Jet Airways' IPO: Good for the Stags
Jet Airways is coming out with an IPO with an issue price in the range Rs.950- and Rs.1125. The issue is opening on Feb 18 and closing on Feb 24. The proceeds from the issue will be utilized to partly prepay some debt. It will also be utilized to finance some capital expenditure. It is definitely worth the effort to see if this price is justified using DCF analysis. The PE ratio is coming out to be about 50 and prima facie it appears to be too high.
Jet Airways is definitely one of the best airways in India. Its market share is about 46% and that is way ahead of its competitor, Indian Airlines (with a market share of 37%). It is the most favored carrier for the business class passengers.
However, there are certain red flags that one has to look at.
a) There is now growing competition from the no-frills carriers like Air-Deccan.
b) The brand name “Jet Airways” is actually owned by Jet Enterprises, a company owned by Mr. Naresh Goyal. As of now Jet is paying license fees to Jet Enterprises on a quarterly basis. Though no information is available about the license fees, one can get some idea about by looking at the profit and loss account of Jet Airways. Other expenses constitute about 30% of the total operating expenses and 27% of the total revenue of the company. One can gauge the significance of this item when one compares it with air turbine fuel (ATF) charges. ATF constitutes about 20% of the total expenses of the company. About 8 to 10% of the expenses will be in-flight foods and beverages. A large part of the remaining other expenses can be the license fees.
c) The cost of ATF has increased by 21% in the last year itself. The air carriers are not allowed to hedge the price risk as of now and hence, will have to bear the expenses themselves. It will be difficult for these companies to pass on the increase in ATF cost to the passengers unless all airlines do it simultaneously. This seems difficult as of now given that a few more players are going to enter the market.
Most analysts are banking on the fact that because the economy is growing, the industry will increase at a fast rate and hence the current price is justified. A quick glance at some of the research reports floating round in the market suggests that it is a good buy because it is the leading player in the civil aviation industry in India, because it is the most preferred airline for the business passengers, that it has one of the youngest fleet in India, etc. All these claims definitely prove that jet Airways is a well managed company. There is no doubt about that. However that in itself does not make it a good investment at the bid price.
DCF Valuation of Jet Airways
World over, civil aviation industry is a cyclical industry. And Jet is no exception. The growth rate in passenger revenue was 0% in 2002, a recession year. It has however increased to 20% for 2003-04. The growth rate in cargo revenue has however remained quite steady at about 18%. One cannot therefore extrapolate the current growth rate into the future to value Jet’s share as this will inevitably overvalue the stock.
Before forecasting the free cash flows, I did a historical sensitivity analysis to find the most important value drivers of Jet Airways. Not surprisingly, other expenses came out as the most important value driver, followed by ATF costs, and passenger revenue growth rate. A 1% decline in DE ratio will increase the share price by about 0.5%. This also a good news because a large part of the issue proceeds will be used to redeem part of the debt of the company. Selling and distribution expense is the fourth largest value driver for Jet. This implies that any valuation of the company is highly sensitive to three things. They are:
a) License fees that Jet is paying to Jet Enterprises. Jet Enterprise is going to transfer the brand name to jet Airways in about six months time. As of now, the value of the brand name is not known and hence the entire DCF valuation becomes highly sensitive to the value of the brand at which the brand name will be transferred to Jet Airways.
b) Air turbine fuel costs: As of now they constitute about 20% of the total expenses and it has increased at the rate of 21% in the last year itself. The airlines in India are not allowed to hedge the price risk. If the airlines simply pass on the high costs to the passengers, then one can use the same cost to revenue ratio while projecting the free cash flows. However, I see increased competition in the industry and hence this may make the final value very sensitive to the projected ATF costs to total revenue. There are rumors (as on 15 Feb, 2005) that the duty on ATF will be slashed. If that happens, it will positively affect the free cash flow of the company.
c) Passenger revenue growth rate: The industry being cyclical, the revenue growth is sensitive to the overall state of the economy. One should not therefore get carried away by the current performance of the economy.
I valued Jet Airways under three scenarios. The first scenario is based on some normal assumptions that take into account the historical performance of the company, projected growth rates, the value drivers, etc and I find the share price comes to about Rs.300 per share. The Investment bankers are obviously more optimistic.
The second scenario is based on somewhat unrealistic assumptions that the current growth rate will continue for ever. This is unrealistic because it ignores the cyclical nature of the industry. This is based on a projected growth rate of 25% in passenger revenue till the end of the explicit forecasting period and a terminal growth rate of 8%. I also kept the ATF cost to total expenditure ratio constant at the current 21% level. This gave a share price of Rs.600 per share.
The third scenario is generated by using a spreadsheet model that uses the principle of reverse engineering. The key idea is to see what assumptions are inherent in the current stock price. I take the lower band of Rs. 950 and try to see what assumptions can justify these numbers. It then becomes easier to see if this growth can be justified. One of the many plausible set of assumptions looks like this:
Passenger revenue growth rate of 30% for the next five years and a terminal growth rate of 10%
Excess baggage revenue growth rate of 15% for the next five years
Cargo revenue growth rate of 20% for the next five years
Other revenue growth rate of 15% for the next five years
Staff cost as a percentage of revenue to fall to 8% (this one seems to be achievable because Jet has succeeded in reducing the staff related costs over the last three years
The ATF cost as a percentage of revenue to come down to 21%.
Other expenses as a percentage of revenue to come down to 26%
If all the above conditions are simultaneously satisfied, then one can justify a price of Rs.950 per share. In all the above assumptions, I assumed that Jet Airways will continue to pay license fees to Jet Enterprises. If Jet Airways buys the brand name by paying the fair DCF value, then it will not have any impact on the value of the share.
Therefore the lower band of Rs.950 seems to be on the higher side by common sense. Nevertheless I will recommend the stock as a short term buy for the following reasons.
a) Most of the stocks are grossly overvalued now. It is the same mad market that will value Jet after its listing. One will not be surprised to see a first day listing price of Rs. 1100 plus for Jet. This is based on the concept of relative valuation where I am assuming that the market will overvalue Jet Airways more or less by the same percentage points as it has done for the other stocks.
b) Prior research shows that most stocks quote at a substantial premium in the week after listing and there is no reason why Jet will be an exception.
c) And finally, this is the first stock from the civil aviation sector that is coming out with a public issue. This definitely gives our shareholders a chance to diversify the risk further.
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Jet Airways is definitely one of the best airways in India. Its market share is about 46% and that is way ahead of its competitor, Indian Airlines (with a market share of 37%). It is the most favored carrier for the business class passengers.
However, there are certain red flags that one has to look at.
a) There is now growing competition from the no-frills carriers like Air-Deccan.
b) The brand name “Jet Airways” is actually owned by Jet Enterprises, a company owned by Mr. Naresh Goyal. As of now Jet is paying license fees to Jet Enterprises on a quarterly basis. Though no information is available about the license fees, one can get some idea about by looking at the profit and loss account of Jet Airways. Other expenses constitute about 30% of the total operating expenses and 27% of the total revenue of the company. One can gauge the significance of this item when one compares it with air turbine fuel (ATF) charges. ATF constitutes about 20% of the total expenses of the company. About 8 to 10% of the expenses will be in-flight foods and beverages. A large part of the remaining other expenses can be the license fees.
c) The cost of ATF has increased by 21% in the last year itself. The air carriers are not allowed to hedge the price risk as of now and hence, will have to bear the expenses themselves. It will be difficult for these companies to pass on the increase in ATF cost to the passengers unless all airlines do it simultaneously. This seems difficult as of now given that a few more players are going to enter the market.
Most analysts are banking on the fact that because the economy is growing, the industry will increase at a fast rate and hence the current price is justified. A quick glance at some of the research reports floating round in the market suggests that it is a good buy because it is the leading player in the civil aviation industry in India, because it is the most preferred airline for the business passengers, that it has one of the youngest fleet in India, etc. All these claims definitely prove that jet Airways is a well managed company. There is no doubt about that. However that in itself does not make it a good investment at the bid price.
DCF Valuation of Jet Airways
World over, civil aviation industry is a cyclical industry. And Jet is no exception. The growth rate in passenger revenue was 0% in 2002, a recession year. It has however increased to 20% for 2003-04. The growth rate in cargo revenue has however remained quite steady at about 18%. One cannot therefore extrapolate the current growth rate into the future to value Jet’s share as this will inevitably overvalue the stock.
Before forecasting the free cash flows, I did a historical sensitivity analysis to find the most important value drivers of Jet Airways. Not surprisingly, other expenses came out as the most important value driver, followed by ATF costs, and passenger revenue growth rate. A 1% decline in DE ratio will increase the share price by about 0.5%. This also a good news because a large part of the issue proceeds will be used to redeem part of the debt of the company. Selling and distribution expense is the fourth largest value driver for Jet. This implies that any valuation of the company is highly sensitive to three things. They are:
a) License fees that Jet is paying to Jet Enterprises. Jet Enterprise is going to transfer the brand name to jet Airways in about six months time. As of now, the value of the brand name is not known and hence the entire DCF valuation becomes highly sensitive to the value of the brand at which the brand name will be transferred to Jet Airways.
b) Air turbine fuel costs: As of now they constitute about 20% of the total expenses and it has increased at the rate of 21% in the last year itself. The airlines in India are not allowed to hedge the price risk. If the airlines simply pass on the high costs to the passengers, then one can use the same cost to revenue ratio while projecting the free cash flows. However, I see increased competition in the industry and hence this may make the final value very sensitive to the projected ATF costs to total revenue. There are rumors (as on 15 Feb, 2005) that the duty on ATF will be slashed. If that happens, it will positively affect the free cash flow of the company.
c) Passenger revenue growth rate: The industry being cyclical, the revenue growth is sensitive to the overall state of the economy. One should not therefore get carried away by the current performance of the economy.
I valued Jet Airways under three scenarios. The first scenario is based on some normal assumptions that take into account the historical performance of the company, projected growth rates, the value drivers, etc and I find the share price comes to about Rs.300 per share. The Investment bankers are obviously more optimistic.
The second scenario is based on somewhat unrealistic assumptions that the current growth rate will continue for ever. This is unrealistic because it ignores the cyclical nature of the industry. This is based on a projected growth rate of 25% in passenger revenue till the end of the explicit forecasting period and a terminal growth rate of 8%. I also kept the ATF cost to total expenditure ratio constant at the current 21% level. This gave a share price of Rs.600 per share.
The third scenario is generated by using a spreadsheet model that uses the principle of reverse engineering. The key idea is to see what assumptions are inherent in the current stock price. I take the lower band of Rs. 950 and try to see what assumptions can justify these numbers. It then becomes easier to see if this growth can be justified. One of the many plausible set of assumptions looks like this:
Passenger revenue growth rate of 30% for the next five years and a terminal growth rate of 10%
Excess baggage revenue growth rate of 15% for the next five years
Cargo revenue growth rate of 20% for the next five years
Other revenue growth rate of 15% for the next five years
Staff cost as a percentage of revenue to fall to 8% (this one seems to be achievable because Jet has succeeded in reducing the staff related costs over the last three years
The ATF cost as a percentage of revenue to come down to 21%.
Other expenses as a percentage of revenue to come down to 26%
If all the above conditions are simultaneously satisfied, then one can justify a price of Rs.950 per share. In all the above assumptions, I assumed that Jet Airways will continue to pay license fees to Jet Enterprises. If Jet Airways buys the brand name by paying the fair DCF value, then it will not have any impact on the value of the share.
Therefore the lower band of Rs.950 seems to be on the higher side by common sense. Nevertheless I will recommend the stock as a short term buy for the following reasons.
a) Most of the stocks are grossly overvalued now. It is the same mad market that will value Jet after its listing. One will not be surprised to see a first day listing price of Rs. 1100 plus for Jet. This is based on the concept of relative valuation where I am assuming that the market will overvalue Jet Airways more or less by the same percentage points as it has done for the other stocks.
b) Prior research shows that most stocks quote at a substantial premium in the week after listing and there is no reason why Jet will be an exception.
c) And finally, this is the first stock from the civil aviation sector that is coming out with a public issue. This definitely gives our shareholders a chance to diversify the risk further.
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posted by Pitabas Mohanty at 3:51 AM
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