Broker's first analysis sees Virgin Australia as fully valued

Virgin Australia Airlines [ASX: VAH] is unlikely to make significant capital returns to shareholders but the threat of a mop-up by the three airlines holding a combined 73% stake provides a floor for the share price, broker First NZ Capital says.

It has initiated coverage on Virgin with a "neutral" rating and target price of 50Ac per share compared with the current share price of 49Ac.

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 25.9%, Singapore Airline 23% and Etihad 21% – have strategic interests in addition to maximising profits.

Virgin's valuation is expensive compared with Qantas Airways and Air New Zealand, trading at a multiple of six times earnings before interest tax, amortisation and rent/restructuring costs (ebitdar), compared with 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 says.

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% so far this year.

Virgin Australia has signalled a return to profitability this year after reporting an annual underlying pretax loss of $A49 million to the end of June 2015, an improvement of $A162.7 million on the previous period.

Fuel cost drop under-estimates profit
First NZ says consensus forecasts from analysts have not materially changed despite crude oil prices plummeting 40%. It forecasts underlying profit of $A152 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% above consensus at $A263 million and First NZ expects Virgin's Velocity loyalty programme to provide significant growth.

Virgin has 80% of its debt dominated in US dollars and the falling Australian dollar will increase that by $A150 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 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.

Risks for minority shareholders
First NZ also criticises the airline's corporate governance, remuneration structures and disclosures, saying minority shareholders risked inadequate representation because Virgin doesn't have at least 75% of the board independent in line with global best practice. (A 10% shareholding is held by Sir Richard Branson's Virgin Group.)

Half of the four independent board members have high external workloads and the board lacks directors with audit or legal experience, the broker says.

The remuneration structure is also management-friendly, with a high proportion of fixed or short-term incentives and stock awards being replaced with 100% cash last year that can lead to less shareholder alignment and lack of "skin in the game."

(BusinessDesk)