedging up to eight quarters forward using jet fuel swap, option and collar, Brent swap and crack swap contracts.

A sensitivity analysis on page 192 in the same report highlights that a change of US$1 per barrel in fuel price impacts its equity by about S$31 million.

So, what changes in hedging policy can we expect from lower fuel prices?

In other words, how does SIA plan to capture the current low jet fuel price of about 65 per barrel?

Management Reply: Our hedging policy remains unchanged, under which we hedge on a declining wedge profile where the hedged volume is progressively built up over time. We use a combination of hedging instruments including swaps, collars and call options.

Please note that we disclose hedging guidance twice per year, at the time of the release of half-year earnings and full-year earnings. Guidance on FY15/16 hedging will therefore be disclosed in May at the release of our FY14/15 full-year earnings.

2. What are the chances that we could see double digit profit margin for SIA?

SIA’s net profit margin was about 1.7 per cent in H1 FY15 and 2.4 per cent in FY14.

The last time we saw a double digit margin of 12.8 per cent was in 2008, a period that witnessed a similar catastrophic fall in oil price.

Management Reply: No reply.

3. Will it pay higher dividends?

DBS Vickers Research expects higher dividends for FY16, given the improved profit outlook and strong balance sheet.

Hence, we would like to know if higher dividends is a possibility.

Management Reply: No reply.

4. Can Vistara break even faster than expected?

Vistara, a joint venture between India’s Tata Sons Limited (51 per cent owned) and SIA (49 per cent), recently received the Air Operator Permit (AOP) from the regulatory authority, which allows the airline to commence commercial operations in India.

The original plan was to commence operation in December 2014.

Constrained by regulation in India, Vistara has to operate domestically in India for five years and have a fleet of at least 20 aircraft by the end of fifth year in order to operate international flights out of India.

As such, Vistara has already committed in an agreement to lease 20 A320 aircraft from BOC Aviation over the next four years.

OCBC Research expects costs to increase significantly when Vistara commences commercial operations.

It believes Vistara is likely to lose money at least for the first year of operations as it scale up operations gradually.

Hence, the analyst expects to see higher losses recorded under its share of losses of associated and joint venture companies upon the start of operations.

Indian media, Business Standard, notes that Vistara is launched at a time when it can leverage the opportunity thrown open by the decline of low-cost carrier SpiceJet, which controlled more than 16 per cent of the domestic market.

Another benefit for Vistara could come from Jet Airways’ changed strategy.

As part of its plan to align with Etihad in Abu Dhabi, the Naresh Goyal-promoted airline has been reducing its presence in the domestic market and deploying its capacity on international routes.

For instance, in the winter schedule of this year, Jet Airways has reduced its capacity by 8.6 per cent, and subsidiary Jet Lite by 10.8 per cent.

That leaves a gap for Vistara to fill.

Lastly, Kingfisher Airlines has stopped its operations.

Management Reply: No reply.

5. How will it offset the impact of expected losses from Tiger Airways?

Singapore Airlines has converted all its 189.4 million non-voting perpetual convertible capital securities (PCCS) issued by Tiger Airways into 358.7 million new Tigerair shares at a conversation price of S$0.565.

The conversion price is a significant premium above its Thursday closing price.

SIA mentioned in the H2 FY15 analyst briefing that a take-over of Tigerair is not under consideration.

With the conversion, SIA takes its stake in Tigerair from 40 per cent up to about 56 per cent.

OCBC Research thinks Tigerair will further drag down SIA’s results in the next few quarters as it continues to think Tigerair will still be making losses on low yield environment.

Management Reply: No reply.

We thank Gina Foo from SIA’s Public Affairs Department for her response.

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