Report to
on the
Proposed Strategic Alliance between Air New Zealand Limited and Qantas Airways Limited
December 2002
Table of Contents
LIMITATIONS AND DISCLAIMER ...... III
Glossary – Key Terms and Definitions ...... v
1 EXECUTIVE SUMMARY...... 1
1.1 Introduction ...... 1 1.2 Summary of Strategic Alliance Agreement ...... 1 1.3 Key Conclusions ...... 2 1.4 Information Sources...... 5 1.5 Appreciation...... 5
2 HISTORICAL FINANCIAL AND OPERATING PERFORMANCE...... 6
2.1 November 2001 Five Year Business Plan ...... 6 2.2 FY2002 Financial Results...... 8 2.3 Share Price Performance...... 11 2.4 Divisional Earnings Summary ...... 12
3 THE CURRENT COMPETITIVE ENVIRONMENT...... 14
3.1 Overview ...... 14 3.2 Air NZ’s Strategic Response – NZ Express...... 14 3.3 Competitive Behaviour ...... 18
4 STAND-ALONE FORECAST FINANCIAL AND OPERATING PERFORMANCE...... 21
4.1 FY2003 Budget ...... 21 4.2 FY2003 YTD Performance...... 22 4.3 Stand-Alone Projections FY2004-2006 ...... 24 4.4 Capital Structure Analysis ...... 30
5 OUTLINE OF PROPOSAL ...... 34
5.1 Overview of Strategic Alliance Agreement (“SAA”) ...... 34 5.2 Overview of the JAO ...... 35 5.3 Equity Investment ...... 41 5.4 Governance ...... 44 5.5 Transition Deed ...... 45 5.6 Termination of the Strategic Alliance Agreement ...... 46 5.7 Process and Timetable...... 48
6 ASSESSMENT OF PROPOSAL ...... 49
6.1 Strategic Rationale ...... 49 6.2 Management Fee and Adjustment Payment...... 51 6.3 Financial Impact of JAO ...... 53 6.4 Comparison of the JAO to Stand-Alone ...... 59 6.5 Gearing ...... 62 6.6 Impact of the JAO on Valuation of Air NZ ...... 62 6.7 Assessment of Equity Investment by Qantas ...... 64
Page i Table of Contents
6.8 Management and Governance...... 71 6.9 Key Risks of the Proposal for Air NZ...... 73
7 IMPLICATIONS FOR THE CROWN AS PRINCIPAL SHAREHOLDER...... 76
7.1 Financial Implications for the Crown ...... 76 7.2 Governance Issues...... 78 7.3 Implications for Divestment of Shareholding...... 79 7.4 Air NZ’s Future Capital Requirements ...... 81
8 ALTERNATIVES TO THE SAA AND JAO ...... 85
8.1 Introduction ...... 85
8.6 Summary of Options ...... 92
9 MODIFICATIONS TO PROPOSAL ...... 94
9.1 Levels of Qantas Shareholding ...... 94 9.2 Shareholders’ Agreement with the Crown ...... 95
10 OTHER MATTERS ...... 96
10.1 Legal Matters for Consideration ...... 96
11 CONCLUSION ...... 97
11.1 Overall Assessment of Proposal ...... 97 11.2 Implications for the Crown ...... 97 11.3 Other Options Available to the Crown...... 97
APPENDIX A: TERMS OF REFERENCE ...... 99
Description of Services (clause 1.1):...... 99
APPENDIX B: SOURCES OF INFORMATION ...... 101
APPENDIX C: QANTAS SUMMARY...... 102
APPENDIX D: VIRGIN BLUE SUMMARY...... 103
Page ii Disclaimer
Limitations and Disclaimer
This Report has been prepared by First NZ Capital Group Limited (“First NZ Capital”) solely for the purpose of enabling the Crown to evaluate the proposal from the perspective of the Crown as the major shareholder in Air New Zealand Limited (“Air NZ”). This Report is furnished by First NZ Capital solely for the purposes described above and is unsuitable for any other purpose and should not be relied upon by any other person or for any other purpose.
The information in this Report is given in good faith and has been prepared from and based on financial and other information provided by Air NZ and its advisors, believed to be reliable at the time of preparation. Whilst First NZ Capital has no reason to believe that any material facts have been withheld or omitted by the aforementioned parties, First NZ Capital does not represent or warrant that it has received all relevant information.
The information provided to First NZ Capital was evaluated through analys is, enquiry and review for the purposes of evaluating the proposal from the perspective of the Crown as the major shareholder in Air NZ. However, First NZ Capital does not represent or warrant that its enquiries have identified or verified all of the matters that an audit or “due diligence” investigation might disclose. The information provided to First NZ Capital included financial projections for the financial years ending 2003 to 2006. First NZ Capital has used and relied upon those financial projections for the purpose of its analysis.
Although reasonable care has been taken to ensure that the facts stated and opinions, estimates, forecasts and projections contained in this Report are fair and accurate, we have not independently verified the information contained in this Report and assume no responsibility for the independent verification thereof. Accordingly, First NZ Capital makes no representation or warranty, express or implied, as to the fairness, accuracy, completeness or correctness of the information, opinions, estimates, forecasts or projections contained in this Report, and nothing in this Report shall be deemed to constitute such a representation or warranty. Neither First NZ Capital nor any of its directors, affiliates, related companies, agents, officers or employees accept any liability whatsoever for any loss or other consequence arising from the use of this Report or otherwise arising in connection therewith.
The report includes certain statements, estimates, forecasts and projections with respect to anticipated future performance of Air NZ. Such statements, estimates, forecasts and projections reflect various assumptions, including those by or on behalf of Air NZ, concerning anticipated future performance which may or may not prove correct. Some assumptions inevitably will not materialise and unanticipated events and circumstances likely occur. Therefore, there can be no assurance that such statements, estimates, forecasts and projections will be realised and actual results achieved during the period of the forecasts/projections will vary from those in the forecasts/projections, and such variations may be material.
First NZ Capital’s Terms of Reference require it to evaluate the proposal from the perspective of the Crown as the major shareholder in Air NZ. First NZ Capital is not required, amongst other things, to evaluate the competition or national welfare impacts of the proposal, or to consider whether overseas investment in Air NZ is desirable, nor to comment on whether the proposal has any implications for Air NZ’s rights under New Zealand’s bilateral air services agreements. First NZ Capital’s views and opinions are based on economic, capital market, business trading and other conditions prevailing at
Page iii Disclaimer the date of this Report. Such conditions can change significantly over relatively short periods of time.
First NZ Capital reserves the right (but will be under no obligation) to review this Report and, if we consider it necessary, to revise the report in the light of any information existing at the date of this Report which becomes known to us after this date.
By accepting this Report, you agree to be bound by the above limitations.
Page iv Glossary
Glossary – Key Terms and Definitions
The terms set out below have the following meanings in this Report. Unless otherwise stated, all dollar ($) amounts refer to New Zealand dollars.
“ACCC” Australian Competition and Consumer Commission “Air NZ” or the “Company” Air New Zealand Limited “ANZES” Air New Zealand Engineering Services “ASK” Available seat kilometre “AUD” or “A$” Australian dollar “Book Gearing” Net debt (including off-balance sheet debt) divided by (net debt plus book value of shareholders’ funds) “BPP” Base Position Protector “CAGR” Compound average growth rate “Capex” Capital expenditure “DCF” Discounted cash flow “EBDRIT” Earnings before depreciation, rental, interest and taxation “EBIT” Earnings before interest and taxation “EBIT Margin” EBIT as a percentage of revenue “EBITDA” Earnings before interest, taxation, depreciation and amortisation “EBITDA Margin” EBITDA as a percentage of revenue “EBITDRA” Earnings before interest, taxation, depreciation, rental and amortisation “EBITDRA Margin” EBITDRA as a percentage of revenue “FFP” Frequent flyer passengers “Five Year Plan” Air NZ Revised Five Year Business Plan dated November 2001 “Free Cash Flow” Calculated as EBITDA less change in working capital, tax paid, capital expenditure, assets sales “FSA” Full service airline “FTE” Full time employee “FX” Foreign exchange “IFE” In flight entertainment “JAO” Joint Airline Operation “JAOB” JAO benefit “NECG” Network Economics Consulting Group “Net Debt” Interest bearing debt less cash and equivalents “NOPBT” Net Operating Profit Before Tax “NPAT” Net profit after taxation
Page v Glossary
“NTA” Net tangible assets “NZCC” New Zealand Commerce Commission “NZD” or “NZ$” New Zealand dollar “NZSE” New Zealand Stock Exchange “p.a.” Per annum
“PBT” Profit before tax “Qantas” Qantas Airways Limited “QSI” Quality of service index “ROCE” Return on capital employed. “ROSF” Return on shareholders’ funds “RPK” Revenue passenger kilometre “SAA” Strategic Alliance Agreement “SAAG” Strategic Alliance Advisory Group “USD” or “US$” United States dollar “VBA” Value based airline “VBA+” Value based airline with certain features of the full service model retained “VWAP” Volume weighted average price “WACC” Weighted average cost of capital “YTD” Year to date
Page vi Executive Summary
1 Executive Summary
1.1 Introduction
First NZ Capital is pleased to present this report to the Treasury on the proposed strategic alliance between Air New Zealand Limited (“Air NZ” or the “Company”) and Qantas Airways Limited (“Qantas”). The principal purpose of the report is to evaluate the proposal from the perspective of the Crown as the major shareholder in Air NZ.1
The background to the proposed strategic alliance is as follows:
§ Air NZ has a number of strengths, including its strong market share in domestic trunk services, relatively low cost base, relatively young fleet and a loyal customer base; § however, Air NZ’s profitability depends heavily on the profitability of its domestic main trunk services – its trans-Tasman and most international routes are not profitable; § in the event that Qantas or another competitor adds capacity to the New Zealand domestic market, operating yields for Air NZ (and its competitors) would most likely reduce whilst Air NZ’s operating costs would largely remain the same due to the relatively high fixed cost base of airline operations. The impact would be to reduce returns for Air NZ and hence the value of the Crown’s shareholding in Air NZ; § whilst financial analysis indicates that under a more competitive environment Air NZ should remain cash flow positive in the short to medium term, it is unlikely to achieve an adequate return on capital. Further, its gearing is likely to remain relatively high, leaving Air NZ exposed to adverse changes in exogenous factors such as fuel prices and exchange rates. In the medium to longer term, Air NZ’s ability to source capital from debt and equity markets to fund its capital expenditure to maintain its existing long-haul business would be limited; and § Air NZ believes it is critical to defend the Company’s strong domestic earnings base if it is to maintain an international network. Accordingly, Air NZ proposes to enter into a Strategic Alliance Agreement (“SAA”) with Qantas to ensure the future sustainability of the Company. 1.2 Summary of Strategic Alliance Agreement
The main features of the SAA are:
§ Establishment of a Joint Airline Operation (“JAO”) - all of Air NZ’s domestic and international air services, and the New Zealand and trans-Tasman air operations of Qantas, would be managed through a joint airline operation (“JAO”). The term of the SAA is indefinite, but either party could terminate the SAA without cause at any time after the fourth anniversary following by giving not less than 12 months’ notice.
1 The terms of reference for the report are shown in Appendix A.
Page 1 Executive Summary
§ Air NZ manages the JAO - Air NZ would be responsible for managing the commercial aspects of the JAO. Qantas’ consent would be required to material changes to Qantas’ product specifications or capacity (such as the removal of the Qantas brand from a market). § Strategic Alliance Advisory Group (“SAAG”) - six representatives, three from Air NZ and three from Qantas, would comprise the SAAG. The SAAG’s function would be to monitor and review the performance of the JAO, review and endorse Air NZ’s commercial planning for the JAO, and provide advice to Air NZ as manager of the JAO. § Management Fee and Adjustment Payment - a management fee and adjustment payment would allocate the JAO’s profits 60% on the basis of relative capacity provided to the JAO, with the remaining 40% split equally between Air NZ and Qantas. This mechanism has been designed to preserve the relatively higher profitability currently experienced by Air NZ on the routes covered by the JAO. § Equity Placement to Qantas - Qantas would subscribe for new equity in Air NZ for a total sharehold ing of 22.5%. It would initially acquire convertible notes on receiving consent from the Kiwi Shareholder that, when converted, would equate to 4.99% of Air NZ’s voting securities. Upon receiving regulatory authorisations and Air NZ shareholder approvals, Qantas must subscribe for ordinary shares that would take its shareholding to 15% (Tranche 1) when aggregated with the shares issued on conversion of the convertible notes. A further issue to Qantas of 7.5% of Air NZ’s ordinary shares (Tranche 2) would also be made (at Qantas’ election) either at the same time as Tranche 1 or three years later. The convertible notes, Tranche 1 and Tranche 2 securities (if subscribed for at the same time as Tranche 1) would be issued at a price of $0.445, being a 10% discount to the volume weighted average price of Air NZ shares over the 20 trading days prior to 25 November. If the Tranche 2 securities are issued three years later, the issue price would be set at a 15% discount to the volume weighted average market price for the 20 trading days prior to the issue. Qantas’ total shareholding would be protected through anti- dilution rights. § Governance - Qantas would have the right to nominate two classes of director to the board of Air NZ. First, Qantas would have the rig ht to nominate one director as an SAA director. Second, Qantas would have the right to nominate a director(s) as a result of its equity position. Under the equity nomination right, if Qantas owns 10% or more but less than 20% of Air NZ’s voting securitie s, it can nominate one equity director. If it owns 20% or more, it can nominate two equity directors. In either case, however, the maximum number of directors nominated by Qantas will be two (increased pro rata if the number of Air New NZ directors increases beyond the current eight). Accordingly, if Qantas holds 20% or more of Air NZ’s voting securities, one of the equity directors will be deemed to be the SAA director. Air NZ would have the right to nominate one SAA director to the board of Qantas. The appointment of the directors so nominated would be subject to shareholder approval in each case. 1.3 Key Conclusions
Overview of SAA
§ The proposal should have a significant positive impact on the financial performance, value and future viability of Air NZ by removing a major competitive threat to the
Page 2 Executive Summary
airline and by providing opportunities for revenue enhancement, cost savings and reduced financial leverage. § Our review of the potential outcomes prepared by Air NZ and its advisors for Air NZ with and without the SAA indicates the following: § the JAO provides significant downside protection to Air NZ’s future earnings; § if the status quo competitive environment continues (i.e. Qantas does not add any more capacity to the domestic main truck routes and no VBA enters the market), then the SAA would not add value for Air NZ shareholders. However, in our view, the probability of the status quo continuing is relatively low; and § if any of the competitive outcomes expected by Air NZ eventuates (eg. Qantas competes aggressively on the trans-Tasman and domestic main trunk routes), then the JAO is materially value adding for Air NZ shareholders. § §
§
§ § § § The main risk to implementation of the proposal is the possible failure to obtain regulatory and shareholder approvals. If it is implemented, there are risks to the sustainability of a joint venture between two parties that historically have been fierce competitors. If the SAA is terminated, Qantas’ competitive position would be enhanced by its access to Air NZ information through the SAAG. Financial Impact of SAA
§
§
§
§ If the SAA is implemented, financial projections indicate that the gearing of Air NZ would improve significantly. The new capital contributed by Qantas (approximately $543 million) would substantially reduce the need for Air NZ to proceed with a
Page 3 Executive Summary
rights issue. Under the JAO Base Case, Air NZ’s book gearing falls below its target of 50 – 60% by FY2004. § Although we have not undertaken a comprehensive valuation of Air NZ, the issue price of $0.445 appears fair and reasonable based on an analysis of comparable company valuation parameters and equity research analysts’ views on the underlying fair value of Air NZ. § If the SAA is not implemented, Air NZ’s earnings are projected to increase between FY2003 and FY2006, except in the Downside Case scenario. However, the Company’s gearing remains above the target level at FY2006 and there is greater earnings volatility.
Implications for the Crown
§
§
§ Qantas’ equity investment will dilute the Crown’s shareholding from 82.0% to 63.5%. § If the SAA is implemented, there would be limited scope for the Crown to sell any of its shareholding to potential strategic partners, except Qantas, without Qantas’ consent or without giving Qantas the right to terminate the SAA. The Crown’s exit options would be limited to selling to Qantas and/or a placement of shares to institutional or public investors. In our view, these are the only realistic options currently available to the Crown irrespective of whether the SAA proceeds. § If the SAA is not implemented, in order for Air NZ to continue offering an international network, it is likely that the Crown would be required to inject additional equity in the medium term. Alternatives to the SAA
§ Other alternatives to implementing the JAO include: forming an alliance with another airline, deferring selection of a strategic partner or restructuring Air NZ’s unprofitable operations. § No other airline is able to offer the same benefits to Air NZ as Qantas. Virgin Blue is essentially a point-to-point airline – its business model is not designed to provide the “feeder” traffic Air NZ seeks. Further, any alliance with another airline would not eliminate the threat of Qantas targeting Air NZ’s profitable main trunk routes and would most likely result in Air NZ losing Qantas’ profitable terminal services business. § Deferring the SAA would most likely result in deferral of the SAA indefinitely. To consummate a transaction with another airline would take many months and, at present, , there appears to be no interest by other strategic partners. One likely consequence of deferral is that the Crown would be required to provide additional capital to Air NZ.
Page 4 Executive Summary
§ In our view, the JAO would enhance the probability that Air NZ can maintain an international network, while it does not preclude the scaling-back of Air NZ’s unprofitable long-haul operations. Whilst scaling-back is an option, it may have adverse consequences on Air NZ’s domestic main trunk profitability, ANZES operations, loyalty programmes and negotiating power with other international airlines, including Star Alliance members. 1.4 Information Sources
Air NZ and its advisers, Cameron & Company and Bell Gully Buddle Weir, have provided First NZ Capital with extensive information about the airline and the strategic alliance proposal. A summary of the information provided and examined by First NZ Capital is set out in Appendix B.
1.5 Appreciation
First NZ Capital records its appreciation of the assistance it has been provided by Air NZ, Cameron & Company and Bell Gully Buddle Weir in preparing this report. Nevertheless, except where noted otherwise, the opinions and conclusions expressed in this report are those of First NZ Capital.
Page 5 Historical Financial and Operating Performance
2 Historical Financial and Operating Performance
In November 2001, Air NZ prepared a Five Year Business Plan that set out the earnings targets required to deliver acceptable returns to shareholders following the Company’s recapitalisation. Air NZ’s FY2002 result was slightly ahead of market expectations and the Five Year Business Plan targets. However, exogeneous factors such as favourable exchange rate movements and fuel prices were major contributors to the result. The share price reacted positively to the result announcement and to Air NZ’s increased weighting in the NZSE40 Index. Air NZ’s profitability has historically been (and is projected to continue to be) underpinned by its strong profitability on domestic routes.
2.1 November 2001 Five Year Business Plan
Air NZ produced a Five Year Business Plan (“the Five Year Plan”) in November 2001 in response to events that had left the Company in a weak financial and competitive position and in need of recapitalisation. The key contributors to the deterioration in the financial position of Air NZ included the significant decline in the financial performance and eventual collapse of the Company’s subsidiary, Ansett Australia; increased operating losses on Air NZ’s trans-Tasman routes resulting from reduced yields caused by excess capacity; and reduced passenger volumes resulting from the negative impact on the aviation market of the September 11 terrorist attacks in the US. In response to this situation, and based upon the business case set out in the Five Year Plan, the Crown recapitalised Air NZ in January 2002.
Air NZ’s stated weaknesses at that time included the small size and low growth of New Zealand as its home market; its unprofitable trans-Tasman operations; its reliance on inbound markets for the majority of international traffic; a weakened balance sheet and liquidity position due to Ansett Australia’s collapse; its lack of a significant presence in Australia; internal instability due to organisational restructuring; and the requirement for a new CEO. The identified business threats resulting from these weaknesses included Qantas continuing to compete aggressively in the New Zealand and trans-Tasman markets further destabilising Air NZ’s position; continued downturn in the aviation market resulting from terrorism fears and US retaliation; and the potential for a low cost carrier to enter the New Zealand domestic market and/or the trans-Tasman market.
Air NZ’s stated strengths included a strong market share and profitability in domestic New Zealand; a low cost base; a relatively young fleet; sound operational integrity; and a loyal customer base. The identified opportunities resulting from these strengths included expanding Freedom Air’s operations in both the trans-Tasman and New Zealand domestic routes; continued investment in analytical capability and information systems to improve decision making; and capitalising on the growth potential of the New Zealand tourism industry and upcoming key events such as the Americas Cup and the Rugby World Cup.
Based on Air NZ’s assessment of its financial and competitive position and its strengths and weaknesses, a number of high-level business strategies were developed in the Five Year Plan to provide the strategic direction and platform by which the challenges faced by Air NZ could be addressed, whilst specific tactics and longer-term strategic opportunities were more fully developed.
Page 6 Historical Financial and Operating Performance
The key financial projections contained in the Five Year Plan are summarised in Table 2.1 below.
Table 2.1 Five Year Plan Forecasts (All amounts in NZ$mm)
Year Ended 2001 2002 2003 2004 2005 2006 CAGR 30 June Actual Plan Plan Plan Plan Plan % EBITDRA 681.2 622.7 697.9 782.6 889.3 991.0 7.8% EBITDRA Margin 18.2% 18.0% 20.4% 21.2% 22.2% 23.6% na EBIT 124.0 21.5 159.1 230.2 302.1 414.6 27.3% ROSF(1) 4.0% (5.5)% 3.6% 6.7% 9.4% 12.9% na Free Cash Flow 378.7 (384.8) 443.8 183.2 276.4 401.1 1.2% Book Gearing 89.3% 79.4% 68.0% 65.5% 62.3% 54.5% na
(1) Calculation is based on closing position and excludes unusual items. Based on actual shares on issue at 30 June 2001 of 756.8 million and projected shares on issue at 1 February 2002 (following the recapitalisation) of 4,444.3 million. Source: Air NZ Revised Five Year Business Plan, November 2001
The projections presented were stated by Air NZ to be “a low growth baseline scenario”. Air NZ noted that “whilst there are a number of risks which could affect achievement of the Plan, it is believed that the projections, particularly in the earlier years, do reflect an appropriate level of conservatism”. Importantly the Plan was not based on divisional earnings estimates, but rather set out the financial performance that would be required from Air New Zealand by its shareholders. In preparing the forecasts, the Company assumed a relatively benign competitive environment and considered that unidentified cost savings would be an important source of earnings improvement.
Figure 2.1 compares Air NZ’s projected EBITDRA and EBITDRA margin performance under the Five Year Plan relative to the Company’s stand-alone historical performance. The chart highlights the substantial improvement in EBITDRA and margins forecast in the Plan relative to the Company’s historical financial performance. Earnings in later years were predicated on Air NZ significantly improving its international long-haul operations.
Page 7 Historical Financial and Operating Performance
Figure 2.1 Air NZ Stand-Alone Historical & Forecast EBITDRA & EBITDRA Margin
$1,200 25.0%
$1,000 20.0%
$800 15.0%
$600
10.0% $400 Air NZ (Stand Alone) EBITDRA Margin Air NZ (Stand Alone) EBITDRA NZ$mm 5.0% $200
– – '91A '92A '93A '94A '95A '96A '97A '98A '99A '00A '01A '02F '03F '04F '05F '06F EBITDRA EBITDRA Margin
Source: First NZ Capital Research Estimates, Air NZ Revised Five Year Business Plan, November 2001
Earnings results since the Five Year Plan was prepared have exceeded the Plan targets. Section 2.2 provides analysis of the Company’s FY2002 EBITDRA and EBIT results.
The differences are largely attributable to favourable currency and fuel price movements and the successful implementation of cost saving initiatives, such as the renegotiation of leases and reduced engineering expenses. Going forward, achieving the EBITDRA and EBITDRA margin targets set out in Table 2.1 would require strong revenue growth and/or aggressive cost cutting. With the competitive environment unlikely to improve, significant growth in revenue is unlikely to occur. Air NZ has also indicated that future cost savings are unlikely to be sufficient to meet the further earnings margin improvements detailed in the Five Year Plan.
The Five Year Plan is a long-term, high-level assessment of performance targets necessary to provide what the Company considers to be a sufficient return to shareholders. Our understanding is that Air NZ does not believe it is likely to meet the longer-term Five Year Plan forecasts if it remains a stand-alone airline.
2.2 FY2002 Financial Results
Air NZ reported a FY2002 earnings result that was slightly ahead of market expectations and significantly ahead of the forecast contained in the Five Year Plan.
Figure 2.2 breaks down the key variances that contributed to the FY2002 EBIT.
Page 8 Historical Financial and Operating Performance
Figure 2.2 Variance of FY2002 EBIT Budget to Actual
Source: Air NZ June 2002 Monthly Management Performance Report, Company Data
Despite the positive earnings result, key performance indicators suggest that Air NZ remained under competitive pressure. Revenues and yields on key routes declined and load factors rose only slightly. Air NZ increased seat capacity on domestic routes, but yields in this key market fell by 9.7% as Qantas also increased its domestic seat capacity. Load factors on international routes increased but a reduction in seat capacity and unfavourable currency movements caused the yield on international routes to fall by 6.6%.
The better than expected financial result for FY2002 and an increase in Air NZ’s share price has resulted in an improvement in the Company’s market gearing and interest coverage ratios. Table 2.2 summarises Air NZ’s financial position as at June 2001, June 2002 and for the four months to October 2002.
Page 9 Historical Financial and Operating Performance
Table 2.2 Air NZ’s Financial Position
YTD 2006 Long- June 2001 June 2002 October 2002 Term Target Book Gearing(1) 93.0% 73.8% 50% – 60% Market Gearing(1) 95.7% 48.0% n.a. EBITDRA / Interest plus Lease Expense 1.5x 1.5x n.a.
(1) Includes aircraft operating leases capitalised by a factor of seven. Source: Air NZ Revised Five Year Business Plan, November 2001; 2002 Annual Report; Air NZ October 2002 Monthly Management Report
As at 30 June 2002, Air NZ’s book gearing improved to 73.8% compared with the budgeted position of 79.4%. Market gearing has improved due to the strong appreciation in Air NZ’s share price and at 30 June 2002 was estimated at 48.0% compared with the budget of 87.2%. This compares to an average of 72.2% for a sample of other international airlines.
The substantial increase in interest and lease expense coverage has been aided by the capital injection by the Crown in January 2002, favourably renegotiated leases and improved earnings in the four months to October 2002. Although Air NZ’s gearing levels ended FY2002 at manageable levels, the high debt balance prior to the recapitalisation incurred substantial interest expense resulting in a low coverage ratio in FY2002. Continued improvement in debt levels and a strong increase in earnings through to October have pushed interest and lease expense coverage to levels above those achieved in previous periods.
Page 10 Historical Financial and Operating Performance
2.3 Share Price Performance
As illustrated by Figure 2.3, Air NZ’s share price has performed strongly since the recapitalisation in January 2002, having appreciated by around 70% during this period. This year the Company’s shares have traded in a wide range, from a low of $0.30 in January to a high of $0.72 in June.
Figure 2.3 Air NZ’s Historical Share Price Performance – 2002 YTD
29-Oct-02 25-Nov-02 30-May-02 Air NZ announces it is on Air NZ and Qantas $0.90 Air NZ announces it has been track to exceed the level of announce SAA 12,000 Air NZ (abs) in discussions with Qantas profitability projected for the second year of the $0.80 NZSE40 (rel) 28-May-02 Five Year Plan Qantas (rel) Air NZ announces 10,000 low cost strategy $0.70 1-May-02 Govt's share fully $0.60 8,000 weighted in NZSE40 28-Aug-02 Air NZ reports NPAT $0.50 before unusual items of $39 million from continuing operations 6,000 $0.40 Share Price (NZ$) $0.30 4,000 Daily Trading Volume (000)
$0.20 2,000 $0.10
$0.00 - Jan-02 Feb-02 Mar-02 Apr-02 May-02 Jun-02 Jul-02 Sep-02 Oct-02 Nov-02
Source: Bloomberg, First NZ Capital
The significant fluctuation in Air NZ’s share price has been in response to a number of company specific factors and has been amplified by the stock’s relatively small free float and low liquidity. Key factors that are likely to have affected the share price over this period include:
§ Air NZ’s increased weighting in the NZSE40 index. As a result of the recapitalisation of Air NZ by the Crown, the Company’s weighting in the benchmark NZSE40 Index increased from approximately 0.5% prior to the recapitalisation in January 2002 to 4.5% in May 2002 following the full inclusion of the shares issued to the Crown in the Company’s index weighting. This is likely to have prompted some buying by domestic institutions that benchmark their performance against the NZSE40 Index. § Better than expected financial performance. As mentioned in section 2.2, strengthening of the NZD against the USD and the announcement of better than expected load factors during FY2002 resulted in an upgrade of consensus earnings forecasts for FY2002. The underlying FY2002 result was ahead of indications the Company had previously given to the market and was slightly ahead of consensus forecasts. § Significant buying support from retail investors . Air NZ continues to remain popular amongst domestic retail investors who have been attracted by the Company’s strong brand, volatile share price and improved operating performance following the recapitalisation.
Page 11 Historical Financial and Operating Performance
§ Announcement of new short-haul strategy. Air NZ’s announcement in May 2002 that it intended to restructure its domestic operations to become a single class carrier on New Zealand domestic services was generally well received by investors. The move was viewed by investors as the first in a number of initiatives by the Company to improve returns and better position it against the potential entry of a new carrier in the domestic market. § Positive response by investors to the announcement of discussions with Qantas . Although the Company did not provide specific details on its negotiations with Qantas prior to the announcement on 25 November, the market appeared to react favourably to the proposal. Broker research prior to the announcement of the JAO indicated that the deal was expected to be value enhancing for Air NZ by enabling it to rationalise its trans-Tasman and international operations and significantly reduce the competition risk domestically. § Proposed changes to the calculation of company weightings in the benchmark NZSE indices. In October 2002, the New Zealand Stock Exchange (“NZSE”) issued a draft proposal under which the NZSE30 and NZSE40 Indices are to be replaced by a new NZSE50 Index. Under the changes proposed by the NZSE, companies in the index are to be weighted on an adjusted free float basis. The calculation of index weightings on an adjusted free float basis will result in a significant decrease in Air NZ’s weighting, reducing it from approximately 3.6% in the NZSE40 Index to 1.1% in the NZSE50 Index. If implemented, the change is likely to depress Air NZ’s share price as institutions re-weight their equity portfolios. 2.4 Divisional Earnings Summary
Figure 2.4 summarises the EBIT profitability of Air NZ’s major business divisions. The chart illustrates Air NZ’s reliance on profitability from its domestic operations, while its international routes are generally unprofitable, . The strong profitability of Air NZ’s domestic operations is largely due to its strong position on main trunk routes.
, the Company’s heavy reliance upon this division highlights the potential risk to the Company should its domestic profitability be substantially impaired through increased competition.
Figure 2.4 also shows the forecast in earnings
Page 12 Historical Financial and Operating Performance
Figure 2.4 Air NZ EBIT by Division
Note: National Includes Air New Zealand Domestic, Mount Cook, Air Nelson and Eagle Air; International includes cargo; EBIT before corporate costs and eliminations Source: Company Data
In summary, Air NZ’s current financial position is better than forecast at the time of the recapitalisation. However, factors outside of the Company’s control such as favourable foreign exchange and fuel price movements contributed significantly to the improved financial performance.
Page 13 The Current Competitive Environment
3 The Current Competitive Environment
The Single Aviation Market Arrangements entered into in 1996 have created a single Australasian aviation market. Air NZ and Qantas have historically competed as FSAs operating full net work models. The emergence of VBAs internationally has attracted price sensitive travellers, often to the detriment of the higher cost and less flexible FSAs. VBA entry into Australia is believed to have resulted in Ansett being “squeezed” into the uneconomic middle ground between a FSA and a VBA. During 2002, Qantas has expanded its capacity in New Zealand based on the FSA model. In response to the potential threat of Air NZ being squeezed (like Ansett) and to provide a product offering that better suits New Zealand domestic travellers, Air NZ introduced a VBA+ short -haul strategy. This strategy is designed to defend Air NZ’s strength on main trunk domestic routes and deter the potential entry of a VBA. In the absence of the strategic alliance, Qantas is expected to further aggressively expand its FSA model in domestic New Zealand.
3.1 Overview
The Single Aviation Market Arrangements between Australia and New Zealand expanded the once discrete markets of New Zealand and Australia into a single aviation market. Qantas’ relatively strong financial position (enabling it to incur operating losses as it builds critical mass) and the inter-relationship of the New Zealand and Australian markets are viewed as reasons for Qantas’ determination to penetrate the New Zealand market. Appendix C summarises Qantas’ current financial performance and financial position. Air NZ considers that Qantas could continue to incur losses over the next few years to build its presence on Air NZ’s most profitable routes.
Virgin Blue entered the Australian market in 2000 as a VBA and is now Qantas’ only major competitor on domestic routes following the demise of Ansett. A summary profile of Virgin Blue is provided in Appendix D.
3.2 Air NZ’s Strategic Response – NZ Express
In May 2002, Air NZ unveiled a new short-haul strategy as part of a three-phase plan to be implemented over the next 18 months. The short-haul strategy is designed to defend Air NZ’s core source of profitability – its New Zealand domestic operations. Air NZ’s revised short-haul strategy followed substantial qualitative and quantitative research involving surveying of customers and an analysis of international trends. Key conclusions of this analysis included:
§ the Company’s product offering had not matched changing dynamics amongst the travelling public, including a better informed population with less disposable income and greater price sensitivity amongst business travellers; § the returns required by shareholders were unlikely to be achieved from the existing business model; and § in its current form and in the face of increased competition, the Company was likely to be squeezed in the domestic market between Qantas operating as a FSA and the potential entry of a VBA.
Page 14 The Current Competitive Environment
The FSA product is the full service, full network model that provides passengers greater connectivity to more destinations and in a relatively more comfortable environment. The competing business model is the VBA service that attracts price sensitive passengers willing toaccept a reduc ed level of service, ticket flexibility and flight availability on selected point-to-point routes. Figure 3.1 illustrates Air NZ’s position under the FSA and VBA business models.
Air NZ was concerned that its position as the pre-eminent provider of the full service product in New Zealand may not have been sustainable if Qantas continued to compete aggressively. In the event that Air NZ’s market position was impaired and it found itself “squeezed” between Qantas as the full service operator and a VBA operator, Air NZ’s cost base would exceed its revenue generating ability, which is an unsustainable economic position.
Figure 3.1 Australasian Competitive Environment
AUSTRALIA NEW ZEALAND SERVICE SQUEEZE FULL SERVICE
SQUEEZE SQUEEZE
? VBA PRICE SQUEEZE
Air NZ cited two examples that highlight the potential impact of being forced into the uneconomic space between the FSA and VBA models. One of the examples is Ansett. Following the entry of VBAs into the Australian aviation market, Ansett was susceptible to pricing pressure from Qantas lowering fares to compete with the new VBAs, but having too high a cost base to compete against the new entrants, Virgin Blue and Impulse. The other example cited by Air NZ occurred in Canada, where Air Canada survived as the full service provider and Canadian Airlines became financially distressed when the VBA, WestJet, entered the market.
To protect itself against being squeezed between Qantas and a potential VBA entrant, Air NZ introduced its NZ Express strategy in November 2002.
3.2.1 NZ Express Strategy NZ Express has replaced Air NZ’s full service offer on all domestic routes, in addition to withdrawing Air NZ’s existing VBA, Freedom Air.
NZ Express is a value-based carrier with a single class, but preserves a number of the key elements of the existing full service model in what Air NZ calls a VBA+ model. Notable changes from the previous full service product offering include:
Page 15 The Current Competitive Environment
§ planes reconfigured to a single class (i.e. no business class and reduced spacing between seats); § no food or alcohol – tea, coffee and water are provided; § audio entertainment only; and § reduced baggage allowance, with a charge for excess baggage. Air NZ has lowered the average cost of domestic airfares by approximately 20% and the average cost on the main trunk routes by approximately 28%. In positioning its domestic product offering, Air NZ has elected to retain certain aspects of the full service model that it believes will result in improved yields or are necessary to complement its international operation. These include:
§ offering connectivity between flights; § retention of the airpoints programme on certain ticket classes; § exclusive access airport lounges; and
§ continued use of agency distribution channels. Figure 3.2 below shows Air NZ’s pre NZ Express passenger mix and illustrates the significant increase in price sensitive leisure passengers that it expects to stimulate under the NZ Express strategy. The increase in the size of the pie chart under the NZ Express scenario represents the stimulation in passenger numbers that is expected to result from lower fares.
Figure 3.2 Historical Yields and Load Factorst
Source: Air NZ Short-Haul Strategic Plan
3.2.2 Earnings Impact of NZ Express VBAs are now relatively common in countries with deregulated aviation markets and some, such as Southwest Airlines in North America, have been highly successful.
Page 16 The Current Competitive Environment
However, overseas VBAs have failed to capture more than 20% of total market share, with full service operators still accounting for the majority of current capacity provided. NZ Express will seek to maintain a greater market share than this due to Air NZ’s dominant market share of approximately 75%. In addition, NZ Express has retained a number of full service features, in particular connectivity between flights, in part to combat the risk that domestic demand for point-to-point VBA services proves to be significantly less than for the previous Air NZ full service model. These features distinguish the NZ Express VBA+ model from other pure VBA airlines.
Air NZ has forecast static revenues under the proposed VBA+ strategy due to substantial discounting from current fare levels. In spite of this, the Company is projecting an increase in earnings through a reduction in both direct and indirect costs. Key areas of cost saving include:
§ § § reduced turnaround cost per landing; and
§ reduction in crew to the legal minimum of three (from four). The impact on an ASK basis projected to be as follows:
Table 3.1 Yield Analysis of Various Airline Product Offerings (All amounts in cents)
Full Service VBA+ VBA Revenue per ASK Cost per ASK Margin per ASK
Source: Air NZ Short-Haul Strategic Development Paper – June 2002
3.2.3 Risks of NZ Express Strategy While the positioning of NZ Express as a VBA+ airline mitigates some of the risks associated with Air NZ’s decision to eliminate its full service offering on domestic routes, in our view, the strategy has a number of uncertainties and risks:
§ although Air NZ has undertaken a comprehensive review of existing and potential airline passengers in formulating its NZ Express strategy, customer reaction is uncertain; § Qantas has stated that it will match NZ Express’ airfares, thereby encouraging customers to migrate to Qantas’ full service product offering; § travel agents may divert bookings from Air NZ due to the reduction in commissions paid; and § a no-frills VBA such as Virgin Blue may enter the domestic market squeezing Air NZ between its own cheaper product offering and Qantas’ full service product.
Page 17 The Current Competitive Environment
Air NZ’s new product offering is largely untested in other countries. Despite this, Air NZ’s current dominant market position will assist it in retaining customers. The company believes the new product will be sufficiently attractive and competitively priced to retain passengers and market share. It is too early to determine the lasting impact of the new short-haul strategy on Air NZ. Information about NZ Express in the short period it has been operating is outlined in section 4.2.
3.2.4 Freedom Air Strategy Freedom Air is Air NZ’s VBA. It formerly operated on selected trans-Tasman and domestic routes.
This difficulty was in part due to an aggressive attempt by Qantas to gain market share domestically, which positioned Qantas’ full service product at a price only marginally above that of Freedom’s.
To compete against a VBA entrant on the trans-Tasman, Freedom Air has increased the number of flights to Brisbane and expanded services to include Coolangatta. However, Freedom Air discontinued services on domestic routes from October 2002, being replaced by NZ Express.
3.3 Competitive Behaviour 3.3.1 Qantas Since the Five Year Plan was developed, Qantas has gradually increased the competitive tension across both domestic main trunk routes and trans-Tasman routes by introducing additional aircraft capacity and marketing attractive airfares. Shortly after the launch of NZ Express in November 2002, Qantas increased its domestic capacity from four to five aircraft and plans to add one additional aircraft in January 2003. By increasing the number of aircraft operating domestically within New Zealand, Qantas should be able to significantly improve its schedule offering on the main trunk routes. Air NZ believes that this should increase Qantas’ ability to target high yielding customers (i.e. business travellers) who place significant value on flight frequency.
Qantas has also sought to improve its competitive position in the New Zealand domestic market through more aggressive pricing of economy class fares. Following the announcement of the NZ Express strategy, Qantas reduced the pricing of its lowest economy class fares on some of the main trunk routes to be comparable to those of NZ Express. This has the effect of significantly increasing the attractiveness of Qantas’ domestic service by offering a full service product at VBA+ price levels.
While Qantas’ recent move to increase capacity and offer more competitive pricing is likely to significantly increase the attractiveness of its product to consumers, Air NZ views the current competitive environment as being unsustainable.
Page 18 The Current Competitive Environment
As a result of the unsustainable nature of Qantas’ current operations, in the event that Air NZ and Qantas do not proceed with the proposed JAO, Air NZ management expect one of two outcomes:
§ Qantas attempts to improve its long-term returns on New Zealand domestic and trans-Tasman routes by significantly increasing the level of competition through increased capacity in an effort to gain market share and weaken Air NZ’s position; or § reduced competition as Qantas exits routes where it generates inadequate returns such as domestic New Zealand. Air NZ believes that Qantas will respond by significantly increasing its capacity, rather than retrench its operations. We note that this view is supported by NECG, which has had access to confidential planning information provided to NECG by Qantas. Air NZ’s reasons for this include:
§ Qantas values the feeder traffic from its trans-Tasman and New Zealand domestic services for its Australian operations; § Qantas is currently in a relatively strong financial position to sustain the potential losses; § Air NZ believes that Qantas wishes to significantly expand to protect itself from rivals such as Singapore Airlines; and § New Zealand represents an important geographic market for Qantas. 3.3.2 Entry by a VBA In addition to the possibility that Qantas increases capacity on New Zealand domestic and trans-Tasman routes, there is also a risk that a VBA will begin operations in one or both of these markets. Although NZ Express’ low cost strategy was implemented to mitigate the risk of a low cost entrant, Air NZ management believes there is still a risk that Virgin Blue will enter the trans-Tasman and New Zealand domestic market. We understand that Virgin Blue’s growth in Australia is abating, following moves by both Qantas and Virgin Blue to fill the supply void created by the exit of Ansett.
3.3.3 Global Situation The financial position and tough competitive environment Air NZ finds itself faced with are not unique; most airlines around the world have found it difficult to earn an economic return. Figure 3.3 shows that for the period 1990 – 2001, only one of ten North American airlines generated a return in excess of its cost of capital. Typically, such poor financial results are signs of an industry in need of major restructuring and/or consolidation.
Alliances such as the Star Alliance and one world have been established over recent years, but they are essentially marketing alliances and do not provide the benefits of consolidation.
Figure 3.4 shows that falling yields have been a key issue facing airlines. The returns of FSAs suggest many have found it difficult to reduce costs in line with falling yields.
Page 19 The Current Competitive Environment
Figure 3.3 Return on Capital of North American Airlines
2%
2001)
- 1%
0%
-1%
-2%
-3%
-4%
-5%
Return on capital less cost of capital (average 1990
-6% Southwest America Delta Alaska UAL AMR Northwest USAir Air Canada Continental West
Source: Air NZ Commerce Commission Briefing, November 2002
Figure 3.4 Historical Global Airline Yields and Load Factors
Yield Load Factor
Source: Air NZ Commerce Commission Briefing, November 2002
Page 20 Stand-Alone Forecast Financial and Operating Performance
4 Stand-Alone Forecast Financial and Operating Performance 4.1 FY2003 Budget
In setting the targets for the FY2003 consolidated budget, the Five Year Plan EBITDRA forecast for Air NZ was allocated across the various divisions. These targets were discussed by the divisional finance teams and were signed off by the heads of each department.
Following the initial release of its FY2003 budget in April 2002, Air NZ subsequently released a revised budget in June. This FY2003 Revised Budget Report was prepared to incorporate the impact of the strengthening of the NZD against other currencies and the introduction of Air NZ’s revised short-haul strategy.
The key variances contributing to this increase are shown in Figure 4.1.
Figure 4.1 FY2002 Actual vs FY2003 Forecast EBIT
Source: Air NZ FY2003 Final Budget Report
Key points to note from Figure 4.1 include:
§
§ §
Page 21 Stand-Alone Forecast Financial and Operating Performance
§ total fuel expenses are expected to reduce due to lower fuel prices; § cost-reduction measures are budgeted to achieve significant direct cost savings; § a change in accounting treatment causes net frequent flyer revenue to fall. In FY2003, revenue will not be recognised until frequent flyer benefits are redeemed; and § Air NZ forecasts unfavourable movements in exchange rates. Due to Air NZ’s high financial and operating leverage and significant uncertainty in the international aviation industry, Air NZ recognises that revenue and earnings forecasts contained within the budget are subject to a high degree of uncertainty.
Similar sensitivities exist with respect to other key assumptions such as fuel costs, for which a US$ decrease in the per barrel price of fuel reduces costs by approximately NZ$ million. The degree of sensitivity to these factors highlights the difficulty in budgeting and forecasting Air NZ’s profitability.
4.2 FY2003 YTD Performance
Page 22 Stand-Alone Forecast Financial and Operating Performance
Figure 4.2 Comparison of Air NZ Budget & Actual EBIT – FY2003 YTD(1)
(1) Data until end of October 2002 Source: Air NZ Monthly Management Accounts
Table 4.1 breaks down the key budget variances that are the drivers behind the EBITDRA and EBIT performances to the end of October 2002.
Table 4.1 Variance of Key Performance Indicators to Budget – FY2003 YTD
July August September October Revenue ($m) Yield (c/RPK) Rev/ASK (c) Cost/ASK (c)
The following points are relevant to analysing the YTD performance:
§ § § §
Page 23 Stand-Alone Forecast Financial and Operating Performance
4.3 Stand-Alone Projections FY2004-2006
Air NZ management has developed three competitive scenarios that reflect the possible future competitive environment for Air NZ. We asked Air NZ to also model a scenario based on the status quo competitive situation.
As part of its analysis of the proposed JAO with Qantas, Air NZ and its advisor Cameron & Company have prepared financial projections under the stand-alone and JAO scenarios. These forecasts build upon the internally prepared FY2003 revised budget forecasts from September 2002 and model the different competitive environments which Air NZ may face. Table 4.2 below sets out the four stand-alone competitive scenarios around which financial projections have been developed by Air NZ.
Table 4.2 Assumed Competition Under Stand-Alone Scenarios
Qantas VBA Status Quo · Increases capacity from 5 to · No VBA entry on trans- 6 aircraft domestically Tasman or New Zealand · Trans-Tasman ASKs CAGR domestic routes of 10.6% (’03 – ’06) · No increase in capacity on Auckland - Los Angeles Upside Case · Increases capacity from 5 to · No VBA entry on New 8 aircraft domestically Zealand domestic routes · Trans-Tasman ASKs CAGR · 3 aircraft on trans -Tasman of 8.6% pa (’03-’06) in 2004 · Increased competition on other selected routes Base Case · Increases capacity from 5 to · No VBA entry on New 8 aircraft domestically Zealand domestic routes · Trans-Tasman ASKs CAGR · 3 aircraft on trans -Tasman of 17.7% pa (’03-’06) in 2004 · Increased competition on other selected routes Downside Case · Increases capacity from 5 to · 6 aircraft on New Zealand 8 aircraft domestically domestic routes in 2005 · Trans-Tasman ASKs CAGR · 3 aircraft on trans -Tasman of 17.7% pa (’03-’06) in 2004 · Increased competition on other selected routes
Source: Company Data
Of the competitive scenarios outlined above, Air NZ has relied on the Upside Case, Base Case and Downside Case scenarios for its own analysis of Air NZ’s stand-alone
Page 24 Stand-Alone Forecast Financial and Operating Performance profitability. All three scenarios imply a substantial increase in competition compared with the Status Quo reflecting the Company’s belief that in the event that the JAO does not proceed it is likely to face significant competition on some of the key trans-Tasman and New Zealand domestic routes. This competition is expected to come in the form of the entry of a VBA such as Virgin Blue and a more aggressive attitude by Qantas on routes where it competes with Air NZ. As detailed in section 3.3, Air NZ considers that Qantas’ current position in the New Zealand domestic market is unsustainable. In the event that the JAO does not proceed, Air NZ expects Qantas to significantly increase capacity on New Zealand domestic and trans-Tasman routes.
Similarly, the assumption that Qantas increases capacity on the trans-Tasman over FY2003-2006 also seems likely as Qantas is currently profitable on this sector. Qantas is projected to achieve yields that are higher than those of Air NZ because of its ability to charge higher fares.
We have assessed the Upside Case, Base Case and Downside Case scenarios developed by Air NZ following discussions with the Company’s network and revenue division, reviewing materials prepared by NECG and our own understanding of the competitive environment. In determining a Base Case scenario, in our view, it is reasonable to assume that Qantas would increase its capacity and hence market share on the routes where it competes against Air NZ in the event that the JAO does not proceed. Moreover, in considering a Downside Case, it is reasonable to assume that Virgin Blue or another VBA will enter the trans-Tasman and New Zeala nd domestic markets.
With regard to the Upside Case developed by Air NZ, whilst it may be a realistic scenario, we believe that it may be overly conservative as an Upside Case. Specifically, the assumption that Qantas increases domestic capacity to eight aircraft and increases capacity on other selected routes, such as beginning a twice-daily service from Auckland to Los Angeles, appears too conservative for an Upside Case.
An alternative Upside Case for Air NZ is a scenario whereby Qantas does not further increase its capacity on New Zealand domestic and Auckland - Los Angeles routes. Similarly, while Virgin Blue has publicly suggested a number of times that it may commence services on selected trans-Tasman and New Zealand domestic routes, it remains uncertain whether it will do so. In the event that Qantas and Air NZ continue to compete on the trans-Tasman, the intense level of competition and comparatively low operating yields may deter the entry of a VBA such as Virgin Blue.
We therefore asked Air NZ to develop financial projections for the Status Quo scenario. While we believe there is less than a 25% probability of this case eventuating, we believe that it should be considered in evaluating Air NZ’s stand-alone profitability and future viability.
4.3.1 Earnings Forecast Methodology Air NZ’s revenue and earnings forecasts for FY2004-2006 have been generated using a “bottom up” approach on a city-pairs basis. Individual route revenues have been generated using forecast weekly aircraft schedules in each of the forecast years. The schedules that have been developed model the expected flight services of Air NZ, Qantas, a potential VBA entrant and other airlines currently operating on the selected
Page 25 Stand-Alone Forecast Financial and Operating Performance routes for the four cases summarised in Table 4.2. Market share and revenue allocation among the airlines have then been calculated using Quality of Service Index (“QSI”) methodology. This methodology is commonly used within the airline industry and is used to estimate the passenger split across carriers based on frequency of service and aircraft type.
Using projected passenger numbers and average route fares, individual route revenues are calculated and aggregated into 13 summary route groups such as trans-Tasman, New Zealand domestic and the Atlantic. The route fares used to calculate revenues are based on current average route fares with no adjustment for inflation in future years (i.e. all fares are in real terms). Going-in average fares are only altered in a small number of cases where load factors fall outside a 65-85% band, in which case prices are either reduced to improve load factors or increased to reduce load factors. This price adjustment has been made to ensure that revenue projections are based on load factors typically experienced by Air NZ.
Air NZ’s projections of direct and indirect operating costs are also based on the company’s forecasts for FY2003. However, in projecting future year expenses, a simplified approach has been taken whereby it is assumed that all operating and fixed costs (excluding aircraft charges) grow at the same rate as Air NZ’s ASKs. Based on views expressed by Air NZ management that fixed costs account for approximately 30% of total expenses and the economies of scale that characterise the airline industry, we believe that the assumption that costs will increase proportionately to ASKs probably overstates costs and is therefore a conservative approach. While it may be preferable to employ a more rigorous approach to forecast expenses, the simplified approach taken by Air NZ is unlikely to materially affect the comparison between the JAO and stand-alone scenarios because the same approach has been adopted for the purpose of generating earnings projections under both scenarios.
Forecasts for Air NZ’s engineering business, ANZES, have been prepared internally within the Company and have been included in the financial forecasts presented below. For the purposes of the modelling under the stand-alone and JAO scenarios, Air NZ has assumed a steady state for ANZES, where EBITDA is projected to increase at a % CAGR between FY2003 and FY2006.
4.3.2 Stand-Alone Earnings Projections
Stand-alone PBT is projected to increase in all scenarios between FY2004 and FY2006, except where Qantas competes aggressively and a VBA enters the trans- Tasman and domestic New Zealand markets. However, pre-tax ROCE remains inadequate at below %.
Figure 4.3 and Figure 4.4 present Air NZ’s stand-alone EBITDRA and PBT projections under the various competitive scenarios and compares these with the Five Year Plan produced in November 2001. The stand-alone earnings forecasts and financial projections incorporate the following key assumptions:
§
§ §
Page 26 Stand-Alone Forecast Financial and Operating Performance
Figure 4.3 Air NZ Stand-Alone EBITDRA Projections
Source: September 2002 FY03 Forecasts, Company Data, Air New Zealand Revised Five Year Business Plan
Figure 4.4 Air NZ Stand-Alone PBT Projections
Note: Five Year Plan forecasts assumes 49% sale of ANZES in FY2003 Source: September 2002 FY03 Forecasts, Company Data, Air New Zealand Revised Five Year Business Plan
Page 27 Stand-Alone Forecast Financial and Operating Performance
The key points to note about these projections include:
§ the Status Quo scenario displays moderate earnings growth in each of the forecast years. This increase is driven primarily by an improvement in load factors on the Japan and Auckland - Los Angeles routes and a decline in operating costs per ASK on the trans-Tasman following the introduction of the A320 aircraft; § earnings for the three stand-alone scenarios determined by Air NZ (Downside Case, Base Case and Upside Case) are lower than the Status Quo scenario due to Qantas’ assumed increase in capacity on the New Zealand domestic, trans-Tasman and Auckland - Los Angeles sectors and the entry of a VBA on the trans-Tasman; § increased Qantas capacity on New Zealand domestic routes reduces projected yields per RPK for each of the three scenarios determined by Air NZ, and reduces Air NZ’s domestic market share from from FY2003 to FY2004; § similarly, increased competition on the trans-Tasman results in a reduction in yields, with Air NZ load factors decreasing from between FY2003 and FY2004; § VBA entry in the New Zealand domestic market in FY2005 increases the differential in profits between the Downside Case and both the Upside Case and Base Case scenarios that assume no VBA entry; and § under all scenarios, Air NZ’s forecast stand-alone profitability in FY2006 is significantly lower than forecast in the Five Year Plan. It is important to highlight that there is an increasing gap (across the scenarios) between the Five Year Plan and the current projections. This is explained by a number of factors. First, the stand-alone projections incorporate assumptions more reflective of the current and expected behaviour of competitors, whereas the Five Year Plan was based on a benign competitive environment. Second, stand-alone earnings forecasts have also been reduced due to the removal of a number of unspecified cost savings contained in the Five Year Plan. Third, and most importantly, the Five Year Plan assumed significant earnings enhancement from an improved long-haul business. Air NZ is currently considering various strategic options for the long-haul business, but no strategies have been fully developed nor finalised to improve this business (see section Error! Reference source not found. for further details on Air NZ’s long-haul position).
4.3.3 Return on Capital Employed Air NZ’s modelling assumes that there is very little variation in its total capacity and hence the number of aircraft employed under the stand-alone competitive scenarios. Hence, the lower earnings that are projected under the Base Case and Downside Case scenarios significantly impact Air NZ’s return on capital employed (“ROCE”). This is demonstrated in Figure 4.5 which shows Air NZ’s ROCE is negatively impacted as a result of increased competition under the Base Case and Downside Case scenarios.
Page 28 Stand-Alone Forecast Financial and Operating Performance
Figure 4.5 Air NZ Return on Capital Employed
1) Return on capital employed = (EBIT plus operating leases less implied depreciation on capitalised operating leases) / (Capital employed being capitalised operating leases plus net debt plus shareholders’ equity, which in aggregate are used to fund net operating assets). Source: Company Data
Air NZ’s ROCE under the stand-alone competitive scenarios is significantly lower than the return required in order to achieve an economic return on capital employed, based upon the Company’s internal pre-tax WACC estimate of %. Although the Upside Case and Base Case scenarios show small improvement from the FY2003 Budget return of %, the earnings improvement under the stand-alone scenarios is insufficient to achieve the Company’s required rate of return. This result is not unique to Air NZ, but rather has historically been a general feature of the airline industry, which has failed to achieve an economic return on capital employed in any one of the past ten years (see section 3).
While Air NZ’s projected failure to meet its ROCE on a stand-alone basis is not unusual within the aviation industry, if this situation cannot be improved it could have significant adverse future implications for the Company. In addition to failing to provide existing equity and debt holders with an acceptable return on their investment, Air NZ’s poor projected returns could impact on its future operations. As detailed in section 4.4 below, Air NZ has significant capital expenditure requirements over the next decade if it is to remain competitive against other carriers. The Company’s ability to finance this expenditure from the equity and debt capital markets is likely to be adversely influenced by its inability to generate an adequate return on capital employed.
Page 29 Stand-Alone Forecast Financial and Operating Performance
4.4 Capital Structure Analysis
Air NZ has significant planned capital expenditure between FY2003 and FY2006. Book gearing under the stand-alone scenarios does not fall to the long-term target range of 50-60%, Further, sensitivity analysis shows that a 20% increase in projected fuel costs would result in Base Case PBT becoming negative for a period of two years.
4.4.1 Projected Capital Expenditure Requirements Analysis conducted by Air NZ suggests that its product offering across all classes of its lo ng-haul fleet is relatively inferior to that of major competitors such as Singapore Airlines, United Airlines and Qantas. Major differentiating factors include Air NZ’s lack of sleeper beds in first class and business class and the absence of in flight entertainment (“IFE”) systems in economy class. The uncompetitive offering restricts Air NZ’s ability to charge premium yields.
In addition to the upgrade of its product offering, over the next decade Air NZ will also need to significantly upgrade of its lo ng and short-haul fleet. Air NZ has already begun the first step of this upgrade with the July 2002 announcement of a fleet overhaul of its short-haul narrow-body Boeing 737-300 and 767-200 aircraft. Delivery of the replacement Airbus A320 aircraft is to take place between FY2003 and FY2005, with Air NZ planning to purchase five aircraft and lease a further ten aircraft.
Most of Air NZ’s wide-body long-haul aircraft employ 1980s technology. Depending on Air NZ’s strategic direction in relation to its long-haul business (discussed in more detail in section Error! Reference source not found.), from FY2005 Air NZ will most likely need to begin replacing its wide-body fleet. This replacement programme will not provide Air NZ with any unique competitive advantage in the long-term (most of Air NZ’s competitors have significant fleet replacement programmes). Instead, it will be required if Air NZ is to offer a competitive product and achieve an efficient cost base.
Table 4.3 below sets out Air NZ’s projected gross capital expenditure between FY2003 and FY2006. Proceeds from the sale of existing aircraft are expected to total only approximately $ million between FY2003 and FY2006. The proceeds from the sale of assets have not been included in Air NZ’s financial analysis.
Table 4.3 Projected Air NZ Capital Expenditure (All amounts in NZ$mm)
Source: Company Forecasts
Page 30 Stand-Alone Forecast Financial and Operating Performance
The aircraft expenditure largely relates to the purchase of the new A320s. The other material aircraft expenditure relates to upgrading the IFE systems in existing aircraft. This is expected to commence from FY2004.
4.4.2 Projected Gearing Notwithstanding the profitability projected under the Upside Case and Base Case scenarios, Air NZ’s book gearing ratio improves only marginally by FY2006, as demonstrated in Figure 4.6. The required capital expenditure reduces the Company’s projected free cash flows and its ability to improve its debt position.
Figure 4.6 Air NZ Book Gearing – Actual and Budget(1)
(1) Includes aircraft operating leases capitalised by a factor of seven Source: Company Data, Air NZ Annual Report
Air NZ’s book gearing ratio is expected to remain above its target range of 50-60% in each of the projected years under all but the Status Quo scenario. This is likely to place constraints on the Company’s future financial flexibility and ability to debt fund the purchase of additional aircraft. Table 4.4 below presents Air NZ’s gearing and credit statistics under the Base Case stand-alone scenario.
Table 4.4 Air NZ Gearing and Credit Statistics – Stand-Alone Base Case
Source: Air NZ Annual Report, Company Data
Page 31 Stand-Alone Forecast Financial and Operating Performance
4.4.3 Sensitivity Analysis In addition to the constraints Air NZ is likely to face in the future as a result of its relatively high level of projected gearing under the stand-alone scenarios, it will also remain significantly exposed to a number of exogenous variables that could further weaken its financial position. While the Company has benefited recently from favourable movements in exchange rates and fuel prices, these variables remain outside of its control and potentially represent a significant earnings risk to the business. This is illustrated in Figure 4.7 that charts the Base Case stand-alone forecasts based on the current fuel budget compared with a hypothetical 20% increase in fuel expenses. This 20% movement approximately equates to the standard deviation of the average annual change in Singapore jet fuel price over the past decade. The result shows that external factors could turn the stand-alone Base Case projected profits into losses.
Figure 4.7 Air NZ PBT Sensitivity to Fuel Prices
Source: Company Data
Figure 4.8 below illustrates the impact on Air NZ’s gearing if Air NZ’s fuel costs in each of the financial years FY2004 to FY2006 are 20% higher than projected.
Page 32 Stand-Alone Forecast Financial and Operating Performance
Figure 4.8 Air NZ Stand-Alone Book Gearing Sensitivity to Fuel Prices
Source: Company Data
As demonstrated above, Air NZ’s projected earnings and gearing impr ovement under the stand-alone scenarios are highly sensitive to a number of key operating variables. The Company’s projected high level of gearing suggests that it may need to raise additional equity to strengthen its financial position if the SAA does not proceed. Further, the Company’s gearing position could deteriorate quickly if feasible adverse movements in key drivers, such as fuel prices, eventuate.
Page 33 Outline of Proposal
5 Outline of Proposal
5.1 Overview of Strategic Alliance Agreement (“SAA”)
Air NZ and Qantas have agreed to enter into a strategic alliance to establish a joint airline operation (“JAO”). The JAO would encompass all domestic and international flying by both airlines that touches New Zealand. The purpose of the JAO is to maximise profits for each airline. Air NZ will manage the commercial aspects of the JAO. 60% of the JAO profits will be allocated to the parties based on relative route group ASKs flown, with the remaining 40% shared equally between the two parties. In addition to the establishment of the JAO, Qantas will be issued new equity amounting to 22.5% of Air NZ’s enlarged share capital.
The key transaction documents relating to the formation of the SAA and the equity subscription are as follows:
§ Strategic Alliance Agreement: defines the strategic alliance between Air NZ and Qantas relating to the establishment of the JAO, the conduct of non-JAO activities and the governance principles for the JAO; § Reciprocal Board Representation Deed: sets out the terms under which Qantas nominates up to two directors to Air NZ’s board and Air NZ nominates one director to Qantas’ board; § Subscription Agreement: contains the terms on which Qantas is to subscribe for a 22.5% shareholding interest in Air NZ by subscribing for convertible notes and shares; § Amended Air NZ Constitution: amends Air NZ’s constitution to make certain provisions relating to Qantas’ shareholding; § Co-ordination Agreement: co-ordinates implementation of the transactions between Air NZ and Qantas and regulates the conduct of both parties during the implementation process; § Transition Deed: defines matters related to implementing the Alliance, including which global airline alliance each airline should be a member of; § Top-Up Deed: provides a mechanism under which Qantas can avoid dilution of its shareholding below that consented to by the Kiwi Shareholder should Air NZ make a new issue of shares; and §
In this section, we summarise the key features of the transaction documents and outline the operating and management structure of the JAO, governance principles proposed and the terms of the equity investment by Qantas. In sections 6 and 7, we provide our assessment of the proposal and the implications for the Crown as Air NZ’s major shareholder.
Page 34 Outline of Proposal
5.2 Overview of the JAO
The purpose of the JAO is to maximise the profits to be derived by the parties on passenger and air cargo services on the JAO networks by maximising revenue and minimising costs without:
§ compromising either party’s autonomy or ownership structure consistent with the aviation policies of the governments of New Zealand and Australia; § adversely affecting the parts of Qantas’ network not included in the JAO; or § restricting Air NZ’s or Qantas’ ability to grow in markets where either party reasonably foresees profitable returns. The proposed JAO is intended to cover all domestic and international Air NZ code flying and all Qantas flying that touches New Zealand. Freedom Air is included in the alliance, but its management and governance is outside of the JAO.
Air NZ will manage all commercial aspects (but not Qantas flight operations) of the JAO networks including pricing, network capacity and scheduling, expansion of the JAO networks and competitive behaviour. This provides Air NZ with day-to-day commercial management of the aircraft contributed by Qantas to the JAO. Generally, the airline with the highest margin will supply operating capacity.
Qantas participates in the management of the JAO through its participation in the Strategic Alliance Advisory Group (“SAAG”) and the involvement of four Qantas secondees to the JAO. Figure 5.1 below sets out the major elements of the proposed JAO.
Figure 5.1 Summary of the Proposed JAO Between Air NZ and Qantas
22.5% Equity Investment QANTAS AIR NZ
STRATEGIC ALLIANCE MANAGEMENT MANAGEMENT ADVISORY GROUP
CONTROL OF SCHEDULE, PRICING, OPERATIONS
QANTAS AIR NZ • TRANS - TASMAN ROUTES • NZ DOMESTIC • NZ DOMESTIC • INTERNATIONAL • LA - AUCKLAND • FREEDOM (Economic only)
QANTAS SHARE AIR NZ SHARE JAO OUTCOME OF BENEFIT (MANAGEMENT FEE AND OF BENEFIT ADJUSTMENT PAYMENT)
Page 35 Outline of Proposal
5.2.1 Strategic Alliance Advisory Group (“SAAG”) The SAAG would comprise six representatives, three from Air NZ and three from Qantas. The SAAG's role would not be to vet or approve decisions taken by Air NZ as manager of the JAO. Rather, the SAAG's function would be to support and advise Air NZ in its management of material elements of the JAO.
As part of its management function, Air NZ must consult the SAAG on all material decisions affecting the JAO. Specific matters that Air NZ must consult the SAAG on and seek endorsement and/or consideration of include the following:
§ the business plan and budget for the JAO networks; §
§ § §
§ §
Air NZ's management discretion is limited to the extent that Qantas' written consent is required in relation to the following:
§ the removal of the Qantas brand from any market in which the JAO operates; § schedule changes for Qantas aircraft; and
§ changes in Qantas product specifications. 5.2.2 Management of the JAO Air NZ would be responsible for managing the JAO, and subject to the restrictions contained in the SAA, would manage the JAO in a manner substantially similar to the manner in which it has managed the Air NZ network to date. In managing the JAO networks, Air NZ shall have the objective of maximising the benefits from (in order of priority):
§ the JAO network; § the Qantas non-JAO network; and § the network of the global airline alliance of which both parties are a member.
Page 36 Outline of Proposal
In accordance with the business plans and budgets endorsed by the SAAG, Air NZ will manage all commercial (as opposed to flight operations2) aspects of the JAO. Specific aspects of the JAO that Air NZ would manage include the following:
§
§ § § § §
§ § To assist the JAO management process, Qantas will second to Air NZ (at Qantas’ cost) four Qantas employees to assist in network management, revenue management, pricing and sales/marketing. The Qantas secondees are to be involved in the preparation of annual business plans and budgets for the JAO networks.
5.2.3 Management Fee and Adjustment Payment As commercial manager of the JAO, Air NZ is appointed to make Air NZ and Qantas equitably profitable. Air NZ may be entitled to a “management fee” from, or be required to make an “adjustment payment” to Qantas, depending on the outcome of its management of the JAO network. The calculation of the management fee and adjustment payment is to be determined in accordance with a manual setting out the detail of how the calculation will be made. Both parties will have their respective auditors review the calculation.
Essentially the parameters of the Management Fee and Adjustment Payment model:
§ recognise Air NZ’s and Qantas’ existing “going-in” profitability; and § allocate incremental gains on an equitable basis.
2 Flight operation means the aircraft flying, providing in-flight services, etc
Page 37 Outline of Proposal
Based upon estimates of Air NZ’s and Qantas’ respective capacity contribution into the JAO, this would result in Air NZ receiving approximately % of the JAOB and Qantas % under the Base Case scenario projections for FY2004.
A Base Position Protector (“BPP”) factor is incorporated in the Management Fee and Adjustment Payment model to ensure that, assuming there is no incremental increase in profitability resulting from the JAO, Air NZ’s and Qantas’ allocation of JAO profits reflects the profits the parties would have separately earned as stand-alone businesses. The adjustment is necessary because, on the basis of capacity contributed to the JAO, Air NZ currently has slightly higher EBITDRA per ASK than Qantas. Without the BPP, the allocation of profits under the model provides Qantas with a disproportionate share of he JAO profits relative to its going-in position.
In order to calculate the “going-in” profitability, a framework was agreed by Air NZ and Qantas to determine each company’s respective profitability following adjustments for a capital and depreciation charge associated with operating aircraft contributed to the JAO. As a result of the significant turmoil within the aviation industry following the September 11 terrorist attacks and the seasonality of earnings, both Qantas and Air NZ have had difficulty in estimating their “normalised” going-in profitability. For this
Page 38 Outline of Proposal reason, rather than calculating the BPP at any particular going-in date, the BPP has been determined following negotiations between Air NZ and Qantas.
Figure 5.2 below shows the annual fee payable to Air NZ under a range of JAO combined profitability scenarios compared to the annual combined going-in earnings agreed by Air NZ and Qantas of $ million. The chart shows that the payment is greatest when JAO profitability is unchanged from the going-in position and declines when there is positive or negative variance from the going-in position.
Figure 5.2 Analysis of Base Position Protector
5.2.4 Other Operational Matters Other key elements of the SAA include the following: §
§
§
§
§
§
Page 39 Outline of Proposal
§
§
Page 40 Outline of Proposal
5.3 Equity Investment
Qantas will acquire a 22.5% shareholding in Air NZ through three tranches of new equity securities issued by Air NZ. Based on Air NZ’s current share price and the terms of the equity subscription, Qantas will invest approximately $543 million in Air NZ. Qantas also receives anti-dilution protection rights to enable it to retain its proportional holding in the event Air NZ undertakes new issues in the future.
5.3.1 Subscription Agreement In addition to establishing the JAO, the SAA involves Qantas subscribing for new shares in Air NZ. Qantas’ equity investment will occur in either two or three tranches with Qantas ultimately owning 22.5% of Air NZ. The key terms of each of the three tranches are as follows:
§ Convertible Notes. Upon receiving the consent of the Kiwi Shareholder, which the parties expect to occur before the end of the 2002 calendar year, Qantas will subscribe for 220.8 million new Air NZ convertible notes, representing a 4.99% equity interest in Air NZ on a fully diluted basis. The subscription price for the convertible notes is $0.445 per note; § Tranche 1 Placement Shares. Upon the key conditions of the transaction being satisfied (see below), the convertible notes will convert to ordinary shares and Qantas will subscribe for another 521.0 million new Air NZ shares to take its aggregate shareholding to 15%. The subscription price for the ordinary shares is the same as that for the convertible notes, being $0.445 per share; and § Tranche 2 Placement Shares. Upon the key conditions being satisfied, Qantas must elect to either subscribe for an additional 7.5% (478.6 million shares) at $0.445; or subscribe three years after the conditions are satisfied. The subscription price in the latter case will be set at a 15% discount to the volume weighted average price (“VWAP”) of Air NZ ordinary shares for the 20 trading days prior to the date of issue. The key conditions to be satisfied include:
§ authorisation by competition regulators in New Zealand and Australia; § Air NZ shareholder approval to issue new shares to Qantas and amend Air NZ’s constitution; and § Kiwi Shareholder approval to issue the new shares and amend Air NZ’s constitution. Another key feature of the Subscription Agreement is that the subscription price for any Air NZ rights issue made prior to the issue of the Tranche 1 shares must be $0.445 and the maximum amount raised cannot exceed $200 million.
Table 5.1 sets out the tranches to be issued to Qantas and the Crown’s resulting shareholding at each stage. As indicated in the table, the Crown retains majority ownership of Air NZ following the final placement of shares to Qantas. If the full 22.5% is subscribed for at authorisation, Qantas would invest approximately $543 million to acquire a 22.5% shareholding.
Page 41 Outline of Proposal
Table 5.1 Issue of Air NZ Shares to Qantas
Tranche Number of Qantas Crown Other Total Cumulative Cumulative Shares Issued Shareholding Shareholding Shareholding Qantas Air NZ Shares to Qantas Holding on Issue(1) Convertible Notes 220.8 4.99% 77.9% 17.1% 100.0% 220.8 4,424.1 Tranche 1 521.0 15.00% 69.7% 15.3% 100.0% 741.8 4,945.1 Tranche 2 478.6 22.50% 63.5% 14.0% 100.0% 1,220.3 5,423.7 Total 1,220.3 (1) Shareholdings Include Convertible Preference Shares Issued to Crown Note: The shares issued to Qantas are calculated based on the current outstanding number of shares
If, after the announcement of the SAA but prior to Air NZ shareholder approval being obtained, either Qantas’ or Air NZ’s board resolves to take any action or make public statements that are inconsistent with the proposal, such as not supporting the proposal, the defaulting party must pay to the other $10 million in reimbursement of expenses and the Subscription Agreement will be terminated.
5.3.2 Top-Up Rights The Top-Up Deed provides Qantas with a mechanism to avoid dilution if Air NZ issues new shares. Key terms include:
§ if Air NZ makes a pro rata or non-pro rata share issue, Air NZ and Qantas will make arrangements to ensure that Qantas can acquire shares sufficient to maintain the percentage interest held by Qantas prior to the share issue; § the number of top-up shares to be issued to Qantas must not allow the stake held by Qantas to exceed that approved by the Kiwi Shareholder; § where the number of Air NZ shares outstanding is reduced by a share buyback, Qantas must sell the number of shares necessary to reduce its holding to or below the level approved by the Kiwi Shareholder; § if Air NZ is unable to issue shares to Qantas under its top-up rights without obtaining shareholder approval, Air NZ may issue the shares which give rise to Qantas’ top-up right so long as it seeks shareholder approval as soon as reasonably practicable; and § Qantas’ rights under the Top-Up Deed terminate once Qantas’ stake falls below 10%. 5.3.3
§ §
§
Page 42 Outline of Proposal
§
Page 43 Outline of Proposal
5.4 Governance
After all of the conditions have been satisfied, reciprocal board representation arrangements would apply. Qantas would be entitled to nominate one director under the SAA, one director if it holds 10% or more, but less than and 20%, and two directors if its shareholding is 20% or more. Qantas’ maximum representation on Air NZ’s board is restricted to two directors, implying one equity director would also be deemed a SAA director if Qantas shareholding is 20% or more. Air NZ would be entitled to nominate one director to Qantas’ board. Each company’s board must unanimously recommend to its shareholders that they vote in favour of the nominated director(s). If either company’s nominee is not appointed, the nominating company can terminate the SAA.
5.4.1 Reciprocal Board Representation The Reciprocal Board Representation Deed provides for Air NZ and Qantas to have representation on each other’s board of directors. The key terms of the deed include:
§
§
§
§
§
§
§
§
§ §
Page 44 Outline of Proposal
§
§
§
§
§
5.4.2 Air NZ’s Constitution Following Air NZ shareholder approval of the proposed transaction, the following changes would be made to Air NZ’s constitution:
§ the quorum for Air NZ board and board committee meetings must include a Qantas nominated director; § the Qantas nominated directors will have no voting rights on the audit committee; § written board resolutions must be signed by at least one Qantas nominated director; and § a schedule will be added providing for Qantas to maintain its percentage shareholding in the event of pro rata or non pro rata share issues by Air NZ, and for Qantas to sell excess shares where its holding increases above the level approved by the Kiwi Shareholder as a result of Air NZ undertaking a share buy back. 5.4.3 Co-ordination Agreement The Co-ordination Agreement requires Air NZ and Qantas to undertake certain actions to satisfy the conditions. This agreement:
§ requires Air NZ and Qantas to co-operate and consult with each other in respect of any applications made or documents filed with regula tors, or in respect of any announcements made; § prior to the effective date of the SAA (when all conditions are met), requires the parties to prepare an implementation plan for the implementation of the SAA; and § sets out requirements for Air NZ’s preparation of documents to seek Air NZ shareholder approval. 5.5 Transition Deed
The key points of the Transition Deed include:
§
Page 45 Outline of Proposal
§
§
§
§
§
5.6 Termination of the Strategic Alliance Agreement
The SAA continues for an unspecified term. However, it contains a number of clauses that specify events that give the parties the right of termination and additionally provides for the right of “termination without cause” after a specified period. Termination of the SAA may occur at the request of the non-defaulting party in the event that:
§ there is a breach of the SAA;
Page 46 Outline of Proposal
§
§
§
§
§
§ §
§ § §
The SAA may be terminated by Air NZ in the event that:
§ § §
Page 47 Outline of Proposal
5.7 Process and Timetable
The projected key milestones related to consummating the SAA are set out in Table 5.2 below.
Table 5.2 Timetable
Date Event 9 December 2002 Applications filed with the NZCC and ACCC
18 December 2002 Kiwi Shareholder grants Qantas and Air NZ applications on a conditional basis
July 2003 Estimated final decisions of NZCC and ACCC
September 2003 Air NZ shareholder approval
Page 48 Assessment of Proposal
6 Assessment of Proposal
The JAO is expected to generate significant commercial benefits for both airlines. These benefits are projected to result in improved financial returns for both Air NZ and Qantas primarily as a result of higher load factors and an improvement in operating costs. The JAO should ensure that Air NZ is a sustainable Australasian airline.
6.1 Strategic Rationale
Air NZ and Qantas have been fierce competitors for a number of years on trans-Tasman routes and more recently on New Zealand’s domestic main trunk routes. Competitive pricing between the two airlines has negatively impacted both companies’ financial returns, particularly on trans-Tasman operations.
Some of the key commercial benefits of collaborating are as follows:
Enhanced Revenues
§ higher load factors, leading to incremental revenue for the JAO without the need to increase airfares; § improved connectivity between Air NZ and Qantas flights is expected to increase the number of passengers seeking to travel to New Zealand and Australia as a joint destination; § improved frequency will result from revising overlapping schedules, particularly on trans-Tasman flights, and is expected to stimulate passenger demand and benefit consumers; § increased “feed” is expected from excess passengers booked on Qantas’ other international flights. For instance, if a Qantas flight from Los Angeles to Sydney is over-booked, Qantas passengers can be rescheduled on the JAO’s Los Angeles - Auckland and Auckland - Sydney services; § joint development and promotion of travel packages to Australasian destinations; § improved flight schedules by adding new non-stop flights and greater frequency. For instance, a new non-stop flight between Auckland and Adelaide is anticipated to stimulate new volume and increase capacity on busy routes such as Auckland to Melbourne; and § Air NZ will also benefit from its engineering services business becoming the preferred external supplier of Qantas’ heavy maintenance requirements. The Company estimates that Qantas will outsource 20% of its maintenance requirement with up to 80% of the outsourced work expected to be made available to ANZES;
Cost Savings and Efficiencies § significant cost savings from the more effective deployment of aircraft. For instance, because of the asymmetrical costs involved in operating narrow and wide- body aircraft, employing larger aircraft and reducing frequency on certain routes will reduce the average cost per seat;
Page 49 Assessment of Proposal
§ benefits from greater fleet size and improved aircraft utilisation, including increased average daily flying time for long-haul aircraft; § seasonal deployment of Qantas aircraft not included fully within the JAO to meet peaks in demand; and § other scale efficiencies. A conservative estimate of approximately $ million, less than % of JAO costs, has been assumed for the purposes of modelling. Potential savings include savings from joint procurement of services and fuel, the combining of services such as membership lounges and functions such as baggage handling and check-in services; Competitive Positioning § under the proposed JAO, Air NZ and Qantas would be required to co-ordinate with each other in all aspects of their JAO operations, including scheduling, connection requirements and route planning. This is likely to significantly improve the JAO’s product offering relative to the current stand-alone scenario and should increase Air NZ’s ability to remain competitive against a VBA entrant competing against it domestically or on the trans-Tasman.
Page 50 Assessment of Proposal
6.2 Management Fee and Adjustment Payment
Under the JAO, Air NZ receives greater downside earnings protection but Qantas receives a higher proportion of incremental profits, relative to its going-in position. In our view, this provides Qantas with an incentive to enhance the JAO earnings. If earnings fall below going-in profitability, Air NZ receives a higher proportion reflecting the greater capacity contributed to the JAO.
6.2.1 Base Management Fee The incorporation of the Base Management Fee within the Management Fee and Adjustment Payment model is designed to protect Air NZ’s existing going-in position.
6.2.2 Capacity Measure and Management Fee
Table 6.1 Relationship Between Profitability and Capacity Shares
JAO Outcome Profit Before Aircraft PBT Capital Charge Base Case
Increased Earnings
Reduced Earnings
Page 51 Assessment of Proposal
Table 6.2 Base Capacity Share Guidelines
Lower Upper FY2003F JAO Forecast(1)
Air NZ
Qantas
(1) Projected share of total JAO ASKs in FY2004 Source: Strategic Alliance Agreement, Company Data
Page 52 Assessment of Proposal
6.3 Financial Impact of JAO 6.3.1 Methodology and Assumptions Air NZ has employed a similar forecasting methodology to that used for the stand-alone scenarios to generate financial projections for FY2004-2006 under the JAO scenario’s. Table 6.3 below presents the three competitive scenarios that have been developed to analyse earnings under the JAO.
Table 6.3 Assumed JAO Scenarios
JAO Services VBA Response Upside Case · New services to Adelaide, · No VBA entry on trans- Canberra and Hobart Tasman or New Zealand domestic
Base Case · New services to Adelaide, · 3 aircraft on trans -Tasman Canberra and Hobart in 2004 · JAO trans-Tasman ASKs · No VBA entry on New 6.9% less than Upside in Zealand domestic 2006
Downside Case · New services to Adelaide, · 3 aircraft on trans -Tasman Canberra and Hobart in 2004 · JAO trans-Tasman ASKs · 5 aircraft on New Zealand 6.9% less than Upside in domestic 2006 · JAO New Zealand domestic ASKs 9.1% less than Upside in 2006
Source: Company Data
We believe that the three competitive scenarios developed to analyse the JAO provide a reasonable summary of the potential competitive environments for the JAO. As discussed in section 3.3, there is a reasonable probability that Virgin Blue will seek to expand the scope of its network by beginning services on selected trans-Tasman and New Zealand domestic routes.
The JAO’s response to VBA entry is also consistent with the undertakings that have been proposed as part of the application for approval by the ACCC and NZCC that place restrictions on changes to capacity.
Page 53 Assessment of Proposal
6.3.2 Earnings Projections Under the JAO
In all JAO competitive scenarios, earnings grow year-on-year. By FY2006, the Base Case is slightly below the Five Year Plan and the Upside Case is ahead of it. Improved profitability is largely attributable to improved earnings on the trans- Tasman and Auckland – Los Angeles routes and continued growth on routes to/from Japan.
Air NZ’s share of EBITDRA under the JAO is calculated using the Management Fee and Adjustment Payment. This is then added to the earnings forecasts for Air NZ’s ANZES business that remains outside of the JAO to generate group EBITDRA forecasts. It should be noted that although ANZES is expected to secure a greater proportion of Qantas’ aircraft maintenance as a result of the JAO, the earnings forecasts prepared under the JAO scenarios do not assume any increase in ANZES earnings over the stand-alone case. Air NZ’s forecast of operating leases, finance charges and exchange rate adjustments are then deducted from the Company’s total EBITDRA to generate net profit.
The JAO earnings forecasts and financial projections incorporate the following key assumptions:
§ § §
Page 54 Assessment of Proposal
Figure 6.1 Air NZ JAO EBITDRA Projections
Source: FY03 Final Budget Report, Company Data, Air New Zealand Revised Five Year Business Plan
Figure 6.2 Air NZ JAO PBT Projections
Source: FY03 Final Budget Report, Company Data, Air New Zealand Revised Five Year Business Plan
The key points to note in the analysis include:
§ the charts show that even under the Downside Case scenario, Air NZ’s profitability improves year-on-year;
Page 55 Assessment of Proposal
§ §
§ profitability is negatively affected by the entry of a VBA on the trans-Tasman in 2005 under the Base Case and Downside Case scenarios and on New Zealand domestic under the Downside Case in 2006; and § despite the earnings impact of VBA entry, Air NZ is less vulnerable to changes in the competitive environment and demonstrates strong earnings growth under all scenarios. 6.3.3 Return on Capital Employed Figure 6.3 below shows Air NZ’s ROCE under the three competitive scenarios developed for the JAO projections.
Figure 6.3 Air NZ Return on Capital Employed
1) Return on capital employed = (EBIT + operating leases – implied depreciation on operating leases) / (Net assets employed + operating leases capitalised by a factor of seven) Source: Company Data
The chart above shows ROCE improving in each of the three competitive scenarios between FY2003 and FY2006. This improvement is largely attributable to the significant increase in profitability over this period, with the asset base remaining similar under each of the scenarios.
While the forecasts imply that in FY2006 Air NZ will still fail to make an economic return on capital, the improvement is likely to significantly ease constraints on Air NZ’s future funding. Specifically, the Company’s ability to raise additional equity to fund future fleet upgrades should be improved.
Page 56 Assessment of Proposal
6.3.4 Gearing Figure 6.4 presents Air NZ’s projected book gearing under the competitive scenarios.
Figure 6.4 Air NZ Book Gearing – Actual and Budget(1)
(1) Includes aircraft operating leases capitalised by a factor of seven Source: Company Data, Air NZ Annual Report
Consistent with the increase in Air NZ’s earnings under all three competitive scenarios, the Company’s gearing is projected to improve during FY2004-2006. Although the replacement of Air NZ’s short-haul aircraft increases capital expenditure and operating lease costs during this period, this is offset by stronger cash flows from operations. Air
Table 6.4 below presents Air NZ’s gearing and credit statistics under the Base Case JAO scenario.
Table 6.4 Air NZ Gearing and Credit Statistics – Base Case JAO
Source: Air NZ Annual Report, Company Data
6.3.5 Sensitivity Analysis In addition to creating a more stable competitive environment, the JAO is expected to reduce variations in operating yields and load factors resulting in greater earnings stability for Air NZ. Nevertheless, Air NZ will continue to remain exposed to changes in a number of key operating variables including fuel costs, exchange rates and interest rates. This is demonstrated in Figure 6.5 that presents Air NZ’s projected PBT under the
Page 57 Assessment of Proposal
JAO Base Case scenario based on the current fuel budget and the effect of a 20% increase in fuel prices.
Figure 6.5 Air NZ PBT Sensitivity to Fuel Prices
Source: Company Data
Figure 6.6 below illustrates the impact on Air NZ’s gearing if it is assumed that there is
Figure 6.6 Air NZ JAO Book Gearing Sensitivity
Source: Company Data
By substantially improving the Company’s financial position, the JAO strengthens Air NZ’s ability to endure a sustained period of reduced earnings without a requirement for additional equity.
Page 58 Assessment of Proposal
6.4 Comparison of the JAO to Stand-Alone
In all three of Air NZ management’s competitive scenarios, earnings under the JAO are projected to be significantly higher than in the stand-alone competitive scenarios.
Figure 6.7 and Figure 6.8 below illustrate the benefit (compared to the respective stand- alone scenarios) to Air NZ from the proposed JAO under the Downside Case, Base Case and Upside Case scenarios. The figures also compare the Upside Case JAO scenario to the stand-alone Status Quo scenario. Under the three JAO scenarios, the benefit increases each year, reflecting the increasing proportion of the benefit of migrating from Star Alliance to oneworld being realised during the transition period. The charts also show that the JAO protects Air NZ’s earnings in the Downside Case scenarios. This highlights the significant downside in the stand-alone scenarios if Qantas and Virgin Blue aggressively compete with Air NZ.
Figure 6.7 Incremental EBITDRA Under the JAO Scenarios
(1) Compares stand-alone Status Quo scenario to JAO Upside Case scenario Source: Company Data
Figure 6.7 above shows that in the steady state FY2006 year, Air NZ’s projected EBITDRA under the JAO is higher in each of the four scenarios. When pre-tax earnings are calculated on a per share basis, as shown in Figure 6.8, the JAO improves earnings per share under the Upside Case, Base Case and Downside Case scenarios. Comparison of the stand-alone Status Quo to the Upside Case shows that there is no earnings per share benefit under this comparison. This can be explained by Air NZ’s increased number of shares on issue following the acquisition of a 22.5% interest by Qantas.
Page 59 Assessment of Proposal
Figure 6.8 Incremental Pre-Tax Earnings Per Share Under the JAO Scenarios
(1) Compares stand-alone Status Quo scenario to JAO Upside Case scenario Note: JAO earnings per share based on shares on issue following final placement of shares to Qantas Source: Company Data
Comparing the two Base Case scenarios, the principal reasons for the increased earnings under the JAO are as follows:
§ the JAO results in moderate revenue increases on all routes operated by Air NZ, with the exception of Sydney – Los Angeles ; § revenue growth is driven primarily by an improvement in load factors of approximately 2.5% in FY2006. Prices and ASKs do not vary between the JAO and stand-alone cases; § higher load factors are derived from stimulation in demand caused by improved connectivity and scheduling under the JAO; § airline profitability is highly sensitive to load factors. For instance, it is estimated that a % increase in load factors results in an increase in Air NZ’s PBT of approximately $ million; § operating costs per ASK are projected to decrease under the JAO from better utilisation of aircraft, such as deploying larger aircraft on trans-Tasman routes. Operating costs per ASK are a key driver. For instance, a reduction in operating costs per ASK from cents to cents on Air NZ’s total projected ASKs of billion represents a savings of approximately $ million; and § other cost savings of approximately $ million per annum are also anticipated (see section 6.1). Air NZ’s ROCE under the JAO also improves, given the higher earnings from a comparable level of capital. Air NZ’s projected ROCE under the JAO Base Case is considerably higher than under the stand-alone Base Case, and marginally higher than the Status Quo Case by the projected steady state year FY2006.
Page 60 Assessment of Proposal
Figure 6.9 Air NZ’s ROCE Under the JAO, Stand-Alone and Status Quo Forecasts
1) Return on capital employed = (EBIT + operating leases – implied depreciation on operating leases) / (Net assets employed + operating leases capitalised by a factor of seven) Source: Company Data
Page 61 Assessment of Proposal
6.5 Gearing
Figure 6.10 shows that Air NZ’s gearing improves strongly under the JAO.
Figure 6.10 Air NZ Book Gearing Under the JAO and Stand-Alone Scenarios(1)
(1) Includes aircraft operating leases capitalised by a factor of seven Source: Company Data, Air NZ Annual Report
6.6 Impact of the JAO on Valuation of Air NZ
To assess the value implications for Air NZ shareholders resulting from the JAO, we employed DCF valuation methodology to value incremental cash flows for each of the JAO scenarios. This was done using the real earnings forecasts prepared by Air NZ for the JAO and stand-alone scenarios for the financial years FY2003 – 2006. To derive a terminal value, Air NZ’s FY2006 EBITDRA was multiplied by its historical trading multiple of 6.4x. The increase in Air NZ’s terminal enterprise value and the incremental cashflows were then discounted at Air NZ’s estimated real WACC of % at a valuation date of 1 December 2002.
In calculating the value implications on a per share basis, we have assumed Qantas subscribes for the Tranche 2 shares at the time of the satisfaction of the key conditions. Under this scenario, Qantas would acquire its 22.5% stake in Air NZ at a price of $0.445 per share and fully shares in the earnings improvement projected under the JAO.
Because of the large number of assumptions underlying the cash flow analysis and the shortness of the period for which projections are available, these estimates should be regarded as indicative only.
Page 62 Assessment of Proposal
Table 6.5 JAO Value Gain (cents per share)
Source: First NZ Capital, Company Data
Page 63 Assessment of Proposal
6.7 Assessment of Equity Investment by Qantas
Based on equity analysts’ valuations of Air NZ and comparable company analysis, we consider that the issue price of $0.445 per share is fair and reasonable.
6.7.1 Overview Under the proposed terms of the Subscription Agreement between Qantas and Air NZ, Qantas is to subscribe for new shares in Air NZ. As detailed in section 5.3.1, Qantas’ equity investment will occur in three tranches with Qantas ultimately owning 22.5% of Air NZ. Table 6.6 below sets out the timing and pricing mechanism for Qantas’ subscription of shares and provides an indication of the subscription amount based on Air NZ’s current share price.
Table 6.6 Issue Price of New Air NZ Shares to Qantas
Tranche Issue Date Issue Price Implied Number of Total Value (1) Shares NZ$mm Issue Price Issued to (2) Qantas 10% discount to 20 day VWAP Convertible Notes Kiwi Shareholder Consent $0.445 220.8 $98.2 prior to JAO announcement 10% discount to 20 day VWAP Tranche 1 Upon authorisation $0.445 521.0 $231.8 prior to JAO announcement
Either at the Tranche 1 price or Either upon authorisation or Tranche 2 at a 15% discount to 20 day $0.445 478.6 $213.0 three years after authorisation VWAP prior to issue of Tranche 2
Total 1,220.3 $543.0 (1) Based on Air NZ 20 day VWAP to 22 November 2002 of $0.4944 (2) Based on current number of Air NZ shares outstanding of 4,203.33 million
In assessing the proposed equity issue to Qantas, First NZ Capital has considered whether the issue prices are fair and reasonable to Air NZ. In evaluating whether the issue price is fair and reasonable, we have considered:
§ the discount to Air NZ’s current share price;
§ Air NZ’s underlying value as assessed by equity research analysts; and § the implied value of Air NZ applying comparable company pricing multiples to Air NZ. The issue price of $0.445 for at least 15% of the 22.5%, and possibly the entire 22.5%, represents a 10% discount to Air NZ’s VWAP over the 20 trading days prior to the announcement of the SAA.
The calculation of this issue price is based on the pre-announcement price (that is, it does not incorporate any impact of the announcement of the JAO on Air NZ’s share price). In our view, this is appropriate given the structuring of the transaction, which is essentially a joint venture where Qantas will bring a substantial proportion of the incremental value to the transaction. Qantas will share in the value upside created from
Page 64 Assessment of Proposal the SAA through any increase in Air NZ’s share price. Existing Air NZ shareholders also share in the share price upside.
6.7.2 Equity Analysts’ Research Valuations Table 6.7 Summary of Research Analysts’ Views
Broker Report Date Valuation Recommendation
(1) ABN AMRO 9-Sep-02 $0.29 REDUCE First NZ Capital 30-Oct-02 $0.39 UNDERWEIGHT Forsyth Barr 29-Aug-02 $0.41 SELL JBWere 29-Oct-02 $0.42 REDUCE (2) Salomon Smith Barney 30-Oct-02 $0.46 IN-LINE, SPECULATIVE UBS Warburg 22-Oct-02 $0.73 BUY Average $0.45 Median $0.42 (1) Midpoint of fair value range (2) Midpoint of 12 month target
Source: Broker research reports, Bloomberg
Based on broker valuations, Air NZ’s current share price is above its fair market value or assessed underlying value. We place most weight on the median broker valuation of $0.42 as this reduces the impact of the substantially higher value placed on Air NZ by UBS Warburg.
The issue price for the convertible notes and Tranche 1 shares (and possibly Tranche 2 shares) of $0.445 is greater than the median of equity research analysts’ valuations of Air NZ by approximately 6%.
Page 65 Assessment of Proposal
Figure 6.11 Comparison of Air NZ and Analyst Consensus Stand-Alone PBT Forecasts
Source: Company Data, ABN AMRO, First NZ Capital, Salomon Smith Barney, UBS Warburg research reports
We have observed that the earnings forecasts published by research analysts are based in part on the Five Year Plan forecasts that were made publicly available as part of the recapitalisation by the Crown.
6.7.3 Comparable Company Analysis Figure 6.12 shows the implied Air NZ share price by applying the EBITDRA multiples of comparable airlines to Air NZ’s FY2002 actual EBITDRA and the Base Case stand- alone FY2003 forecast EBITDRA.
Page 66 Assessment of Proposal
Figure 6.12 Implied Value of Air NZ Shares Based on EBITDRA Multiples
Note: 2003F based on FY03 Revised Budget
Source: Bloomberg, Broker Research Reports
Figure 6.12 shows that even when the current EBITDRA trading multiples of Qantas and Cathay Pacific are applied to Air NZ’s EBITDRA, the implied share price does not reach the Qantas subscription price of $0.445. It could be argued that Air NZ should trade at a discount, rather than a premium, to Qantas and Cathay Pacific due to its smaller size, historical performance and more limited growth opportunities.
The median multiples of European airlines also imply an Air NZ share price below the Qantas subscription price, while Singapore Airlines’ FY2002 multiple implies a price close to the issue price. The precarious state of the US airline industry, reflected in low earnings, explains the high prices implied by US airlines and, as a consequence, the world airline median. Low earnings forecasts combined with enterprise values inflated by extremely high levels of debt produce very high multiples and hence implied share prices that do not provide a good benchmark for the value of Air NZ.
Figure 6.13 shows Air NZ’s implied share price based on the market price/NTA multiples of comparable airlines.
Page 67 Assessment of Proposal
Figure 6.13 Implied Value of Air NZ Shares Based on NTA Multiples
$0.60
Current Air NZ Share Price $0.50
Issue Price to Qantas
$0.40
1.6x
$0.30 1.3x
0.9x 0.9x
Implied Share Price (NZ$) $0.20 0.7x 0.6x
$0.10
$- Qantas Singapore Airlines Cathay Pacific European Airline US Airline Median World Airline Median Median
Note: 2003F based on FY03 Revised Budget
Source: Bloomberg, Broker Research Reports
Like Figure 6.12, Figure 6.13 indicates that the issue price to be paid by Qantas is higher than that implied by the trading multiples of comparable airlines. Even the NTA multiples of financially stronger Asian airlines imply an Air NZ share value well below $0.445.
6.7.4 DCF Valuation First NZ Capital generally favours DCF valuation methodology in estimating a company’s underlying equity value. However, after examining the financial information available for Air NZ, we do not believe that this methodology is applicable due to the following factors:
§ the revenue and earnings projections prepared by Air NZ under the stand-alone scenarios are available only to FY2006. As a result, the assessed equity value of the business is highly dependent upon the estimated terminal value, which accounts for approximately 90% of total enterprise value. This makes the value of the business highly sensitive to the free cash flow forecast for FY2006 and the growth rate applied to this forecast to derive the terminal value; § Air NZ has significant future capital expenditure requirements to upgrade its short- haul fleet and maintain the average age of its wide body long-haul aircraft at current levels. As discussed in section 4.4.1, the Company is currently in the process of determining the total amount of this expenditure along with the optimal timing and method of financing. This is likely to have a significant effect on the DCF valuation of the business which is not captured in the three year forecast period; § Air NZ’s high level of financial and operating leverage, which is typical of the airline industry, makes its valuation highly sensitive to a number of key revenue and operating assumptions. This sensitivity was alluded to in the November 2001 Grant Samuel fairness opinion assessing the recapitalisation of Air NZ by the Crown. The report noted that a US$1 movement in the price of oil resulted in the
Page 68 Assessment of Proposal
per share value changing by approximately 10 cents. Air NZ has not undertaken forecasting of exogenous variables in its modelling of the JAO and stand-alone scenarios. Instead it has used static variables in both cases to focus on the incremental benefit of the JAO relative to the stand-alone scenarios. Consequently, the projections available to us have not been prepared for valuation purposes.
6.7.5 Should Qantas Pay a Premium? Under the terms of the SAA, Qantas will gain a substantial degree of influence over Air NZ at both board and management levels. In addition, it will acquire a substantial shareholding in Air NZ of 22.5%. It could therefore be argued that Qantas should pay a premium above the market price of Air NZ shares to reflect the strategic influence it will have over Air NZ.
Factors that argue against Qantas paying a premium are as follows:
§ the strategic value of Qantas’ 22.5% stake is substantially limited by the Crown’s controlling stake. In particular, the Crown could remove Qantas’ influence on the Air NZ board by voting the Qantas nominees off the board; § Qantas would have a maximum of two nominees on Air NZ’s board. While they would be able to monitor Air NZ’s performance and have a say on board and board committee matters, they would have no veto powers. If the other directors (whose appointment is controlled by the Crown) wish to, they could override the Qantas nominees on all board and committee resolutions; § while Qantas may in practice acquire significant management influence over Air NZ, the agreements provide it with only a limited contractual basis for this influence. Contractually, Air NZ retains full board and management discretion over its affairs, although it is required to consult Qantas on all significant matters and to involve the Qantas secondees in the preparation of annual budgets and business plans. If there is a disagreement between the parties, a dispute resolution procedure applies; § Qantas would not acquire any rights over the Crown’s shareholding or any augmentation of its rights or influence that might otherwise occur through it entering into some form of shareholders’ agreement with the Crown as controlling shareholder; and § Qantas would contribute a large amount of equity to Air NZ and assist in substantially strengthening the operating performance of the Company.
In summary, the strategic value of Qantas’ shareholding is largely negated by the Crown’s controlling shareholding and by the limited contractual basis for the influence it would exercise over the management of Air NZ. In these circumstances, we consider that it would be commercially unreasonable to expect Qantas to pay a premium to the market price of Air NZ shares.
We note that, based on the valuation analysis presented earlier in this section, the issue price of the convertible notes and Tranche 1 shares is at a premium to the underlying value of the shares.
Page 69 Assessment of Proposal
6.7.6 Timing of Qantas Subscription As detailed in section 5.3.1, Qantas has the option under the Subscription Agreement of electing to subscribe for the additional 7.5% Tranche 2 shares at $0.445 upon the key conditions being satisfied; or subscribe three years after the conditions are satisfied. The subscription price in the latter case would be set at a 15% discount to the VWAP of Air NZ ordinary shares for the 20 trading days prior to the date of issue.
In our analysis, it has been assumed that Qantas, subject to having sufficient capital available, elects to increase its holding to the full 22.5% upon the key conditions being satisfied for the following reasons:
§ by subscribing for the additional 7.5% at the time the key conditions are satisfied, Qantas is able to purchase Air NZ shares at a 10% discount to the pre-announcement price. Unless Air NZ’s share price falls, based upon our valuation analysis and the positive response by investors to the announcement of the JAO, we believe that the alternative issue price will heavily favour the earlier subscription for Tranche 2 shares; and § while the deferral of payment for three years would provide Qantas with additional financial flexibility, Air NZ’s share price would be expected to increase at Air NZ’s cost of equity for each of the three years. The result would be a theoretical subscription price well in excess of the $0.445. In the event that Qantas elects to defer subscription until three years after satisfaction of the key conditions, the subscription price would be set at a discount to the then prevailing market price. For modelling purposes, we have (conservatively) assumed that if Qantas elects to subscribe for Tranche 2 shares three years after the conditions satisfaction date, this is done at the Tranche 1 issue price of $0.445. In this case, we have assumed that Qantas subscribes for Tranche 2 shares in FY2006. Figure 6.14 presents Air NZ’s gearing under this scenario.
Page 70 Assessment of Proposal
Figure 6.14 shows that the impact on Air NZ’s gearing of Qantas deferring the subscription of the Tranche 2 equity until FY2006 is that gearing does not fall below the 50% band until FY2006.
Figure 6.14 Air NZ Book Gearing – Timing of Tranche 2 Subscription(1)
(1) Includes aircraft operating leases capitalised by a factor of seven Source: Company Data, Air NZ Annual Report
6.8 Management and Governance 6.8.1 Implications of JAO Governance Principles Key implications of the proposed governance structure are as follows:
§ the shared decision making created under the SAAG is consistent with the principles of a joint venture arrangement. Through the SAAG, Qantas will effectively obtain a significant influence over the strategic direction and material decisions relating to Air NZ’s operations; § other elements of the SAA that highlight the shared decision making power include:
Ø all decisions by the SAAG must be unanimous (with Qantas having three of the six members);
Ø Qantas can veto changes to its product specifications, schedules or removal of the Qantas brand; and
Ø all decisions that ordinarily would require the authority of the chief executive or board of Air NZ must be submitted to the SAAG for consideration. In our view, in practice the JAO will be managed jointly by Air NZ and Qantas through the SAAG. Any disputes not resolved within the SAAG will be escalated to the respective chief executive officers, and if still unresolved, escalated to the respective
Page 71 Assessment of Proposal chairpersons. If any dispute is still unresolved following this process, the parties would be entitled to take such action as may be available to it at law.
Joint venture arrangements typically provide for power sharing among the parties. The rationale is to protect the rights of minority partners and to give them the ability to contribute valuable ideas and resources to the governance of the joint venture. In this instance, Qantas is a large, successful airline that can provide valuable expertise to the JAO to not only protect its interests, but also enhance the overall performance of the JAO. Further, in our view it would not be commercially realistic to expect Qantas to transfer the management of its trans-Tasman and New Zealand domestic operations fully to Air NZ. Accordingly, the SAA is designed to give Air NZ primary responsibility for management of the JAO, with Qantas having significant influence.
6.8.2 Sustainability of JAO The term of the JAO is four years, with a minimum notice period of one further year.
There are a number of factors that could threaten the sustainability of the JAO in our view. These include, but are not limited to, the following:
§ the JAO is a relatively complex structure, particularly in terms of the benefit sharing principles. It may be too complex and rigid to cater for future developments in the industry; § due to Qantas maintaining an international airline outside of the JAO, there is potential for conflicts of interest in relation to the JAO's international operations. For instance, Qantas may seek to shift long-haul JAO passengers to services outside of the JAO; § although significant effort has gone into mitigating the differing views on operating principles, such as the remuneration structure for the sales channel, there is a possibility that the divergent views will create friction within the SAAG; § as noted earlier, it will be a challenge for two airlines that historically have been fierce competitors to generate mutual trust and to co-operate effectively in the operation of the JAO; and § in First NZ Capital’s experience, mergers, acquisitions and joint ventures have the highest success rate when the transaction is implemented and integrated expeditiously. The long implementation timetable increases the potential for one or both companies’ focus to change and the assumed benefits to be reduced. 6.8.3 Governance of Air New Zealand Under the proposed amendments to Air NZ’s constitution, a Qantas director must be present for there to be a quorum at board meetings and board committee meetings, unless this requirement is waived by Qantas. In order to prevent Qantas from being able to frustrate board decisions, a meeting adjourned due to the lack of a quorum may be reconvened by the Air NZ chairperson on not less than 24 hours’ notice. At such a reconvened meeting, any four directors will constitute a quorum. On this basis, there is little risk of Qantas being able to frustrate decisions by Air NZ’s board.
Page 72 Assessment of Proposal
6.9 Key Risks of the Proposal for Air NZ
The competition authorities could require undertakings that reduce the projected benefits of the JAO in its current form.
If the competition authorities and shareholders decline the proposal, Air NZ’s position with the Star Alliance may be impaired, although we view this as a low risk. Air NZ and Qantas are likely to continue competing aggressively. If the JAO is implemented and subsequently terminated, Qantas’ competitive position is likely to have been strengthened by the access it would have had to sensitive Air NZ information.
In the discussion below, we have separated risks into three categories. The first category highlights the risks that arise if the JAO proposal is authorised by the regulators and Air NZ and Qantas implement the JAO. The second category highlights the risks if the JAO proposal is not authorised by the regulators. The third category considers the situation if the JAO is implemented and subsequently terminated.
6.9.1 Risks if JAO Implemented Potential Undertakings Required for Approval by Competition Authorities
Authorisation by the Commerce Commission and/or Australian Competition and Consumer Commission may be granted subject to Air NZ and Qantas agreeing to certain undertakings and conditions that compromise the commercial rationale and/or some of the financial benefits of the JAO.
In particular, if certain undertakings are required that facilitate the entry of a VBA such as Virgin Blue into the New Zealand domestic market, then Air NZ’s view of the Base Case competitive scenario under the JAO would be optimistic and the Downside Case which includes entry of a VBA on New Zealand’s domestic main trunk routes would be a more appropriate competitive scenario. We note that NECG’s most recent analysis concludes that a VBA will enter the domestic New Zealand market if the JAO proceeds.
It is important to highlight, however, that the Downside Case under the JAO is still expected to deliver higher profits and value for Air NZ’s shareholders than the Base Case without the JAO.
Undertakings may also be required in terms of price increases and changes to capacity. The financial modelling of the JAO assumes constant real airfares.
Competitor Response
.
Virgin Blue or international airlines operating services to and from New Zealand, such as United Airlines, could make a competitive response to the formation of the JAO.
Page 73 Assessment of Proposal
The effect on Air NZ would be reduced revenue. In our view, and in the view of Air NZ management, such an aggressive response is less likely than more likely.
Further, some of Air NZ’s competitors currently face significant internal issues that are likely to be of higher importance than attempting to weaken Air NZ.
Air NZ Shareholder Approval
6.9.2 Risks if Authorisation Declined Relationship with Star Alliance
Response by Qantas
There is a reasonable likelihood that in the event that Air NZ and Qantas do not enter into the JAO, Qantas will significantly increase capacity on Air NZ’s most profitable routes to build market share and improve its profitability. This scenario is modelled in the stand-alone scenarios reviewed in section 4. As a result of the information sharing that has taken place between the parties during the JAO discussions, Qantas is likely to have an increased understanding of Air NZ’s operations and profitability. However, Air NZ management state that care has been taken to prevent Qantas obtaining specific
Page 74 Assessment of Proposal information such as route specific passenger flow information that would assist Qantas (and be detrimental to Air NZ) if the JAO does not proceed.
6.9.3 Exiting the SAA Dependency on JOA Resources
Under the SAA, Air NZ and Qantas are to co-ordinate and co-operate in a wide number of areas, such as information technology. Depending on the degree of co-ordination, it may become more difficult for Air NZ to practically exit the JAO. If Air NZ’s ability to operate independently is weakened, its negotiating power within the SAA may diminish.
Maintaining an equal negotiating position within the SAA will be important for Air NZ. The SAA does not provide for renewal terms – it has an indefinite term but can be terminated after four years by either party giving not less than one year’s notice. The notice period should enable Air NZ to restructure to operate as a stand-alone business. If the SAA is terminated because of a breach, the notice period is only 20 days.
Information Risk
Although the Reciprocal Board Representation Deed enables Air NZ’s chairperson to limit Qantas’ access to sensitive information at board meetings, Qantas’ representatives on the SAAG and its secondees to the JAO will have access to sensitive Air NZ information. Even if Qantas’ representatives act in good faith, there will, in our view, be a practical transfer of detailed knowledge about the operations of Air NZ. If the JAO is terminated, and Qantas and Air NZ continue to compete aggressively, Qantas’ competitive strength is likely to be greater than it is today. Air NZ’s only access to Qantas information is through its representation on the Qantas board.
Page 75 Implications for Crown as Principal Shareholder
7 Implications for the Crown as Principal Shareholder
The Crown’s share of the indicative value gain under the JAO is estimated at $ - million. The Crown’s operating balance will improve through Air NZ’s higher earnings and significantly lower debt. There is a high probability that the Crown would be required to inject further capital if the JAO is not implemented.
7.1 Financial Implications for the Crown 7.1.1 Value of Air NZ Shareholding Table 7.1 shows the estimated incremental increase in the total value of the Crown’s interest in Air NZ under each of the JAO and stand-alone Upside Case, Base Case, Downside Case and Status Quo scenarios. The increase for the Crown has been estimated by multiplying the incremental value gain per share shown in Table 6.5 by the number of Air NZ shares held by the Crown.
Table 7.1 Incremental Effect on Value of Crown’s Air NZ Stake (All amounts in NZ$mm)
Source: First NZ Capital estimates
The key points to note from Table 7.1 are:
§ the largest gain is projected when the stand-alone Downside Case is compared to the expected JAO outcomes. This reflects the potential reduction in Air NZ’s profitability if the JAO is not implemented and Qantas and a VBA compete aggressively with Air NZ; § if the status quo competitive environment continues, which we consider is less than a 25% possibility, then the JAO may not maximise value, but based on the balance of probabilities, it is likely that the JAO will materially enhance the value of Air NZ; and
Page 76 Implications for Crown as Principal Shareholder
§ if the Status Quo scenario is ignored, the JAO is estimated under all scenarios to add significant value for the Crown, even when the effect of dilution of the Crown’s shareholding is taken into account. 7.1.2 Operating Balance Table 7.2 compares the impact on the Crown’s consolidated operating accounts under the JAO and stand-alone Base Case scenarios.
Table 7.2 Base Case Impacts on the Crown’s Operating Balance (All amounts in NZ$mm)
Note: JAO Base Case assumes convertible notes placed in 2003 and Tranches 1 and 2 placed in 2004 Source: Company Data
The key points to note from Table 7.2 are:
§ net surplus from FY2004 onwards is higher under the JAO scenario, notwithstanding the Crown’s diluted shareholding (from 82.0% to 63.5%); §
§ the greater share of earnings attributable to minority interests under the JAO Base Case scenario reflects the JAO’s higher earnings as well as the 22.5% placement to Qantas.
Page 77 Implications for Crown as Principal Shareholder
7.2 Governance Issues
The Crown will continue to control the appointment of the Air NZ board. Qantas will effectively obtain an element of negative control through its shareholding. In our view, the proposed constitutional amendments do not materially affect the Crown. The Crown can elect not to vote for Qantas directors, if it so desired. The consequence would be that Qantas could terminate the SAA.
7.2.1 Board and Voting Rights We note in section 6.8.1 that in our view Qantas will obtain shared management of Air NZ’s JAO operations. At the board level, it will have two directors. The Crown will continue to control appointments to the board of Air NZ, but it will be obliged to vote in favour of the Qantas nominees if it wishes the SAA to continue.
Qantas’ 22.5% shareholding will provide it with a degree of “negative control” of Air NZ. That is, its 22.5% shareholding should be sufficient to enable it to block any special resolution since it is uncommon for all shareholders to vote on shareholder resolutions.
The amendments to Air NZ’s constitution do not adversely affect the decision-making powers of Air NZ’s board. The need for a meeting to be adjourned for 24 hours may be inconvenient but should not materially affect board decisions. Similarly, the requirement for a Qantas director to sign all written resolutions would not result in Qantas obtaining any additional board power over and above its representation of two out of ten directors. It does, however, protect Qantas from Air NZ’s board passing a written resolution without the knowledge of one of the Qantas directors.
7.2.2 Other Matters As the controlling shareholder, the Crown could vote against the appointment or re- election of a director nominated by Qantas. If this occurs, under the SAA Qantas would terminate the SAA immediately. The Crown therefore does have some level of influence over the continuation of the JAO.
There are no other avenues for the Crown or other shareholders of Air NZ to influence or effect Air NZ’s exit of the SAA, except through making appointments to the board of people who oppose the SAA and JAO.
Based on the Crown’s current shareholding in Air NZ, it has sufficient voting power to pass the special resolution in relation to Air NZ entering into the SAA with Qantas.
Page 78 Implications for Crown as Principal Shareholder
7.3 Implications for Divestment of Shareholding
7.3.1 Sale to Qantas
§ § §
§ §
7.3.2 Sale to Other Strategic Purchaser
Page 79 Implications for Crown as Principal Shareholder
Page 80 Implications for Crown as Principal Shareholder
7.4 Air NZ’s Future Capital Requirements
In First NZ Capital’s view, if the SAA and JAO are implemented (resulting in Qantas subscribing for new shares in Air NZ), Air NZ may not need to undertake a rights issue. If the SAA is not implemented, Air NZ is likely to need to conduct a rights issue and the Crown may need to inject further equity in the medium to long- term to fund Air NZ’s future capital expenditure requirements.
7.4.1 Requirement for Rights Issue
§
§
§
§
Page 81 Implications for Crown as Principal Shareholder
Table 7.3 Air NZ Gearing and Credit Statistics – JAO Base Case
Note: Assumes no rights issue by Air NZ Source: Company Data, Air NZ Annual Report
Figure 7.1 Air NZ Book Gearing Under JAO Scenario(1)
(1) Includes aircraft operating leases capitalised by a factor of seven Note: Assumes no rights issue by Air NZ Source: Company Data, Air NZ Annual Report
7.4.2 Assessment of Reasonable Rights Price Range
§
Page 82 Implications for Crown as Principal Shareholder
§
§
§
7.4.3 Potential Strategy for the Crown
Page 83 Implications for Crown as Principal Shareholder
7.4.4 Future Capital Contributions
Table 7.4 Projected Long-Haul Capital Expenditure (All amounts in NZ$mm)
Source: Company Projections
Page 84 Alternatives to SAA and JAO
8 Alternatives to the SAA and JAO
Qantas is the only strategic partner that can provide the benefits to Air NZ sought under the strategic alliance proposal, which include reduction of the competitive threat facing Air NZ on many of its core routes, better capacity utilisation, co- ordination of scheduling and securing feed from the Australian market. No other partner can offer these benefits. Deferring the selection of Qantas as a strategic partner would most likely terminate Air NZ’s current relationship with Qantas and the Crown would almost certainly be required to invest $150 million in the short- term and probably more in the longer term.
8.1 Introduction
§
§ § §
8.2
Page 85 Alternatives to SAA and JAO
Figure 8.1
Source: Company Data
8.3
Page 86 Alternatives to SAA and JAO
8.4 8.4.1
Figure 8.2 Air NZ FY2003 Forecast Return on Assets Employed (All amounts in NZ$mm)
Source: Company Data
Page 87 Alternatives to SAA and JAO
8.4.2
Table 8.1 Air NZ Long-Haul Strategies
Name Strategy
Source: Company Data
Page 88 Alternatives to SAA and JAO
Figure 8.3 Air NZ Stand-Alone EBIT Forecasts
Source: Air NZ Board Presentation November 2002, Company Data
8.4.3
Page 89 Alternatives to SAA and JAO
Table 8.2
Source: Company Data
§
§
§ §
§ §
§ §
§
Page 90 Alternatives to SAA and JAO
§
§ §
Figure 8.4 Change in Projected ROCE: FY2003 to FY2006 (All amounts in NZ$mm)
Source: Company data
8.5
Page 91 Alternatives to SAA and JAO
8.6 Summary of Options
We consider that Qantas has the most to offer Air NZ as a strategic partner. The New Zealand market is important to Qantas. In the first quarter of 2002, New Zealand was the primary destination for approximately 20% of all short-term outbound traffic from Australia.
While the interest of other potential partners has not been fully explored, we consider that there is a low probability of attracting an alternative airline strategic partner:
§ the New Zealand market is not strategic to any other airline except Qantas; § many airlines are in a relatively weak financial position as a result of the global downturn in air travel following September 11; § airline alliances achieve many of the commercial objectives of strategic partnerships without the need for equity investment;
Page 92 Alternatives to SAA and JAO
§ the presence of the Crown as the large majority shareholder reduces the attractiveness of a strategic stake to any other party; § because of its relatively small size and recent financial difficulty, Air NZ is unlikely to be perceived as an attractive investment opportunity; § Singapore Airlines, as the obvious alternative strategic partner, decided not to proceed with a similar proposal in 2001. At that time, Singapore’s principal interest was Ansett Australia, which was controlled by Air NZ. With Air NZ no longer having a presence in the Australian domestic market, Singapore is unlikely to be interested in Air NZ; § Cathay Pacific, another potential Asian partner, has expressed no interest in entering into discussions with Air NZ; and §
§
Page 93 Modifications to Proposal
9 Modifications to Proposal
We have considered whether there are changes to the proposal developed by the two airlines that would improve it from the perspective of the Crown as the principal shareholder.
9.1 Levels of Qantas Shareholding
If the proposal receives all of the authorisations it requires, Qantas would hold 22.5% of Air NZ that would have cost it $543 million (assuming it acquires all of the shares at the time all key conditions are satisfied). While the outlay required to acquire a 22.5% interest is significant, it would represent only 3.5% of Qantas’ total assets.
In our view, the main purposes of the shareholding from Qantas’s perspective are to:
§ secure board representation to enable Qantas to monitor the performance of Air NZ and its compliance with the SAA; § through its board representatives and participation in the SAAG, enable Qantas to have a significant influence over the direction and strategy of Air NZ; and § restrict other strategic partners in Air NZ. Qantas’ objective may be to minimise the amount it needs to invest in Air NZ to achieve these purposes. A higher level of shareholding than that would not enhance Qantas’s position in relation to the above factors. It would provide a higher level of investment return for Qantas, but presumably that is a secondary consideration, particularly since Qantas would share in Air NZ’s incremental profits through the JAO profit sharing arrangement.
The higher the level of shareholding Qantas has in Air NZ, the greater its incentives should be to ensure that Air NZ is a successful and profitable airline. It is notable that, when Qantas was a shareholder in Air NZ during the period from 1989 to 1997, a 20% shareholding was not sufficient to incentivise Qantas to work more closely with Air NZ. It can also be argued that the rights Qantas would be granted under the JAO are excessive for a party that would be a 22.5% shareholder in Air NZ.
For these reasons, we suggest that Air NZ could be asked to explore the feasibility of Qantas taking a higher level of shareholding in Air NZ. Specifically, the following options could be considered:
§ Qantas acquires a 35% interest, the level of total airline shareholding permitted under current government policy; § Qantas acquires a 49% interest through a combination of new shares and a pro rata offer to all existing shareholders, including the Crown. Under this option, an exemption from the Takeovers Code would be required to enable Qantas to acquire more than 20% of Air NZ since Air NZ shareholders could not vote on any resolution to approve the acquisition; and § the option Qantas has to defer subscribing for the Tranche 2 Placement Shares is removed resulting in Qantas owning 22.5% once all conditions are satisfied. Whilst this option does not increase the absolute shareholding, Qantas has a greater economic interest sooner and Air NZ has new equity earlier. If Qantas does not
Page 94 Modifications to Proposal
have the financial capacity to subscribe for the Tranche 2 shares at this time, Air NZ could provide deferred settlement on arm’s-length terms. We have no information on the willingness or otherwise of Qantas to take a higher shareholding in Air NZ.
Simplification of JAO Arrangements
As noted in section 4, the governance of the JAO and Management Fee and Adjustment Payment model arrangements are complex. They have the potential to be a major source of conflict and friction between the parties in the future. The higher the level of shareholding Qantas has in Air NZ, the less it should be concerned with the split of profit between itself and Air NZ. This in turn may facilitate a simplif ication of the joint venture arrangements in the future.
9.2 Shareholders’ Agreement with the Crown
Subsequent to the Terms of Reference set out as Appendix A being drafted, First NZ Capital was instructed to not consider issues that could be included in a shareholders’ agreement.
Page 95 Other Matters
10 Other Matters
10.1 Legal Matters for Consideration
A number of shareholder approvals are required to effect the strategic alliance. Bell Gully, Air NZ’s legal advisor, has provided us with the following summary of necessary shareholder approvals.
Table 10.1 Summary of Shareholder Approvals
Air NZ Action Approval Issue of convertible notes § Kiwi Shareholder approval required
Issue of ordinary shares § Kiwi Shareholder approval for share issues § Ordinary resolution – NZSE LR 7.3.1 (share issues beyond 10%) § Ordinary resolution – Rule 7(d) Takeovers Code
Amendments to constitution § Kiwi Shareholder approval required § Air NZ shareholder approval required
Appointment of directors § Air NZ shareholder approval required
In addition, certain clarifications and approvals have been sought from the NZSE prior to both parties entering into the Subscription Agreement. Various waivers will also be required from the ASX.
10.1.1 Takeovers Code An acquisition by Qantas of 22.5% or more of the voting securities in Air NZ would require approval by an ordinary resolution of the shareholders of Air NZ under the Takeovers Code. This is because Qantas would be acquiring a voting interest in Air NZ, a “Code” company, of greater than 20%, without making a full or partial offer to all shareholders.
Given the Crown’s majority shareholding in Air NZ, this is not considered to be a material risk to the proposal unless the Crown is not entitled to vote.
10.1.2 Related Party or Associated Persons If the Crown becomes a party to the proposal, which could occur if it had a beneficial interest in the transaction from selling down some of its Air NZ shares to Qantas, the Crown would not be entitled to vote at the meeting of Air NZ shareholders to consider the ordinary resolutions required.
Page 96 Conclusion
11 Conclusion
11.1 Overall Assessment of Proposal
The proposal should have a significant positive impact on the value of Air NZ by:
§ removing the major competitive threat facing the airline in the domestic market; § facilitating rationalisation of the airlines’ schedules on trans-Tasman routes;
§ providing feed into Air NZ’s domestic schedule from the Australian market; § improving the profitability of Air NZ; and § injecting capital into Air NZ. The main disadvantages for Air NZ are:
§ the need to share decision making with Qantas. In practice, the proposed management arrangements could mean that Qantas’ agreement is required to all significant decisions made by Air NZ; and § Qantas would be allocated part of the profits that would otherwise have accrued to Air NZ. Overall, we consider that the proposal would be of major benefit to the Company and its shareholders. Uncertainty about the long-term viability of Air NZ would largely be removed and the future profitability of the Company should be enhanced substantially.
There are, however, risks to the sustainability of the arrangement, notably as a result of frictions resulting from Air NZ’s loss of management autonomy or the operation of the profit-sharing arrangements. In the event that the SAA is terminated, Qantas would have the benefit of access through the SAAG to sensitive information on Air NZ’s operations.
11.2 Implications for the Crown
The main implications of the proposal for the Crown are:
§ there should be a substantial increase in the value of the Crown’s shareholding and a reduction in the risk of its investment in Air NZ; § a reduction in the level of control that the Crown can exercise over the Company through its majority vote at director elections; and § the loss of scope for the Crown to divest part of its shareholding to a strategic partner (other than Qantas) during the term of the agreement. 11.3 Other Options Available to the Crown
The main alternatives available to the Crown are to:
§ support a stand-alone strategy for Air NZ. If the status quo competitive environment is maintained, Air NZ’s profitability under this outcome improves marginally year- on-year. However, in our view, there is only a low probability of the current
Page 97 Conclusion
competitive environment continuing. The most likely outcome is that competition intensifies either through a VBA entry or Qantas increasing capacity on New Zealand domestic routes. In these circumstances, the profitability of Air NZ is projected to be materially worse than under the JAO. Financial analysis indicates the Crown would be required to inject new capital in the medium to long term to reduce Air NZ’s gearing and fund its future capital expenditure (fleet replacement) requirements; § seek to modify the arrangement as currently proposed; and § propose a joint venture between the Crown and Qantas to manage and control Air NZ. The changes to the current proposal that we believe that the Crown could consider are:
§ sale of part of the Crown’s shareholding to Qantas. Taking into account the new Air NZ shares Qantas would acquire, a sale of shares by the Crown to Qantas would require Air NZ shareholder approval. The Crown could not vote on the shareholder resolution; and § Removal of the option Qantas has to defer for three years the subscription date for the Tranche 2 shares, resulting in Qantas owning 22.5% of Air NZ once all conditions are satisfied. §
Page 98 Appendix A: Terms of Reference
Appendix A: Terms of Reference
Description of Services (clause 1.1):
The Contractor will provide a report on Air New Zealand Limited as outlined below (the “report”):
Priority Terms Analyse the business cases provided by Air NZ regarding strategic options available to it. Identify the advantages and disadvantages of each option, comment on the robustness of the cases presented and Air NZ’s recommendations, identify any omissions, errors or inconsistencie s.
Identify and comment on any ownership options that may be available to Air NZ that have not been included in the Air NZ submission and the risks, costs and benefits of each option from the perspective of the principal shareholder.
Advise on the implications for the Crown, as principal shareholder, if it wished to preserve an option to seek a strategic partner at a later date including the likely cost of that option (i.e. the magnitude of any further capital required from shareholders over the period if Air NZ’s business is not sustainable in the absence of a strategic partner immediately), an assessment of the valuation implications of selling a stake now versus selling a stake later and the probability of a strategic partner presenting itself.
Comment on the value implications of all viable options from the perspective of the principal shareholder (the Crown).
Advise a range of prices that it may be considered reasonable for Air NZ to make its rights placement at. Provide justification for that range.
Second order terms Comment on the value implications of the content of a shareholders’ agreement between Qantas and the New Zealand Government. If one is not identified, advise the issues that the Crown could agree to have included in a shareholders’ agreement.
Comment on and/or identify any potential exit strategies that could be invoked in order to remove Qantas at a later date if necessary.
Comment on the implications of the proposals for the governance of the airline, including risks and benefits.
Advise on measures that the airlines (particularly Qantas) could take to mitigate any public detriments that are likely to arise as a result of reducing competition in the marketplace (note, the Commerce Commission will analyse and report on competition implications).
Access to Information In connection with the Contractor’s provision of the above Services, the Crown will make reasonable endeavours to secure:
Page 99 Appendix A: Terms of Reference
§ Air New Zealand’s co-operation so that the Contractor has access to all information concerning Air New Zealand and Qantas which the Contractor reasonably deems appropriate; and § access to Air New Zealand’s officers, directors, employees, accountants, counsel and other representatives (collectively, the “Representatives”). The Crown acknowledges that the Contractor will rely on such information supplied by Air New Zealand and Qantas and their Representatives without assuming any responsibility for independent investigation or verification thereof.
All non-public information concerning Air New Zealand and Qantas which is given to the Contractor will be used solely in the course of the performance of its services hereunder and will be treated confidentially by it for so long as it remains non-public. Except as otherwise required by law, the Contractor will not disclose this information to a third party without Air New Zealand’s and Qantas’ consent.
Page 100 Appendix B: Sources of Information
Appendix B: Sources of Information
In preparing this report, First NZ Capital has had access to and relied upon, without independent verification, the following infor mation:
§ various board papers dated between February 2002 and November 2002 on the short-haul product strategy;
§ a July 2002 board discussion paper on long-haul strategy; § the draft report by Network Economics Consulting Group on the economic analysis of the proposed JAO; § board meeting agenda items in relation to a potential rights issue; § board meeting agenda items in relation to Air NZ’s fleet replacement programme; § management accounts for the years ended 30 June 2000, 2001, 2002 and the months of July, August, September and October 2002; § various draft legal documents relating to the proposed JAO and equity subscription, including the Strategic Alliance Agreement, Subscription Agreement, Transition Deed, Sell-Down Deed, Reciprocal Board Representation Deed, Co-Ordination Agreement, and Air NZ Constitution; § various board papers on the rationale for the JAO and other options available to Air NZ; § Air NZ’s FY2003 Budget Report; § Air NZ’s Revised Five Year Plan (prepared November 2001); § Air NZ’s projected statement of financial performance, financial position and cash flow for FY2003-2006 assuming six different competitive scenarios; and § the report by GRA, Incorporated valuing alternative one world scenarios for Air NZ and Qantas. First NZ Capital has also held discussions with, and obtained information from, senior management of Air NZ, and legal and financial advisors to Air NZ.
Page 101 Appendix C: Qantas Summary
Appendix C: Qantas Summary
Description Investment Fundamentals
§ Founded in 1920, Qantas is the world’s second oldest airline Enterprise Value Current Share Price $3.79 § In 1993, the Australian Government Shares Outstanding (mm) 1,756.8 sold 25% of Qantas to British Market Capitalisation (mm) $6,658.2 Airways, another founding member Net Debt (mm) $3,307.0 of the oneworld alliance Enterprise Value $9,965.2
§ Listed on the ASX in 1995 CSFB Valuation Target Price $5.80 § Revenue predominantly generated Total Return 53.0% from Australasian region CSFB Recommendation § Domestic market position has One Year Outperform strengthened since the demise of Ansett. Market share is currently approximately 80%
§ International network links Australia to Japan, the Orient, SE Asia, the US and Canada, UK, Europe, New Zealand, Africa and others
Financial Performance Balance Sheet
Year to 30 June, All amounts A$mm Year to 30 June, All amounts A$mm 2001A 2002A 2003F 2004F 2001A 2002A 2003F 2004F
Revenues 10,188 11,472 12,270 13,082 Cash & Eq. 397 113 397 397 EBITDA 1,275 1,479 1,831 2,112 Total Assets 12,514 14,802 16,777 16,652 EBITDA Margin 12.5% 12.9% 14.9% 16.1% Total Debt 3,330 4,407 5,866 5,135 EBIT 569 713 976 1,147 Net Debt 2,933 4,294 5,469 4,738 EBIT Margin 5.6% 6.2% 8.0% 8.8% Equity 3,316 4,254 4,275 4,564 Net Interest 99 48 124 267 Gearing NPAT 291 423 597 711 Net Debt/EBITDA 2.3x 2.9x 3.0x 2.2x EBITDA / Interest 12.9x 30.6x 14.7x 7.9x
Major Shareholders (as at 27/8/02) Research Views
Shareholder Stake Firm Name Recommendation
British Airways 21.3% CSFB Outperform JP Morgan Nominees 14.7% UBS Warburg Buy National Nominees 8.1% Deutsche Bank Buy Westpac Custodian Nominees 6.1% JBWere Hold RBC Global Services Nominees 2.6% Goldman Sachs Outperform Commonwealth Custodial Services 2.4% ABN Amro Add Queensland Investment Corp 2.2% Merrill Lynch Buy
Sources: Broker Research, Bloomberg
Page 102 Appendix D: Virgin Blue Summary
Appendix D: Virgin Blue Summary
Overview Financials
§ Value-based airline flying between § A$35 million pre-tax profit for year 16 Australian cities and towns. ending March 2002 Currently has approximately 18% domestic market share § The company has publicly stated that it will comfortably meet operating § CEO has announce intention to profit target of A$100 million for the have international flights operating year ending March 2003 by mid-2003
§ Company publicly stated the possibility of an IPO in 2003 with up to 20% of the company to be floated
Ownership Business Description
§ Initially 100% owned by Virgin § Founded by Sir Richard Branson in Group late 2000, based on the model of low fare European airline Virgin Express § Australian transport conglomerate, Patrick Corporation, purchased 50% § Aims to have 50% of the Australian of Virgin Blue in May 2002 for domestic market within five years A$260 million § Currently an Australian domestic § Virgin Group expects to float up to airline but plans to expand to 20% of Virgin Blue in late 2003 international flights in the Asian and Australasian/South Pacific regions § Patrick has indicated that it would reduce its holding to no less than § Will have 28 all-economy class 45% if a float occurs Boeing 737s operating by the end of 2002, and intends to increase its fleet to 46 jets by March 2005
Recent Media
§ Sent tender documents to more than 20 South Pacific airports, and is investigating New Zealand as a launch pad for South Pacific routes
§ Faces the prospect of increased price competition as Qantas increases capacity in 2003
§ Reached a 17 year tenancy agreement with Sydney Airport. Virgin has agreed to feed at least four million passengers through the airport in 2003
Source: Media reports
Page 103